A BANKER BEAT DOWN THAT COULD HURT HOUSING / THE WALL STREET JOURNAL

A Banker Beat Down That Could Hurt Housing

Banks are likely to keep pulling back from making FHA loans

By John Carney

Sept. 4, 2015 2:41 p.m. ET

 A house in Oradell, N.J., this past May. Some

Dreams of reconciliation between big banks and the Federal Housing Administration got a rude awakening this week.

On Tuesday, the agency sought to entice banks into making more of the kind of loans the FHA says it will insure. That appears to have backfired.

The Mortgage Bankers Association and nonpartisan policy research group the Urban Institute warned that lenders may continue to pull back on FHA lending. Wells Fargo WFC -2.65 % said it would actually tighten its standards on FHA loans. J.P. Morgan Chase JPM -2.39 % announced its retreat from FHA loans last year and has largely stopped making such loans.

FHA loans are a small part of the overall U.S. mortgage market. Even so, if not resolved, this conflict between banks and the FHA could crimp banks’ mortgage operations and prove a longer-term headwind for housing. That, in turn, isn’t good for the wider economy given housing’s importance as well as the fact that this has been one area that is doing well despite fears over how slowing global growth could ripple through the U.S.

At issue are the additional protections against defaults, known as “credit overlays,” that banks impose on top of the 580 credit score and 3.5% down payment the FHA requires to insure home loans. Most lenders require a minimum credit score of 640, according to Jim Parrot of the Urban Institute. That excludes about 13 million potential borrowers.

Why would banks seek to reduce credit risk on loans in which the FHA agrees to assume that risk? Lenders fear they might wind up on the hook for up to three times the size of an FHA-backed loan’s outstanding balance should the loan sour.

In the wake of the financial crisis, federal prosecutors began to use the False Claims Act to penalize banks for troubled loans. Under the act, banks can be held responsible not just for the loss to the FHA arising from a default but for up to three times the outstanding loan amount.

So a bank could be asked to pay $600,000 on a $200,000 loan.

Because the FHA can’t prevent prosecutors from seeking penalties, lenders and housing policy advocates asked the agency to limit lender liability to serious errors that were otherwise avoidable. This is where lenders and housing policy advocates say the FHA fell short. The new proposal still leaves banks with too much uncertainty about what might incur a penalty.

While FHA lending tends to be just a small part of a bank’s business, the overlays can have outsize effects. Real-estate agents and home builders often seek relationships with lenders who can support their full line of business, so banks can lose more than just the FHA loan business to nonbank competitors. Similarly, loan officers can defect in favor of nonbank lenders willing to make the loans.

But even with nonbank lenders stepping in, large gaps remain. Many of those who wind up on the wrong side of the overlays are would-be first-time home buyers. Preventing or delaying their purchases is a long-term drag on the housing market and mortgage lending, making it harder for existing homeowners to trade up.

While the latest proposals will likely be revised at the end of the 30-day comment period, hopes for anything aligning bank and FHA standards are now much dimmer.