An FHA Bailout Won't Be Its Death Sentence

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It looks like taxpayers will have to rescue the agency, but that's kind of the point

615 mortgage Mark Stout Photography Shutterstock.jpg

The government's implicit guarantee of mortgages backed by Fannie Mae and Freddie Mac has cost taxpayers more than $150 billion so far. Soon, its explicit guarantee of mortgages might cost taxpayers as well: a bailout appears to be inevitable for the Federal Housing Authority. This should not be surprising news to anyone who follows the mortgage market closely, but a new study by Wharton finance professor Joseph Gyourko makes this conclusion clearer. As a bailout for the FHA looms, Congress will likely become enraged again -- on behalf of the taxpayers they represent. What impact would an FHA bailout have on the housing finance policy debate?

Understanding the FHA's Mission

The FHA does not buy loans; it insures them. Here's its role in the market, according to its website:

Unlike conventional loans that adhere to strict underwriting guidelines, FHA-insured loans require very little cash investment to close a loan. There is more flexibility in calculating household income and payment ratios.

In other words, the FHA's mission is to boost home ownership by providing insurance on loans to borrowers who would have a tough time qualifying for a mortgage provided by a bank. Most of these mortgages would be considered non-prime.

This is fundamentally different from the central purpose that Fannie and Freddie serves. First and foremost, they seek to provide mortgage market liquidity by purchasing and guaranteeing prime mortgages. Over the past few decades, however, increasing home ownership became a significant goal for the firms. They began to compete with the FHA for non-prime borrowers. Many lawmakers agree that the goal of providing affordable housing should be stripped from their mission, however.

Where Housing Finance Is Headed

If you're a pessimist about housing finance policy reform, then you probably believe that the government's role in ensuring mortgage market liquidity by guaranteeing most mortgages will continue, even if Fannie and Freddie are dissolved. Two bills are floating around Congress that would provide this outcome.

Abolishing the FHA would take housing policy reform to an even more extreme level than just abolishing the government's role in providing liquidity. By getting rid of the FHA as well, the government would have no role in boosting home ownership for Americans on the margins.

Even if Congress doesn't take this strict of a stance, the FHA may be  be subject to some modest reforms. Over the past couple of decades, its already lax underwriting requirements got even looser. This chart compiled by the American Enterprise Institute's Ed Pinto, a former chief credit officer for Fannie Mae, shows the evolution of the FHA's underwriting criteria and its effect on loan quality:

fha underwriting pinto.png

If home prices were to increase rapidly forever, then this foreclosure trajectory might not be a big concern. But as home prices fall steeply, additional foreclosures result in severe losses. So we should expect to see one of two things happen: either the FHA will increase the size of the premiums it charges in order to cover the additional risk it faces or it will tighten its loan standards to avoid future losses.

On some level, an FHA bailout might not be that surprising. If the premiums the agency collects could always be expected to cover subsequent losses, then the government wouldn't need to be involved. If the business was actuarially sound, then it could be easily privatized as a non-profit firm. So getting rid of the FHA is only a radical idea if you assume that taxpayers ought to subsidize home ownership for non-prime borrowers. A bailout would provide that subsidy.

But that does turn out to be a radical idea in Washington. At most, we could expect some the reforms to the FHA described above and possibly Congress shrinking the size of its portfolio. In the future, it will also probably have the advantage of no longer having to compete with Fannie and Freddie: whatever new government-sponsored mortgage liquidity entity exists in the future will almost certainly not be charged with boosting homeownership for non-prime borrowers.

Image Credit: Mark Stout Photography / Shutterstock

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.
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