We’ve been talking for many months about the need to open the credit box so that more borrowers with less-than-pristine credit can obtain mortgages. A continued decline in Federal Housing Administration (FHA) lending to those with less-than-perfect credit has led many, including ourselves, to suspect that the way FHA evaluates lender performance has had at least a partial role in restricting access to mortgages. But FHA’s new “Supplemental Performance Metric” announced recently could open up lending to borrowers with lower credit scores.
FHA has traditionally used the “compare ratio” to assess lender performance
The ratio compares the early stage weighted average seriously delinquent rate (WASDQ) of a lender’s FHA loans to that of all FHA-insured loans. Lenders whose seriously delinquent rate is significantly higher than the FHA average can ultimately lose their license to originate FHA loans. Even if FHA allows a lender to continue, a high compare ratio can cut off warehouse lending—financing critical to many FHA lenders.
Specifically, WASDQ is based on delinquency rates within three FICO buckets: below 640, 640 to 680, and above 680.
A lender with an FHA loan mix of say, 25 percent, 25 percent and 50 percent, and seriously delinquent rates of 3 percent, 2 percent and 1 percent in these three buckets respectively, would have a WASDQ of 1.75 percent. If the corresponding WASDQ for all FHA loans was 1.5 percent, this lender’s compare ratio would then be 117 percent (1.75 percent divided by 1.5 percent). Lenders whose compare ratios exceed 150 percent can face enforcement action under FHA’s Credit Watch Termination Initiative, which can include termination of the authority to originate FHA mortgages.
While this approach is perfectly reasonable, it has a major downside. Lenders that predominantly serve lower FICO borrowers are more likely to end up with higher compare ratios because these loans have inherently higher delinquency rates and they form the bulk of such lenders’ portfolios. Let us look at another example. A second lender with a mix of 70 percent, 15 percent, 15 percent and seriously delinquent rates of 2.5 percent, 1.5 percent and 0.5 percent respectively (same FICO buckets) would have a WASDQ of over 2.1 percent and corresponding compare ratio of 137 percent. Therefore, even with lower delinquency rates than the previous lender, especially in the below-640 bucket, the second lender still ended up with a far worse compare ratio, increasing its likelihood of facing action. In other words, the second lender is getting penalized for going out of its way to help underserved borrowers.
Lenders obviously want to avoid facing action and therefore are always looking for ways to keep compare ratios down. They can be done either by working proactively to keep delinquencies low, or by simply curtailing lending to low-FICO borrowers. The second approach is easier and cheaper. While it helps lenders stay out of compare ratio trouble, it also leads to a systematic reduction in credit availability for lower-FICO borrowers, many of whom can be creditworthy. Indeed, the share of FHA borrowers with FICO scores below 640 has plummeted from 47 percent in 2001 to just 3 percent in 2013. This drop comes despite FHA’s authority to insure loans with FICOs as low as 580. (See HFPC’s August chartbook page 14 for a more comprehensive look at origination FICO scores over time.)
New metric will measure lender performance more accurately
The FHA in August took a big step towards increasing credit availability for underserved low-FICO borrowers by announcing the Supplemental Performance Metric (SPM). This new metric will be used in conjunction with compare ratio and will enable the FHA to discern the root cause of compare ratio deterioration before taking any action. The compare ratio calculation will stay the same, but before taking any action against lenders with high compare ratios, the FHA will now also calculate their SPM to discern whether deterioration in loan performance, or simply more lending to lower-FICO borrowers drove the increase. This additional analysis will make enforcement less dependent on lender loan mix and allow the FHA to target lenders with worsening loan performance as opposed to those serving more underserved borrowers.
The SPM is not an attempt to incentivize unwilling lenders to lend to low-FICO borrowers. Lenders that don’t intend to serve this segment can continue to go about their business as before without increasing their chances of facing enforcement. But lenders that want to serve this segment—either because they specialize in it or want to better serve their communities—will now have to worry a little less about their loan mix.