FHA Bailout Risk Looming After Guarantees: Mortgages

NYU Economics Professor Andrew Caplin
"The Federal Housing Administration's economic projections are surreal," said New York University economics professor Andrew Caplin. "They must believe there will be very few readers in Congress able to critically review such a complex report." Photographer: Scott Eells/Bloomberg

The Federal Housing Administration won’t be able to earn its way to financial health this year, increasing the chance it will need a taxpayer bailout, based on an updated forecast from Moody’s Analytics, which provides the agency’s housing-market analysis.

The U.S. government mortgage-insurer, which guarantees $1.1 trillion in home loans, had been counting on “robust growth” in home prices to help rebuild its insurance fund after paying out $37 billion to cover defaults the past three years, according to its annual report to Congress, filed in November.

It won’t get that growth until 2014, according to the latest outlook from Moody’s Analytics. One measure of the market, the S&P Case-Shiller Home Price Index, will decline 2 percent in fiscal 2012, said Celia Chen, a Moody’s Analytics housing economist who updated her estimate after providing the housing-market forecast for the FHA’s annual actuarial report. Moody’s Analytics hasn’t taken a position on the FHA’s future solvency, said Mark Zandi, the company’s chief economist, in an e-mail.

“The FHA’s economic projections are surreal,” said Andrew Caplin, a New York University economics professor who has testified to Congress on the agency’s finances. “They must believe there will be very few readers in Congress able to critically review such a complex report.”

Actuaries’ Projections

In their annual review, the FHA’s actuaries -- risk analysts who specialize in insurance -- used earlier projections that called for increases of 1.2 percent in 2012 and 3.8 percent in 2013. The agency, which backs mortgages that cover as much as 96.5 percent of a home’s value, is sensitive to changes in home prices. While the insurance fund’s 2012 outlook called for net growth of about $9 billion, that will drop if home prices decline, according to the FHA’s November report.

By law, the fund is supposed to hold 2 percent of its portfolio in reserve; as of Sept. 30, it held only 0.24 percent, or $2.6 billion, according to the report.

While the FHA issues an annual report and hasn’t updated its outlook since the new Moody’s forecast, Carol J. Galante, the acting FHA commissioner, says there’s no indication that home prices will fall to a level where the agency would need help from the U.S. Treasury.

“The independent actuaries rely on the best available data that most closely reflects our portfolio to estimate how the market will behave in the future,” Galante said in a statement yesterday. “All things considered, we’re doing everything we can to remain in positive territory and to avoid needing additional support from the Treasury.”

Deeper Than Predicted

Losses will be deeper than the FHA predicts, in part because the agency uses a home-price index that excludes distressed sales, Caplin said. Distressed sales, which refer to sales at prices lower than what borrowers owe on their mortgages, will make up 40 percent of transactions this year, Chen said. Excluding them produces a rosier forecast on sale prices and may mean the agency is underestimating potential claims, Caplin said.

“They can’t even track their data correctly,” Caplin said in an interview. “Not knowing how to measure the performance of your borrowers is tragic and profoundly wrong.”

White House Plan

The White House submitted a budget plan to Congress this year that would have provided the FHA as much as $688 million from the U.S. Treasury, the first bailout in the agency’s 78-year history. The money wasn’t needed because the FHA will get almost $1 billion from the government’s $26 billion settlement with the five biggest U.S. mortgage servicers over alleged foreclosure abuses, according to Shaun Donovan, secretary of the U.S. Department of Housing and Urban Development, which oversees the FHA. Mortgage servicers collect monthly payments and manage the foreclosure process.

As the FHA tripled its home-loan insurance to $1.1 trillion since 2007, defaults and expected defaults drained its cash reserve below the 2 percent legal threshold the last three years. The reserve is a cushion to offset possible future losses and is held in addition to $29 billion the agency has set aside to pay expected claims.

Caplin and others say the FHA’s plan to grow out of its cash squeeze amid rising property values won’t work. Taxpayers will be on the hook for between $50 billion and $100 billion “over many years,” says Joe Gyourko of the University of Pennsylvania’s Wharton School.

Improved Credit Quality

FHA officials dispute that conclusion, and note that they’ve taken steps to improve the credit quality of borrowers and to increase premiums and fees. The agency’s role in U.S. housing grew as private mortgage insurers retreated after the credit contraction of 2008. The FHA, created in 1934 to help low- and moderate-income people buy homes and to stabilize credit markets, insured 30 percent of U.S. house purchases last year, up from 4.5 percent in 2006. It charges lenders and borrowers a fee to guarantee that mortgages will be paid.

“To be clear, FHA is not broke,” Galante told a House Financial Services subcommittee hearing on Feb. 28.

To help bring in more money, the FHA will increase the premiums it charges most borrowers by 0.10 percentage points, starting April 9. For borrowers with homes worth more than $625,500, the hike will be an additional 0.25 percentage points, as of June 11. Upfront fees will also rise, to 1.75 percent of the loan from 1 percent, effective April 9.

Rate Reductions

President Barack Obama said Feb. 1 he wants to reduce rates on FHA refinancings for about 3.4 million eligible FHA homeowners. Their upfront fee would drop to 0.01 percent from about 0.55 percent and their annual premiums would be cut to 0.55 percent from 1.2 percent.

The net effect of the hikes and proposed discounts would add a total of $1 billion to FHA receipts in fiscal years 2012 and 2013, Galante told a Senate subcommittee March 8.

The agency’s reserve fund -- the amount held back after making provision for expected claims -- declined from 0.53 percent of its total portfolio in 2009, to 0.5 percent in 2010 and 0.24 percent last year. For single-family mortgages, which make up 94 percent of the portfolio, the 2011 reserve was just 0.12 percent.

“The FHA clearly didn’t allocate enough capital to the loans it insured from 2007 to 2010,” said Morris A. Davis, a professor of real estate and urban land economics at the University of Wisconsin-Madison’s School of Business.

Expected Claims

Apart from the reserve account, the FHA had budgeted $29 billion for expected claims at the end of fiscal 2011, about $900 million less than the agency will need, according to its actuary’s estimates. The FHA said in November it wouldn’t set aside the additional $900 million, an action that would have reduced its capital reserve further.

Over the last three years, the agency paid out $37 billion in claims -- more than it expected and more than double the preceding three years -- and “has not yet seen the peak of claim expenses,” which could come this year, according to the annual report.

Property values are important to the FHA insurance fund. Negative equity -- homeowners owing more on their mortgages than their houses are worth -- is one of the most important triggers of defaults, Gyourko wrote in a November 2011 paper, “Is FHA the Next Housing Bailout?” published by the American Enterprise Institute, a Washington think tank that advocates for limited government.

Tax Credit

The FHA will lose at least $10 billion more than it projects on 2009 and 2010 loans to first-time homebuyers who also took advantage of an $8,000 tax credit, Gyourko says. The credit was offered as part of Obama’s $787 billion economic stimulus package.

Gyourko called the credit a form of down-payment assistance, and noted that borrowers who receive such assistance are more likely to quit paying their mortgages.

Raphael Bostic, HUD’s assistant secretary for policy development and research, called Gyourko’s assessment “completely false and irresponsible” in the agency’s blog, The HUDdle. About 1 million first-time buyers used FHA insurance during the 13 months the tax credit was available, and their “failure rate” is less than 1 percent, he wrote.

The FHA was more accepting of arguments raised by Caplin and others, who say its actuary wasn’t correctly estimating risk for so-called streamline refinancing. The program moves borrowers from one FHA loan to another and doesn’t require updated property appraisals.

Negative Equity

Caplin and six other researchers estimated that as many as 71 percent of FHA borrowers who streamline-refinanced in Los Angeles County, California, in 2009 owed more than their houses were worth, according to a February 2010 paper. Using the FHA actuary’s methodology, only 1.5 percent of the streamline refinanced borrowers would have had negative equity, Caplin said.

For its 2011 estimates, the FHA’s actuary, Integrated Financial Engineering Inc. of Rockville, Maryland, changed its approach to try to capture home values after the refinancings, said Barry Dennis, the firm’s president. The change was one of several that increased the insurance fund’s potential payouts as of Sept. 30 by about $6 billion.

“Some borrowers have streamline-refinanced 10 times,” Dennis said.

Not Far Enough

Caplin said the change didn’t go far enough. The actuary counts each refinancing as a “successfully terminated mortgage,” he said. If a borrower refinances three times, the FHA counts that as three successful payoffs, Caplin said. That makes the agency’s performance look better -- and that history helps shape estimates of future losses, he said.

“The refinance is just a rate reduction, it’s not a successfully terminated mortgage,” Caplin said. “Ask yourself if we’re creating sustainable homeownership. How many borrowers are ending their reliance on FHA?”

Dennis said his firm’s approach uses FHA performance data to determine whether loans have had trouble in the past. While a refinancing removes risk from one year’s projections -- the year in which the original loan was made -- it adds risk in the year of the new loan, he said.

“It’s the same risk in the portfolio; it’s just in a different year,” Dennis said. “We’ve continued to improve our modeling.”

Gauging the Market

Caplin, Gyourko and others also question how the FHA gauges the condition of the housing market. The agency uses the Federal Housing Finance Agency index, which shows that home prices have declined 15 percent from a March 2007 peak. Another measure, the Case-Shiller index, shows that values have declined 34 percent since a July 2006 peak.

The FHFA index is more appropriate because the properties it tracks tend to be in the same geographic areas where the FHA insures mortgages, according to the agency’s annual report to Congress. Also, it said the Case-Shiller index “includes concentrations of properties subjected to subprime loans, and those sold in distress sales,” which aren’t in the FHFA index.

Distressed sales tend to drive down home prices. Using the FHFA index “is just one of the many choices FHA makes that are completely unjustified and that coincidentally make the situation appear better than it is,” Caplin said in an interview.

Integrated Financial Engineering’s Dennis said he “wouldn’t argue that the FHFA index is perfect.”

“Some have suggested that the FHA use an FHA-specific home-price index,” he said.

One change in the FHA’s approach this year may help improve the quality of its mortgages. It will spend more time and money checking for potential wrongdoing by mortgage originators, said Helen R. Kanovsky, HUD’s general counsel.

‘Limited Resources’

Until recently, FHA officials chose to direct their “limited resources” to examining loan servicing rather than loan origination, Kanovsky said. In general, the agency trusts lenders to certify the quality of mortgages it guarantees and to report paperwork flaws or possible fraud.

On Feb. 9, Charlotte, North Carolina-based Bank of America Corp. agreed to pay $1 billion to settle claims it failed to do so, while on Feb. 15 Citigroup Inc. admitted it certified loans for FHA insurance that didn’t qualify and will forfeit $158 million. Some of that money will compensate the FHA for claims it paid for defaulted home loans certified by Citigroup and Bank of America’s Countrywide mortgage unit.

The FHA can negotiate indemnification agreements in which the loan originator reimburses the agency for losses to its insurance fund. It typically requests indemnifications after a loan goes bad or when there are basic underwriting problems with the mortgage, such as missing paperwork or fraud.

Over the last seven years, the agency has averaged 1,282 indemnification agreements a year out of an annual average of 993,355 total loans guaranteed -- a little more than 0.1 percent.

(Corrects forecasted decline of home-price index in third paragraph of story published March 27 and clarifies that Moody’s Analytics has no position on FHA’s solvency.)
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