Subprime Debt Insured by FHA Climbs in Bet on Housing Recovery: Mortgages

In Honolulu, on the southern coast of the island of Oahu, there’s a four-bedroom home priced at $785,000 that has views of the sun setting over the Pacific Ocean. The beaches of Waikiki are 15 minutes away.

Starting this month, the property is available to buyers with a subprime credit score, limited cash reserves and a 3.5 percent down payment using a loan backed by the Federal Housing Administration. Without the agency, a buyer would need a 20 percent down payment and an unblemished financial history for a jumbo mortgage.

The FHA is betting housing can recover enough to expand financing and earn bigger fees to revive its record-low capital levels. The agency increased the size of mortgages it’s willing to insure to as high as $793,750 in Hawaii and $729,750 in the costly real estate markets of states including California, Florida, and Virginia. In his State of the Union address on Jan. 24, President Barack Obama proposed a new refinancing program that may expand FHA’s responsibilities, and risks, even further.

It’s “not the best time to begin guaranteeing houses that the average American couldn’t afford,” said Anthony Yezer, director of the Center for Economic Research at George Washington University. “It may be that the insurance fund even now is insolvent.”

Obama told Congress he would send it legislation that would allow all U.S. homeowners to refinance their mortgages to take advantage of record-low interest rates. The proposal, and the Congressional mandate, come a year after officials vowed to shrink the role of government in the mortgage markets.

Refinancing Borrowers

The initiative would apply to all borrowers, whether or not their loans are currently government-backed, with details still to be worked out, according to senior administration officials, who asked not to be named. Neither Obama nor the officials specifically said FHA would insure the private mortgages that refinance, though that was a conclusion drawn by analysts including Mahesh Swaminathan of Credit Suisse Group AG in New York.

“Our preliminary interpretation is that the program is aimed at refinancing borrowers with underwater private label mortgages into FHA loans,” he said in a note to clients yesterday.

About 12 percent of FHA loans had payments a month or more overdue in the third quarter, compared with 8 percent for the overall market, according to the Mortgage Bankers Association in Washington. In Florida, the rate was 13 percent and in Virginia the rate was 11 percent.

Wipe Out Equity

Slight declines in home prices could wipe out equity for a home bought using the FHA’s 3.5 percent minimum down payment, increasing the risk of a default. Michelle Meyer, Bank of America Corp.’s senior U.S. economist, last month forecast a 3.5 percent drop in home prices this year.

In the case of a default, larger home loans put taxpayers on the hook for bigger payouts on luxury properties many can only dream of owning, Yezer said. In Hawaii, home prices in the third quarter dropped 2.3 percent from a year earlier, according to the Federal Housing Finance Agency. In California, where cities such as Los Angeles, San Jose, and San Francisco have a cap of $729,750, prices were down 5.4 percent.

“We’re already at the point where the FHA is raising fees on current borrowers to make up for past mistakes, and these loans have the potential for much bigger losses,” said Yezer. “If people really want to buy a $700,000 house, maybe they should save the 20 percent down and not rely on taxpayers, or else they could buy something smaller.”

Capital Reserve Level

Three years after Fannie Mae and Freddie Mac were seized by the regulators, the agency that backs a third of U.S. home loans is straining to meet its federally mandated capital reserve level, said Edward Pinto, a housing specialist at American Enterprise Institute who was Fannie Mae’s chief risk officer in the 1980s.

By law, the FHA must maintain a 2 percent capital ratio, measuring assets against risks. The current measure is 0.24 percent, according to an independent actuarial study by Rockville, Maryland-based IFE Group. The findings were sent to Congress by the Department of Housing and Urban Development two weeks before members voted to restore the record-high caps after they expired last year.

“The FHA is leveraged to the hilt, and it has over $1 trillion of loan guarantees outstanding,” Pinto said. AEI is a Washington think tank that supports limiting the role of government.

Insurance Fee

The FHA capital ratio probably will rise above 2 percent by 2014, Housing and Urban Development Secretary Shaun Donovan said in testimony as part of the agency’s annual Congressional report. If needed, the agency could meet a shortfall by raising fees, Donovan said. Last year, the agency boosted its annual insurance fee by a quarter of a percentage point to 1.15 percent for most borrowers.

“FHA’s financial condition, while still facing risks that must be addressed, is remarkably resilient in the wake of the extraordinary turmoil in the housing market,” Donovan said. “Amid nearly unprecedented economic conditions that have devastated other institutions, FHA continues to provide a critical source of mortgage capital.”

The agency in 2010 began mandating credit scores of at least 580 for borrowers who use its minimum down payment of 3.5 percent. Home buyers rated below that level, down to 500, have to put 10 percent down. Credit scores lower than 640 are considered subprime, according to the Federal Reserve.

Low-Income Borrowers

The FHA was created in 1934 by President Franklin Delano Roosevelt as part of his New Deal. For almost 70 years, the agency’s mission was to fund mortgages for low-income and first- time buyers. On its website, it still describes its goal as expanding homeownership for “underserved” communities.

The agency’s insurance mainly helps to protect investors in Ginnie Mae mortgage bonds, which have the explicit backing of the federal government. The debt returned 7.8 percent last year compared with 5.2 percent for global corporate bonds, according to Bank of America Merrill Lynch index data.

Ginnie Mae, which is based in Washington and formally named the Government National Mortgage Association, was created in 1968 as a U.S. government-owned corporation to securitize loans backed by the FHA, the Veterans Administration, and other government housing programs.

Positive Bond Values

“The increase in fees has had a positive impact on bond values as it reduced the incentive to refinance higher paying loans,” according to Siddarth Ramkumar, a Barclays Capital mortgage strategist in New York. While the FHA “doesn’t see the capital ratio is in danger,” further increases in mortgage insurance premiums would slow prepayments and support bond values, he said in a telephone interview.

About 84 percent of the U.S. is covered by the FHA’s standard loan cap of $271,05O, said Brian Sullivan, an FHA spokesman. The higher limits in some regions is based on their median home price. The highest cap in the continental U.S. is $729,750.

“FHA keeps responsible mortgage financing available when times are tough,” Sullivan said. “Quite simply, it’s what FHA was born to do.”

There “isn’t a means test for FHA insurance,” said Brian Montgomery, the FHA commissioner for the administration of former President George W. Bush and co-founder of Collingwood Group LLC, a Washington consulting firm. “The agency is being called on to perform a counter-cyclical role, to support the real estate markets in higher-cost areas.”

In Key West, at the end of a chain of islands off Florida’s southern tip, you could use a 3.5 percent down payment to get a three-bedroom home listed for $699,000 that has a private dock on a lagoon leading to the Gulf of Mexico, or for $645,000 a two-bedroom home with a pool in a so-called gated community that has guard houses to screen visitors.

‘Sound Sky-High’

“For the rest of the country, our prices may sound sky- high, but for our market, it’s just middle of the road,” said Robert Frechette, a real estate broker with Compass Realty in Key West, Florida.

In other high-cost markets, a buyer could use an FHA loan to purchase a home with marble baths listed in Falls Church, Virginia, for $729,000, or a $669,000 three bedroom home in Jackson, Wyoming, where Wall Street bankers go for trout-fishing vacations.

The FHA needs the bigger fees from high-balance loans to pay off a rising number of defaults from lending in previous years, said AEI’s Pinto.

“It’s the same principle as they way we fund Social Security -- you get money from today that pays off earlier obligations,” said Pinto.

To contact the reporter on this story: Kathleen M. Howley in Boston at kmhowley@bloomberg.net.

To contact the editor responsible for this story: Rob Urban at robprag@bloomberg.net

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