[Federal Register Volume 78, Number 238 (Wednesday, December 11, 2013)]
[Rules and Regulations]
[Pages 75238-75245]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2013-29170]


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DEPARTMENT OF HOUSING AND URBAN DEVELOPMENT

24 CFR Chapter II

[Docket No. FR-5595-N-01]
RIN 2502-AJ07


Federal Housing Administration (FHA) Risk Management Initiatives: 
New Manual Underwriting Requirements

AGENCY: Office of the Assistant Secretary for Housing--Federal Housing 
Commissioner, HUD.

ACTION: Final notice of new manual underwriting requirements.

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SUMMARY: On July 15, 2010, HUD issued a document seeking comment on 
three initiatives that HUD proposed would contribute to the restoration 
of the Mutual Mortgage Insurance Fund capital reserve account. This 
document implements one of these proposals. Specifically, through this 
document, FHA is providing more definitive underwriting standards for 
mortgage loan transactions that are manually underwritten.

DATES: Effective date: This document will be effective for FHA case 
numbers assigned on or after a date to be established by Mortgagee 
Letter following publication of this document. The effective date shall 
be no earlier March 11, 2014. HUD will publish a document in the 
Federal Register announcing the effective date. Comment due date: 
February 10, 2014.

ADDRESSES: Interested persons are invited to submit comments regarding 
the revised credit score threshold for use of compensating factors to 
the Regulations Division, Office of General Counsel, Department of 
Housing and Urban Development, 451 7th Street SW., Room 10276, 
Washington, DC 20410-0500. Communications must refer to the above 
docket number and title. There are two methods for submitting public 
comments. All submissions must refer to the above docket number and 
title.
    1. Submission of Comments by Mail. Comments may be submitted by 
mail to the Regulations Division, Office of General Counsel, Department 
of Housing and Urban Development, 451 7th Street SW., Room 10276, 
Washington, DC 20410-0500.
    2. Electronic Submission of Comments. Interested persons may submit 
comments electronically through the Federal eRulemaking Portal at 
www.regulations.gov. HUD strongly encourages commenters to submit 
comments electronically. Electronic submission of comments allows the 
commenter maximum time to prepare and submit a comment, ensures timely 
receipt by HUD, and enables HUD to make them immediately available to 
the public. Comments submitted electronically through the 
www.regulations.gov Web site can be viewed by other commenters and 
interested members of the public. Commenters should follow the 
instructions provided on that site to submit comments electronically.

    Note: To receive consideration as public comments, comments must 
be submitted through one of the two methods specified above. Again, 
all submissions must refer to the docket number and title of the 
rule.

    No Facsimile Comments. Facsimile (FAX) comments are not acceptable.
    Public Inspection of Public Comments. All properly submitted 
comments and communications submitted to HUD will be available for 
public inspection and copying between 8 a.m. and 5 p.m. weekdays at the 
above address. Due to security measures at the HUD Headquarters 
building, an appointment to review the public comments must be 
scheduled in advance by calling the Regulations Division at 202-708-
3055 (this is not a toll-free number). Individuals with speech or 
hearing impairments may access this number via TTY by calling the 
Federal Relay Service at 800-877-8339. Copies of all comments submitted 
are available for inspection and downloading at www.regulations.gov.

FOR FURTHER INFORMATION CONTACT: Karin Hill, Director, Office of Single 
Family Program Development, Office of Housing, Department of Housing 
and Urban Development, 451 7th Street SW., Room 9278, Washington, DC 
20410; telephone number 202-708-2121 (this is not a toll-free number). 
Persons with hearing or speech impairments may access this number 
through TTY by calling the toll-free Federal Relay Service at 800-877-
8339.

SUPPLEMENTARY INFORMATION:

I. Executive Summary

A. Purpose and Legal Authority

    Under the National Housing Act (12 U.S.C. 1701 et seq.), which 
authorizes Federal Housing Administration (FHA) mortgage insurance, HUD 
has a responsibility to ensure that the Mutual Mortgage Insurance Fund 
(MMIF) remains financially sound. During times of economic volatility, 
FHA has maintained its countercyclical influence, supporting the 
private sector when access to housing finance capital is otherwise 
constrained. FHA played this role in the recent housing crisis, and the 
volume of FHA insurance increased rapidly as private sources of 
mortgage finance retreated from the market. However, the growth in the 
MMIF portfolio over such a short period of time contributed 
significantly to the projected losses to, and financial soundness of, 
the Fund.\1\ Consistent with the Secretary's responsibility under the 
National Housing Act to ensure that the MMIF remains financially sound, 
FHA has taken steps to improve the health of the Fund. Therefore, HUD 
published a July 15, 2010, notice, and sought public comment on three 
proposals designed to address features of FHA mortgage insurance that 
have resulted in high mortgage insurance claim rates and risk of loss 
to FHA.
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    \1\ U.S. Department of Housing and Urban Development, Annual 
Report to Congress Regarding the Financial Status of the FHA Mutual 
Mortgage Insurance Fund, Fiscal Year 2012. See http://portal.hud.gov/hudportal/documents/huddoc?id=F12MMIFundRepCong111612.pdf.
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    At the close of the public comment period on August 16, 2010, HUD 
received 902 public comments in response to the July 15, 2010, notice. 
The majority of the public comments focused on the proposal to reduce 
allowable seller concessions. In order to provide itself with the 
necessary additional time to consider the issues

[[Page 75239]]

raised by the commenters, HUD decided to separately implement the 
proposals contained in the July 15, 2010, notice.

B. Summary of Major Changes

    This final document implements the revised manual underwriting 
requirements, and takes into consideration the public comments received 
on this proposal. Through this final document, FHA is providing more 
definitive underwriting standards for mortgage loan transactions that 
are manually underwritten. In response to comment, HUD has made five 
changes to the proposed manual underwriting requirements at this stage. 
First, HUD has taken the opportunity to address the issue of borrowers 
who exceed the 31 percent housing-to-income ratio, yet carry little or 
no discretionary debt and, therefore, do not exceed the maximum 43 
percent debt-to-income ratio. Second, HUD has addressed the 
relationship between compensating factors and ``stretch ratios'' that 
permit borrowers to exceed the housing payment and total debt-to-income 
ratios under certain FHA mortgage insurance programs. Third, this 
document establishes additional compensating factors that can be used 
to qualify borrowers who exceed FHA's standard housing payment and debt 
to income ratios. Fourth, HUD has reduced the credit score (from 620 to 
580) below which compensating factors may not be cited and the standard 
ratio guidelines may not be exceeded. Fifth, HUD has extended the 
applicability of these underwriting policies to FHA-to-FHA rate and 
term refinance transactions (no cash-out) and credit-qualifying FHA 
streamline refinance transactions.
    Manually underwritten loans are required to have reserves equal to 
at least one full monthly mortgage payment (1-2 unit properties) or 
three full monthly mortgage payments (3-4 unit properties). FHA 
currently has standard guidelines for the debt-to-income ratios. The 
mortgage payment-to-income ratio (the front-end ratio) may not exceed 
31 percent, and the total fixed payment-to-income ratio (the back-end 
ratio) may not exceed 43 percent. Either or both of these ratios may be 
exceeded provided that there are compensating factors. This document 
establishes for manually underwritten loans a maximum front ratio and a 
maximum back ratio that may not be exceeded based on the borrower's 
credit score. Borrowers with no credit score \2\ or with credit scores 
below 580 may not exceed the standard 31/43 ratios. Borrowers with 
credit scores of 580 or higher may be approved for ratios as high as 
37/47 with one compensating factor, and 40/50 with two compensating 
factors. In addition, the final document restricts the use of 
compensating factors to borrowers with credit scores of 580 or higher. 
Borrowers not meeting this standard are limited to maximum ratios of 
31/43 unless they meet the Energy Efficient Mortgage requirements which 
provide maximum stretch ratios of 33/45.
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    \2\ For manually underwritten loans with insufficient credit 
references and with greater than 31/43 ratios, HUD currently does 
not to allow for compensating factors. Under this document, HUD will 
continue not to allow for compensating factors for these borrowers.
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    The manual underwriting requirements are applicable for purchase 
transactions and all credit qualifying FHA refinance transactions

C. Requests for Comments on Credit Score Threshold for Use of 
Compensating Factors

    As noted above, and discussed in more detail in the response to 
comments that follows, HUD has reduced the credit score (from 620 to 
580) below which compensating factors may not be cited and the standard 
ratio guidelines may not be exceeded. This change will expand the pool 
of eligible borrowers who may qualify for the use of such compensating 
factors. Although this document is being issued for effect, HUD 
nonetheless invites public comment on this one change. HUD is not 
soliciting comments on other aspects of the document. Comments on the 
revised credit score threshold for use of compensating factors are due 
on or before February 10, 2014, and submitted in accordance with the 
procedures described in the ADDRESSES section of this document. HUD 
will publish a follow-up document addressing the comments received on 
the revised credit score threshold.

D. Benefits and Costs

    The effect of the document is to reduce underwriting losses by 
strengthening manual underwriting guidelines and thereby increase 
revenue per loan for FHA as a result of more rigorous underwriting 
practices that reduce the number of claims. FHA can control costs 
through risk management practices. The lower costs are a gain to FHA. 
The target of the document is low net-revenue loans, which have higher 
claim rates and higher loss rates. HUD expects the net revenue per loan 
to increase by $2,300 (discounted at 3 percent) primarily because the 
expected claim amount falls. At a 7 percent discount rate, the increase 
in net revenue per loan is $1,900. Any gain to the FHA is a transfer. 
Whether there are net transfers to FHA depends on the impact of the 
rule on volume and thus the proportion of the current borrowers 
excluded from receiving a loan. When 10 percent of applicants are 
excluded, the gain (transfer) to FHA ranges from $35 to $42 million. 
Under certain circumstances, reducing the riskiest of loans will allow 
FHA to return additional revenues to the U.S. Treasury.
    The new underwriting guidelines will postpone (perhaps indefinitely 
for some) the purchase of a home or the refinancing of a loan until the 
excluded households can satisfy more specific requirements. As noted by 
many of the public commenters on the July 15, 2010, notice, the policy 
changes being made by FHA have already been adopted by the private 
mortgage lending industry. Accordingly, the borrowers excluded by the 
document would not be able to purchase mortgage insurance from a 
private mortgage insurance company.
    Many of the borrowers who would not qualify under the underwriting 
requirements may adjust their financial situation in order to meet the 
requirements. If the front-end ratio is the disqualifying factor, then 
a borrower could adjust by purchasing a less expensive home. Longer 
term solutions include saving to build reserves and repaying non-
housing debt to meet the back-end ratio. A household could work to 
repair their credit score which would raise the allowable debt ratios. 
Once the borrower reaches a credit score of 580 or greater, 
compensating factors such as 3 months of reserves or the purchase of an 
energy-efficient home will raise the qualifying ratios even further. 
Thus, not all of the 16,000-19,000 borrowers affected by the document 
will be excluded from an FHA loan. Some will be able to adjust 
immediately and others within a year or two.
    Another consideration in measuring the costs of the document is 
that by excluding potential borrowers from the benefits of an FHA loan 
guarantee, the new manual underwriting requirements may lead to a 
reduction in the social benefits of homeownership. HUD assumed two 
potential outcomes: that homeownership has positive net public benefits 
or that there are no public benefits of homeownership. The first 
scenario is motivated by economic theory and the second by recent 
empirical evidence. One study estimated the public benefits of 
homeownership to be $443 ($341 adjusted to the 2013 price level). 
Assuming that homeowners leave their current homes every seven years, 
the annualized benefit per loan is $70 (at a 3 percent discount rate) 
or $80 (at a 7 percent discount rate). The exclusion of

[[Page 75240]]

homeowners may reduce these public benefits of homeownership. However, 
HUD also notes that some studies find that a negative social effect of 
home ownership is reduced mobility, which leads to rigidity in the 
labor market and thus lengthens economic downturns. In addition, a full 
analysis of the expected cost to society of excluding a household from 
homeownership would account for the expected social costs of 
foreclosure for every homeowner created.
    The aggregate economic impact of the document is found by examining 
the aggregate changes to FHA's net revenue, the total impact on 
consumers (rejected applicants and accepted borrowers), and the public 
benefits of homeownership. HUD quantifies the revenue impacts and 
discusses qualitatively the impacts on consumers and social benefits. 
The pre-document number of loans is estimated to be 18,000. HUD assumes 
that some proportion of those loans will be excluded as a direct result 
of the document. The implications of raising the number of loans that 
cannot make the transition into higher quality loans are that the gain 
to the FHA will decline and the total cost to borrowers will rise 
(since the loss due to exclusion is assumed to be greater than the loss 
due to compliance). As long as not more than 13 percent of applications 
are excluded, the net transfers to FHA outweigh the burdens of the 
document regardless of the discount rate.
    The aggregate revenue impacts of the document for a variety of 
assumptions concerning key parameters are summarized in the table 
below.

                                                     Annual Aggregate Impacts of the Final Document
                                                                [In millions of dollars]
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                                             0% of loans excluded        10% of loans excluded       20% of loans excluded      100% of loans excluded
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                Category                       discount rate of            discount rate of            discount rate of              discount rate
                                         ---------------------------------------------------------------------------------------------------------------
                                               3%            7%            3%            7%            3%            7%            3%            7%
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Transfers
    FHA Gain............................          +42           +35           +20           +16           -17            -3          -176          -156
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II. Background

    On July 15, 2010, at 75 FR 41217, HUD submitted for public comment 
three policy changes that HUD proposed would contribute to the 
restoration of the MMIF capital reserve account. The volume of FHA 
insurance has increased rapidly as private sources of mortgage finance 
retreated from the market. FHA's share of the single-family mortgage 
market was estimated at 17 percent (33 percent for home purchase 
mortgages) in Fiscal Year (FY) 2010, up from 3.4 percent in FY 2007, 
and the dollar volume of insurance written has jumped from the $77 
billion issued in FY 2007 to $319 billion in FY 2010. The growth in the 
MMIF portfolio over such a short period of time coincided with 
worsening economic conditions that have seen high levels of defaults 
and foreclosures, and consequently FHA has had to balance its social 
mission, which includes meeting the needs of homebuyers with low down 
payments and first time homebuyers, with the risk of incurring 
unexpected losses that could deplete capital reserves in the MMIF.\3\ 
The National Housing Act, which authorizes FHA mortgage insurance, 
envisions that FHA will adjust program standards and practices, as 
necessary, to operate the MMIF, on a financially sound basis.
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    \3\ While the Federal Credit Reform Act of 1990 requires that 
FHA (and all other government credit agencies) estimate and budget 
for the anticipated cost of mortgage loan guarantees, the National 
Housing Act imposes a special requirement that the MMIF hold an 
additional amount of funds in reserve to cover unexpected losses. 
FHA maintains the MMIF capital reserve in a special reserve account, 
which the National Housing Act mandates maintain a 2 percent ratio 
of reserve relative to the amount of outstanding insurance in force. 
The capital ratio generally reflects the reserves available (net of 
expected claims and expenses) as a percentage of the current 
portfolio, to address unexpected losses.
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    Consistent with HUD's responsibility under the National Housing Act 
to ensure that the MMIF remains financially sound, HUD published the 
July 15, 2010, notice and sought public comment on three proposals 
designed to address features of FHA mortgage insurance that have 
resulted in high mortgage insurance claim rates and risk of loss to 
FHA. Specifically, HUD proposed to reduce the amount of closing costs a 
seller may pay on behalf of a homebuyer purchasing a home with FHA-
insured mortgage financing for the purposes of calculating the maximum 
mortgage amount; to introduce a credit score threshold as well as 
reduce the maximum loan-to-value (LTV) for borrowers with lower credit 
scores who represent a higher risk of default and mortgage insurance 
claim; and to provide more definitive underwriting standards for 
mortgage loan transactions that are manually underwritten.
    The proposed changes were developed to preserve both the historical 
role of the FHA in providing a home financing vehicle during periods of 
economic volatility and HUD's social mission of helping underserved 
borrowers. Interested readers are referred to the July 15, 2010, notice 
for details regarding the proposed changes to FHA requirements.
    At the close of the public comment period on August 16, 2010, HUD 
received 902 public comments in response to the July 15, 2010, notice. 
The majority of the public comments focused on the reduction in seller 
concessions and revised manual underwriting requirements. In order to 
provide itself with the necessary additional time to consider the 
issues raised by the commenters on these two issues, HUD decided to 
separately implement the proposals contained in the July 15, 2010, 
notice. On September 10, 2010, HUD published a final rule, at 75 FR 
54020, implementing a credit score threshold and reducing the maximum 
LTV for borrowers with lower credit scores.

III. This Document--Implementation of Revised Manual Underwriting 
Requirements; Additional Compensating Factors

    This document implements the revised manual underwriting 
requirements, and takes into consideration the public comments received 
on this proposal. The new manual underwriting requirements will reduce 
the risk to the MMIF by reducing the probability of default and 
protecting consumers from predatory, irresponsible lending practices.
    Section III of this document discusses the significant issues 
raised by the public comments regarding the new manual underwriting 
requirements, as well as HUD's responses to these issues. Section IV of 
this document implements the new manual underwriting

[[Page 75241]]

requirements. HUD will also issue additional guidance through Mortgagee 
Letter to assist in implementation of these new requirements.
    As discussed in the July 15, 2010, notice, the purpose of mortgage 
underwriting is to determine a borrower's ability and willingness to 
repay the debt and to limit the probability of default. An underwriter 
must consider the borrower's credit history, evaluate their capacity to 
repay the loan based on income, assets and current debt, determine if 
cash to be used for closing is sufficient and from an acceptable 
source, determine if the value of the collateral is adequate security 
for the amount being borrowed and reserves are adequate. In cases where 
mortgage loans cannot be rated by FHA's TOTAL Mortgage Scorecard, the 
loan is referred by TOTAL, or the loan is manually downgraded the loan 
must be manually underwritten. Where FHA's standard qualifying ratios 
for total mortgage payment-to-income and total fixed payment-to-income 
are exceeded, lenders must cite at least one compensating factor. Under 
FHA's current manual underwriting standards, there is no limit on the 
maximum debt to income ratios a lender may approve nor does FHA define 
which or how many compensating factors must be cited to exceed FHA's 
standard qualifying ratio guidelines \4\ FHA has determined that 
factors concerning housing and debt-to-income ratios, along with cash 
reserves, are particularly good predictive indicators as to the 
sustainability of the mortgage. Through this document, FHA is 
implementing additional requirements for consideration of these factors 
for manually underwritten mortgage loans. These additional requirements 
will consider the borrower's credit history, LTV percentage, housing/
debt ratios, reserves, and compensating factors.
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    \4\ The manual underwriting procedures are detailed in HUD 
Handbook 4155.1 ``Mortgage Credit Analysis for Mortgage Insurance.'' 
The handbook may be downloaded at: http://www.hud.gov/offices/adm/hudclips/handbooks/hsgh/4155.1/41551HSGH.pdf.
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    In response to comment, HUD has made five changes to the proposed 
manual underwriting requirements at this stage. First, HUD has taken 
the opportunity to address the issue of borrowers who exceed the 31 
percent housing-to-income ratio, yet carry little or no discretionary 
debt and, therefore, do not exceed the maximum 43 percent debt-to-
income ratio. Second, HUD has addressed the relationship between 
compensating factors and ``stretch ratios'' that permit borrowers to 
exceed the housing payment and total debt-to-income ratios under 
certain FHA mortgage insurance programs. Third, this document 
establishes additional compensating factors that can be used to qualify 
borrowers who exceed FHA's standard housing payment and debt to income 
ratios. Fourth, HUD has reduced the credit score (from 620 to 580) 
below which compensating factors may not be cited and the standard 
ratio guidelines may not be exceeded. Fifth, the manual underwriting 
requirements are applicable to all purchase loans and all credit 
qualifying refinance loans, including FHA-to-FHA rate and term 
refinance transactions (no cash out) and credit qualifying FHA 
streamline refinance transactions.

IV. Discussion of the Public Comments Regarding Proposed Revisions to 
Manual Underwriting Requirements

    Comment: Support for revised manual underwriting requirements. The 
majority of the commenters submitting comments on the revised manual 
underwriting requirements wrote to express support for the new policy. 
The commenters agreed that clarifying the underwriting standards for 
manually underwritten loans would reduce risks to the FHA MMIF and help 
to stem the tide of home foreclosures. Moreover, these commenters wrote 
that the new manual underwriting standards would protect consumers from 
predatory and irresponsible lending practices, thereby assisting in 
stabilizing the housing industry.
    HUD Response. HUD appreciates the support expressed by these 
commenters, and agrees that the changes will reduce the risk to the 
MMIF and help ensure that homebuyers are offered FHA-insured mortgage 
loans that are sustainable.
    Comment: Opposition to revised manual underwriting guidelines. 
Several commenters opposed the proposed manual underwriting standards. 
Some of these commenters questioned the need for the proposed changes. 
These commenters wrote that lenders have voluntarily implemented 
stricter underwriting standards to help ensure borrowers are 
financially capable of meeting their loan obligations. Other commenters 
focused on the potential impacts of the new standards on low- and 
moderate-income homebuyers. The commenters wrote that borrowers are 
already facing limited access to credit as a result of stricter 
underwriting standards being adopted by lenders, and that the standards 
proposed by FHA would further restrict the ability of these homebuyers 
to obtain financing for the purchase of a home.
    HUD Response. HUD has considered these comments and as a result, 
revised its proposal to reduce the credit score requirement for the use 
of compensating factors from 620 to 580, thereby expanding the pool of 
eligible borrowers who may qualify for the use of such factors. In 
addition to expanding access to compensating factors, the new threshold 
provides for the more precise and historically accurate use of credit 
scores. The formerly proposed thresholds would have grouped borrowers 
with non-traditional/insufficient credit together all borrowers with 
credit scores up to 619. Such a grouping would have been overly broad. 
The new threshold recognizes that the loan performance of FHA borrowers 
with non-traditional/insufficient credit is comparable to that of 
borrowers with credit scores of 579 or lower. Moreover, the use of the 
credit score of 580 is consistent with HUD's recent guidance on manual 
underwriting contained in Mortgagee Letter 2013-05 (January 31, 
2013).\5\
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    \5\ http://portal.hud.gov/hudportal/documents/huddoc?id=13-05ml.pdf.
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    In response to these comments, HUD is also providing more flexible 
front-end and back-end ratios. The document also establishes better 
defined compensating factors, and provides that HUD may establish 
additional compensating factors through Mortgagee Letter, thereby 
enabling HUD to more promptly address changes in market conditions and 
the population of borrowers being served by the FHA programs. While HUD 
does not presently anticipate the need for issuing such a Mortgage 
Letter, HUD emphasizes that the purpose of any such issuance would be 
to add to, but not subtract from, the list of compensating factors 
established in this document.
    HUD believes that these changes strike the appropriate balance 
between fulfilling the Department's historical and social mission as 
well as its statutory duty to preserve the financial health of the 
MMIF. Moreover, sustainable homeownership is essential to a healthy and 
well-functioning housing market. These changes will promote that goal 
by helping to ensure that homeowners are able to afford their FHA-
insured mortgage loans.
    The preamble to the July 15, 2010, notice specifically solicited 
public comment on acceptable compensating factors and, in particular, 
on how FHA could serve borrowers with housing ratios above the proposed 
threshold and debt-to-income ratios below the threshold (see 75 FR 
41222). These borrowers, while having established

[[Page 75242]]

credit lines, traditionally do not use credit to finance purchases over 
a period of several months or years or pay them off within the billing 
cycle. Therefore, they have a history of carrying little to no 
discretionary debt. While the housing debt assumed by such a borrower 
may be higher than the housing ratios established by this document, 
their overall debt-to-income ratios fall within acceptable underwriting 
levels and reflect a record of responsible credit. To address this 
issue, HUD has established an additional ``compensating factor'' that 
would allow such borrowers to qualify for FHA mortgage insurance. 
Specifically, a borrower will be permitted to exceed the housing and 
debt-to-income ratios, if the borrower has access to credit but carries 
no discretionary debt. For example, the borrower's monthly housing 
expense is the only open installment debt with an outstanding balance 
and revolving debt is paid off every month.
    HUD also agrees that borrowers are already facing limited access to 
credit as a result of stricter underwriting standards being adopted by 
mortgagees. To provide additional consideration for manually evaluating 
the borrower for expanded ratios, HUD has included a residual income 
compensating factor that can be used to determine if the borrower has 
sufficient income after making their monthly mortgage payment, 
including taxes and insurance, to meet their needs for food, utilities, 
clothing, transportation, work-related expenses, and other essentials. 
HUD will permit the use of a compensating factor modeled on the 
Department of Veteran's Affairs (VA) residual income requirements 
(codified in regulation at 38 CFR 36.4340). Under the VA regulations, 
residual income is calculated by determining the borrower's gross 
monthly income, then deducting the borrower's monthly expenses from the 
total gross monthly income. The balance remaining is ``residual 
income'' and the mortgagee can determine if the mortgagor meets the 
applicable residual income requirements, which vary based on family 
size, region, and loan amount as described in tables codified in the VA 
regulations. If the mortgagor meets the residual income test, the 
mortgagee can use residual income as a compensating factor.\6\
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    \6\ For more details on the VA residual income requirements, 
please refer to Chapter 4 of VA Pamphlet 26-7, ``Lenders Handbook,'' 
available at http://www.benefits.va.gov/warms/pam26_7.asp.
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    Second, HUD has clarified the relationship between the compensating 
factors and the ``stretch ratios'' provided for under certain FHA 
mortgage insurance programs that authorize borrowers to exceed 
qualifying housing and debt-to-income ratios. For example, as noted in 
the preamble to the July 15, 2010, notice, borrowers using FHA energy 
efficient mortgage insurance may have stretch ratios of 33/45 if the 
homes are built or retrofitted to exceed the applicable International 
Energy Conservation Code (IECC) standard. HUD has taken the opportunity 
afforded by this document to clarify that, although such borrowers may 
not be subject to the 31/43 percent qualifying ratios established by 
this document, these borrowers may not exceed the 33/45 percent upper 
limit for stretch ratios established by the document unless they 
qualify for higher ratios based on credit score and additional 
compensating factors.
    Comment: Hold underwriters to a higher standard. Several commenters 
suggested that, in addition to the proposed manual underwriting 
requirements, HUD should hold underwriters themselves to a higher 
standard. The commenters recommended that HUD require underwriters to 
absorb a higher percentage of the risk associated with manual 
underwriting. For example, one of the commenters recommended that HUD 
suspend lenders with high default rates on their manually underwritten 
loans.
    HUD Response. HUD has not revised its proposal based on these 
comments. The Department has already implemented the types of action 
recommended by the commenters. Mortgagee Letter 2010-03, issued on 
January 21, 2010, announced several steps undertaken by HUD to enhance 
its authority to address deficiencies in a lender's performance, 
focusing on all underwriting decisions, not just those that were 
manually underwritten.\7\ Specifically, Mortgagee Letter 2010-03 
advised that every three months, HUD reviews the rates of default and 
claims on all FHA-insured single family loans. This review analyzes the 
performance of every participating lender based on its area of 
operation. HUD may terminate an underwriting lender's approval to 
underwrite FHA-insured loans in an area where the lender's default and 
claim rate exceeds the established Credit Watch Termination thresholds.
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    \7\ Mortgagee Letter 2010-03 is available for download at: 
http://www.hud.gov/offices/adm/hudclips/letters/mortgagee/files/10-03ml.pdf.
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    Comment: Clarify what are acceptable compensating factors in 
underwriting guidelines. Several commenters, while expressing support 
of the proposed changes to the manual underwriting requirements, also 
suggested that HUD simplify the acceptable compensating factors. For 
example, one commenter recommended that FHA develop a list or chart 
that more clearly identifies the relationship between the compensating 
factors and the acceptable housing and debt to income ratios. Another 
commenter suggested that FHA more specifically define the compensating 
factors.
    HUD Response. As noted above, HUD has, in response to these 
comments, made changes to clarify the compensating factors and their 
relationship to the qualifying housing and debt-to-income ratios. In 
addition, HUD is providing a matrix outlining credit score, front-end 
ratios, back-end ratios, cash reserves, acceptable compensating 
factors, and criteria for stretch ratios.

V. Establishment of Revised Manual Underwriting Requirements

    Commencing on the effective date:
    Manual Underwriting. On manually underwritten mortgage loans, 
borrowers are required to have minimum cash reserves equal to one 
monthly mortgage payment for one- and two-unit properties, and 3 months 
for three- and four-unit properties, which includes principal, 
interest, taxes, and insurance. For borrowers with credit scores of 500 
to 579 or non-traditional credit the maximum housing and debt-to-income 
ratios for manually underwritten loans are set at 31 percent and 43 
percent, respectively, unless the borrower qualifies for 33/45 stretch 
ratios available for manually underwritten borrowers with homes built 
or retrofitted to exceed the applicable IECC standard including Energy 
Efficient Mortgages. For borrowers with credit scores of 580 or higher 
the maximum housing and debt-to-income ratios for manually underwritten 
loans are set at 31 percent and 43 percent, respectively, unless the 
borrower (1) qualifies for 33/45 stretch ratios available for manually 
underwritten borrowers with homes built or retrofitted to exceed the 
applicable IECC standard including Energy Efficient Mortgages or (2) 
meets the compensating factors criteria in the matrix below. To exceed 
31/43 ratios or, in the case of homes built or retrofitted to exceed 
the applicable IECC standard including Energy Efficient Mortgages, the 
33/45 stretch ratios, not to exceed 37/47 percent, borrowers must meet 
at least one of the acceptable compensating factors. To exceed the 
qualifying ratios of 37/47 percent, not to exceed 40/50 percent, 
borrowers must

[[Page 75243]]

meet at least two of the acceptable compensating factors. These minimum 
cash reserve and maximum qualifying ratio requirements are applicable 
for purchase transactions and all credit-qualifying FHA refinance 
transactions, where the loan received a REFER scoring recommendation 
from TOTAL, where TOTAL cannot score the loan (non-traditional credit) 
or where the TOTAL Scorecard scoring recommendation is Accept, but the 
underwriter manually downgrades it to Refer. These maximum front and 
back ratios requirements and reserve requirements are not applicable 
for non-credit qualifying FHA streamline refinance transactions and 
Home Equity Conversion Mortgage transactions.

----------------------------------------------------------------------------------------------------------------
                                            Maximum front     Acceptable compensating factors  (Note: HUD may
               Credit score                   and back       establish additional compensating factors through
                                               ratios                        Mortgagee Letter)
----------------------------------------------------------------------------------------------------------------
500-579 or Non-traditional/Insufficient             31/43  Not applicable. Borrowers with credit scores below
 Credit.                                                    580 or with Non-traditional/insufficient credit may
                                                            not exceed 31/43 ratios.
580 and above............................           31/43  No compensating factors required.
580 and above............................           37/47  One of the following:
                                                            Verified and documented liquid cash reserves
                                                            equal to at least three total monthly mortgage
                                                            payments (1-2 units) or six total monthly mortgage
                                                            payments (3-4 units).
                                                            New total monthly mortgage payment is not
                                                            more than $100 or 5% higher than previous total
                                                            monthly housing payment, whichever is less; and
                                                            verified and documented twelve month housing payment
                                                            history (1X30 only).
                                                            Sufficient Residual Income as calculated per
                                                            VA requirements
580 and above............................           40/40  Borrower with established credit and open credit
                                                            lines carries no discretionary debt. Monthly housing
                                                            payment is only open installment account and
                                                            revolving credit is paid off monthly.
580 and above............................           40/50  Two of the following:
                                                            Verified and documented liquid cash reserves
                                                            equal to at least three total monthly mortgage
                                                            payments (1-2 units) or six total monthly mortgage
                                                            payments (3-4 units).
                                                            New total monthly mortgage payment is not
                                                            more than $100 or 5% higher than previous total
                                                            monthly housing payment, whichever is less; and
                                                            verified and documented twelve month housing payment
                                                            history (1X30 only).
                                                            Sufficient Residual Income as calculated per
                                                            VA requirements.
                                                            Verified and documented additional income
                                                            that is not considered effective income. Overtime
                                                            and bonus income can be cited as a compensating
                                                            factor if the mortgagee verifies and documents that
                                                            the borrower has received this income for at least
                                                            one year but less than two years, and it will likely
                                                            continue. Part-time and seasonal income can be cited
                                                            as a compensating factor if the mortgagee verifies
                                                            and documents that the borrower has worked the part-
                                                            time or seasonal job uninterrupted for at least one
                                                            year but less than two years, and plans to continue.
----------------------------------------------------------------------------------------------------------------
Note: Maximum ratios for manually underwritten borrowers with homes built or retrofitted to exceed the
  applicable IECC standard including Energy Efficient Mortgages are eligible for stretch ratios of 33/45
  regardless of credit score or Nontraditional credit, but must meet the minimum required reserve requirement
  for manually underwritten loans (1 month for 1-2 units, 3 months for 3-4 units). These transactions may also
  be eligible for higher ratios if they meet additional criteria, i.e. minimum 580 FICO and one or more
  additional compensating factors.

VI. Findings and Certification

Regulatory Review--Executive Orders 12866 and 13563

    Under Executive Order 12866 (Regulatory Planning and Review), a 
determination must be made whether a regulatory action is significant 
and therefore, subject to review by the Office of Management and Budget 
(OMB) in accordance with the requirements of the order. Executive Order 
13563 (Improving Regulations and Regulatory Review) directs executive 
agencies to analyze regulations that are ``outmoded, ineffective, 
insufficient, or excessively burdensome, and to modify, streamline, 
expand, or repeal them in accordance with what has been learned. 
Executive Order 13563 also directs that, where relevant, feasible, and 
consistent with regulatory objectives, and to the extent permitted by 
law, agencies are to identify and consider regulatory approaches that 
reduce burdens and maintain flexibility and freedom of choice for the 
public. This document was determined to be a ``significant regulatory 
action'' as defined in section 3(f) of Executive Order (although not an 
economically significant regulatory action, as provided under section 
3(f)(1) of the Executive Order).
    As noted above, this document implements one of the three 
initiatives announced in HUD's July 15, 2010, notice to aid in the 
restoration of the MMIF capital reserve account. Specifically, this 
document provides more definitive underwriting standards for mortgage 
loan transactions that are manually underwritten to overcome lender 
uncertainty and resistance to manually underwritten, credit-worthy FHA 
borrowers in this time of tighter mortgage credit. The benefit of the 
document is to reduce underwriting losses by strengthening manual 
underwriting requirements and thereby increase net revenue to the FHA. 
Whether there are net transfers to FHA depends on what proportion of 
the current borrowers is excluded from receiving a loan. As long as not 
more than 13 percent are excluded, the net transfer to FHA is positive. 
When 10 percent of applicants are excluded, the gain (transfer) to FHA 
ranges from $35 million to $42 million. HUD has prepared an economic 
analysis assessing costs and benefits of the new manual underwriting 
requirements. HUD's full analysis can be found at www.regulations.gov. 
A summary of HUD's analysis follows:
    A. Transfers/Revenue Effects. The broader purpose of the policy 
change is to reduce the risk to the MMIF so that FHA can continue to 
provide mortgage loans. Facilitating the provision of credit during a 
liquidity crisis is a welfare-enhancing activity, and FHA provides such 
a public benefit.
    A government agency's increase in net revenue is usually treated as 
a transfer because governments traditionally raise revenue through 
taxes and fees. In the case of the manual underwriting document, the 
increase in FHA revenue occurs as the result of more rigorous 
underwriting practices that reduce the number of claims. FHA can 
control its costs through risk management practices. The lower costs 
are a gain to

[[Page 75244]]

FHA. When 10 percent of applicants are excluded, HUD's estimate of the 
expected net gain to the FHA (and subsequent transfer to the U.S. 
Treasury) ranges from $35 million to $42 million depending upon the 
discount rate. Any gain to the FHA is an eventual transfer to others. 
Under certain circumstances, reducing the riskiest of loans will allow 
FHA to return excess revenues to the U.S. Treasury.
    HUD expects a reduction in the number of loans but also a reduction 
in the number of claims. The target of the document is low net-revenue 
loans, which have higher claim rates and higher loss rates. HUD expects 
the net revenue per loan to increase by $2,300 (discounted at 3 
percent) primarily because the expected claim amount. At a 7 percent 
discount rate, the increase in net revenue per loan is $1,900.
    B. Benefits/Costs. The new underwriting guidelines will postpone 
(perhaps indefinitely for some) the purchase of a home or the 
refinancing of a loan until the excluded households can satisfy more 
specific requirements. As noted by many of the public commenters on the 
July 15, 2010, notice, the policy changes being made by FHA have 
already been adopted by the private mortgage lending industry. 
Accordingly, the borrowers excluded by the document would not be able 
to purchase mortgage insurance from a private mortgage insurance 
company. The only choice for a rejected applicant would be to improve 
the strength of their financial position. A few analytical options 
exist for estimating the magnitude of the cost of being excluded from 
homeownership. The costs are: the direct private costs of meeting the 
new requirements, the private costs of delaying the loan, and the 
public costs of delay.
    Many of the borrowers who would not qualify under the underwriting 
requirements may adjust their financial situation in order to meet the 
requirements. If the front-end ratio is the disqualifying factor, then 
a borrower could adjust by purchasing a less expensive home. Longer 
term solutions include saving to build reserves and repaying non-
housing debt to meet the back-end ratio. A household could work to 
repair their credit score which would raise the allowable debt ratios. 
Most of the negatives will be removed from a credit report after 7 
years, and it is possible to increase credit scores significantly after 
3 years by better managing consumer debt. Once the borrower reaches a 
credit score of 580 or greater, compensating factors such as 3 months 
of reserves or the purchase of an energy-efficient home will raise the 
qualifying ratios even further. Thus, not all of the 16,000-19,000 
borrowers affected by the document will be excluded from an FHA loan. 
Some will be able to adjust immediately and others within a year or 
two.
    Another consideration in measuring the costs of the document is 
that by excluding potential borrowers from the benefits of an FHA loan 
guarantee, the new manual underwriting requirements may lead to a 
reduction in the social benefits of homeownership. HUD assumed two 
potential outcomes: that homeownership has positive net public benefits 
or that there are no public benefits of homeownership. The first 
scenario is motivated by economic theory and the second by recent 
empirical evidence. One study estimated the public benefits of 
homeownership to be $443 ($341 adjusted to the 2013 price level). 
Assuming that homeowners leave their current homes every seven years, 
the annualized benefit per loan is $70 (at a 3 percent discount rate) 
or $80 (at a 7 percent discount rate). The exclusion of homeowners may 
reduce these public benefits of homeownership. However, HUD also notes 
that some studies find that a negative social effect of home ownership 
is reduced mobility, which leads to rigidity in the labor market and 
thus lengthens economic downturns. In addition, a full analysis of the 
expected cost to society of excluding a household from homeownership 
would account for the expected social costs of foreclosure for every 
homeowner created.
    C. Aggregate costs and benefits. The aggregate economic impact of 
the document is found by examining the aggregate changes to FHA's net 
revenue, the total impact on consumers (rejected applicants and 
accepted borrowers), and the public benefits of homeownership. HUD 
quantifies the revenue impacts and discusses qualitatively the impacts 
on consumers and social benefits. The pre-document number of loans is 
estimated to be 18,000. HUD assumes that some proportion of those loans 
will be excluded as a direct result of the document. The implications 
of raising the number of loans that cannot make the transition into 
higher quality loans are that the gain to the FHA will decline and the 
total cost to borrowers will rise (since the loss due to exclusion is 
assumed to be greater than the loss due to compliance).
    The aggregate revenue impacts of the document for a variety of 
assumptions concerning key parameters are summarized in the table 
below.

                                                     Annual Aggregate Impacts of the Final Document
                                                                [In millions of dollars]
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                             0% of loans excluded        10% of loans excluded       20% of loans excluded      100% of loans excluded
                                         ---------------------------------------------------------------------------------------------------------------
                Category                       discount rate of            discount rate of            discount rate of              discount rate
                                         ---------------------------------------------------------------------------------------------------------------
                                               3%            7%            3%            7%            3%            7%            3%            7%
--------------------------------------------------------------------------------------------------------------------------------------------------------
Transfers
    FHA Gain............................          +42           +35           +20           +16           -17            -3          -176          -156
--------------------------------------------------------------------------------------------------------------------------------------------------------

    As long as not more than 13 percent of applications are excluded, 
the net transfers to FHA outweigh the burden of the document regardless 
of the discount rate.
    The docket file is available for public inspection in the 
Regulations Division, Office of General Counsel, Department of Housing 
and Urban Development, 451 7th Street SW., Room 10276, Washington, DC 
20410-0500. Due to security measures at the HUD Headquarters building, 
please schedule an appointment to review the docket file by calling the 
Regulations Division at 202-402-3055 (this is not a toll-free number). 
Individuals with speech or hearing impairments may access this number 
via TTY by calling the Federal Information Service at 800-877-8339.

Regulatory Flexibility Act

    The Regulatory Flexibility Act (RFA) (5 U.S.C. 601 et seq.), 
generally requires an agency to conduct a regulatory flexibility 
analysis of any document subject to notice and comment

[[Page 75245]]

rulemaking requirements unless the agency certifies that the document 
will not have a significant economic impact on a substantial number of 
small entities. The document does not establish new and unfamiliar 
regulatory requirements on FHA-approved mortgage lenders. Rather, the 
document builds on existing requirements and procedures that are 
familiar to lenders. Specifically, the document tightening portions of 
FHA's current underwriting guidelines that present an excessive level 
of risk to both homeowners and FHA. The benefit of the set of actions 
to regulated lending institutions will be to reduce the risk to the 
MMIF so that FHA can continue to insure mortgage loans originated and 
serviced by these lenders.
    As noted in the economic analysis for the document, relative to the 
total FHA portfolio, few borrowers are served in the categories that 
would be excluded under the new policies, relative to the total FHA 
portfolio. Further, as noted by many of the public commenters on the 
July 15, 2010, notice, the policy changes being made by FHA have 
already been adopted by the private mortgage lending industry. The 
impact of the policy changes will, therefore, largely be limited to 
conforming FHA standards to widespread industry practice. Accordingly, 
to the extent this document has any economic impact on the minority of 
lenders that have not already adopted such stricter underwriting 
standards; they will be minimal, encompassing a relatively small 
proportion of their FHA business activities.

Environmental Impact

    A Finding of No Significant Impact (FONSI) with respect to the 
environment has been made in accordance with HUD regulations at 24 CFR 
part 50, which implement section 102(2)(C) of the National 
Environmental Policy Act of 1969 (42 U.S.C. 4332(2)(C)). The Finding of 
No Significant Impact is available for public inspection between the 
hours of 8 a.m. and 5 p.m. weekdays in the Regulations Division, Office 
of General Counsel, Department of Housing and Urban Development, 451 
7th Street SW., Room 10276, Washington, DC 20410. Due to security 
measures at the HUD Headquarters building, please schedule an 
appointment to review the FONSI by calling the Regulations Division at 
202-708-3055 (this is not a toll-free number). Individuals with speech 
or hearing impairments may access this number via TTY by calling the 
Federal Information Relay Service at 800-877-8339.

Executive Order 13132, Federalism

    Executive Order 13132 (entitled ``Federalism'') prohibits an agency 
from publishing any document that has federalism implications if the 
document either imposes substantial direct compliance costs on state 
and local governments and is not required by statute, or the document 
preempts state law, unless the agency meets the consultation and 
funding requirements of section 6 of the Executive Order. This document 
would not have federalism implications and would not impose substantial 
direct compliance costs on state and local governments or preempt state 
law within the meaning of the Executive Order.

Unfunded Mandates Reform Act

    Title II of the Unfunded Mandates Reform Act of 1995 (2 U.S.C. 
1531-1538) (UMRA) establishes requirements for federal agencies to 
assess the effects of their regulatory actions on state, local, and 
tribal governments, and on the private sector. This document would not 
impose any federal mandates on any state, local, or tribal governments, 
or on the private sector, within the meaning of the UMRA.

    Dated: December 3, 2013.
Carol J. Galante,
Assistant Secretary for Housing--Federal Housing Commissioner.
[FR Doc. 2013-29170 Filed 12-10-13; 8:45 am]
BILLING CODE 4210-67-P