FHA-backed loans: the next subprime crisis?

A swelling ‘tsunami’
Congress and the Bush Administration are strongly encouraging lenders to apply for FHA approval and tap into the government's loan-guarantee reservoir. In September, the agency guaranteed 140,000 new loans, up from 60,000 in January. In October, as Congress and the White House scrambled to respond to the spreading financial disaster, the FHA began to extend $300 billion in additional loan guarantees under the banner of a new program called HOPE for Homeowners. The limit on the amount buyers may borrow will rise in January to $625,000 from $362,790 in 2007.

Some current and former federal housing officials say the agency isn't anywhere close to being equipped to deal with the onslaught of lenders seeking to cash in. Thirty-six thousand lenders now have FHA licenses, up from 16,000 in mid-2007. FHA "faces a tsunami" in the form of ex-subprime lenders who favor aggressive sales tactics and sometimes engage in outright fraud, says Kenneth M. Donohue Sr., the inspector general for HUD. "I am very concerned that the same players who brought us problems in the subprime area are now reconstituting themselves and bringing loans into the FHA portfolio," he adds.

FHA staffing has remained roughly level over the past five years, at just under 1,000 employees, even as that tsunami has been building, Donohue points out. The FHA unit that approves new lenders, recertifies existing ones, and oversees quality assurance has only five slots; two of those were vacant this fall, according to HUD's Web site. Former housing officials say lender evaluations sometimes amount to little more than a brief phone call, which helps explain why questionable ex-subprime operations can re­invent themselves and gain approval. "They are absolutely understaffed," says Donohue, "and they need a much better IT system in place. That is one of their great vulnerabilities."

Joseph McCloskey, a former director of FHA's single-family asset management branch, says workers reviewing lender applications have had difficulty for years tracking whether executives of previously disciplined mortgage firms were applying for new FHA licenses. "Technologically, they are challenged," McCloskey, now a consultant to FHA lenders, says of his overmatched former colleagues.

The FHA's Wooley disputes these criticisms. The agency can cross-check names and thoroughly examine lender applications, he says.

Like flies to honey
There are numerous law-abiding FHA lenders and brokers, just as there are subprime mortgage firms that behaved honestly and cautiously in recent years. But the current economic crisis has turned the FHA into a profit magnet for all kinds of financial players. Major Wall Street investment firms are finding their own angles, which are entirely legal.

In April 2007, Goldman Sachs purchased a controlling stake in Senderra Funding, a former subprime lender in Fort Mill, S.C. Goldman, which has received $10 billion in direct federal rescue money, converted Senderra into an FHA lender and refinance organization. The strategy appears likely to produce hefty margins. In September, Goldman paid 63 cents on the dollar in a $760 million deal with Equity One, a unit of Banco Popular, for a batch of subprime mortgage and auto loans. Through Senderra, Goldman plans to refinance at least some of the mortgages into FHA-backed loans. Because of the government guarantee, it can then sell those loans to other financial firms for as much as 90 cents on the dollar, according to people familiar with the mortgage market. That's a profit margin of more than 40 percent.

Goldman's dealings suggest another reason FHA-insured lending is booming: The federal guarantee creates an incentive for banks to buy FHA loans and bundle them as securities to be sold to investors. This is happening as the securitization of subprime and conventional mortgages has largely ceased.

Operating far from Wall Street, the Cugno clan of Clearwater exemplifies a certain indefatigable American spirit in the face of economic setbacks. Whether that enterprising drive is always something to celebrate is less clear.

The Cugnos concede that their older mortgage firm, Premier, had its flaws. "My dad's company got too big," says Nicole Cugno. "It was too hard to control." At its peak in 2006, Premier originated $1 billion in loans each month and had annual revenue of more than $200 million. It sold what amounted to franchises to brokers around the country who frequently operated with little supervision from the 200-employee home office. "Everybody had a few bad apples, and I had a few of them," Nicole's father, Jerry, says. "If they got in trouble, we fired them."

Mark Pearce, deputy commissioner of banks in North Carolina, one of the five states that banned Premier, counters that the company seems to have invited abuses. North Carolina investigators concluded that Premier's branch in Charlotte allowed, among other deceptive practices, unlicensed brokers from around the country to "park" loans there for a fee. The aim was to make it appear that the mortgages were associated with a licensed broker trained and supervised by a substantial firm. "This is a company that should not be doing business in North Carolina," Pearce says.

But the Cugnos are very much staying in business. While Premier's bankruptcy proceedings continue in Tampa, members of the family are employing essentially the same model with their new company, Paramount. Only this time they are stressing federally guaranteed FHA loans. Paramount charges branches $1,625 a month to use its name, FHA license, and software. On its Web site, it tells brokers that FHA loans are "the new subprime."

"We're taking some of the things Premier did and tweaking [them]," says Barry McNab, a former Premier executive who now heads FHA lending for Paramount. About 9 out of 10 Paramount loans have FHA backing, he explains. It's difficult to evaluate most of those guaranteed loans, since they are so new. But a look at the experiences of some past Premier borrowers isn't encouraging.

U.S. District Judge Richard Alan Enslen in Kalamazoo, Mich., began a June 2007 written opinion about Premier's practices with this observation: "The crooks in prison-wear (orange jump suits) are easy to spot. Those in business-wear are not, though they do no less harm to their unsuspecting victims."

The case before Judge Enslen concerned Marcia Clifford, 53. She won a civil verdict that Premier had violated federal mortgage law when it replaced the fixed-rate loan it had promised her with one bearing an adjustable rate. Enslen also found that Premier had misrepresented Clifford on her application as employed when she was out of work and living on $700 a month in disability payments. Despite his ire, the judge decided to award Clifford, who did sign the deceptive documents, only $3,720 in damages, an amount based on unauthorized fees Premier had pocketed.

Clifford's name now appears along with a lengthy list of Premier's other creditors in the bankruptcy court in Tampa. Unable to make her $600 monthly mortgage payment, she received an eviction notice in June and says she is likely to lose her three-bedroom house in Belding, Mich. "It was a bait and switch," Clifford says, sobbing. "The folks at Premier are coldhearted."

Janice Dixon is also owed money by Premier. In March 2006 an Alabama jury awarded her $127,000 in damages related to a fraudulent refinancing in which, she alleged, the company didn't disclose the full costs of her borrowing. "Who will fix this?" Dixon, 49, asks. "They will continue to do these same things over and over."

Wooley, the FHA spokesman, says the agency noticed Premier's default rate rising earlier this year. But he adds that both Premier and Paramount met FHA requirements.

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