Tangled in Housing Bust, FHA Seeks a Hand

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The Wall Street Journal
By:  Nick Timiraos
February 11, 2013

U.S. housing markets finally are improving, but taxpayers may not be off the hook yet.

The Federal Housing Administration, a significant backer of new mortgage lending over the past five years, is facing billions of dollars in potential losses, as many loans that it guaranteed during the recession have soured. The agency's independent audit last fall showed that at its current pace, the FHA would exhaust its reserves and need $16 billion from the U.S. government to cover projected losses.

That would be a blow because, since its creation in 1934, the agency has never required Treasury assistance. The FHA doesn't issue mortgages. Instead, it insures lenders against losses on loans that meet its standards, and charges fees to borrowers to cover any losses. The agency's newly installed commissioner will testify before a congressional panel on Wednesday, but the FHA won't say how much it may need until the White House releases its annual budget request in March.

Comparisons to bailed-out mortgage giants Fannie Mae and Freddie -- the recipients of more than $137 billion from taxpayers--are tempting. But the FHA never relaxed its standards during the boom and didn't insure the toxic mortgages that inflated the housing bubble.

Before the bubble burst, lenders considered the FHA's standards too stringent, and in 2006 the agency's share of the home-purchase market fell below 5%. The FHA requires borrowers to prove they earn enough to make their monthly mortgage payment--thereby ruling out "liar loans." It backs mostly fixed-rate loans--meaning no teaser rates.

It does, however, allow borrowers to make down payments of just 3.5%, which it has done profitably since the 1960s. As a result, lenders rushed to the FHA in 2008 as the private market evaporated and as Fannie and Freddie ratcheted up standards. Congress sent more business its way by boosting the maximum loan amount the FHA could insure. In recent years, the agency has insured as many as a third of home-purchase loans.

While the federal government's response to the foreclosure crisis has drawn fire, the FHA's role stands out as a bright spot, says Kenneth Rosen, a housing economist at the University of California, Berkeley, because it helped stave off worse price declines. The losses the FHA is facing today are "the price of the bubble unwinding," Mr. Rosen says.

Economists at Moody's Analytics estimate that home prices, already down around 30% from their peak, would have fallen by an additional 25% without the FHA.

"We put the FHA into business in 1934 not because it was a risk-free time to create a government agency, but because you wanted to absorb risk and put a floor under the economy," says Lou Barnes, a third-generation mortgage banker in Boulder, Colo.

That isn't to say the agency hasn't made mistakes. The most problematic loans are those insured from 2007 to 2009, particularly from a program that allowed home sellers to make "gifts" of down payments to buyers through nonprofit groups. FHA officials belatedly prevailed on Congress to pull the plug on those risky lending programs in 2008.

Since 2009, FHA loans have been doing better. Agency officials have tightened some standards, but shied away from more dramatic steps amid fears that making it harder to get a loan could smother the incipient housing upturn. And the FHA's market share has fallen over the past year as it has raised fees for new loans in a bid to replenish reserves.

Still, a debate is brewing between those who say the government should stop making highly leveraged bets on housing and those who say a quick federal retreat would only make losses worse.

On one side are critics such as Edward Pinto, a resident fellow at the American Enterprise Institute. In a recent report, he says the FHA's above-average default rates in certain low- and moderate-income communities are proof that its lending practices harm the neighborhoods it is designed to help. "They're creating a cycle of delinquency, blight and foreclosure," he says.

Others call that analysis flawed. They say it doesn't account for the fact that many of those communities already were seeing prices plunge--largely due to destructive private lending during the boom--when the FHA stepped in to provide credit after the bubble burst. "If the foreclosure crisis was a fire, Mr. Pinto would be blaming the firefighters for getting the house wet," says John Griffith, a senior analyst at housing nonprofit Enterprise Community Partners.

Shrinking the agency's role overnight would be tricky. The housing bust wiped out trillions of dollars of wealth, leaving many consumers without much of a down payment if they want to sell their home and buy another one, or help their children buy a place. On top of that, low interest rates have made it harder for aspiring owners to build up a down payment.

In the long run, policy makers will have to determine whether such federal guarantees are wise public policy. But that discussion will be harder to have if the housing market is stuck in first gear because only certain households can get a loan.

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