Celebration of FHA solvency premature
The FHA traded in a viable long-term income stream for some short-term refinance revenue creating potential for future shortfalls to the fund.
Supporters of HUD Secretary Julián Castro, a potential VP running mate, gloated over the recent news that the FHA insurance fund swelled to reach it’s 2% capital reserve mandate. But the celebration is premature. The FHA insurance fund is not as strong as politicians want to spin it.
The FHA became the replacement for subprime lending during the housing bust. It insured millions of loans as prices crashed, and many of those borrowers defaulted and many more are still underwater. With many delinquent loans and collateral values below loan balances, the FHA stands to lose billions.
The FHA is mandated by Congress to hold a 2% reserve for loan losses. As the losses mounted, they fall below their minimum loss reserve requirement, prompting critics to warn of an expensive bailout. To combat the problem, the FHA raised fees to increase revenues — high enough to be branded a predatory lender.
Unfortunately, the high cost of FHA insurance caused FHA originations to plunge, particularly at the entry level in the housing market, which fell to a three-decade low. I opined that lowering the FHA would spur the housing market, and that pressure would mount to lower the fees to revive sales. Not long thereafter, the FHA did lower its fees, and it’s one of the main reasons sales are higher this year.
Reducing FHA insurance fees was controversial because many believed lowering fees would lead to insolvency because the FHA would not have the income stream necessary to meet future obligations. The wager was that spurring the housing market would lift home prices and improve the recovery on the bad loans. But did it really pay off?
The investment property refinance analogy
What policymakers accomplished by increasing FHA insurance fees is best understood by comparing the accounting to refinancing an investment property.
Imagine you owned a cashflow positive investment property. If the property has no debt, the future cashflow of this property is the the net income over time. The higher the rent, the larger the future cashflow. Similarly, the FHA can estimate its future cashflow by projecting the future insurance payments over time. The higher the insurance rate, the larger the future cashflow to the fund.
Now imagine you decide to take cash out of the investment property. You would obtain a large, up-front payment, but since you must repay the debt, the ongoing cashflow will be lower. Something similar is at work at the FHA.
When an FHA insured loan is originated, the FHA charges both an up-front fee and an ongoing fee. When they lowered their ongoing fee earlier this year, in addition to prompting more sales originations, it also prompted a great deal of refinances to lower the long-term fee. That refinancing triggered a new up-front fee, which is why the money flooded into FHA coffers ahead of projections.
So be clear about what they did: They traded in a more-valuable long-term income stream for a short-term boost in revenue.
The Federal Housing Administration surprised some observers Monday when it announced that its Mutual Mortgage Insurance Fund grew significantly in fiscal 2015, reaching its Congressionally mandated threshold of 2% well ahead of the FHA’s own projections. …
A deeper look at the FHA’s data shows that the increase was not entirely driven by the significant increase in loan volume during fiscal 2015, due largely to a 50 basis point cut in annual mortgage insurance premium prices announced in January by the Obama Administration.
According to analysis from Compass Point Research and Trading, the FHA’s mortgage interest rate reduction actually had “little impact” on the capital ratio.
… much of the increase was driven by the FHA’s Home Equity Conversion Mortgage program.
Without the HECM program, the MMI Fund would sit at 1.65%, below the 2% threshold set by Congress.
The inclusion and impact of the HECM program in the FHA’s total capital reserve ratio was specifically noted by House Financial Services Committee Chairman Jeb Hensarling, R-Texas, who said in a statement that the achievement of the 2% threshold is hardly a cause for celebration. …
“Hardworking taxpayers remain exposed to more than $1 trillion in FHA insured mortgage credit risk, and the FHA capital reserve remains woefully insufficient,” Hensarling said. “In fact, were it not for the FHA’s volatile reverse mortgage program, the FHA single-family loan portfolio would still be below the legally required 2% threshold.”
Like all the can-kicking from the housing bubble, the move to lower the FHA insurance fees was a gamble on future house prices. If lowering the fees brings first-time homebuyers back to the market, and if this increased demand continues pushing prices higher, then when the FHA closes out these old bad loans, they will recover enough money to bail themselves out. If prices aren’t high enough, then the fund will probably need another bailout.
It was a courageous move. If it all works out, Obama (and probably Castro) will look like geniuses. If it blows up and the FHA needs a future bailout, the politicos will have some spinning to do.