FHA, Lawmakers Dither Over Reform Efforts

The Federal Housing Administration is certain to be the target of major reform efforts by Congress, but it remains to be seen whether the agency will face an overhaul or will get away with some tweaks at the margins to restore it to financial health.

The FHA faces a projected $16.3 billion shortfall thanks to massive defaults on loans made during the height of the financial crisis, which includes $2.8 billion of losses on a popular reverse mortgage product for seniors. To shore up its finances, the FHA has asked Congress for more authority to help it avoid a bailout from the Treasury Department in September 2013.

Illustrating the urgency, Senate Banking Committee Chairman Tim Johnson, D-S.D., last week introduced a bill that aims to stabilize the agency's finances. The FHA Emergency Fiscal Solvency Act would allow the FHA to raise the ceiling for annual insurance premiums, terminate poor-performing lenders from originating FHA loans, and require lenders to repay FHA for losses if they are found to have violated the FHA's guidelines.

To help gain support for the bill and her own bid to head the agency, the FHA's acting commissioner, Carol Galante, said this week that the agency would adopt a series of new changes aimed at bolstering its finances, including eliminating one reverse mortgage product and raising down payment requirements on large loans.

Galante's proposal appeased one key lawmaker, Sen. Bob Corker, R-Tenn., who said it was a good first step toward broader reform. Corker also said he would support Galante's appointment as commissioner, which has been held up in the Senate since she was nominated nearly 18 months ago.

Complicating matters, however, is the glacial pace of the housing recovery. Even as some members of Congress, particularly Republicans, rail against the FHA for digging itself into a hole and call for an agency overhaul, they have been reluctant to give it the authority to raise fees or take other steps to shore up its finances out of fear that it could reduce home sales.

Ed Pinto, a resident fellow at the American Enterprise Institute and a former Fannie Mae executive, says the FHA and Congress are standing in the way of substantive reform because they do not want to eliminate what he calls "marginal homebuyers," those with low down payments and low credit scores that result in high levels of default.

"This is too little too late, and while it shows the FHA is trying to do something, it's not enough, it's not fundamental reform," Pinto says.

He said the recent changes by Galante will not have much impact. Requiring a maximum debt-to-income ratio of 43% for borrowers with credit scores below 620 would affect just 3% of FHA-insured loans, he says. Meanwhile, raising the down-payment requirement to 5% from 3.5% for borrowers with loans above $625,500 would apply to less than 5% of FHA-insured loans.

"The changes being made are totally on the margins, it's really nothing," Pinto argues. "They need to stop making bad loans in the first place not deal with it after the fact."

Pinto has argued that FHA's business model is flawed because 70% of FHA-insured loans are given to borrowers with credit scores between 620 and 660 or those who have a debt-to-income ratio of 50% or higher. Since the FHA only requires a minimum 3.5% down payment, the layering of risks means most borrowers have very little "skin in the game," and are at a higher risk of defaulting.

Sarah Rosen Wartell, president at the Urban Institute and a former deputy assistant for economic policy in the Clinton administration, says it would be "irresponsible" of Congress to not pass the FHA reform bill, which has 17 provisions. A House version earlier this year received overwhelming support.

"Many of the measures in the Johnson bill are tools to help the FHA control the risk in its portfolio and achieve stability," Wartell says. "I would argue that over the next few months we can have a more extensive discussion about reforms to FHA to help it better protect the taxpayer against losses. But measures that would shut FHA off … would have the effect of exposing all of us to much more dramatic swings in the economy."

Isaac Boltansky, a policy analyst at Compass Point Research and Trading, has been handicapping the reform effort and expects the legislation will pass. "There is a very good chance that FHA will be able to stave off a bailout with incremental legislative measures," he says.

But, he adds, "there also is little doubt that there will be more legislative scrutiny of FHA in 2013."

Indeed, some Republicans in Congress are loath to use quick-fix solutions and are likely to press for broader reforms that would curtail the FHA's reach. The agency is widely credited with rescuing the housing market by insuring loans that otherwise would never have been made, but critics say it has been too lax in its underwriting and would like to see it slash key programs — including reverse mortgages — and significantly tighten its credit standards to eliminate certain low-income borrowers.

They are particularly frustrated because the Department of Housing and Urban Development, which oversees the FHA, painted a far rosier picture of its financial health this summer. At that time HUD had expected the FHA to end fiscal 2012 with $3 billion in reserves, down from nearly $5 billion last year, but still in positive territory.

HUD and FHA officials have tried to defend the agency after an independent audit in November found the FHA's capital reserve ratio fell into negative territory of negative-1.44% at Sept. 30, with a $16.3 billion shortfall. Though the FHA has $30.4 billion in its Mutual Mortgage Insurance Fund to cover projected losses, it is required to maintain at least a 2% capital buffer.

HUD says the actuarial report did not take into account improving economic conditions including the cash flow from newly originated loans — estimated to account for $11 billion in economic value — that will put the FHA on firmer financial ground.

Housing advocates have long argued that the FHA played a critical role during the financial crisis by providing credit when private capital fled. The FHA and the Department of Veterans Affairs currently insure 21% of all mortgages, up from just 2.8% in 2006, according to the Federal Reserve. In 2011 the FHA insured 27% of all home purchases.

But the FHA has more than 735,000 delinquent loans. Loans originated from 2007 to 2009 account for an estimated $70 billion in future claim payments, according to the actuarial report. Its delinquency rate of 11.2% is much higher than the industry average of 7.4% at Sept. 30, according to the Mortgage Bankers Association.

Perhaps the FHA's biggest problem is that it needs additional congressional authority to hold mortgage lenders accountable for soured loans that were originated outside its guidelines and Congress, to date, has been reluctant to do so. Realtors, lenders and home builders are largely opposed to any changes that could potentially reduce availability of credit.

While Fannie Mae and Freddie Mac can force lenders to repurchase soured loans for almost any reason, the FHA has authority over just 30% of approved lenders. For two years, Donovan has asked Congress to require that all FHA-approved lenders compensate the agency for losses if they do not comply with its guidelines

In addition, while Fannie and Freddie require mortgage lenders to retain all fraud-related risk, the FHA only holds lenders accountable for fraud if they "knew or should have known" that it occurred. It has asked Congress to eliminate that standard as well. Both proposals are in the current reform bill.

When the actuarial report was issued last month, Galante outlined a series of steps the agency could take on its own to bolster reserves including ramping up bulk sales of distressed loan to 40,000 next year and revising its loss mitigation program to help borrowers avoid costly foreclosures.

Clement Ziroli Jr., president of First Mortgage Corp., an FHA lender in Ontario, Calif., described the conundrum that the FHA is in when a borrower stops paying a mortgage and fraud is suspected. First Mortgage originated a loan in Phoenix and the borrower had supplied a 35% down payment — unusual for an FHA loan. The house went into foreclosure after about a year. An investor bought the home for $360,000 then resold it after four months for $550,000, Ziroli says.

"In this case, FHA lost a couple of hundred thousand dollars because their process is very inefficient," Ziroli says. "FHA is not in the REO asset management business, they're in the insurance business. If First Mortgage was responsible for the loan on behalf of FHA, we would be on the hook for it." He says FHA lenders should be responsible for marketing and selling distressed properties, which would help the agency reduce fraud.

Among the 17 different provisions in the Johnson FHA reform bill is a requirement that the FHA create a program to review loans that are 90 days delinquent in the first year in which the borrower took out a mortgage.

But several other changes HUD Secretary Shaun Donovan has asked for are not included in the Johnson bill and could be fodder for future reform efforts, Boltansky says. To avoid losses on poor-performing loans, Donovan wants the FHA to have the authority to transfer servicing from a poor-performing mortgage servicer to a specialty servicer, or to require that a servicer hire a third party to assist in loss mitigation if they're doing a lousy job.

Donovan also needs legislative authority from Congress to manage the reverse mortgage program better. It had a negative economic value of $2.8 billion and a negative-3.58% capital reserve ratio as of Sept. 30, the actuarial report found.

A reverse mortgage allows homeowners 62 and older to tap the equity in their home without the necessity of selling it. But the vast majority of borrowers are taking out 80% or more of the maximum amount possible in one lump sum. As a result, nearly 1 in 10 reverse mortgages are now in default because seniors fail to set aside enough cash for taxes and insurance, a huge embarrassment for the FHA.

The Consumer Financial Protection Bureau is scrutinizing the program. In a June report, the CFPB said reverse mortgages are rife with deceptive marketing tactics and that seniors lack an understanding of the program.

At a Senate hearing Dec. 7, Corker, told Donovan the FHA was "losing its shirt" on reverse mortgages and called for the program to be shut down for two years. Galante has proposed shutting down one reverse mortgage product while keeping three others in place.

The FHA might not be in its current precarious financial hole if it hadn't been for a policy change made more than a decade ago when the agency was flush. In 2000, when the FHA had a positive economic value of $16 billion, its then-commissioner William C. Apgar Jr. decided the agency would cancel annual mortgage insurance premiums when the loan-to-value ratio on a home fell below 78%. The only problem was that the FHA was still responsible for insuring 100% of the unpaid principal balance of the loan for the entire life of the loan, even though it stopped collecting premiums.

The policy was put in place at a time when it was assumed home prices would not fall. But when home prices fell 35% nationally during the downturn, suddenly the FHA was on the hook for the credit risk of billions of underwater mortgages for which it was no longer collecting premiums.

An analysis by the FHA's Office of Risk Management found the FHA will lose $10 billion to $12 billion because there was no insurance to cover losses. HUD Secretary Donovan has repealed the policy but the change will only apply to newly originated loans.

The next mile marker for the FHA comes in February when President Obama unveils his proposed budget. The budget will include a new estimate of the agency's financial condition and expected actions needed to be taken to boost its reserves. Still the decision on whether the FHA will need to tap the Treasury for additional funding will not be made until Sept. 30, 2013. If Congress passes the FHA reform bill this year, and other policy changes are adopted, the agency likely won't need a bailout, experts say.