The Subprime FHA

The Subprime FHA

Berlau op-ed in The Wall Street Journal
October 15, 2007

After two months of economic jitters over bad lending decisions, it looks as if the credit markets may have turned a corner. The stock market has regained its ground, and repriced deals are moving through the business pipeline.

But just as financial players are applying more scrutiny to private-sector loans, the elected trustees of the taxpayers' piggy bank are looking to engage in some real estate speculation of their own by expanding a 73-year-old New Deal edifice: the Federal Housing Administration.

FHA-backed loans are being touted for their "safety" -- to consumers and the financial system. "If we can get people into the FHA rather than to some of the other kinds of loans they have, everybody will be better off," argued Rep. Barney Frank (D., Mass.), chairman of the House Financial Services Committee, during a hearing this year.

Although differing on details, Bush administration officials agree with Mr. Frank on the basics. Secretary of Housing and Urban Development Alphonso Jackson, whose department is parent to the FHA, has described the loans the agency backs as a "safe alternative to . . . exotic subprime loans."

Both Mr. Frank and President Bush support major increases in the limits on the value of loans the agency can make, which are contained in a bill that passed the House of Representatives last month. Only 72 Republicans, mostly members of the conservative Republican Study Committee, voted against the bill. A similar bill cleared the Senate Banking Committee 20-1.

But before the FHA's loan spigots are opened up, a little due diligence by the political sector is in order. The FHA's recent credit history shows it is far from the prudent institution it is said to be. By its own estimate, next year the agency expects to be in the red, paying out more for defaulted loans than borrowers pay to it in insurance premiums. "Because of adverse loan performance," the FHA states in its budget submission for 2008, "total costs exceed receipts on a present value basis, and therefore would require appropriations . . . to continue operation."

The agency poses more than just a threat to taxpayers. The collapse of whole segments of the housing market can be traced to FHA-subsidized mortgage products. Despite its decreasing market share, the FHA appears to have played a significant role in the current mortgage "meltdown" attributed to subprime loans.

For the past three years, delinquency rates on the oh-so-safe mortgages insured by the FHA have consistently been higher than even those of the dreaded subprime mortgages. In the last quarter of 2006, for instance, the delinquency rate for subprimes had increased to 13.33% in the National Delinquency Survey compiled by the Mortgage Bankers Association. But in the FHA category, the rate had risen to 13.46% -- "a new record."

Nationally, FHA-backed loans do have a lower foreclosure rate than subprimes do, but one that's nearly twice as high as the rate for all mortgages. And in certain regions, FHA-insured loans account for a disproportionate share of mortgage woes.

Take Colorado. For months the state has had one of the highest foreclosure rates in the nation, and a Denver Post investigation lays much of the blame on FHA products. "FHA program key in surge of foreclosures," stated the headline of the Post article. The newspaper found that while the FHA backed less than one-fifth of home loans in two Denver-area counties, the loans that were FHA-insured actually accounted for about a third of the counties' foreclosures.

FHA-insured loans have also been at the center of some of the worst excesses of the housing boom, including mortgage fraud, loans made without income verification, and property "flipping" with inflated appraisals. Last month, in a case brought by federal prosecutor Patrick Fitzgerald, a Rockford, Ill., real-estate agent pleaded guilty to conspiring to defraud the U.S. government through the use of phony pay stubs and credit letters to obtain FHA loans for home-buying clients.

Several similar schemes involving FHA-backed loans have been documented by congressional probes and newspapers such as the Baltimore Sun. GOP Sen. Susan Collins of Maine, who supervised a 2001 Senate subcommittee investigation of mortgage fraud, said bluntly that "the federal government has essentially subsidized much of this fraud."

How could an agency with a reputation for being so conservative have made loans that turned out to be so problematic? Part of the answer rests in a foolish quest to compete with the private sector for "market share." In both the Clinton and Bush administrations, the FHA's response to private alternatives for low-income borrowers was to aggressively compete with them -- by making the agency's own lending standards even more "subprime" than those of the private sector.

Since its inception in 1934, the FHA has required a down payment -- originally 20%, but gradually whittled down to 3% -- for a home loan. The down payment requirement was to help ensure that borrowers were responsible, even if they didn't have perfect credit histories.

But in 1997, home sellers and buyers started to get around this rule by donating money to foundations that provide down-payment assistance to buyers. Since the FHA does not count assistance from these foundations as a seller inducement -- as many non-FHA lenders do -- seller-funded charities can contribute virtually unlimited amounts to borrowers to cover down payments, closing costs and even FHA borrower insurance premiums. A recent paper by HUD researcher Austin Kelly notes that, since 2000, studies by HUD's Office of Inspector General "have found that sales prices of homes using seller-funded nonprofits tend to reflect the assistance" provided by the charities.

In other words, the buyer's assistance is frequently rolled into the home price, inflating the value of the home and leaving the FHA -- and ultimately the taxpayer -- holding the bag for a defaulted loan. And studies also indicate that the FHA will be picking up the tab at a higher level for these loans.

In 2005, Congress's Government Accountability Office found that FHA borrowers who received assistance from a seller-funded nonprofit were more than twice as likely to default as the agency's borrowers who received no down-payment assistance. They were also more likely to default than borrowers with other types of assistance.

Despite these trends, HUD Secretary Jackson's biggest concern has appeared to be not the FHA's solvency, but the government agency's loss of business to the private sector. "I am absolutely emphatic about winning back our share of the market," he told the Washington Post in 2005.

Looking at the agency's dismal performance over the past few years, we can predict that, if the FHA racks up more "wins," taxpayers and low-income home buyers will likely be suffering the losses.

It is important to note that the vast majority of home mortgages, FHA-backed or otherwise, are not in danger of foreclosure. Overly burdensome regulation of any type of lender would be counterproductive. But those concerned with the fiscal health of the mortgage market and the U.S. Treasury should be emphatic in opposing the expansion of a government agency that added so much fuel to the current "meltdown."