An outside auditor has now has a chance to look at the FHA’s books for fiscal 2008 and fiscal 2009 and the verdict looks like this: The FHA needs to re-think how it figures loan losses.

The report from the independent certified CPA firm of Urbach Kahn & Werlin LLP may sound like the dullest nonsense in the world, but it actually gets to a very important issue: Is the FHA charging enough for the loan insurance it provides? Should FHA premiums be higher? Or maybe even lower?

“Currently,” says the report, the “FHA does not have an effective process to assess and document the impact of other potential risk factors or loading indicators, such as delinquencies or unemployment data, that may impact program performance and either support the reliability of management estimates based on the model, or provide evidence to support an adjustment of the model estimates. Federal accounting standards allows an agency to integrate management assumptions when current models may not be reliable.”

Ugh. If you’re an insurance outfit you’re supposed to have lots of bright actuaries and seers to foresee the future and tell you what you should expect in the way of losses.

Politics

The idea that “federal accounting standards allows an agency to integrate management assumptions when current models may not be reliable” ought to scare reasonable people for two reasons.

First, you can bet with absolute certainty that “management assumptions” will reflect the bias and worldview of whichever political party is currently in power.

Second, if there are models which are reliable then how come Wall Street took billions of dollars from Uncle Sam? Their models were obviously not so hot. In contrast, the FHA is actually doing pretty well in dealing with the current crisis. Not perfectly, but not badly. Not a dime has been loaned to the FHA from the Treasury, something few large banks can say.

Models

The report says “the econometric models developed for this study are driven by historical claim payment patterns and numerous economic and portfolio variables. The projections for future claim payments for endorsements made in the last two years, which represent over half of the total liability, are based on very limited direct claim performance. Notable changes in the composition of these loans relative to past history and drastic changes in the housing market may impact the model’s ability to fully incorporate the impact of these changes. Due to significant declines in house prices, the liability estimates are also acutely sensitive to small changes in house price projections.”

This criticism is inherent in all economic models. This is not an FHA problem, this is a general forecasting problem whether you’re insuring mortgages or buying beans. In other words, a large number of FHA loans have been made during th past two years and we don’t know how many will default based on prior experience because the world has changed.

What this report really says is that there’s risk in the marketplace and that the FHA cannot fully assess such risk. That’s true of the FHA — and it’s also true of every other lender and insurance company.

The view here, for what it’s worth, is that we will see higher FHA insurance premiums and changed FHA loan guidelines in 2010 because the future is fuzzy and the main reserve account has had large claims. These higher FHA premiums will not impact current borrowers, so if you agree with the idea that premiums are likely to rise then it may be wise to get an FHA finance or and FHA refinance now.

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