The FHA Is Toast
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Yesterday, the Federal Housing Administration (FHA) released its widely anticipated annual report to Congress. The FHA is a government-owned mortgage insurance agency that guarantees the principal payment on mortgage loans extended by FHA-approved lenders. For over a year, observers have worried about the explosive growth in the FHA’s guaranteed loan portfolio. As delinquencies in other mortgage products have climbed, observers in recent months have warned of the FHA’s potential collapse due to its low capital reserves and the riskier profile of its borrowers. Yesterday’s release did nothing to downplay those fears: the FHA reported that its capital reserves fell to 0.53% of its total insurance-in-force. This means that the FHA is $10.05 billion below the minimum capital reserve threshold mandated by Congress in the National Affordable Housing Act (NAHA).
The FHA is a $700 billion financial behemoth that’s leveraged 188-to-1. If FHA so much as slips on a banana peel from this point forward, its losses are going to exceed its reserves several times over. According to Table 3 of the report, 17.71% of the FHA’s single family loans are delinquent by 30 days or more. If these loans experience 30% losses – below the 50% losses currently encountered on defaulted 2007 and 2008 vintage loans – the FHA would need a taxpayer bailout of more than $30 billion. And this assumes there are no further delinquencies.
Luckily, the FHA report explains that “just-completed actuarial studies show that FHA’s capital reserve ratio will not dip below zero under most of the economic scenarios considered” (emphasis added). Rather than reassure skeptics that its $3.6 billion in net capital reserves are sufficient to meet future losses, this admission likely means that “most” of the scenarios considered were insufficiently stressful. In June, Housing and Urban Development (HUD) Secretary Sean Donovan said "there's a better than even chance that we will stay above the two percent reserve threshold.” The FHA finished 2008 with a capital reserve ratio of 3.22%, meaning that Donovan believed there was a better than 50% chance that the expected losses on the portfolio would be $8.353 billion or less. Just three months later, we’re told expected losses are over $27 billion, or more than 3-times Donovan’s implied forecast.
It would be easier for deficit hawks to accept this unnerving report were FHA’s financial problems not so predictable. According to Table 9 of the report, over 85% of the home purchase loans the FHA has guaranteed during the Obama Administration have down payments of less than 5% of the property value. With the average real estate commission running at 6% of the sales price, the net cash generated by the sale of the house would be insufficient to cover the outstanding principal balance on the FHA-insured mortgage. If the price of the house declines, then the borrower has an even greater incentive to default in the event of job loss or divorce since it would be the only way to avoid owing thousands of dollars on top of whatever money could be gained from selling the property.
In September, the Obama-appointed head of the FHA said that “it isn’t the down payment on its own that causes a default.” Of course that’s true, but Tables 2a and b of the report demonstrate that FHA borrowers are already higher risk and the down payment is all that’s left to protect FHA in the event that something else happens. It was not the leverage ratio of Lehman Brothers “on its own” that caused the investment bank to file for bankruptcy, but its losses would have been far more manageable had the firm had a greater “down payment” on its assets in the form of more equity capital.
Life is full of instances where one reflects on past mistakes, wishing he had “known then what he knows now.” The crisis of 2008 taught the incoming Obama Administration everything it could possibly have learned about the impact of household leverage on mortgage default and loss rates. Yet, upon assuming the reins of government, the volume of FHA mortgage guarantees increased by 75% (Table 1), and its FHA Director downplays low down payments’ contribution to defaults. Let us just hope that this episode is not emblematic of the Administration’s overall ability to adjust its policy stance to new information.