According to the American Enterprise Institute, the Federal Housing Administration (FHA is engaging in practices that are resulting in a high proportion of low and moderate-income families losing their homes.  The conservative think-tank just released a paper titled How the FHA Hurts Working Families, by Steven J. Pinter.  He looks at FHFA's 21009 and 2010 books of business and concludes that the agency's lending practices violate its own mission to be a targeted provider of mortgage credit for low-and moderate-income Americans and first-time home buyers and instead is providing a disservice to that very group of Americans.

Pinter says the mission must be balanced by asking "what is the tolerance for failure?"  All lending entails risk but when does lending become abusive because the direct and indirect costs associated with a high foreclosure rate are unacceptably high for FHA borrowers and the affected community?

The findings of this study indicate:

• An estimated 40 percent of the FHA's business consists of loans with either one or two subprime attributes-a FICO score below 660 or a debt ratio greater than or equal to 50 percent (based on loans insured during FY 2012).
• The FHA's underwriting policies encourage low- and moderate-income families with low credit scores or high debt burdens to make risky financing decisions- one combining one or both a low credit score or a high debt ratio with a 30-year loan term and a low down payment.
• A substantial portion of these loans have an expected failure rate exceeding 10 percent and once that rate exceeds 10 percent, the resulting direct and indirect costs to low- and moderate-income families and communities are a disservice to the very families and communities FHA is intended to help.

Pinter said the FHA, founded during the Great Depression, established a standard of insuring fully amortizing 20-year mortgages with minimum 20 percent down payments; a standard which continued into the mid-1950s.  As a result homeowners accumulated nearly 30 percent in earned equity in four years and debt to income ratios averaged 15/19.5 percent helping to cushion adverse income shocks.  Over its first 20 years, FHA paid only 5,712 claims out of 2.9 million insured mortgages.

The FHA began to abandon these lending principles in the late 1950s Pinter said and become "the leverage leader, spurring the housing finance industry and borrowers to multiple forms of increasing leverage."

Borrower leverage takes six forms, and the FHA has promoted the simultaneous and excessive use of each, particularly with respect to low- and moderate-income families and communities.

• Assets are leveraged in two ways; by lowering the down payment and increasing the loan period
• Income is leveraged by increasing the debt-to-income ratio and, increasing the loan term. While the Federal Reserve is responsible for lowering interest rates, FHA's underwriting policies turn low rates into increased buyer leverage.
• Credit is leveraged by lowering the acceptable credit score thus increasing the pool of buyers.

Pinter says that FHA, at the behest of Congress and encouraged by special interests moved further and further out the risk curve until a down payment of less than 5 percent, a loan term of 30 years, and a mortgage debt burden more than double the level in 1954 became the norm.

While the FHA utilized all forms of leverage over the period of 1954 to 2012, data are only available to track the progress of growing asset and income leverage for 1954 to 1966, picking up again in the "00" years.

Asset leverage increased by a factor of 5 as the average down payment declined from 20 percent to 4 percent. Household income leverage increased by a factor of nearly 3.5 as loan terms increased on average from 21 to 30 years, expanding buying power by about 12 percent.  The average housing debt ratio increased from 15 percent to 35 percent, expanding buying power by 133 percent.

The above comparisons are all based on a constant interest rate of 6 percent. Today, interest rates are about 3 percent, or half this rate, allowing buying power to increase by a further 30 percent.

With asset and household income leverage compounding each other, as figure 1 demonstrates, from 1954 to 2012 the average leverage on an FHA loan increased by a factor of 17 while the

FHA's foreclosure start rate increased by a factor of 19.  Foreclosure starts were elevated even during the boom years of the 1990s and 2000s. Today, 1 in 20 FHA borrowers enters foreclosure every year.

The use of compound leverage led to increased dependence on unearned equity rather than earned equity and responsible lending. Leverage creates a windfall of unearned equity when home prices are increasing rapidly but when they rise more slowly or decline or when income drops, it exposes home buyers to foreclosure.

The artificially low interest rate environment provided by the Federal Reserve magnifies buying power which is being built into home sale prices. If rates were to return to a still historically low 6 percent this buying power would also return to historic levels - a decline of nearly 25 percent.  "The seeds of the next crisis are being sown by the FHA (and the Fed) today."

Today, the FHA has 7.7 million loans outstanding and pays 12,000 claims per month, as opposed to the 5,000 it paid over its first 20 years of existence.  Its FY 2009 book of business is experiencing serious delinquency rates 8 times the rate of the largest PMI company's (MGIC) book of privately insured loans for the same period and the FY2010 book is 11 times higher.

Pinter takes issue with the contention of many that without FHA lending during the recent crisis the housing market would have collapsed. Instead he says this claim sets up a false choice.  While FHA may have played a countercyclical role, the real choice is between responsible and irresponsible underwriting policies targeted at low- and moderate income families.

If one looks at the last four years with its high affordability, he says, FHA could have materially improved outcomes for borrowers by offering refinancers lower rates combined with shorter term loans to speed equity building and by offering purchase mortgages with either a lower down payment or a 30 year term but not both.  . 

Instead, The FHA has placed a high percentage of low- and moderate-income families and communities at risk. The FHA's 2011 Actuarial Study projects that 9.6 percent, or 330,000, of the 3.45 million loans it insured during FY 2009 and 2010 will ultimately be foreclosed or otherwise result in a claim against FHA's insurance fund.

Pinter maintains that, "The FHA operates as the government's subprime lender" because of their credit attributes, low FICO scores and high debt ratios.  "These high-risk attributes are then generally layered with the additional risks related to a low down payment and a slowly amortizing 30-year loan term."

Rather than meeting its mission of being a targeted provider of responsible mortgage credit, the FHA's underwriting policies encourage low- and moderate-income families with low credit scores to make a risky financing decision-one combining a low score with a 30-year loan term and a low down payment, setting up for failure the very families and communities it is supposed to help.

The figure below shows that as a zip code's median income declines in relation to the area median, the projected foreclosure rate increases, especially for the 50 percent most risky. For the riskiest zips the average projected foreclosure rate is over 17 percent. Even this masks levels of failure in individual zip codes. In Chicago and Atlanta, the five zip codes with the highest projected foreclosure levels ranged from 35 to 73 percent and 24 to 30 percent, respectively.

Families in zips where the median income is below the applicable metro area median also suffered substantially larger home price declines than in zips above the area median income.

The impact of abusive lending on borrowers extends beyond excessive foreclosures. For every FHA borrower in foreclosure, another four are at an earlier stage of delinquency. Today, one in six FHA loans is delinquent 30 days or more. This financing path keeps families in a cycle of delinquency, foreclosure, and dependency.

The analysis conducted for this study finds that credit scores consistently predict loan performance within all population groups.  The analysis also finds that some groups perform worse on their credit accounts, on average, than individuals in the broader population with similar credit scores.

Pinter says the FHA does not price for risk.  When pricing is risk based, a higher rate signals to the borrower that his or her risk profile is higher. Flat pricing by the government encourages adverse selection, promotes moral hazard, distorts market competition, and leads to higher levels of foreclosure that impose personal as well as social costs.

High-risk behavior is promoted with subsidies.  A high risk $100,000 FHA loan with a 30-year term, a 3.5 percent down payment, and a FICO score between 620 and 639 benefits from a subsidy of $5,250 compared to a similar Fannie loan. A medium risk $100,000 30-year FHA loan with a 5 percent down payment and a FICO score between 700 and 719 is subsidized at $1,695 compared to a similar Fannie loan.  About one-third of this subsidy results from the pricing advantage Ginnie Mae provides when an FHA loan is securitized and the rest comes from various subsidies and cross-subsidies that the FHA either receives or creates.

Subsidies motivate borrowers to take on more risk and provide little incentive to save for a down payment, improve their credit profile, or keep debt levels moderate. The FHA's ability to cross-subsidize high-risk loans with premium income from lower-risk loans enables it to mask the damage to low- and moderate-income families and communities and to absorb catastrophic losses in those communities.

Pinter points out that at FHA lower-risk loans is a relative concept. While these are the loans providing the previously mentioned cross-subsidy, they themselves are high-risk loans when compared to low- down-payment, privately insured conventional loans.

FHA also does not consider risk in its underwriting of home purchase loans. 

• While its minimum down payment on a home purchase is 3.5 percent, the average is 4 percent which indicates that down payment is not being used as a factor to offset other risks present on an individual loan.
• Ninety-two percent of all fully underwritten fixed rate loans have a 30-year term which indicates that term is also not used to offset other risks.
• A slightly higher percentage of borrowers with a 620-659 FICO scores had a total debt ratio greater than 50 percent than did borrowers with a 720+ FICO score. This indicates that total debt ratio was not used as a factor to offset other risks present on an individual loan.

Having eliminated underwriting variation based on down payment, loan term, and total debt ratio, only FICO score remains.  The FHA's failure to underwrite in a responsible manner leads it to largely ignore risk layering on individual loans and Pinter says reducing loan term is highly effective as a risk mitigant.

More volatile home price movement for lower-price-tier homes was generally the case during the Great Boom/Bust of the 1990s/2000s. The lowest price tier had the largest percentage price increases followed by the steepest declines. Figure 10 provides a representative example:

A study of 16 large metro areas found that in every case, the prices of homes in the lower price tier have fallen more from the peak than homes in the median and high price tiers and lower-price-tier homes insured by the FHA in FY 2009-10 have also seen greater price declines or smaller price increases than higher-priced homes.

The combination of the FHA's underwriting policies and practices and low-tier home price volatility results in a disproportionately high level of low- and moderate-income families losing their homes.

Pinter examined FHA's 2009 and 2010 books of business to determine which loans were most likely to suffer a foreclosure and which zip codes would bear the brunt of these foreclosures.  It appeared that while LTV, FICO scores, and DTI were captured in the origination process FHA did not appear to use them in any significant way in determining whether to grant the loan and under what terms.

He then looked at zip codes where the median family income was below the median family income for the larger metro area. 'The results were striking in that most metro areas showed an extremely wide dispersion of projected cumulative foreclosure rates, typically from a low of 3-5 percent to a high of 20-30 percent or higher across a broad range of incomes below the median for the metro area."  FICO scores largely accounted for the variation and declining home prices had a disproportionate impact on low-and moderate-income families and communities, the groups traditionally served by FHA.

These results raise serious policy issues:

1.   The lending policies that FHA has in place today promote the financing of failure for too many families and too many communities:

2.   The FHA's lending policies are putting borrowers in low- and moderate-income communities in a negative equity hole that will be difficult to escape from.

3.   Although many agree the FHA's activity needs to be refocused on its traditional mission of serving low-income borrowers, if this occurs and the FHA continues its irresponsible lending policies, it will be financing failure on an even larger scale.

4.   The guarantee of the taxpayer is used to put low- and moderate-income families and communities at risk.

A review at the zip code and metropolitan area levels confirmed that risk layering, combined with high FHA loan volumes, leads to a concentration of high foreclosure and delinquency rates in low- and moderate-income communities.

The FHA projects that its FY 2009 and 2010 books will result in 330,000 foreclosures.  This study found that an estimated 85 percent of these foreclosures will occur in zip codes with a median income below the metropolitan area median. This has two distinct, direct adverse financial impacts. First, the FHA's losses on the 280,000 foreclosures (85 percent of 330,000) equal $20 billion. Second, studies indicate that each foreclosure results in an average estimated 1 percent price reduction on every home within a 600 foot radius. At an average home price of $133,000, the impact is $1,333 per affected home.

Pinter maintains that FHA is able to continue "Its irresponsible and abusive lending practices targeted at low and moderate income families and communities" because of a number of enablers.  It is part of the "Government Mortgage Complex" consisting of the GSEs, FHA, USDA, VA, and Ginnie Mae and benefits from a web of subsidies, benefits, and mandates-all of which stem from the presence of an unlimited full faith and credit government guarantee.

Those who benefit from the FHA program (MBS investors, real estate agents, home builders) act as enablers, exerting pressure on Congress to continue these practices.  Ginnie Mae investors, Congress, regulators, and loan originators are indifferent to the quality of the underlying mortgages because they are government guaranteed and Ginnie MBS are given a zero risk-based capital weighting compared to 20 percent for GSE MBS. Additionally, Ginnie MBS get preferential treatment in meeting bank liquidity requirements and are exempt from the risk-retention requirements of the Dodd-Frank Act. 

Pinter singles out the National Association of Realtors® (NAR) as a special enabler.  Real estate agents get their profits at the time a home is sold, he says, leaving them with no "skin in the game."  "Thus, it comes as no surprise that the National Association of Realtors (NAR) has a long history of promoting looser lending-meaning more marginal buyers, meaning more sales, meaning higher prices, meaning more commissions."

Pinter says the FHA needs to return to its traditional mission of being a targeted provider of mortgage credit for low- and moderate-income Americans and first-time home buyers and puts forth four principles for responsible FHA lending reform.

Principle 1: Step back from markets that can be served by the private sector.

Principle 2: Stop knowingly lending to people who cannot afford to repay their loans.

Principle 3: Set loan terms that help homeowners establish meaningful equity in their homes with the goal of ending their dependence on FHA lending.

Principle 4: Concentrate on those home buyers who truly need help purchasing their first home.  

Pinter recommends that first time buyers should be limited to an income of less than 100 percent of area median income and repeat home buyers to an income of less than 80 percent of area median income.

It will require a series of steps to implement the four principles.

Step 1: FHA will not knowingly insure a loan with a projected claim termination rate greater than 10 percent, assuming no house price appreciation or depreciation.

Step 2: FHA will target an average 5 percent projected claim termination rate, assuming no house price appreciation or depreciation. This is well over five times the historic default level for prime loans and two times that of 90 percent LTV ratio loans with private mortgage insurance.

Step 3: Stop guaranteeing lower-risk loans and high-dollar-balance borrowers, ending cross-subsidization of those loans with excessive risk.  Let the FHA step back from markets that can be served by the private sector and concentrate on home buyers who truly need help. Start by limiting loans to 100 percent of county median house price then limit first-time home buyers to less than 100 percent of area median income and repeat buyers to less than 80 percent of area median income.

Step 4: Price for risk which gives the borrower the information needed to understand the true risk of the loan.

Step 5: Implement underwriting that results in the extension of responsible mortgage credit.  Balance down payment, loan term, FICO score, and DTI ratio in a manner to achieve meaningful equity.

The goal of the above underwriting policies is to reduce risk layering, particularly for borrowers with low FICO scores, by providing a choice between a lower down payment and a 30-year loan term.