FHA Is Headed for a Taxpayer Bailout
"Is the Federal Housing Administration the next bailout?" The question has become all too common these past several months. It's also the title of a policy forum held December 13 at the free-market Cato Institute in Washington, D.C. Based on the evidence, it would be hard to avoid concluding "yes." Three speakers highly familiar with the workings of FHA - Mark Calabria, Edward Pinto and Michael Frantantoni - explained why the mortgage insurance agency is a prime candidate for a first-time-ever dose of taxpayer support. FHA, part of the U.S. Department of Housing and Urban Development, aggressively ramped up activity following the banking collapse of 2008. Accordingly, the default rate on its more than $1.15 trillion portfolio has shot up. Congress in the near future may be forced to enlist a reluctant public to cover a deficit of $50 billion or more.
National Legal and Policy Center in October and again in November covered this issue at length - and with good reason. The Federal Housing Administration, established by Congress in 1934, in theory is a self-financing entity; it generates most of its revenues through the up-front and periodic premiums it charges lenders to protect them against the risk of default. But as its mandate has expanded to reach higher-risk borrowers, it has become a fiscal liability. About one in six of the 7.6 million FHA-insured home loans in force are at least 30 days delinquent. Roughly one in 10 are at least 90 days delinquent. An independent audit of the agency's main insurance fund, the Mutual Mortgage Insurance Fund (MMIF), showed that as of September 30, 2012, the MMIF had $16.3 billion less in capital reserves than what would be necessary to meet obligations during the current fiscal year. The fund had only $30.4 billion in cash reserves compared to as $46.7 billion short-term loss. Reserves effectively are in negative territory at -1.44 percent. By law, FHA must maintain a minimum capital reserve level of 2 percent.
While these indicators don't necessarily mean FHA can't pay all lender claims over the short term, they do strongly suggest that the agency won't be able to hold out much longer on its own. The day before the audit's release, Rep. Spencer Bachus, R-Ala., chairman of the House Financial Services Committee, admitted: "They (FHA) have indicated they will have to come to the American people and ask for money." FHA Commissioner Carol Galante realizes the seriousness of the situation. "It's a tightrope," she remarked at the time. "We continue to look at that balance every day."
Mark Calabria, director of financial regulation studies at the Cato Institute, and Edward Pinto, a resident fellow at the American Enterprise Institute, has been predicting this outcome. While acknowledging that the worst-performing loans mostly date back to around a half-decade ago, when sleazy lenders used all manner of tactics to close deals with non-creditworthy borrowers, they asserted that the loans FHA has insured since that time haven't done that much better. And the agency probably will remain in harm's way in absence of dramatic steps to erase the agency's reputation as a source of easy money. The agency has experienced explosive growth since the collapse of the housing bubble of 2002-06 and now accounts for some 30 percent of all new home purchase mortgages. Risk, in other words, has been shifted to FHA, which was ill-equipped to assume it. As Pinto noted in November following the release of the audit: "(T)he FHA deliberately tried to ‘grow' its way out of trouble, essentially betting the house on housing's recovery. Friday's numbers confirm that like Fannie (Mae) and Freddie (Mac), it's easy to gamble when the taxpayer covers your losses."
Mark Calabria, the first speaker, summarized and expanded upon the findings of a Cato paper he published in February, "Fixing Mortgage Finance: What to Do with the Federal Housing Administration?" (see pdf), and explained its implications. FHA, he emphasized, during its first three decades actually geared its insurance programs toward the middle class. It was federal housing legislation in 1964 and especially 1968 that began to shift FHA's role toward reaching less financially capable homebuyers, especially blacks. The Section 235 low-income homeownership program created by the 1968 law, with its zero-down mortgages, within a half-decade led to an avalanche of urban defaults and foreclosures. Later on, inflation and risky lending practices set loose by banking deregulation of the early Eighties, led to a crisis by the end of the decade. In 1989, FHA set up an independent audit. The findings led to the creation of a minimum capital requirement of 1.25 percent, part of the Cranston-Gonzalez Affordable Housing Act of 1990. This floor eventually proved insufficient to cover claims, necessitating a further rise about a decade later to 2 percent. Apparently, even that hasn't been enough.
"The phrase, ‘FHA is the new subprime,' isn't quite accurate," said Calabria, noting that until about a decade ago most conventional subprime loans went to middle- and even upper-middle-income buyers. "But there's a strong element of truth to it." He referred to an article appearing last year in the Journal of Real Estate Finance and Economics, "FHA vs. Subprime Mortgage Originations: Is FHA the Answer to Subprime Lending," which concluded from a sample of home purchases in 2005 that a large proportion of borrowers who received subprime loans would have qualified for FHA loans as well. It is little coincidence, argued Calabria, that close to a third of all loans whose outstanding debt currently exceeds market value (known as "negative equity" or "underwater") are FHA-insured. Nor is it a coincidence that the riskiest borrowers are those defaulting with an alarming frequency. The most recent default rates by FICO score (i.e., credit rating) are: less than 500 (87 percent); 500-549 (71 percent); and 550-599 (51 percent).
FHA shouldn't have gotten involved with such borrowers, even with the political pressures to do so, said Calabria. As a result, a bailout is "almost inevitable." The issue, he said, is what kind of bailout? To mitigate its long-term effects, Calabria recommended a series of reforms. On the lender side, he recommended: reduce the maximum claim coverage on a given home loan from the present 100 percent to 80 percent and eventually 50 percent; require a lender "take back" of properties whose owners defaulted early; and bring back appraiser qualification boards, which FHA for some reason had abolished during the Nineties. On the borrower side, he called for these steps: increase minimum down payments; mandate a reasonable maximum debt-to-income ratio, preferably 31 percent; require pre-purchase counseling for borrowers with FICO scores below 680; and cease all subprime lending to borrowers with FICO scores below 600. The size of the bailout, he emphasized, would depend on factors such house price shifts, FHA capital reserves, and the stability of the agency's activity.
The next speaker, Edward Pinto, also has been a voice warning of an impending FHA implosion. Pinto is a longtime veteran of the financial services industry, having served during 1987-89 as Fannie Mae chief credit officer. At his current post of American Enterprise Institute senior fellow, he edits and authors an invaluable AEI monthly feature column, FHA Watch. Once upon a time, he noted, FHA didn't need much watching because it was run responsibly. Prior to the early 60s, in fact, its default rate was near zero. Its operations strongly resembled those of the Veterans Administration. Things have changed dramatically, and no more so than during the aftermath of the mortgage meltdown of 2007-08. At the end of 2006, noted Pinto, the total of FHA mortgage insurance in force barely stood at $300 billion. Yet for 2009 it had risen to $680 billion. And for 2010, 2011 and 2012, the respective figures were $950 billion, $1.1 trillion and $1.17 trillion. When the banks and thrifts sharply curbed conventional lending following 2008, FHA picked up the slack, raising its share of total mortgage originations from around 5 percent to 30 percent.
This has created a dangerous situation. Under Generally Accepted Accounting Principles (GAAP), said Pinto, FHA has a total net asset base of minus $47 billion, assuming the current 2 percent minimum capital requirement. And the Mutual Mortgage Insurance Fund has a long-term deficit of $77 billion. He offered a grim prognosis: "I do not expect the FHA to get back to zero until two or three years - and that's under optimal circumstances." Pinto added that a "positive subsidy" of $10 billion to $15 billion probably will be included in the Fiscal Year 2014 budget. Over the long run, the figure will be higher. If there is a mild recession, the total bailout will be around $50 billion.
Michael Frantantoni, vice president for economics and research at the Mortgage Bankers Association of America, offered an industry counterpoint. While not denying that FHA has major problems, he noted that the housing industry as a whole has been recovering beyond standard expectations. About 75 to 80 percent of all mortgages underwritten over the past several months have gone to first-time homebuyers, a sure sign of a broad-based recovery. And the federal government has been instrumental in financing it. About 40 percent of all home purchases now are financed either by FHA or VA. "Modeling the FHA future," added Frantantoni, "is more sophisticated than it looks." And looking at the details, the situation is overall more positive than is imagined, presenting overhead data for factors such as MMIF reserves, economic value under alternative scenarios, and FICO score distributions.
Officials at HUD and FHA aren't oblivious to the peril that lies ahead. Last February, HUD announced that it would phase in higher FHA premiums. "FHA will increase its annual mortgage insurance premium (MIP) by 0.10 percent for loans under $625,000 and by 0.35 percent for loans above that amount," stated the press release. "Upfront premiums (UFMIP) will also increase by 0.75 percent." Starting this July, FHA sharply boosted sales of foreclosed properties under its Distressed Asset Stabilization Program. This past November, pursuant to the release of the latest audit, FHA announced a monthly premium rate hike. And this past December FHA announced that it would tighten eligibility standards for certain homeowners and suspend its reverse-mortgage program, which allows homeowners aged 62 and older to tap their home equity for cash, in favor of a more restrictive Home Equity Conversion Mortgage Saver Program. In a letter to Sen. Bob Corker, R-Tenn., FHA Commissioner Galante assured that the changes would be implemented by the end of January.
Yet such steps, while welcome, may be too late to avert a situation in which FHA can't pay its creditors. It isn't just Calabria and Pinto sounding the warning bells. A year prior to the Cato conference, Joseph Gyourko, a professor of real estate economics at the University of Pennsylvania's Wharton School of Business, argued in a paper for the American Enterprise Institute (see pdf) that FHA would need a $50-$100 billion taxpayer bailout. This shortfall owes primarily to the rapid and highly risky growth of the agency's portfolio immediately following the mortgage industry collapse. Improvements in borrower credit scores, he said, probably won't make that much of a difference.
The good news, at least for the time being, is that the overall housing market is picking up. Last Wednesday, the Standard & Poor's/Case-Shiller 20-metro-area index showed that house prices rose by 4.3 percent in October 2012 over the previous October. Since January 2012, prices have risen 6.9 percent, the largest annual gain since 2005. Another sign of recovery is that the Dow Jones home construction price index was up more than 75 percent for 2012; Bloomfield Hills, Mich.-based nationwide homebuilder Pulte Homes Inc., in fact, led all Standard & Poor's 500 companies for 2012 with a gain of 187.8 percent. But this rebound, aside from being heavily driven by government insurance, is likely an inevitable reaction to prices hitting rock bottom and staying there for a few years. The underlying problem behind FHA's woes remains intact: an assumption that owning a home is a right and that we should marshal the nation's private and government resources to realize it. We've been finding out the hard way that this implicit social contract carries high hidden costs.