The FHA was supposed to lead the U.S. mortgage industry out of crisis, but rising defaults are prompting the agency to tighten up its lending standards.

In the video game Collapse!, the player must eliminate blocks of similar colors before they pile up too high. The FHA, a government agency that provides mortgage insurance, is dabbling in its own form of Collapse!-only the enemy that's piling up is mortgage defaults.

The FHA has announced new, stricter loan-to-value requirements on cash-out mortgage refinances. Formerly, the agency's borrowers could refinance their homes for up to 95 percent of the property's value; the new standard lowers this figure to 85 percent. An FHA letter to lenders explains the move as a measure to limit its risk exposure.

FHA loans in trouble

When the subprime mortgage market sputtered and then disappeared, the federal government put its money on the FHA to step up and fill the void. Loan limits were increased, and new FHA loan programs were announced. In less than two years, the FHA had grown its share of the market from 2 to roughly 30 percent of all new mortgages funded.

This transition hasn't come without growing pains. The Washington Post and The Wall Street Journal have both recently weighed in on the agency's battle with rising defaults. The Journal quoted an FHA spokesperson who estimated that 7.5 percent of the agency's insured mortgages were at least 90 days past-due. And The Post evaluated federal data to determine that three times as many FHA borrowers defaulted without making a single mortgage payment in the last year, versus the year prior.

When FHA borrowers default, the agency uses its reserves to pay off the lender. These reserves are built and replenished by the FHA mortgage insurance premiums collected from borrowers. If the default rates run too high for too long, the FHA reserves will be depleted. In that scenario, Congress will step in and use taxpayers' money to bail out the agency.

Cash-out refinance program closer to norm

The maximum 85 percent loan-to-value on cash-out mortgage refinances moves the FHA's refinance standards closer to what conventional lenders will offer. It's a prudent change, considering that the FHA borrower is generally less creditworthy than someone who qualifies for a conventional mortgage loan. Most conventional lenders cap cash-out mortgage refinances at 80 percent or less of the property's value. The difference between the maximum loan amount and the property value acts as a cushion, keeping the lender from becoming over-exposed if the property value drops. Given the way property values have crashed in the past two years, even a 15 or 20 percent cushion seems a touch inadequate.

The FHA's new cash-out refinance standards became effective on April 1. We'll have to wait and see if the move keeps the FHA's defaults from piling up to the point of collapse.

Published on April 25, 2009