Current State of FHA Financing, and a 2013 Sneak Peek

The FHA financing program has been around since 1934, when it was born from the Great Depression. It was created to broaden the home-buyer pool, specifically by making mortgage loans available to people who wouldn’t otherwise qualify for a loan. Today, it is the mortgage program of choice for many home buyers. Recent and forthcoming changes in the lending industry could increase the FHA’s market share even more.

When the housing crisis began in 2008, more and more home buyers had to rely on government-backed financing. As a result, the FHA’s market share rose significantly. The chart below presents this trend clearly enough. At one point, FHA financing accounted for nearly 40% of all mortgage activity. For many borrowers, these loans were the only viable option.

FHA’s share of the mortgage market, 2003 – 2012

This chart shows the percentage of total mortgage loans that were made through the FHA financing program. Stated differently, it shows the agency’s share of the mortgage market, when measured by loan origination. The green bars represent purchase loans (home buyers), and the blue bars represent refinance loans (homeowners).

As you can see, FHA financing accounted for less than 10% of the market for the first half of the decade. The spike you see starting in 2008 coincides with the collapse of the U.S. housing market, which started that same year. On the purchase side, FHA market share peaked at nearly 40% toward the end of 2009. It has hovered at about 30% for the first few months of 2012.

There’s a good chance the agency’s market share will rise again in 2013, when new mortgage regulations are introduced. We will talk about those new regulations in a moment. But first, a bit of background information:

Quick Primer: What is FHA Financing?

What is FHA financing, and how does it work? Where does the money come from? Here’s a quick primer on the government-insured mortgage program.

Mortgage lending is a risky business. When a financial institution makes loans to borrowers, it takes on a certain amount of risk. The primary risk comes in the form of default. As long as the lender retains and services the loan, there is a risk that the borrower will someday be unable to make the payments.

To minimize these risks, lenders (and the institutions that purchase their loans) establish certain criteria for borrowers. These criteria include such things as credit scores, income verification, debt ratios and more. Borrowers who fall short in these areas may not be able to qualify for a home loan.

The same is true for other types of financing as well, such as personal and auto loans. Lenders protect their interests and reduce their risks by ensuring borrowers meet minimum standards of qualification. This means some people simply won’t qualify for financing. Such is the case with home loans. In fact, in the current mortgage environment, there are more denials of credit than there are approvals.

That is where the FHA financing program comes into the picture. Since 1934, the federal government has been insuring mortgages against borrower default. This reduces risks for lenders and increases the chance of approval for borrowers. The graphic below explains how FHA financing works, in a general sense.

Overview of FHA Financing

Key takeaways from this graphic: (1) The purchase money comes from a regular lender, not from the government. (2) The government’s insurance is designed to protect the lender’s interests, not the borrower’s. (3) It is generally easier to qualify for an FHA loan, as compared to conventional mortgage financing.

An Uncertain Future?

FHA financing currently accounts for about a third of all mortgage activity in the U.S. We expect this trend to continue through 2012. But there is also some uncertainty around the future of the agency, and the level of its involvement in the mortgage market.

The Department of Housing and Urban Development (HUD), which oversees this program, is currently struggling with financial losses resulting from defaulted loans. These are home loans that were insured through the FHA financing program and later went bad as the homeowners stopped making their payments.

By current estimates, the government agency has more than 700,000 of these bad loans, representing 9% of all loans in its portfolio (source: Reuters). These loans put a serious financial drag on the program. Desperate for solutions, HUD has developed some creative strategies for reducing the number of bad loans.

There is also much uncertainty surrounding the qualified mortgage (QM) and the qualified residential mortgage (QRM). These new regulations are expected in early 2013, and they could raise the bar in terms of mortgage-qualification procedures. I wrote about these forthcoming rules last week, if you’re interested. Here they are at a glance:

Diagram: QM and QRM Regulations

As you can see from this diagram, the QRM rules are an offshoot of the risk-retention requirements built into the Dodd-Frank Act. Risk retention forces lenders to retain at least 5% of the home loans they securitize and sell. But FHA loans will be exempt from these retention rules (under the current proposal, at least).

The new QRM rules could result in higher interest costs and stiffer lending criteria for conventional home loans. But the new rules should have less impact on government-insured loans, since they are exempt from those rules. This could steer even more buyers toward the FHA financing program in 2012, and could result in another rise of the agency’s market share. Time will tell.