April 21st, 2015
from the Cleveland Fed
During the Great Recession, lending standards tightened, making it difficult for some borrowers to get or refinance their mortgages. Several indicators suggest that conditions have eased up, and credit may be more available now. But since the financial crisis was precipitated by lending standards that were so loose that credit was extended even to borrowers who did not have the ability to pay it back, there is heightened sensitivity to the possibility that we could go too far again. In light of that concern, we investigate the degree to which FHA lending is being extended to creditworthy borrowers.
The Federal Housing Administration (FHA) is a government agency that has been helping borrowers to obtain mortgage loans since 1934. The FHA makes mortgage loans more accessible chiefly by allowing qualified borrowers to provide lower down payments. Traditional loans require a down payment of up to 20 percent of a home's purchase price, while down payments for FHA-facilitated loans can be as low as 3.5 percent. For this service, the FHA charges a mortgage insurance premium (MIP), which is calculated in terms of basis points and is a percentage of the amount financed. The premium - which is often interpreted as a measure of housing affordability - was around 50 basis points before the crisis but rose steeply after it,hitting 135 in 2013. In January 2015, the MIP rate was lowered substantially, to 85 basis points.
Before the subprime mortgage boom, FHA loans were an important source of credit for first-time home buyers and borrowers with less than prime credit ratings. In 2001, for example, 21.6 percent of all new mortgage loans were backed by the FHA. But in 2003, subprime loans began to take off, and FHA lending began to decline. By 2005, subprime loans represented 16.3 percent of the mortgage market and FHA loans were down to 3.5 percent.
While the FHA was still offering favorable mortgage terms for qualified borrowers, subprime lenders were offering a much easier and faster application process, at times with no down payment requirement. When lending standards tightened after the subprime market crashed in the middle of 2007, three types of potential borrowers could no longer obtain a mortgage loan: borrowers who would have gotten a subprime loan had the subprime market continued to exist, borrowers with subprime mortgages who needed to refinance into loans with better terms, and borrowers who could not afford large down payments but were otherwise creditworthy.
To assist some of these underserved people, the FHA began to increase its lending at the end of 2007, regaining market share which eventually peaked at 43.8 percent of mortgage market originations in November of 2009. During this timeframe, FHA-supported mortgage originations increased more than 500 percent. After the recession, FHA-supported lending steadily declined to around 11 percent of all purchase mortgage originations, where it remains.
An open question is which of the three types of borrowers unable to get loans after 2007 is getting them now? Hopefully, credit conditions have relaxed to the point where underserved but creditworthy borrowers are getting credit, and bad credit risks are still being excluded. To answer this question, we check if the composition of after-crisis FHA originations resembles the pre-crisis subprime market in terms of borrowers' credit scores. We split all FHA originations into four groups by the borrowers' FICO score. We find that prior to the recession in November 2007, 62.8 percent of FHA borrowers were either deep subprime (scores less than 600) or subprime (scores between 601 and 660). However, when FHA loans began to increase at the end of 2007, FHA lending to deep subprime borrowers was in decline and ended completely by 2010. Since then, FHA loans have been going more often to prime (with scores above 700) and near-prime (with scores between 661 and 700) borrowers. Currently, 73.9 percent of FHA-originated loans go to prime or near-prime borrowers.
We also compare the performance of subprime loans made by the FHA with that of subprime loans made by other lenders. We look at the rate of default, which is defined as a loan in any of the following conditions: those with more than two missed monthly payments, those in foreclosure, or those that are REO ("real estate owned," meaning the bank reposessed the home). We see that in the 2000s and prior to the recession, both the FHA's subprime and deep subprime loans performed about as badly as the subprime loans of non-FHA lenders: between 7.8 and 20.6 percent of the FHA's deep-subprime loans were in default, and between 3.6 and 10.5 percent of the FHA's subprime loans were in default, while between 7.9 to 25.2 percent of non-FHA lenders' total subprime loans defaulted.
Although the standards for FHA originations have improved substantially in that originations to the deep subprime segment stopped and originations to near-prime and prime segments increased, the performance of the overall FHA mortgage market has not improved. The default rate of all FHA loans combined is still higher than it was before the onset of the subprime boom in 2003.
The reason for the underperformance of the overall FHA market even with the improved standards is seen when analyzing the stock of outstanding FHA loans. Outstanding loans are those that were previously originated. Despite the fact that deep subprime loans ceased to be originated after 2010, they still represent 6.2 percent of all outstanding FHA loans. Likewise, subprime loans still constitute 30.5 percent. However, if the FHA continues to facilitate lending to more creditworthy borrowers, the performance of the overall FHA market is poised to improve in the future.
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