Over the last few weeks we’ve documented important changes to the Federal Housing Administration’s (FHA) mortgage insurance program and suggested there might be more on the horizon. Well, it looks like the biggest one yet is about to land: the FHA will likely require a bailout from the federal government. For all 79 years of its history, the FHA has operated without ever taking a taxpayer subsidy. But due to extraordinary losses it is becoming increasingly likely that the agency will have to take one by September 30, when it is required by law to be solvent.
The FHA currently insures mortgages worth more than $1.1 trillion, a large share of the total housing market. To back those loans, the agency maintains the Mutual Mortgage Insurance (MMI) fund, which as of its November 2012 report, held reserves of $32.1 billion. However, the same report projected nearly $48.4 billion in losses for 2013, essentially predicting a budget shortfall of $16.3 billion. Factoring in recent changes, a bailout of around $943 million is being currently planned, though it might require a “little bit more, or a little bit less” according to Carol Galante, the FHA Commissioner.
Causes of the Shortfall
The origin of the FHA’s current problems is well documented and agreed on by most parties: The agency backed a large number of bad loans after the 2008 housing crisis and has been forced to pay out far more than originally planned due to extremely high foreclosure rates
Before the financial crisis, the FHA insured only 4% - 5% of the new mortgages originated each year. However, that share jumped considerably during the crisis years, reaching almost 20% in 2010 and falling to 16% recently. While some argue this is merely because the number of private mortgages has fallen, while the FHA’s numbers have remained stable, the FHA’s lending practices have also either stayed stable or become more lenient at a time when the rest of the mortgage market has tightened its proverbial belt significantly. The result has been an astronomical default rate on FHA loans: 9.5%.
Things look even worse when you look at specific agency programs. With a nearly 90% market share, the FHA has a near monopoly on risky reverse mortgages. The high loan amounts offered on many reverse mortgages, coupled with a sky high default rate, have led the FHA to lose money on the program year after year.
To combat its projected deficit, the FHA has initiated a series of major reforms. The first adjustment: elimination of the FHA’s flagship reverse mortgage program (the Home Equity Conversion Mortgage or HECM). Enacted on April 1st, the FHA restricted the manner in which borrowers could take out a new reverse mortgage, leading to smaller loan amounts and hopefully fewer losses.
The second adjustment affects the FHA’s main mortgage insurance program. Also begun on April 1st, the rates on mortgage insurance for new loans were increased by 10 basis points or 0.1% per year. A second, more subtle change was also enacted at the same time: going forward, most borrowers will not be able to cancel mortgage insurance policies on their home. In the past, a borrower had the opportunity to cancel their insurance after five years if they met certain requirements and most did so somewhere between years seven and eight. Now, those borrowers will have to pay for mortgage insurance for the full length of their loans, usually 30 years. This will more than double the cost of a mortgage insurance policy for the average borrower.
While few would argue that the FHA has taken a hands off approach to shoring up its books, many contend that its recent changes are counterproductive and not likely to protect the agency’s interests now or over the long-term. The common critique is that the FHA’s lending practices do not attract good borrowers and that the changes seem only to limit future losses and do nothing to eliminate them.
Critics immediately pointed out that the FHA’s adjustments only affect one of the four reverse mortgage products offered by the agency. Since the FHA will continue to offer the most accessible type of reverse mortgage, it figures that borrowers will simply flock to one of the other three products still available. While the FHA might save some money due to the newer program’s lower loan limits, the aforementioned changes would do nothing to address the high default rates seen on reverse mortgages.
A different but similar critique was leveled at the FHA’s changes to their general mortgage insurance program. While raising the cost of mortgage insurance would certainly increase in the agency’s revenue, it would also discourage many of the most reliable borrowers from taking out an FHA loan in the first place. Given the choice the between saving for a bigger down payment or paying mortgage insurance for the full life of the loan, many borrowers would opt out of FHA loans altogether.
Without further changes, it’s likely that the FHA will be taking a bailout sometime this year. While it would be deeply unpopular, current politicians have little leverage – the FHA already has a credit line to the US Treasury; it requires no special authorization to draw its proposed subsidy. The larger question is what will become of the agency in the future as both sides of the political spectrum seem intent on transforming the agency: Democrats on expanding its role as a lender to disadvantaged borrowers, while Republicans want to tighten its lending standards considerably.
The agency will have to find a way to get back to stability, because over the long-term public-will simply will not tolerate the FHA relying on the federal government for a handout. That likely means the FHA will have to find ways to attract more reliable and more stable borrowers, instead of trying to extract very high payments from a set of borrowers who really have no other loan options.
While the FHA has taken serious steps to shore up its portfolio, its future as a major player in the mortgage market is not secure. With both sides of the political spectrum intent on making changes, it seems unlikely the FHA will continue to operate in its current form for much longer. Whether that means it will adopt lending practices more akin to those in the private mortgage market or become more of a federal entity is unknown, we can say one thing for sure: significant changes are on the way.