Photo credit: Simon Cunningham
Loan performance deterioration will be more of the focus rather than loan mix.
Federal Housing Administration (FHA) lending to consumers with less-than-perfect credit scores continues to decline; with many in the industry calling for opening the credit box to allow more consumers with lower credit scores to obtain mortgages. Credit overlays and lender performance evaluation by FHA may play partial roles in restricting access to mortgages. This may soon change with FHA’s new Supplemental Performance Metric (SPM), which could expand lending to include borrowers with lower credit scores.
Lender performance has been traditionally assessed by FHA using the “compare ratio”. The ratio includes comparing the early stage weighted average seriously delinquent rate (WASDQ) to that of all FHA-insured loans. Lenders with WASDQ’s significantly higher than the FHA average could eventually lose their license to originate FHA loans. Warehouse lending can be cut off even if a lender is allowed to continue making FHA loans after the compare ratio exceeds the threshold.
WASDQ is specifically based on delinquency rates within three FICO buckets: 0-639, 640 to 680, and 681 and above. For example, a lender with a FHA loan mix of 25 percent, 25 percent and 50 percent and seriously delinquent rates of 3 percent, 2 percent and 1 percent in the three respective buckets, would have a WASDQ of 1.75 percent. If all FHA loans had a corresponding WASDQ of 1.5 percent, the example lender would have a compare ratio of 117 percent (this comes from dividing 1.75 percent by 1.5 percent. Lenders with compare ratios exceeding 150 percent may see enforcement under FHA’s Credit Watch Termination Initiative, which includes the possibility of termination of being able to originate FHA mortgages.
This approach, while a reasonable response to helping maintain solvency in the industry, it has a major downside. Lenders that predominately serve borrowers with lower FICO scores are most likely to have higher compare ratios because these loans tend to have higher delinquency rates and they form the majority of these lenders’ portfolios.
Using an example of another lender with a mix of 70 percent of FHA loans in the 0-639 bucket, 15 percent and 15 percent respectively in the 640-680 and 681 and above buckets; with seriously delinquent rates of 2.5 percent, 1.5 percent and 0.5 percent respectively, the WASDQ is 2.1 percent and a compare ratio of 137 percent. Although the second lender example has lower delinquency rates than the first lender example, the second lender ended up with the worst compare ratio and this increases the likelihood that it would face enforcement action. To frame it another way, this lender will get penalized for going out of its way to help underserved borrowers.
In attempting to avoid enforcement action, lenders are always looking for ways to keep compare ratios down. There are only two ways to do this, either proactively work to keep delinquencies down or stop lending to low-FICO consumers. While the second approach is cheaper, simpler and will help lenders stay out of compare ratio trouble, this approach leads to a systemic reduction in credit availability for low-FICO consumers. Many low-FICO scoring consumers can be creditworthy. Between 2001 and 2013, the share of FHA borrowers with FICO scores below 640 has dropped from 47 percent to just 3 percent. This drop comes despite FHA’s authority to insure loans with a FICO score as low as 580.
Lender performance measured more accurately
In August, FHA made a push to increase credit availability for underserved low-FICO consumers by announcing the SPM. This new metric will be used along with the compare ratio and would allow the FHA to determine the main cause of compare ratio deterioration before taking any action. The compare ratio calculation will remain in place, but rather than taking action against lenders with high compare ratios, FHA will now calculate their SPM to discern if it was loan performance deterioration or an increase in lending to lower-FICO borrowers that made the compare ratio increase. This deeper analysis would put more emphasis on lenders with deteriorating loan performance and make enforcement less dependent on lender loan mix.
The purpose of the SPM is not to incentivize unwilling lenders to make loans to low-FICO consumers. Lenders that are not intending to serve this demographic are not required to as before, but the lenders that want to serve this segment will now have less to worry about their loan mix.
See FHA Goes Digital
Urban Institute. FHA’s new performance metric could open the credit box