FHA’s Delicate Balancing Act
Posted by James H. Carr and Lisa Rice on December 21, 2012
The FHA’s recent financial report card to Congress indicating that the agency may need to turn to the US Treasury for financial support has given detractors of that agency new ammunition with which to disparage its operations and challenge its existence. A recent study by Ed Pinto of the American Enterprise Institute (AEI), for example, claims that FHA is pursuing irresponsibly risky lending to unqualified borrowers with low credit scores and low downpayment.
But FHA’s financial status is actually a remarkable testament to shrewd financial management in a time of incredible financial stress. And criticisms of its current underwriting practices are unfounded.
That said, the agency’s actions to improve its financial outlook are not without controversy. Serious concerns exist about the manner in which the agency may increasingly be falling short on protecting the consumer and civil rights of current and potential borrowers, particularly working families and people of color.
Getting Its Financial House in Order
The headline story in the agency’s independent actuary report is that the FHA’s insurance fund has an economic value of negative $16.3 billion. Not good for sure. But the fund’s negative value is a future projected shortfall, not a current deficit. The agency is nowhere near running out of cash. The actuary report shows FHA still has more than $30 billion of combined capital resources. Moreover, the manner in which the FHA’s fund is calculated does not include future projected income. As a result, $11 billion of anticipated income expected in the current 2013 fiscal year is not included in the fund’s negative value calculation.
The decision whether the insurance fund will need to draw on the Treasury will be determined when the President’s budget is released in January. Even then, FHA would not likely tap the Treasury until next fall, at the earliest. As a result, FHA’s performance is impressive when considering that as early as 2007, most major private mortgage lenders and mortgage insurance funds either filed for bankruptcy, were bailed out or were shuttered.
Not only has the FHA continued to operate without a single dollar of taxpayer support going to its insurance fund, it has expanded its annual share of the mortgage market from a modest 3 percent to more than 30 percent during the past few years, specifically to compensate for the failure of its private sector counterparts. And it did so while improving the quality of loans on its books; FHA’s book of business for the past two years is arguably the strongest in its history.
FHA’s losses are largely the result of loans made during the brief period 2007 to 2009, and disproportionately due to a single loan product, seller-financed downpayment assistance (DPA) loans. Interestingly, FHA had attempted to eliminate seller financing of downpayment, which allowed third parties (nonprofit organizations) to contribute funds obtained from the home seller to the buyer’s downpayment costs, as far back as the year 2000. But in spite of widespread abuses in the DPA program and high default rates, the agency’s efforts to stop the practice did not prevail until Congress banned seller-financed DPA loans in 2009.
AEI’s report attempts to blame the FHA’s current financial challenges on borrowers with low credit scores and low downpayment, but this is unsupported by the data. While it’s true FHA insures a large share of loans that might not be originated in the conventional conforming market, correlation should not be confused with causation. Given that the FHA has operated for almost 78 years without ever needing to draw on the Treasury to finance its insurance fund, AEI’s attempt to paint that agency as a failed or financially irresponsible federal program is without merit.
Going forward, FHA’s financial condition will depend on the performance of the economy and, in particular, future home prices and interest rates. Other assertions by AEI argue that FHA’s economic assumptions are overly optimistic and that a significant draw on the Treasury is inevitable. But Urban Institute president Sarah Wartell and Center for American Progress research analyst John Griffith have reviewed and debunked similar criticisms last year. They argue that AEI researchers overstate and misrepresent key economic data or inaccurately interpret FHA’s capital reserve requirements.
A more recent report by University of North Carolina-Chapel Hill professors Roberto Quercia and Kevin Park highlight the critical role that FHA has played historically to promote access to mortgage credit, particularly in overcoming borrower wealth constraints, promoting product innovation and standardization, and expanding its crucial role during highly adverse economic periods.
And, Griffith points out that any taxpayer dollars that might be needed by the FHA have already been more than offset by the extraordinary value to the economy FHA has provided throughout the recent financial crisis. Griffith cites an unpublished Moody’s Analytics report that estimates the value of FHA’s intervention in the housing market to compensate for the loss of private market institutions. Among the key findings of that report, Moody’s estimates that without FHA’s expanded housing role during the recent crisis, home prices would have fallen by an additional 25 percent, construction spending would have slid 60 percent lower, 3 million additional jobs would have been lost, GDP would have been reduced an additional 2 percentage points and the US economy would have experienced a double dip recession.
Reasons for Concern
Improving the financial health of FHA’s insurance fund has not come without its costs. At least four concerns are increasingly being raised by housing and civil rights advocates who work on behalf of moderate-income families and borrowers of color. These concerns include:
- Rising fees;
- Lender credit score overlays;
- Less than adequate loan modifications; and
- Increasing unrestricted loan sales to investors.
1. Rising Fees. FHA has raised its insurance fees three times since 2008 and further adjustments may be instituted. FHA has also announced it will repeal its policy of allowing mortgage insurance premiums to be cancelled when homeowners reach a loan-to-value ratio of 78 percent.
This latter action alone is estimated to be worth as much as $10 billion to $12 billion to the FHA insurance fund for the 2010-2012 books of business. While positive for the agency, those substantial costs will be passed onto borrowers who, on average, earn less and pay more for mortgage credit relative to borrowers receiving Fannie Mae and Freddie Mac loans. And because roughly 60 percent of loans made to African-American and Latino home buyers are FHA, there will be a significant negative impact on those borrowers. Further, because these exceptional fees are needed to address past lending mistakes, rather than to cover expected losses from future loans, African Americans and Latino borrowers are effectively and disproportionately paying for FHA’s past lending mistakes.
Of course, prevailing historically low interest rates offset, somewhat, the financial impact of premium increases and changes to FHA’s mortgage insurance policy. But to the extent that FHA fees negate the benefit of lower interest rates, lower-income and lower-wealth borrowers are precluded from benefitting from the current favorable interest rate environment in the same manner enjoyed by high-income and high-wealth families who are not dependent on FHA for their mortgage credit.
2. Lender Credit Score Overlays. FHA could do more to challenge lenders that fail to provide mortgages to borrowers with credit scores on the lower end credit of what is allowed by FHA. This is a growing issue. In 2010, the National Community Reinvestment Coalition brought legal action against 22 lenders claiming possible fair housing violations for failing to originate loans with credit scores below 620 and in some instances 640. Although several lenders have changed their policies, credit scores for FHA borrowers continue to rise.
Lenders justify their resistance to originate loans to borrowers with credit scores down to 580, as allowed by FHA, on the basis that lower credit scores translate into higher losses that are not fully reimbursed by FHA insurance coverage. Lenders further argue that FHA’s regulations penalize lenders that have higher losses than their peers and that this practice, intended by FHA to promote quality underwriting, has become an additional disincentive to originate loans with lower-end credit scores. The problem with both of these arguments by lenders is that they place an overreliance on the significance of credit scores in predicting default that is not justified by independent industry research.
Credit scores are only one input into the underwriting equation and allowing lenders to ignore FHA’s lower credit score eligibility guidelines potentially presents fair lending concerns. A 2008 study published by the Federal Reserve Bank of St. Louis examined credit scores of borrowers who received subprime mortgages. The study found that between 2005 and 2007, the serious delinquency rate for borrowers with high credit scores (above 700) grew by a factor of four while the rate for borrowers with low credit scores (500-600) only doubled. The study concluded that credit scores were neither a predictor of the risk of subprime mortgage defaults nor of the subprime mortgage crisis.
Sound underwriting and loan qualification standards have proven to be more determinative of credit quality than an overreliance on credit scores. Best practices include verification of employment, income and rental payments, avoiding abusive loan terms, ensuring that consumers understand their loan products, independent and accurate appraisals, and high quality loan servicing.
FHA should not just accept the failure of lenders to deliver loans with lower credit scores. Rather the agency should conduct due diligence and monitoring of lenders originating only high credit score FHA loans. The goal of those assessments would be to determine whether lenders are over-weighting credit scores and if so, take appropriate action. Unfortunately, FHA’s actions appear to be moving in the opposite direction; at least one report indicates that FHA is considering raising minimum credit score requirements.
3. Less than Adequate Loan Modifications. According to the National Consumer Law Center (NCLC), servicers of FHA loans routinely foreclose on properties or assign defaulted loans back to FHA without complying with FHA’s loss mitigation rules. Yet helping borrowers to avoid foreclosure would not only help families and communities it would also strengthen FHA’s balance sheet. The Government Accountability Office recently highlighted FHA’s servicing oversight deficiencies and recommended several changes to the agency’s loss mitigation rules that might lead to more sustainable loan modifications under FHA’s existing servicing guidelines. FHA should aggressively put into place the appropriate monitoring and systems to ensure servicer compliance as well as penalties for failing to comport with the agency’s loss mitigation guidelines.
4. Increasing Unrestricted Loan Sales to Investors. Finally, FHA is increasingly selling foreclosed properties and distressed loans to investors with no requirements that purchasers offer loan modifications to existing borrowers. NCLC has outlined numerous concerns regarding that practice. Although FHA does sell pools of loans with precise directives requiring loan modifications and other community-focused stabilization efforts as part of a Neighborhood Stabilization Program (NSP), those sales are a minor share of total assets sold. As NCLC observes, the current design of the loan sales to investors program, which is not part of FHA’s NSP initiative, raise many concerns about HUD’s supervision of private lenders who own FHA-insured loans and HUD’s accountability for dispositions of those loans.
The Road Ahead
Over the past 78 years, FHA has backed more than 40 million home loans. It has been and remains a critical component of the U.S. housing finance system. Concern over the financial health of the agency is legitimate. But the exceptional role FHA has played for decades in building wealth for working families, and the exceptional role it has played during the financial crisis easily justify providing FHA with whatever support it requires.
At the same time, FHA must be cautious to not manage its balance sheet in a way that limits access to its traditional constituency of working families. The agency must ward against an over-reliance on credit scoring mechanisms by lenders and require them to place greater emphasis on sound underwriting practices. The agency further must ensure that borrowers who are eligible for loan modifications are given every opportunity available to help them to maintain their homes. Finally, FHA should require, to the greatest extent possible, that its sales of foreclosed properties and distressed loans sustain or create affordable homeownership opportunities and rebuild communities, regardless of whether the buyer is an investor, nonprofit or local government. By sustaining and promoting homeownership for working families and leveraging foreclosed properties and distressed loan assets to maximize community stabilization, FHA will improve its bottom line while promoting the economic wellbeing of moderate-income households and communities of color.
Photo of HUD Building by Flickr user magandafille, CC BY-NC.