On Wednesday the House Financial Services Committee held the first of a scheduled series of hearings on the financial condition of the Federal Housing Administration (FHA).  A memo released by the Committee's chairman Jeb Hensarling (R-TX) says that the FHA's single-family insurance fund which insures more than $1 trillion worth of home mortgages, has a negative economic value of $16.3 billion, according to an independent actuarial report released in November which means that if the FHA stopped writing new business today, it could not cover the losses anticipated on loans it has already insured.

Hensarling opened the February 6 hearing saying that, while the recently reported negative economic growth in the last quarter does not necessarily indicate a trend, subpar economic growth of 1-1/2 to 2 percent is now expected and millions of Americans lay awake at night worrying about insecure financial futures.  "Hardworking Americans demand a healthy economy and we cannot have a healthy economy until we have a housing finance system that is both sustainable and competitive.  In its current form FHA is clearly an impediment to such a system. " The Chairman said FHA had strayed far from its original purpose and no longer focuses on low and moderate income Americans but rather caters to a risky market with high loan limits and extremely low down payment requirements that put it in direct competition with the private sector.  "In addition, we know that as bad as that is, its single family insurance fund is flat broke.

"Finally, given their high Loan-To-Value, low credit score policies and high rates of default, it is an open question whether FHA has now morphed into Countrywide. Arguably, the FHA has now become the nation's largest subprime lender, all with the blessing of the Administration."

Four experts spoke to the panel, three of which were highly critical of FHA's current practices.  The hearing and Hensarling's opening statement to it included a number of references to a report written in December by Edward J. Pinto, Resident Fellow of the American Enterprise Institute titled How the FHA Hurts Working Families. Pinto's appearance before the committee was based on that paper

Pinto said his study identified specific reforms to focus the FHA on responsible lending and return it to its traditional mission of serving low and middle income, minority, or first time buyers. 

  1. Step 1: Do not knowingly insure a loan with a projected claim termination rate greater than 10 percent, assuming no house price appreciation or depreciation.
  2. Step 2: Target an average 5 percent projected claim termination rate with the same assumption.
  3. Step 3: Stop guaranteeing lower-risk loans and high-dollar-balance borrowers, as this allows for cross-subsidization of those loans with excessive risk. This will also let the FHA step back from markets that can be served by the private sector so it can concentrate on home buyers who truly need help.
  4. Step 4: Price for risk, since not doing so deprives the borrower of the price information needed to understand the true risk of the loan. Until this is done, the FHA should disclose to the borrower his or her expected claim rate, assuming no house price appreciation or depreciation.
  5. Step 5: Implement underwriting that results in the extension of responsible mortgage credit, by balancing down payment, loan term, FICO score, and debt-to-income ratio to achieve meaningful equity.

Anthony B. Sanders, Senior Scholar, The Mercatus Center Professor of Real Estate and Finance, School of Management George Mason University told the committee members that the first step towards shrinking the FHA's footprint is to reduce the loan limit to $625,000 and then reduce it by another $100,000 per year.  He quoted a George Mason study that concluded that current FHA policies are unlikely to assist the agency in reaching its historical constituencies, first time, minority, and low-income homebuyers, and that FHA's current market share exceeds what is needed to serve those markets.  In light of the significant decline in home values FHA could reduce its loan limits by about 50 percent and still almost entirely satisfy its target market.

Sanders recommended installing a credit score floor at 660 as loan performance deteriorates rapidly below that level and cap LTV at 95 percent; 90 percent for FICO scores below 680.  A maximum mortgage debt-to-income ratio of 31 percent should also be established.

The FHA has the highest spread of FHA 30 mortgage rates to GNMA 30 year current coupon rate (the rate paid to GNMA investors) of any of the government finance entities, and considerably above levels prior to 2008. ""In other words, the Federal Reserve's manic pushing of interest rates and mortgage rates downwards is NOT getting passed through to borrowers as had been hoped.""

Basil N. Petrou, Managing Partner of Federal Financial Analytics, Inc. presented the Committee with a laundry list of recommendations for the agency.

  • Congress should reduce the 100 percent guarantee provided by the FHA to parallel the limited coverage of 25% to 50% successfully used by the Veterans Administration (VA) for the mortgages it guarantees. This will effectively cap the severity of loss on FHA loans and improve their underwriting by putting the lender at risk.
  • The FHA should be targeted to borrowers based on income, not home price. By supporting mortgage finance for higher-income borrowers the government supplants private capital and creates market distortions because of the lack of market discipline applicable to these larger loans.
  • FHA policy with regard to delegating underwriting to the loan originator and reviewing underwriter performance only after the fact should be revised so FHA shares risk with regulated, capitalized providers of private credit –risk enhancement for mortgages (if unaffiliated with the originator) which would conduct a second underwriting prior to loan origination.
  • A strict capital requirement should be set for the FHA single-family fund incorporated through a new actuarial model that accurately predicts losses and the budgetary treatment of FHA should be changed to reflect the fair value analysis recommended by the Congressional Budget Office (CBO).

Putting his recommendations for FHA in the broader framework of U.S. mortgage-finance regulation and government intervention, Petrou said he also recommends that Congress work to ensure that an array of pending prudential rules for banks (e.g., those implementing the Basel III capital and liquidity rules) do not block the re-entry of private capital and prevent constructive reform of Fannie Mae and Freddie Mac. He also advised that the pending qualified residential mortgage (QRM) rule not set a simple down-payment requirement without regard to the use of regulated, capitalized providers of credit-risk mitigation like private mortgage insurers.  Doing so would make it extremely difficult to securitize high- LTV loans for first-time home-buyers and other borrowers and these loans will flood into the GSEs and FHA and, once the conservatorships are closed, then only into the FHA.

Julia Gordon, Director, Housing Finance and Policy, Center for American Progress Action Fund defended FHA which she said appears to be returning to normal profitability as it has after playing a countercyclical role in the past."FHA's new business is significantly less risky and will likely perform better than any books of business in the agency's history yet critics continue to attack FHA's basic business model, she said. 

Gordon rebutted part of the Pinto report in which she said he used reported losses in the wake of the crisis to portray FHA as a destabilizing force while omitting the context surrounding the loss and the way in which FHA stabilized the U.S. housing market during the financial crisis.

Pinto has come up with projected losses that far exceed those predicted by other analysts, she said.  A major reason for this is that he fails to take into account both the superior performance of FHA loans vis-à-vis Private Label Securitized loans, and changes made to FHA's business meant to improve its bottom line.  He fails to take into account any of the policy changes that FHA has made to improve its financial position, and uses the 2009-1010 book as a neutral period of time in which to evaluate FHA's lending.

Gordon said that Pinto uses a correlation between FHA and high foreclosure rates in distressed communities as if to imply that the FHA is responsible for the rate instead of unsustainable private subprime mortgages which she said were pushed in these communities during the housing bubble."FHA's presence helped to stabilize the neighborhood and was not a cause but a consequence of the neighborhood's financial distress.

Gordon said it is important to give the changes FHA has already made time to work but also recommended it should take additional steps to improve its loss mitigation efforts and better inform homeowners of its availability and should also ask Congress for more authority to manage its risk effectively including revised indemnification authority, greater flexibility related to the Compare Ratio requirement, and additional servicing transfer authority.

FHA Commissioner Carol Galante will testify at the next hearing on February 13 regarding the November actuarial report on FHA's finances.