FHA Time Bomb Explodes...Bailout Coming Next!

Mortgage-related losses may push the reserves at the Federal Housing Administration below the level required by Congress. The Wall Street Journal describes this as “a development that could raise concerns about whether the agency needs a taxpayer bailout.”

The FHA has played a key role in the government’s attempts to stabilise the housing market. In the past two years, it has rapidly expanded its loan guarantee portfolio in an effort to encourage mortgage lending. FHA-backed loans outstanding, which totaled $429 billion in fiscal 2008, are projected to hit $627 billion this year. FHA market share rose from 2.7% in 2006 to 23% last quarter.

The FHA will insure loans with down payments as little as 3.5% of a home’s price, and until last year it guaranteed down payment assistance programs that basically let borrowers buy houses with no money down. Many of those borrowers soon had negative equity in their homes when housing prices dropped. Its programs have helped keep the per cent of borrowers who buy with less than 10% down steady, despite many lenders returning to a more traditional 20% down payment requirement. 

The expansion of the FHA’s role in the housing market was supposed to have no cost to taxpayers, according to lawmakers like Barney Frank who backed the expansion. So what went wrong?

It’s a story familiar to anyone who has watched our financial institutions fall apart. Basically, home-price declines have exceeded those used to model their expected losses. It now seems likely that losses will diminish reserves beyond the required 2% level. If that happens, Congress will either have to allow the FHA to operate with thinner reserves, order the FHA to raise fees on homebuyers or bailout the agency with additional taxpayer dollars.

Only the bailout seems likely, despite reassurances from government officials that there is “zero risk” that the drop in reserves will cost taxpayers money. But the alternatives are untenable. A further dropping of the reserves below 2% will mean the agency will be so thinly capitalised that lenders will not be able to rely on the guarantees. Raising fees charged on guarantees will make home loans more expensive, perhaps derailing the hoped for housing recovery.

One alternative may be to have the Treasury or the Fed wrap the FHA guarantee with an additional guarantee. A guarantee squared. This would eliminate the FHA credit risk without immediately requiring taxpayer money. It would, in short, be the same “no cost to taxpayer” promise that was made when the FHA first expanded its portfolio.

Who knows? Maybe this time it’s different.

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