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No down payment? No problem

You probably thought nothing-down mortgage loans disappeared in the wake of the American subprime lending crisis, which ensnarled much of the world in a credit crunch.
Image: A house for sale in Stockton
Despite the subprime crisis, a loophole in the law allows home buyers to put no, or little money into a home purchase. Marcio Jose Sanchez / AP
/ Source: Forbes

You probably thought nothing-down mortgage loans disappeared in the wake of the American subprime lending crisis, which has ensnarled much of the world in a credit crunch.

They didn't. Even more surprising, many Americans can still buy homes with nothing down thanks in large part to the federal government and a legal loophole that lets builders and bankers ensure a steady stream of asset-challenged borrowers for taxpayer-insured loans.

With quietly expanded powers, the Federal Housing Administration is already offering the next-best thing to nothing down on a house: a payment of just 3.0 percent will get practically any American with a pulse and a job a mortgage of up to $729,000, at least until the end of this year.

But for those who lack the wherewithal to put even a little skin in the game, there's a workaround: a not-for-profit organization can give prospective buyers the teensy downpayment. The spigot is wide open. Of the 180,881 loans that the FHA insured in the first half of fiscal 2008, 36.7 percent, or 66,337, were seller-funded. With home builders and sellers desperate to make sales in a slowing real estate market, this percentage is likely to grow.

The FHA has traditionally allowed family and friends to gift a downpayment to homebuyers. In the last 10 years, homebuilders and sellers have gotten into the act by funneling their upfront consideration through down-payment assistance not-for-profits. Technically wiping out a conflict of interest, the charitable outfit collects the cash and hands it over to the mortgage lender taking a bit off the top for all its trouble.

According to a 2005 U.S. Government Accountability Office report, the sleight-of-hand results in higher home prices for FHA borrowers. The agency found that homes sold with nonprofit assistance were appraised and sold for prices about 2 to 3 percentage points higher than comparable homes without such assistance. The report said that appraisers interviewed had sometimes been pressured by lenders, real estate agents and sellers to increase home prices to “bring in the value.”

Not only does this practice burden FHA borrowers with pricier homes, it also increases the odds that the new homeowners can't afford their monthly mortgage payments. Indeed, seller-financed, no-downpayment loans have default rates that are three times the FHA average.

No need for loan originators to worry about defaulting loans; taxpayers shoulder the risk that these loans bring to the FHA's pool of loans. All of the mortgages insured by the agency are backed in full by the U.S. government so when borrowers default, Uncle Sam takes the hit and makes the mortgage payment instead.

The FHA tried and failed to unilaterally prohibit the seller-funded loans last year. After it issued a decree that the practice's end was nigh, Sacramento-based Nehemiah, a market leader in seller-backed financing, challenged the agency's ban and won. The judge ruled against the Department of Housing and Urban Development 's policy shift for failing to provide follow protocol in announcing the change.

Seller-funded nonprofit operations are being investigated by the Internal Revenue Service. In May 2006, the agency said it had found "that organizations claiming to be charities are being used to funnel down payment assistance from sellers to buyers through self-serving, circular financing arrangements." Since February 25, 2008, 47 of these middlemen have had their not-for-profit status revoked by the IRS.

The financiers of these not-for-profits are naturally reluctant to advertise their back-door lending, but after requesting permission from its partners Nehemiah said that builders that work with it include Lennar, Pulte Homes, and Shea Homes. A glut of inventory in a slowing market has the builders scrambling for sales.

Nehemiah also identified some of its lending partners: Wells Fargo, Bank of America, JPMorgan Chase, and National City. Interestingly, the FHA has not pulled its certification of these lenders, even though it opposes their participation in the financing arrangements.