Officials at the Department of Housing and Urban Development have moved to close a loophole in the Federal Home Administration's loan-insurance program that has cost the FHA thousands of dollars in default losses on some loans.
As of May, people or corporations getting an FHA- insured loan for refinancing single-family homes owned as an investment rather than a residence no longer were able to take equity out of the property in the form of cash. Such transactions are known as "equity skimming."
The change was designed to solve FHA's mounting problem with losses from defaults on such investor-owned, refinanced properties. HUD officials said that, even though such loans make up only 8 percent of FHA's loans, they account for 20 percent of default claims for the federal home loan insurance program.
The total loss to the program from default claims resulting from such loans has not been determined, but one HUD official said they could run as high as $80 million if the average loss is as high as on a normal FHA claim.
HUD officials said that the equity-skimming scheme, which comes in various guises and was essentially legal until May, caught them by surprise, largely because unanticipated changes in the housing market came together in an unexpected way to make the scheme work.
According to Brian Chappelle, chief of the FHA's single-family-development division, the main culprit is the slowdown in housing appreciation. During the 1970s, when housing appreciation pushed home values through the roof, loan insurers such as FHA could rely on rapid appreciation to cover any possible loss in a default. FHA simply sold the property, which in most cases had appreciated above the amount of the unpaid loan, and recovered its loss.
Because housing appreciation has slowed, that no longer is possible, and FHA has more unsold properties. In addition to the change in May, FHA also has proposed changing how a lender makes a claim on FHA insurance. This change would be made to reduce FHA's cost of managing its foreclosed properties and to make it easier for FHA to recover losses by going after assets held by investors who have refinanced with FHA through equity-skimming schemes.
FHA was created in 1934 to stimulate the housing industry and make owning a home affordable. It provides federal mortgage insurance to private lenders making home loans. The fee for the insurance is built into the borrower's total home loan.
To keep the programserving only people of moderate means, there are ceilings on the size of the loans FHA will insure. In most parts of the country, this limit is $67,500, although it is higher in markets where the average cost of housing is higher. For the Washington area, the limit is $90,000.
FHA allows owner-occupants to borrow up to 95 percent of the value of their home. Although its mission is to serve moderate-income owner-occupants, FHA also allows investors to obtain FHA-insured loans, arguing that such investment loans support the rental market. Investor owners, however, can obtain loans only as high as 85 percent of the value of the house.
In a typical equity-skimming scheme, an investor uses a short-term loan to buy property that, for various reasons, is undervalued. He or she then refinances with an FHA loan at full market value. If the spread between the purchase price and the appraised value at the time of refinancing is wide enough, the investor can walk away with cash from the transaction.
In other cases, an investor may have held a property long enough to have built up some equity. Such an investor may refinance the property with an FHA loan, pull out his or her equity in the form of cash, and then abandon the property instead of shouldering the typically higher mortgage payments of the new loan.
In some areas, investors have bought properties from builders who could not sell them because of local gluts and who therefore were anxious to unload extra houses to pay off their construction loans. Investors could buy the houses at below-market prices, then refinance them with FHA loans based on the full market value of the house and pull cash out of the deal.
In another version of the scheme, the investor does not get cash out of refinancing the property with an FHA loan, because he or she can obtain a loan only up to 85 percent of the value of the house. After refinancing, however, the investor turns around and sells the property to a third party, who assumes the FHA loan and gives the investor a down payment that covers the other 15 percent of the value of the house.
All FHA loans are assumable, and people assuming such loans do not have to meet FHA credit standards. But the original borrower can ask FHA to qualify the person assuming the loan. Unless FHA does so, the original borrower remains liable if there is a default. Many of the FHA loans now in default were assumed by people who would not have met FHA's credit standards, Chappelle said.
But Alan Kappeler, director of FHA's office for insured single-family housing, said that the way FHA reimburses lenders foreclosing on FHA-insured loans limited FHA's ability to go after borrowers and people liable on such assumed loans who might have additional assets to help pay the losses incurred by FHA.
When a borrower defaults on an FHA-insured loan, a lender who moves to foreclose must bid the entire unpaid amount of the outstanding mortgage at the foreclosure auction, because the lender must have title to the property to turn over to FHA to get reimbursed for any losses incurred by the default. This means that no one else bids any higher, and that, consequently, all foreclosed properties end up in the hands of FHA.
Handling these properties has proven to be costly to FHA, however. In addition, that system leaves FHA without a legal basis for getting a court judgment that would allow FHA to try and cover its losses by taking other assets of the defaulting borrower, according to Kappeler.
In the past, most people defaulting on loans were flat broke, and FHA would not have been successful going after other assets, he said. With the recent increase in investors looking for FHA loans -- particularly refinancing old loans with FHA-insured loans now that interest rates are coming back down -- some of the people defaulting on FHA loans have significant assets FHA could go after.
In a rule proposed this spring, HUD would like to allow other bidders to buy FHA-insured properties at foreclosure auctions, instead of continuing to require the lender to get control of the title. Under the new rule, lenders still would be reimbursed the full amount owed on the loan by FHA, even if they had to take less than the full amount at the foreclosure auction.
This would keep many properties from coming under FHA control and save the agency thousands of dollars in handling costs, Kappeler said. The rule is expected to be adopted by the end of the year, he added.