Moving the market forward: Principles for returning FHA to its traditional mission

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Article Highlights

  • Today the FHA has 7.5 million loans outstanding and pays 12,000 claims per month.

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  • Increased leverage and loosened underwriting standards sowed the seeds of the financial crisis.

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  • The FHA is impeding the return to a normal market.

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  • The FHA performs a disservice to American families and communities by continuing practices that result in a high proportion of families losing their homes.

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  • Through reform using sustainable lending standards, FHA would serve a targeted market focused on borrowers with poor credit.

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Moving the market forward: Principles for returning FHA to its traditional mission

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Many look at today's Federal Housing Administration (FHA) and nostalgically recall the Depression-era FHA. Set up in 1934, it insured fully amortizing 20 year term loans combined with a 20% down payment. As a result homebuyers could accumulate nearly 30% equity after 4 years without relying on inflation. Initially FHA's loan terms were sustainable and appraisal standards countercyclical. When introduced in 1934, a fully amortizing 20 year loan term combined with a 20% down payment was designed to build substantial equity over 5 years without needing inflation. FHA lending was backed by a rigorous property appraisal process. The appraiser's role, as set forth by FHA in the late-1940s, was defined as determining "a price at which a purchaser is warranted in paying for a property, rather than the price at which the property may be sold....", noted in McMichael's Appraising Manual, 4th Edition, 1951. As a result, FHA's default experience was extraordinarily low. From 1934 through 1954, FHA insured 2.9 million mortgages. During this period, FHA paid claims on 5,712 properties for a cumulative claims rate of 0.2 percent.. In 1951 FHA averaged a down payment of 18% on new homes and 23% on existing homes, with an average loan term of 23 years on new homes and 21 years on exiting homes. Today the FHA has 7.5 million loans outstanding and pays 12,000 claims per month. This is not your great-grandmother's FHA. High leverage lending through the FHA, VA, and USDA continue to spread throughout the market. The private sector followed the government's lead in increasing LTVs and loan terms. The upward trend of balance sheet and income leveraging continued for 70 years. The combination of lower down payments and longer term loans results in a reliance on inflation to create unearned equity.

Increased leverage and loosened underwriting standards sowed the seeds of the financial crisis. The increased leverage and affordable housing mandates have resulted in home prices falling disproportionately more at the low end of the market. Today, the combination of home price corrections and low rates have made the housing market the most affordable in decades. However, as home prices and rates declined, the FHA first increased and then maintained the share of its loans with a very high total debt-to-income ratio. This is short-sighted, unsustainable, and is creating a new bubble. The FHA is impeding the return to a normal market. In an effort to return to prime lending standards, between 2007 and 2011, Fannie and Freddie reduced their acquisitions in the <675 FICO category to 5% of volume in 2011, down from 24% in 2007. They are back to level for prime loans in 1990, at 6%. To bolster its deteriorating financial condition, the FHA expanded into the prime >=675 FICO category. In 2011, 65% of FHA's business had a FICO of >+675, from 22% in 2007. The GSEs can't compete on FICOs of 675-725. Currently one-in-six FHA loans are delinquent 30- days+, predominantly on borrowers with FICOs below 660. By not focusing on the sustainable nonprime market, the FHA is impeding on the return of a normal market. The private sector could do more in the 675+ FICO market. In 2011, the median FICO score on new real estate loans was about 765. As a result only about 9% of new loans had a FICO of between 580 and 675. The median FICO should return to about 735 resulting with about 97% being above 580. Of these,

•About 20% would have a FICO between 580-675 and should be served by FHA.
•About 77% would have a FICO above 675 and should be served by the private sector.

Principles for Reforming the FHA

The FHA needs to return to its traditional mission of being a targeted provider of mortgage credit for low- and moderate-income Americans and first-time homebuyers. It performs a disservice to American families and communities by continuing practices that result in a high proportion of families losing their homes. Reform can be accomplished by following these four principles:

Principle 1: Step back from markets that can be served by the private sector.

FHA has significant advantages that allow it to offer much lower rates than the private sector. These include a free explicit federal guarantee and no need to earn a return on capital, or pay taxes. FHA also has a lower minimum capital requirement than private competitors and the Federal budget covers administrative costs, currently running at 25 basis points per year. Much like private mortgage insurance, FHA's risks are cross-collateralized across multiple book years, but rely on weak government accounting principles. Unless these substantial advantages are narrowly targeted, they lead to unfair and dangerous competition with the prime and subprime private sector, political interference, and the muting of pricing signals.

The loss rates associated with non-prime borrowers require greater levels of initial capital (and the build-up of substantial reserves) to meet high levels of both expected and unexpected losses. The table below shows the required interest rate to cover risk. Rates of 3+ percent above the prime loan rate of 4.5% are not predatory; they are the risk adjusted rates necessary to cover expected and unexpected default losses. The risks associated with non-prime borrowers cannot be funded by private capital except at high rates of interest. FHA loans have lower rates due to a combination of its substantial government advantages and cross-subsidies transferred flowing from high FICO loans guaranteed by FHA to its riskiest loans.

The Treasury/HUD Report on Housing Reform stated "FHA should be returned to its pre-crisis role as a targeted provider of mortgage credit access for low- and moderate- income Americans and first-time homebuyers.". Over a period of 3-5 years FHA should return to a purchase market share of 10% rather than today's 30%.

Principle 2: Stop knowingly lending to people who cannot afford to repay their loans.

While the loans FHA insured in 2009-2011 are called the good books of business, the 2011 Actuarial Study projects that even under a rosy scenario these will experience an average cumulative claim rate of 8.5 per 100 loans or about 1 in 12 loans. But averages can be deceiving. The worst performing twenty-five percent will likely have a claim rate of 15% under the rosy scenarios used in FHA's 2011 Actuarial Study and of 20% or more under more likely scenarios. This group is largely comprised of thirty-year fixed rate term loans with an loan-to-value (LTV) >90% and a FICO credit score less than 660 with most also having a total debt-to-income (DTI) ratio >40%. The FHA is projecting that by 2015, over 40% of its loans will have these high risk characteristics.

Instead, the FHA should aim for a projected rate of 5 foreclosures per 100 loans. While this is about 50% of FHA's long-term average, it is still five and two times the historic default level for 90% LTV loans with private mortgage insurance. FHA should limit the worst credit risk categories to a claim rate of 7.5, and eliminate risky lending practices, such as loans with FICO < 580, ARMS and those with seller concessions greater than 3%. FHA should also price for risk. Not doing so deprives the borrower of price information needed to understand the true risk being entered into. Until it does so, it should disclose to the borrower his expected claim rate, assuming no price appreciation or depreciation.

Principle 3: Set loan terms that help homeowner establish meaningful equity in their homes.

FHA should help home owners build meaningful equity by limiting guaranty to home purchase loans and refinance loans where the lower rate is used for term reduction only. The benefit of lower interest rate on a refinance should be used to speed amortization. FHA should not enable cash-out refinances, since these work against wealth building.

FHA should balance downpayment, loan term, FICO and debt-to-income (DTI) ratio so as to allow borrowers to achieve meaningful equity. Principle 4: Concentrate on those homebuyers who truly need help purchasing their first home.

In fiscal year 2011, 54% of FHA's dollar volume went to finance homes that were greater than 125% of an area's median house price. This is up from 22% in 2009. How does this happen if GHA has been limited to 125% of the median priced home? First, the law mandates the use of home prices from the 2007 peak even though prices today are substantially lower. Second, the county with the highest median home price has that price applied to the entire MSA.

For example, Riverside, CA in the two properties shown here:
• $500,000: which is 125% of the 2008 limit, based on 2007 prices (current FHA loan limit)

• $228,000: which is 100% of 2010 median price. Given FHA's mission is to help low- and moderate income homebuyers, the homes it finances should cost less than the median priced home for an area. Additionally, first-time homebuyers should be limited to an income of less than 100% of area median income and repeat home buyers to an income of less than 80% of area median income.

Congress has set 80% of area median income as guide for CRA lending and Fannie/ Freddie affordable housing goals, so why would this not be appropriate for the FHA? Targeting sustainable lending has positive policy impacts. Income and home prices have obvious utility and targeting to 580-675 FICO band has significant benefits.

Conclusion

Adopting these four principles would return FHA to its traditional mission of being a targeted provider of sustainable mortgage credit to low- and moderateincome Americans and first-time homebuyers.

Implementing these principles will have positive market impacts. FHA, using sustainable lending standards, would serve a targeted market focused on borrowers with poor credit (a FICO below 675 - the current median credit score of all scored households is 720). Also, this would also allow the private sector (Fannie and Freddie and private mortgage insurance today and a much expanded private sector in the future) to better serve the prime market, since these markets can price for risk without resorting to government subsidies or cross-subsidies.

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Edward J.
Pinto

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