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A rehab lending milestone: last year FHA's 203(k) program celebrated its 25th birthday. Having survived scandals, audits and high defaults, the program may be ready to prove its worth in reviving declining neighborhoods.

THERE IS NOTHING EASY ABOUT RUNNING A SINGLE-FAMILY rehabilitation loan program. * It is really an attempt to make regular that which is inherently irregular, to make predictable that which defies prediction. Your time might be better spent trying to predict interest rates. This is especially true for a program that finances the rehabilitation as part of a permanent loan after closing and tends to work with a large number of first-time homebuyers. No two projects are the same. It is a monster of uncertainty. * And yet, there are lenders that specialize in this type of lending. You may know them. They often speak like fanatical believers. They appear to be on a mission, converting the nonbelievers, raging against the nay-sayers. They are the ones that always have something to say in production meetings when discussion turns to identifying new markets. * Don't bother them with production goals; they know that rehabilitation lending is on the verge of becoming more than just a niche product. They know they are just a few steps away from making rehabilitation lending a predictable, easy-to-administer product that creates huge volumes for the company. These believers have the vision--and they want to convince the rest of us. * Why do they do it? * Maybe it's the sense of accomplishment--turning a run-down, obsolete property into a livable home. Maybe it's realization (along with knowledgeable borrowers) that rehabilitating properties can provide great financial rewards. Maybe it's the very fact that every project is different and requires the special touch of an experienced hand. And maybe they just love the challenge of wrestling with a monster that has yet to be tamed.

Whatever the reason, rehabilitation lenders tend to be a hardy lot. They have to be in order to work on a type of lending that has yet to be fully forged into a commodity.

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But they are smart, too, for they have created allies to assist them in their battle with rehabilitation financing. One long-term ally has been the Department of Housing and Urban Development (HUD).

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In the late 1970s, the federal government entered the fray with passage of the Housing and Community Development Amendments of 1978. The new law amended Section 203(k) of the National Housing Act and not only committed HUD's Federal Housing Administration (FHA) to insuring rehabilitation mortgages but also created the moniker by which the program is known today: the 203(k) program.

The 203(k) Rehabilitation Loan Program, as it is officially known, is both loved and abhorred by many in the industry and in government. And while the program turned 25 last year and has financed the rehabilitation of more than 118,000 homes, it appears the silver anniversary passed quietly, without any celebration.

History

The goal of the 203(k) program was (and is) to provide bridge financing for owners of single-family properties in need of substantial rehabilitation. Typically such projects would require separate construction and permanent financing. The concept was (and still is) simple: Provide borrowers with financing to purchase or refinance properties and undertake substantial rehabilitation all in a single, permanent loan.

Under the program, a borrower works with a lender after identifying a property, entering into a purchase agreement and estimating the cost of rehabilitation. The lender credit-qualifies the borrower based on the information provided. If acceptable, the borrower then works with an FHA-approved consultant to inspect the property and develop a work write-up and estimate. The repairs must be in excess of $5,000 in eligible improvements (generally, noncosmetic).

The borrower is then responsible for obtaining a bid from a contractor. An appraisal is commissioned to develop the as-is and after-rehabilitation value of the property. The lender then determines the maximum mortgage amount as the lesser of (1) the as-is value of the property plus rehabilitation costs, or (2) 110 percent of the expected property value after the rehabilitation work is completed. The lender can also roll the first six months of mortgage payments into the loan amount.

At closing, the lender places the amount necessary for rehabilitation into an escrow account and disperses funds as work is completed and inspected by a HUD-approved inspector. The lender submits the binder to FHA after closing and receives mortgage insurance. The borrower generally has six months to complete rehabilitation.

Borrowers benefit by obtaining all the capital they need without separate construction financing or a second closing (and can even finance the first six months' worth of mortgage payments). Lenders receive mortgage insurance from FHA for the full value of the rehabilitated home despite the fact that the rehabilitation is not completed at closing. Neighborhoods benefit by the return of abandoned or obsolete housing into productive use.

The program came at the right time, when the mass urban renewal projects of the 1960s were out of favor and smaller-scaled projects and "urban homesteading" were becoming trendy tools for community development. Many local governments and nonprofits have combined the 203(k) program with other programs, such as HUD's Community Development Block Grants to serve the dual goal of housing rehabilitation and affordable homeownership.

Of course, rhetoric and high hopes aside, one needs to remember that there is nothing simple about running a rehabilitation loan program.

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FHA found this out as it attempted to introduce the program. Production was slow, with inconsequential volume through the 1980s. That changed as lenders became more aware of the program. In federal fiscal year 1988, FHA endorsed 432 loans under the program, but that number grew to more than 3,000 in fiscal year 1992. Lenders were beginning to make more loans and the secondary market--initially lukewarm to this type of product--began to expand so these lenders had a place to sell them.

The big push came in 1992. The new FHA commissioner, Nicolas Retsinas, seized on the possibilities of the 203(k) program as a tool for urban revitalization (he had used the program successfully as executive director of the Rhode Island Housing and Mortgage Finance Agency). "We were particularly interested in re-engineering FHA to make it better meet the needs of homebuyers, and in particular for people of color. When we looked at the options available, the 203(k) program looked like a program that could meet those goals," said Retsinas, now with Harvard University's Joint Center for Housing Studies, Cambridge, Massachusetts. A working group was put together to streamline the program, and FHA field offices were given production goals.

In fact, the program exploded. From just 3,737 loans in fiscal year 1994, production skyrocketed fivefold in two years to 17,416 loans in 1996 (see Figure 1). The following year it reached its peak production of 18,994 loans.

With growth came growing pains. HUD's Office of Inspector General (OIG) initiated an audit of the 203(k) program during July 1995, and released an interim report the following year. This would be the first of many audits and investigations of the program in the ensuing five years.

The interim report indicated that the program, as designed, was prone to fraud, waste and mismanagement, particularly by for-profit and nonprofit developers. The report cited examples of land schemes, property flipping and fraudulent appraisals that netted "excessive profits" for developers using the program.

In reviewing the performance of 203(k) loans from 1988 to 1995, the report found the overall default rate for 203(k) loans was 5.1 percent, but was 8.6 percent for investors (who represented just under 16 percent of the volume). The default rate for the FHA's regular 203(b) program was approximately 3.1 percent for the same time period.

The profit motive was primarily blamed and FHA quickly acted on this report by placing a moratorium on for-profit investors' use of the program in October 1996. Seven years later, this moratorium is still in place.

In 1998, FHA commissioned a front-end risk analysis (FERA) to evaluate the program. This report identified six major risks associated with the program: program complexity, low program volume, insufficient performance management and lender monitoring, hesitant management direction, inadequate guidance concerning 203(k) consultants' role and increased loss potential from not-for-profit participants.

It is interesting to note that of the six major risks, four spoke to FHA's own oversight of the program. In fact, all the specific risks but one identified in the report as "high risk" had to do with management of the program. The clear implication was not enough resources were applied to managing the program, given its complexity and high growth in the mid-1990s.

But then again, it's just not easy to run a rehabilitation loan program.

The FERA also first mentioned the relative default rate of the 203(k) in relation to the regular 203(b) program as a problem: "... claim rates for 203(k) over the past 10 years have averaged 32 percent higher than those for 203(b) loans. This claim rate is indicative of the relatively high level of risk in the program."

Congress placed the program in FHA's General Insurance fund, as opposed to the self-sustaining Mutual Mortgage Insurance fund that covers FHA's regular loans authorized under Section 203(b) of the National Housing Act. It did this out of recognition that 203(k) loans would be higher-risk and the program was expected to be subsidized.

This comparison of default rates between the 203(k) and 203(b) programs began to develop the view that the 203(k) program should be at some level self-sustaining. It raised, but did not answer, the question of what the appropriate default rate should be for a rehabilitation loan program. This question has yet to be answered.

It seems the 203(k) program's higher default rate, coupled with egregious stories of abuse, was a potent mix that fueled investigators and auditors, and filled the pages of numerous reports developed during the latter half of the 1990s. A 1999 Government Accounting Office (GAO) report indicates obvious frustration in its conclusion: "Because of reports issued over the last four years by HUD's Inspector General and others, HUD is fully aware of the weaknesses in the program but has done little to correct them."

This is not entirely true today, as FHA has issued guidance and made minor changes through Mortgage Letters to improve the program. But resource allocation to the program remains somewhat of a quandary for FHA. This was evident in a response by one FHA regional official when asked about the program at a public forum: He prefaced his answer with the point that the 203(k) program represented "1 percent of the production but 50 percent of the problems."

Although to many the program is still obscure, the 203(k) program caught some unusual limelight when it went Hollywood recently.

In the midst of the reports and attempts at program reform, a particularly bad fraud scheme was uncovered in New York where approximately 270 fraudulent loans totaling $77.8 million were made through 13 nonprofits. This time, the defrauders worked around the investor moratorium by using naive or unscrupulous nonprofit corporations to acquire properties through the program at inflated prices and with no intention of completing rehabilitation.

The scheme was so dramatic that it prompted a congressional inquiry. The biggest notoriety, though, came a few years later when the scheme was incorporated into the plot of the popular HBO show "The Sopranos." In episode No. 46, Tony Soprano, played by James Gandolfini, on a tip from a fellow mobster, pulls together a state assemblyman and a nonprofit to exploit a "federal Department of Housing and Urban Development program." The scheme Tony outlines to his cronies looked very similar to the fraud perpetrated in New York using the 203(k) program.

While this scheme might have provided The Sopranos with a good storyline, it was old news to FHA and to lenders. The 203(k) program has been quiet over the past couple of years. Production has been steadily declining--whether as a result of the industry's focus on refinances or a lack of lender interest in working through the program's intricacies is unclear.

The current need for the program, however, is not unclear. A review of the 1997 and 2001 American Housing Survey (AHS), conducted by the U.S. Census Bureau for HUD, indicates that the number of occupied units (both owner-occupied and rental) in buildings with one-to-four-4 units with physical characteristics described as "severe" grew by 56 percent--from 855,000 to 1,338,000--between 1997 and 2001. These numbers do not include vacant units, which would likely increase the number, as severely distressed units are likely to be vacant. The need for renovation will only grow as the existing housing stock continues to age. The 2000 decennial census estimated that 13,589,814 units are in one-to-four-unit buildings that were built prior to 1940--that's approximately one out of seven single-family housing units.

"We have the largest percentage of older homes than we have ever had in the U.S.," says Retsinas. "The 203(k) program can be an important tool in niche markets as a part of an overall community development program, especially for community-based organizations in their work to increase home-ownership and revitalize neighborhoods."

And what is FHA's view of the program today?

John J. Coonts, acting deputy assistant secretary for single-family housing at FHA says, "The Department of Housing and Urban Development is committed to ensuring that the 203(k) program remains financially solvent and continues to provide homebuyers nationwide with an affordable way to rehabilitate their single-family homes."

This emphasis on financial solvency harkens back to the 1998 risk assessment and the unanswered question as to acceptable performance levels. Financial solvency issues are also reflected in FHA's most recent proposed rule change to the program: to begin collecting upfront mortgage insurance premiums similar to those collected under the 203(b) program.

"FHA is also concerned about the financial viability of the 203(k) program .... This change will ensure the program operates without a loss to FHA, as a negative credit subsidy program," Coonts commented about the proposed rule.

Between 1998 and 2002, about four out of five loans were made to one-unit properties. This may be what prompted FHA to issue another proposed rule in August 2002 that would limit the program to single-unit houses and cap the rehabilitation amount at 20 percent of the FHA loan limit in high-cost areas (that would mean the cap under current loan limits would be $58,064).

FHA found the bulk of its problems in the 203(k) program were with multi-unit houses and houses requiring a large amount of rehabilitation. While the proposed rule has been out nearly a year and half and has met with strong opposition from lenders, it appears FHA still plans to go forward with some form of this rule. "After reviewing FHA statistics on default rates of 203(k) loans and further considering the public comments, HUD is now in the process of preparing a final rule," Coonts said late last year.

Who does the program serve today?

Production has trailed off from its peak in 1997 to only 5,028 loans during fiscal year 2003. But that's still significantly more than the average production in the early 1990s. Looking beyond overall volume numbers, though, tells us who this program serves.

An analysis of the production under the 203(k) program for fiscal years 1998 through 2002 paints a picture of a program that appears to be serving some of the primary goals of HUD. Minority use of the program in fiscal year 2002, for example, was 40.4 percent--markedly higher than minority use of the regular 203(b) program, which averaged 32.6 percent. Additionally, 58.4 percent of 203(k) loans are made on properties in what HUD defines as "underserved areas." Between 1998 and 2002, first-time homebuyers comprised more than two-thirds of 203(k) borrowers. While a lower rate than the 203(b) program, that still is a relatively high number given the complexity of the program (see Figure 2).

One such borrower is Gerry Walker, a police officer who worked with Whitman Mortgagee and bought his first home through the 203(k) program in Hempstead, New York. Walker also used FHA's Officer Next Door program by purchasing a HUD real estate-owned (REO) property. He was able to finance the purchase of the home and approximately $35,000 in needed repairs through the 203(k) program.

Now, six months after closing, he has sizable equity in a home that he has improved to his liking. "The process went really smooth," says Walker. "Being my first time for everything involved made it a little uncomfortable, but all in all everything was OK." Walker closed on his home at the end of July and the work was completed by October. His 78-year old, three-bedroom Colonial home now has a new roof, upgraded boiler system, new carpeting and windows. And the neighborhood has an improved home and a resident police officer.

Never having owned a home before, the key to Walker's success has been working with knowledgeable lenders and a contractor with a good reputation. Eric Kepner, national account manager for Irwin Mortgage Corporation, who purchased the loan after closing and worked with the originating lender and borrower during rehabilitation, says about the project, "Mr. Walker had a good contractor--a person that we have worked with before--and that helped ensure a smooth process." Walker agrees with the positive assessment of the contractor and the quick timing. "I was in a position where I had to move out of my apartment in a short amount of time," he says.

Walker's story reminds us why some lenders are willing to run a rehabilitation lending program.

So to FHA on the 203(k) program's 25th anniversary and for all the Gerry Walkers that it has served: Thank you for wrestling with this monster called rehabilitation financing.

For every two-bit defrauder, there have been hundreds of homeowners who were able to get a decent place to live and neighborhoods that saw empty houses returned to productive use. For every audit outlining the program's problems, there are thousands of successful homeowners who are shining examples of the program's potential. On behalf of the fanatical rehabilitation lenders: Thank you.

And now that the refi boom is waning, let's talk about how we can increase production.
Figure 1 203(k) Endorsements

Federal Fiscal Year Number of Loans

1994 3,737

1995 8,398

1996 17,416

1997 18,994

1998 14,196

1999 12,998

2000 10,627

2001 8,668

2002 7,376

2003 5,028

SOURCES: MBA, FEDERAL HOUSING ADMINISTRATION (FHA)

Figure 2 Total Production by Unit Size, 1998-2002

 1-Unit 2-Unit 3-Unit 4-Unit Total

Total Production 44,312 5,185 2,130 2,201 53,828
First-Time Homebuyers 30,362 3,509 1,388 1,144 36,403
Minority Homebuyers 15,685 2,874 1,210 1,111 20,880
Underserved Areas 23,882 3,972 1,714 1,864 31,432

SOURCES: MBA, FEDERAL HOUSING ADMINISTRATION (FHA)


Timothy Doyle is a director of government affairs for the Mortgage Bankers Association (MBA) in Washington, D.C.
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Title Annotation:Affordable Lending; Federal Housing Administration
Author:Doyle, Timothy
Publication:Mortgage Banking
Geographic Code:1USA
Date:Jan 1, 2004
Words:3185
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