Toll Brothers (TOL) Results Positive, but FHA Audit Results Loom

Last night, Toll Brothers Inc. (TOL) announced better-than-expected numbers. They signed 42% more contracts in their fiscal fourth quarter, on a year-over-year basis. This news is causing most of the housing sector to rally. TOL is up over 10%, Hovnanian Enterprises Inc. (HOV) is up 6%, and both Pulte Homes, Inc. (PHM) and Lennar Corporation (LEN) are up almost 5%.

Obviously, this helps the perception that the housing market is stabilizing, and the recovery can continue to gain traction. However, last week the Federal Housing Administration (FHA) had to delay its audit results because of questions between itself and its auditor. This is not a good sign, as far as I can tell.

Previously, I have written about issues surrounding the FHA. Unlike Fannie Mae (FNM) and Freddie Mac (FRE), the FHA has an explicit guarantee from the government. It guarantees mortgages so lenders will be more willing to accept mortgages, rather than making loans itself.

However, the FHA has some rules that may not run in parallel with best lending practices. One of the biggest problems is that people can put as little as 3.5% down. Independent mortgage brokers (yes, some of the same guys who pushed the subprime garbage) can get people into these mortgages now. Their track record speaks for itself around cutting corners to get people in the door and make a commission. With the demise of subprime lending, the FHA has gone from less than 5% of all mortgages to approaching a quarter of all new mortgages. This is a huge driver in the market now.

FHA loans appear to be defaulting at an alarming rate, which may cause the Administration to go to the Treasury to get more money to meet its capital requirement. This happens without a trip to Congress. Now the government has two choices: tighten lending standards around the FHA to get the default rate lower, or just keep it going to pump up home sales. Part of this doesn’t matter because the loans it has made over the last couple of years are out the door. New standards will not help them. Going forward, however, it would possibly slow defaults.

As always, the politicians are going to probably take the easy way out. Don’t change requirements, and pay the bailout on the back end. They are playing against the clock. If housing prices go up, then this is less of an issue. Fewer defaults will ensue if people make money selling their house. However, if the numbers get really bad, they might be forced to tighten the lending policy. That would probably stop a lot of progress in getting through unsold inventory. Not great for the homebuilders.

If you want to read more about some of the issues around FHA check out this piece from National Public Radio (NPR).