The authors of a study just released by the University of North Carolina's Center for Community Capital suggest that the current condition of the Federal Housing Administration's (FHA) finances is not as important as the public purpose of the agency.
In Sustaining and Expanding the Market: The Public Purpose of the Federal Housing Administration, authors, Roberto G. Quercia and Kevin A. Park find three essential benefits that FHA has historically provided to the U.S. housing markets; regional and countercyclical stabilization, overcoming household wealth constraints, and providing product innovation and standardization.
The private sector cannot maintain the mortgage credit through economic downturns the way the public sector can. FHA and private mortgage insurance (PMI) have the same purpose but technical differences that set them apart, especially the fact that FHA is backed by the full faith and credit of the federal government.
PMI companies can and do become insolvent, file for bankruptcy or are seized by regulators. Even those that remain solvent must maintain acceptable levels of capital. While FHA is currently experiencing problems with its capital ratio, it is not illiquid and does not face capital constraints. The government guarantee insures that investors will still value FHA's insurance.
Resiliency is especially important for housing finance because of its susceptibility to periods of boom and bust and because of the circular nature of value. The value of property which serves as collateral for credit is itself dependent on the availability of credit. Price declines are particularly destabilizing because American homeowners are leveraged and mortgage debt will deepen housing downturns when homeowners are unable to refinance to a lower interest rate or move into a new house, lowering market liquidity. A drop in home equity increases the risk of foreclosure and any foreclosure further depresses the value of nearby homes.
Conventional risk management has difficulty with such systematic phenomena, where probabilities are not independent but correlated. In contrast, public insurance is extremely capable of diversifying risk across time.
It is easy to see that FHA has a countercyclical role to that of PMI. Between 1990 and 2003, PMI accounted for roughly 12.6% of the entire mortgage market by dollar volume and FHA just 6.7%. Then subprime lenders with high loan-to-value ratios and subordinate "piggy back" loans stole their market share. As the housing market collapsed, private mortgage insurance briefly rallied, but losses constrained its ability to write new business. Since the beginning of 2009, private mortgage insurance has accounted for less than five percent of the market while FHA has accounted for almost 18.6%.
FHA's is also countercyclical geographically. Private mortgage insurers implemented "distressed area" policies, refusing to insure over 90 percent LTV loans in some regions. FHA does not vary its insurance premiums by region, automatically stabilizing distressed areas.
Between 2006 and 2009 FHA's market share of owner‐occupied home purchase mortgages increased most in metropolitan areas that suffered the largest decrease in house prices. Though FHA typically had a very minor role in those markets during the run‐up, these were the markets most severely cut off from conventional credit when the crisis hit, and therefore most benefited by FHA's revival. FHA has always stepped in when and where private lenders have retreated, preventing a downward spiral of house prices and a reduction in credit availability.
A second purpose of FHA has been to serve borrowers and neighborhoods poorly served by the private sector. While subprime mortgage lenders targeted these individuals and regions with disastrous results, FHA has proven capable of supporting sustainable lending to them.
Despite higher defaults rates common in loans with high LTV ratios, FHA has lowered its down payment requirements over the years from 20 percent to 5 percent while maintaining a relatively modest rate of claims. This is particularly important for first time homebuyers who accounted for 75 percent of all FHA endorsements in 201. FHA lending served 41percent of all first time homebuyers. Since the subprime bubble burst FHA has accounted for 61 percent of purchase mortgages for Hispanic and black borrowers and these loans have been more sustainable than products in the conventional market.
The third essential role of FHA over the years has been to test and standardize new types of mortgages when the private sector is not willing or able. Many mortgage products now called "traditional" were pioneered by FHA. Before the Great Depression, most mortgages were short‐term, interest‐only loans that had to be continually refinanced. FHA popularized loans that are fully amortizing and with first 20-year and then 30-year terms, which reduced the required monthly payments and increased the acceptable LTV. Fully underwritten 30‐year fixed‐rate mortgages have accounted for three‐fourths of FHA endorsements by volume since FY2000 and FHA‐insured mortgages have performed significantly better than conventional subprime mortgages through the Great Recession.
The success of FHA led to the rebirth of a private mortgage insurance industry in 1957 and revolutionized the secondary mortgage market through Government National Mortgage Association ("Ginnie Mae") guaranties. The experiences of FHA‐insured mortgages also helped inform the development of credit scoring and automatic underwriting.
FHA's Mutual Mortgage Insurance Fund has been self‐sustaining through borrower fees for 80 years. These premiums flow into a financing account equal to projected costs and a capital reserve account for any remaining funds. The two accounts have over $30 billion in capital resources, which, given the rate of losses of the last four quarters, is enough capital to continue paying claims for the next seven to ten years.
Unfortunately, not all of FHA's innovations have proven successful. Seller‐funded down payment assistance programs artificially inflated sales prices and loan amounts and caused high rates of default and substantial Fund losses. HUD attempted to prohibit these loans many times, but was prevented by legal and political obstacles until 2008.
The National Affordable Housing Act mandates that the Fund maintain at least a two percent capital ratio. As recently as FY2007, the Fund had a capital ratio of 6.4, but in the last five years, the economic value of "forward" loans (which excludes so-called reverse mortgages or HECMs) endorsed by FHA has fallen by almost $35 billion. At the same time, FHA more than tripled its level of insurance‐in‐ force, from $332 billion to over $1.1 trillion. The simultaneous decrease in the denominator and the increase in the numerator has caused the capital ratio to fall to under 0.1% in FY2011 and ultimately to a negative 1.2% in FY2012.
As of the latest, FY2012 actuarial review, projected losses on loans (excluding HECMs) are expected to eventually exceed projected revenues and current capital resources by nearly $13.5 billion. HUD's 2012 report to Congress notes these losses exceed those projected last year for three reasons: a lower house price appreciation forecast (‐$10.5 billion); the continued decline in interest rates (‐$8 billion); and a refinement in methodology (‐$10 billion).
A negative economic value requires FHA to supplement its capital with funds from the U.S. Treasury, an option that was not available in the early 1990s when the fund also had a negative economic value. In that period the Fund was able to grow out of its negative position by reforming its premium structure and endorsing new books of business. The Fund may again grow out of its current predicament without exhausting its capital resources.
The Fund has $30 billion in capital resources and the actuarial analysis estimates there is only a five percent chance these resources will be exhausted in the next seven years, partially due to its highly profitable new books of business. Until the capital resources are exhausted, any Treasury draw would simply be used to stock the financing account, which is held in Treasury bonds.
The authors stress that financial calculations fail to account for FHAs value to the broader economy-its true economic value. The expectation that the MMI Fund should operate through a "hundred‐year flood" like a private company ignores its public purpose. In conducting the first independent actuarial study of the fund in 1989 Price Waterhouse considered a "Great Depression" scenario but argued "the social purpose of the Fund is such that it should not be expected to withstand such a calamity" Instead, FHA is intended to use the full faith and credit of the federal government to stabilize the housing market even if it means temporary technical insolvency.
By continuing to finance mortgages even as house prices fell and unemployment rose, FHA fulfilled its duty to step in when and where the private market fails. Moody's Analytics estimates that, if FHA had refused to stop insuring new mortgages in October of 2010, by the end of 2011 house prices would have fallen another 25%, new and existing home sales would have fallen an additional 40%, and new home construction would have dropped 60%. This would have resulting in another two percent contraction of the economy, the loss of another three million jobs, and an unemployment rate of 12 percent. This would have increased FHA losses as well as that of PMI companies, GSEs, lenders, investors, and American Households.
Those who will decide how FHA should be structured going forward should bear in mind how FHA has fulfilled its public purpose over the past 80 years and mindful of the agency's challenges to fulfilling that purpose.
FHA should be empowered to protect communities from steering and abuses by lenders and given greater flexibility and resources to keep step with the market, particularly in the areas of risk and loss management. The agency also faces the on‐going risk of adverse selection from private sector insurers and investors. Policymakers have an extraordinary opportunity to address such fundamental issues as they seek to shape a more effective and resilient FHA for the future.
It may be tempting to reassess FHA's role based on its current fiscal predicament and while that is concerning further major pricing and underwriting changes beyond those already made or underway may not be necessary to restore FHA's financial cushion and improve the value of recent years' business.
Right now an active FHA insurance program is still critical for supporting the fragile housing recovery. FHA's current elevated market share merely indicates the weakness in the private conventional mortgage market. In fact FHA's market share has already decreased substantially from the height of the housing crisis and an over‐correction may actually hinder the process of recapitalizing the MMI Fund.
The massive portfolios and guarantees of the GSEs are scheduled to be gradually reduced without any clear sense of what will replace them in the secondary market and definitions for Dodd-Frank Qualified Residential Mortgages are not set. A strict standard would limit the conventional lenders' ability to serve the entire market so either FHA must be able to do so or else the housing market must be prepared for a likely drastic reduction in the supply of mortgage credit.
Even when conventional mortgage lending does return, FHA will remain critical to the long‐term health of the housing market which future demand is likely to come from traditionally underserved populations. This is the very type of borrower that FHA has served successfully over the decades.
The purpose of FHA is to fill in the gaps in the availability of mortgage credit and its purpose is likely to become even more relevant as a result of the restructuring of housing finance system and of the likely demographic changes that will characterize America's mortgage demand. The actuarial soundness of the Mutual Mortgage Insurance Fund is only an indication that FHA fulfills its public purpose efficiently. A full measure of that efficiency must take into account the whole range of benefits derived from the fulfillment of its public purpose.
