FHA: Lending with a 20%+ default rate expectation

This blog has mentioned before that FHA is subprime in sheep's clothing. But how bad is it?

"Although the FHA has tightened credit standards, many of the 2007 and early 2008 mortgages are going bad. The agency expects defaults on 24% of all loans insured in 2007, and 20% of those backed in 2008. "The orders from Congress and us were clear: We want to save as many families as we can, recognizing that a lot of loans people were looking to refinance out of should never have been made in the first place," said Brian Montgomery, who served as the agency's commissioner for four years ending in July."(1)

Although there have been lots of assurances to the contrary, it looks like a bailout is now in the works.

"Two House Republicans warned that growing losses at the Federal Housing Administration could lead to a taxpayer-funded bailout and have asked the Department of Housing and Urban Development for data backing up the FHA’s assertion that it won’t need to ask Congress for any taxpayer money.

“Congress and HUD must take whatever steps are necessary to ensure that this program operates in a manner that does not expose the taxpayer to yet another bailout,” wrote Republicans Darrell Issa of California and Spencer Bachus of Alabama in a letter, dated Monday, to HUD Secretary Shaun Donovan."

Apparently news leaked that the stress tests used in the audit showed FHA is doomed at current capital levels.

Likelihood that a bailout will be avoided, I put it at 10%. But who cares, the DOW is up. Right?

(1) "FHA digs out after loans sour", WSJ, written by Nick Timiraos, Nov 4, 2009

(2) "FHA postpones release of audit as bailout worries mount" WSJ, written by Nick Timiraos, Nov 5, 2009

FHA is subprime

When it was discovered that Fannie and Freddie were insolvent due to the poor performance of mortgages, Treasury Secretary Paulson, as a condition of guaranteeing the debt, mandated that Freddie and Fannie shrink their portfolios going forward.


The government need another agency to step into the gap and be the guarantor of mortgages so banks would not stop mortgage lending cold turkey. The agency given that charge was FHA and since then the government has become "the market" in mortgages.


"The FHA now insures $560 billion of mortgages—quadruple the amount in 2006. Among the FHA, Ginnie, Fannie and Freddie, nearly nine of every 10 new mortgages in America now carry a federal taxpayer guarantee."

As a house shopper I have been waiting for the strictest lending environment to achieve the best purchasing deal. Yet in the winter of 2007 my mortgage broker approached me at dinner (at the time he was moonlighting as a waiter) and said "Nothing has changed, FHA is the new subprime".

Since 2007 FHA has gone from single digits market share to providing over 25% of the mortgages in the US market. It was thought that the FHA full doc process would prevent the widespread fraud that underminded the ratings on securitized packages of mortgages. Although fraud has declined, I hear from mortgage brokers is still ways to game the FHA mortgage approval system.

Who will pay for the flaws of FHA? You will.

"Federal law says the FHA must maintain, after expected losses, reserves equal to at least 2% of the loans insured by the agency. The ratio last year was around 3%, down from 6.4% 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."(1)

This is a big problem. The agency has been the stop gap in the housing market, but now the stop gap is going insolvent. Officials think it could go insolvent by the end of this year.


...Officials said as recently as May that they didn't expect to fall below the 2% 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%" if the current study follows last year's methodology, says Mr. Lawler."(1)


Although the problems is obvious, the solution is not. Congressional mid term elections are coming up and the Republicans would so much enjoy yelling "spendthrift" at Democrats for making another federal enterprise insolvent in two years. At the end of the day, another back door bailout including a relaxation of capital standards and additional borrowing capacity will probably occur. But the Republicans and Blue Dog Democrats may be able to extract a higher required down payment requirement for FHA loans going forward, or stricter payment to income ratios for borrowers.


The author purchased SDS at $44.5.




(1) Wall Street Journal, Sept 4, 2009, "Loan Losses Spark Concern Over FHA" by Nick Timiraos



(2) "FHA ready to join Fannie and Freddie"



(3) Wall Street Journal, Aug 11, 2009, "The Next Fannie Mae"