USDA Home Loans: Subprime Redux?

Builders and lenders are dusting off a familiar pitch: mortgages with $0 down and 100% financing. The deals, which take advantage of a little-known loan program at the U.S. Agriculture Dept., are bolstering sales in some areas. These new mortgages share some characteristics with the old ones now wreaking havoc on the housing market—and critics fear lending standards could slip. Says Daniel Oppenheimer, an analyst with Credit Suisse: "Unlike beef, these loans should be described as USDA subprime."

In the grand scheme of the $1.89 trillion residential real estate market, the USDA program—founded in 1949 to spur home sales and development in rural areas—is still a blip. But since the financial crisis, the program has exploded in size. As part of the Obama Administration's effort to prop up housing, the U.S. allocated $10.5 billion to the Agriculture Dept.'s guaranteed loan program this year, up from $6 billion in 2008 and $3 billion in the past.

The result: The number of home loans guaranteed by the USDA swelled to nearly 120,000 in the first nine months of 2009, up from roughly 35,000 in all of 2007. Given the rampant development during the boom, many communities where the USDA loans are available aren't technically "rural" anymore—and include exurbs near big cities. Ashley-Gayle Boothe and her husband Scott have applied for a USDA-backed loan to buy their first home, a three-bedroom house 30 minutes north of Tampa, for $127,500. "We didn't want to put anything down," says Ashley-Gayle Boothe. "We figured we'd have to buy appliances."

The government-backed loan program is buoying builders and lenders. Analysts say federal loans, including those guaranteed by the USDA, accounted for 64% of sales at builder D.R. Horton (DHI) in the latest quarter. In Port St. Lucie, Fla.—a coastal town littered with foreclosures and empty subdivisions—roughly one in five mortgages is coming through the Agriculture Dept., according to local industry players. "Everyone is fighting for every little sale they can get, and the USDA financing is a huge opportunity," says Jim Belfiore, president of Belfiore Real Estate Consulting in Phoenix.

Housing experts question the wisdom of 100% financing for any borrower. Similar questionable lending decisions during the housing boom lie at the root of many distressed properties today. In the current environment the mortgages are particularly problematic since prices continue to fall in the areas where the Agriculture Dept. loans have proliferated. In one such place, Menifee, Calif., record foreclosures continue to depress home values. For owners, falling prices and no equity in their homes have proven a toxic combination, especially when they try to sell.

The USDA, builders, and lenders defend their use of the loans. The agency argues it adheres to strict underwriting standards, assessing each borrower's credit, income, and cash flow. Joaquin Tremlos, acting director of the USDA's home loan program, says the agency's portfolio of loans has a low default and delinquency rate. The USDA "has not relaxed our guidelines.... We've intensified them to make sure that these loans continue to be sound."

Even so, some observers worry the department will stumble under the flood of new loans. A similar program run by the Federal Housing Administration has experienced a significant uptick in fraud since the agency's share of the market ballooned this year. "Some people have cleverly figured out this [USDA program] is the way to target a good chunk of people," says Michael R. Widner, an analyst at Stifel Nicolaus Equity Research. "The question is, do they have the capacity to handle it? If you are getting massive growth, you are probably getting a good number of the wrong people."

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