Report: Only ‘Delicate Balancing Act’ Can Manage FHA’s Risk

Research data and analysis are adding up to industry fears that the Federal Housing Administration’s sharp loan volume increase of recent years is moving the agency “into uncharted, risky territory” making it more crucial than ever for policy makers to come up with “a delicate balancing act” that would ensure the FHA “is not pushed too far.”

An FHA Assessment Report released by the George Washington University Center for Real Estate and Urban Analysis warns that since the agency continues to grow market share and switched focus from its historical goal to insure low-downpayment home mortgages for low-to-moderate and first-time buyers to higher-balance mortgages, more reforms are needed to manage growing risks.

The report notes that even though HUD secretary Shawn Donavan has stated that the agency is “committed to stepping back” and support the return of private capital to the market, “unfortunately there is no discussion” of such plan.  “In fact the current FHA program is sold as a ‘cross-subsidy’ in which better risks are overcharged to support losses elsewhere in the program both over time and within cohorts.”

What will not be easy for the FHA to pull off, according to the report, is “overcharging one line of business to subsidize another line,” which risks getting worst performing loans “as the better ones gravitate to cheaper alternatives.”

“The Role and Reform of the Federal Housing Administration in a Recovering U.S. Housing Market” report states that it is still possible to control FHA’s growth in times when “it cannot count on house price growth to bail it out.”

Co-authored by Robert Van Order and Anthony Yezer, this first in the center’s planned 2011 series recommends that the FHA revert back to its traditional role and allow the private sector to shoulder more of the risk associated with insuring larger loans.

Specifically, the report finds that the 2008 expansion of the FHA’s loan limits gives it the ability to insure nearly 90% of the available low-downpayment market. As a result, the FHA’s share of the home purchase market ballooned from more than 6% in 2007 to more than 56% in 2009. The report finds that loans valued at the highest levels—more than $350,000—perform approximately 20% worse than smaller loans that are within the historical scope of the FHA.

“Without question, FHA played a major role in keeping the housing market afloat during the economic collapse of 2008 and 2009, and we need to be careful about cutting back too rapidly,” the authors wrote. But they also warn that these large loan sizes “are unlikely in the long run to assist FHA in reaching its historical constituencies” because larger loans are likely to perform worse than the FHA’s traditional market, so the rapid increase in its market share will be even harder to manage.

Largely due to Congressional increases in loan limits the FHA’s share of the market increased from under 5% of the overall share by dollar volume of both purchase and refinance in 2007 to over 20% in recent times.

In 2006 the FHA could insure loans of up to $362,790 in the higher-cost markets. Since the credit crunch began in response to the 2008 housing crisis FHA loan limits were revised to insure loans of up to $729,750 in higher-cost markets.

What makes things worse is that Congress extended these pre-crash limits through 2011, while median home prices have significantly declined.

The report finds that 95% of both African-American and Hispanic borrowers selecting FHA mortgages had loan amounts under $300,000—meaning the increase in loan limits beats the original purpose of the FHA since loans beyond that size are not reaching minority borrowers.

Furthermore, the authors wrote, while numerous administration officials within Treasury and the Department of Housing and Urban Development “have expressed their commitment to the government allowing for the return of private capital to the market,” they have not accompanied those claims with actual suggestion or policies that would help manage FHA risk and help it return to its traditional role.

The key question, going forward, the report concludes, “Is whether the size of FHA’s market share represents sound national housing policy. Should the government provide a 100% guarantee on such a large portion of home mortgages, many of which are originated with very small downpayments, leaving the homeowner with a thin layer of equity?”

These FHA risk management concerns also bring forth another question that has been at the heart of the mortgage industry debate for years now: Is the low-downpayment mortgage good for homeowners?

The report offers several policy solutions that can help reduce the FHA’s “large and risky” market share, including reverting back to using the current area median home price, rather than the 2008 number, as the basis for its regional limits and reducing both the high- and low-end FHA loan limits.

The FHA Reform Act of 2010 proposed a number of FHA reforms designed to manage risk for FHA insured loans.

The Mortgage Insurance Premium flexibility allows FHA to adjust premiums according to increased risk, higher delinquencies and benefiting lower risk customers increasing the MI premium from 50-55bp to 85-90bp.

Also, Congress gave FHA permission to demand lenders indemnify the insurance fund against losses from substandard underwriting practices.

Other risk management improvements include the expansion of the FHA credit watch authority so lenders provide data transparency and are put on notice as their loan performance becomes accessible by the public and the media.

Since “FHA is at a critical juncture,” the report says these steps are helpful but not enough.

For example, financial reports and data from FHA’s 2008 book of business suggest that FHA “needs to earn a substantial surplus” so it can boost reserves to the congressionally mandated level of 2%, up from the 0.5% ratio it reported in fiscal year 2010.