Will FHA Fall into the Sub-Prime Trap?

By Dirk van Dijk

Friday’s New York Times has an important article on the Federal Housing Administration. The FHA has stepped in to back up mortgage loans as the private sector has stopped making them.

Essentially, it is playing the role of a sub-prime lender, and appears to be making many of the same mistakes the fallen or defunct sub-prime lenders made. For starters, it is allowing people to buy with down payments of only 3.5%. Further, people can use the $8,000 first time homebuyer tax credit for that 3.5%. Buy a house and walk away from the closing with a check in your pocket.

The historical record of people who bought houses with the assistance of charitable down payment assistance programs (DAP) is not a pretty one when it comes to default rates. The tax credit is acting like a massive DAP.

The agency now insures 5.4 million mortgages worth a total of $675 billion. Its reserves are down to just $30 billion. A total of 411,000 FHA loans are in default, up 76% from 233,000 a year ago. Recent loans are defaulting at far higher rates than older loans.

Private lenders, on the other hand, have gotten religion and have returned to the safer, more conservative and traditional 20% down payments. The graphic from the story below speaks volumes. The number of loans being insured has soared, and so have the number of loans that are defaulting.

The number of defaults should come as no surprise, since the policy is to make loans to people who will have very little skin in the game. When housing prices are declining, it means that the homeowner is almost immediately in an underwater situation. Owing more on your house than what it is worth is the single biggest risk factor in defaulting on your mortgage.



The huge increase in risky loans by the FHA is a deliberate policy to try to prop up house prices nationwide. In a remarkable quote, this was admitted to by Rep. Barney Frank (D-MA) who chairs the House Banking Committee:

“I don’t think it’s a bad thing that the bad loans occurred,” he said. “It was an effort to keep prices from falling too fast. That’s a policy.”

The question is, can such a policy be sustained? Residential housing is a very big market, and trying to place a price floor under it can get very expensive.

On the other hand, one has to realize that if the FHA were not out there being as aggressive as it is, there would probably be no residential housing market at all right now. Very few people can come up with the $40,000 in cash needed to buy a $200,000 home with 20% down. In the past, people who were selling a previous home at a big profit during the boom years could easily do so, but the pool of potential buyers with that kind of cash is very small now.

From the anecdotes in the story, it seems like many of these FHA buyers really have no business being homeowners in the first place, and are being set up to fail.

In effect, the very low down payment policy of the FHA is an attempt to move people from being renters to being owners. It clearly has had some success in doing that. However, it really doesn’t do anything to encourage household formation or do anything to diminish the supply of housing units. It just shifts people out of rentals at a time when the rental vacancy rate is heading higher. This will put downward pressure on rents.

Since a house is an asset, and the value of an asset is determined by the discounted value of all future cash flows, it will put further downward pressure on housing prices. After all, what are the cash flows from owning a house but the value of not having to pay rent for a similar house to live in?

The ratio of home prices to rents was one of the biggest red flags out there that we were in a housing bubble. Since the top, that ratio has come back towards more normal historical levels, but it is still near the high end of normal. If rents start to fall significantly, it will be shooting at a moving (falling target).

In other words, we are shifting the problem, not curing it. While the big apartment REITs like Equity Residential (EQR) or Apartment Investors (AIV) might not go broke, it sure will not help them. Smaller landlords could start defaulting on their holdings. Thus, banks are able to find buyers for the homes they have foreclosed on, but will be hit with higher defaults in their commercial real estate portfolios.

The FHA is heading down the same path that eventually killed Fannie Mae (FNM) and Freddie Mac (FRE) as well as such dearly departed as Downey S&L and Washington Mutual. While the head of the agency claims that there will be no need for a bailout, those other institutions also insisted on their solvency -- almost right up until the day they went under.

The FHA has done some social good in slowing the decline of housing prices, but it has come at a cost -- one that taxpayers may end up paying. The massive federal propping up of the housing market makes one question if the recent increases in the Case Schiller home price indexes are for real, or are just a temporary blip.

Comments

[a fat panda:]

The government looks like the little dutch boy trying to plug holes in the dyke. Now that he has run out of fingers, he is simply shoving dollar bills into the ever widening cracks.

Oct 09 11:31 PM

[Seth Chalnick:]

As a real estate insider I whole-heartedly agree with this article, with the exception of the error the author makes in saying that people can “use the $8,000 first time homebuyer tax credit for that 3.5%” down payment. While the FHA allows for this in theory, no lender extends this feature in practice, because it is unclear how and when the semi-government institution will credit back the lender.

Meantime, to add key perspective to this article, the FHA loans cost consumers considerably more per month than conventional loans do, and they become downright cost prohibitive as the sale price approaches $400k… and yet buyers can borrow right up to “agency jumbo” loan limits, which for example in SD are $697,500.

Approximately half of the increased monthly payment stems from the borrowing of more money… the rest comes from the multiple whammies of higher rate, upfront mortgage insurance premium (added to the loan balance), and monthly mortgage insurance premium… all of which are applied to the whole balance enchilada, which is obviously really high… i.e. 96.5% loan to value.

I say key perspective, because the higher cost of all this directly impacts the ability of folks to repay.

For further perspective on this issue, and insight into the party line rhetoric most real estate agents regurgitate via groupthink… SA fans may be interested in checking out a very telling thread on Trulia.com, whereby industry insiders go at it, pitting party line sound bytes against fundamental analysis.

The Trulia question is posed by a Long Beach broker, named Ben Nicola, and it is entitled, “What’s Wrong with FHA financing?”

This link should take you there… www.trulia.com/voices/...

Oct 10 02:05 AM

[Mr. Ed, Jr.:]

"The FHA has done some social good in slowing the decline of housing prices, but it has come at a cost -- one that taxpayers may end up paying"

Well.....It is not clear to me why falling home prices are to be considered a social ill. Lower home prices allow an easier entry to home ownership (Proven benefits to society) and let people spend their money in other areas of the economy, if they desire.

The housing market is too big for the government to prop up. Any attempt is doomed to failure, and then everybody pays-- including renters, whose tax dollars are also wasted in the failed attempt to keep the neighbor's house price up. Of course, propping up real estate prices also means that the renter must pay higher rents, but if they can't take a joke....

How and why is it the role of our government to prop up house prices for some citizens ?

If the government wants to give a tax rebate to ALL citizens, to be used to pay down their home mortgage or spend on lap dances or whatever they want to do with it-- fine. But propping up free market house prices (particularly after the government's policies created the housing fiasco in the first place) is a corrupt policy, designed to protect banking and Wall Street interests. Again.

And is it any wonder the dollar keeps falling ? What must people around the world be thinking as they hear the daily news reports of the latest absurd US government scheme ? Just this summer, government was buying cars for citizens...now it is giving homebuyers 8k while helping them obtain get almost nothing down home loans . Again. The President and Vice-President keep giving speeches about free college education.....and government health care for all. Free stuff from the biggest debtor nation in the history of the world.

It is hard to believe that this nonsense...this chaos and corruption....is now permeating every nook and cranny of the United States of America. It has happenned incredibly fast. And it just keeps getting worse.

Oct 10 04:25 AM

[JAMES CARLINI:]

Aren't they looking for another bailout? Everyone is afraid to let them fail - well when do we finally say no?

GM needed the money to survive and they still went bankrupt. How many of you rushed out to buy a GM car now that they are "saved"?

Oct 10 07:33 AM

[Michael Clark:]

Thank you, Mr. Ed. Declining prices are apparently ALWAYS a bad thing. We NEED lower prices. We have become heavily indebted as a nation BECAUSE of the inflationary spiral forced upon us over the last two decades.

Always, food prices have to accelerate, clothing, housing, profits for industry....profits DO NOT always go up. Profits go up and down. People get rich and get poor.

This obsession with inflating prices of everything under the sun is destroying us as a nation, it's ruining our currency, and it's creating a huge underclass of impoverish and indebted citizens. It has to stop.


On Oct 10 04:25 AM Mr. Ed, Jr. wrote:

> "The FHA has done some social good in slowing the decline of housing
> prices, but it has come at a cost -- one that taxpayers may end up
> paying"
>
> Well.....It is not clear to me why falling home prices are to be
> considered a social ill. Lower home prices allow an easier entry
> to home ownership (Proven benefits to society) and let people spend
> their money in other areas of the economy, if they desire.
>
> The housing market is too big for the government to prop up. Any
> attempt is doomed to failure, and then everybody pays-- including
> renters, whose tax dollars are also wasted in the failed attempt
> to keep the neighbor's house price up. Of course, propping up real
> estate prices also means that the renter must pay higher rents, but
> if they can't take a joke....
>
> How and why is it the role of our government to prop up house prices
> for some citizens ?
>
> If the government wants to give a tax rebate to ALL citizens, to
> be used to pay down their home mortgage or spend on lap dances or
> whatever they want to do with it-- fine. But propping up free market
> house prices (particularly after the government's policies created
> the housing fiasco in the first place) is a corrupt policy, designed
> to protect banking and Wall Street interests. Again.
>
> And is it any wonder the dollar keeps falling ? What must people
> around the world be thinking as they hear the daily news reports
> of the latest absurd US government scheme ? Just this summer, government
> was buying cars for citizens...now it is giving homebuyers 8k while
> helping them obtain get almost nothing down home loans . Again. The
> President and Vice-President keep giving speeches about free college
> education.....and government health care for all. Free stuff from
> the biggest debtor nation in the history of the world.
>
> It is hard to believe that this nonsense...this chaos and corruption....is
> now permeating every nook and cranny of the United States of America.
> It has happenned incredibly fast. And it just keeps getting worse.

Oct 10 09:20 AM

[Forever Bear:]

When are people going to realize that renting isn't such a bad deal? There are too many people who bought a house but shouldn't have. For some reason, many people believe that unless you own your home, you are a pathetic loser. Especially for those who have only 1 source of income (single...worse if you have dependents). These days, there is no such a thing as job security any more and everyone should be saving up for rainy days. I have owned a home (free and clear) in the past and now I am renting. I have been able to save up over 60% of my take home pay on top of my 401k when I could barely save 10% when I owned a home. People don't realize how much money you have to spend when you own a home and sometimes the tax advantage of having a mortgage is simply not worth it.

Oct 10 01:14 PM

[D. McHattie:]

What made subprime subprime? The underwriting standards, the qualifying criteria.

FHA now has similarly low underwriting standards and qualifying criteria. We can expect the result to be the same: high mortgage default rates.

Oct 10 04:46 PM

[BullnBear:]

The bottom line for this and all other housing related articles is that the housing issue hasn’t been fixed and I suggest that you try running the “jobless recovery” garbage against the backdrop of the housing market and see where that leaves you.

Oct 10 09:41 PM

[BullnBear:]

Great addition with the FHA lending data and I’m curious what your thoughts on the “jobless recovery” theory may be in relation to the housing markets.


On Oct 10 02:05 AM Seth Chalnick wrote:

> As a real estate insider I whole-heartedly agree with this article,
> with the exception of the error the author makes in saying that people
> can “use the $8,000 first time homebuyer tax credit for that 3.5%”
> down payment. While the FHA allows for this in theory, no lender
> extends this feature in practice, because it is unclear how and when
> the semi-government institution will credit back the lender.
>
> Meantime, to add key perspective to this article, the FHA loans cost
> consumers considerably more per month than conventional loans do,
> and they become downright cost prohibitive as the sale price approaches
> $400k… and yet buyers can borrow right up to “agency jumbo” loan
> limits, which for example in SD are $697,500.
>
> Approximately half of the increased monthly payment stems from the
> borrowing of more money… the rest comes from the multiple whammies
> of higher rate, upfront mortgage insurance premium (added to the
> loan balance), and monthly mortgage insurance premium… all of which
> are applied to the whole balance enchilada, which is obviously really
> high… i.e. 96.5% loan to value.
>
> I say key perspective, because the higher cost of all this directly
> impacts the ability of folks to repay.
>
> For further perspective on this issue, and insight into the party
> line rhetoric most real estate agents regurgitate via groupthink…
> SA fans may be interested in checking out a very telling thread on
> Trulia.com, whereby industry insiders go at it, pitting party line
> sound bytes against fundamental analysis.
>
> The Trulia question is posed by a Long Beach broker, named Ben Nicola,
> and it is entitled, “What’s Wrong with FHA financing?”
>
> This link should take you there… www.trulia.com/voices/...

Oct 10 09:45 PM

[Fighting Yoda:]

FHA is following a much worse plan than even Fannie/Freddie - only 3.5% down payment. So the likelihood of failure here is much much higher, it is not likelihood anymore - it has already happened. By end of year bailout would become necessary. It is the same policies as articulated by Barney Frank - socialism, and propping up a over priced and unsustainable housing market.

There is a lot more pain still to come on the economic and jobs front - lot more foreclosures will happen. The green shoots myth and Wall Street hype will all die its usual miserable death. You simply can't borrow or print your way to prosperity. America is the only country that still believes in this Ponzi myth.

Oct 11 12:32 AM

[Dave Wrixon:]

Further proof that the US is now a Command Economy just like the former Soviet Union. The Free Market is Dead!

Oct 11 02:33 AM

[George Dave...:]

The sub prime mortgage crisis has been triggered by a rise in the foreclosure and mortgage delinquencies in the US. The problem became apparent in the year 2007 when refinancing of these adjustable-rare mortgages became gradually difficult and has been one of the huge challenges which have led to the global financial economic crisis.
Read more.
www.housingnewslive.co...

Oct 13 02:16 AM

[Seth Chalnick:]

Hi BullnBear,

Re: “jobless recovery”… a paradox consists of two seemingly opposite terms that make sense when joined together… like “jumbo shrimp”.

The idea of a “jobless recovery” is just wishful thinking. Subprime crashed because people couldn’t afford their payments. When they couldn’t afford their payments, and they couldn’t get more cash out from refinances, this put the whammy on spending, not just for the subprim-ers, but for everybody trying to do refinances, because the re-sets reversed the trend of appreciation.

Then, consumer discretionary spending died because people had less money. Spending makes up 70% of our GDP. So our GDP decreased. But on paper the GDP, along with corporate earnings reports, continue to defy gravity because corporations are cutting back on payroll and marketing and every other expense they can to make their earnings reports attractive. The banks, with the help of the government, are just flat out ignoring their non-performing assets and the costs that go with them.

Meantime, everyone I talk too seems to be counting their blessing that they’re only earning 30% less than they did last year while nobody’s spending since 20% of folks are unemployed and the majority of the rest of the folks are either underemployed or afraid they’ll potentially become unemployed.

The real problem with housing didn’t even start yet in earnest and it will wreak havoc on the jobs market, especially when the real stimulators of the economy… the small business owners… start seeing their own home loans adjust to principal and interest over 25 year amortizations while the rest of their credit lines get cut out from under them, on personal credit cards, and business tradelines.

No jobs = no recovery.

To me, the stock market seems manipulated beyond belief… sort of like fattening up the 401k chickens before the short sell slaughter.

Oct 14 02:30 PM

[JAMES CARLINI:]

GERORGE DAVE wrote:
The sub prime mortgage crisis has been triggered by a rise in the foreclosure and mortgage delinquencies in the US. The problem became apparent in the year 2007 when refinancing of these adjustable-rare mortgages became gradually difficult and has been one of the huge challenges which have led to the global financial economic crisis.

GEORGE - I wrote an article in 2006 about the rise in foreclosures. Many were not following it back then but it was already happening in 2006.

READ---> www.midwestbusiness.co...

Oct 24 12:10 PM