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It was no surprise to this observer when the recently released 2012 fiscal year actuarial review of the Federal Housing Administration’s (FHA’s) main single family mortgage insurance fund concluded that it was insolvent. The so-called economic value of the fund, which measures the difference between expected insurance program revenues and expected costs associated with defaults on the underlying mortgages, was reported to be a negative $13.48 billion. Various critics of the program had long claimed that important risks were being undervalued by FHA and its actuary. Last year, I wrote the report Is FHA the Next Housing Bailout? for AEI, which concluded that the main insurance fund already was broke and would need a $50–100 billion capital infusion to put the program on a sound financial foundation.
The most recent actuarial review confirms that FHA is indeed the next housing bailout. While there are various improvements to the underlying model used to predict default and claims, it still does not fully capture all program risks. Hence, I believe true program costs ultimately will be higher, along the lines proposed in my 2011 report. Future research I’ll undertake for AEI will detail why, with the most important reason being that the risk and full cost associated with homeowners becoming unemployed still are being underestimated. Another potentially important factor noted by AEI’s Ed Pinto is that recent Federal Reserve policy that keeps interest rates lower for longer than expected by FHA’s actuarial reviewer will result in greater losses for the FHA mortgage insurance portfolio. These modeling issues are empirically important, but they also are technical in nature and require standalone research to analyze fully. In any event, the purpose of this note is not to settle those matters, but to focus on an overarching risk factor that Congress needs to consider as it decides on policy remedies going forward—namely, that FHA essentially has made an extremely large and highly leveraged bet that it can grow out of insolvency via profitable new insurance business.
Table 1 provides some key risk metrics to help understand this better. The first two columns report total capital resources and outstanding insurance-in-force for each fiscal year dating to 2005. Total capital resources can be thought of as the liquid funds FHA has available to pay off any claims for losses on defaulted loans it guaranteed. Outstanding insurance-in-force is just what its name implies. It reflects the total value of single-family mortgages that FHA has insured and is the potential liability to which FHA is exposed. The third column is a measure of FHA’s leverage. Leverage is a measure of the concentration of debt usage for private companies. Government entities have no equivalent measure because they are not capitalized with debt or equity. Hence, the one used here is the outstanding insurance per dollar of liquid capital reserves (which is the ratio of column 2 to column 1). As of fiscal year 2012, there is $41.19 in outstanding insurance per dollar of liquid capital reserves. Stated differently, total potential liabilities are 41 times total capital reserves, which implies those reserves are leveraged 41 to 1. Quite frankly, no major entity, public or private, should operate with its core capital reserves so highly leveraged. And FHA clearly is getting riskier over time. Four years ago in 2008, as it was just beginning to ramp up its volume of insurance, FHA had less than $15 in potential liabilities for every dollar of capital reserves. Since then, it has become unsafe and unsound.
The next columns of table 1 highlight how this highly leveraged enterprise really is a bet on future growth. Each year, FHA’s outside actuary provides an estimate of the net worth of the next seven years of mortgage insurance that FHA is expected to write. Naturally, this is a highly speculative number because it is based on mortgages not yet taken out by borrowers who have not yet bought a new home or refinanced an existing mortgage. The latest actuarial review predicts that FHA’s not-yet-extant books of business will be worth a whopping $63.99 billion (column 4 of table 1). It is largely that huge value on purely hypothetical books of future business that allows FHA’s actuary to conclude that FHA will grow its way out of insolvency to have a positive economic value of $54.25 in seven years by the end of fiscal year 2019.
Effectively, this means that not changing FHA’s current path is a bet that the future of its mortgage business will be bright even though its past was dark and riddled with losses. The figures on the value of future insurance going forward in column 4 of table 1 show that Congress and the Obama administration have been making just this bet, especially since 2008, when future books of business began to balloon in value. Column 5 then helps illustrate how risky this is by reporting the amount of liquid capital resources per dollar of future insured value. Presently, there is only 40 cents of actual capital on hand per dollar of purely hypothetical future business on which the viability of the entire enterprise effectively rests. This is a very low number compared to the $3–6+ of capital per future dollar of gain that existed prior to 2008 when FHA operated on a much sounder basis. If these predicted future values do not materialize, losses will be very large because the remaining loans from the existing books of business are known to be money-losers on average. For example, the latest actuarial review estimates that the existing books of business will combine to generate $39.05 billion in net losses for FHA going forward.
Albert Einstein is reputed to have defined insanity as doing the same thing over and over, while expecting the outcome to change. For the past several years, the FHA has been doing the same thing over and over again, expecting future insurance proceeds to cover past losses. It has not been working and we need to ask whether this time really will be different. The evidence suggests it won’t, and the agency’s consistent overestimation of insurance fund economic value helps explain why. In addition to predicting the future value of individual annual books of insurance business, the actuary forecasts the next year’s overall fund economic value. This is an extremely challenging task, but if its model is sound, it should be able to come close to estimating economic value 12 months in the future. No forecast will be spot on, of course, but an unbiased estimate should be within a reasonable range of the actual outcome each year, a little over the final result in some years and a little under in others.
What is the track record of these forecasts? Not good, as each subsequent year’s economic value has been overestimated every year since 2005. Moreover, there is no sign that the forecast errors are shrinking in size. The most recent fiscal year’s forecast was especially large. In the 2011 fiscal year report, the economic value of the main FHA single family insurance fund was estimated to be a positive $8.16 billion at the end of fiscal year 2012. We just learned from the 2012 report that the economic value turned out to be a negative $13.75 billion, for a forecast error of −$21.91 billion. Consistent “overoptimism” in the forecasts reflects systematic underestimation of some risk factors. That technical work will be taken up in future research, but my point here is that we need to take more seriously Einstein’s wry admonition for scientists regarding failed experiments. Continuing to bet on a brighter future for a business that consistently underperforms is not very sensible. Even more important, it is extremely risky for America’s economic future. FHA’s current outstanding insurance-in-force amounts to about 6 percent of national output. Given the present precarious state of the public fisc, the nation cannot afford a significant failure in a program of such economic magnitude. FHA’s main insurance fund needs to be recapitalized and put on a sound financial basis immediately. Going forward, we then need to rationalize the agency’s operations, after carefully looking at what it can and cannot achieve at a reasonable cost to the taxpayers.
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