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Quickie FHA Defaults — How Are They Possible?

by Peter G. Miller
March 30th, 2009

In the world of mortgage lending there’s one thing every lender wants to avoid. That one thing? Quickie defaults.

In other words, if you make a loan you absolutely want the borrower to make at least a few payments. Here’s why:

Imagine that Smith mortgage originates a loan with Mr. Johnson. Smith gets a lot of fees and charges from its work and the loan is promptly re-sold to an investor. If Smith makes all payments for the next 120 days all is well — Smith gets to keep its money. However, if Mr. Johnson defaults during the first 120 days then the buyer of mortgage can demand that Smith buy it back.

That’s a problem because lender Smith likely has nowhere near enough money to repurchase the loan. One of the reasons for so many lender failures during the past two years is not that they could not generate more loans; instead the problem was that they could not afford to buy-back loans which had quickly defaulted.

All of which brings us to an amazing story in the Washington Post.

Instant Defaults

“More than 9,200 of the loans insured by the FHA in the past two years have gone into default after no or only one payment, according to the Post analysis. The pace of these instant defaults has tripled in one year. By last fall, more than two dozen FHA home loans on average were defaulting this way every day, seven days a week.

“The overall default rate on FHA loans is accelerating rapidly as well but not as dramatically as that of instant defaults.” (See: The Next Hit: Quick Defaults, March 8, 2009)

The paper quotes Kenneth Donohue, HUD’s inspector general, as saying that if a loan “is going into default immediately, it clearly suggests impropriety and fraudulent activity.”

Remember I said that loan originators can typically be forced to buy back loans if the debt goes into default within 120 days. That’s true, but there’s a caveat: The 120-day limitation does not count in the case of fraud. If there’s been fraud then all bets are off, the 120-day deadline is out and there is no end to the originator’s liability to take back the loan.

The numbers from the Post — numbers dug up by the paper and which reflect a skilled journalistic effort — are stunning for several reasons.

Reasons Why

There may well be a legitimate reason why someone fails to make even one mortgage payment — they are hit by a bus, suddenly laid off, struck by lightening, suffer a brain aneurysm, etc. But such events are hardly common and there’s no possible reason why FHA borrowers should suffer disproportionately from such events.

As well, there is the little matter of FHA underwriting. With FHA loans you have to fully document your income, assets and debts. There are no stated-income loan applications with FHA mortgages, no fooling with the numbers, no estimates and no guesses. How is it possible that 9,200 borrowers could go through the rigorous FHA origination process and then fail to make a single payment just a few weeks later?

Did the borrowers have absolutely no reserves? The FHA does not require a buyer reserve for the purchase of a property with one to two units, for properties with three or four units the buyer must have a three-month cash reserve in the bank. That said, would not common sense and simple prudence dictate that buyers have some money on hand just in case a few unexpected costs arise?

We need to bulk up employment in this country and one way to do that is to audit every mortgage that fails. There may well be a good reason why some loans did not produce even a single monthly payment, but otherwise Mr. Donohue is surely right when he suggests that foul play was at work. In those cases where fraud is found, we ought to bring loan officers and underwriters to court and let a jury look at the facts and circumstances.

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