One of the largely untold stories of the current mortgage crisis is the resurgence of FHA lending. While FHA’s market share was less than 2 percent at the height of the housing boom, it now accounts for about 25 percent of all single-family mortgage originations. In fact, as conventional lenders tighten their underwriting standards, FHA has become virtually the only game in town for borrowers with blemished credit or little equity to put into their homes.
The reemergence of FHA comes at a time when seemingly invincible institutions have been brought to their knees by mounting credit losses. Fannie Mae and Freddie Mac are now essentially wards of the State. Former industry giants such as Countrywide have been acquired or forced to close their doors. Yet on the surface, at least, FHA has so far managed to weather the storm. Is it really possible that this beleaguered, much maligned Federal agency will be the only one left standing after the dust has finally settled? Unfortunately, we believe that the answer is no.
The most recent HUD audit declared the FHA insurance fund to be financially sound. Although its capital ratio dropped from 6 to 3 percent in the last fiscal year, the Fund was projected to meet the statutory minimum of 2 percent over the next few years, albeit with an extremely small margin for error. Our analysis of roughly 2.5 million FHA loans comes to a different conclusion. Under relatively conservative assumptions regarding future house price trends and economic conditions, we project that Fund will experience a capital shortfall of between $3 billion and $4 billion by the end of this fiscal year.
Given the shifting geographic distribution of FHA loans and the continued deterioration of the housing market, we believe that our projections more accurately reflect conditions going forward. With the recent increase in its loan limit, FHA lending is rising rapidly in high cost states experiencing some of the most rapid house price declines. For example, California’s share of new originations has risen from one to 10 percent in less than a year. Growth rates are similarly high in Florida and Nevada. While our methodology enables us to capture these important trends, the HUD approach does not.
Our application of a so-called “stress test” further underscores the vulnerability of FHA. Such tests, which will now be required for banks participating in TARP, are designed to measure an institution’s ability to survive an unexpectedly adverse economic environment. While government agencies are not required to hold capital in the traditional sense, i.e., to guard against unexpected losses, applying a risk-based capital standard nevertheless provides a useful benchmark for measuring the capital adequacy of FHA. Under a risk-based capital standard, FHA could face capital deficits as high as $50 billion within the next two years.
Our conclusion that FHA will not be immune from the market forces currently ravaging the mortgage industry should hardly come as a surprise. In fact, the real question is how the Agency has been able to dodge the bullet thus far. Part of the explanation is that FHA was largely out of the market at the peak of the housing boom. As a result, most FHA borrowers entered the housing downturn with at least some accumulated equity in their homes. In addition, while most FHA borrowers put little money down and have relatively weak credit profiles, FHA mortgages have none of the toxic features characteristic of subprime loans, for example, reduced documentation or teaser rates.
Our analysis suggests that the forces that have protected the FHA Fund thus far have more or less come to an end. While the projected capital shortfalls at FHA may pale in comparison to the losses at Fannie Mae and Freddie Mac, the prospect that the Fund may fail to meet its mandatory capital requirement by the end of the year is nevertheless troubling. The continued availability of FHA mortgages will be critical to the recovery of the housing market. Without a strong and active FHA presence, millions of prospective borrowers will lose access to mortgage credit.
It would undoubtedly take many years and resources to solve the long-standing problems at FHA. Most observers believe that the agency does not have the staff, technology or authority it needs to operate effectively. However, several things could be done in the near term to limit the exposure of the federal taxpayer. At a minimum, FHA should be required to provide more timely reports on its ongoing financial health. Waiting another year for the next official audit is unacceptable in today’s economic environment. FHA should also appoint a Chief Credit Risk Officer, and hire or reallocate additional staff to support this role. As it currently stands, no one in the Agency is directly accountable for the management of credit risk. Finally, FHA should begin to recapitalize the Fund through a series of incremental price increases. While a large increase at this point in time would be inconsistent with the Agency’s mission, moving towards a more risk-based capital approach would help to ensure the long-term solvency of the Fund.
None of these actions will solve the long term problems at FHA. Nevertheless, they would represent a step in the right direction at this critical moment in our country’s history.