In mid-November the Federal Housing Administration (FHA) announced that its Mutual Mortgage Insurance Fund (MMI) had returned to solvency. The fund, damaged by the collapse in housing prices and skyrocketing delinquencies caused by a number of factors, had fallen below the Congressional mandated requirement that it maintain capital reserves representing 2 percent of its outstanding mortgage guarantees.
In a previous article, we noted "The Department of Housing and Urban Development (HUD) said on Monday that the Fund has gained nearly $6 billion in value over the last year and now stands at $4.8 billion with a capital ratio of .41 percent. One year ago that ratio was a negative .11 percent." The funds recovery meant that, while it was still a ways from its required position, it no longer needed to seek funds from the U.S. Treasury as had been expected.
Still, the 2014 annual actuarial report upon which HUD's announcement had been based was less favorable than the report a year earlier, which had projected a return to the required reserves by 2015. The new report pushed that date back to 2016.
Almost three months later three researchers, writing in the Urban Institute's Metro Trends blog questions why, if the fund is so improved, "its insurance premiums remain at record high levels." The three, Laurie Goodman and Bing Bai and Jun Zhu contend, in the words of the article's title, (It's) "Time to stop overcharging today's borrowers for yesterday's mistakes."
Their analysis, they say, indicates that FHA could significantly lower its premiums, charging a more appropriate fee for risk, while continuing to build the necessary reserves against losses. The current high premiums penalize current borrowers for the pricing and performance of earlier loans and for problems experienced in the so-called reverse mortgage program. These are the primary causes of FHA's ongoing inability to reach the 2 percent reserve ratio, not any deficit in the current loan vintages.
FHA was designed to be self-funding through premiums paid by mortgage borrowers into the MMI in return for the agencies guarantee of their loans. The fund ideally will be sufficient to cover losses in the event of borrower defaults. During the housing collapse and subsequent recession projected claims against the fund began to outstrip its projected revenue so FHA took steps to tighten its standards for guaranteeing loans and raised its fees.
Goodman, Bai and Zhu said their analysis of the 2014 Actuarial Report concludes that MMI's failure to keep to the 2013 projections was driven by "negative revisions to the economic value of the Home Equity Conversion Mortgage (HECM) book, poor performance of loans made before and during the financial crisis, and a shortfall in revenues driven in part by today's higher premiums."
There is, however the question of whether, in a business which continues to improve but at a slower rate than expected, the agency can afford to lower its premiums even if this would expand access to credit and avoid in part an adverse selection problem wherein borrowers with higher credit scores avoid the high costs of FHA mortgages. The researchers analyzed the credit mix of FHA's current and its desired books of business in an attempt to answer that question.
The research looked at 90 day delinquency rates under a normal scenario, using the 2001-2002 default rate, and a stressed economic scenario based on defaults in 2005 and 2006. Defaults in the former period resulted in a 50 percent severity loss by the FHA and the latter in a 65 percent loss. This severity number are high and consistent with those reported by the agency but do not mean that all loans that become that delinquent will result in a claim against the fund.
Based on its current mix of FHA's business, losses during normal periods would be 3.8 percent and 13.8 percent during periods of stress. Given the last 100 years of economic history the study assumes a 0.9 normal to stress ratio leading to expected losses of 4.83 percent.
The analysis further assumes that, over a weighted-average time to repay of six years FHA would collect 1.75 percent in an upfront premium and 8.1 percent in annual premiums or 9.85 percent against the 4.83 percent losses; an expected profit of 5 percent. If FHA were to insure $135 billion in loans in 2015 as it did in 2014 this would lead to a profit of $6.8 billion.
FHA's median FICO score at origination climbed from around 645 in 2007 to about 700 in 2007 and is now at 684. FHA has indicated it wishes to move its book of business somewhat lower, to include more 620-680 FICO borrowers and fewer with scores over 680. This would raise the losses to 5.6 percent resulting in a profit of $5.7 billion.
If the FHA's ultimate goal is to break even each year, there is room for a significant cut in premiums. Even if it takes on a greater number of higher risk borrowers and thus higher losses it could cut annual premiums in half, to 0.65 percent, and still break even. This without even considering the lure of lower premiums for higher credit score borrowers.
With the affordability of lower premiums confirmed, the researchers ask to what extent and how quickly new borrowers should be required to pay for the performance of older vintage loans and for the deficit in the HECM reverse mortgage business. The MMI fund now stands at $4.8 billion where it is mandated to be at $23 billion. They note that maintaining the higher premiums dissuades many potential higher credit borrowers from taking FHA loans, leading to less revenue and a more costly credit mix.
They recommend making up the shortfall more slowly, pricing new business more appropriately for the risk. "If the FHA lowered the annual premium on the 2015 book to 0.9 percent, it would make $2.0-$3.1 billion, depending on the loan mix. While that may not be the right number, we believe the wisest course of action is some reduction in the insurance premium, with the exact amount depending on the FHA's own internal estimates and policy preferences."
They conclude that netting $2 to $3 billion this year, rather than the $5.7 to $6.8 billion it might make on its current path, depending on how quickly its desired business mix is achieved, is a more appropriate pace that won't overcharge new borrowers to make up for undercharging in the past.
