Housing

Five Free-Wheeling Follies of the Federal Housing Administration: What Taxpayers Need to Know

August 13, 2015 wchristian

It is very interesting how swiftly Washington can move when taxpayers aren’t “in the know.”

On January 9, 2015, the Federal Housing Administration (FHA) announced a 37 percent reduction in annual mortgage insurance premiums (down 50 basis points from 1.35 percent to .85 percent), notwithstanding the concerns expressed by members of Congress and fiscal policy experts. While the announcement of a controversial policy late on a Friday afternoon was not unusual for a federal agency, the length of time to consider and reveal the change in premiums was out of the ordinary. Since 2010, the average time from announcement to implementation of changes in FHA premiums was almost 48 business days, but in this instance, the change was effectuated in only nine business days.

Following the announcement, the House Financial Services Committee held hearings on February 11 and February 26. When he testified before the latter hearing, former Congressional Budget Office (CBO) Director Douglas Holtz-Eakin made three points to underscore the folly of FHA’s dark-of-the-night decision.

First, FHA’s premium reduction threatens “ongoing efforts to limit the government’s footprint in housing finance.” Second, it jeopardizes the solvency of the Mutual Mortgage Insurance (MMI) Fund, which is far below its statutory requirement of having a minimum 2 percent of capital reserves. And finally, “the decision to prematurely reduce premiums only underscores the long overdue need to simultaneously reform FHA and address damaging weaknesses in the U.S. housing finance system.”

FHA was created in 1934, against the backdrop of the Great Depression banking crisis (exacerbated by job losses and ensuing home foreclosures), to provide greater access to homeownership for those low- and moderate-income borrowers who were unable to obtain loans via the conventional market. These new lending practices regulated the rate of interest and the terms of FHA-insured mortgages, increasing the number of qualified borrowers and helping to restore the devastated housing market. But now, with its higher loan limits geared toward the wealthiest of homebuyers, the FHA has strayed far beyond its original mission. Indeed, FHA is causing market distortions by undercutting private capital and offering premiums lower than conventional lenders. Moreover, as its lower costs also entice less qualified borrowers into the mix, FHA creates even greater risk for the government, with the unwitting backing of taxpayer resources needed to backstop the agency’s 100 percent guarantee against any loan defaults.

The results of this farce can be summed up in the following five follies of a free-wheeling FHA that wastes money and pulls mortgages out of the private market.

FHA does not have to meet the same capital and reserve requirements, nor safety and soundness requirements, as its private sector competitors in the marketplace. The backing of the government allows FHA to price products much more cheaply (and with drastically less cushion to absorb losses) than the private sector. The January 2015 premium reduction is even less actuarially sound, as it prolongs further the date by which the MMI Fund will reach its 2 percent minimal level of reserves. Not only has FHA historically overestimated its reserve projections, the lower premiums will result in even less revenues accruing to the fund. Sure, the FHA can steal market share from the private sector, but almost non-existent reserves increase the risk of a taxpayer bailout in the event of another housing downturn.
The FHA has set its loan limits at levels equal to (or in some cases above) the loan limit for conventional mortgages. This means the full benefit of FHA’s 100 percent guarantee and its government-subsidized fees are all available to the wealthiest borrowers in America (not just low- to moderate-income families), as it takes income in the top tier to afford the top available mortgage of $625,000.
The FHA is allowed to use looser, more liberal rules to approve mortgage loans than the private sector. The Consumer Financial Protection Bureau (“CFPB”) established the Ability-to-Repay Rule for Conventional Mortgages, but left FHA with the discretion to write its own definition. The FHA rule allows the lender to use personal judgment (within some loosely defined recommendations) in determining if a consumer should be authorized to take on debt relative to income in excess of 43 percent, in addition to other loosening of risk factors. The private market has no such permission. This is a key issue because loans meeting the definition of “ability to repay” are granted a “safe harbor” limiting their extended liability. If the FHA’s “ability to replay” definition is more liberal than conventional loans, lenders are going to direct more loans to the broader definition provided only by FHA in order to reduce their liability.
The FHA has provided nearly every mortgage lender “delegated approval” to make the determination as to whether FHA should insure the loan. This relinquishment of oversight effectively puts the checkbook of America in each lender’s back pocket. With private capital taking credit risk on loans with less than a 20 percent down payment, there is a second set of eyes. Private mortgage insurers review the borrowers’ capability to repay the loan and must render approval of the borrower before the loan is insured. Not so with FHA: the loan is insured with no questions asked.
All FHA loans are assumable. As interest rates go up, FHA mortgages become more valuable to borrowers and new buyers because they can pay today’s 4 percent interest rates when the prevailing rates are likely much higher. It’s like handing the recipients a check with their loan. At the same time, the federal government doesn’t know what credit risk is presented by the person assuming the loan. As long as FHA loans are assumable, FHA has future credit risk that has not been factored into its risk models. Furthermore, borrowers can exercise this option free of charge. Therefore, FHA premiums should not be lowered (already an enticement for riskier borrowers) and should be retained for the life of the loan. Again, these premiums are “insurance” against possible default (with taxpayers on the hook), and with unknown risks associated with those assuming the loans, taxpayers deserve to have this insurance in place for as long as they are the guarantors.

FHA reform must be undertaken to reduce the role of the federal government in the mortgage market, increase the role of private sector capital, and prevent future taxpayer bailouts. This means scaling back FHA to its traditional role of supporting underserved borrowers, while discontinuing housing policies and practices that provide a competitive advantage to FHA over private mortgage insurance.

Usually, taxpayers are not hurt by what they don’t know. But any time the federal government tries to undercut the private sector, everyone should know better. So, consider this article as the “need to know.”

We recommend a handful of reforms that would put FHA back on a prudent path. First, restore FHA’s historical loan limits: although Congress allowed FHA to radically increase their loan limits to be equivalent to Fannie Mae and Freddie Mac levels (roughly $625,000 in high-cost areas), Congress should use the historical calculation established in 1998, while loan limits should be based on the median price for that area for the preceding calendar year.

Restore Historical FHA Loan Limits

Congress gave FHA the authority to radically increase their loan limits to be equivalent to the GSE loan limit (roughly $625,000 in high-cost areas). This policy is driving business toward the FHA and away from the private MI industry, which is ready, willing, and able to insure many of these mortgages. Congress should calculate FHA’s loan limits according to the historical calculation (established in Pub. Law No. 105-276 in 1998). Additionally, the loan limits should be based on the median home price for that area for the preceding calendar year. Doing so would also scale back FHA’s market share, reduce taxpayer exposure, improve FHA’s financial condition, and refocus FHA on its historical mission.

Limit FHA Eligibility to Low- and Moderate-Income, First-Time Borrowers

FHA should explicitly limit its insurance to first-time home buyers. Further, FHA should only insure loans for borrowers who make less than 100% or 115% of the median household income in their area. Today, FHA’s taxpayer subsidy is being used to benefit a substantial number of borrowers who already own a home and are making well over the median income in their area. These changes would ensure that FHA’s limited resources are only used to insure loans for those borrowers who are unable to access financing in the conventional market, thereby returning FHA to its historical mission, while enabling private mortgage insurers to serve their historical share of the low down payment market.

Qualified Mortgage Symmetry or Manual Underwriting

Require the CFPB and the FHA to have identical qualified mortgage standards. This means that the CFPB rule should permit loans that exceed the 43% debt-to-income ratio if the borrower has compensating factors (as defined by the FHA). For FHA loans that exceed the 43% debt-to-income standards, the loans should be manually underwritten by the FHA (e.g., the FHA Home Ownership Centers) rather than by lenders.

Reduce the FHA’s Guarantee Below Its Current 100% Level

Congress should reduce the FHA’s guarantee below its current 100% level. An essential feature of mortgage insurance that is lacking in the FHA is the concept of coinsurance on the part of all parties to the transaction. For private MI, coinsurance means that the private MI stands in the first position of loss behind the borrower’s equity and is generally 25–35% of the loan amount, which covers most (but not necessarily all) of the losses that the parties to the transaction experience. This serves as an important incentive to avoid foreclosure. FHA, on the other hand, insures 100% of the loan amount if the loan goes into foreclosure so that the loan originator lacks any meaningful risk of loss. As a result, the FHA guarantee does not properly align incentives between originators, borrowers, and the FHA. Reducing the 100% coverage will provide lenders with an incentive not to foreclose, push for additional refinancing, and even conduct more prudent underwriting when originating a loan.

Establish Reasonable FHA Premiums

FHA should (1) increase its annual premium by 50 basis points immediately for the most creditworthy borrowers who would be better served by private MI, and (2) increase its annual premium by 10 basis points every 6 months until it reaches its statutorily required 2% capitol ratio. Doing so would scale back FHA’s market share, reduce taxpayer exposure, improve its financial condition, and refocus FHA on its historical mission.

Risk Sharing

Authorize risk-sharing between private mortgage insurers and FHA. This will introduce private-sector discipline to FHA underwriting and reduce taxpayers’ exposure to losses.

Tethered Analytics

FHA and GSEs use different numbers when calculating home price appreciation, which allows them to draw different conclusions about how to price future risk and the fees associated with that insurance. The calculations should be the same in order to avoid incongruous pricing policies between the GSEs and the FHA.

Compulsory Housing Counseling

FHA should require all of its borrowers to undergo housing counseling prior to endorsing the mortgage for insurance. By teaching consumers basic principles of home ownership and money management, homeowners will learn to increase strategies to increase their savings and the responsibilities of homeownership, which ultimately reduces the risk to the taxpayers

According to Dr. Holtz-Eakin, “this decision directly affects FHA’s fiscal outlook in these ways:”

Lower prices mean less revenue.
Delay reaching the congressional mandate (2 percent).
More refinancing.
Added risk.
Pushes out private capital.

On February 11, 2015, the House Financial Services Committee held a hearing, “The Future of Housing in America: Oversight of the Federal Housing Administration,” with Housing and Urban Development (HUD) Secretary Julian Castro as the only witness.

In his opening statement, Committee Chairman Jeb Hensarling (R-Texas) focused on the solvency of the Federal Housing Administration’s (FHA) Mutual Mortgage Insurance (MMI) Fund and pointed out that FHA was operating in violation of the law by not maintaining 2 percent capital and (by reducing premiums) further delaying the time it could meet that requirement. Housing and Insurance Subcommittee Chairman Blaine Luetkemeyer (R-Mo.) said that if FHA was a bank or a private mortgage insurer, its regulator would have shut it down due to undercapitalization.

Committee members also expressed strong concerns that when FHA lowered mortgage interest rates on January 26, 2015 by 50 basis points, or 37 percent, from 135 basis points to 85 basis points, the agency was further undercutting private-sector providers and taking over greater market share at the same time that it is out of compliance with federal law. On top of the agency’s loose underwriting standards and high loan limits, the lower rates will add to the pressure on the FHA to reach its statutory capitalization requirements and put taxpayers at greater risk.

In his testimony, Secretary Castro cited FHA’s history of serving the interests of “folks of modest means.” Yet FHA covers mortgages of up to $625,500, thanks to an unwise decision by Congress to permit such limits for so-called “high cost” areas, which means that borrowers could use FHA-backed loans to purchase million-dollar homes.

It is ironic that on the same day Secretary Castro testified about how the FHA is doing such a great job, the agency was once again included on the Government Accountability Office’s [GAO] High Risk List due to the agency’s “substantial growth in its insurance portfolio and significant financial difficulties.” The secretary struggled to deliver basic information about the FHA’s trillion-dollar loan portfolio when asked by members of the committee, and several times shied away from verbally confirming the well-established fact that taxpayers are the explicit backers of its loan portfolio.

In its six years in office, the Obama administration has failed to unwind government involvement in Fannie Mae and Freddie Mac, the two housing government-sponsored enterprises (GSEs) whose risky business practices dragged the housing market and ultimately the whole economy into a deep recession. The GSEs have been under federal conservatorship since September, 2008 and were only implicitly backed by the taxpayers at the time of their implosion. Nonetheless, the administration continues to expand risk at FHA, which is explicitly backed by the taxpayers.

The GAO report noted that “FHA’s Mutual Mortgage Insurance (MMI) Fund has been out of compliance with its statutory 2-percent capital requirement since fiscal year 2009. Additionally, a weakening in the projected performance of FHA-insured mortgages led to FHA receiving $1.68 billion from the Treasury at the end of fiscal year 2013, to ensure that the MMI Fund had sufficient funds to pay for all expected future losses on existing insurance obligations.”

Through its reckless policies, FHA remains at risk of further bailouts. Indeed, the $1.68 billion cash infusion overstates the FHA’s financial position.

Several Republicans also raised the concern that FHA and the Consumer Financial Protection Bureau (CFPB) use a different definition of a qualified mortgage and that the resulting discrepancy provides FHA with an advantage over its private sector counterparts. In addition, FHA and the GSEs use different numbers to calculate the appreciation of home prices, which results in dissimilar assumptions about pricing future risk and the fees associated with mortgage insurance. The definitions should be the same for FHA and CFPB and the calculations should be the same for the GSEs and FHA.

Finally, Subcommittee on Capital Markets and Government-Sponsored Enterprises Chairman Scott Garrett (R-N.J.) said that FHA engages in predatory lending by using gimmicky premium fees, accepting lowered credit scores and lower down payments, and inadequately pricing for those risks. He also asserted that FHA is enticing borrowers to use FHA mortgages rather than private-sector mortgages with promises of savings of $900 annually, or about $75 per month.

The committee’s hearing confirmed what Citizens Against Government Waste has been saying: FHA’s misguided policies have strayed above and beyond its original mission to provide access to only those low- and moderate-income borrowers unable to obtain conventional loans. The agency is placing taxpayers at higher risk of future (and bigger) bailouts, while discouraging participation by the private sector. FHA does not have to meet the same capital and reserve requirements, nor safety and soundness requirements, as their private sector competitors in the marketplace. This allows FHA to price their products much more cheaply (and with less cushion to absorb losses) than the private sector. This pricing advantage is exacerbated by actuarially unsound practices that even further reduced FHA prices in January 2015.

Congress and the administration should be working tirelessly to get the federal government out of the mortgage business, starting with bringing FHA loan limits down dramatically and requiring the agency to price its loans based upon actual risk. The agency has already come hat in hand to taxpayers to cover its losses and even under the agency’s rosiest economic predictions, it won’t meet the 2 percent statutory capital requirements until 2016.

The FHA should also be required to limit its insurance to first-time home buyers who make less than 100 percent or 115 percent of the local median household income. That would get FHA out of the business of helping a substantial number of borrowers who already own a home and are making well over the median income in their area. FHA could then be in a better position to fulfill its original mission and enable the private sector to serve its historical share of the low down payment market.

EXCESS NOTES INCLUDED HERE (EXCLUDED FROM ABOVE FOR BREVITY)

FHA used to serve the housing finance system by providing access to homeownership to only those low-and moderate-income borrowers who were unable to obtain loans via the conventional market. Not anymore. By 2015, this Administration has allowed FHA to totally abandon its original mission and cause market distortions that put private capital in the backseat and allow the government to take on even greater risk with taxpayer resources.

HA has set its loan limits at levels equal to (or in some cases ABOVE) the loan limit for conventional mortgages. This means the full benefit of the 100% guarantee and its government-subsidized fees are all available to the wealthiest borrowers in America, as it takes income in the top tier of America to afford a mortgage of about $625,000.

The Consumer Financial Protection Bureau (“CFPB”) established the Ability-to-Repay Rule for Conventional Mortgages, but left to the discretion of the FHA the ability for them to write their own definition—which the FHA did. The FHA rule allows lender to use personal judgment (within some loosely defined recommendations) in determining if a consumer should be authorized to take on debt relative to their income in excess of 43%, in addition to other loosening of risk factors. The private market has no such permission.

This is a key issue because loans meeting the definition of “Ability to Repay” are granted a “safe harbor” limiting their extended liability. If the FHA definition of Ability to Repay is more liberal than Conventional loans, lenders are going to direct more loans to the more broad/liberal definition (provided by FHA) in order to reduce their liability.

Fully Delegated Underwriting:

FHA has provided nearly every mortgage lender “Delegated Approval” to make the determination as to whether the FHA should insure the loan, no questions asked. This relinquishment of oversight effectively puts the checkbook of America in each of these lenders back pocket. The FHA has guaranteed the lenders that the FHA WILL insure the loan—no questions asked.

With private capital taking credit risk on loans with less than a 20% down payment, there is a second set of eyes. Private mortgage insurers review the borrowers’ capability to repay the loan and must render approval of the borrower before the loan is insured.

Loan Assumption:

Most people do not know that all FHA loans are assumable. This means that as interest rates go up in the future, FHA mortgages become more valuable to borrowers and new buyers because they can pay today’s 4% interest rates when the prevailing rates are likely much higher. It’s like handing the recipients a check with their loan. At the same time, the Government doesn’t know what credit risk is presented by the person assuming the loan. As long as FHA loans are assumable, the FHA has future credit risk that they have not factored into their risk models. Furthermore, they allow borrowers to exercise this option free of charge. As a result, FHA premiums should NOT be lowered and should be retained for the life of the loan.

CAGW supports FHA reforms that would reduce the federal government’s role in the mortgage market, increase the role of private sector capital, and prevent future taxpayer bailouts. This will require returning FHA to its traditional role of supporting underserved borrowers, as well as discontinuing policies that provide FHA a competitive advantage over private mortgage insurance (PMI).

Congress gave FHA the authority to radically increase their loan limits to be equivalent to the GSE loan limit (roughly $625,000 in high-cost areas). This policy is driving business toward the FHA and away from the PMI industry, which can and will insure many of these mortgages. Congress should calculate FHA’s loan limits according to the historical calculation (established in Pub. Law No. 105-276 in 1998). Additionally, the loan limits should be based on the median home price for that area for the preceding calendar year. Doing so would also scale back FHA’s market share, reduce taxpayer exposure, improve FHA’s financial condition, and refocus FHA on its historical mission.

In keeping with its originally intended role, FHA should explicitly limit its insurance to first-time home buyers. Further, FHA should only insure loans for borrowers who make less than 100% or 115% of the median household income in their area. Today, FHA’s taxpayer subsidy is being used to benefit a substantial number of borrowers who already own a home and are making well over the median income in their area. These changes would ensure that FHA’s limited resources are only used to insure loans for those borrowers who are unable to access financing in the conventional market, thereby returning FHA to its historical mission, while enabling PMI to serve its historical share of the low down payment market.

Congress should reduce the FHA’s guarantee below its current 100% level. An essential feature of mortgage insurance that is lacking in the FHA is the concept of coinsurance on the part of all parties to the transaction. For PMI, coinsurance means that PMI stands in the first position of loss behind the borrower’s equity and is generally 25–35% of the loan amount, which covers most (but not necessarily all) of the losses that the parties to the transaction experience. This serves as an important incentive to avoid foreclosure. FHA, on the other hand, insures 100% of the loan amount if the loan goes into foreclosure so that the loan originator lacks any meaningful risk of loss. As a result, the FHA guarantee does not properly align incentives between originators, borrowers, and the FHA. Reducing the 100% coverage will provide lenders with an incentive not to foreclose, push for additional refinancing, and even conduct more prudent underwriting when originating a loan.

FHA should (1) increase its annual premium by 50 basis points immediately for the most creditworthy borrowers who would be better served by private MI, and (2) increase its annual premium by 10 basis points every 6 months until it reaches its statutorily required 2% capital ratio. Doing so would scale back FHA’s market share, reduce taxpayer exposure, improve its financial condition, and refocus FHA on its historical mission.

Authorize risk-sharing between PMI and FHA. This will introduce private-sector discipline to FHA underwriting and reduce taxpayers’ exposure to losses.