The next big bailout

Christopher Papagianis Managing Director, Economics21
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On Tuesday, an independent actuary released a report on the finances of the Federal Housing Administration (FHA). The report showed that FHA now has a 50% chance of requiring a taxpayer bailout in the near future.

Combined with Fannie Mae and Freddie Mac, these three agencies are now responsible for ~97% of all new mortgages in this country. To put this number in perspective, before being taken over by the government Fannie and Freddie generally controlled or guaranteed about 30-45% of the market. FHA’s market share has been closer to 10% over the past 20 years, but it dipped down below 5% during 2005-2006. Now, FHA is responsible for ~30% of new mortgages.

FHA prides itself on being a self-financing agency, which is a fancy way of saying that it has not historically asked for congressional appropriations to cover the mortgage guarantees that it provides to lenders on an annual basis. The way FHA works is that a borrower pays an insurance premium and a private lender gets a 100% government guarantee on the credit risk of the loan. In short, FHA guarantees help reduce the cost of mortgages for consumers, or home buyers, by taking on the credit risk that lenders would otherwise have to assume on their own.

Today, FHA’s mortgage guarantees have effectively exposed the taxpayer to more than $1 trillion in credit risk (i.e., the amount of FHA mortgage insurance that’s still in-force today). The new actuarial report shows that the capital reserve account at FHA — or the money it has to pay for default claims in the future after accounting for embedded losses — has declined from $4.7 billion to $2.6 billion. The dwindling capital account at FHA means that the agency is now levered over 400 to 1. When Lehman failed, it was levered closer to 32 to 1.

The actuary makes clear, however, that the size of any future FHA bailout will largely be a function of what happens to home prices nationally. This is because the relationship between house price and unpaid mortgage principal balance is the most relevant predictor for mortgage default. For example, FHA expects home prices to appreciate in 2012 by 1.2%. But, if home prices fall 1.3-8.3% next year, the actuary states that a taxpayer bailout, on the order of $13-43 billion, will be required to keep FHA solvent.

Now, there should still be time for the government administrators at FHA to change some policies to stave off a bailout. One option would be to raise the insurance premiums they charge to borrowers. But, the real irony of this situation is that on the day that the actuary released its report, Congress is poised to double-down on FHA and increase the taxpayer’s exposure to a future bailout. One might reasonably ask, how is that even possible?

Historically, FHA only provided guarantees for mortgages that were under $360,000. After all, FHA has traditionally served low- and moderate-income families, first-time home buyers, and those who may not have the cash for a sizable down payment. During the financial crisis, Congress decided to massively increase the limit on the size of loans that would be eligible for an FHA taxpayer-backed guarantee to $729,000. This extraordinary ceiling for loans expired at the end of September, moving to a new limit of $625,000 — still way above the lower level that was in place as recently as 2007 and nearly four times the median price of existing homes. In cooperation with Senate Democrats, House Republicans have decided as part of the appropriations process to re-instate the $729,000 level. Amazingly, the agreement surfaced at almost the exact time that the actuary released its report that an FHA bailout is now a 50-50 proposition. If you look at other private market forecasts for home prices over the next few years, a fairer statement would be that it’s now likely that FHA will require a bailout. In many ways, the more appropriate questions to ask are how much it will cost and when the Treasury will have to cut the check.

Congress would be wise to let the loan limit fall, at least to $625,000, for Fannie Mae, Freddie Mac, and FHA. The fact that lawmakers are only allowing the loan limit for FHA to remain elevated suggests that both Republicans and Democrats realize how politically toxic it is to continue to advocate for higher loan limits for Fannie and Freddie. It’s unfortunate that this logic did not extend to FHA — and it certainly should have, given that the latest data on FHA’s books indicate that a taxpayer bailout is on the horizon. Indeed, it is actually counterproductive, as underwriting standards at Fannie and Freddie (down payment requirements and credit scores) are now more stringent than they are at FHA.

An even more cynical interpretation of this situation is that fewer constituents understand how FHA works, especially since the agency has avoided a bailout to date and the corresponding negative publicity. But, it should not be lost on policymakers that FHA provides a 100% government-guaranteed product — and increasing, or even maintaining, the old policies makes it that much more likely that FHA will follow the sad history of Fannie and Freddie. Politically, this outcome should be particularly depressing for the average taxpayer since neither party appears interested in saving taxpayers a lot of money by advancing the solutions that would stave off a bailout at FHA.

Christopher Papagianis is managing director of Economics21, a nonpartisan policy-research institute, and previously was special assistant for domestic policy to Pres. George W. Bush.