FHA’s Lender Insurance Program Will Soon Cost Lenders More Money

By: Krista Cooley, Phillip L. Schulman, Holly Spencer Bunting

FHA mortgagees participating in the Lender Insurance (“LI”) program will be required to indemnify HUD for self-endorsed loans that HUD deems ineligible for FHA insurance based on a final regulation to be published by HUD on January 25, 2012. Since January 1, 2006, FHA mortgagees, with approval from HUD, have been permitted to endorse loans themselves, without first having to send the loans to HUD. The final regulation marks the first time HUD will make significant changes to the LI program, one of which automatically increases LI lenders’ liability for the loans they close and self-endorse. These changes finalize LI regulations proposed by HUD in October 2010 and will take effect on February 24, 2012.

Under the final regulation, LI lenders will be required to indemnify HUD for an FHA insurance claim paid within five years of mortgage endorsement if the lender knew or should have known of a serious and material violation of FHA origination requirements that would have rendered the mortgage ineligible for FHA insurance, regardless of whether the violation caused the default. An LI lender also will be required to indemnify HUD for an insurance claim if the lender knew or should have known that fraud or misrepresentation was involved in connection with the origination of the loan. While FHA-approved mortgagees may be used to receiving periodic indemnification requests from HUD as part of an enforcement action, until now, HUD has not had the authority to require lenders to indemnify the Department. Effective February 24, 2012, each time LI lenders self-endorse FHA loans, they are agreeing to automatically indemnify HUD for any losses on loans identified as containing serious and material violations or fraud.

HUD notes in the preamble to the final regulation that it will use existing practices, such as post-endorsement technical reviews, quality assurance monitoring reviews, lender self-reports, OIG audits, and other HUD investigations to identify loans for which HUD will demand indemnification. HUD assures lenders that these processes will afford ample opportunities to submit additional information to HUD. While LI lenders may have the opportunity to defend themselves against indemnification demands, it is likely, with this new financial recovery regulation, that HUD will focus its audits on LI loans, rather than loans from non-LI lenders. And, that inevitably means that participation in the LI program will be costly for FHA mortgagees.

HUD also will begin to monitor a lender’s eligibility to participate in the LI program on an “ongoing basis,” rather than annually as it does now. HUD will change its formula for calculating a lender’s default/claim rate by measuring whether the LI lender’s default/claim rate is below 150% of the average rates for the states in which it does business, as opposed to 150% of the national average. Finally, new mortgagees resulting from merger, acquisition, or restructuring will now be eligible for the LI program under certain circumstances, despite having less than a two-year performance history. Should a lender be terminated, the regulation provides a process, similar to that used for the Credit Watch program, to seek reinstatement.

Lenders may find themselves re-evaluating the costs and benefits of participating in the LI program. And, should lenders determine that these costs are too high, HUD may find itself manually reviewing every FHA loan prior to endorsement, wiping out the benefits of the LI program for both HUD and FHA mortgagees.