Like our economy, the FHA is treading water. Pulled to shrink their footprint, pushed to keep the housing market afloat, what will be their role in 2014?

FHA to the rescue

Five years after the sub-prime mortgage meltdown and financial crisis, our mortgage markets are just beginning to sort themselves out. We continue to cover many developments at the Federal Housing Finance Agency (FHFA) and its ugly stepchildren, Fannie Mae and Freddie Mac.

But changes to the secondary mortgage market are merely in their nascent stages —the FHFA’s new Director, Mel Watt, was just confirmed last week. For the moment we turn our full attention to the other big “F” of housing finance: the Federal Housing Administration (FHA).

With conflicting perspectives on the current health of the national housing market, the FHA finds itself in a bit of a pickle. Certain members of Congress continue to urge the federal mortgage insurer to shrink its footprint and shield taxpayers from future risk. This comes on the heels of recent news the FHA projects a $1.3 billion budget shortfall for 2013.

Still, the FHA ramped-up its presence during the Great Recession and bumpy-plateau recovery in a policy response termed “the FHA’s countercyclical contribution” by the New York Times. Economist Jared Bernstein describes the FHA’s “countercyclicity” in a passage worth quoting at length:

“One of the more unfortunate aspects of the political response to the Great Recession has been willful ignorance about the need for policy interventions to ramp up in response to the downturn. When people become seriously ill, we tend not to jump all over them for going to the hospital. Yet opponents of government intervention continue to object to precisely that dynamic whether it’s safety net programs like food stamps or unemployment benefits, or the F.H.A.’s temporary expansion of its footprint in the housing market.”

And expand its footprint it did. In 2007, while the housing market was just crashing down from its dizzying highs, the FHA insured just 6.1% of all purchase-assist loans and 4.2% of refinancings. By 2008 their market share soared to 24.1% of purchase-assist loans and 15.6% of refis.

The FHA’s expansion was brought about by two different market events. First, most of the homeowners who were going belly-up during the crash were defaulting on sub-prime, adjustable rate mortgages (ARMs). The FHA allowed many of these homeowners to refinance with fixed rate FHA-backed loans.

Second, after lenders were caught giving away the store, private mortgage insurers lost billions of dollars.  Those private mortgage insurers who weren’t driven out of business jacked their underwriting standards through the roof. Thus the vast majority of first-time buyers from 2007 to, well, today, have entered the market thanks to the now ubiquitous FHA guarantee.

The bottom line: the FHA kept lender funds flowing during the entirety of the global credit crunch while private market guarantees dried up almost entirely.

Say what you will about the FHA’s footprint, the evidence is clear their expansion worked. Home prices may have fallen an additional 25% if not for the FHA’s intervention, according to Moody’s Analytics.

Putting the “balance” in “balance sheet”

Given the share of mortgages the FHA backed during the crisis, and the number of FHA-insured reverse mortgages that went bad, no one was surprised to hear they suffered substantial losses. The FHA has been locked in a struggle to continue insuring loans while also making good on its guarantees. The math here is pretty simple — from 2007 to 2009, the FHA was writing checks they could not cash.

As a result, they accepted a federal bailout of $1.7 billion in late 2013.  The bailout was added to their loan fund in order to meet their 2% cash reserve requirement. Like all other federal bailouts so far, this one appears to be working. Although they are still running a deficit, they generated over $15 billion in revenue over 2013 and project they will be back in the black by 2015.

As national housing data has improved, the FHA has undeniably reined-in its stimulus. The goal is to get back to their original mission: guaranteeing low-cost loans to buyers of low- and mid-tier homes.

In order to put the brakes on their balance sheet, so far the FHA has:

The retraction has been effective. While the FHA’s market share of purchase-assist mortgages has only fallen slightly, conventional-to-FHA refis are down 80% from their peak.

There is no question the FHA is in a tough spot. While it is clear to us that we remain in a period of secular stagnation and stimulus must proceed, there must be a time when the private market steps in and the FHA can return to their original mandate.

They’ve taken a recent step that just may strike that balance for now.

Striking a balance with “Back to Work”

As of mid-August 2013, the FHA enacted its “Back to Work — extenuating circumstances” program. The program makes it possible for homeowners affected by short sale or foreclosure to qualify for a new FHA-insured loan after just one year.

To qualify for the program, borrowers are required to:

  • prove that either job loss or severe income reduction caused the loss of their previous home;
  • establish satisfactory income;
  • maintain satisfactory credit for 12 months; and
  • complete a one-hour housing counseling session.

You can find the fine print for the program here.

Since the initiation of the program, many are wondering if the recently dispossessed will come rushing back in to homeownership. A recent and wide-reaching study from the Federal Reserve suggests they likely will not.

The Fed looked at a 12-year sample period from 1999 to 2011. They found that only 13% of homeowners with a short sale or foreclosure on their record took out a new mortgage within the sample period. Keep in mind this sample period includes the Millennium Boom, when subprime financing was easily had.

FHA, PMI or neither?

The FHA’s “Back to Work” program was not yet in existence during the Fed’s sample period. So will it make all the difference going into 2014? What about the increased cost of MIPs and the fact they now extend to the life of many FHA-backed loans? FHA-insured financing is unquestionably more expensive than PMI. But does this mean borrowers will increasingly eschew FHA-insured financing in favor of the now more cost-effective PMI?

These are the questions surrounding the FHA’s current status as the ad hoc savior of the housing market. Here’s how we see it breaking down.

The Achilles heel of PMI remains its prohibitive down payment requirements. It is important to remember there are two sides to buyer demand:

  • willingness; and
  • ability.

It is generally fair to say, “once a homeowner, always a homeowner.” In other words, those who lost their homes during the housing crisis are in all likelihood disposed to buying again. The question is, are they able to buy?

The FHA’s “Back to Work” program certainly increases the pool of technically able homebuyers by eliminating lengthy penalty periods for delinquency and default. But recall the FHA continues to demand minimum qualifying standards from their applicants — standards such as sufficient income and stable credit requirements that much of the country’s workforce just can’t hack at this point.

On the other hand, the FHA continues to allow 3.5% down payments for qualified borrowers. The prevailing wisdom among seasoned mortgage loan brokers is that the overall higher cost of an FHA-insured loan is a non-issue for most borrowers. Borrowers just don’t think very far in advance, and very few borrowers in today’s market can qualify for PMI. Even if they did, producing a 10 to 20% down payment is next to impossible given today’s savings rate.

So what’s the final word in the continuing saga of the FHA?

Pretty much more of the same.

With the new “Back to Work” program, the FHA will inevitably capture more borrowers. Millions were foreclosed on and went through a short sale as a result of the housing bust and financial crisis. Those one-time homeowners are hungry for homeownership again and will likely slink back to the FHA as soon as they will have them.

However, increased and life-of-loan MIP is adding revenue to the agency while perchance dissuading a few financially literate homebuyers. Yes, the FHA is still in the hole, but steadily gaining ground back to solvency. Essentially, they appear to be walking a tight rope between market share expansion on one hand and balance sheet equilibrium on the other.

It’s true — buyers are generally more interested in the FHA’s low down payment requirements than a sober accounting of mortgage insurance costs. But given sub-prime loan refis have generally been worked through as well, the FHA will most assuredly not balloon back into the mainstream mortgage insurer it was during the years of the Great Recession. But we are still in a sluggish, bumpy plateau recovery. One in which programs like “Back to Work” will provide needed stimulus for a healthy number of loan originations going forward.