The FHA Is Broke

The FHA insures approximately $680 billion of single family home mortgages. An audit, conducted by Integrated Financial Engineering of Rockville, MD, found that FHA reserves against losses had dropped to $3.6 billion (0.53%) as of September 30. This was due to losses because of defaulting mortgages.

According to law, the minimum required reserves are 2%, or $13.6 billion currently. If the FHA exhausts its reserves, the government is obliged to make future loan guarantees in place of the agency. If this happens, it would be the first such occurrence since the FHA was formed in 1934. In the past year, the FHA has consumed $9.3 billion of reserves. One might conclude that a similar experience for the next 12 months would put the agency close to $6 billion in the red. However, the accounting is more complicated than that, as we shall see later in this article.

According to an article by Dina ElBoghdady in The Washington Post (here), the auditors concluded that the FHA can remain self-sustaining under five of six possible economic scenarios. A base line scenario projection has the FHA covering projected losses for the next 30 years and returning to the required 2% reserve by the end of fiscal 2012. The market assumptions for the base line scenario are: home prices bottom by 2H/2010; price appreciation resumes by 2013; and little refinancing out of FHA mortgages will occur. Refinancing out of FHA mortgages would reduce their premium income and negatively impact the accumulation of reserves.

Under the most negative scenarios, home prices would fall another 30%, unemployment would reach 12.5%, and mortgage interest rates would drop 2% (to near to 3%). The worst case scenario has the FHA needing an infusion of $1.6 billion in 2011.

None of the audit scenarios foresee another year of $9.3 billion in reserve losses. Apparently, the conditions producing these outlooks depend on some combination of lower default rates and increased premium income. The reports available in the press do not give the details. A quote from The Washington Post article indicates some of the obfuscation presented during a press briefing on Thursday:

Housing and Urban Development Secretary Shaun Donovan said the reserve fund has played the role for which it was intended by allowing the FHA to continue to support lenders at a time when they otherwise would have been forced to retrench.

But Donovan acknowledged that the current $3.6 billion reserve is too thin a margin for the agency's $685 billion portfolio. "It is absolutely critical going forward to build that cushion back up," he said.

Donovan said newer loans are expected to have much more modest claims, and belong to more credit-worthy borrowers than the FHA has served in the past.

Donovan and FHA Commissioner David H. Stevens also pointed out that the $3.6 billion in the reserve fund represents only part of the money the agency maintains to cover losses on insured mortgages. The agency, on an ongoing basis, pays for losses directly out of a second fund. Money is shifted into that second fund from the capital reserve fund based on loss projections, but it can also be moved back if loans don't go bad.

So, what is being discussed is not a reserve fund but a contingency reserve fund that can be used to beef up the true, but hidden (based on what has been revealed to the press) reserve that is funded based on loan loss projections. This means that what is reported in the press is not related to the $9.3 billion drop in the reserve over 12 months. Much of that amount may have been merely put into the real reserve against projected loan losses, much of which may not yet have occurred.

What is revealed in the press can be very misleading because the details of the agency books are not discussed. What is in the fund that provides for projected losses? According to a New York Times article (here), the total of the two funds is about $31 billion. What are the projected losses? What is the time line of projected losses? Why can't the books be open and discussed with the press? Is it because the press and the public are assumed to be stupid? Is it because the agency spokesmen don't understand the accounting themselves? Or is it simply an effort to keep the public in the dark?

I am feeling very like a mushroom reading what has been reported in the press. You know mushrooms - they grow best in the dark, fed a diet of equine excrement. FHA insures loans to buyers who lack the down payment and/or credit scores to qualify for mortgages without the FHA insurance. These home buyers pay higher interest rates with the difference from an uninsured mortgage rate going into the FHA coffers to pay for defaulted loans. FHA has reportedly tightened credit requirements somewhat in 2009, but still accepts 3.5% down. This can be covered by the first-time homebuyer tax credit for home purchases up to approximately $200,000, creating a whole new crop of zero equity home purchases. This was discussed in a recent article (here).

David Streitfeld, writing in The New York Times (here), reports the following:

* Nearly 20% of FHA insured mortgages issued in 2007 are seriously delinquent or in foreclosure.

* About 12% of FHA insured mortgages issued in 2008 are already seriously delinquent.

Mortgages at least 90 days without payment are classified as seriously delinquent. Just how 2009 turns out remains to be seen, but Streifield states that the FHA has insured $360 billion in mortgages so far in 2009. This is four times the 2007 amount. According to Nick Timiraos, in The Wall Street Journal (here), the market share of FHA insured mortgages has risen from 2% in 2006 to about 25% in 2009.

If the housing market is not near a price bottom, this could be the next big bailout. More than 50% of all FHA insured mortgages issued since 1990 had less than 5% equity at the time of origination. For 2007-2009, the ratio has been between 55% and 60% each year. That means that more than half of all FHA mortgages issued in 2007 and 2008, as well as early 2009, are under water (owe more than the current market value). A further drop in housing prices would be devastating. Having about $30 billion available to cover defaults hardly seems sufficient in that scenario.

The Timiraos article (here) has some summary graphs covering some of the data discussed in this article.

Comments

[woollyB:]

This is way too sobering for a Friday evening post.

It is beyond me why anyone thinks that the masses of underwater "homeowners" will continue paying their mortgages. Once they get far enough underwater and see that home prices are not rebounding, it won't be long before the fear of ruined credit score (which was really just a bi-product of the housing boom anyway) is no longer enough of an incentive to keep making that payment. In the era of moral hazard, get ready for armageddon in the residential housing market, coming soon to a non-recourse state near you.

Nov 13 05:56 PM

[Jason Rines...:]

Excellent article John. I agree with Woolly about his sentiment of the situation.

Allow me to frame the macro situation with a quote from Thomas Jefferson:

"If the American people ever allow private banks to control the issuance of their currency, first by inflation and then by deflation, the banks and corporations that will grow up around them will deprive the people of all their property until their children will wake up homeless on the continent their fathers conquered."

I am long the American people.

Nov 13 06:12 PM

[john s. gordon:]

T. Jeff was right.
we have all been mushroomized,
but of course the " social security trust fund" was the prototype for all other mushroom capers.
> jack

Nov 14 10:11 AM

[flow5:]

If? Muckraker? Sensationalist? Your solution critic?

Nov 14 12:37 PM

[Ricard:]

"Under the most negative scenarios, home prices would fall another 30%, unemployment would reach 12.5%, and mortgage interest rates would drop 2% (to near to 3%). The worst case scenario has the FHA needing an infusion of $1.6 billion in 2011."

"None of the audit scenarios foresee another year of $9.3 billion in reserve losses. Apparently, the conditions producing these outlooks depend on some combination of lower default rates and increased premium income. "

Unbelievable. A chimpanzee could make better projections. I don't see how a portfolio full of near zero-down-payment mortgages can see less than a 2% loss on default, let alone 0.5%. What in the world is going on here?

Nov 14 01:08 PM

[Moon Kil Woong:]

FHA is already below their mandated 2% and most likely are fudging the numbers. More and more the financial industry is moving to only cash flows. As long as they have cash flow they are able to stay alive even if they have no net worth and no net positive assets whatsoever. The accounting merely becomes a charade.

Nov 14 01:08 PM

[HunterGVL:]

I have been taking notice of the strategic defaults on home loans lately and as an investor, I have to say it has some appeal. Anyone who has purchased a home or refinanced within the last 5 years has felt the sting of falling home prices. For those homeowners with adequate income, the allure of simply stepping out, on a huge loss has to have some appeal. If, as I suspect the Option Arms and Alt-A mortgages that will reset in 2010 and 2011, result in an additional 20% decline in housing values, then strategic defaults will play an even larger role in the housing debacle. Round and round she goes........

Nov 14 03:50 PM

[Steven Hansen:]

lies, lies, simple white lies. spinning of data is becoming the mode of operation of our government.

as the future is not certain, all can claim they had no idea the future would be so bad. after all, many blue ribbon economists are saying the housing price decline is over. we even have case-shiller indicating the fall is over.

but you must be in a drunken stupor to think the housing market has stabilized. new mortgage originations have fallen off a cliff in the last month.

the party is not over.

Nov 14 08:26 PM

[John Lounsbury:]

Ricard - - -

I tried to estimate a possible liability exposure in a reply to a comment on the Instablog version of this article. You can read that seekingalpha.com/insta... . Also look at the comment immediately following the one linked to get another thought on the same subject.


On Nov 14 01:08 PM Ricard wrote:

> "Under the most negative scenarios, home prices would fall another
> 30%, unemployment would reach 12.5%, and mortgage interest rates
> would drop 2% (to near to 3%). The worst case scenario has the FHA
> needing an infusion of $1.6 billion in 2011."
>
> "None of the audit scenarios foresee another year of $9.3 billion
> in reserve losses. Apparently, the conditions producing these outlooks
> depend on some combination of lower default rates and increased premium
> income. "
>
> Unbelievable. A chimpanzee could make better projections. I don't
> see how a portfolio full of near zero-down-payment mortgages can
> see less than a 2% loss on default, let alone 0.5%. What in the world
> is going on here?

Nov 15 01:54 AM