Risky Business-Expanding FHA Guidelines

The FHA is enjoying a surge of popularity for its insured loans, but part of the reason is that it has relaxed its guidelines to appease bankers. Making risky loans backed by paltry amounts of home equity increases the risk to both the FHA and the American taxpayer.

The new FHA initiative dubbed "Hope for Homeowners" now makes it easier for borrowers who have trouble paying their risky loans-such as expensive ARM and hybrid mortgages-to qualify for a newly modified, FHA-backed loan. Many see a potential pitfall, however:  these looser guidelines may inspire a new wave of delinquencies and defaults that will have to be borne by American taxpayers.

Investors in risky loans

When Hope for Homeowners was originally unveiled, it called for lenders to write down, or basically forgive, the principal on risky loans to levels that made the mortgage balance not more than 90 percent of the current value of the home.  While it put less risk on the taxpayers who fund the FHA, it also cost lenders more money in lost principal.  Many investors in these loans, however, have been resisting any effort to modify them or allow refinancing that would cut into their investment profits.  This is one of the main reasons that banks have not been more aggressive about reworking loans.

Even lenders who wanted to rework loans ran the risk of being sued by investors with whom they have legal contracts that clearly state how much income and interest the investor is to receive. Lenders, pressured by investors who funded such risky loans in the first place, balked at the idea because it was going to cost them too much money.

In fact, the Hope for Homeowners program met with such a lukewarm reception, that apparently less than 200 lenders even applied to participate in it.  In response, the FHA went back to the drawing board and further eased the guidelines.

New FHA guidelines

Now, lenders have only to cut principal down to 96.5 percent of the current value, and the term of the loan can be extended to 40 years. That still worries some industry observers, though, because taxpayers are ultimately responsible for paying back mortgages that have as little as 3-1/2 percent equity.

Meanwhile, most lenders aren't lending unless the homeowner has at least 20 percent equity or, in other words, a 20 percent down payment. That's because the housing market has not yet shown any signs of a bottom, and if prices continue to deteriorate, it will be easy to wipe out whatever equity now exists by virtue of market devaluation. Under the eased Hope for Homeowners rules, a 4 percent decline in the value of one's home would wipe out all of the equity and leave the homeowner upside down-once again-in his mortgage. That level of risk is hard to justify in today's market.