HUD recently released a paper entitled "Myths and Facts Regarding the FHA Single Family Loan Guarantee Portfolio". http://portal.hud.gov/hudportal/documents/huddoc?id=MythsandFactsLoanPortfolio.pdf

HUD lists 19 myths.  A number of these relate to analysis and commentary raised in past issues of the FHA Watch. 

There is broad agreement that the FHA is in need of broad and fundamental reform, both fiscally and programmatically.  Rather than going through each of HUD's so called myths, I have chosen to use a few of HUD's statements to demonstrate the need for common-sense reform consistent with the principles I have laid out in FHA Watch, March 2012.     

Principles for Fiscal Reform:

1. Utilize generally accepted accounting principles, and set rigorous disclosure standards.
2. Establish and maintain loan loss and unearned premium reserves.
3. Establish and maintain a minimum capital requirement of 4 percent of amortized risk in force.
4. Fund a countercyclical premium reserve.

HUD labels as a myth:

FHA would be declared insolvent by state regulators were it a private mortgage insurance (MI) company.

HUD's response does not deny the truthfulness of this statement.  Instead HUD points out FHA's counter-cyclical role.  Yet during the boom HUD used FHA and other agencies and policies to lead a self-described "revolution in affordable housing". The central policy of this revolution was the near elimination of downpayments, a pro-cyclical policy in the extreme.   HUD seems to espouse a policy of being pro-cyclical in booms and counter-cyclical in busts.

Elsewhere HUD points out that the FHA's access to funding from the Treasury Department makes complying with private sector standards unnecessary.  This may be comforting to HUD, but the Congress and taxpayers deserve more than HUD's assurances that all will be well. The FHA is the third largest financial guarantee entity in the United States, surpassed only by Fannie Mae and Freddie Mac (the GSEs). Yet it continues to operate under fiscal standards that can only be described as Byzantine.

Consider the experience with the GSEs. In July 2008 the GSEs were given a clean bill of health by its regulator, the Office of Federal Housing Enterprise Oversight (OFHEO, now FHFA).  In a statement, OFHEO Director James B. Lockhart opined:

OFHEO has been monitoring and continues to monitor closely Fannie Mae, Freddie Mac, and the mortgage and financial markets. As one would expect, we are carefully watching the Enterprises' credit and capital positions.  As I have said before, they are adequately capitalized, holding capital well in excess of the OFHEO-directed requirement, which exceeds the statutory minimums.  They have large liquidity portfolios, access to the debt market and over $1.5 trillion in unpledged assets.

During the month of August 2008, the Department of Treasury hired Morgan Stanley to undertake an independent review of the GSEs. 

The taxpayers know all too sadly the outcome of this review-the very next month the GSEs were placed in conservatorship by FHFA with the bailout bill now approaching $200 billion.  

The questions relating to FHA's current safety and soundness are substantive.  A review similar to the one undertaken with respect to the GSEs in 2008 is undoubtedly needed.  Under private accounting principles FHA likely has a current net worth of -$13.5 billion and an overall capital shortfall under its mandated 2 percent standard of over $32 billion.  This is clear evidence that FHA's current capital is woefully inadequate today.   

There is hope that this critical review will take place.  On March 27, 2012 the Financial Services Committee of the U.S. House of Representatives without objection from a single Republican or Democrat agreed to H.R. 4264: "The FHA Emergency Fiscal Solvency Act of 2012."     

Section 15 mandates that the Comptroller General of the United States provide for an independent third-party one-time safety and soundness review of the FHA "in accordance with generally accepted accounting principles applicable to the private sector."

HUD also labels as a myth:

FHA should hold capital levels like a private MI.

HUD bases its entire response on the erroneous statement that private MIs must "isolate their older' weaker books of business from any recent and healthier year-by-year activity."  This is not true.  Like the FHA, each MI consolidates all its annual books of business in computing a single capital position. Further, the private MI industry has raised or received over $10 billion in new capital since September 2007, none of which was segregated by book year.

FHA should not be allowed to operate is an unsafe and unsound condition, while it unfairly competes with a private sector that has invested and continues to invest real capital. As is noted below, FHA and other government guarantee agencies should credibly begin stepping back from markets that can be served by the private sector and return to a traditional 10 percent home purchase market share.  If this were done, more not less capital would enter the market.

Another myth:

 FHA masks expected losses by using overly optimistic assumptions regarding future home prices.

HUD appears to agree with this "myth," but uses the excuse that the projections used in the November 2011 Actuarial Study date from July 2011.  No publicly traded company would be allowed to hide behind such an excuse.   

Again there is hope that HUD's disclosures will be held to a similar standard as applies to the private sector.  Section 16 of the above referenced H.R. 4264 also sets disclosure standards for HUD with respect to FHA:

1.       Disclosures must provide meaningful financial information and other information that is timely, comprehensive, and accurate;

2.       Disclosures must not contain any material misstatements or misrepresentations;  

3.       Disclosures must make available all relevant information; and

4.       Disclosure must not have material omissions that make the contents misleading.

The Congress and taxpayers deserve nothing less than timely, comprehensive and accurate disclosures from a trillion dollar financial entity.

While HUD is to be commended for taking steps to increase premiums, eliminate incompetent lenders, and tighten some underwriting standards, it has done little to:

• Address the urgent need to move forward with housing finance privatization; and

• Credibly undertake a return to FHA's core mission to provide sustainable lending to low- and moderate-income and minority borrowers. Today 90 percent of all mortgages are guaranteed by the Government Mortgage Complex (GMC), consisting of Fannie, Freddie, Ginnie/FHA. Ginnie/USDA, and Ginnie/VA. Clear and credible steps must be taken to step back from the GMC's market domination. Yet even as FHA takes steps to reduce its share, much of the slack is merely taken up by Ginnie/USDA and Ginnie/VA.

Principles for FHA Program Reform:

1. Step back from markets that can be served by the private sector by taking steps to return to a traditional 10 percent home purchase market share.
2. Stop knowingly lending to people who cannot afford to repay their loans.
3. Help homeowners establish meaningful equity in their homes.
4. Concentrate on homebuyers who truly need help purchasing their first home.

HUD cites two related myths:

FHA loans today are just as risky as those it insured prior to 2008 because they still involve low downpayments and house prices are still falling.

FHA continues to insure risky loans. Even on more recent originations, the FHA 90-day delinquency rate is many multiples of that for the GSEs and MIs.

HUD points out that it has tightened underwriting standards.  Yet its 2011 Actuarial Study projects that, even under rosy economic scenarios, it 2009-2011 books will experience an average cumulative claim rate of over 9 per 100 loans. 

Averages can be deceiving. The worst-performing 25 percent of these loans are thirty-year fixed-rate loans with FICO credit scores less than 660. Most of these loans also have high debt ratios (> 40 percent) and/or high loan-to-value (LTV) ratios (> 90 percent); however, even those with lower LTV and debt ratios have unacceptably high expected claim rates.  Since the beginning of FY 2009 FHA has endorsed nearly 4 million loans totaling nearly $900 billion.  Of these about 1.2 million have a FICO score of less than 660.  That is more than the number of below 660 FICO score loans FHA endorsed in FY2006-2008. 

While these newer low-FICO loans are not as risky as those from 2006-2008, they will still likely have an estimated claim rate of:

1.       15 percent or more under the scenario used in FHA's 2011 Actuarial Study, which assumes an average 4 percent annual price appreciation over 2012-2020. 

2.       20 percent if home price increases average about 2 percent annually over the same period.

3.       25 percent expecting no house price appreciation.

4.       30 percent under economic stress.

At the same time, FHA is projecting that by FY 2015 over 40 percent of its loans will have a FICO below 660, about fifty percent higher than in FY Q.1:2012.

Consider what this means to the homebuyers and the neighborhoods where these future claims will be located.

HUD should follow its own admonition:

Given FHA's mission, allowing the continuation of practices that result in . . . a high proportion of families losing their homes represents a disservice to American families and communities.

Reform focused on sustainable lending would have FHA target a projected average claim rate of 5 per 100 insured loans under normal circumstances and 10 per 100 insured loans under stress circumstances.

This rate is about five times the normal default level for prime loans and about half the FHA's traditional default level under normal circumstances.

This should be accomplished by:

• Eliminating specific risks that are difficult to offset with lower-risk features such as borrowers with FICO scores below 580, adjustable-rate mortgages (ARMs), and loans with a seller concession greater than 3 percent;

• Limiting individual loan risk layering so as to yield a projected claim rate of 5 per 100 insured loans under normal circumstances;

• Helping homeowners establish meaningful equity in their homes.by balancing the layering of key risk factors, such as loan term, LTV ratio, FICO score, and total debt-to-income (DTI) ratio as laid out in Table 1.

Table 1. Underwriting Standards That Help Homeowners Establish Meaningful Equity in Their Homes

* FHA annual premium payable until (1) the amortized loan balance is equal to 70 percent of the lesser of original sales price or original appraised value or (2) the sum of upfront premium plus annual premium of 0.50 percent exceeds a cumulative 4.5 percent.

** Earned equity is the sum of initial equity plus scheduled amortization based on an interest rate of 4.5 percent.

*** Maximum LTV Limit inclusive of financing up to a 1.75 percent upfront mortgage insurance premium.  Where two limits are noted, the first is for the lower term listed under Maximum Loan Term and the second is for the higher term.