Problems at FHA Too Big for Congress to Ignore

Recent blog posts from the House Financial Services Committee about the risks in the Federal Housing Administration indicate significant and growing political risk for the program. Clearly Chairman Jeb Hensarling (R-TX) and his fellow Republicans have some issues with the program, but even less partisan observers of the program recognize there are significant problems. Most recently, the U.S. Government Accountability Office identified the program as high risk and in need of reform.

The deteriorating financial condition of the FHA stems mainly from its slow response to changing market conditions and its attempts to prop up a rapidly deteriorating residential housing market. As the bubble began to burst, the FHA was slow to adjust its guarantee programs and Congress even significantly increased the size of loans the FHA could make in 2008, moving the FHA far beyond its original mission of providing home loans to low-income Americans. As a result, the dollar volume of new loans guaranteed by the FHA tripled between 2007 and 2008, then almost doubled again in 2009, to more than $330 billion. As of the end of FY 2012, the FHA insured $1.1 trillion of loans through its Mutual Mortgage Insurance Fund programs.

The FHA continued to increase the amount of loans it guaranteed despite not meeting its congressionally mandated capital threshold of 2%. According to the FHA, this was done to help prop up the housing market, which is plausible. A less charitable interpretation, however, is that the FHA continued to "double down" on the housing market in an attempt to keep its capital levels above zero, but ran out of room to keep doubling its exposure as its market share rose from less than 5% of originations in 2006 to almost 30% of all originations in the third quarter of 2008. The rapid addition of new loans, which had not yet had time to sour, allowed the FHA to offset the impact of its older insured loans with expected revenue from insurance on new loans.

The FHA has dramatically improved the credit scores of its borrowers in recent years, but continues to be a major source of mortgages to people with bruised or nonexistent credit histories. In the fourth quarter of FY2012, 44% of all FHA borrowers either had no credit score or a score of 679 or lower. In addition, the FHA's commitment to low down payment financing has not wavered through the depths of the credit crisis, as 95% or greater loan-to-ratio financing has continued to make up an overwhelming majority of the loans guaranteed by the FHA.

As a result, most FHA borrowers owe more on their home than they are likely to net on sale for at least several years after origination, assuming a stable housing market. Given the huge volume of loans guaranteed by the FHA in recent years, the preponderance of FHA borrowers who are mediocre to poor credit risks, and the likelihood of these borrowers owing more than their house is worth after factoring in sales costs, the FHA could continue to have the potential to incur huge losses in the event of future housing market downturns for the foreseeable future.

The housing market, at least for now, seems to have stabilized and while the FHA continues to struggle with its legacy of bad loans from 2006 to2009, its financial projections show continued recovery of its finances over the next few years. However, in recent years as its finances have steadily deteriorated, the FHA has continued to assure taxpayers that it was on the cusp of turning things around, so there is ample cause for skepticism.

Congress hasn't yet attempted major reform of its home loan guarantee programs, and given the current political climate in Washington and the bipartisan cooperation required, no action seems likely during this Congress.

However, continued deterioration of the FHA's finances could result in it becoming a problem that is politically impossible to ignore. Given the apparent hostility toward the agency from Republicans on the House Financial Services Committee, this is likely to result in a much smaller scope of permissible lending at the FHA, with a renewed focus on its traditional core of low-income customers resulting in fewer and smaller loans, higher credit score requirements and potentially increased down payments.

Larry Taylor is a managing principal at Capco, a global business and technology consultancy.