Nearly one out of every four loans guaranteed by the Federal Housing Administration would go belly up over the next five years if the country was hammered by a severe recession, according to a new measure of loan safety.
The National Mortgage Risk Index finds that overall, 10.9% of mortgages in October that were backed by the FHA or purchased by either Fannie Mae or Freddie Mac would go into default over the next five years if an economic crisis similar to the 2008 debacle would strike the country.
But a whopping 23.2% of all FHA loans would falter, as opposed to just 5.6% of loans bought by the two government-sponsored enterprises combined, according to the new index.
The index was developed by noted GSE critic Edward Pinto, a resident fellow at the American Enterprise Institute, along with Stephen Oliner, also a resident scholar at the conservative think tank. It was developed under the aegis of AEI's new International Center on Housing Risk.
Pinto, who has been a thorn in the side of Fannie, Freddie and the FHA for years, called the index "a transparent and objective measure" of mortgage risk, home-price risk and the capital adequacy needed to evaluate and manage housing risk.
"The numbers aren't conservative or liberal," Pinto says. "How people use the numbers can be done through the lens of political orientation, but not the numbers themselves."
During a media briefing, Pinto and Oliner, who is co-director of the new center, said the index will help investors, lenders, policymakers and even consumers better evaluate how mortgages will perform under severely stressed conditions. The financial crisis of 2007 stemmed largely from a failure to understand the build-up of housing risk, and better information could help dampen the boom-bust cycles of real estate, potentially eliminating severe home-price declines.
The authors say mortgages should be evaluated in the way cars are tested for their crashworthiness. They should be put through a stress test to see if they can sustain a substantial drop in prices without defaulting.
The new index uses 1990-vintage loans as a benchmark "a time when a preponderance of loans were considered safe" as well as loans originated at the height of the mortgage market in 2006 and 2007 when lending standards were more lax.
The index found that fewer than half of all loans originated between August 2013 and October 2013 can be considered low risk, while 22% are considered to be medium risk. More than 30% would be considered high risk, and would have a preponderance of defaults in the event of a recession.
Low-risk loans have a default rate of 6% or less, while those that are high risk have a default rate of 12% or more.
"It's really not fair to say that the current vintage of loans is pristine," Pinto says. "They are of better quality than the worst loans we've seen, but they're not pristine."
More troubling is that FHA's share of lower-risk mortgages is less than 1%. Meanwhile, Fannie's share of higher-risk loans has grown dramatically over the past year from 5.5% to 9.2% a development Pinto attributes to a loosening of combined loan-to-value and debt-to-income ratios. As Fannie's market share has increased, so has its percentage of risky loans.
"Fannie Mae is adopting a higher-risk profile and taking business away from Freddie," Pinto says. "It is willing to accept riskier loans."
Fannie, Freddie and the FHA declined to comment. Overall, the mortgage industry's delinquency rates are their lowest levels since 2008.
While the government has attempted to curb perceived risk factors, common-sense credit standards have yet to be adopted, the authors say. Without such measures, they argued that housing markets will remain vulnerable to what caused the last collapse the gradual abandonment of sound underwriting standards
This is occurring at the same time that new regulations defining ultra-safe loans known as "qualified mortgages" are set to take effect Jan. 10.
Pinto is quick to point out that the FHA is exempt entirely from the requirement that QM loans have a maximum 43% debt-to-income requirement. Fannie and Freddie were given an exemption from the DTI requirement for eight years. Currently 44% of loans backed by the FHA and 23% purchased by Fannie and Freddie combined have DTI ratios above 43%. That DTI ratio is higher now than it ever was in the past, another indication that underwriting standards have, in fact, loosened since the crisis.
The center plans to introduce new indices covering collateral risk and capital adequacy in the first half of 2014. The index currently is limited to home purchase loans but will add traditional rate-and-term refinances and cash-out refinances next year as well.
Morris Davis, academic director of the Graaskamp Center for Real Estate at the University of Wisconsin and a visiting AEI scholar, and economist Michael Molesky, a leading expert on mortgage default risk and insurance regulation, are also working on the project with Pinto and Oliner.