The Future of FHA

The Federal Housing Administration was created in the dark years of the Great Depression to help bring financial stability to a battered housing market. Remember that the unemployment rate was 25 percent back then. There was obviously a foreclosure problem then too, although only 33 percent of families owned their own homes to begin with.

The FHA has been insuring loans ever since. The insurance program operates like any other insurance program. Money from policyholders – borrowers – goes into a fund that is used to absorb losses in the event of future foreclosure. For over 70 years, the FHA insurance fund has remained solvent. That being said, the fund has never been faced with a period of significant decline in housing values like we have today.

The impact of FHA loans on the market has varied over the years. Speaking from the perspective of a loan originator, it was never a big part of my market in Southern California because the maximum loan amount was well under what borrowers required given the higher home values here. I understand that in 2005, only about 4,000 FHA loans were done in all of California, a miniscule share of market.

As part of the stimulus programs, the FHA loan limits for 2008 were increased to the same levels as Fannie Mae and Freddie Mac, $417,000 for most areas but as much as $729,750 in high cost areas like Los Angeles. At the same time, the Private Mortgage Insurance companies that insure loans over 80 percent loan-to-value were getting more risk averse, and they refused to write insurance on loans over 90 percent LTV in California and other high-risk areas. 

This change in the loan limit and the loss of significant competition meant that the FHA loan volume almost tripled from 400,000 loans per year to about 1.8 million in the last fiscal year. Borrowers who hadn’t accumulated much of a down payment were shut out of every other kind of loan other than an FHA loan.

In fact, the increase in loans was so significant that the loans originated in the last fiscal year amount to some 40 percent of the total FHA portfolio. Add in the increased volume in 2008 and you have to conclude that of the total FHA portfolio, about 75 percent was originated in the last two years. Only 25 percent of the portfolio consists of loans originated in prior years.

You can conclude from this statistic that the expansion of FHA during this financial crisis has really had an impact on the market when it needed it the most.

Forgetting the economic crisis for a moment, from a purely business risk standpoint, let’s consider the wisdom of these actions. Borrowers can get an FHA loan with only a 3.5 percent down payment. The initial insurance premium of 1.75 percent is “financed,” meaning it is added on to the loan balance, not paid in cash. That means that the loan is really at about 98 percent LTV. You can see that these are really risky loans.

Then you have to add into this mix the stated goals of all of the government-related entities to “serve” low- and moderate-income borrowers. This may be a worthy objective from the standpoint of long-range national policy, but it sure doesn’t look like a very sound policy during a period of economic instability when unemployment is likely to dramatically increase. It’s a fair assumption that lower-income citizens are more likely to be negatively affected in times like these. 

In a declining market, such borrowers become even more risky. After all, there just isn’t much equity to absorb a loss. The market drops 2 percent, and already the borrowers are “under water”, meaning they owe more on their homes than it is worth. But here was FHA raising its loan limits, dramatically increasing its volume, and increasing it emphasis on serving lower income borrowers. This is exactly the opposite strategy that a “smart businessman” would adopt.

So how is it working out?

According to the latest data from HUD, the results are mixed. From an historical perspective, a default rate of 2 or 3 percent was normal. On the basis of their history, FHA had created reserves for future losses of about 14 billion, about 3 percent of the portfolio. In addition, they maintain another reserve account called the Capital Reserve Account that is supposed to equal 2 percent of the portfolio. Combined, that is about 5 percent of the portfolio. That was at the end of last year. All well and good, but it gets more complicated.

Remember that there are 30 years’ worth of loans in the FHA portfolio. Many of these loans issued years ago are at a small fraction of the value of the home and are thus not likely to be a problem. What should concern us is the performance of loans that were recently issued, the ones with the least equity, those issued in the last five years when we have been in a rocky housing market.
 
As we get into the years when the housing values started dropping, it gets worse. For loans issued five years ago, in 2004, the default rate is about 10 percent, a lot worse then the average. For loans originated in 2005, the default rate is about 20 percent. Even worse, loans originated in 2006 show a default rate of an astounding 30 percent, with 2007 loans even a little worse.

If there is good news here, it is that those were low-volume years, so a 20 percent default rate in those years would not be as bad as a similar default rate in 2008 or 2009 when the volume was higher.

In fact, loans originated in 2008 have only had an average of 18 months to become problematic, but already the default rate on those loans is 20 percent. And remember that the 20 percent default rate is on a volume that is about three times as great as the previous historic volume.

When you get further into the data, you find that virtually all of the problems in 2008 loans were from the program called the “Seller Financed Down Payment Assistance Loans.” In fact, the problem loans in this category alone are responsible for an estimated $10 billion in losses, almost 40 percent of the FHA’s total loss reserves. That program has been terminated, but it does show the perils of tweaking a program for political purposes and having it rack up $10 billion in projected losses in a short twelve months. No one has heard a word about this disaster until now.

We heard stories in the industry that it was really hard to get turned down for an FHA loan during that period. To me, that suggested very loose underwriting standards, and the performance numbers proved it. So what about the 2009 loans?

In a press conference, HUD Secretary Shaun Donovan told of the difference between 2008 and 2009. Wiser people prevailed, and in 2009 the average FICO scores are higher and the qualifying ratios are lower, both indicative of higher loan quality. I hope that the auditors are right and that they have accurately predicted the losses that might occur during various economic scenarios going forward. 

This may be the skeptic in me, but I hope that the insiders don’t know something else that they’re not telling us. Remember that something like 75 percent of the portfolio was created in these last two years. The performance of the 2008 loans is not good, and we will not know about the performance of the 2009 loans for a year or two. If the experts are wrong, these statistics demonstrate the possibility of a disaster the size of the subprime fiasco, where more than 25 percent of the loans went into foreclosure. And now we have the taxpayer on the hook for losses in this sector. 

Unfortunately, the government is running this whole industry, and that means that decisions are being made with political considerations, not purely business considerations. Although FHA’s Capital Reserve Account has dropped below the 2 percent standard, Secretary Donovan says that a bailout of FHA will not be necessary. We’ll see.

For those who wish to see the data presented at the press conference, check out the FHA Fiscal Year 2009 Actuarial Review Briefing.