Mortgage Observer

Challenges at the Federal Housing Administration Were Forseen

With few exceptions, news on the housing front has been overwhelmingly positive in recent months. In spite of weak employment trends, historically low mortgage rates and the plodding but inexorable rebalancing of supply and demand have combined to lift sales volumes, prices and perceptions of a housing recovery.

But a rising tide does not relegate housing to a lower rung on the policy ladder. As conditions improve, policymakers will be obliged to address the long-term role of government in promoting specific housing outcomes. Since the government embarked on the conservatorship of Fannie Mae and Freddie Mac more than four years ago, the immediate goal of resuscitating the housing market has taken precedence over the larger question of how policy goals have supported—and undermined—the sustainability of the sector.

Sam Chandan.

Sam Chandan.

While the private sector is not ready to subsume the role of the agencies in secondary market-making, a serious debate over the eventual structure of housing finance is overdue.

The question may be forced as Congress and the administration begin their horse trading over durable solutions to the federal budget imbalance. In steering the optics between tax increases and the curtailment of deductions, the treatment of mortgage interest is almost certainly on the table, at least in relation to high-income earners. A reconsideration of this mainstay housing subsidy will necessarily open the door on a wider discussion of whom the government should—and whom it need not—support.

If Congress does not bring the question of the government’s role in the post-crisis housing sector to the fore, other stakeholders will have the opportunity to raise their voices. Relating specifically to the enterprises operating under conservatorship, the Federal Housing Finance Administration is an obvious candidate, since it has done so already.

As other sources of liquidity become available, the FHFA’s strategic plan points to a reduced presence for Fannie Mae and Freddie Mac. Conceding that no private secondary market could exist in our present circumstance, the FHFA’s plan also calls for a new housing finance infrastructure with a greater role for the private sector. But beyond that, the ultimate fate of the enterprises rests with Congress.

The Federal Housing Administration, which boasts a 78-year history during which it has remained in the black, may be the proximate cause of a more vigorous debate over housing policy. Contrasting better outcomes in the sales data, the widely reported new audit of the FHA’s Mutual Mortgage Insurance Fund shows a loss of $16.3 billion for the fiscal year ending September 30, 2012. That is an actuarial measure, and the FHA is at pains to remind us that its needs will be quantified with the federal budget in February.

In defending the FHA, a range of policymakers will point out the enormous benefits of its activities; the housing downturn would have been even more severe in its absence. Through the mechanism of its guarantee, the FHA has played a significant role in supporting marginal households’ access to mortgages during the housing downturn. Nonetheless, the potential deployment of taxpayer dollars to prop up the venerable institution will serve as a lighting rod for policy conflict.

And so it should. As important a function as the FHA has served, the problems it faces now were both foreseen and avoidable. Capital was allowed to fall below the statutory requirement of 2 percent, in full view and knowledge of both the FHA and Housing and Urban Development.

Ramping up during the crisis, the FHA increased the MMI’s insurance-in-force from approximately $305 billion in 2007 to $1.1 trillion at the close of the 2012 fiscal year. Both historically and during the crisis, the vast majority of the insured mortgages had loan-to-value ratios of 95 percent or more. If we accept the premise that credit should be extended to a degree that credit is due, this seems at odds with basic lessons in risk management that are the financial crisis’s teachable moment.

Irrespective of any policy motivations that might override the judicious handling of taxpayer commitments, the meat of the problem is in the FHA’s capital reserves, not its direct support of the market. One year ago, in a paper from Wharton Real Estate Chair Joe Gyourko and the American Enterprise Institute, Professor Gyourko pointed out that “for the past two years, [the FHA] has been in violation of its most important capital reserve regulation, under which it is supposed to hold sufficient reserves against unexpected future losses on its existing insurance-in-force.” This was not the first warning of the FHA’s riskier overall position, though it did elicit a visible rebuke.

Among its explanations for why it is a less risky institution today, the FHA points out that its newer book of business measures favorably and that the actuarial assessments capture issues relating to legacy loans. Be that as it may, there are fundamental questions of housing policy that arise when the government guarantees high-leverage mortgages and allows its institutions to breach their statutory limits. These are policies and policy choices that now define housing in the United States and that must come under much greater scrutiny.

Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School. The views expressed here are his own. He can be reached at dsc@chandan.com.