Can The FHA Avoid A Bailout Through Higher Premiums?

Yesterday, I wrote about the how the Federal Housing Authority is on the road to a bailout, with its cash reserves quickly drying up as mortgage losses soar. This would be a significant departure from history -- the FHA has always been self-sustaining. It has done so by its mortgage insurance premiums paying for any losses its portfolio has incurred. Unfortunately, defaults are higher these days than FHA management anticipated, so the premiums might not be enough. This points to an obvious way for the FHA to avoid a bailout: it could increase premiums. While a possible solution, I doubt it would happen.

When yesterday's news hit, Bloomberg reported that Housing and Urban Development Secretary Shaun Donovan cited higher premiums as a distinct possibility to address the problem:

"It's likely that you'll see further changes in the coming months," Donovan said in an interview following an event today in Washington held by Bloomberg Ventures, a unit of Bloomberg LP, parent of Bloomberg News. "A number of the steps that we are looking at that are possible around the mortgage insurance premium would help to accelerate FHA stepping back as the private market returns."

While this could technically work to prevent a bailout, I'm not convinced that Washington will find it very politically palatable.

First, it's important to understand how these insurance premiums work. There are two parts: an initial insurance premium payment at the origination of a mortgage and a monthly premium payment for the first five years of the loan. That monthly premium is generally included in the homeowner's monthly mortgage payment.

So let's imagine you increase either of those. Bigger initial premiums would effectively cause home prices to rise for those seeking FHA-insured loans. The higher monthly premiums would mean homeowners mortgage payments would increase. And remember, the consumers that the FHA caters to are low-income borrowers.

So for the FHA to increase premiums, it would have to reduce the housing prospects for poorer Americans and put additional strain on the monthly mortgage costs to people with relatively low incomes. Does that sound like an outcome Congress or the Obama administration would advocate?

I'd be shocked if Washington allowed this to happen. That's why I'm pretty skeptical that the FHA could really increase its premiums in this economic environment, given the potential political fallout. As a result, I think a bailout is far more likely.