The FHA may be heading for a few rough patches, as it attempts to adjust to a more prominent position in the U.S. mortgage industry.

Living in the limelight has its challenges. For one, everyone starts noticing your flaws. Consider Ed Westwick of Gossip Girl; Perez Hilton recently called him out for packing on a few pounds. The FHA is also facing criticism: now that HUD's mortgage insurance unit is taking a more prominent role in the mortgage industry, rumors are flying that the agency doesn't have the resources to get the job done.

FHA loans' growing prominence

Since the subprime mortgage industry blew up in grand fashion, HUD's Federal Housing Administration (FHA) has been slowly picking up the slack. In 2006, the FHA was involved in 3 percent of the mortgage market. The agency's market share has surged tenfold, to a whopping 30 percent.

The growing importance of the FHA has some top officials worried that the agency won't be able to keep up with the demand. Kenneth Donohue, HUD's inspector general, recently expressed concern that the higher level of activity will expose the FHA's dated systems and inadequate fraud prevention resources. Senator Christopher Bond of Missouri has voiced concerns, too, citing growing defaults that could drain the agency's financial resources.

The FHA has never been a government-funded operation. The agency raises its operating capital by charging mortgage insurance premiums to borrowers. When FHA loans go bad, the agency taps into its reserve funds to pay off the lender. Higher-than-expected defaults would eat up those reserves faster than insurance premiums could replace them.

Fraud magnet

Problematic defaults appear to be on the horizon for the FHA. Earlier this year, the agency announced that default-related losses and foreclosures were outpacing expectations. The official explanation cited rising unemployment and generally poor economic conditions as main causes. But critics argue that fraud could be a factor, as well.

Patrick Duffy, of MetroIntelligence Real Estate Advisors, argues that the tricksters who made money selling fraudulent subprime loans are attempting to continue those practices through the FHA system. It's true that the agency has been processing a flurry of FHA license applications. Between mid-2007 and September 2008, the pool of FHA-licensed lenders have more than doubled, jumping from 16,000 to 36,000. Critics believe that many of those new licenses went to documented perpetrators of subprime mortgage fraud-possibly because the FHA doesn't have the resources to conduct thorough background checks. That's no surprise: the size of the FHA's staff has remained relatively unchanged for the past five years.

The FHA doesn't fund mortgages directly, but it does insure mortgages that meet its guidelines. The guidelines on FHA loans have historically been more lenient than those of traditional mortgage lenders, in terms of credit score and down payment requirements.

Overweight actors may face blog-based ridicule, but an understaffed and inadequate FHA implies far more serious consequences. If the agency has a meltdown, taxpayers will have to pay for the cleanup.

Published on May 10, 2009