Unfounded optimism: The danger of FHA's mispriced unemployment risk

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Article Highlights

  • FHA's main insurance fund is valued at negative $13.5 billion, meaning it is economically insolvent.

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  • At minimum, at least $50–$100 billion in taxpayer bailouts are needed to put FHA on a sound financial basis.

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  • FHA’s share of loans in serious delinquency has risen by 6 percent since 2011.

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Key Findings

News from the housing market is finally positive: house prices are rising and the share of seriously delinquent loans is down. One major exception? Federal Housing Administration (FHA)-guaranteed mortgages. FHA’s share of seriously delinquent loans has risen by 6 percent since 2011, while its main insurance fund is valued at negative $13.5 billion, meaning it is economically insolvent.

Drawing on original risk analysis, Wharton School professor Joseph Gyourko explains why FHA’s failure to accurately account for the unemployment risk in its Single-Family Mutual Mortgage Insurance Fund is a key cause of its predicament—and a recipe for high defaults and insurance fund losses going forward. His key points include:

How did we get here?

  • FHA’s past failures to acknowledge unemployment risk: If a borrower becomes unemployed, he or she is highly likely to default—especially because the newly unemployed are now staying unemployed for longer periods of time. Yet until 2012, FHA did not account for the risk of its borrowers becoming unemployed when valuing its books.
  • FHA’s continued failure to accurately account for unemployment risk: Though the FHA now attempts to control for this influential factor, its efforts still fall far short. The true impact of an individual becoming unemployed on the probability that that individual will default is roughly 100 times greater than FHA’s latest analysis suggests. In reality, unemployment risk is a more powerful predictor of default than even borrower credit scores. At the portfolio level, FHA’s most recent default model does not allow it to accurately forecast aggregate losses on its insurance fund.

 

How serious are FHA’s fiscal troubles?

  • FHA-insured loans are going bad quickly: In contrast to housing market trends as a whole, FHA’s share of loans in serious delinquency has risen by 6 percent since 2011. And 12 percent of all FHA-insured mortgages in serious delinquency in the third quarter of 2012 were originated since 2010—triple the fraction of the full Mortgage Bankers Association portfolio.
  • FHA books of business are consistently overvalued: For example, FHA’s initial review projected its 2010 book of business to be worth a positive $5.7 billion. This fell to a negative $1.1 billion in its 2011 actuarial review, and is currently at a negative $4.3 billion in its latest 2012 review. 

 

What are the future implications?

  • High defaults and insurance fund losses: Because FHA encourages little upfront equity investment, borrowers are frequently unable to ride out an unemployment spell. The borrower is left with no job and no equity, and FHA’s insurance fund is saddled with the losses. FHA must correctly account for that risk.
  • Potential taxpayer losses: Should the US economy not continue its recovery, the economic downside would be staggering. At a minimum, at least $50–$100 billion in taxpayer bailouts are needed to put FHA on a sound financial basis.

 

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About the Author

 

Joseph
Gyourko

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