Moving the housing market forward: Principles for returning FHA to its traditional mission

Reuters

A newly built home is shown as sold in a subdivision under construction in Carlsbad, California February 21, 2012.

Article Highlights

  • The FHA needs to return to its traditional mission of being a targeted provider of mortgage credit for low- and moderate-income Americans and first-time home buyers.

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  • FHA should step back from markets that can be served by the private sector.

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  • FHA should stop knowingly lending to people who cannot afford to repay their loans.

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  • FHA should set loan terms that help homeowner establish meaningful equity in their homes.

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  • FHA should concentrate on those home buyers who truly need help purchasing their first home.

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Set up in 1934, it insured fully amortizing 20 year term loans combined with a 20% down payment.  As a result homebuyers accumulated nearly 30% equity after 4 years without relying on inflation.  By 1954 the FHA had insured 2.9 million mortgages, yet had only paid claims on 5,712 properties for a cumulative claims rate of 0.2 percent.  Today the FHA has 7.5 million loans outstanding and pays 12,000 claims per month.  This is not your great-grandmother’s FHA.  

The FHA needs to return to its traditional mission of being a targeted provider of mortgage credit for low- and moderate-income Americans and first-time homebuyers. It performs a disservice to American families and communities by continuing practices that result in a high proportion of families losing their homes.

Reform can be accomplished by following these four principles:

Principle 1: Step back from markets that can be served by the private sector.  FHA has significant advantages that allow it to offer much lower rates than the private sector.  These include a free explicit federal guarantee and no need to earn a return on capital, pay taxes or cover administrative costs.  Unless these substantial advantages are narrowly targeted they lead to unfair and dangerous competition with the prime and subprime private sector, political interference, and the muting of pricing signals.  Over a period of 3-5 years FHA should return to a purchase market share of 10% rather than today’s 30%

Principle 2: Stop knowingly lending to people who cannot afford to repay their loans.  While the loans FHA insured in 2009-2011 are called its good books of business, its 2011 Actuarial Study projects that even under a rosy scenario these guaranty books will experience an average cumulative foreclosure rate of 8.5 per 100 loans or about 1 in 12 loans.  But averages can be deceiving. The worst performing twenty-five percent will likely have a claim rate of 15% under the rosy scenarios used in FHA’s 2011 Actuarial Study and of 20% or more under more realistic scenarios.  This group is largely comprised of thirty-year fixed rate term loans with an loan-to-value (LTV) >90% and a FICO credit score less than 660 with most also having a total debt-to-income (DTI) ratio >40%.   By 2015 the FHA is projecting over 40% of its loans will have these high risk characteristics.  Instead, the FHA should aim for a projected rate of 5 foreclosures per 100 loans.  While this is about 50% of FHA’s long-term average, it is still five and two times the historic default level for prime loans and 90% LTV loans with private mortgage insurance respectively.  FHA should limit the worst credit risk categories to a maximum claim rate of 7.5   FHA should also price for risk since not doing so deprives the borrower of price information needed to understand the true risk being entered into. Until it does so, it should disclose to the borrower his expected claim rate, assuming no house price appreciation or depreciation.

Principle 3: Set loan terms that help homeowner establish meaningful equity in their homes.  FHA should balance the layering of risk factors such as low LTV, low FICO. 30-year loan term, and high DTI ratio so as to allow borrowers to achieve meaningful equity and build wealth.  It should limit its insurance to refinance loans where the lower rate is used enable a reduction in loan term.  This way the benefit of the lower interest rate speeds amortization and builds wealth.  FHA insurance should not be used to enable cash-out refinances, since they work against wealth building. 

Principle 4: Concentrate on those homebuyers who truly need help purchasing their first home.  In fiscal year 2011, 54% of FHA’s dollar volume went to finance homes that were greater than 125% of an area’s median house price.  This is up from 22% in 2009.  Given FHA’s mission is to help low- and moderate-income homebuyers, the homes it finances should cost less than the median priced home for an area.  Additionally, first-time homebuyers should be limited to an income of less than 100% of area median income and repeat home buyers to an income of less than 80% of area median income.

Adopting these four principles would return FHA to its traditional mission of being a targeted provider of sustainable mortgage credit to low- and moderate-income Americans and first-time homebuyers

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Edward J.
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