Who really benefits from FHA short refis?

by Peter G. Miller
March 9th, 2011

With the end of the FHA short refi program plainly in view, it might be useful to take a look at who wins and who loses.

As explained earlier, the program allowed underwater borrowers to refinance provided the lender is willing to take at least 10 percent of the principal.

This sounds as though the lender is taking a beating, and no doubt that’s true. Equally true is that the program could have helped many lenders.

To understand why let’s take a look at the housing market. The Federal Housing Finance Agency home prices in November were 14.9 percent below their April 2007 peak and roughly the same as values in August 2004.

Home Values

The catch is that home values have not fallen equally. From November 2009 through November 2010 home values fell by an average of 11.2 percent in the Mountain states — Montana, Idaho, Wyoming, Nevada, Utah, Colorado, Arizona, New Mexico.

At the same time, home prices fell just 1.2 percent in Oklahoma, Arkansas, Texas, Louisiana — the South Central area.

So, if you’re a lender you might want to ask what’s better: To take a 10 percent loss or to take the vastly larger loss that might result if the property is foreclosed or the owner’s walk away.

For lenders there’s no good answer. Neither option is especially attractive.

The FHA loan guidelines for the short refi program might actually work for lenders in local areas which have seen extreme price drops — think of the foreclosure centers in Florida, California, Nevada, Arizona and Ohio. Not work great, not produce a massive profit or more reasons for executive bonuses, but work in the sense that things could be worse.

FHA Risk

Truth is, the FHA short refi program is a woeful idea because it exposes the FHA to great risk. Had lenders been smart, they would have dumped a ton of weak properties by allowing owners to refi with an FHA mortgage. In that way, if prices continue to decline or the owners walk off, it’s the FHA’s problem.

But lenders didn’t go for the FHA refinance plan. Instead, they essentially boycotted the short-refi effort. Only 44 of the loans have been made to this point in a nation with 310 million people.

FHA Commission David H. Stevens says the “FHA is well aware of the potential for moral hazard in principal reduction. That is why we carefully designed the guidelines of the FHA Short Refinance Option to discourage borrowers from purposefully becoming delinquent on their loan, otherwise known as strategically defaulting, solely to receive a principal writedown. To this end, borrowers are required to be current on their existing loan to be eligible to refinance into a FHA-insured mortgage.”

But the problem is not strategic defaults — another way to say that people will simply walk away from their loans. The problem is that only a microscopic number of lenders have any interest.

“Principal writedowns,” says Stevens, “can be difficult to implement due to the multiple entities that must be coordinated, including investors, servicers, originators, and the borrower. Despite this difficulty, they have been shown to be an attractive option that can be both more sustainable for the borrower and fair for the investor.”

Well, no. The short refi program has been shown to be attractive only 44 times. That’s it. Let it go.

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