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 (NYSE:EQR) or Apartment Investors (NYSE: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.