FHA: A Huge Risk To Your mREIT Investment?

by: Ry Frank

The Federal Housing Administration (FHA), the U.S. government agency that underwrites mortgage insurance, seems to be running out of money. The number of holders of FHA-insured mortgages that had not made a payment in 90 days or more increased by 27% in the fiscal year that ended on March 31.

Things have gotten so bad at the FHA that some observers now think that a federal bailout of the agency will be necessary. A report from federal regulators indicated that the number of foreclosures on FHA-insured mortgages increased by 17% in the last year.

The interesting thing is that the problems at the FHA are coming to light just as things in the rest of the mortgage industry seem to be getting better. The rate of delinquent mortgages issued by Fannie Mae and Freddie Mac was recently down by 39%.

mREITs are Less of a Risk

Mortgage real estate investment trusts (mREITs) that buy government paper issued by those agencies are less of a risk now. This will help the stock value of companies such as AG Mortgage Investment (NYSE:MITT) and Anworth Mortgage Asset (NYSE:ANH), which buy government paper. Since most of the government paper is issued by Freddie and Fannie, those companies are taking fewer risks.

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The problem is that some of the mREITs, such as Annaly Capital Management (NYSE:NLY) and Cypress Investments (NYSE:CYS), could be taking on more risk because they could be buying FHA-insured mortgages. They could be faced with more defaults and foreclosures.

If a major mREIT is heavily invested in FHA paper and the FHA needs a bailout, then mREIT's stock values could take a huge hit. The problem is that there could be no way to tell if a major mREIT was buying up a lot of FHA paper. It is likely that some of them were, because FHA mortgages now make up about 29% of the market.

FHA is a Very Bad Risk

Why are FHA mortgages a greater risk for mREITs and other investors than Freddie and Fannie's paper? The reason for this is clear. Most FHA mortgages are riskier, and they are issued to lower income buyers. More importantly, the FHA only requires a down payment of 3.5%. That means it is essentially in the subprime mortgage business.

Another frightening thing about the FHA from a mortgage investors' standpoint is that 48% of the loans it made defaulted after less than 12 months. That means it is a pretty bad investment for anybody, including mREITs.

FHA Could be Soon be Out of Cash

This is more likely than you think because the agency's emergency reserves have dropped to less than 2%; in other words, it is out of cash. The only place the FHA can turn for money is to Uncle Sam, namely Congress. The agency is likely to be unable to cover its insurance policies sometime this year.

The rate of FHA foreclosures has been made worse by the First Time Homebuyer Tax Credit, which many people used instead of down payments. Those buyers simply did not have the cash to cover the mortgage payments in the first place. Now with the economy stalling and unemployment, these people are having trouble making the mortgage payment.

FHA's Troubles Could be Good for mREIT Investors

There is good news in the FHA's troubles for mREIT investors. The figures indicate that the overall mortgage market is improving and the number of non-FHA foreclosures and delinquencies is decreasing significantly. That would indicate that most mortgages are now a safer investment and the mortgage industry is taking fewer risks.

Conservative mREITs such as American Capital Agency (NASDAQ:AGNC) and MFA Mortgage Investments (NYSE:MFA) are safer and more secure investments than previously thought. Those companies seem to have avoided the risks that the FHA took, and could now be poised for even more growth.

Some mREITs Could be Boosted by FHA Meltdown

Very conservative mREITs that invest in specific kinds of government backed paper would benefit from this, so would those mREITs, such as Dynex Capital (NYSE:DX), that carefully pick and choose their mortgage portfolios. Those companies should be able to manage risk and avoid pitfalls like the FHA, so their share prices might be able to come through the turbulence produced by an FHA bailout unscathed.

In such a scenario, the best mREIT shares to buy would be those of the companies such as Anworth and AG Mortgage Investment, which concentrate on buying federally-backed mortgages. Many investors might dump those because they don't realize that all federally-backed mortgages are not the same. Fannie Mae and Freddy Mac are not taking the kind of risks that the FHA did, so their paper is still a good investment. So is the stock of those mREITs that buy it. No matter what happens at the FHA, many mREIT stocks are still a good buy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.