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FHA proposes change to help end lender overlays

The Federal Housing Administration (FHA) recently rolled out a proposed overhaul of its system for flagging problems in loan applications, a move intended to reduce the beefed-up credit requirements, or “overlays,” that some lenders have imposed on borrowers of FHA-insured loans.

FHA’s new taxonomy would categorize and rank the many possible deficiencies that can crop up in an FHA-loan application and provide more specific information about the individual defect. The idea is that if lenders have a clearer idea of what might be deficient with a loan, they are less likely to impose a blanket harsher standard on all borrowers. 

“The overlays are a huge issue,” said Laurie Goodman, director of Housing Policy at the Urban Institute. 

“Both the FHA and the GSEs [government sponsored enterprises] have been working diligently on how to get the lenders to reduce the overlays. At FHA, they are trying to do [several] things. Number one is this taxonomy, where you essentially grade the severity of the defects, so you know exactly what the remedy is.” 

Goodman said some lenders are imposing additional credit standards out of fear of reprisals from federal regulators over minor deficiencies and because of confusion over the guidelines. Several big banks and lenders, including JPMorgan Chase & Co. and Bank of America, reached giant settlements with the federal government in cases brought under the False Claims Act over alleged systematic defects in their FHA originations. Wells Fargo and large nonbank lender Quicken Loans are currently fighting the same allegations in the federal courts.

“The consequence is that you have a ton of overlays,” Goodman said. “The overlays have grown over time as lenders have become more reluctant to do FHA lending because they are afraid of the [requirement to buy back the loans] since the False Claims Act has been enforced. There have been a lot of settlements on that.”

New taxonomy aims to be more specific

If the FHA finds issues with an application when it is submitted for an insurance endorsement, the agency notifies the lender electronically of the problem. The lender is given an opportunity to provide additional paperwork or information to clear it up.

Under the current system, however, the FHA uses 99 deficiency codes that don’t always explain the particular defect. The new system proposes to arrange all problems under nine broad categories, such as a borrower’s income or credit score, or the property appraisal. The new format would allow the agency to provide more case-specific information about the defect within these categories, and rank the severity of the defect. 

This proposed change is part of a broader effort by the FHA to give lenders a clearer picture of what qualifies under its guidelines at the time of origination. In September, the agency is scheduled to release a portion of its updated handbook. FHA, however, has not provided a date on when it plans to roll out the new taxonomy, which is still under review and could be changed. 

One FHA mortgage compliance specialist, however, said it is unclear how much impact this new system for identifying errors will have.

“The guidelines are out there,” said Sue Young, director of product implementation for Ditech Mortgage Corp. “When you are not clear, you should be reaching out through the different mechanisms to get clarity on the guidelines. Where there is not clarity, [lenders] need to raise their hand and say, ‘Hey, what do you mean by this?’” 

Young did say any move to clarify the guidelines can’t hurt. 

“Any information that takes the mystery out of what you are identifying as a deficiency is going to be helpful,” she said.


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