(This is Part 5 of a five-part series. See Part 1, Part 2, Part 3 and Part 4.)
Previous articles in this series emphasized that the subprime market remains open for business, with more realistic underwriting rules than before the house-price bubble broke. Hopefully, ill-advised actions by government won’t shut it down before something better is in place.
The Federal Housing Administration, or FHA, is the only plausible substitute. But converting FHA into a viable substitute for the subprime market requires a number of far-reaching changes.
Risk-Based Pricing: A core feature of the subprime market is risk-based pricing over a very wide range. On the price sheet of a typical subprime lender, the interest rate on the worst risk is 7-8 percent higher than the rate on the best risk. For FHA to operate effectively in this market, it must do the same.
For risk-based pricing to work, FHA has to be free to set premiums over a wide range. Congress can’t impose limits on the premiums or require FHA to favor one category of borrowers over another. These would be difficult limitations for Congress to accept.
With risk-based pricing, there would be no need for Congress to specify down-payment requirements. FHA would be free to insure no-down-payment loans at an appropriate premium, or it might decide (as subprime lenders have) that no risk premium would be adequate for zero-down loans when the borrower also has poor credit.
Enlisting Mortgage Brokers: More subprime loans are taken out for refinances than for purchases. In many cases, borrowers who have no plans to refinance are actively solicited by mortgage brokers. For FHA to make significant inroads on the subprime market, it must enlist the brokers while protecting borrowers against broker abuse.
To enlist mortgage brokers, FHA must relax its capital and audit requirements. It should be as easy for brokers to originate an FHA loan as it would be a conventional loan. FHA holds lenders responsible for following FHA rules, and brokers should be the sole responsibility of the lenders, as they are in the conventional market.
Protecting Against Broker Abuse: Broker abuse consists of overcharging borrowers by collecting payments from lenders for delivering higher-rate loans. These payments are called “yield spread premiums,” or YSPs. FHA could prevent this abuse by adopting a rule that YSPs must be credited to borrowers, who would have to authorize their payment to brokers.
Protecting Against Lender Abuse: Because FHA is an insurer rather than a lender, adjustments to risk are in the FHA insurance premiums rather than in the interest rate. This is advantageous to borrowers because it narrows the range of FHA interest rates. The lender can’t tell the borrower the rate is high because of poor credit, small down payment or anything else that affects risk. The borrower pays for these in the insurance premium, and the premium is set by FHA, not by the lender.
Nonetheless, too many price variables remain: interest rate, points, fixed-dollar lender charges and third-party charges. The last two, in particular, are a potential source of abuse because they are not part of the price quotes that borrowers shop and can be manipulated at the 11th hour.
FHA currently provides protection against egregious abuse by limiting lenders to a 1 percent origination fee plus other “customary and reasonable costs.” Third-party charges are limited to actual charges, with no lender markups permitted. These rules made sense four decades ago when FHA set the interest and points, but with the rate and points set by the market, they are obsolete.
The “customary and reasonable” rule eliminates any competitive pressure to reduce lender costs. The “no-markup” rule does not prevent lenders from having an ownership interest in, and thereby profiting from, their referrals to high-priced third-party service providers.
FHA should require lenders to absorb all costs and third-party fees, and pass them to borrowers in the rate and points. Then borrowers would have only two price variables to shop, and competition by lenders would force down their own costs and the prices of third-party services.
Disclosure Requirements Need Updating: It isn’t enough that FHAs become a better deal for disadvantaged borrowers than subprime. Borrowers must also perceive that these loans are a better deal. Comparisons can be misleading because of what is not disclosed.
For example, when the subprime loan is 6 percent compared with 7.5 percent for the FHA, the borrower may not be aware that the balance of the subprime loan will be loaded with fees, or that the subprime rate will jump to 9 percent in two years even if the market is stable. For a revamped FHA to compete on a level playing field with the subprime market, the disclosure system must be fixed so that this and other critical information hits the borrower between the eyes, and the garbage disclosures that are now a distraction are removed.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
