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FHA Insures Private Lenders, But Will It Need a Bailout to Ensure Low Reserves Don't Dip Below Required Level?

Source: Wall St. Journal

Posted on 04 Sep 2009

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The Federal Housing Administration, hit by increasing mortgage-related losses, is in danger of seeing its reserves fall below the level demanded by Congress, according to government officials, in a development that could raise concerns about whether the agency needs a taxpayer bailout.

The rising losses at the FHA, part of the U.S. Department of Housing and Urban Development, come as the agency has rapidly increased its role in guaranteeing loans in an attempt to stabilize the housing market.

It isn't clear how the rising losses may affect home buyers. Options for the agency could include politically unpalatable choices, such as asking for taxpayer funds to boost reserves or increasing the premiums borrowers pay for the insurance offered by the agency. Agency officials say if there is a shortfall, they don't have to do anything except report it to lawmakers. But some mortgage and housing analysts see trouble ahead. "They're probably going to need a bailout at some point because they're making loans in a riskier environment," says Edward Pinto, a mortgage-industry consultant and former chief credit officer at Fannie Mae. "...I've never seen an entity successfully outrun a situation like this."

The FHA insures private lenders against defaults on certain home mortgages, an inducement to make such loans. Insurance from the New Deal-era agency has enabled lending to buyers who can't make a big down payment or who want to refinance but have little equity. Most private lenders have sharply curtailed credit to those borrowers.

HUD Secretary Shaun Donovan said in June the FHA would be 'more than likely to stay out of a broader need for any taxpayer funding.'

In the past two years, the number of loans insured by the FHA has soared and its market share reached 23 percent in the second quarter, up from 2.7 percent in 2006, according to Inside Mortgage Finance. FHA-backed loans outstanding totaled $429 billion in fiscal 2008, a number projected to hit $627 billion this year.

Rising defaults have eaten through the FHA's cushion. Some 7.8 percent of FHA loans at the end of the second quarter were 90 days late or more, or in foreclosure, according to the Mortgage Bankers Association, a figure roughly equal to the national average for all loans. That is up from 5.4 percent a year ago.

Resulting FHA losses are offset by premiums paid by borrowers. Federal law says the FHA must maintain, after expected losses, reserves equal to at least 2 percent of the loans insured by the agency. The ratio last year was around 3 percent, down from 6.4 percent in 2007.

If its reserves fall short, the agency is obliged to notify Congress, which could spark a commotion over the extent to which the government is funding losses in the housing market. Some housing analysts have said losses might lead the FHA to pull back lending, which has helped boost flagging housing demand.

A senior official at HUD, which oversees the FHA, said there is "no risk" that the FHA would require money from Congress if the ratio falls below 2 percent. Asked about the agency's capital ratio, the official said a report detailing that number won't be completed until the FHA's fiscal year ends Sept. 30.

HUD Secretary Shaun Donovan said in June, "there's a better than even chance that we will stay above the two percent reserve threshold. That suggests, not just for the 2010 business, but overall for the portfolio, that we'll more than likely to stay out of a broader need for any taxpayer funding."

Some economists say the FHA's lending has been crucial to preventing a deeper bust in property. Thomas Lawler, an independent housing economist, said "the alternative could have been a complete meltdown of housing finance" that would have ultimately led to much larger losses. Critics have said the FHA, which has never had a chief risk officer, isn't able to manage such a large portfolio in an unstable market.

Policymakers have used the FHA to stabilize the housing market by pushing it to offer credit with far easier terms than that offered by most private lenders. For example, it will back loans with down payments as low as 3.5 percent.

Much of the FHA's risk comes from its growing exposure to the broader economic downturn. The FHA is particularly sensitive to home-price declines because of the small down payments it will accept, which can quickly become wiped out by a fall in home values.

"The size of their footprint in the mortgage market is so large that it exposes the FHA to economic risk, even if the products are performing well," says Howard Glaser, a mortgage consultant and former HUD official.

A review conducted this year by mortgage consultants Ann Schnare and Michael Goldberg found the estimated value of the FHA's reserve could have a shortfall below the mandated 2 percent minimum of $3 billion during the fiscal year ending Sept. 30, and $4 billion for the coming year.

The FHA's total assets have increased to around $31 billion, up from $27 billion one year ago. The pending review, however, accounts for projected losses over 30 years. That put the estimated economic value of the fund at $12.9 billion last year, or around 3 percent of all FHA-backed loans.

Before the boom, the FHA wasn't a big player in the housing business because it didn't follow private lenders in loosening its standards. Borrowers had to fully document incomes and insured loans were capped at $362,000. Congress increased those limits last year to as high as $729,750 in the most expensive markets. In August, the FHA and the U.S. Department of Veterans Affairs backed 40 percent of loans for all home sales.

Officials said as recently as May that they didn't expect to fall below the 2 percent limit, but home-price declines have exceeded those used to model their expected losses. Given the pace of those declines, "there is no way they will make the 2 percent if the current study follows last year's methodology, says Mr. Lawler.

The FHA says it has seen loan quality improve in recent months, including an increase in average credit scores and a decline in loans that were one month delinquent. The agency expects to make $1.4 billion on loans it will insure for the fiscal year that begins in October.

Last year, the agency ended a program that allowed sellers to fund down payments. While that program accounts for around 11 percent of the FHA's loan book, it has generated 22 percent all loans that are seriously delinquent or in foreclosure.

In 2005, the FHA loosened its maximum loan-to-value limit on cash-out refinancing to 95 percent, from 85 percent. The agency moved that limit back to 85% earlier this year.

While most private lenders have raised lending standards and now require minimum 20% down payments, the share of borrowers who are able to make down payments of less than 10% hasn't changed in the last two years, largely because of the FHA, says Mr. Pinto, the former credit officer at Fannie Mae.