by February 6, 2012No. 123
Fixing Mortgage Finance
What to Do with the Federal Housing Administration?
by Mark Calabria
Mark Calabria is the director of financial regulation studies at the Cato Institute. He served on the staff of the U.S. Senate Committeeon Banking, Housing and Urban Affairs and drafted significant portions of the FHA Modernization Act of 2008. He also servedas deputy assistant secretary for regulatory affairs at the U.S. Department of Housing and Urban Development, where he oversaw FHA’s minimum property standards program.
While Fannie Mae, Freddie Mac, and privatesubprime lenders have deservedly garnered thebulk of attention and blame for the mortgagecrisis, other federal programs also distort ourmortgage market and put taxpayers at risk of having to finance massive financial bailouts.The most prominent of these risky agencies isthe Federal Housing Administration (FHA).The FHA currently backs an activity portfo-lio of over $1 trillion. With an economic value of only $2.6 billion, representing a capital ratio of 0.24 percent, relatively small changes in the per-formance of the FHA’s portfolio could result insignificant losses to the taxpayer. As the taxpayeris, by law, obligated for any losses above the FHA’scurrent capital reserves, these are not losses thatcan be avoided. Reasonably foreseeable changesto the FHA’s performance could easily cost thetaxpayer tens of billions of dollars, surpassing theultimate cost of the Troubled Asset Relief Pro-gram (TARP) bank bailouts.To protect the taxpayer and the broadereconomy, the FHA should be scaled back im-mediately, and an emphasis should be placedon improving its credit quality. At the sametime, the agency should be placed on a path toultimately be eliminated, with its risk-takingbeing transferred back to the private sector.
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Executive Summary
2
Payments fromthe FHA aremade directly to the lenderand benefit theborrower only insofar as thepresence of the FHA eitherlowers the costof borrowingor increases theavailability of credit.
Introduction
The Federal Housing Administration (FHA),currently housed within the Department of Housing and Urban Development, insureslenders against the risk of borrower default.The FHA does not make loans itself, but rathersets guidelines for the mortgages it will insure.Mortgages are originated by the lender andcan be either held by the lender on its balancesheet or sold to investors or other financial in-stitutions. Payments from the FHA are madedirectly to the lender and benefit the borroweronly insofar as the presence of the FHA eitherlowers the cost of borrowing or increases theavailability of credit.Lenders pay premiums to the FHA for thisinsurance, the cost of which is passed alongto the borrower. The basic premise is that by mutualizing default risk across lenders andborrowers, the FHA creates overall efficien-cies that offset the premiums that would ex-ist under a purely private system of mortgageinsurance.The FHA currently backs an activity port-folio of over $1 trillion. With an economic value of only $2.6 billion, representing a capital ratio of 0.24 percent, relatively smallchanges in the performance of the FHA’sportfolio could result in significant losses tothe taxpayer. As the taxpayer is, by law, obli-gated for any losses above the FHA’s currentcapital reserves, these are not losses that canbe avoided. Reasonably foreseeable changesto the FHA’s performance could easily costthe taxpayer tens of billions of dollars, sur-passing the ultimate cost of the TARP bankbailouts.
History of the FHA
The FHA did not create the concept of guaranteeing mortgages against default. Thefirst private mortgage insurance company appears to have been the Title and Guaran-tee Company of Rochester, New York, whichopened in 1887.
1
By the time of the stock mar-ket crash in 1929, some 37 private mortgageinsurance companies operated in the state of New York alone.The initial years of the Great Depressionactually saw an increase in the provision of private mortgage insurance. Private mort-gage insurers did not begin failing
en masse
until 1933, in tandem with the wave of bankfailures occurring that same year. As nomi-nal house prices were flat by 1932, with realprices actually rising,
2
the failure of the pri- vate mortgage insurance appears to havebeen more the result of high unemploymentand the banking crisis rather than stress inthe housing market.The combined failure of the mortgage in-surance industry and the reduction of creditavailability from some 4,000 bank failuresin 1933 led Congress to pass the NationalHousing Act of 1934, Title II of which cre-ated the FHA. This paper will focus solely onthe FHA’s single-family business, generally referred to as its 203(b) program, authorizedin Section 203(b) of the National Housing Act, but the agency also provides insurancefor multifamily housing (apartments, co-op-eratives, and condominiums), manufacturedhousing, and hospitals. Although FHA requirements were con-sidered quite radical and risky at the time,the FHA’s initial loan requirements would be viewed as rather stringent under today’s stan-dards. At its inception, the agency required a minimum down payment of 20 percent witha maximum loan term of 20 years. The FHAalso limited its insurance to loans we wouldtoday call “prime”—maintaining credit stan-dards that would have excluded borrowerswith poor or marginal credit. FHA loans werealso required to have an annual interest rateof 5.5 percent, along with an annual insur-ance premium of 0.5 percent. By comparison,private mortgages that were available duringthat time were generally priced around 4 or4.5 percent, making FHA loans a relatively ex-pensive option.The FHA also attempted to minimizecredit losses via restrictions on both the prop-erties and neighborhoods that would be eli-gible. Property quality restrictions were quiteextensive, with the agency maintaining anexhaustive handbook detailing various mini-
3
The 1970s alsowitnessed therebirth of theprivate mortgageinsuranceindustry, whichprovided directcompetition withthe FHA.
mum quality standards that would have to be verified via inspection before FHA insurancewas written. The agency, rather than the pri- vate sector, was also the creator of mortgage“redlining,” a policy by which the FHA refusedto write insurance on loans located on proper-ties within communities with high concentra-tions of racial and ethnic minorities.
3
Despite its promise to be the heart of theNew Deal solution to the housing problems of the Great Depression, the FHA maintained a relatively small role in the U.S. mortgage mar-ket, rarely rising beyond 10 percent of totalmortgage debt outstanding during its first de-cade of operation.
4
Indeed, the agency’s mar-ket share did not break 15 percent until thebeginning of World War II. During the 1950sand 1960s, the FHA’s market share hoveredbetween 15 and 20 percent.
5
Due to its relatively low activity and highcredit standards, coupled with its higher pric-ing, the FHA posed little financial threat to thetaxpayer during its initial decades. Over its first20 years, the agency maintained an income of almost $500 million in premiums with claimspayments of only half that amount.
6
Withhousing prices and employment steadily ris-ing throughout the 1940s and 1950s, theagency was able to maintain a position of fi-nancial health and stability, with both defaultsand foreclosures remaining low.The 1960s witnessed a dramatic turn forthe FHA, as the program was among many federal programs that were increasingly seenas not simply a backstop for the market butas a tool of social engineering. President Lyn-don Johnson, in his first State of the Union Address, asked Congress to allow the agency to postpone foreclosure for those homeown-ers who defaulted due to circumstances be-yond their control. The Housing Act of 1964and the Housing and Urban Development Act of 1968 both expanded the reach of theFHA, while adding a mandate to “assist fami-lies with incomes so low that they could nototherwise decently house themselves.” While itwould take some time for these seeds to bearfruit, the FHA entered the 1970s with a man-date to reduce its underwriting standards.The inflation of the 1970s was not kind tothe agency’s traditional fixed-rate mortgageproduct.
7
The FHA’s market share, by dollar volume, plunged from over 24 percent in 1970to just 6 percent by 1976.
8
Its market shareremained just above that level for most of the1980s, while its activity increased along withthe rest of the mortgage market as declinesin mortgage rates, due to reduced inflation,led to a massive expansion in mortgage lend-ing. Unfortunately, the FHA was not immunefrom the mortgage market boom and bust of the late 1980s. It required restructuring andreform. In 1989, for the first time, Congressrequired annual audited financial statementsfor the agency and established the MortgageeReview Board, intended to reduce lender fraudand abuse within the agency.The 1970s also witnessed the rebirth of theprivate mortgage insurance industry, whichprovided direct competition with the FHA.While a number of private mortgage insur-ance companies went public in the 1960s—themost prominent of which was the MortgageGuaranty Insurance Corporation—it was notuntil 1972 that the level of private mortgageinsurance issued surpassed that of the FHA.Since that time, private mortgage insurershave maintained a market share comparableto that of the FHA, while presenting no risk tothe taxpayer.During the 1980s the agency underwentseveral program expansions that would even-tually result in significant costs to both theFHA insurance fund and the taxpayer. Fore-most among these costly expansions was thereduction of the required down payment from10 percent to 3 percent. Congress also elimi-nated the agency’s maximum interest ratecap, allowing lenders to charge rates abovethe previous cap. Repeatedly Congress alsoraised the size limit on FHA loans, expand-ing the agency’s market share in higher-costhousing markets. When the housing marketeventually turned south, the FHA insurancefund lost about $6 billion, while its economic value plunged toward zero.
9
The early 1980swere some of the worst years witnessed by theagency. Loans written in 1981 displayed a life-
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Fixing Mortgage Finance: What to Do with the Federal Housing Administration?, Cato Briefing Paper No. 123
While Fannie Mae, Freddie Mac, and private subprime lenders have deservedly garnered the bulk of attention and blame for the mortgage crisis, other federal programs also distort our mortgage market and put taxpayers at risk of…
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