Has D.C. learned Econ 101?

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Article Highlights

  • Think a Lehman-style crisis can't happen again? It’s about to—with the Federal Housing Administration

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  • If the FHA's annual report doesn’t own up to huge risk it’s taking on, it'll be a sign that Washington hasn't learned from its failures

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  • Negative home equity and unemployment are primary triggers of mortgage default—and both will affect FHA’s fortunes

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Leveraged bets as high as 30 to 1 on risky investments with little equity cushion against potential losses is what helped bring down the likes of Lehman Brothers, Bear Stearns, Fannie Mae and Freddie Mac. Think it can't happen again? It's about to—with the Federal Housing Administration.

"This could put taxpayers on the hook again for tens of billions of dollars—and possibly much more." - Joseph GyourkoThis could put taxpayers on the hook again for tens of billions of dollars—and possibly much more.

The agency's annual report is set for release Tuesday. If it doesn't own up to the huge risk it's taking on, it will be a distressing sign that Washington has not learned from those earlier failures.

When the mortgage market imploded in 2008, FHA shifted from being a backstop for relatively poorer borrowers to the lender of last resort. In 2007, FHA insured the mortgages of just 6 percent of new home purchases. By 2010, it insured 30 percent. Its insurance guarantees tripled from $305 billion in 2007 to more than $1 trillion today. Meanwhile, its capital reserve has fallen perilously low—to less than one-third its required level.

If home prices rise, unemployment drops and defaults decline all in short order, then FHA's strategy of tripling down on its insurance guarantees will pay off. Unfortunately for taxpayers, my research shows that FHA has seriously underestimated the risk it has taken on since 2008 - by as much as $50 billion. If the housing and labor markets take another turn for the worse, then FHA—and taxpayers—are in even bigger trouble.

Congress shouldn't wait for the bottom to drop to act. Election years are difficult ones to pass reform—but at the very least, Congress should strengthen FHA's capital reserves.

More broadly, we need to have a serious conversation about the government's role in promoting high home ownership, when the costs of achieving it are so high.

FHA's extraordinary recent growth represents a sharp increase in its insurance of mortgages taken out by borrowers typically making down payments of less than 5 percent of home value. Given so small an equity cushion, and the fact that house prices have fallen consistently since FHA began its rapid expansion, it is no surprise that more than half of FHA's insurance is on mortgages backed by homes with negative equity.

Negative home equity and unemployment are the two primary triggers of mortgage default—and both will affect FHA's fortunes for the foreseeable future.

FHA's position is precarious even if housing and labor markets do not weaken further because it has substantially underestimated the risk of its insurance liabilities. Various weaknesses in its statistical modeling and risk analysis have led it to understate the probability of future defaults and insurance losses.

One example is from the recent stimulus program to provide up to $8,000 in tax credits for first-time homebuyers. We now know this had little lasting impact on the housing market.

To make matters worse, it encouraged people to buy homes with little or no personal equity investment. Essentially, taxpayers provided down-payment assistance. Existing research indicates that defaults will be high among those who did not make the down payment out of their own resources.

It is likely that FHA insured mortgages on one million or more of these purchases in 2009-2010. These costs alone could be more than $10 billion. FHA also underestimates the extent of negative equity in its insurance portfolio; incorrectly evaluates the risk of its mortgages that refinance, and has made other decisions that give false hope about how large future defaults and insurance losses will be.

These factors are not minor, according to my research, but amount to more than $50 billion of future losses beyond what FHA expects. While it's true that these losses would be spread over several years, a recapitalization is still urgently needed.

Just to meet the minimum capital required by law will require an infusion of between $50 and $100 billion on top of its current reserves of $30 billion. And, if house prices fall further, or unemployment increases, even more money will be needed.

Large losses are to be expected when insuring extremely highly leveraged investments. These investments are risky even in the best of economic environments - and become markedly more so in weak ones.

If we want the federal government to be in that business, the only sensible strategy is to properly reserve for high expected losses - not triple down again on what is now a trillion-dollar taxpayer exposure and hope for the best. Having proper reserves in place also makes clear the true costs of being in this business.

There are social benefits of higher homeownership. But we cannot tell if they outweigh the costs of achieving it if we systematically underestimate them.

Joseph Gyourko is the Martin Bucksbaum professor of real estate, finance and business & public policy at the University of Pennsylvania's Wharton School. This essay is adapted from a paper he prepared for the American Enterprise Institute.

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About the Author



  • Joseph Gyourko is the Martin Bucksbaum Professor of Real Estate, Finance and Business & Public Policy at The Wharton School of the University of Pennsylvania.  He also serves as Director of the Zell/Lurie Real Estate Center at Wharton and is Chair of the Real Estate Department.  Professor Gyourko received his B.A. from Duke University and a Ph.D. in economics from the University of Chicago.  His research interests include real estate finance and investments, urban economics, and housing markets.  Professor Gyourko is a Research Associate of the National Bureau of Economic Research (NBER) and is Co-Director of the NBER Project on Housing Markets and the Financial Crisis.  A former editor of Real Estate Economics, Professor Gyourko presently serves on various journal editorial boards.  Professor Gyourko is a past Trustee of the Urban Land Institute (ULI) and currently serves on the Board of Directors of the Pension Real Estate Association (PREA).  Finally, he consults and advises real estate various companies and investors.


  • Email: gyourko@wharton.upenn.edu
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