An independent audit of the Federal Housing Administration (FHA) released recently raised eyebrows as it projected anticipated losses in the FHA's mortgage portfolio will exceed revenue, resulting in a shortfall of $16.3 billion. As the funding gap is only "projected" at this point, FHA officials are assuring the general public that measures are being adopted to raise revenues and avoid the agency's first taxpayer-funded bailout since its inception in 1934. Time will tell as to the efficacy of the FHA's proposed measures, but the high degree of FHA participation in U.S. home loan originations means that an FHA insolvency, and any associated concerns regarding the availability of mortgage financing, could directly influence Fed policy - which is currently aimed at stimulating the economy via home purchases.
As gold is highly sensitive to monetary debasement (i.e. money printing) and broader monetary policy in the U.S., any developments in this arena will have direct implications for the gold outlook. First we will establish the fiscal position of the FHA, how said position will influence Fed policy, and then explore what implications the Fed policy outlook has for gold.
The FHA basically guarantees loans if borrowers meet certain requirements. The FHA's less stringent requirements enable borrowers that could not acquire financing through conventional loan structures to purchase homes. For example, most FHA loans only require a minimum down payment of 3.5% and the agency is more flexible regarding the provenance of these funds (i.e. can come from a family member, charitable organization, government grant, etc.). The FHA also maintains more lenient terms regarding a borrower's credit profile. By guaranteeing these loans, the FHA enables lenders to finance home purchases for individuals they may not have dealt with otherwise. More information regarding the FHA's services can be found at the U.S. Department of Housing and Urban Development's website.
Since the recession, the FHA's market share of purchase mortgages, by loan count, in the U.S. has steadily grown. The table below provides further insight:
Data Source: FHA-Insured Single-Family Mortgage Originations and Market Share Report 2012-Q2, US Department of Housing and Urban Development: Single Family Insurance Activity Mortgage Market Shares by Loan Count 2012 Q2; US Department of HUD, data compiled from FHA, Mortgage Bankers Association, and CoreLogic, October 2012; accessed Nov. 21, 2012.
As can be seen in the table above, the FHA has consistently guaranteed north of 25% of mortgages for home purchases almost every quarter since the recession. By the second quarter of 2012, the FHA guaranteed almost 15% of total outstanding mortgages in the U.S. (to include refinanced mortgages). This dynamic is mainly the product of the more accommodative credit requirements that the FHA maintains.
As mentioned earlier, the FHA has promised certain changes that its hopes will avert the need for a bailout. These measures were detailed in a press release by the U.S. Department of Housing and Urban Development (HUD):
- Continue to sell expanded pools of defaulted mortgages headed for foreclosure through the Distressed Asset Stabilization Program (DASP), offering investors and borrowers the opportunity to avoid costly foreclosures - and even giving homeowners an additional chance at staying in their homes - while reducing costs to the Fund. The FHA is committing to sell at least 10,000 distressed loans per quarter over the next year;
- Revise its loss mitigation program to target deeper levels of payment relief for struggling borrowers, allowing more families to retain their homes and avoid foreclosure, reducing associated losses to FHA;
- Expand the use of short-sales, which will provide opportunities for distressed borrowers who have been unable to get out from under hundreds of thousands of dollars of mortgage debt to move to a new job or start anew while improving recoveries for FHA. Foreclosures are expensive, for families and the Fund. By reducing the likelihood that a family will be foreclosed upon, we reduce costs for the Fund;
- Continue to streamline policies to increase efficiency and decrease losses associated with the sale of foreclosed properties;
- Reverse a policy made in a prior Administration to cancel required premium payments after a certain period that effectively meant that while FHA's 100% insurance guarantee remained in effect for the 30-year life of a loan, borrowers were only required to pay premiums for less than ten years. FHA has been left without premiums to cover losses on loans held beyond the period for which it collects premiums. This change will apply to new loans.
- In 2013, enact an increase of 10 basis points or 0.1 percent to the annual insurance premium paid by borrowers on new FHA loans. This premium increase is expect to add $13 per month for the average borrower and will strengthen FHA's capital position without limiting access to credit for qualified borrowers.
Besides dropping securitized pools of defaulted and/or delinquent mortgages onto the market, the bulk of the FHA's proposed measures are either lip service the public wants to hear or measures that will end up costing the end consumer more.
"Revise its loss mitigation program," "expand the use of short-sales," and "continue to streamline policies" (the second, third, and forth measures listed above) are hardly tangible and amount to nothing more than fluff for an otherwise lackluster list of "solutions." If the FHA can achieve a more attractive bottom line by reviewing programs and streamlining polices, shouldn't that have been done before this news dropped? Why should it take the risk of a projected deficit to elicit the policy reviews needed to increase efficiency?
The following table tracks the FHA's loss rate on REO (real estate owned - or properties the FHA owns due to foreclosure) and short sale properties. The data clearly evidences an agency experiencing rising losses on this front - a trend that will probably not change merely as the result of "policy reviews."
Data Source: FHA Single-Family Mutual Mortgage Insurance Fund Programs -Quarterly Report to Congress- FY 2012 Q3, US Department of Housing and Development: FHA Single Family Mortgage Insurance Pre-Foreclosure and REO Dispositions and Loss Severity; US Dept of HUD, Office of Housing/FHA, July 2012; accessed Nov. 21, 2012.
Considering the facts that more than 17% of the FHA's loans were delinquent in September 2012, and the agency has loss rates that have consistently intensified across-the-board, it seems unlikely that some new revelations will come out of the FHA's proposed policy and program reviews…
The last two measures listed among the FHA's proposed solutions will provide the only substantive boost to the FHA's revenues - but at the expense of the borrower. By increasing the insurance premium and the timeframe during which those premiums are paid, FHA loans will consume a larger portion of borrowers' disposable income; income that Fed Chairman Ben Bernanke hoped people would use to start spending again. With this in mind, the only real measures the FHA can adopt to address their budget concerns will directly conflict with the Fed's espoused goals of driving consumer spending via home purchases.
While the additional cost to the consumer introduced by the FHA's proposed changes may not be crippling, they do amount to yet another deflationary pressure weighing on American consumers (or at least those subject to the FHA's increased costs). Additionally, it seems unlikely that the measures listed above will be sufficient to address more systemic concerns within the FHA's mortgage portfolio - namely that increasingly impoverished borrowers are unable to capitalize on the Fed's artificially low rates because of underwater mortgages (house is worth less than the mortgage balance) that do not meet refinancing requirements.
More specifically, older loans guaranteed by the FHA before the recession at higher interest rates will remain moribund - splotches of red on the FHA's balance sheet - as an inability to refinance continues to plague this component of the agency's mortgage portfolio. For these loans to become eligible for refinancing at more affordable rates, thereby saving borrowers money and allowing them to continue making mortgage payments, home prices need to rise. For home prices to rise, the FHA needs to keep guaranteeing its family of approved loans so more home sales can be financed. Given the fiscal state of the FHA and other institutions that service increasingly unattractive loan portfolios, we may not be able to count on robust growth in loan originations - despite record low interest rates.
As long as underwater borrowers are unable to capitalize on lower rates and lower monthly payments, there will be a consistent supply of foreclosed homes that are introduced into the market. For as long as this dynamic continues, the excess supply will weigh on home prices despite whatever rises in home sales the Fed can elicit with its low-rate policy.
The graph below highlights this dynamic of rising delinquency rates despite the low rate environment. The red line represents the delinquency rate on single-family residential mortgages and follows the percentages detailed on the right Y axis. The blue line represents the average 30-year fixed mortgage rate and follows the percentages detailed on the left Y axis. As you can see, delinquency rates have not begun to fall despite the record low interest rates which should have presumably enabled borrowers to refinance and achieve a lower monthly payment. While the delinquency rates have observably stalled, we're currently at an inflection point and will have to wait and see which way the trend decides to go. For as long as the unemployment rate and home prices remain the same, we probably cannot expect a material decrease in the delinquency rate.
Data Source: FRED, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis: 30-Year Fixed Rate Mortgage Average in the US and Delinquency Rate on Single-Family Residential mortgages, Booked in Domestic Offices, All Commercial Banks; Freddie Mac; U.S. Department of Labor: Bureau of Labor Statistics; accessed November 30, 2012.
Even assuming the FHA can miraculously increase revenues and avert the need for a bailout, the agency's brush with default will almost certainly influence their lending standards going forward. Realizing the malignant nature of many of its older loans, the FHA will have to adopt a harder line to credit requirements and eek out as much profit as possible from new loans - meaning less favorable terms for borrowers. Ultimately, this dynamic will weigh on the volume of loans guaranteed by the FHA going forward. Without the FHA, many of the home purchases taking place in this post-recession environment would no longer be feasible (according to the FHA market share graph above, the agency projects its guarantees of purchase mortgages in the third quarter will represent 25.9% of the market).
Should the worst occur, and the FHA requires a taxpayer-funded bailout, how long will the agency be out of commission? How many potential home buyers will be out of luck because without the FHA they cannot satisfy the requirements maintained by conventional lenders (i.e. higher down payments, tougher credit standards, etc.)?
Now let's consider the implications of the FHA's fiscal position within the context of the Fed's current monetary policy. In a press release following the announcement of QE3, Bernanke was quoted:
"So the extent that home prices begin to rise, consumers will feel wealthier, they'll feel more disposed to spend.
"If house prices are rising, people may be more willing to buy homes because they think that they'll, you know, make a better return on that purchase. So house prices is one vehicle. Stock prices, many people own stocks directly or indirectly. The issue here is whether or not improving asset prices generally will make people more willing to spend. One of the main concerns that firms have is there is not enough demand, there's not enough people coming and demanding their products. And if people feel that their financial situation is better because their 401(k) looks better for whatever reason, their house is worth more, they are more willing to go out and spend and that's going to provide the demand that firms need in order to be willing to hire and to invest."
Straight from the horse's mouth: home purchases as a corollary to rising home values are integral to the Fed's policy approach. The main goal of QE3 is to decrease unemployment as rising home prices make people "feel wealthier" and more inclined to spend. The Fed has basically said it will print money and initiate monthly mortgage-backed security purchases - indefinitely - until the measure has precipitated a material and sustained decrease in overall unemployment. However, if much of the success of this proposed program is riding on rising home purchases, tribulations within the FHA and other financing institutions could directly compromise the Fed's approach.
Besides a structural change in consumer profiles that has taken place - which is characterized by a preference for paying down debts and saving as opposed to consuming - the Fed now has to worry about the availability of home financing. The FHA, which subsidizes home purchases for those borrowers who may be otherwise blocked from the market as a result of their credit profile, is integral to growth in home sales. However, this revelation about the agency's fiscal situation represents a wrench in the gears of the Fed's strategy.
Now the question is, if the Fed appreciates the true nature of the U.S. economic environment, and recognizes the implausible assumption that it can force home values higher by sheer might of policy and irrespective of observable market dynamics, will it change course? With its policy arsenal all but expended, it's sadly safe to assume that the Fed will simply maintain its current approach and probably even expand its asset purchases (via money printing) in the face of non-existent results. The questionable solvency of the FHA is yet another reason why QE3 and the Fed's associated strategy probably won't work - at least in the short-to-medium term. However, the probability of the Fed adjusting its policy course accordingly is low. More than likely, we will see an obstinate continuation and intensification of the Fed's efforts in the face of lackluster results. This means a longer persistence of monthly Fed bond purchases and more monetary debasement as the central bank prints money to "accomplish" its goals.
As is well established, gold benefits from monetary dilution and the associated inflationary implications. The Fed overseeing the creation of an ever-rising quantity of dollars will naturally benefit gold prices. The sluggish performance of gold in the aftermath of the QE3 announcement in September indicates a large number of market participants are not overly concerned about this newest round of quantitative easing. This is probably because inflation rates have remained muted despite the Fed's unprecedented expansion of its balance sheet. However, should the FHA's insolvency and associated implications increasingly limit the efficacy of the Fed's approach, and the central bank adopts more expansive measures, it is likely that a rising number of investors will allocate a portion of their portfolios to the shelter provided by gold and other intrinsically valuable assets. While definitive figures are near-impossible to find, it is estimated that anywhere from 2-9% of Americans own precious metals. As more and more Americans are cognizant of the Fed's monetary debasement, that percentage of precious metal owners could balloon in short order. Mortgage-backed securities (MBS) - and the funds that invest in them - would also benefit as the Fed bolstered QE3's monthly MBS purchases in response to muted gains in home purchases and broader consumer spending.