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Is The FHA Too Risky?

by Peter G. Miller
April 14th, 2010

A research paper has been floating around for the past few weeks which argues that the FHA mortgage program faces risks which have not been fully recognized. This would be a big ho hum except that if the authors are right it would mean far fewer FHA loans and far tougher FHA loan guidelines.

But are they right?

The paper, Reassessing FHA Risk, was written by several economists, including individuals working for the New York Federal Reserve Bank and New York University. In brief terms it suggests that the FHA is underestimating for forms of excess risk faced by the FHA reserve fund, which is formally called the Mutual Mortgage Insurance (MMI):

Four Risks

___ “More FHA borrowers are severely underwater than the actuarial review identifies. Moreover, unemployment rates are particularly high in areas in which FHA borrowers are furthest underwater. This natural connection is not captured in the actuarial review. The end result is an underestimate of default costs, which directly deplete the MMI Fund.”

___ House values are being over-estimated — meaning that there may be more claims against the FHA system than are now anticipated. “In recent transactions in Los Angeles (LA) County,” says the report, “more than one in three homes is over-valued by 20% or more based on standard valuation methods, and there are also errors in the other direction. The large scale of these valuation errors is important in and of itself. Houses that are less valuable than estimated disproportionately end up in default, hence
depleting the MMI Fund.”

___ “The audit analyzes only final claims to the FHA’s MMI fund and does not take advantage of information about future claims that is contained in current delinquency rates. It also does not properly account for the loan-to-value ratios for streamline refinanced mortgages.”

___ “Most recent FHA borrowers borrow 96.5% of the house value. In principle, they are then required to bring at least 5% to the closing table: 3.5% of the house value, and the 1.5% up-front FHA insurance fee. In practice, almost all borrow the 1.5% up-front insurance fee. In addition, 75% of FHA purchasers in 2009 are first-time buyers (HUD [2009], p.22), who were likely eligible for the First-Time Homebuyer tax credit. As a result, they are required to put up little to none of their own money, and are also effectively able to save most of the insurance premium if they default. There is no analysis in the actuarial report to date of either of participation in this government down-payment assistance program, or of the potential risk to the FHA insurance fund going forward.”

A little Context

In looking at these ideas one should recognize that they could be true, the FHA may well be underestimating loan risks and therefore there may be huge losses ahead for the FHA program. That said, it’s the FHA which is solvent today, something a lot of lenders who made toxic loans can’t claim.

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