FHA to the Rescue?

As the housing and mortgage markets have foundered, the FHA (Federal Housing Administration) has suddenly become the focus of a variety of efforts to stabilize the market. It has already filled much of the breach left by vanishing financing sources, but now it is being eyed for more dubious heroics.

FHA doesn't provide mortgages, but it guarantees that the mortgages will be repaid, if not by the borrower, then by the government. Although in theory taxpayers are ultimately responsible, the main FHA program is a mutual insurance arrangement under which borrowers pay premiums to insure against their own defaults, potentially receiving rebates of money left over after claims are paid. Unlike conventional (not-government-insured) mortgages, FHA loans may be, and usually are, packaged into Ginnie Mae mortgage-backed securities, which are fully and unambiguously backed by the federal government (on top of the federal insurance on the underlying mortgages).

When FHA was created in 1934, it was intended for economic stimulus and mostly insured loans on new homes in segregated communities (see my 1998 article). A few decades later, however, it evolved into a program mainly for insuring mortgages for lower-income, minority, and/or first-time home buyers. FHA-insured loans were available to borrowers who lacked the downpayments and credit ratings required for conventional prime loans.

With the rise in subprime lending, especially after 2001, the FHA share shriveled (as documented and analyzed in a June 2007 GAO report). Subprime lenders were willing to accept borrowers that even FHA, with its relatively-relaxed standards, rejected. Subprime loans also, in some cases, offered lower initial payments, but had terms that became more expensive over time.

Now subprime lending has dried up, and FHA lending has soared--more than doubling in the past year, despite fewer home sales. The growth is likely to accelerate, moreover, as a result of a sharp increase in the maximum loan size, provided for in the February 2008 economic stimulus package. The "FHA Secure" program provided somewhat more lenient underwriting rules for refinances of conventional ARMs, starting in September 2007, and those rules will be further liberalized in July 2008, promising additional volume, and possibly greater risk.

Legislation now under consideration, and apparently headed toward adoption, would create a much more ambitious role for FHA. New loans would be made available to seriously delinquent borrowers facing foreclosure whose homes are worth less than the outstanding balances on their mortgages. The holder of the previous mortgage (aka mortgagee--the lender, not the borrower) must be willing to accept less than the current value of the home as payment in full. The rescued borrower would have to agree to split any subsequent gains from resale of the house with FHA.

The previous lender would presumably only agree to such a deal if borrower and the house appeared to be pretty worthless. With the homeowner obligated to share any gains with FHA, there wouldn't be much incentive to improve, or even to maintain, the house. Compounding the adverse selection and moral hazard issues, this would seem to be a pretty difficult program to administer.

Desperate times may call for desperate measures, but the congressional plans look a little too desperate.

May 21, 2008 -

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