Lawmakers began 2011 with sweeping ambitions to shrink the U.S. government’s involvement in mortgage finance. They ended the year enacting policies that increase it. An 11th-hour extension of the payroll tax cut, signed into law on Dec. 23, will for the first time divert funds from Fannie Mae and Freddie Mac, the two mortgage finance companies under U.S. conservatorship, to pay for general government expenses. Congress also took steps that are likely to increase the role of the Federal Housing Administration in the market—at the same time that the agency’s reserves hit a record low. And some economists are charging that the FHA’s finances are even worse than they appear.
Last February, Treasury Secretary Timothy Geithner announced three options for reducing government’s role in housing finance. Soon after, Republicans introduced bills to wind down Fannie Mae and Freddie Mac, which have cost taxpayers about $153 billion since 2008 because of defaults on loans they guaranteed. The legislation never advanced because there was no agreement even among Republicans on the best way to proceed.
Then in December, as Congress looked for $36 billion to cover a two-month payroll tax cut, it ordered a 10-year increase in the fees that Fannie Mae and Freddie Mac charge lenders to guarantee principal and interest on home loans. The money will go into the U.S. Treasury. The move is drawing criticism because it relies on long-term revenue from entities that Democrats and Republicans want to shrink or eliminate, and the money won’t be spent to offset the risk of loan defaults. “The goal was, at the beginning of the year, how do we wind these down?” says Edward Pinto, a resident fellow at the American Enterprise Institute, a Washington-based research organization that favors limited government. “And at the end of the year we have further entrenched them and made it more difficult to wind them down, which is classic Washington.”
The controversy comes on top of other policy changes that housing analysts say could keep the government involved in the mortgage market. In November, House and Senate lawmakers increased the maximum size of FHA-insured loans to $729,750, from $625,500. Congress also failed to extend a tax break on private mortgage insurance for borrowers with low down payments that expired on Dec. 31. Private mortgage insurers indemnify lenders against loan defaults, with the cost of premiums passed to homeowners. Eliminating the tax deduction raises the cost of private insurance and makes FHA insurance a more attractive alternative.
The FHA, which is part of the Housing and Urban Development Dept., insures mortgages. Fannie and Freddie buy mortgages and package them into securities with guaranteed principal and interest. The FHA finances itself through fees charged to borrowers. As private mortgage insurance companies curtailed their businesses in the wake of the housing bust, the volume of FHA-backed loans outstanding has more than tripled over the past four years, to $1.1 trillion. “The FHA has saved the housing market and the economy’s bacon,” says Mark Zandi, chief economist at Moody’s Analytics. “If it had not at least partially filled the void left by the collapse of the private mortgage industry, the housing crash and Great Recession would have been much deeper.”
At the same time, the FHA has paid $37 billion in claims related to defaulted mortgages over the past three years. It has $2.6 billion in cash reserves, down from $4.7 billion in 2010, according to a November report by the agency’s independent auditor. The auditor said there’s a 50 percent chance the FHA will have to seek a capital infusion from taxpayers if the housing slump continues.
Some economists say the agency’s finances are in far worse shape. In testimony before the House Financial Services Committee in December, New York University economics professor Andrew Caplin challenged the auditor’s methodology. Citing two years of research he did with Joseph Tracy, an economist at the Federal Reserve Bank of New York, he said the auditor treated FHA-backed refinancings as if they represented successful termination of the FHA’s insurance obligation. That was wrong, he said, because only a sale to a non-FHA-backed buyer would take that mortgage off the FHA’s books. That flaw, Caplin told the committee, both overstated past FHA success rates and understated future loss projections. That means, he said, “there is a far higher likelihood than currently projected that a large bill will be due taxpayers.”
Joseph Gyourko, chair of the real estate department at the University of Pennsylvania’s Wharton School, raised similar issues in a November paper titled “Is FHA the Next Housing Bailout?” The FHA is underestimating default rates, Gyourko wrote, and therefore underpricing the insurance it sells. That’s “exactly what Fannie and Freddie did,” says Gyourko in an interview. He calculates that the agency will need $50 billion to $100 billion in federal funds to stay solvent. “Some misinterpret my analysis,” he says. “It’s not a call to kill the FHA. It’s a call to recognize the real costs and losses.”
The FHA plays down the prospect of a bailout. “It would take very significant declines of home prices in 2012 to create a situation in which the current portfolio would require any kind of additional support,” Carol Galante, acting FHA commissioner, said during a November conference call with reporters. Asked for comment, a HUD spokesman pointed to a November blog post by HUD Assistant Secretary for Policy and Development Research Raphael Bostic responding to Gyourko’s paper. Citing the auditor’s report, Bostic said the FHA’s mortgage insurance programs “are sound.”
Any resolution may have to wait until after the elections. “Lawmakers want to make sure that FHA is adequately but not overfunded until after the 2012 elections and the more fundamental policy questions can be addressed,” says Terry Haines, a financial policy analyst with Potomac Research. “The best anyone will do until then is slap Band-Aids on existing programs.”