While it is very good news that the FHA has woken up to the disaster it has been building by enabling some of the worst mortgages, their solution is badly guided.
Yesterday the FHA said that it will allow most borrower’s to make down payments of as little as 3.5 per cent when they take out a loan. But it is tightening the screws on those with a credit score of less than 580, who will to make a down payment of at least 10 per cent.
The idea is that the FHA shouldn’t be insuring the riskiest kinds of loans—high loan to value mortgages—going to the riskiest borrowers. In the future, only relatively safer borrowers will get the riskiest loans.
But we’re not confident that the FHA has really employed any intelligence when it comes to the issue of default risk. In the first place, we’d like it if the FHA would, as they used to say in grade school, show their work. How did it conclude that the cut off point should be 580? That seems awful low to us. Traditionally anything below 620 was considered subprime. How did it conclude that it could balance the risk involved with sub-580 borrowers with a 10 per cent down payment?
We suspect that the FHA didn’t do anything approaching risk management here. Instead, it most likely took a look at the number of loans that it would have to turn away by imposing the 10% requirement at various credit scores. Frighteningly, that number was only small enough for them all the way down at 580. In short, they decided this on a political rather than a financial basis.
There probably is no connection at all between the 580 credit score and the 10% down payment. Those are just arbitrary numbers linked together for political reasons. If there was a rational connection, you’d expect the FHA to employ a sliding scale rather than an all or nothing cut-off.
In fact, there really cannot be a connection between the 580 credit score and the 10% down payment that reduces risk. That’s because a credit score is not an absolute predictor of default risk. Instead, it is a relative predictor of default risk. Credit scores tell us that people with low scores are more likely to default than people with high scores, but they don’t tell us anything at all about the absolute risk of defaults. If you don’t have an absolute number predicting borrower default risk, you cannot figure out what the right level of down payment is to make up for that risk.
We’re glad the FHA isn’t just denying it is in trouble. But knowing you have a problem is very different from effectively addressing it.
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