Liberally prudent or imprudently liberal? Part 1, how we got here
By: David A. Smith
Every lender faces the challenge of setting credit policies: tight but not too tight.
That’s too tight
Too tight and the lender loses market share. Not tight enough and the additional market share acquired turns into loan losses that sink the lender.
A public-policy lender faces the same dilemma but in reverse: liberal but not too liberal. Too liberal and the government doesn’t merely mirror the exuberant market, it enables that market’s exuberance. Not liberal enough and it merely eats market share without advancing affordability and helping deserving families improve their housing.
The Federal Housing Administration, the original government lender and hence the precursor to Fannie Mae and Freddie Mac; as a forerunner, FHA’s government connection was and is more direct. It’s an arm of HUD, hence its securities carry the full faith and credit of the
[Uh, until recently. – Ed.]
“It’s pronounced ‘feefa’ not ‘fiefdom’”
That means that unlike Fannie and Freddie, who are likely to return to a non-guaranteed state some day, the government is always exposed for the entire FHA portfolio. And FHA has a further tool that Fannie and Freddie do not: in addition to making direct loan, it offers mortgage insurance.
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.
Any FHA-insured loan carries a lender-protection guarantee – upon the occurrence of any non-cured material default, the lender may sell the loan back to FHA, no questions, asked, for 99 cents on the dollar.
Backed by the
With the FHA’s entire balance sheet – loans plus insurance commitments – at risk, the portfolio’s health is of critical interest to the nation, and its capital ratios are closely watched, as reported in the Wall Street Journal:
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.
‘Bailout’ here is a misnomer. Unlike private entities (yes, even the GSEs), where capital must be injected, we taxpayers already have guaranteed all their loans. ‘Bailing out FHA’ is equivalent to ‘bailing out Treasury.’
Agency officials say if there is a shortfall, they don’t have to do anything except report it to lawmakers.
“Your majesties, your eldest son – the swaying fop behind you – as run up enormous debts.”
They are correct; in point of fact, there is no such thing as the ‘FHA insurance fund,’ it’s just journal entries on the Federal balance sheet.
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 think Mr. Pinto is being inadvertently misquoted by context. He has to be too knowledgeable to have spoken of a bailout except in a shorthand sense.
” … I’ve never seen an entity successfully outrun a situation like this.”
Given that followup comment, I suspect Mr. Pinto means that FHA’s capital ratio will fall below the 2% mandated by statute.
Federal law says the FHA must maintain, after expected losses, reserves equal to at least 2% of the loans insured by the agency.
If not, FHA is expected to curtail too-liberal lending practices, but as for the capital, FHA simply passes the buck to Treasury.
All yours, Uncle Sam!
FHA’s taken those risks because it, Fannie, and Freddie, basically are the
Fannie, Freddie, and little FHA!
In the past two years, the number of loans insured by the FHA has soared and its market share reached 23% in the second quarter, up from 2.7% in 2006, according to Inside Mortgage Finance.
Readers will recall, from my post Who’s next?, that Inside Mortgage Finance does a terrific job of tracking and compiling public-domain statistics and interpreting them perspicaciously. I trust their figures.
Before the crisis, FHA had drifted almost into irrelevance as foolish private lenders (including Fannie Mae, as we documented presciently in Who’s next?) loosened their standards beyond even those of FHA. Now FHA’s market share has increased ninefold, and it’s still rising rapidly:
FHA-backed loans outstanding totaled $429 billion in fiscal 2008, a number projected to hit $627 billion this year.
Fannie and Freddie have mortgage backed securities. FHA has insurance. Same macro-leverage.
We can extract any equity, no matter how painful
Rising defaults have eaten through the FHA’s cushion. Some 7.8% 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% a year ago.
An additional 2.4% delinquency on a $627 billion portfolio represents $15 billion more in delinquencies.
The [FHA capital] ratio last year was around 3%, down from 6.4% in 2007.
An additional 2.4% delinquency is not the same as losses. Loss = Default Rates x Principal-Writedown Given Default.
Let’s do some simple arithmetic. How much of a writedown can FHA afford on those delinquencies? 40% losses on 2.4% delinquency represents 0.96% lost portfolio value. In short, FHA had better recover 60 cents on the dollar. Or else what?
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.
The Journal is mightily pumping its bellows; ’spark commotion’ is a far cry from ‘go bankrupt.’
Keep reading, we’re sure you’ll get fired up
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%.
The Journal knows full well that FHA is the Treasury – it will keep going indefinitely, losses be damned, as long as Congress keeps giving its authority.
Some housing analysts have said losses might lead the FHA to pull back lending, which has helped boost flagging housing demand.
That is the more practical risk – political, not economic.
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.”
Spoken with Shaun’s usual prudence and restraint.
Just trying to lay out the facts
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% minimum of $3 billion during the fiscal year ending Sept. 30, and $4 billion for the coming year.
This is less critical than it would be for a commercial bank, because with the entire balance sheet guaranteed already – think Fannie/ Freddie post-conservatorship – there’s no need to maintain net worth all in liquid form.
Some economists say the FHA’s lending has been crucial to preventing a deeper bust in property.
I’m not an economist, but count me among them.
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.
Together with the GSEs, Fannie Mae and Freddie Mac, FHA has been the mainstay of US housing finance. Had they stopped lending, we would have been in the soup.
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.
Better late than never.
We’re going to slap FHA into shape
[Continued tomorrow in Part 2].
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