Federal Housing Administration (FHA) loans once served a broad spectrum of borrowers until the subprime mortgage meltdown came along and pushed lenders to tighten underwriting standards and credit score requirements.

Today, the average credit score on an FHA-insured mortgage is 700.

The Department of Housing and Urban Development (HUD) would like to see FHA lenders relax their credit score minimums allowing more borrowers to qualify for FHA loans. But lenders are telling HUD officials the agency must first change FHA's lender/monitoring system known as Neighborhood Watch so they aren't stigmatized for making loans to borrowers with lower credit scores.

Lenders are urging FHA officials to change the system so performance comparisons are made with loans with similar credit scores and risk characteristics, according to FHA consultant Brian Chappelle.

Currently a lender's performance is compared to the average default rate for all FHA loans. "I know they are considering options to change Neighborhood Watch,” he said. "And they know the implications of the issue." Chappelle is a co-founder of Potomac Partners in Washington.

The Neighborhood Watch system tracks early defaults for each lender. FHA lenders with above average default and claim rates are placed on a watch list of sorts.

Every FHA lender — large and small — keeps an eye on their Neighborhood Watch ratio as do their counterparties, including warehouse lenders.

A very high default and claim rate can trigger audits by FHA or the HUD Inspector General. These audits often lead to indemnification demands for actual and future loan losses.

As a result, FHA lenders are more comfortable catering to borrowers with higher credit scores.
"We are aware of some lenders' concerns with particular aspects of FHA's compare ratio," said HUD spokesman Lemar Wooley. "We are taking those comments into consideration as we continually evaluate our policies and procedures for evaluating counterparty risk to FHA.”

Mortgage Bankers Association president and chief executive David Stevens noted that access to credit is an important consideration as the market recovers. "If the secretary of HUD and the administration wants to encourage lenders to use the full breadth of the FHA credit box — they have to address the compare ratios," Stevens told ASR sister publication National Mortgage News.

The former FHA commissioner noted, however, that changing Neighborhood Watch could create other distortions in the market. FHA, he said, does not want lenders “who just target the low end of the credit score box," Stevens said.

Neighborhood Watch was developed in the 1990s to protect low-and moderate-income communities from predatory FHA lenders.

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