With the market for subprime mortgages in a virtual free fall, new home loan applications for Federal Housing Administration (FHA) loans are up sharply. But FHA officials say the increase -- welcome though it is -- should be even higher given the degree of shrinkage in the subprime sector.

All that's needed, they say, is for Congress to pass long-pending FHA modernization legislation raising maximum mortgage limits and lowering minimum downpayments. FHA, which serves primarily first-time buyers and consumers with moderate incomes, has in recent years seen its market share drop from double digits to roughly 3 percent.

On the surface, the numbers being generated so far this year look promising for the agency. New loan applications have increased by 76.8 percent since last December. In April, new applications hit 67,525, their highest level since April 2004.

However, loan applications are not the true measure of FHA's business. Closed loans-with insurance endorsements-are what really matters. And there's a serious gap between shoppers who put in applications at FHA and at other loans sources, and actual buyers, whose loans close and receive insurance coverage. Endorsed loan totals grew by just 18.8 percent between April and June-a performance FHA considers less than stellar given the heavy shutdown of subprime loan sources for buyers and refinancers.

Another indication that FHA loan growth volume isn't as impressive as it could be: Most of the big jumps in loans are coming from states with moderate to low housing prices -- Ohio, Indiana, Michigan, Texas and Georgia -- where FHA remained an established presence throughout the subprime boom years. Relatively little closed loan volume, on the other hand, is coming from higher cost states where first-time buyers find it most difficult to finance-places such as California and the Northeast -- and where current statutory loan limits make FHA noncompetitive.

Finally, looking at historical norms, FHA remains far below its traditional share of the market. This year, according to FHA projections, the agency will insure 559,000 home loans -- 60,000 above 2006, but far below the 892,000 mortgages it insured in 2000, before the subprime boom.

"The fact that FHA has not returned to a more historic level of applications and originations suggests that FHA is constrained by its underwriting and loan limits," says an internal research paper prepared by the agency. With subprime originations expected to be down by as much as 50 percent this year, according to mortgage industry estimates, FHA should be picking up more of the slack than it appears to be.

To illustrate the loan limit problem, the research paper points to California, the largest state housing market in the U.S. In the Los Angeles metropolitan area, the median house price is $525,000. For a family that earns the area median income, only 3 percent of all homes in the metropolitan area are now affordable. FHA should be a major player in such a market, but its $362,000 statutory loan maximum for Los Angeles is about $163,000 below the median-priced home.

Under the pending reform legislation -- expected to be passed by the House after the summer recess, and to move out of committee in the Senate-FHA limits in high coast areas would rise significantly. In high cost Los Angeles, for example, they would float with the Fannie Mae/Freddie Mac maximums, currently $417,000. In other areas, they would rise to the median home sale price for the area, capped at the Fannie/Freddie maximum.

Downpayments would drop to as low as zero from the current 3 percent, and applicants would be underwritten on a risk-based pricing basis, like the rest of the mortgage market.

Published: August 6, 2007

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Kenneth R. Harney writes an award-winning, nationally-syndicated column on housing and real estate from Washington, D.C. He is also managing director of the National Real Estate Development Center, a professional education company. He is a past member of the Federal Reserve Board's Consumer Advisory Council, a committee that by federal statute reviews all Fed actions on home mortgage, consmer credit and banking industry regulation. He served as a member of the U.S. Department of Housing and Urban Development's Working Group on Computerized Loan Origination (CLO) systems, and is a member of the Editorial Board of the Fannie Mae Foundation's journal, Housing Policy Debate. He is the author of two books on mortgage finance and real estate.