FHA Financing…Are We Headed For Trouble?

Westcoe Realtors, Riverside California…There is starting to be some grumbling in the financial world about FHA loans and the potential for a possible meltdown like what occurred in the conventional loan world over the past 2 years or so.  One of our clients asked us our opinion…so here it is.

First, you need to understand how FHA loans work.  FHA is not a bank, and they do not lend money.  All FHA loans are originated and funded by your local bank…a bank that has been approved by FHA to originate FHA loans.  However, the big difference here is that once the loan is funded, approved and accepted by FHA,  that loan is now insured for 100% of its face value by FHA.  In essence, the bank who made the loan has no potential for loss if the borrowers decide to stop making their payments, because like any type of insurance policy, if the lender has a loss (foreclosure, short sale, etc.), they simply collect from their “FHA insurance plan” whatever money they lost on the property.

Secondly, understand that an FHA loan only requires the borrower to have as a down payment 3.5% of the purchase price…and the closing costs associated with the loan can be paid by the seller if that is how the transaction is negotiated (in many cases, the sales price is “bumped” by the closing costs the seller is being asked to pay).  The bottom line here is that on a $200,000 home, a buyer would only have to have $7,000 down…the rest could be financing.  Hence, when things get tight for an FHA borrower, it is far easier to walk away from 3.5% than the required 10-20% down for a conventional loan.  Many experts feel an FHA buyer does not have enough “skin” in the game.

The irony here is that the government decried the existence of the 100% financing  loans as the major reason for the mortgage crisis, yet they offer a program that finances 96.5% with a 100% money back guarantee to the lender.  This may be good for the real estate business, and for buyers to purchase a home, but as a fiscal policy where tax payer money may be at risk, it is fairly insane.  Think about it…would you lend 96.5% to a perfect stranger?

Anyway, when our real estate market was inundated with all the 100% ”funny money” loans, FHA was regulated to the dinosaur heap.  Why pay 3% down when you could buy a home for “0″ down?  However, once the you-know-what hit the fan in 2006-2007, FHA came back into vogue like wide ties and mini-skirts.  The Wall Street Journal recently reported that in approximately the past 3 years, the insurance commitments for FHA loans has risen from 410 billion to just over 1 trillion dollars…with 1 in 4 new loans now being insured by FHA.

So, what’s the problem?

There is none if everyone who has a FHA insured loan makes their payments…but if they don’t, then FHA is on the hook for some very serious money….and right now, the delinquency rate on FHA loans created since 2006 is hovering near 15%…which is 2-3 times higher than conventional loans created during the same time period.  Also, FHA is required to have in reserve 2% of their potential liabilities…and they are rapidly approaching that number.  Rumor has it that there is a very real possibility that by the end of this year, that reserve number may fall below the 2%…which, by the way, is a congressionally mandated percentage amount. Never mind that the Administration has imposed much higher reserve requirements on all lenders who make the loans (in order to prevent future meltdowns)…for FHA, that number is still at only 2%. 

So…what happens now?  Who knows…we will all have to wait and see.  Could FHA get in over it’s head and require a taxpayer bailout?  According to the head of FHA, that answer is no…but to the rest of us, this looks an awful lot like the bank mess of 2 years ago.  Understand, again according to the Wall Street Journal, FHA is leveraged far greater than Bear Stearns was when it went under.  The other possibility here is that FHA could either raise their qualifying requirements, down payment required, or a variety of other things bandied about in fiscal conversation these days.

For now, the ship sails ahead at maximum speed.  But as for what lies ahead, well, we suggest you baton down the hatches…because no one really knows for sure what potential storm my be coming our way.