FHA: Next in the Bailout Line?

by: Rolfe Winkler, CFA

A must-read in today’s WSJ talks about the solvency crisis facing FHA:

The Federal Housing Administration, hit by increasing mortgage-related losses, is in danger of seeing its reserves fall below the level demanded by Congress, according to government officials, in a development that could raise concerns about whether the agency needs a taxpayer bailout.

The required reserve level is a paltry 2%. Readers may recall that was the capital level Fannie and Freddie were operating with just before they were taken into conservatorship:

Federal law says the FHA must maintain, after expected losses, reserves equal to at least 2% of the loans insured by the agency. The ratio last year was around 3%, down from 6.4% in 2007.

No doubt the reserve ratio has fallen substantially since last year. The revised figure won’t be made available until FHA’s fiscal year ends Sept. 30th.

In the past two years, the number of loans insured by the FHA has soared and its market share reached 23% in the second quarter, up from 2.7% in 2006, according to Inside Mortgage Finance. FHA-backed loans outstanding totaled $429 billion in fiscal 2008, a number projected to hit $627 billion this year.

Rising defaults have eaten through the FHA’s cash cushion. Some 7.8% of FHA loans at the end of the second quarter were 90 days late or more, or in foreclosure, according to the Mortgage Bankers Association, a figure roughly equal to the national average for all loans. That’s up from 5.4% a year ago.

FHA’s exploding volumes are just another indicator of the substantial government support propping up house prices.

With all that volume, one would hope FHA had a robust risk management apparatus. Nope:

Critics have said the FHA, which has never had a chief risk officer, isn’t able to manage such a large portfolio and has weak underwriting standards.

Policymakers have used the FHA to stabilize the housing market by pushing it to offer credit with far easier terms than that offered by most private lenders. For example, it will back loans with down payments as low as 3.5%.

Over $600 billion of loans backed by the end of this year — many very risky due to very low downpayments — but no chief risk officer….

A canary in the coal mine was the raid on Taylor Bean & Whitaker, a multi-billion dollar lender that had seen its FHA lending business expand very quickly over the past year. But TBW’s underwriting was terrible so FHA suspended them from issuing its loans. By the end, TBW’s business had grown to $100m-$150m worth of loans per day. The suspension put TBW out of business overnight.

It’s likely FHA will need a bailout. It’s equally likely the agency will continue to be a conduit through which the Obama administration funnels cash to the housing market.