On this Veterans Day, I was reminded of the Urban Institute’s 2014 article on VA loan performance and its explanation of why VA loans outperform FHA loans.1 The article illustrated how VA loans outperformed comparable FHA loans despite controlling for key variables like FICO, income, and DTI. The article further explained the structural differences and similarities between the veterans program and FHA loans—similarities that include owner occupancy, loan size, and low down payments.
The analysis was well thought out and clearly showed how VA loans outperformed FHA. The article took great care to understand how FICOs, DTI, and income levels could impact default performance. The article further demonstrated VA outperformance wasn’t a recent or short-lived trend.
Its concluding rationale for superior performance was based on:
- VA’s residual income test
- VA’s loss mitigation efforts
- Lender’s “skin in the game”
- Lender concentration
- Military culture
Two of these reasons assume VA’s internal policies made the difference. Two of the reasons assume lenders’ ability to self-regulate credit policy or capital had an influence. The final reason centered on veterans as a social group with differing values that contributed to the difference.
As someone who has spent his mortgage career between modeling credit, counterparty risks and managing credit underwriters, the lack of good analytical data or anecdotal evidence makes it hard to see how these reasons can account for VA’s strong relative default performance versus FHA. While I understand their rationale, I don’t see how it makes for a compelling explanation.
VA Internal Policies
The residual income test is a tertiary measure used by lenders to qualify borrowers. It is used after applying the traditional MTI (mortgage payment to income) and DTI (total debt to income) ratios. The test mandates that the borrowing veteran have a minimum net income after paying all mortgage and debt payments. But as a third-level underwriting test, it is hard to see how it could be the source of so much of default performance improvement.
The same goes for VA’s loss mitigation outreach efforts. It sounds good in the press, but it is just a secondary loss mitigation effort used in conjunction with the servicer’s own loss mitigation efforts. Perhaps it is responsible for some of the incremental improvement, but it’s hard to believe it accounts for much more.
Lenders’ Ability to Self-Regulate
“Skin in the Game” attempts to explain how lenders manage their retained credit risk when the VA insurance payment is insufficient to cover all loan losses.2 The “Skin in the Game” theory holds when lenders have exposure to losses they will adjust their lending policies to reduce their risk. This translates into tighter credit policies, like floors on credit scores or ceilings on DTIs. Having worked for companies with strong credit cultures that nearly failed in the recent financial crisis, I find it hard to believe privately held mortgage bankers can manage this risk. Quite the opposite, my experience tells me: 1) lenders always underestimate their residual credit risks, and 2) pressure for volume, market share, and profits quickly overwhelm any attempts to maintain credit discipline.
The notion that lender concentration in the VA originations market somehow means that those lenders have more capital or the ability to earn more money also makes little sense. Historically, the largest source of origination revenue is the capitalized value of the MSRs created when the loan is securitized. Over the past several years Ginnie Mae MSR prices have collapsed. This severely limits the profit margins from VA loans. Trust me, the top lenders are not making it up on volume.
Effect of Military Culture on VA Loans
So, what’s left? Military culture. This I believe. And not just because it is the only reason left. As the son of a retired Army colonel and the brother of both a retired Navy captain and a retired Marine Corps lieutenant colonel, I think I understand what the military culture is.
My view of military culture isn’t that veterans are more disciplined or responsible than the rest of the American public. My view of military culture is that institutional, structural, and societal differences make the military personnel workforce different than that of the general public. How?
- Active duty military personnel are not subject to mass layoffs or reductions in force typical in the business world.
- Poor performing military personnel are typically eased out of the military and not fired. This process of “getting passed over” spans several years and not weeks or months.
- Most active duty military personnel have the flexibility to determine their exit strategy/retirement date, so they can defer when economic times are bad.
- Military personnel can retire with 50% pay of their base pay after 20 years of service.
- This pension is received immediately upon retirement and is indexed to inflation.
- A high percentage of retired military personnel re-enter the workforce and work for governmental agencies.
- Military personnel typically leave active duty with more marketable skills than their similarly educated peers.
- Active duty, retired, and former military personnel have jobs/careers/professions that are in higher demand than the rest of the American population.
- Active and retired military pay is transparent, public, and socialized. The only variables are rank and years in service. The pay schedule provides for automatic pay increases based on the number of years in service and rank. Every two years you will get a pay increase. If you get promoted, you will get a pay raise. You know how much your boss makes. Female service-members make the same pay as their male counterparts.
- Military pay is indexed to inflation.
- In addition to their base pay, all military personnel are given a tax-free monthly housing allowance which is adjusted regionally.
- All military families, active duty and retired, receive full medical care.
- This health insurance has nearly no deductible or out-of-pocket expenses.
- This means veterans don’t default due to catastrophic medical emergencies or have their credit capacity impacted by unpaid medical bills.
It is for these reasons that I believe VA borrowers default less frequently than FHA borrowers. The U.S. military is not a conscripted force, but rather an all-volunteer force. The structural programs offered by the U.S. Government provide the incentives necessary for people to remain in the military.
The Federal Government has designed a military force with low turnover and backed by an institutionalized social safety net to help recruit, retain, and reward its personnel. Lower default rates associated with the VA loan program are just the secondary benefits of a nation trying to keep its citizens safe.
So, on this Veterans Day, remember to thank a veteran for his service. But also, remember the efforts of the Federal Government to ease the difficulties of those protecting our nation.
 Housing Finance Policy Center Commentary, “VA Loans Outperform FHA Loans. Why. And What Can We Learn?”, Laura Goodman, Ellen Seidman, Jun Zhu. Urban Institute – July 16, 201
 VA insurance is a first loss guaranty like MI insurance. If the loss is greater than the insurance payment the mortgage servicer is responsible for the additional loss