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FHA: The Incredible, Shrinking Mortgage Resource

Is FHA sending its most profitable, lowest-risk customers — homebuyers who have very good to excellent credit — to Fannie and Freddie for their mortgages, thereby losing significant market share?


Are FHA’s multiple and costly hikes to its insurance premiums — and worst of all, its revocation of borrowers’ rights to cancel premium payments during the term of the loan — beginning to have a negative impact on its ability to retain good-quality homebuyers?


Are credit scores on the downgrade at FHA as the agency turns off new buyers with FICO scores above 700?


But is all this necessarily bad news? Does it point to an emerging case of adverse selection — something that’s especially ill-timed given Congress’ mandate to the agency to rebuild its depleted insurance fund reserves in the wake of the agency’s first federal bailout in its history?

Though unwilling to speak on the record, key officials say FHA’s current course is exactly where they want to go.”

Or does it simply mean the agency is refocusing its efforts on its traditional core market segment: homebuyers with moderate credit dings and debt levels who simply don’t have the cash to put up a big down payment?

It depends on whom you ask. But the underlying numbers are clear:

FHA is starting to reap what it sowed in the way of higher premiums and non-cancellability. The percentage of FICO credit scores coming in the door above 720 — these are prime home purchasers who are at relatively low risk of default but keep paying their premiums on time every month — declined from nearly 35 percent in the fourth quarter of fiscal 2010 to just 23.6 percent in the same quarter of fiscal 2013. During the same period, new borrowers with scores ranging from 640 to 679 soared to 40.5 percent from 26.6 percent.

New-home purchase mortgage production is down at FHA as well. In the final quarter of fiscal 2013, home purchase financings dropped by 12 percent from the same period a year earlier.

Market share for FHA is plunging. In the third quarter of fiscal 2013, the agency accounted for just 17.2 percent by dollar volume of all purchase mortgages. A year earlier, its share was 27.1 percent. Factoring in refinances as well as home purchase loans, FHA’s overall market share has sunk to 12.2 percent. As recently as early 2011, it was just over 19 percent.

Perhaps most ominously, many of FHA’s best existing customers are jumping ship, at least partially because they can get a better deal elsewhere, such as a conventional loan with cancellable private mortgage insurance. In the insurance field this is known as “runoff,” and it’s usually not a healthy sign. In FHA’s world, runoffs mean that current borrowers are prepaying their loans either because they’ve sold their house, found an attractive refi elsewhere, or are refinancing into a new FHA loan. Typically, they are solid customers with good credit — otherwise they couldn’t qualify for new loans.

Last September FHA had 80,630 prepayments, of which 60,000-plus (75 percent) were full payoffs and 20,000-plus (25 percent) were refinancings into a new FHA loan. In the final quarter of fiscal 2013, the agency had a retention rate of just 28 percent.

In the view of some mortgage market experts, this is the inevitable result of FHA’s steep premium increases and reneging on its previous policy allowing premium cancellations. Brian Chappelle, a former FHA official and now a principal of Potomac Partners, a mortgage market consulting firm in Washington, D.C., told me last week that “FHA’s primary threat today is not from the origination of risky (new loans), but rather the excessive runoff of quality loans” from its existing portfolio.

What do Obama administration officials think about statistics like these that appear to be troublesome for an agency trying to rebuild its insurance fund reserves? Are they worried ? Well, you might be surprised. Though unwilling to speak on the record, key officials say FHA’s current course is exactly where they want to go.

In the past decade, the agency flipped from having an abnormally tiny share — less than 3 percent — of the market during the subprime mortgage heyday years to a much more prominent footprint after the bust in 2008. In jumping in where the private market would not venture, including serving some high-credit-score homebuyers, FHA performed its historical countercyclical role well, and helped buoy housing sales to the benefit of the overall economy, according to officials.

But now it’s time to head back to FHA’s more typical market share, they argue — somewhere closer to 10 percent. The recent decline in high-FICO borrowers is part of the pullback strategy, as is the re-emphasis on pulling in more applicants with moderate scores in the 640 to 680 range — the agency’s new strike zone target. Private mortgage insurers are picking up the higher-score buyers, and that’s their proper role, not FHA’s, so that’s the way the market is supposed to work, officials say.

Adverse selection? No way — as long as FHA has properly priced its incoming batch of customers for risk, which is the case, they add.

So what’s the upshot of all this for professionals who sell or finance houses? For starters, don’t expect any major backtracking of FHA on premiums or other issues anytime soon. If the agency plays third fiddle to Fannie and Freddie in competition for homebuyers with good to excellent credit, that’s fine with the Obama administration. The private sector should do its thing, the government sector its thing.

However, for buyers who have subpar but not terrible credit backgrounds and those who can’t quite make the “qualified mortgage” standards now used by Fannie and Freddie, remember this: FHA’s QM standard is more flexible on debt-to-income ratios, more generous on extenuating circumstances. The agency is aiming at a lower strike zone than its conventional competitors — 640 to 679 FICOs and 3.5 percent down payments.

FHA may be doing fewer loans and have a smaller piece of the market, but it’s heading back to its multidecade goal: financing creditworthy buyers who can’t quite make the grade in the conventional market.