Major FHA Underwriting & Program Changes

In this update, we are going to focus on major changes to the FHA program that we expect will be implemented in 2010, starting later this month. FHA Commissioner Dave Stevens and his team have been reviewing FHA's performance data and operations for several months and we believe there will be dramatic changes to the FHA program and policies.

Over the next several months, we expect at least five significant policy changes in the FHA program. They are:

I. Major FHA Underwriting & Program Changes

As we discussed in our update on the December 2^nd Congressional hearing at which HUD Secretary Donovan and FHA Commissioner testified, we expect FHA to announce major changes to ensure FHA's long-term financial soundness.

FHA is trying to balance three fundamental objectives: 1) financial soundness - ensuring that its capital ratio does not fall below zero and quickly returns above 2%, 2) its mission of serving those borrowers not adequately by the private sector and 3) facilitating the recovery of the housing industry and the over-all economy. In looking for solutions to FHA's financial concerns, raising cash (i.e. insurance premiums) and lowering loan-to-value ratios have the most significant impact on the FHA's actuarial soundness.

We expect changes in the following areas (Attached is the Secretary's testimony which we believe provides an excellent road map for these changes) :

A. Improve FHA loan quality

· Increase "upfront cash that a borrower has to bring to the table"

· Two options

1) eliminating the ability to finance the upfront premium

2) raising the cash investment requirement above 3.5%

· Reduce seller concessions (from 6% to as low as 3%)

· Raise minimum FICO score

· They could impose an LTV maximum by FICO score (i.e. borrowers w/ higher FICO scores could have higher LTVs)

B. Increase MIP

· Up-front premiums can be raised up to 3%

· An increase to about 2 - 2.25% is more likely

· FHA could also establish higher premiums for specific products (e.g. refinance transactions)

Timing: We expect these changes to be announced in January and could be implemented within a couple months of the announcement. These changes can be made administratively (i.e. without Congressional approval or going through regulatory process) and therefore can be implemented quickly.

II. FHA Budget Proposals

As part of the Administration's FY 2011 budget, which the President will announce in his State of the Union speech in late January-early February, we expect there will be several FHA legislative initiatives. They will likely include:

· Increase the current cap for annual premiums (currently .55%) - FHA has said that raising the annual premium is the "most effective means of raising capital for the fund w/ least impact per borrower"

· Obtain a legislative change to Credit Watch to facilitate the suspension of an FHA lender's entire operation not just individual branches

· Increased accountability of FHA lenders for fraud or misrepresentation

· We are not sure what this could entail. We do know FHA is concerned about the performance of its correspondent business.

Timing: These changes will require legislation and therefore will take at least several months to enact. It would take several more months to implement. The increase in the annual mortgage insurance premium could be "fast-tracked" meaning it could be passed and implemented in several months.

III. Credit Watch Expansion

In addition to the legislative change mentioned above, FHA appears ready to implement Credit Watch for underwriting lenders. Under this program, FHA will compare a Direct Endorsement lender's early default performance for loans underwritten to the HUD field office average similar to what FHA has done for retail branches. FHA will evaluate the Direct Endorsement lender's underwriting performance by field office jurisdiction.

In reviewing the regulation, it states:

"The Secretary will review, on an ongoing basis, the number of defaults and claims on mortgages originated, underwritten or both, by each mortgagee in the geographic area served by the HUD field office."

While we had always seen this rule as a tool to monitor wholesaler performance, the regulation does provide FHA with considerable flexibility. FHA could include loans underwritten in principal-agent relationships as well as total loans underwritten by individual lenders (including retail originations) in the aggregate. In other words, FHA could compare a lender's performance on all loans underwritten (including retail) or loans underwritten for third parties (i.e. mortgage brokers or principals) to the field office average. (We expect FHA to continue to compare retail branch performance like it has been doing.) At the bottom of this email is the Neighborhood Watch screen that you can use to evaluate your company's Direct Endorsement performance. If you have questions, please let us know.

Timing : The Credit Watch change could be announced in conjunction with another initiative or on its own. It should be announced in the first quarter. This change requires no additional legislative or regulatory action prior to implementation.

We assume FHA will start w/ a higher compare ratio (e.g. 300%) like it did when FHA implemented Credit Watch for retail. However, we have a new Commissioner now and there is no requirement that FHA start at a higher percentage. We also assume that FHA will commence this program for the March 2010 quarter.

IV. FHA Lender Eligibility Changes

As you know, FHA published a proposed rule on lender eligibility changes in late November and the comment period ended on December 30^th . The rule would raise net worth requirements for FHA approved lenders and eliminate the loan correspondent approval and renewal process. In other words, an FHA approved mortgagee would be permitted to accept a loan from any source assuming the originating entity met State laws and federal regulatory requirements (e.g. RESPA) subject to the "applicable requirements" discussed below.

There are three main parts to the rule. They are:

Ø Elimination of loan correspondent approval process

We expect FHA will stop approving new loan correspondents or renewing existing loan correspondents. There will be no grandfathering of existing loan correspondents into the FHA process. The loan correspondent program will be stopped in its entirety.

HUD would still collect in FHA Connection the unapproved "entity's legal name and tax identification number". On two operational issues, the rule would only permit "FHA approved mortgagees ... to request FHA case numbers" and the loan would have to be closed in the name of the FHA approved lender.

The key question is: What are the "applicable requirements" that unapproved originators would have to meet and wholesalers would be required to implement?

Many industry groups and individual lenders submitted comments encouraging HUD to establish basic broker approval standards (e.g. net worth and audited financial statements) that FHA approved lenders would be required to apply. Some also asked HUD to provide flexibility on the case number assignment and closing processes. We will have to see what FHA does on these issues. We believe they will consider the comments before making a final decision.

Ø Increased net worth requirements

The proposed rule increases FHA net worth requirements from $250,000 to $2.5 million over a three year period. Within one year (of the effective date of the final rule), all participating mortgagees would be required to have a net worth of $1 million, of which 20% must be liquid assets. The 20% liquid asset requirement would also be required when the net worth is increased in three years.

Some groups asked for an extension of the time period for implementing the $2.5 million net worth requirement from 3 to 5 years.

Ø Codification of rules in ML 2009-31

The proposed rule also includes the changes in ML 2009-31 implementing lender eligibility criteria in the "Helping Families Save Their Homes Act"

Timing: We believe HUD wants to move quickly on finalizing this rule because it does not want to process renewals for the approximate 8,000 brokers currently in the FHA system.

V. Risk Management Improvements

We expect FHA will be overhauling its approach to risk management throughout 2010. FHA historically has focused its resources on post-endorsement technical reviews (PETR reports) and the "box checking" that is extremely frustrating for everyone. Like the GSEs, FHA will likely begin targeting early payment defaults for reviews and loans that result in claims in the first couple of years. This change will likely increase indemnification requests since FHA will be targeting their reviews on early payment defaults (i.e. loans with potential problems).

We also believe that FHA will be highlighting "poor performing" lenders more prominently on their website and in press releases. The Commissioner has frequently discussed the development of a Lender Scorecard. We assume that FHA will follow the outline provided in Neighborhood Watch.

Conclusion

FHA will be transformed over the next several years. We believe that the changes outlined above are the beginning of this process with many more changes occurring during Dave Stevens' tenure as FHA Commissioner. We also believe that FHA will continually evaluate these changes and withdraw those changes that are no longer necessary particularly when the capital ratio returns above 2% (e.g. higher premiums and borrower cash investments). We do not believe that there will be any relaxation of risk management and lender monitoring changes.