Tuesday, November 24, 2009

FHA - The Last Man Standing

As we get set to give thanks for what we still have, those of us in the mortgage business are also giving thanks for FHA. After all, the population of home buyers these days consists mainly of investors buying at the bottom (or the perceived bottom) and first time home buyers utilizing an FHA insured mortgage.

FHA mortgages are loans that are 100% insured by the Federal Housing Administration in case the borrower defaults. Most of the mortgage loans used to purchase homes over the past couple of years are FHA loans. The reason for this is that a borrower only needs a down payment of 3.5% and a credit score around 640. Other conventional mortgage guidelines require higher down payments and have stricter credit score requirements.

For several years, FHA was much less relevant in the mortgage marketplace. There was discussion of dissolving FHA during the 1996 election campaign. I even referred to FHA as obsolete a number of times as the private sector had plenty of 3% down payment, and even zero down payment loans available for people with marginal or no credit history. Those private sector organizations I referred to were Fannie Mae & Freddie Mac which ironically have been rescued by the federal government and are therefore no longer private. In addition the private mortgage insurers who made those low down payment programs possible have reeled back after heavy losses from a tidal wave of claims.

Therefore FHA is now the mortgage program of choice. It meets the needs for many first time home buyers who, due to falling home prices, can finally afford to buy their first home. Also armed with the incentive of a tax credit, first time home buyers are the big winners in today's market. FHA = Sunshine & Rainbows.

Before you skip away singing Zip-a-dee-do-dah, there is a black cloud on the horizon for FHA. Just as the private mortgage insurers had their losses, now FHA is suffering from similar losses due to a massive rise in claims from lenders who are seeing their customers default. All of the FHA loans are fully document, in other words no stated income (liar's loans). And the vast majority are have fixed rates. So why are FHA borrowers defaulting?

Defaults in the FHA universe are occurring for the same reason they occur with other mortgages: a reduction in the borrower's income; and/or the property is now worth less than the balance on the loan. Certainly the ongoing recession contributes to the defaults, but when someone owes more than the property can be sold for, it makes the decision to walk away much easier. With only a 3.5% down payment, there is little "skin in the game," and in many cases there was no down payment due to a down payment assistance program. Also, since FHA is an insurance program, the borrower pays a premium (at closing, and monthly). The upfront portion is financed into the loan amount therefore eating into the already paltry 3.5% equity. Therefore it takes only minimal price declines to put a home owner upside-down when the down payment is small.

A Wall Street Journal report this morning indicated that one in every four home owners is upside down. That number is one in every two here in Arizona according to the graphic that accompanied the report. Another number that was a bit more startling is that one out of every ten homes purchased this year is already upside down. This year! If you are wondering how that has happened, remember the popularity of FHA loans and re-read the previous paragraph.

When the only bright light for aspiring homeowners is taking a financial hit, what is to be done? There is a bill in the House to increase the minimum down payment to 5%. That's not a terrible idea. While it will make it a bit tougher for home buyer's to come up with a down payment, it is not so big to make FHA loans out of reach for a significant number of first time home buyers. There has also been some discussion about raising the minimum down payment to 10%. Now that is a terrible idea, and would make buying a home near impossible for a large portion of the population.

The most palatable solution is to raise mortgage insurance premiums. The most equitable way to do that is to raise premiums for the highest risk borrowers (those with the lowest credit scores). By keeping premiums the same for borrowers with higher creidt scores, they can be rewarded for maintaining excellent credit.

We need FHA because it is the best solution for most home buyers to purchase a home. Our legislators need to find a way to keep it solvent. If that means raising premiums, then that is what needs to be done, let's just do it in a way that benefits those borrower's with the strongest credit history.

Friday, November 6, 2009

Tax Credit Extended (with some enhancements)

The first time home buyer tax credit that was set to expire at the end of this month has been extended through April 30, 2010. Both the House & Senate have passed the legislation which is expected to be signed by President Obama very soon. Let's discuss what the extension does, then we can talk about whether or not it is a good thing.

Like the previous tax credit, this extension offers up to $8000 in the form of a tax credit to first time home buyers. It extends the credit through April 30 of next year. In order to be eligible, buyers must have an executed contract by April 30, and then close on the transaction within 60 days of the April 30 deadline. Here are some enhancements to the new plan:
  • Income limits raised to $125,000 for single buyers and $225,000 for married couples
  • Up to $6500 tax credit for "move-up" buyers that are not first time homeowners
  • Extends tax credit through April 30, 2010
For those that will take advantage of the program and those that work in the housing market (like me) this is a great program. It will provide stimulus to the housing market as first time home buyers have greater financial incentive to purchase their first home. Despite the housing meltdown, I believe getting families into their first home is still a good and noble deed.

Move-up buyers may have a more difficult time taking advantage of the program since they will typically have to sell another home in order to qualify. The $6500 tax credit will provide some financial incentive for them, but it hardly seems to be enough in markets that have seen steep devaluation like Arizona, Nevada, California, & Florida.

Some will argue that the tax credits are just another "Cash for Clunkers" type program that will provide only temporary relief, then cause another decline in sales when the program is ended. That's probably true. Any government rebate or incentive has some affect in affronting the free market process.

The government cannot continue to extend the program in perpetuity. It must end sometime as they will eventually need to collect tax revenue to pay for dramatic increases in spending. Can the government continue these tax credits until the housing market has rebounded? How will we know when the market has rebounded? What is our definition of rebound? Sorry for all the questions, but there should be some definition if the plan is to continue these incentives until there is a rebound. Prices going back to 2005 levels should definitely NOT be the definition. If the definition is to be based on the number of sales taking place, then we have already rebounded. But that shouldn't be the definition either since a large portion of current sales are investors (another issue I will write about soon). Perhaps owner occupied sales should be the definition of the rebound.

At some point we have to stop the tax credit. I am glad that it has been extended for several more months, but we need to be ready to move on when it eventually ends.