Is FHA the Next Disaster?

The Wall Street Journal article about FHA’s declining reserve problem sparked a lot of comment yesterday. The Journal said that FHA was in danger of falling below their 2% reserve requirement and FHA said that wasn’t the case at all.

From the Journal:

In the past two years, the number of loans insured by the FHA has soared and its market share reached 23% in the second quarter, up from 2.7% in 2006, according to Inside Mortgage Finance. FHA-backed loans outstanding totaled $429 billion in fiscal 2008, a number projected to hit $627 billion this year.

Rising defaults have eaten through the FHA’s cushion. Some 7.8% of FHA loans at the end of the second quarter were 90 days late or more, or in foreclosure, according to the Mortgage Bankers Association, a figure roughly equal to the national average for all loans. That is up from 5.4% a year ago.

Resulting FHA losses are offset by premiums paid by borrowers. Federal law says the FHA must maintain, after expected losses, reserves equal to at least 2% of the loans insured by the agency. The ratio last year was around 3%, down from 6.4% in 2007.

If its reserves fall short, the agency is obliged to notify Congress, which could spark a commotion over the extent to which the government is funding losses in the housing market. Some housing analysts have said losses might lead the FHA to pull back lending, which has helped boost flagging housing demand.

A senior official at HUD, which oversees the FHA, said there is “no risk” that the FHA would require money from Congress if the ratio falls below 2%. Asked about the agency’s capital ratio, the official said a report detailing that number won’t be completed until the FHA’s fiscal year ends Sept. 30.

And FHA’s response from Reuters:

“Even if that level falls below 2 percent, FHA continues to hold more than $30 billion in its reserves today, or more than 5 percent of its insurance in force,” FHA Commissioner David Stevens said in a statement. “Given this reserve level, FHA will not need a congressional subsidy even if the congressional capital reserve calculation falls below 2 percent.”

We’ve seen this rodeo before, haven’t we. Someone starts raising questions about the quality of a loan portfolio and the capital standing behind it, a lot of confusing numbers get thrown around by the institution in question as it assures us all that nothing bad could happen and you know the rest of the story. One would hope that this would lead to a proper investigation by Congress in which the real economic risk is quantified but don’t count on it.

The reality is that FHA has always taken too much risk. It missed the bubble not because it was smart or had better underwriting but because it was an afterthought. They weren’t making many loans. As the rest of the market melted, FHA has become the go to lender.

Even though the housing crisis has pretty well documented that no or low downpayment loans are a prescription for a disaster, FHA continues to make them. Though ostensibly they require a 3.5% downpayment, there are any number of ways around that. The $8,000 tax credit has only exacerbated the problem. Many local government programs allow for the tax credit to be used for a downpayment. Moreover, FHA allows for downpayment gifts from family members and certain other parties. It doesn’t take a whole lot of imagination to figure out that you can go to dear old dad and get him to fork over $8,000, sign a piece of paper that says it’s a gift, use that to buy the house, get the refund from the treasury and hand the money back to from whence it came with nobody being the wiser.

There is the chance we can dodge this bullett. FHA’s rapid growth is new and to the extent they’re lending at the bottom of the market, price appreciation may keep them away from Fannie (FNM) and Freddie’s (FRE) fate. It better because they’re piling on the risk and doing it in bigger chunks (they’re lending limit is way up). With little in the way of borrower equity going in, the only two things that can bail them out are price appreciation and a good economy. Neither one of those two has been seen around these parts lately.

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