Monitoring Mortgage Underwriting

The Federal Housing Administration, the government agency that insures a bigger and bigger portion of home loans, plans to rely more heavily on lenders to police mortgage brokers.

The changes will put more of the onus on lenders to make sure there is no fraud or faulty underwriting in the loans they fund, and less on the FHA. The lenders could be held liable for losses if a loan insured by the FHA goes bad and there are signs of fraud or mistakes in the underwriting.

The new approach comes as the FHA is straining to monitor mortgage brokers seeking to arrange FHA-backed loans, a number that has mushroomed in the last few years.

The FHA doesn’t make loans. Instead, it guarantees lenders against losses on loans made by FHA-approved lenders and brokers. Brokers serve as middlemen between borrowers and lenders.

Because it didn’t loosen its lending standards, the FHA largely sat out the subprime-mortgage boom. When defaults sent housing and financial markets reeling, lenders and brokers scurried to the FHA for backing on loans that had become hard to fund otherwise. The agency’s market share rose to about one-third of the mortgage market last year, up from 2% in 2006.

As a result, the number of brokers approved to arrange FHA-backed loans swelled to 9,043 at the end of 2009, from 5,759 two years earlier. The FHA has required mortgage brokers to submit an annual audit to the agency and to maintain a $63,000 net worth. It also tracks the performance of brokers’ loans.

But the FHA says it isn’t equipped to monitor thousands of mortgage brokers. “For us as a government agency to be expected to police small mortgage brokers, that doesn’t make any sense,” said FHA Commissioner David Stevens.

Instead, the agency wants to beef up oversight of lenders and revamp itself along the lines of other mortgage investors that guarantee or buy loans in the secondary market, such as Fannie Mae and Freddie Mac.

Under changes set to take effect May 20, the FHA will stop certifying mortgage brokers or tracking the individual performance of loans that they originate. Instead, it will require lenders to sponsor brokers and to assume responsibility for those loans, including losses from fraud or poorly underwritten loans, such as those in which the income stated on a loan application doesn’t match accompanying financial documents.

Mortgage brokers have borne the brunt of blame for bad loans made during the housing bubble, and lenders have become more wary of dealing with them as a result.

The National Association of Mortgage Brokers generally supports the FHA’s changes. Grant Stern, president of Miami brokerage Morningside Mortgage Corp., said they represented a “huge cut in red tape” that should produce better rates for consumers.

While lenders agree that the changes will decrease risks for the FHA, they have called for the FHA to provide more detail on how to evaluate brokers. The American Bankers Association has expressed concern that the change would lead to “boundless liability” on lenders.

Some critics say the FHA’s new approach shifts responsibility to the private sector but doesn’t limit risk for the FHA. “The industry is very poor at self-policing, ” said Krista Railey, a mortgage-industry consultant in Canyon Lake, Calif. “Now is not the time to eliminate broker oversight” or to “emulate the practices of struggling entities” like Fannie and Freddie, she said.

The FHA says the new policies will result in better risk-management. The FHA has already stepped up efforts to eject lenders that it says aren’t playing by the rules.

In addition to revamping broker oversight, the FHA will increase minimum net-worth requirements for mortgage lenders to $1 million, from $250,000. The rules, which take effect in one year for existing lenders, could force some smaller lenders to instead become brokers that rely on large lenders to fund loans.

The FHA is also asking Congress for greater authority to recoup losses from lenders on defaulted loans that were improperly underwritten. Currently, the FHA has that indemnification authority for loans from some 600 lenders that account for 71% of all FHA-backed loans. The new rules would apply to the remaining 1,400 lenders that account for the remaining 29% of FHA originations.