Are FHA Loans the Next Subprime Bubble?

As the Federal Housing Administration (FHA) prepares to ask Congress for another $800 million in rescue funds, many industry experts predict that FHA loans will soon become the new version of bad credit subprime mortgages. That could trigger a new foreclosure avalanche.

During the expansion of the housing bubble, subprimes were all the rage, and the FHA saw its affordable loan business fall off by about 80 percent. But in the wake of the subprime collapse, the FHA was authorized to double the maximum amount of mortgages that it insures. Now it's possible to borrow as much as $719,000 with an FHA-insured loan, at a time when these affordable loans are back in vogue with a vengeance. But many mortgage industry observers wonder whether the increasingly popular FHA mortgage products are setting the nation up for another costly foreclosure epidemic.

FHA back in power

The problem is that while FHA loan activity has surged, the default rate on these suddenly trendy loans has soared. If the momentum continues, it could set off a whole new wave of foreclosures across the U.S., just as the nation begins to see signs of a recovery from the subprime meltdown. Lots of people are now facing unemployment and other financial hardships as the economy struggles to survive.  Many people who bought pricy houses with FHA loans now have no job, no income, and bad credit. Walking away from their mortgage debt and letting the bank foreclose is an option that many Americans are choosing.  That leaves the FHA-and taxpayers-in a dangerously precarious position. The FHA doesn't directly lend to homeowners, but it does insure loans.  When those mortgages fail to turn a profit, the FHA is often forced to pay a subsidy to offset the losses of the mortgage lenders involved.

Reverse mortgage losses

The FHA already wants rescue money. A recent $800 million request relates to the agency's anticipated losses on reverse mortgages-special loans made to senior citizens in exchange for an equity stake in the senior's primary residence. Because home values have plummeted, wiping out significant equity, many lenders who sold reverse mortgages are being forced to take huge losses on those transactions. But, despite losses in the reverse mortgage arena, the FHA stands to make almost a $2 billion profit this year, thanks to a surge in business related to FHA single-family home buying programs.

The FHA has seen its share of the mortgage market grow exponentially in the past two to three years.  As major players like Fannie Mae and Freddie Mac faltered, subprime mortgages disappeared, and banks raised prices on mortgage loans, or rejected borrowers with bad credit. The FHA took up much of the slack because they offer affordable home loans with low down payments and competitive interest rates. But if borrowers still can't make their payments and go into foreclosure, rapid progress at the FHA could precipitate its own imminent downfall.