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528 July 29, 1986 HOW CONGRESS CAN DEFUSE THE FEDERAL HOUSING ADMINI STRATION TIME BOMB INTRODUCTION The housing industry is booming. With mortgage interest rates dipping to their most affordable levels since 1978, the housing market in many areas is so vibrant that homes are routinely selling within a day of listing. Pred icts Kenneth Rosen, chairman of the Center for Real Estate and Urban Economics at the University of California, "This should belthe best year in mortgage-origination volume in American history.
That is the good news. The bad news is that in the process of this housing boom the Federal Housing Administration, the government's eventually explode in the American taxpayer's lap. In the past year the FHA has accommodated the surge in home ownership by.more than doubling its credit ceiling, from $57 billion to a record level of 132 billion. The frightening aspect of this growth in FHA credit is that the agency is failing to take prudent measures to protect itself and thus the American taxpayer, against the huge contingent liability the agency carries the FHA coul d easily be facing multi-billion dollar losses. And because the FHA's reserves fall far below industry standards taxpayers would be forced to pay the bill popular home mortgage insurer, has become a fiscal time bomb that may Should the economy slide into a deep recession 1 Lower Mortgage Rates Spur Sales of Houses in Much of the U.S The Wall Street Journal, March 3, 1986, p 1. I I And to make matters worse, the FHA is much more susceptible to large losses now than it ever has been. The reasons First, the FH A is insuring increasingly risky loans. Down payments on FHA-backed mortgages, for instance, have declined significantly since 1980, and the lower the downpayment, the greater the likelihood of default Second, FHA premiums have not been adjusted to reflect changed market conditions. The premiums are based on the default rate on home mortgages during the 1960s and 1970s, but during the 1980s, default rates have been about twice as high raised their premium rates about 25 percent to protect against this great e r risk, but FHA premium rates have remained unchanged Private mortgage insurers have Third, the FHA's recently initiated direct endorsement program by which the agency forgoes its own loan verification procedures and relies on those of the lender, could s e nd FHA claim rates skyrocketing. In fact, FHA's direct endorsement already has been criticized sternly by the Department of Housing and Urban Development's Inspector General, who found that under the new procedures 'WUD has little assurance that [FHA's] q uality controls are effective.
Congress soon will have a chance to review FHA behavior. Later this summer, the lawmakers will consider legislation to determine the level of FHA funding for FY 19
87. In doing so, Congress should require the FHA to provide adequate protection against the huge risk it is placing on taxpayer's shoulders. FHA should be forced to make its level of reserves comply with those imposed on private insurers by state law. Since these are the levels considered llsafe,ll the FHA should not be permitted to fall below them. FHA premiums, moreover should be adjusted to actuarially sound levels taking into account the recent explosion in claim rates experienced by the entire industry.
Finally, the FHA should impose a small coinsurance requirement on lenders under its direct endorsement program to discourage fraud and misrepresentation.
These changes will place the FHA on more firm financial footing and thus minimize the taxpayer's risk. They will also assure that, as the FHA competes with the private mortgage insurance industry, the competition takes place on an even playing surface.
In addition to assuming disaster-courting risk, the FHA has strayed far from-its legislative mandate. It was established a half century ago to provide mortgage protection to those of low and moderate income possibly underserved by the private mortgage insurance industry. Today, however, more than one of every four FHA recipients has an income of over $40,0
00. This makes FHA one of the largest yet most .inconspicuous federal subsidies to America's upper middle- and 2upper-income classes. Under current law, there is no income ceiling for recipients of federal mortgage insurance; there should be.
Where the FHA perhaps veers farthest from its legislative intent is in the guarantees given to second homes wrote about 700 million worth of insurance for vacation homes. Yet it seems unfair for taxpayers to have to subsidize the purchase of mountain or b e achfront properties by,the wealthy of the FHA's insurance portfolio. These real estate acquisitions by business syndicates are made purely for investment purposes, rather than for.promoting home ownership, which was and is the sole justification for FHA. S yndicate acquisitions also are particularly bad risks: investor property losses will cost the FHA an estimated 700 million this year, a figure that could soar if the real estate sections of the pending tax reform bills are enacted. Also, the HUD Inspector General is currently investigating potential fraudulent activities associated with 500 investor loans. In its review of the FHA, therefore, Congress should consider prohibiting FHA insurance on vacation homes and investor properties Last year the agenFy I n vestor-owned properties, meanwhile, constitute about 11 percent The FHA has strayed far from its original charter. Rather than focusing on helping Americans with modest incomes to buy homes, it is increasingly supporting the real estate deals of the rich. And it is doing so in a manner that could be very costly to the American taxpayer original purpose.
Congress should rein. in the agency and return it to its PRIVATE AND GOVERNMENT MORTGAGE INSURANCE The Federal Housing Administration was established under the National Housing Act of 1934 to provide government-backed mortgage insurance to lower- and middle-income families unable to receive mortgages during the early years of the Depression. The purpose of the federal insurance has been to promote home owne r ship by encouraging banks, savings and loans, mortgage companies, and other lenders to grant mortgages to applicants otherwise viewed as too risky four and five million homeowners currently enjoy FHA mortgage protection, for which the agency charges the h o me buyer a flat one-time premium of 3.8 percent of the loan principal. In the event the homeowner defaults, the FHA typically reimburses the lending institution the full value of the covered mortgage and acquires title to the defaulted property Between 2. Office of Management and Budget, unpublished data, 1986 3By the late 1950s, the private mortgage insurance industry, which had collapsed during the Depression years, was enjoying a resurrection. over half of the mortgage insurance market from the FHA. Leo Grebler, formerly of the Federal Home Loan Bank Board and now an economist at UCLA, describes this phenomenal business success as "A case of private enterprise beating a firmly entrenched government agency at its own. game Today .there are twelve private m ortgage insurance companies underwriting over 200 billion worth of housing loans of all types. These private businesses compete directly with the FHA for customers By the mid-l970s, the for-profit industryshad captured A 1975 study by the Arthur D. Little international consulting firm concluded that the private mortgage insurance industry could withstand mortgage default rates as hiFh as 10 percent--far higher even than those during the Depression.
Standard and Poorls noted that, despite 'suffering large l osses during the early 1980s, llImplementation of more conservative industry-wide underwriting, favorable premium structures, and emphasis on profitability rather than market share should lead to better operating performance for the industry A more recent assessment by HOW THE FHA CROWDS OUT PRIVATE INSURANCE The role of the FHA always has been to complement private insurance, not to supplant it. This was reaffirmed explicitly by Congress with the passage of the 1948 National Housing Policy Act.
According to this law The policy to be followed in attaining the national housing objective hereby established shall be (1) private enterprise shall be encouraged to serve as large a part of the total need as it can 2) government assistance shall be utilized where I 3. For a detailed discussion of the growth rate of the private mortgage insurers, see Robert L. Waldo The Role of Private Mortgage Insurance Mortnane Ban king, February 1982 pp. 32-38 4. Leo Grebler, "Deal the FHA Out of the Housing Markets," Op-Ed in Th e Wall Streel Journal, March 20, 1986 5. Arthur D. Little, Incorporated, The Private Mortgage Insurance Tndustrv, Final Report to the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation, April 1975 I 6. Standard and Poor's Credit Comment Credit Week, June 23, 1986, p. 12 4feasible to enable private enterprise to serve more of the total need.
In practice, however, the FHA has ignored this unambiguous mandate. The agency has operated as if it were created to compete aggressive ly with the private sector. Exploiting its subsidized premium rates, its unique access to unlimited funds from the federal Treasury, and its. exemption. from..industry regulations_,.and taxes the FHA seems intent on stifling the private mortgage insurance market not encouraging it. If the FHA were a private business, it would no doubt be accused of engaging in predatory pricing. Private insurers share of the market has shrunk from 70 percent in 1984 to 60 percent in 1985, and it is anticipated that it will fall to 45 percent by the end of this year.g This is at least partially attributable to FHA subsidized rates A key advantage enjoyed by the FHA is that it is exempt from the rules imposed by every state that mortgage insurers hold 4 percent of the risk th e y underwrite.in capital reserves. This protects against the natural temptation for mortgage insurers to overinvest their premium income in good times and thus not hold sufficient capital reserves to handle claims in the event of unexpectedly large numbers of mortgage defaults.
Last year, however, the FHA mortgage insurance program accumulated equity (the closest equivalent to capital rgeserve) of only 2.02 billion on its $190 billion contingent liability. This represents a capital reserve ratio of 1.0 perc ent, far below the minimum required of private firms by the states and far below the level a self-sustaining business would have to hold. The FHA can do this, of course, because it enjoys a special privilege unavailable to private insurers: in the event o f an unexpectedly large number of defaults, the FHA will be bailed out by the Treasury Department federal income taxes, as private mortgage firms must.
Nor does the FHAlpay any premium taxes, sales taxes, or state and 7. Public Law 171, 81st Congress; 63 S tat. 413, 42 U.S.C. 1441 8. Mortgage Insurance Companies of America, Fact Book and Directorv, 1985 9. Office of Management and Budget, Budnet of the United States Government, Fiscal Year 1987 i 10. Waldo, OD. cit., p. 36 5THE FHA'S FISCAL TIME BOMB Mortga g e insurance is very different from other types of insurance in that its purpose is not to protect lenders against random events, such as a robbery, a fire, or an injury, where the risk can be assessed according to actuarial tables. Rather, mortgage insura n ce as explained-by the Mortgage Insurance Companies. of.America is issued to protect lending institutions against the hazards of I1catastrophic economic risks stemming from a national recession or a regional depression, or systematic overbuilding in housi n g markets 1111 Claims against mortgage insurers tend to come in clusters: such claims are highly sensitive to the state of the economy. Chester C Foster and Thomas N. Herzog, financial officers at the Department of Housing and Urban Development, explain t hat "Under favorable economic conditions, losses are likely to be small. The great risk in the residential mortgage loan insurance field would appear to be a period of adverse general economic conditions of sustainable duration.
Because of this peculiarity of mortgage insurance, it is misleading to use the deficit/surplus situation of a mortgage insurer in any given year to draw conclusions about the long-term financial viability of that institution. To do so would be as misleading as to look at a departme n t store's revenues and expenses during the Christmas shopping season and then to suppose that the same level of profits would continue throughout the following year. Thus though FHA had a paper profit of $160 million in 1985, this does not mean that the.a g ency is in sound financial condition. Indeed, an examination of the FHA's entire portfolio of risk in the perspective of potential claim rates during severe downturns of the business cycle renders a far bleaker picture. This is because of four recent tren ds in FHA lending practices.
The FHA's Worsenina Loan Portfolio The agency is underwriting record numbers'of risky loans. On average, down payments on FHA-insured homes declined from 10 percent I I 11. The Mortgage Insurance Companies of America, Factbook and Directorv, 1985, p. 1 12. Chester C. Foster and Thomas N. Herzog The Role of FHA Mortaape Banking November 1981, p. 33 613 in 1982 to 7.8 percent in 1985 agency's insured mortgages had loan-to-value ratios or greater. There is near unanimous agreement among housing experts that the less equity homebuyers havs tied up in their homes the greater is their likelihood of default.
Maxwell, Chairman of the Federal National.Mortgage Association, !Ithe conclusion is inescapable that the most central element in weighing the soundness of a mortgage loan is the amount of the homeownerls equity. 1117 Recent FHA claim experience substantiates this: claim rates on FHA-insured mortgages originated during 1981 with loan-to-value ratios over 96 percent have default rate s twice as high as those with ratios of less than 90 percent. This means that FHA default rates are very likely to grow substantially in the future In 1985, 40 percenA of the of 96 percent According to David 0 2) FHA's Relaxed Underwritins Guidelines The a g ency historically has adopted more liberal underwriting practices than the private mortgage insurance industry. As Table 1 demonstrates, the industry standards for Debt to Income Ratio and Expense to Income Ratio on any single loan are 28 and 36 percent r espectively. Prior to 1982, FHA guidelines were 35 and 50 percent.
What is worrisome is that in 1982, when interest rates were high and housing affordability low, these ratios were raised, putting them 13. Office of Management and Budget, unpublished. data , 1986 14. The loan-to-value ratio is the amount of the mortgage divided by the value of the home. The higher the ratio, the less equity the home buyer has put into his home, and thus the higher the likelihood that he will walk away from the loan. A loan- t o-value ratio over 95 percent is considered quite high 15. B. Ellington Foote Federal Housing Administration: An Examination of the Proposed Program Changes Congressional Research Service, March 1986, p. 10 16. The literature on this subject is lengthy an d incontrovertible. Some of the better analyses include: Tim S. Campbell and J. Kimball Dietrich The Determinants of Default on Insured Conventional Residential Mortgage Loans Journal of Finance, December 1983 pp. 1569-1 581; James R. .Barthy and Mortgage M arkets in The Regulation of Financial Institutions (Boston: Federal Reserve Bank, 1979 and John P. Herzog and James S. Early, Home Morteaae Delinauencv and Foreclosure (New York: National Bureau of Economic Research, 1970 a Financial Institution Regulatio ns, Redlining 17. David
0. Maxwell, Address before the National Press Club, August 5, 1985 18. Office of Management and Budget, unpublished data, 1986 7 TABLE 1 FINANCIAL STATISTICS FOR THE FHA AND PRIVATE INSURERS I I Private Insurers FHA Pre-19
82. FHA -Post-1982 1985 Total Debt to Income 35% 38% 28 Total Expense to Income 50% 53% 36 Source: Office of Management and Budget, 1986 even farther out of line with the private sector guidelines. And the FHA does not even adhere to these loose standards: in rec ent years about 30 percent of FHA's insured mortgages exceeded these ratios.
This would suggest that the industry is far more unstable than its 1984 budget llsurplusll might indicate to lawmakers 19 3) FHA's Move toward Dir ect Endorsement The FHA recently initiated a "direct endorsement" program. With this, the agency forgoes its own verification on the soundness of loans and relies instead on the credit and property appraisal procedures of the bank or other lender granting the mortgage endorsement speeds the underwriting process greatly and thus is enormously popular with mortgage bankers and the real estate industry. But direct endorsefient without proper guidelines or without careful monitoring also compromises the integr i ty of the underwriting function by inviting misrepresentation and fraud. Private insurers learned this the hard way in the early 1980s when they adopted direct endorsement on a wide scale. According to Steve Doehler, executive vice president of the Mortga g e Insurance Companies of America, Ilsome insurers had loss rates three to five times higher on the direct endorsement loans than the traditional loans.I1 Direct There are already signs that the FHA is having severe problems with direct endorsement. The In s pector General of the Department of Housing and Urban Development released an audit of FHA activities criticizing the appraisal activities of lenders whose loans FHA had underwritten with direct endorsement. The report notes' that Itproperty 19. The FHA c a lculates these rates in a slightly different manner than private mortgage insurers. However, this does not significantly alter their comparability 20. Telephone conversation, July 1986 8- values and project net income estimated by lenders consistently exc e eded supportable market values. The report also complains that, because of the unexpectedly high volume of requests for FHA insurance over the past six months, HUD llcould not effectively monitor direct endorsement lenders," to detect llpossible adverse t r ends and patterns As a result, HUD has little assurance that its quality controls are effective or that its risks or insurance losses are minimized. Direct endorsement in other .wordsr has been adopted at the expense of compromising underwriting standards 4) FHA's Undermiced Premiums In 1984 President Reagan signed OMB Circular A-70, which established long overdue reforms in the setting of fees under federal credit programs, such as the FHA. Among these guidelines, the presidential directive mandates that: a agencies set fees by reference to insurance premiums charged by private financial intermediaries or other private sources11; and b) I1programs whose fees recover only a portion of expected default costs should be reviewed at least annually, and adjusted as necessary to recover the prescribed percentage of the estimated cost to the government of expected liabilities.I1 FHA's low premium rates violate both of these guidelines and loss gates on all FHA insurance policies originated between 1957 and 19
81. S ince 1981, however, the FHA claim rate has risen from the 3.5 percent typical of the 1960sto 8.3 percent. Claim rates of the past five years are the highest in the program's history. Yet the FHA refuses to raise its premiums to take into.account these cha n ged market conditions and the increased risk associated with mortgage insurance, as is required by OMB Circular A-70 The FHA set its premium at 3.8 percent by examining the claims Worse yet, FHA premiums today average 30 to 35 percent below those of priva t e industry. This policy also flaunts the recent presidential directive. As long as the FHA offers subsidized premium rates, the program will remain financially remiss and will continue to attract record numbers of new customers at the expense of the priva t e market. These new customers, of course, are particularly risky, and 8 21. Office of Inspector General, Report to the Congress for the Six Month Period October 1, 1985, through March 31, 1986, p. 10 22. Ibid 23. A claim rate is the percentage of FHA-insu red mortgages that go into default 24. u 9the greater likelihood of their default will burden the federal taxpayer.
HOW THE FHA SUBSIDIZES THE RICH Putting the .taxpayer. at..risk might be. reasonable if the. FHA only assisted low- and moderate-income home owners who could not afford insurance at market rates buyers, vacation home buyers, and real estate investors. None of these groups warrant federal subsidies, and each could be adequately serviced by private mortgage insurance companies But it helps many upper-income home The FHA imposes no income cap of any kind on program participants insure: in most areas, the cap is now about $75,000, with a $90,000 mortgage ceiling in certain high cost areas such as New York City.
Between 1982 and 1985, nearly 30 perc ent of homeowners receiving FHA assistange had incomes over $40,000, almost twice the national average. One in eight FHA beneficiaries are in the top 5 percent household earnings bracket. Low- and moderate-income families constitute just 45 percent of the FHA portfolio, not much above the 38 percent of private insurers' business. The FHA, therefore, does not serve a special market neglected by private insurers It only restricts the size of the mortgage it will Allowing real estate investors to qualify for F HA insurance has exposed the .agency to huge losses. Though FHA-insured properties purchased for business investment purposes rather than home ownership constitute only 12 percent of FHA endopements, they account for an The latest estimates are that defau l ts on investor-owned properties wilh cost the federal government $630 million in claims during 1986. astounding 30 percent of FHA defaults POLICY RECOMMENDATIONS When Congress reauthorizes the FHA this year, it should consider a number of reforms to place the agency on more solid long-term financial footing.. Policies to consider include 25. Department of Housing and Urban Development, Division of Policy Studies An Assessment of FHA's Section 203(b) Program," March 1986, p. 3-3 26. These HUD statistics wer e cited in: The Wall Street Journal, Turbs on Government-Backed Mortgages Are Instituted by Reagan to Battle Fraud April 4, 1986, p. 3 27. Office of Management and Budget, unpublished data, 1986 10 1) Requiring the FHA to build sufficient reserves. These s h ould equal 4 percent of FHA contingent liability, as is required by private insurers. This would assure that the agency holds funds sufficient to cover catastrophic losses I 2) Requiring that FHA premium rates be at least 80 percent of the level charged b y ..private industry This-would.move -FHA policies toward conforming with OMB Circular A-70, while still providing a subsidy to low-income homebuyers expense-to-income ratios compatible with industry standards would reduce the risk of default on FHA-insured mortgages 3) Requiring the FHA to establish debt-to-income and This 4) Requiring the FHA to revise its premium rates every year in conformance with OMB Circular A-
70. The agency should take into account the latest changes in market conditions in setting premium rates. This would be less stringent than the Administration's proposal to raise the premium level to 5 percent of the mortgage, to be paid at the time of the home purchase 5) Imposing a 5 percent coinsurance requirement on the lender on direct end o rsement loans. By requiring the lender to underwrite a portion of the insurance on the ioans it originates, the FHA would have greater protection against fraudulent claims 6) Phasing in an income cap on participation in the FHA mortgage insurance program. In the first year of the phase in, only families with incomes less than 200 percent of an area's median income might be eligible. This cap would decline to 180 percent the following year then 160 percent and so forth. A permanent cap could be set at 140 p e rcent of the area's median family income, thus assuring access to the housing credit market to low- and many middle-income families phasing in the income limit slowly, Congress would minimize any possible short-term disruptions to the housing market that might be caused by FHA's contraction By 7) Discontinuing FHA mortgage insurance protection for vacation home buyers and investors. Both these groups should turn to readily available private mortgage insurers.
CONCLUSION With demand for Federal Housing Admi nistration mortgage insurance I now shattering previous records, and the agency on the way to Capitol I Hill to argue for a greatly increased 1987 budget, Congress must rethink FHA's role in the housing markets. To do so, it should move the agency's polic i es back in line with its original mandate to 11 - service low- and moderate-income home buyers who might be excluded from the private market. The FHA should not require taxpayers to carry the ultimate risk of providing subsidized mortgage insurance rates to upper-income homeowners, purchasers of vacation homes, and real estate investors. Each of these groups should be required to turn to one of the twelve private insurers.
Over the next five.years it is.estimated..that Americans will seek half a trillion dollars worth of mortgage insurance protection.
It is essential to the housing market that there be a strong private mortgage insurance industry to underwrite most of this insurance. Yet it seems undeniable that the FHA is driving private insurers out of t he market by using its access to the taxpayer's pockets to encourage homeowners to opt for federally subsidized insurance. At the very least, the FHA should be required to compete with private insurers on an even playing surface.
With the housing market i n its best financial shape in years, and the near future looking equally bright, this is the right moment for Congress to start weaning the mortgage bankers and upper-income families from direct federal assistance. By establishing actuarially sound premiu ms on FHA insurance, and allowing program access only to low- and moderate-income families, Congress could push the FHA toward equity and fiscal responsibility.
Stephen Moore Policy Analyst 12