Is FHA the next housing bailout?

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  • Unless economy makes a swift recovery, the FHA will need a massive taxpayer bailout—between $50 and $100 billion.

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  • The Federal Housing Administration is in deep, deep trouble. Will it be the next housing bailout?

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  • After tripling the size of its insurance in the past 4 years, the FHA is now balancing an extremely dangerous portfolio

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Is FHA the Next Housing Bailout?

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Yes, is the answer to the question posed in the title of this report. That will seem a brave conclusion to some, given that the Federal Housing Administration (FHA) has not needed a direct recapitalization from Congress since its founding over three-quarters of century ago. However, it is highly likely, given FHA's current condition.

FHA's present state is precarious. For the past two years, it has been in violation of its most important capital reserve regulation, under which it is supposed to hold sufficient reserves against unexpected future losses on its existing insurance-in-force. To be barely compliant with this rule would have required just over a $12 billion capital infusion in fiscal year 2010, and that presumes that future losses are not being underestimated by FHA. This report suggests that they are by many tens of billions of dollars, so that the recapitalization required will be at least $50 billion, and likely much more, even if housing markets do not deteriorate unexpectedly.

"Unless one believes that the risk of the mortgages it insures has declined substantially, FHA has become a much riskier organization." --Joseph Gyourko

Rather than requesting that Congress strengthen its capital resources as the housing bust deepened, FHA decided to pursue a strategy of growing out of its problems beginning in 2008. Aggregate insurance-in-force more than tripled since then, from $305 billion at the end of the 2007 fiscal year to just over $1 trillion according to the latest data available from July 2011. This is nearly 7% of aggregate national output for the United States, so the potential pool of risk now is very large. FHA has not increased its capital resources commensurately. In fact, it has more than doubled its own operating leverage in recent years, as there is less than half the capital backing each dollar of insurance guarantee than there was only a few years ago. Unless one believes that the risk of the mortgages it insures has declined substantially, FHA has become a much riskier organization.

That the riskiness of its mortgage insurance pool has grown, not declined, since 2007 is evident from FHA's expansion during a time of declining nominal house prices and rising unemployment. Research shows negative equity and job loss to be the two most important triggers of mortgage defaults. It is estimated below that more than half of FHA's current insurance-in-force is on mortgages taken out by owners who presently have negative equity in their homes (i.e., the house value is below the outstanding balance on the mortgage). And, unemployment remains stubbornly high, with many forecasters (including the Office of Management and Budget) now projecting unemployment rates at or above 9% well into 2012.

This combination of increasing leverage at the entity level (i.e., FHA having far less capital per dollar of insurance guarantees) and among the homeowners being insured (many with negative equity in their homes) has made FHA a very risky proposition for taxpayers, who bear the downside risk if its expansion strategy does not work out. That it will not work out is highly likely because the risk of future defaults, and the losses associated with them, is being systematically underestimated. This makes the projections of FHA's main insurance fund value look far rosier than really is the case. No model is perfect, and it is unreasonable to expect FHA's model and estimation to be without fault. However, a combination of unrecognized risks in recent large pools of insured mortgages, an important error in estimation strategy, and an unsubstantiated administrative decision to down weight the influence of an empirically important variable that predicts higher future defaults leads to future losses being underestimated by many tens of billions of dollars. This leaves a quick and substantial economic and housing market recovery as the primary way for FHA to avoid generating substantial losses for American taxpayers. That certainly is to be hoped for, but hope is not a sound foundation on which to run what is now a trillion dollar entity.

The plan of the report is as follows. The next section provides background information on the history of FHA and its operations. This is followed in Section III with a more detailed discussion of the recent, extraordinary growth of FHA. Section IV then analyzes how and why default risk and insurance losses are being underestimated. That leads to the key conclusion that FHA's main insurance program is materially undercapitalized, with the likely amount of capital infusion required being in the $50 billion-$100 billion range, even if there is no unexpected deterioration in housing markets.

Joseph Gyourko is the Martin Bucksbaum Professor of Real Estate, Finance, and Business & Public Policy at the Wharton School at the University of Pennsylvania


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