The FHA revival

Is the Federal Housing Authority following Fannie Mae and Freddie Mac down the zombie path? Unlike Fannie and Freddie, the smallest and healthiest-seeming of the U.S. government-sponsored mortgage giants hasn’t had to be bailed out. Unfortunately, its relative health led it to ramp up its lending over the past two years to counter the declining housing market.

That may not be a problem if the housing market continues its recent recovery – housing prices in most cities have risen for three straight months, according to the most recent S&P/Case-Shiller figures. But the durability of this recovery is questionable given still-rising unemployment. The FHA could still need to tap taxpayers just as its larger cousins have.

The FHA guarantees home loans, predominantly for lower-quality borrowers who don't have much equity – the agency allows down payments as small as 3.5% of the purchase price of a home. Like Fannie and Freddie, it is in theory self-funded, and the debt it issues benefits from an implicit government guarantee.

Also not so differently from its bigger relatives before they were bailed out, the FHA has a fairly thin cushion of capital should things go pear-shaped. It has $30 billion of reserves against its $675 billion of outstanding guarantees. To be fair, this is much fatter in percentage terms than the cushions Fannie and Freddie used to hold. But it’s still worrying considering how poorly its loans have performed recently.

The default rate on its portfolio was 8.1% in August. That’s up from 5.7% a year ago. And it is likely to rise further because of the combination of the FHA’s ill-timed recent expansion and the economics of the loans it makes.

The agency’s share of the mortgage market slipped to 3% in 2006, the height of the subprime boom. While the FHA is hardly at the cutting edge of risk management – it has only recently got around to hiring a chief risk officer – it nonetheless lost market share because its practices didn’t allow it to match aggressive private sector tactics such as offering loans with minimal documentation requirements to the unemployed.

But by sidestepping that crisis, the FHA set itself up for the possibility of another. The government encouraged the FHA to fill the vacuum that resulted when other lenders collapsed – and even when Fannie and Freddie were stretched.

For example, last year Congress increased the size of the mortgages the FHA could guarantee to $729,750, partly to support rapidly deflating coastal property markets. Since 2006, its market share has risen to about one-quarter of all single family mortgages. It now has $675 billion of guarantees, as opposed to $395 billion at the end of 2006.

Because the FHA accepts such low down-payments and house prices have fallen sharply over the past two years – by 29% even after a recent upturn, according to the S&P/Case-Shiller index of 20 U.S. regional markets – this suggests many FHA loans of recent vintage now exceed the values of the properties they were used to buy.

The FHA, for its part, says its capital buffer is adequate. And it says it is now tightening up on things ranging from borrowers’ credit scores to the lenders it will work with. Yet the damage may have been done. Expanding its reach so quickly at the same time as housing markets were going into steep decline is a potentially toxic combination.

Throw in still-rising unemployment and the result is lots of delinquencies, defaults and foreclosures. Furthermore, the amount lost by mortgage lenders on loans that are foreclosed is high and climbing. The FHA’s losses could hit $70 billion or more according to Edward Pinto, a former Fannie chief risk officer who recently testified on the matter in Congress.

The FHA may get by if initial hints of a housing recovery turn into a clearer upward trend. But if that doesn't happen, its fiscal position will deteriorate. As with Fannie and Freddie, taxpayers may end up regretting their elected representatives’ focus on supporting housing markets by making mortgages easier for buyers to obtain – just when everyone else was learning that excessive leverage could be dangerous.