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House Hearing on FHA Capital Reserves

with 3 comments

A panel of economists and real estate industry executives spoke this evening at 2 p.m. about the state of FHA’s capital reserves and the implications of the current housing crisis on the future of FHA policy.

Here is a link to the webcast and prepared testimony: http://www.house.gov/apps/list/hearing/financialsvcs_dem/scmhr_100809.shtml

There have been varying opinions on the significance of the FHA’s announcement that they expect to fall below their 2% reserve limit in the near future, but the one thing that is acknowledged by nearly everyone is the need to mitigate risk given the current economic environment.

One thing that has consistently irked me throughout this housing debacle is how blatantly people employed or subsidized by NAR, NAHB, and MBA have falsely sold the public on the idea that everything is going to be alright and things will be back to normal very soon. It’s also becoming more apparent that the real estate industry as a whole fully believes this propaganda and the public hasn’t seemed to raise even an eyebrow at how counter-intuitive some of this jibberish actually is.

First, let’s start with some blasts from the past:

This annotated housing price chart was created by the blog “Lawrence Yun Watch“, a blog devoted to exposing the absurd propaganda vomited upon the American public by the Chief Economist and Senior Vice President of Research at the National Association of Realtors.

More quotes from a late 2007 interview with Yun (before he was promoted to Chief Economist… I sure wish I could completely fail at my job and get a promotion)

I’ll leave it to the reader to examine the accuracy of those statements and predictions made by the hypeman for NAR, but because this post is not about him in particular I’d instead like to focus on one passage from that 2007 interview:

RM:But what about all those subprime borrowers? Many of these are the first-time borrowers who helped fuel the growth we saw in home sales over the last few years. What are the options for them?

Yun: We certainly won’t see the number of subprime borrowers that we saw during the boom. But borrowers who can’t qualify for prime loans will still have options, particularly if we see enactment of reforms to the FHA that NAR has been championing. The FHA has historically been the safe and affordable financing option for these borrowers. Largely because it comes with a lot of red tape and lacks a big choice in products, lenders rushed to fill the void with their much-riskier subprime loans. So a reformed FHA can go a long way to returning moderate-income and first-time borrowers to the market.

The real estate industry’s “championing” efforts are a large part of the reason that FHA’s market share continues to rise in the face of the worst housing environment since the Great Depression. There can be no doubt from the above comment that NAR’s intentions were for the FHA to help replace the collapsing supply of non-prime mortgage loans since private insurers wanted no part of that market as long as their survival depended upon risk management. The risk to the taxpayer grows greater as long as this trend continues.

Let’s now move on to the prepared testimony for today’s hearing and extract some interesting comments. There is a lot of testimony, so I’ll focus on the few that interested me the most. Everyone should read the full testimony from all participants at the link above. The fun begins here (bolded passages are marked by me for emphasis):

Testimony of The Honorable David Stevens, Assistant Secretary for Housing and Federal Housing Administration Commissioner, U.S. Department of Housing and Urban Development

“A report released by the Federal Reserve last Wednesday, October 1, 2009 states:
Beginning in the early part of 2008, PMI companies started limiting their issuance of PMI insurance and raising prices because of rising claims and binding capital restrictions in certain states. As a consequence, Fannie Mae and Freddie Mac substantially reduced their purchases of loans with loan-to-value ratios (LTV) above 80 percent, which by statute require PMI (or other credit enhancement). Both GSEs [Fannie Mae and Freddie Mac] also raised their credit guarantee fees for such loans at this time as well.
These actions taken by PMIs and GSEs in reaction to losses on their historical portfolios have led to FHA-insured loans becoming relatively cheaper and more accessible to borrowers, compared to PMI-insured loans than they were during the boom. FHA’s increased market share is a result of this countercyclical market dynamic and not in itself a reflection of the riskiness or lack thereof of newly insured loans.

Calling mass risk aversion a “countercyclical market dynamic” is completely dismissive of the factors that led to the current situation and shows a surprising disconnect from the fundamentals of the insurance business. Insurance premiums are by design a product of implied risk. This is the reason that flood insurance has higher premiums in coastal areas, life insurance is more costly for the elderly, and auto insurance premiums lower as driving experience increases.

Therefore, it should be easy to determine that rising premiums indicate an elevated level of implied risk by the market. Options traders know this implied risk or volatility as beta and the increasing use of options pricing models in the private insurance industry is a testament to the accuracy of the approach. A business which ignores this implied risk and continues to price premiums at the same rate will have a portfolio that is exposed to greater implied volatility.

FHA market share growth is indeed cyclical as Mr. Stevens suggests, but that is largely due to their implied government guarantee which has resulted in complacency with regards to proper risk valuation. This valuation gap is exposed in times of economic crisis when implied volatility rises and FHA premiums remain cheap in comparison to the rest of the market. This business model does serve to assist demand in housing, but it is not something that any private enterprise would pride themselves on and it can actually hurt home buyers by artificially inflating house prices in times where default risk is elevated.

The bottom line here is that the increase in FHA market share is directly correlated with the decrease in private market share for insurance on non-prime loans. That correlation is not coincidental, but instead is a reflection of how FHA insurance has become the new preferred product for those seeking similar risk to what was seen during the housing boom.

“Today, FHA is critical to the recovery of the housing market for both existing and new homeowners. FHA’s single-family purchase-loan portfolio is currently 80 percent first-time homebuyers, of which 27 percent are minorities. FHA provides opportunities for first-time homebuyers who have good credit histories but may not have a large downpayment to purchase homes, which has a stabilizing effect on home values.

The first sentence explains how the FHA is critical to “homeowners”, NOT home buyers, because home owners stand to benefit far more from the “stabilizing effect on home values” which protects their equity. Home buyers simply want to purchase an affordable home, not buy into an artificially inflated market. Interventionist policies and programs generally have a poor track record and usually come back to hurt those they were intended to benefit in the long run. First-time home buyers, as I described in this post, are advertised to be the primary beneficiaries of these programs intended to derail true price discovery but will end up paying the greatest price.

“The primary reason for this increase in dedicated loss reserves is a new home price forecast produced by IHS Global Insight, which is one component used by the actuarial firm to project future losses, which shows the bottom of the market delayed from 2009 to 2010, and reflects an additional 8.4 percent price decline in the US Single Family housing market.

This was the real eye-opener for me in this testimony. Numerous economists who correctly predicted the collapse of the housing bubble have predicted far greater losses than 8.4% from current levels and nearly all economists have acknowledged that rising foreclosures and inventory pose significant risks to housing price stability in 2010. How can a reserve budget be based upon only a 8.4% decrease, which is one of the more optimistic forecasts that I’ve seen to date? But this is only the beginning… this same forecast model from IHS Global Insight predicts a return to the peak of bubble prices as soon as 2015. This chart below is the visual representation of an asset bubble.

IHS Global Insight Aug09 Home Price Forecast

“The drop in the capital reserve ratio below two percent is anticipated to be for a relatively short period of time and the ratio is expected to return above two percent within the next two to three years, on its own, even if FHA were to make no policy changes at all. The current drop in the capital ratio in no way indicates that FHA is at risk of needing an immediate capital infusion as it currently holds more than $30 billion in total reserves. To the extent that FHA’s newly insured MMI loans are expected to earn revenues in excess of expected losses on a present value basis further strengthens its capital position as new mortgage insurance premiums will continue to add to FHA’s reserves.”

This short-term revenue injection is a direct result of taking a larger market share and therefore increased UFMIPs.  It seems that they are primarily concerned with short-term results based on optimistic projections instead of planning for an adverse scenario. Foreclosure rates will almost certainly rise as FHA’s newly insured loans mature and that will be the period of potential crisis depending on how well the economy has rebounded, if at all.

“As newly insured loans are being underwritten at or close to the bottom of housing prices, there is potentially lower risk that housing values of these new loans will become underwater in the future.”

This is called averaging down… how Kerviel-esque of them! Great if it works… disastrous if it doesn’t. I fail to see how this is much different than selling a naked put option on housing prices and that would truly be a risky endeavor in today’s market.

Despite my disagreement with a lot of this testimony, there were some positive developments that I’ll point out:

“On September 18, 2009, FHA announced that it will be appointing a Chief Risk Officer, for the first time in FHA’s history.”

A long overdue move and hopefully a very risk-averse person is given the position.

“FHA’s appraisal validity period will be reduced to four months for all properties including existing, proposed and new construction.”

This along with the crackdown on cherry-picked appraisers should help mitigate some of the risk exposure when housing prices become volatile.

Testimony of Mr. Edward Pinto, Real Estate Financial Services Consultant

“My purpose in testifying today is to advise you of the growing fiscal crisis facing the Federal Housing Administration (the FHA). Many witnesses over the years have made repeated warnings to this and other congressional committees. By my testifying today, this subcommittee will not be able to say that no one told them of the magnitude of the impending losses at FHA.”

Ouch… not exactly the first thing you want to hear.

He follows up with this chart detailing the rising trend in foreclosure starts for FHA mortgages that precedes even this mortgage crisis.

FHA Foreclosure Start Ratio

“There is no amount of insurance premium that is sufficient to cover the losses incurred by deliberately insuring loans based on poor underwriting standards”

Now here is one place where I’ll disagree with Mr. Pinto. FHA underwriting standards may not be excellent, but they are certainly not poor or very similar to the UW standards seen in the bubble years from the private side. The FHA requires full documentation in all cases and that one step alone removes a lot of the fraud from the system.

Next, he drops the hammer with a startling prediction:

“Back to FHA – I believe it appears destined for a taxpayer bailout in the next 24-36 months”

I’ve already addressed why I don’t believe failure will come that soon for the FHA, but it’s certainly possible if prices plummet beyond their predicted 8%  and/or the employment situation deteriorates faster than expected.

Mr. Pinto states the reasons for this prediction along with many supporting statistics, but I’ll quickly summarize the few that caught my eye:

  • The FHA and VA now account for over 90% of all loans with 90%+ LTV (high-LTV) being made
  • “Total high LTV lending in the first half of 2009 was equal to 23% of all originations by all lenders. It was only 17% of originations in 2006, a year notorious for its high risk lending”
  • At the end of Q1 ’09, the average equity of all homeowners with a mortgage in the U.S. was only 10% (lowest level ever recorded)
  • FHA’s default rate for loans originated within last 24 months: 5.73%
  • For the month of August, four lenders were responsible for 85% of all FHA loans added: Wells Fargo, Bank of America, Chase, and Citi

Let’s go back to Bernanke’s quote earlier this month: “I think it is undeniable that the FHA loans, because of a low downpayment, are riskier than other mortgages made”. So the question must be asked… Why are 90% of the risky mortgages guaranteed by the government? Clearly this is not in the best interest of the American public, yet all we continue to hear is that the FHA is saving the day for the common American. Sure there are certain low-income households who need some assistance to become homeowners, but they aren’t going to be getting a $700,000 home at 3.5% down. Government entities or agencies stepping in to help the economy in perilous times is not a problem, but when they risk the taxpayer’s dollars to the tune of tens of billions of dollars it becomes hard to justify the decision as beneficial to the nation as a whole. I’m not going to go into much detail about who benefits the most from this economic backstop, but their names are listed above and they are some of the same ones that have been on the winning side of every legislative decision and and economic stimulus package for the past 24 months.

He finishes by giving the following suggestions to possibly avert a crisis for the FHA:

1. Raise the minimum FHA downpayment on purchases to 10% with reduced seller concessions.
2. Limit FHA volume of low downpayment loans to a 5-10% market share.
3. Reduce FHA max loan limits to a level commensurate with low and moderate income housing
4. Establish a coinsurance requirement of 10% for FHA lenders and raise capital requirements.

1. Raise the minimum FHA downpayment on purchases to 10% with reduced seller concessions.

2. Limit FHA volume of low downpayment loans to a 5-10% market share.

3. Reduce FHA max loan limits to a level commensurate with low and moderate income housing

4. Establish a coinsurance requirement of 10% for FHA lenders and raise capital requirements.

I’m not a huge fan of hard limits across the board for #1 and #2 because the FHA’s mission of helping low and moderate income households is something that can help a lot of Americans get their foot in the door. I am, however, in support of the logic behind these suggestions. There should clearly be higher downpayment requirements for higher loan values and such a tiered approach would reduce exposure to the high-LTV market throughout the financial industry until private firms have adjusted their risk pricing models to reflect a stable economy. As for #3, I’m fully supportive of this suggestion. It shouldn’t be possible for banks to give someone a government guaranteed mortgage for $700,000 with only a $25,000 downpayment. It is perhaps even more ridiculous that there is aggressive campaigning by Senator Dodd (can we get this guy out of office already?) and others to have these loan limits permanently extended for all GSE’s and FHA. Lastly, I can’t see the bankers accepting the first part of suggestion #4, although it would help, and the second part won’t matter as proven by the fact that the vast majority of FHA volume is generated by the “too big to fail” entities.

The Numbers Game

Now on to the numbers behind this potential FHA crisis:

FHA reserves stand at approximately $30 billion.

The FHA’s single-family portfolio of 5.8 million loans is $725 billion. ($125,000 per loan)

According to Mr. Pinto, Fannie Mae’s high-LTV defaults are averaging around a 50% loss of principal. It does seem, as he suggests, that it is safe to assume similar results for FHA defaults.

Therefore my basic math says that the FHA can withstand about 480,000 foreclosures before the reserves hit the zero boundary and the “full credit” clause of the government guarantee kicks in. The Q2 ’09 OCC and OTS Mortgage Metrics Report from the Treasury tells us that government guaranteed mortgages, of which FHA accounts for 77 percent, had 93,231 foreclosures in process, 194,934 defaults (90 days delinquent), and another 161,684 seriously delinquent loans (60-89 days or bankruptcies). If we just assume again that 50% of these 90 day defaulted mortgages are foreclosed upon then that brings us to 190,698 total loans to be foreclosed upon in the immediate future. 77% of that should be a fair estimate of the FHA’s share which would be 146,837 foreclosures.

Add that number to the 5.73% rate of default for loans originated in the last 24 months by the FHA (928,000 annual rate reported in May 2009 for FHA loans x 2 years = 1.856 million). Multiplying 1,856,000 x 0.0573 gives us another 106,348 foreclosures.

A rough estimate of 253,185 likely foreclosures based on the 90-day default and foreclosure in progress data from 4-5 months ago doesn’t bode well for the FHA reserves in the near future. The number of foreclosures and the unemployment rate have both continued to rise since Q2 ’09 and house prices are destined to fall again this winter due to seasonal factors alone. The FHA would need a truly immaculate turnaround for the American economy and the housing market to avoid depleting their reserves at this pace. It would be even better if the FHA and our government would instead dare to be proactive in reducing this risk instead of simply crossing their fingers and hoping for an improbable recovery in the near future.

Conclusion

The implications for the real estate industry are huge if the FHA does decide to reduce its risk in the markets. I’m in favor of them reducing market share in such rough economic times, especially in the jumbo and >95% LTV markets, but the FHA could quickly dig their own grave by reducing risk too quickly. If the FHA decided to dramatically cut market share then house prices could plummet for a second time which would increase their current book risk and potentially lead to an even greater loss than if they had stood pat. Such an exit strategy would have to be carefully planned and executed in a similar fashion to the massive stimulus plans of central banks.

Because of the inherent risk involved with exiting the market completely, I’d be in favor of the following changes to protect the taxpayer against risk:

1. Raising downpayment requirements from 3.5% to 5% for loan values above the local median home price.

2. Lowering the loan limits to 125% of the local median home price, up to $417,000 in high-cost areas.

3. Increasing UFMIP from 1.75% to 2% in a declining market.

Hopefully someone wakes up and starts doing something to protect us from another bailout before it is too late, but as Mr. Pinto said… it’s not as if there was no warning.

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Written by Myron

10/08/2009 at 11:21 PM