Constructing an Alternative to the Subprime Market

16 06 2007

The subprime mortgage market remains open for business, with more realistic underwriting rules than before the house-price bubble broke and the number of troubled loans began to rise.

Nonetheless, there is talk of coming up with a new way to provide mortgages to the credit-impaired borrowers the subprime market serves. The Federal Housing Administration is the only plausible substitute. But converting the FHA into a viable substitute for the subprime market would require a number of far-reaching changes:

· Pricing based on risk : A core feature of the subprime market is risk-based pricing over a very wide range. On the price sheet of a typical subprime lender, the interest rate on the worst risk is seven to eight percentage points higher than the rate on the best risk. For the FHA to operate effectively in this market, it must do the same.

For risk-based pricing to work, the FHA has to be free to set premiums. Congress shouldn’t impose limits on the premiums or require the FHA to favor one category of borrowers over another — and it could be difficult for Congress to refrain from doing that.

With risk-based pricing, there would be no need for Congress to specify down-payment requirements. The FHA would be free to insure no-down-payment loans at an appropriate premium, or it might decide (as subprime lenders have in recent months) that no risk premium would be adequate for zero-down loans when the borrower also has poor credit.

· Enlisting mortgage brokers: More subprime loans are taken out for refinancing than for purchases. In many cases, borrowers who have no plans to refinance are actively solicited by mortgage brokers. For the FHA to make significant inroads on the subprime market, it must enlist the participation of brokers while protecting borrowers against broker abuse.

To enlist mortgage brokers, the agency must relax its capital and audit requirements. It should be as easy for brokers to originate an FHA loan as a conventional loan. The FHA holds lenders responsible for following FHA rules, and brokers should be the responsibility of the lenders, as they are in the conventional mortgage market.

· Protecting against abuse by brokers: Abuse by brokers consists of overcharging borrowers by collecting payments from lenders for delivering higher-rate loans. These payments are called yield-spread premiums. The FHA could prevent this abuse by ruling that yield-spread premiums be credited to borrowers, who would have to authorize their payment to brokers.

· Protecting against abuse by lenders: Because the FHA is an insurer rather than a lender, adjustments to risk are in the FHA insurance premiums rather than in the interest rate. This is advantageous to borrowers because it narrows the range of FHA interest rates. The lender can’t tell the borrower the rate is high because of poor credit, small down payment or anything else that affects risk. The borrower pays for these in the insurance premium, and the premium is set by the FHA, not by the lender.

Nonetheless, too many price variables remain: interest rate, points, fixed-dollar lender charges and third-party charges. The last two, in particular, are a potential source of abuse because they are not part of the price quotes that borrowers shop for and because they can be manipulated at the last minute.

The FHA provides protection against egregious abuse by limiting lenders to a 1 percent origination fee plus other “customary and reasonable costs.” Third-party charges are limited to actual charges, with no lender markups permitted. These rules made sense four decades ago, when the FHA set the interest rate and points, but with the rate and points set by the market, the rules are obsolete.

The “customary and reasonable” rule eliminates any competitive pressure to reduce lender costs. The no-markup rule does not prevent lenders from having an ownership interest in, and thereby profiting from, their referrals to high-priced third-party service providers.

The FHA should require lenders to absorb all costs and third-party fees and pass them to borrowers in the rate and points. Then borrowers would have only two price variables to shop for, and competition by lenders would force down their own costs and the prices of third-party services.

· Updating disclosure requirements : It isn’t enough that FHA loans become a better deal for disadvantaged borrowers than subprime loans. Borrowers must also perceive that these loans are a better deal. Comparisons can be misleading because of what is not disclosed.

For example, when the subprime loan rate is 6 percent compared with 7.5 percent from the FHA, the borrower may not be aware that the subprime loan will be loaded with fees or that the subprime rate will jump to 9 percent in two years even if the market is stable.

For a revamped FHA to compete on a level playing field with the subprime market, the disclosure system must be adjusted so that this and other critical information hits the borrower between the eyes and the garbage disclosures that are now a distraction are removed.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site,

Copyright 2007, Jack Guttentag

Distributed by Inman News Features




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