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  FHA-Backed Loans: The Next Subprime Crisis Looms

FHA-Backed Loans The Next Subprime Crisis Looms

By Chad Terhune and Robert Berner

Part 2: Low Income? No Problem

Joseph McCloskey, a former director of FHA's single-family asset management branch, says workers reviewing lender applications have had difficulty for years tracking whether executives of previously disciplined mortgage firms were applying for new FHA licenses. "Technologically, they are challenged," McCloskey, now a consultant to FHA lenders, says of his overmatched former colleagues.

The FHA's Wooley disputes these criticisms. The agency can cross-check names and thoroughly examine lender applications, he says.

Like Flies to Honey

There are numerous law-abiding FHA lenders and brokers, just as there are subprime mortgage firms that behaved honestly and cautiously in recent years. But the current economic crisis has turned the FHA into a profit magnet for all kinds of financial players. Major Wall Street investment firms are finding their own angles, which are entirely legal.

In April 2007, Goldman Sachs purchased a controlling stake in Senderra Funding, a former subprime lender in Fort Mill, S.C. Goldman, which has received $10 billion in direct federal rescue money, converted Senderra into an FHA lender and refinance organization. The strategy appears likely to produce hefty margins. In September, Goldman paid 63¢ on the dollar in a $760 million deal with Equity One, a unit of Banco Popular, for a batch of subprime mortgage and auto loans. Through Senderra, Goldman plans to refinance at least some of the mortgages into FHA-backed loans. Because of the government guarantee, it can then sell those loans to other financial firms for as much as 90¢ on the dollar, according to people familiar with the mortgage market. That's a profit margin of more than 40 percent.

Goldman's dealings suggest another reason FHA-insured lending is booming: The federal guarantee creates an incentive for banks to buy FHA loans and bundle them as securities to be sold to investors. This is happening as the securitization of subprime and conventional mortgages has largely ceased.

Operating far from Wall Street, the Cugno clan of Clearwater exemplifies a certain indefatigable American spirit in the face of economic setbacks. Whether that enterprising drive is always something to celebrate is less clear.

The Cugnos concede that their older mortgage firm, Premier, had its flaws. "My dad's company got too big," says Nicole Cugno. "It was too hard to control." At its peak in 2006, Premier originated $1 billion in loans each month and had annual revenue of more than $200 million. It sold what amounted to franchises to brokers around the country who frequently operated with little supervision from the 200-employee home office. "Everybody had a few bad apples, and I had a few of them," Nicole's father, Jerry, says. "If they got in trouble, we fired them."

Mark Pearce, deputy commissioner of banks in North Carolina, one of the five states that banned Premier, counters that the company seems to have invited abuses. North Carolina investigators concluded that Premier's branch in Charlotte allowed, among other deceptive practices, unlicensed brokers from around the country to "park" loans there for a fee. The aim was to make it appear that the mortgages were associated with a licensed broker trained and supervised by a substantial firm. "This is a company that should not be doing business in North Carolina," Pearce says.

But the Cugnos are very much staying in business. While Premier's bankruptcy proceedings continue in Tampa, members of the family are employing essentially the same model with their new company, Paramount. Only this time they are stressing federally guaranteed FHA loans. Paramount charges branches $1,625 a month to use its name, FHA license, and software. On its Web site, it tells brokers that FHA loans are "the new subprime."

"We're taking some of the things Premier did and tweaking [them]," says Barry McNab, a former Premier executive who now heads FHA lending for Paramount. About 9 out of 10 Paramount loans have FHA backing, he explains. It's difficult to evaluate most of those guaranteed loans, since they are so new. But a look at the experiences of some past Premier borrowers isn't encouraging.

U.S. District Judge Richard Alan Enslen in Kalamazoo, Mich., began a June 2007 written opinion about Premier's practices with this observation: "The crooks in prison-wear (orange jump suits) are easy to spot. Those in business-wear are not, though they do no less harm to their unsuspecting victims."

The case before Judge Enslen concerned Marcia Clifford, 53. She won a civil verdict that Premier had violated federal mortgage law when it replaced the fixed-rate loan it had promised her with one bearing an adjustable rate. Enslen also found that Premier had misrepresented Clifford on her application as employed when she was out of work and living on $700 a month in disability payments. Despite his ire, the judge decided to award Clifford, who did sign the deceptive documents, only $3,720 in damages, an amount based on unauthorized fees Premier had pocketed.

Clifford's name now appears along with a lengthy list of Premier's other creditors in the bankruptcy court in Tampa. Unable to make her $600 monthly mortgage payment, she received an eviction notice in June and says she is likely to lose her three-bedroom house in Belding, Mich. "It was a bait and switch," Clifford says, sobbing. "The folks at Premier are coldhearted."

Janice Dixon is also owed money by Premier. In March 2006 an Alabama jury awarded her $127,000 in damages related to a fraudulent refinancing in which, she alleged, the company didn't disclose the full costs of her borrowing. "Who will fix this?" Dixon, 49, asks. "They will continue to do these same things over and over."

Wooley, the FHA spokesman, says the agency noticed Premier's default rate rising earlier this year. But he adds that both Premier and Paramount met FHA requirements.

Low Income? No Problem

Like the Cugnos, Hector J. Hernandez lately has shifted his mortgage business away from subprime and toward FHA loans. The Coral Gables (Fla.) lender has a different twist on the business: He uses FHA-backed loans to help hard-pressed borrowers buy condominiums in buildings he owns.

Sascha Pierson was an unlikely borrower. She had no employment income when she bought a three-bedroom condo in Palmetto Towers, a Hernandez property in Miami, in July 2007 for $318,000. She borrowed almost the entire purchase price from Great Country Mortgage Bankers, Hernandez's loan company. Pierson, 29, says she is pursuing a psychology degree online from Kaplan University. She lives on a $42,000 annual educational grant from the government of the Cayman Islands, where she is a citizen. But the grant ends this year, and even with two roommates, she doesn't know how she's going to pay the $2,600 monthly bill for her mortgage and condo fee. "I am seriously worried about defaulting on my loan," she says.

Less extreme versions of Pierson's situation seem common at Palmetto Towers, a pair of eight-story stucco buildings Hernandez acquired in 1996. BusinessWeek interviewed eight condo owners at the complex, all of whom had obtained FHA-backed loans from Great Country. All eight, including Pierson, say they agreed to terms that required them to make mortgage and condo-fee payments that total considerably more than the FHA's guideline of 31 percent of their monthly income. Four of the eight owners say they received cash payments at closing of $10,000 or more as incentives to buy. The payments, which the FHA says are prohibited, were included in the loans. Pierson says she received $19,500. "They called it a 'cash-back opportunity,'" she explains.

Her neighbor, Lorena Merlo, 27, received a Great Country check for $14,640 at the closing in April on her $316,375 three-bedroom unit. Merlo, a part-time legal assistant, and her husband, Renny Rivas, a drywall laborer, earn a total of $52,000 a year and have two young sons. Their monthly home payments amount to 58% of their gross income, way over the FHA limit. "We are four months behind on our mortgage," says a mournful Merlo.

Defaults and Denials

Of the 158 units in Palmetto Towers, 66 are in foreclosure, records show. An additional 33 are unsold. Great Country has originated 1,855 FHA mortgages since November 2006; 923 of those were in default proceedings as of Oct. 31. The firm's 50 percent default rate is the highest in the entire FHA program.

Hernandez blames the high failure rate on the disastrous South Florida real estate market, not Great Country's practices, which he says are all legitimate. Asked in a phone interview whether he encourages buyers to purchase condos they can't afford, paying them questionable cash incentives, he says flatly, "That is not true." He adds: "(The buyers) are lying. They are disappointed by falling prices."

In October, however, the FHA decided it had seen enough. It ended Great Country's guaranteed-lending privileges in the Miami and Orlando markets where it had been active. Borrowers on nearly half of the company's defaulted loans made payments for only three months or less; 105 borrowers never made any payments at all. Brian Sullivan, another FHA spokesman, says the agency has referred the case to its inspector general's office. In response to BusinessWeek's questions, the Florida Financial Services Dept. has started a separate investigation, a person close to the state agency says.

But don't assume that Hernandez is through with FHA-guaranteed loans. At the Palmetto Towers sales office, Alexis Curbelo, a loan officer for Great Country, explains in an interview that buyers can now obtain FHA loans through Ikon Mortgage Lenders in Fort Lauderdale. Public records show Ikon closed a Palmetto Towers FHA loan in September for $222,957. Edgard Detrinidad, Ikon's president and a former business associate of Hernandez, denies he is financing any other loans for Hernandez's buyers.

With Brian Grow and Jessica Silver-Greenberg.

Terhune is a senior writer for BusinessWeek based in Florida. Berner is a correspondent for BusinessWeek in Chicago.