FHA's Role in the Mortgage Market

The December 1 2008 issue of Business Week includes a cover article "The Subprime Wolves are Back". The theme of the piece is that former subprime mortgage brokers and mortgage bankers are now pushing FHA mortgage products. The article suggests FHA will create another $100 billion in taxpayer liabilities due to the higher levels of risk FHA is taking on.

It is a good piece and Business Week actually has done quite a bit of pro-consumer journalism on issues of consumer credit. The content and tone of this article raises is worrisome in several respects, however.

Remember FHA was created in the Depression to insure mortgage loans. FHA-approved lenders can make loans on which they can more or less count on FHA approving a mortgage insurance policy. FHA insurance covers most of any losses a lender might take on a foreclosed loan. The lender ends up paying about $3,000 in costs regardless, so it is not 100% insurance, but pretty close. FHA loans are also more costly to make due to added forms and regulatory processes. So this is not a free lunch for lenders.

But FHA will allow smaller downpayments -as low as 3% - and will permit borrowers to receive loans even if they have less than perfect credit. FHA loans will allow a borrower to access credit sooner after bankruptcy (1-3 years) or a past foreclosure (3 years) than prime loans. FHA historically has not been credit score driven but few FHA loans go to borrowers with credit scores below 580. Borrowers pay an insurance premium - both at the close of the loan and as part of the monthly payment.

In the last decade FHA has generated far more in premiums than it paid out in claims. In 2000 the annual FHA 'surplus' was over $16 billion. Of course all of this went right into the Federal budget - like most programs there is no 'lockbox' for future liabilities. In some years the FHA actually paid out a mutual benefit payment to insureds - and there were many proposals to use the FHA surplus to cut premiums (which happened) or to set up a set-aside fund for affordable housing (which did not). Of course the rise of subprime cut into FHA's business. In 2006, before the bubble burst, policymakers were trying to re-invent FHA since its market share plummeted from about 1 in 5 loans to 1 in 20 loans. The current credit crisis has spawned some new FHA products - like Hope for Homeowners (H4H in HUD-speak). This product allows borrowers who owe more than their home is worth to refinance for a smaller loan, if the lender will write off the remainder. Loan volume has been slow, as you might imagine lenders are not eager to write off loan amounts. There's no free lunch here, either, since homebuyers share half of any future home price gains with FHA.

The Business Week article misses a few points in my opinion. First, FHA has always had issues with fraud. The Sopranos even based an episode on FHA fraud. Mortgage brokers continue to be a problem because they act without skin the the game. The FHA insurance is not the problem, although FHA may be slower to move against problematic lenders than private mortgage insurance companies (this is anecdotal - I have not seen evidence on this). The problem continues to be the structure of the brokerage regulatory structure where states have little ability to oversee individual brokers. FHA adds complexity to the transaction and may create a wedge that makes lenders and borrowers feel they can get away with shadier tactics, but FHA is not a problem by itself.

The second issue the article touches on but fails to detail is FHA's own capacity. The new administration will soon nominate a new FHA commissioner. Most of the recent commissioners of the last 2 decades have been very capable administrators who generally were not pure political appointees. This is a big agency and includes a majority of the staff of the entire department of HUD. It deserves a prominent role with other agencies at the table in addressing the credit crisis. And FHA's aging staff and systems need support, training and replacement.

Finally, the tone of this article suggests that low-income and credit blemished borrowers will all end up in foreclosure. Even among the worst books of business in subprime 2 out of 3 borrowers have not defaulted. FHA's standards are higher and as designed FHA really is supposed to be a credit backstop for smaller first mortgage loans for owner occupants trying to on their feet in the housing market. Some borrowers - especially borrowers from minority communities who historically mistrust banks - trust the FHA brand and prefer FHA insured loans. FHA charges a premium and based on audits these premiums should be able to cover any required payouts. Even if they don't and require a year or two of additional federal budget allocations, years of the FHA 'surplus' likely more than offsets any shortfall during this credit crisis.

It's easy to disparage a government program with ongoing liabilities, especially one involving mortgages. FHA single-family mortgage insurance is generally a good program. As the credit market tightens it is plain old mortgage insurance programs are becoming more important. Its more exotic (and temporary) programs like H4H remain small and mostly experimental. Hopefully FHA administrative capacity will be enhanced and the cases of fraud and lenders with a history of problems will be fixed in the near future. .