New Rules Allow the FHA to Buy Troubled Loans

The FHA will fill some of the void in the mortgage market. But can it handle such a big burden?
Christoph Niemann

For much of the real estate boom, the Federal Housing Authority sat frustrated on the sidelines. Handcuffed by congressional limits on the cost and size of its loans, the original government buyer of mortgage loans couldn't compete with private firms in the subprime game. As a result, the agency's share of the loan market dwindled from its long-term average of 18% to less than 2% by 2007. "We were marginalized," FHA Commissioner Brian Montgomery said in July.

But with the crisis at Fannie Mae (FNM) and Freddie Mac (FRE), the FHA is stepping into the spotlight again. The agency, created during the Great Depression to encourage banks to lend to home buyers, provides insurance on loans originated in the private market. Unlike Fannie and Freddie (which buy loans and repackage them as investments), the FHA has always enjoyed explicit government backing.

Under new rules that take effect in October, the FHA will be able to insure an additional $300 billion of troubled mortgages. Another federal program, launched late last year, lets homeowners refinance high-cost subprime loans into FHA-backed mortgages with lower fixed rates. That new rule authorizes the FHA to refinance up to 500,000 loans.

The worry is that the FHA will stumble under the extra weight. By some estimates, the new initiatives could double the agency's loan volume. Already, its share of the housing market has ballooned to more than 14% in 2008. And many of the new loans may be riskier than the ones already on the FHA's books. "If you shuffle around who owns these loans, nothing is going to change," says Robert A. Eisenbeis, a retired director of research at the Atlanta Federal Reserve and an economist for money manager Cumberland Advisors. "We're going to end up looking at losses that are going to make the [savings and loan] crisis look like peanuts."

Lemar C. Wooley, a spokesman for the FHA, says it's well equipped: "The FHA has previously demonstrated a capacity to take on periodic surges in business. The FHA in all times, good and bad, is a countercyclical and stabilizing force in the housing market."

But the FHA was showing signs of trouble before the new laws were passed. Roughly a third of its loans feature "down-payment assistance," a controversial practice in which private groups grant money to first-time buyers. Those mortgages have the highest foreclosure rate among all FHA-backed loans. Losses last year, among the largest in the FHA's history, forced the self-funded agency to tap $4.6 billion of its $21 billion reserves.


Now the agency could become a dumping ground for other risky loans. First, there are the mortgages that lenders will convert into FHA-backed loans. Critics are concerned that the necessary loan modifications will prove a temporary fix, since the borrowers' finances are still fraught and housing's outlook remains bleak. The Congressional Budget Office estimates that 30% of the loans refinanced through the FHA's new program will end up in foreclosure.

What's more, with the flurry of new activity at the FHA, more cases of mortgage fraud are likely, potentially weakening the portfolio further. The Housing & Urban Development Dept., the FHA's overseer, opened 151 fraud investigations into FHA-backed loans in 2007. That was down from 239 in '06, but HUD attributes the decline mostly to shrinking market share. With the FHA's role expanding, HUD anticipates an increased caseload. It doesn't help matters that many of the same brokers who drew in subprime borrowers are now trumpeting FHA-backed loans, says Keith Johnson, chief operating officer of Clayton Holdings, a firm hired by banks to assess loans for fraud and other risks. Says Wooley: "[The agency] has devoted considerable attention to the problems of deceptive practices and fraud by investing in automated monitoring and risk analysis tools."

If there are major blowups in the FHA's portfolio, taxpayers could be on the hook—again.

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