FHA – The Next Housing Bailout

On February 29, 2102, like a perverted state-run version of Charles Dickens’ novel Oliver Twist, officials at the bankrupt government-sponsored housing enterprise (GSE) Fannie Mae, after sustaining another $24 billion in losses during the previous quarter, trundled up to the federal trough once again, bleating “May I have some more.” The GSE needed $4.6 billion.

Since they fell into the arms of the taxpayers in September of 2008, Fannie Mae and Freddie Mac have cost taxpayers $150 billion; their ultimate estimated bailout package is expected to top $259 billion. Bailing out the two GSE behemoths will cost more than the entire S & L bailout in the 1980s and 1990s.

The Congressional Budget Office (CBO), using “fair value” accounting, estimates that taxpayers will eventually be on the hook for closer to $320 billion.

CBO views the GSEs as government agencies and calculates the cost of the capital that has been pumped into them, the cost of buying shares of their stock, and the current cost of operating the entities. It is unlikely that the taxpayers will see any of the bailout money returned to the Treasury. The Federal Housing Finance Administration (FHFA) Acting Director Ed DeMarco has stated that “It ought to be clear to everyone at this point, given the (firms’) losses since being placed into conservatorship…(they) will not be able to earn their way back to a condition that allows them to emerge from conservatorship.”

While so many eyes have been understandably riveted on the mounting price tag associated with the GSEs’ bankruptcies, much less attention has been paid to the 78-year-old Federal Housing Administration (FHA). The FHA provides private lenders with a 100 percent taxpayer-backed guarantee against defaults on home mortgages that meet certain underwriting criteria, such as a minimum down payment and credit score, which had, until the mortgage crisis in 2007, meant predominantly first-time homebuyers and low- to moderate-income families who pay an insurance premium for this loan guarantee. The FHA’s under-the-radar status is going to change because it is exhibiting signs of severe financial stress which will require remediation in the very near future.

An FHA audit released on November 15, 2011 revealed that the insurance fund has a 50 percent chance of requiring a bailout in the near term. The audit exposed the fact that the fund has only $2.6 billion in cash reserves to back up $1.1 trillion in FHA-insured mortgages. The reserves were $4.7 billion in 2010. This marks the fourth year in a row that the fund has operated below its statutorily required minimum capital requirements of 2 percent. At this level, the FHA is operating with a 422:1 leverage ratio, yet FHA officials have deemed the chances of an FHA bailout slim.

However, that prediction is only as reliable as the FHA’s shaky underlying assumptions. For example, the audit estimates that housing prices will rise by 18 percent over the next several years, when most analysts expect housing prices to rise by no more than about 8 percent, if at all. Should housing prices fall short of the FHA’s predictions, the audit projects a “situation in which the current portfolio would require additional support” from the taxpayers, possibly as much as $43.2 billion.

According to American Enterprise Institute scholar Joseph Gyourko, “This combination of increasing leverage at the entity level (i.e., FHA having far less capital per dollar of insurance guarantees) and among the homeowners being insured (many with negative equity in their homes) has made FHA a very risky proposition for taxpayers, who bear the downside risk if its expansion strategy does not work out.”

Instead of protecting taxpayers and enacting policies that will take the government out of the mortgage business and allow the private sector back in, recent congressional action has only made matters more dangerous for taxpayers.

On September 30, 2011, the loan limits for Fannie and Freddie, which had been increased to a stratospheric $729,000 with the passage of the American Recovery and Reinvestment Act (stimulus), dropped back to pre-meltdown levels of $625,000. The higher GSE and FHA loan limits were originally intended to remain elevated only until the private sector was able to return to the market. Allowing them to drop back would have been a good (albeit first) step toward ditching the hybrid housing finance model that had led to the 2007 collapse.

The House of Representatives was prepared to allow the loan limits to settle back to lower levels, but under intense lobbying pressure from realtors and homebuilders, Sens. Robert Menendez (D-N.J) and Jonny Isakson (R-Ga.) tacked on an amendment to H.R. 2112, the “minibus” spending bill, that would maintain the loan levels at $729,000 for both the GSEs and the FHA mortgage insurance fund. During the conference, a deal was cut to allow the GSEs’ limits to drop, but preserved the higher limits for FHA-backed mortgages. That created a historically unprecedented differential between the two programs.

President Obama signed H.R. 2112 into law as on November 18, 2011, despite his stated goal of returning FHA to its traditional mission and reducing the government’s role in the housing market.

By establishing this differential, Congress created a financial incentive for homebuyers to drift toward the FHA. Since the FHA provides lenders with a 100 percent government guarantee against the loans that they insure and the fund is already grossly undercapitalized, lawmakers planted the seeds of the next housing bailout.

Congress then proceeded to compound its first misstep. In December 2011, when lawmakers were frantically searching for offsets to help pay for a two-month extension of the expiring payroll tax cut, they chose to increase the guarantee fees (G-fee) that Fannie Mae and Freddie Mac charge lenders.

Aside from the absurdity of increasing a tax on homeownership at a time when the home mortgage industry is still struggling and enacting a harebrained scheme of imposing the higher G-fee for 10 years to pay for two months’ worth of a payroll tax cut extension, this short-sighted gimmick will add to the complexity of Washington’s Rube Goldberg-like housing policies.

The G-fee increase creates a perverse incentive to drive homeowners to use FHA to insure their mortgages, rather than private sector mortgage insurance. The shift will also increase pressure on the already tottering FHA fund.

Starting in 2008, FHA began to aggressively expand its portfolio, attempting to “grow its way” out of its progressively more tenuous fiscal condition. This was a huge gamble; research demonstrates that the two key catalysts for home mortgage defaults are negative home equity and job loss, both of which have been prominent features of the country’s economic downturn since 2007. So, while the FHA’s market share has risen from 5 percent before the crisis to around 30 percent now, its cash on hand in case of massive defaults has not grown commensurately. Furthermore, as of October 31, 2011, at least 18 percent of all FHA loans were at least one payment behind of in foreclosure, compared with 14 percent for all loans, according to the Mortgage Bankers Association.

The FHA also has a poor track record when it comes to dealing with lending fraud. A USA Today investigation in March, 2011 determined that “the agency’s weak enforcement of its own rules put thousands of home buyers in danger of getting loans based on fraudulent records or sloppy work at a time when lending companies were pushing high-risk loans…The FHA has no reliable system for learning when one of its lenders is charged with or convicted of mortgage fraud. Since 2005, at least 13 mortgage companies continued to write FHA-insured loans after federal or state authorities brought criminal or civil mortgage-fraud cases against them.”

It took the agency six years to announce that it would begin monitoring its lenders’ default rates, then another four to implement the program, which started in 2010. Even more bizarrely, the FHA has no system for tracking whether its lenders have been charged or convicted of mortgage fraud. Only in 2009 did the FHA hire its first ever “chief risk officer,” a former Freddie Mac executive.

As happened with the GSEs, the risk factors for the FHA are piling up and the tipping point may be coming faster than officials had anticipated. President Obama’s FY 2013 budget included a request for a first-in-history $688 million infusion of taxpayer money for the FHA insurance fund. However, according to CNBC, “As part of the $25 billion attorneys general settlement with the nation’s five largest mortgage servicers over so-called, ‘robo-signing ’foreclosure paperwork fraud, and a concurrent $1 billion settlement with Bank of America/Countrywide, the FHA nets a cool $1 billion infusion into its Mutual Mortgage Insurance fund (MMI). Add to that increased insurance premiums and the fact that the FHA’s 2010/2011 book of business are performing far better than previous books, and officials at FHA say the previous OMB estimate is, ‘obsolete.’”

The FHA may have dodged a bullet in the short run, or, basing its sunny predictions on inaccurate assumptions, may be throwing up a convenient smokescreen. Regardless, Congress has created a much more dangerous environment for the FHA, once again meddled with the private mortgage business, endangered taxpayers, and made it more difficult to disentangle the federal government from the private housing market.