When everyone else gets sick, even the healthy start having symptoms too.

Oh, I should never have gorged on those ‘07 and ‘08 loans

As one of only three stores left open, still selling single-family and multifamily long-term financing, the Federal Housing Administration – the GSE from the right side of the blanket, as it were, the one always acknowledged as part of the Federal government – is showing stresses in its portfolio of new loans.  As reported by The Washington Post:

The share of borrowers who are falling seriously behind on loans backed by the Federal Housing Administration jumped by more than a third in the past year, foreshadowing a crush of foreclosures that could further buffet an agency vital to the housing market’s recovery.

As I posted back in September, FHA’s loan losses will not ‘buffet’ the entity because it is a direct arm of the Federal government, and as such cannot go bankrupt independent of a Federal bankruptcy – and while sovereign bankruptcy is on the horizon for Dubai and Greece, we are not in that situation (thankfully) (yet).

About 9.1% of FHA borrowers had missed at least three payments as of December, up from 6.5% a year ago, the agency’s figures show.

Not only is a 9.1% serious delinquency rate high, that’s atop an already high 6.5% rate.  The homeownership arena is still hurting – now not because of declining property values, but rather because of the ongoing structural weakness that the so-called stimulus legislation has clearly done nothing to reverse.

Year-over-year delinquency rate change; it’s worse in the West

Although the FHA’s default rate has been climbing for months and eating into the agency’s cash, the latest figures show that the FHA’s woes are getting worse even as the housing market shows signs of improvement. The problems are rooted in FHA mortgages made in 2007 and 2008.

Loan defaults have an incubation/ contagion phase delay.  As we saw in the decade’s biggest invisible stories, during 2007 and 2008 originators like Countrywide offloaded swaths of their inventory onto long-term government players (like naive Fannie Mae).

Those loans are now maturing into their worst years because failures most often occur two to three years after a mortgage is made.

By now we know it’s regionalized: California/ Nevada, Florida, and the Upper Midwest

If the trend continues and the FHA’s cash reserves are exhausted, the federal government would automatically use taxpayer money to cover the losses –

Which I noted months ago:

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 United States, unlike its GSE heirs Fannie and Freddie, which borrowed money on the capital markets without direct Federal support.

[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. 

Now the piper may need to be paid:

– a first for the agency, which has always used the fees it charges borrowers to pay for its losses.

Uh – except for that Great Depression thing we had during 1934, when FHA was created.

And back then, we had much lower homeownership rates

As these loans from 2007 and 2008 go bad and clear off of the FHA’s books, agency officials said, losses are expected to taper off, aided by the housing market’s anticipated recovery and an influx of more creditworthy borrowers, who have flocked to the FHA’s home-buying program in the past year.

We thus have a race of sorts.  Which will mature first – the capitalized value of the new insurance premiums, or the recognized losses from the recent vintages?  Fortunately, because FHA is already owned by the Federal government, it’s more of an academic and economic-efficiency question than one of national consequences. 

Agency officials said they have cracked down on poorly performing lenders and announced higher qualifying fees for borrowers. On Monday, the agency projected that the fees should generate $5.8 billion in fiscal 2011 [Which ends 30 Sep 10 – Ed.], up from $2 billion this year.

That seems highly plausible.  With Fannie, Freddie, and FHA the only games in town, they are all gulping new market share.

Two whose patrimony was only recently acknowledged

One who always knew who was its mother and its father

That would fatten the FHA’s cash cushion, used to cover unexpected losses.

An exasperating imprecision – FHA has no banks accounts of its own, it draws from the Treasury as required.  A better formulation is that the incoming premiums will significantly increase FHA’s net worth, giving reassurance to the check-writers at Treasury.

The FHA does not make loans but insures lenders against losses. And claims have already spiked. The agency had to pay out on 47% more loans in October and November than in the corresponding period a year earlier, according to an FHA report.

Ouch!

Didn’t see that coming

The number of loans in foreclosure, including those that have not yet been billed to the agency, has also increased. They were up 26% in the last quarter from a year earlier.

Ouch.  Foreclosure, though, is simply a lagging indicator of claims, as claims as a lagging indicator of serious delinquencies.  Neither is an independent variable in itself.

Nice dependent variable

FHA Commissioner David H. Stevens, who joined the agency in July, flagged his agency’s troubles with the 2007 and 2008 loans in October, when he told a House panel that “rogue players on the margin” immediately migrated to the world of FHA lending after the subprime mortgage market collapsed.

Oh, you think?

I don’t like being linked to a phrase like ‘rogue player’

Their aggressive lending tactics attracted borrowers with unusually poor credit profiles to the FHA. “That clearly impacted the books of business in 2007 and 2008, and that performance data is showing up very clearly in today’s balance sheet,” Stevens said at the time.

Even so, at the time Mr. Stevens was optimistic, and no one was under any illusions about the essentiality of keeping FHA in business.  As I posted in October:                            

Would that elected officials and journalists could refrain from politicizing what should be bipartisan evaluations of entity performance and importance.

“FHA has stepped into the void left by the private market,” Representative Maxine Waters, Democrat from California, said at the hearing. “Let’s be clear; without FHA, there would be no mortgage market right now.”

Ms. Waters knows where she stands

Together with Fannie and Freddie, FHA is the credit backstop for about 80% of all US residential lending right now.  While it’s terrifying to think of that much lending being concentrated behind the government, it’s more terrifying to think of any one of the three stopping cold.

No more lending?

But [Stevens] acknowledged that some 20% of FHA loans insured last year — and as many as 24% of those from 2007 — faced serious problems including foreclosure, offering a preview of a forthcoming audit of the agency’s finances.

This shouldn’t be entirely surprising, recognizing that in 2008 FHA was the lender of last resort, and as we have chronicled, many of these refinancings were done hopefully.

“Let me simply state at the outset that based on current projections, absent any catastrophic home price decline, FHA will not need to ask Congress and the American taxpayer for extraordinary assistance — we will not need a bailout,” Mr. Stevens said in his testimony.

That is a direct and clear statement.  Let’s hope it’s true. 

If I’m wrong, strike me dead

Is Commissioner Stevens rethinking his view?

With  new facts, I have no choice but to rethink

Plunging home prices have exacerbated matters by leaving some FHA borrowers unable to sell or refinance their homes because they owe more than their homes are worth. Yet with unemployment running high, many borrowers can’t afford to keep up their payments.

Adding to the trouble was a now-defunct FHA program that enabled sellers to cover the down payments of buyers. This meant many borrowers had no skin in the game and were more likely to walk away at early signs of trouble.

In May, 2007, I first wrote about this scandalous program, lambasting it:

It’s sounding more and more like the buyer is merely a patsy, and the non-profits are acting as the sellers’ paid agent.   Do the non-profits act as surrogates for the buyer, making sure prices are held down?

Sellers have tried to recover the cost of the fee they pay nonprofits by raising the price of the house an average of 3%, a 2005 study [text version here -- Ed.] by Congress’s nonpartisan Government Accountability Office found [also referenced here -- Ed.].  

So let’s keep score here:

In a cruder world, what the non-profits are doing might be called ‘procuring.’  In such a procurement, two entities get screwed: buyers and the Federal government (that’s us taxpayers).

This is for us taxpayers

By June, 2008, it was clear FHA was looking at $4.6 billion in losses, mostly from Nehemiah.  That number has now more than doubled:

The program resulted in excessive defaults before it was ended in late 2008, and it is projected to cost FHA an additional $10.5 billion in losses, Stevens said.

Every time I revisit this subject, I become more angry about it.  Congress birthed this atrocity, and Congress protected it against diligent and persistent Bush Administration efforts to kill it. 

For all these reasons, the FHA projects that it will pay out claims to lenders on one out of every four loans made in 2007 – the worst rate in at least three decades.

A 25% claim rate is hideous – but fortunately, Risk = P x L, where P is Probability of default and L is Loss given default.  We can hope for improved recoveries, since the newer-vintage delinquencies are borrower weakness, not property weakness.

The claim rate should be nearly the same on the vastly larger volume of loans made in 2008.

In any case, we can see FHA coming out the other side.

Dirty but still breathing

The FHA-backed loans made in 2009 tended to go to borrowers with higher credit scores than in previous years. These borrowers turned to the FHA when the mortgage market collapsed and other lending sources dried up. By then, reputable lenders doing business with the agency were already imposing tougher restrictions on FHA borrowers, further boosting the credit profile of those loans. The average credit score of an FHA borrower is now 690, up from 630 only two years ago, agency officials said.

These higher-quality loans are expected to result in lower losses, so the agency should make money on loans issued this year and over the next few years, according to an independent audit designed to gauge the agency’s health.

The audit, released in November, found that the cash the FHA set aside to pay for unexpected losses had dipped to historic lows, well below the level required by law. As of Sept. 30, those reserves were estimated at $3.6 billion, down from nearly $13 billion a year earlier. The most recent figure represents 0.53% of the value of all FHA single-family-home loans – far lower than the 2% required by Congress.

Certainly that is low, but compare that against the $3.8 billion “extra” premium FHA earned this year, and if you add that back, you’re at 1.06%, which is not great but is heading the right way.

Yes, I admit it’s getting better

It would become even rosier if, as most private lenders do (and the GSEs did), one counts the capitalized value of the future servicing rights as assets.

But Ann Schnare, a former Freddie Mac official, said the situation could be even worse. She said the audit underestimates future losses because it does not take into account all loans that are now overdue, only those that the FHA has paid claims on.

True enough, but with FHA mortgage insurance, the lender normally assigns the loan as quickly as possible, thirty days after the default.

Stevens said his agency has pored over its data to analyze risk and is taking steps to shore up its financial health. “You have a limited set of options under these circumstances: Raise fees [for borrowers] or make policy changes,” Stevens said in an interview. “We’ve done both.”

In short, tighten credit, limit losses, hence increase profits.

The agency banned 268 lenders from making FHA loans last year, more than double the total terminated in the previous eight years. The FHA suspended six other firms. Among them were some of the largest FHA lenders – Taylor, Bean & Whitaker and Lend America, both of which shut their doors soon thereafter.

The long-overdue cleanup continues.

You made the mess, you clean it up

The agency also proposed a rule that would require banks to hold up to $2.5 million in capital that they can use to repay the agency for losses if they were involved in fraud.

Absolutely!  Originators should always take first loss, and should have liquid capital to cover a substantial loss rate; otherwise the principal-agent risk is too great.

Banks are now required to hold only $250,000.

Not enough.  A ten multiple is a good idea.

Borrowers are also facing tougher scrutiny from the agency. People taking out FHA loans will have to pay higher upfront fees, perhaps as early as this spring. Those with especially weak credit scores will also have to put down at least 10% instead of the usual 3.5% down payment. The amount of money sellers can kick in toward closing costs and other fees will also be limited.

Another Nehemiah abuse being shut down.

Should have pressed the Nehemiah shut-down button a long time ago

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[Continued from yesterday's in Part 1.]

In yesterday’s post, we compared the public pronouncements of two enormous governmental lenders whose financial viabiltiya nd liquidity are in question: FHA in the US, from the New York Times (in plain text) and the World Bank, from the UK Telegraph (in indigo palatino).  The World Bank, which wants more capital from its member nations, says it’s not broke but illiquid, while the FHA told Congress that even though it can never be illiquid (because it’s guaranteed by Treasury), it’s not broke.

The hearings on Thursday came on the same day that the federal agency charged with overseeing Fannie Mae and Freddie Mac provided a somber assessment of those giants’ health. In the year since the government stepped in to rescue them, the companies have taken $96 billion from the Treasury, and may need more.

Since the bottom fell out of the mortgage market, the FHA has assumed a crucial role in the nation’s housing market. Created in 1934 to help lower-income and first-time buyers purchase homes, the agency now insures roughly 5.4 million single-family home mortgages, with a combined value of $675 billion.

While those figures are well short of what Fannie and Freddie have been financing, they represent a large and rapidly rising inventory.

 “It appears destined for a taxpayer bailout in the next 24 to 36 months,” Edward Pinto, a former Fannie Mae executive, said in testimony prepared for the hearing. Mr. Pinto, who was the chief credit officer from 1987 to 1989 for Fannie Mae –

I can’t find out much about Edward Pinto.  His December, 2008 testimony describes his background this way: “real estate financial services consultant … left the company in 1989 and since then I have specialized in providing mortgage finance related consulting services.  Since leaving Fannie Mae, I have followed the GSEs closely.”  He thinks CRA is toxic – and I don’t.  Color me cautious in accepting his opinion as gospel.

I suspect no one … and everyone

– went further than most housing analysts and predicted that FHA losses would more than wipe out the agency’s $30 billion of cash reserves.

Mr. Pinto seems to be dining out on these gloomy predictions, which to be sure doesn’t necessarily make him wrong.

The troubled loans are nevertheless weighing on the agency’s capital reserve fund, which has fallen to below its Congressionally mandated minimum of 2%, from over 6% two years ago.

The optimism expressed by Mr. Stevens, the FHA commissioner, places him at odds not only with some outside experts but with Kenneth Donohue, the inspector general of the Housing and Urban Development Department, who is also FHA’s watchdog. Mr. Donohue said the drop in reserves was “a flashing red light” that the agency was not taking seriously enough.

“It might be we’ll get ourselves out of this and that everything will be fine, but I don’t paint that rosy a picture,” Mr. Donohue said. “They’re banking on the fact that the economy will continue to improve, that the housing market will begin to sustain itself.”

We are in unknown territory; all actions involve risk. 

Anywhere you go, hic sunt dracones

Maybe I’m parsing too carefully, but Mr. Donohue’s warnings – entirely appropriate ones, he’s the Inspector General – are not the same as claiming that FHA “appears destined for a taxpayer bailout.” 

Rather, he’s sounding a warning similar to Mr. Zoellick’s World Bank warning:

Mr Zoellick, speaking at the opening of the IMF and World Bank annual meetings in Istanbul, said the Bank needed a capital increase of $3bn-$5bn, though others suspect the eventual need could be higher still.

The increased capital will represent hard equity that will provide the first-loss cushion for future lending.

Think of hard equity as the lender’s air bag

He said he hoped that its shareholders, including the UK and other leading nations, would decide on resources before its spring meeting next April.

Mr Zoellick said: “We recognise that all countries are under budgetary strain and it is not an easy time to be asking for these things”. He said that a shortfall of cash for the IFC was a cause for particular concern, Mr Zoellick added, “because one of the issues in this recovery is the hand-off from government stimulus programs to private-sector development.”

He’s reminding us of a point all too often forgotten: government should be a catalyst, stimulating first-mover activity on the bankable frontier, colonizing the space and then vacating it when it has been formed and stabilized.  Government must boldly go where no private market has gone before.

“To seek out new loans and new innovations”?

The World Bank intends to lever that $3-5 billion in new equity 95-97%:

Critically, the Bank’s three-year $100bn programme, committed to last year because of the virulence of the financial and economic crisis, is expected to fall short of the eventual demand from struggling economies. The majority of the money has been spent ensuring the survival of the most vulnerable nations.

If $3-5 billion of new equity will lever $100 billion in new lending, that’s a 3-5% ‘down payment.’ Oddly enough, that’s the same ratio at which FHA is now lending:

The government has stepped into the breach, facilitating loans with down payments as low as 3.5% and offering other incentives to stabilize the market. Real estate agents in some hard-hit areas say every single one of their clients is using the FHA.

Anyone with a PhD in Common Sense knows that the more hard equity a borrower has in the investment, the lower the default risk, both because of favorable loan-to-value ratios and because

people care more when they’ve put their own money in. 

“They’re counting their pennies, scraping up that three point five percent,” Bonni Malone of Prudential Americana in Las Vegas said. “Mostly they’re buying foreclosed homes from banks, although I had one client who bought from a guy that was dying. It’s turning around the market.”

Houses cost more than people can afford unless they borrow.  So the withdrawal of credit from real estate lending can easily collapse prices, and its replenishment can help stabilize them. 

You need a lot of green to keep the nation from sinking further into the red

The Depression was brought on in part because credit fled to the sidelines, starving businesses and homeowners of capital to enable them to keep their businesses open.  It’s why FHA was born in the Depression; why FDIC and FSLIC came out of the Depression; why, in short, the government entered the lending-liquidity business 75 years ago. 

One of the cards was labeled, FHA

While the government’s actions have helped avert full-scale economic disaster, there is growing concern that it might have doled out its favors with too generous a hand.

Many of the loans the FHA insured in 2007 and last year are now turning delinquent, agency officials acknowledge. The loans made in those two years are performing “far worse” than newer loans, dragging down the whole portfolio, Mr. Stevens of the FHA said in an interview.

This is unsurprising.  Older loans having been seasoned, they establish a performance history.  And if you lend into the teeth of a recession, as we now know FHA (and others) did, you have to brace for higher losses.

You want to lend into this?

How high can we afford?

The number of FHA mortgage holders in default is 410,916, up 76% from a year ago, when 232,864 were in default, according to agency data.

Anyone with an ounce of sense would be worried by these figures, not just the numbers but the spike in percentages:

Despite the agency’s attempt to outrun its fate by insuring ever-larger amounts of new loans [snip] — the current rate is over a billion dollars a day — 7.77% of the portfolio is in default, up from 5.6% a year ago.

Observe that the default rate is up only 40%, whereas the default numbers are up 76%, simply because FHA is insuring so many more loans.  In other words, it’s not quite as bad as the default numbers would suggest.

Meanwhile, statements like this don’t help, even making due allowance for Mr. Frank’s propensity to give the super-compressed response with the subject-to’s and qualifiers omitted:

If you misunderstood me, you forgot to hear the words I left unsaid

Barney Frank, the Massachusetts Democrat who is chairman of the House Financial Services Committee, said in an interview that the defaults were, in essence, worth it.

“I don’t think it’s a bad thing that the bad loans occurred,” he said. “It was an effort to keep prices from falling too fast. That’s a policy.”

He can’t have meant that the way it sounded (can he?).  Mr. Frank must have meant that if you are going to liberalize lending, so as to keep liquidity flowing and to prevent a credit-crunch asset collapse, you must accept that some bad loans occur.  The question, as I posed a month ago, is, how liberal is too liberal?

[HUD Inspector General Donohue] noted that if private lenders had raised their down payment requirements in the last two years, it raised the question, “what does the FHA think it is doing by asking only 3.5%?”

It thinks it’s taking a prudent risk because the private lenders have a liquidity crunch that compels them to tighten capital, whereas FHA does not.

As the number of loans has soared, random quality control checks have decreased sharply, FHA staff members say.  [Ah, the ultra-reliable 'unnamed sources. – Ed.]

Is FHA headed for a crackup?  Is the World Bank?  Nobody knows for sure, because prediction is very difficult, especially about the future.

The future, Wener, is uncertain

Mr. Donohue, the inspector general, cited numerous examples of organized fraud in testimony to Congress earlier this year.

“They need to stop taking bad loans in the door,” he said in an interview. “They’re taking on all this volume, they have to have very active underwriting standards.”

Nobody will argue with that.

“No man of sense could dispute that.”

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Can a government bank fail? 

Something a little less visible than that

In the space of a week, that question’s surfaced about two governmental banks – FHA in the US and the World Bank – in stories in the New York Times (which I’ll excerpt in plain text) and UK Telegraph (in indigo palatino), but as we’ll see, the source of the evidence, and hence the threat credibility, vary extraordinarily.  Let’s start with the World Bank:

The World Bank is close to ‘running out of money’, its president, Robert Zoellick, has disclosed.

World Bank president Robert Zoellick has launched a major campaign secure more funding from rich nations

Mr. Zoellick succeeded the brilliant blockhead Paul Wolfowitz (brilliant economist, blockhead manager) and has evidently brought stability and a renewed sense of organizational worth to the World bank staff (full disclosure: I know many incredibly good people who work there).  He’s in a position to know the bank’s financial position.  However, in saying that the bank could ‘run out of money,’ he does not mean bankruptcy, but rather lack of liquidity:

The Bank, whose job it is to support low-income countries, has had to hand out so much cash in the wake of the financial crisis that it faces a shortfall in what it can spare for new projects within 12 months.

“By the middle of next year we will face serious constraints,” said its president Robert Zoellick, as he launched a major campaign to persuade rich nations to pour more money into the Washington-based institution.

Formerly open for business

The bank gets its capital from developed nations, and then makes loans to developing nations.  If those nations do not repay as timely as expected, the bank may have capital (loans receivable) without cash.  Should those loans go bad – as commercial and residential loans do, as we have discovered – then the World Bank could become insolvent, but since its creditors are sovereign nations who as a general rule are not seeking repayments to pro up their own liquidity, a more practical outcome is an inability to lend further.

Lack of liquidity or total insolvency?

That’s less serious than the problem being alleged about FHA:

A year after Fannie Mae and Freddie Mac teetered, industry executives and Washington policy makers are worrying that another government mortgage giant could be the next housing domino.

Problems at the Federal Housing Administration, which guarantees mortgages with low down payments, are becoming so acute that some experts warn the agency might need a federal bailout.

As we’ll see, this appears to mean ‘one expert.’

Running questions about the FHA’s future — underscored by interviews with policy makers, analysts and home buyers — came to the fore on Thursday [October 8, 2009 – Ed] on Capitol Hill. In testimony before a House subcommittee, the FHA commissioner, David H. Stevens, assured lawmakers that his agency would not need a bailout and that it was managing its risks.

Stevens says he’s managing the risks

Unlike most of his recent predecessors at FHA, Mr. Stevens’ background is in single-family, not multifamily.  That’s logical since the HUD secretary, Shaun Donovan, has a stronger background in multifamily, and as FHA is integral to then continued flow of housing finance capital.  Roughly a month ago, I posted about the declining FHA loan reserves; at the same, HUD Secretary Donovan said there was a better than even chance of staying above the 2% capital ratio statutorily required.  That, however, is less significant than it may seem, since, as I noted then:

The Federal Housing Administration is 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 United States.

Nevertheless, if it proves true that FHA’s loan book goes sour – badly sour – then the government will be further on the hook.  Worse still, the World Bank could stop lending without calamity ensuing; FHA basically cannot. 

Maybe we shouldn’t have braked so hard

The government is giving as many people as it possibly can the chance to buy a house or, if they are in financial difficulty, refinance it. The FHA is insuring about 6,000 loans a day, four times the amount in 2006. Its portfolio is growing so fast that even FHA backers express amazement.

I don’t understand the Times’s phrasing there – what does being an FHA backer have to do with observing that its activity growth is a remarkable byproduct of our remarkable times?

Many Democrats insist the FHA is playing a vital role in the housing market, which is only just starting to stabilize.

Would that elected officials and journalists could refrain from politicizing what should be bipartisan evaluations of entity performance and importance.

“FHA has stepped into the void left by the private market,” Representative Maxine Waters, Democrat from California, said at the hearing. “Let’s be clear; without FHA, there would be no mortgage market right now.”

Together with Fannie and Freddie, FHA is the credit backstop for about 80% of all US residential lending right now.  While it’s terrifying to think of that much lending being concentrated behind the government, it’s more terrifying to think of any one of the three stopping cold.

No more lending?

But [Stevens] acknowledged that some 20% of FHA loans insured last year — and as many as 24% of those from 2007 — faced serious problems including foreclosure, offering a preview of a forthcoming audit of the agency’s finances.

This shouldn’t be entirely surprising, recognizing that in 2008 FHA was the lender of last resort, and as we have chronicled, many of these refinancings were done hopefully.

“Let me simply state at the outset that based on current projections, absent any catastrophic home price decline, FHA will not need to ask Congress and the American taxpayer for extraordinary assistance — we will not need a bailout,” Mr. Stevens said in his testimony.

That is a direct and clear statement.  Let’s hope it’s true. 

If I’m wrong, strike me dead

Conversely, Mr. Zoellick wants money so he can reopen for new business. 

Zoellick conceded that such a task [Raising money from member nations – Ed.] was likely to be extremely difficult, given the difficulties facing countries in the wake of the developed world’s biggest recession since the Second World War.

Said in plain English, when you’re worried about domestic lending to your own homeowners, you’re highly unlikely to ship precious capital overseas to facilitate lending to foreign homeowners.

Make no mistake: we have reason to be watchful.

Superhero Sentry at your service

[Continued tomorrow in Part 2.]

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[Continued from yesterday's Part 1]. 

Yesterday’s post dismantled a slightly fear-mongering Wall Street Journal suggesting that FHA’s net worth would fall below the statutorily mandated 2%, and if so, that FHA would need a ‘bailout.’  In fact it does seem that FHA’s portfolio is under stress, with delinquencies up from 5.4% to 7.8%, and that this will bring its net worth, last year a little over 3% of portfolio, down to or just under the target.

Steering between the capital-reserve pylons

Even though that under-capitalization will be no more than an accounting entry – unlimited credit does have its little advantages, does it not? – it signals a larger challenge, and one that needs addressing:

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.

With the FHA’s entire balance sheet – loans plus insurance commitments – at risk, the portfolio’s health is of critical interest to the nation.  Against that, FHA’s information systems and its risk-management policies have been archaic.  Add this to the list of major initiatives to be undertaken soonest – but in the meantime, keep lending on the successful programs, and shut down the risky or rotten ones – some of them foisted upon it by Congress.

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%.

Last year, the agency ended a program [Nehemiah – Ed.] that allowed sellers to fund down payments.

That is fantastic news; I’m chagrined to have missed it.  As I wrote two years ago, in 3% altruistic, it was little more than a transparent scam: 

No, I’m truly substantial 

 Do the non-profits act as surrogates for the buyer, making sure prices are held down?

Sellers have tried to recover the cost of the fee they pay nonprofits by raising the price of the house an average of 3%, a 2005 study [text version here -- Ed.] by Congress’s nonpartisan Government Accountability Office found [also referenced here -- Ed.].   

So let’s keep score here:

·         Buyers use FHA-insured financing for 97% of the purchase price.

·         Even though there is a 3% down payment, buyers do not pay it themselves.  Independent non-profits give them the money.

·         Non-profits get the money from property sellers.

·         Sellers also pay the non-profits a processing fee.

·         Property sellers raise prices by 3%.

In a cruder world, what these particular non-profits are doing might be called ‘procuring.’  In such a procurement, two entities get screwed:

What happens to those receiving a procurement

1.             The buyers get screwed.

The higher prices contribute to the increase in foreclosures by buyers who have no equity in the homes, the GAO found. 

2.             The Federal government (that’s us taxpayers) gets screwed.

The programs are “a contributing factor of increased risk in our portfolio’ of loans, HUD spokesman Lemar Wooley said in an e-mail.  

More than 100,000 low- and moderate-income consumers bought homes using such programs last year. The percentage of foreclosures on these homes is more than double that on other loans sponsored by the Federal Housing Administration, according to agency audits.

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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 United States, unlike its GSE heirs Fannie and Freddie, which borrowed money on the capital markets without direct Federal support.

[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 US government

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 US mortgage market right now.  When the other lenders pulled back – of their own volition or because of regulatory order – the three F’s kept the money flowing.

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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