If confirmed as the new Department of Housing and Urban Development (HUD) secretary, Ben Carson should take two immediate steps to improve lending through the Federal Housing Administration (FHA), the HUD agency created to support lending to borrowers the market doesn’t otherwise well serve.
Currently, many banks and other well-capitalized lenders are reticent to make FHA-insured loans because of the risk of being sued for small mistakes under the False Claims Act and the extremely high costs involved in servicing delinquent FHA loans.
As a result, the share of FHA lending done by banks has fallen by nearly two-thirds in only three years (from 60 percent to 22 percent), undermining FHA’s ability to reach underserved borrowers and increasing the risk to the taxpayer. The new HUD secretary can address both of these problems effectively and expeditiously.
Remove the cloud of uncertainty created by the False Claims Act
The FHA provides lenders with insurance to cover the cost of defaulting loans. Today, if a lender submits a claim on a loan that is found to have any sort of underwriting defect, the lender can be sued by the Department of Justice for submitting a “false claim.” The applicable statute, the False Claims Act, provides for a penalty of three times the size of the loan. Thus, any mistakes whatsoever, however small or immaterial to the risk of the loan, can lead to a penalty that dwarfs the value of the loan to the lender. Because lenders are unable to eliminate all mistakes through improved underwriting, they are unable to eliminate the risk of these penalties.
Not surprisingly, well-capitalized lenders are increasingly deciding this risk isn’t worth taking and have pulled back dramatically from their FHA lending. That reduction has constrained FHA lending and increased the exposure of the taxpayer, since the FHA lending that remains falls to less well-capitalized lenders that may not weather the next economic storm.
Fortunately, the pieces of the solution are already in place. FHA has developed a thoughtful defect taxonomy to parse the types of lender errors according to their significance. To address this problem, therefore, the HUD secretary can direct his team to develop a hierarchy of penalties that matches this hierarchy of mistakes, so that smaller mistakes get smaller penalties and the heavy hammer of the False Claims Act is used only for the significant mistakes that actually deserve it. Under this new system, lenders would finally be able to use improved underwriting to guard against the risk of heavy penalty and thus would no longer need to flee the FHA.
Reduce the costs and complexities of servicing troubled loans
FHA also maintains a host of requirements for servicing the loans they insure, requirements which are designed to protect FHA’s and the taxpayers’ interest in the loans. The problem is that FHA rules are so burdensome when a loan goes into default that the costs of servicing a portfolio of FHA loans have become uneconomical. Once again, this is increasingly pushing well-capitalized lenders away from doing FHA business, to the detriment of underserved borrowers and the taxpayer alike. The HUD secretary can address this problem by directing his team to improve the most burdensome rules, including:
- The conveyance process. FHA properties are held in the name of the borrower until foreclosure, after which they are transferred to the servicer. Servicers must keep properties in their name until they are conveyed to the FHA for sale, which is on average 12 months later. In the meantime, the servicer must bear the considerable cost of managing the post-foreclosure process and maintaining often deteriorating properties. FHA eventually reimburses them for some of this cost, but that left to the servicer is typically a multiple of whatever revenue they would have made on the loan. The solution is to transfer the property from servicer to FHA immediately upon foreclosure, allowing the foreclosed property to be re-sold more quickly, reducing the cost to both the servicers and the FHA.
- Repair budgets. Prior to conveyance to the FHA, the servicer must put the home into conveyable condition. While the FHA provides for a budget for what they deem reasonable repairs, the sums are typically well short of what is needed for badly damaged homes, leaving servicers out of pocket for the difference. The solution is to raise these budgets to levels consistent with what is needed to repair badly damaged homes to the levels required for conveyance.
- Foreclosure timelines. The FHA has a tight timeline for each stage of the loss mitigation process. Servicers are often unable to comply with it without unnecessarily harming the borrower or running afoul of the mitigation requirements of the Consumer Financial Protection Bureau or state laws. To avoid penalty for delays, though, servicers must receive special dispensation on a loan by loan basis, a cumbersome and expensive process. The solution is to allow for more servicer discretion and an expanded timeline, where slowdowns in one part of the process can be offset by more speedy action on anther.
The bottom line
The nation’s well-capitalized lenders are in retreat from FHA, to the detriment of those families that most need it and to the taxpayers who support it. If the new secretary takes the steps outlined above it will help give lenders the confidence they need to bring them back to this critical institution. Doing so will require additional funding, however, as FHA will need to overhaul its outdated systems to take many of these steps. But it is well past time to welcome FHA to the modern era, so that it can finally become a counterparty upon which both the market and the many families it was created to serve can rely.