FHA's Fiscal Woes Mount

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The Federal Housing Administration is facing its own fiscal cliff amid dwindling capital reserves, raising the possibility that the agency may have to tap Treasury for funding for the first time in its 78-year history.

This week, FHA will release its annual independent actuarial report that is expected to show that its capital reserve ratio – which measures reserves held in excess to cover projected losses – will fall into negative territory for the first time, according to people briefed on the report's findings. By law, the FHA must maintain a 2% buffer.

The report is expected to trigger a contentious battle in Washington on how to shore up the agency's finances, which have been depleted by high levels of defaults on FHA-insured loans. Already some lawmakers are calling for higher down payments and mandatory premium increases on FHA loans, though such proposals are likely to anger housing advocates because they would shut out large swaths of low- and moderate-income borrowers. http://www.americanbanker.com/issues/177_40/fha-finances-obama-hud-shaun-donovan-1047041-1.html

FHA also could announce changes of its own on top of insurance premium increases it made in April.

Meanwhile, bankers and mortgage lenders could be facing more buyback requests from the FHA as the agency scrambles for new sources of revenue. The FHA was able to avert a financial crisis earlier this year only by negotiating a $1 billion settlement with Bank of America (BAC) to compensate the agency for past losses as part of the national mortgage settlement. http://www.americanbanker.com/issues/177_154/fha-spin-on-its-numbers-hides-mounting-risks-1051700-1.html

"As reserves go down, enforcement increases," says Phillip Schulman, a partner at K&L Gates.
FHA would not comment before the actuarial report is issued, but it painted a far rosier picture of its financial health this summer when officials with the Department of Housing and Urban Development, which oversees FHA, were pushing for Carol Galante to be confirmed to head the agency. HUD expected to end fiscal 2012 with $3 billion in reserves, down from nearly $5 billion last year, but still in positive territory. Either way, its capital reserve ratio is expected to below the congressionally mandated 2% level for the fourth consecutive year. http://www.americanbanker.com/issues/177_36/fha-carol-galante-bank-of-america-mortgage-insurance-bailout-1046874-1.html

FHA's charter allows it to tap the Treasury for funds to bolster its reserves, but to date it has never done so, according to FHA.

Schulman says that FHA's fiscal woes should be making lenders nervous.

"There's no question that the stakes have been raised for FHA participants," he says. "They would be wise to put their compliance divisions on the same par with production offices given the potential liability."

It is unclear, however, whether HUD Secretary Shaun Donovan can extract enough settlements to avoid tapping the Treasury for funding.

The $25 billion national mortgage settlement that B of A, Citigroup (NYSE:C), JPMorgan Chase (JPM), Wells Fargo (WFC) and Ally Financial signed early this year with the Department of Justice and 49 states was supposed to release banks from liability related to their loss-mitigation efforts on delinquent FHA-insured loans.

Donovan has been trying to negotiate agreements with the nine other mortgage servicers that were not part of the national mortgage settlement including BB&T (BBT), Regions Financial (RF), SunTrust Banks (STI) and U.S. Bancorp (USB).

The sensitive negotiations with senior HUD and DOJ officials may be even tougher now that Wells Fargo is contesting a lawsuit filed by the Manhattan U.S. Attorney's office, accusing the San Francisco bank of poor underwriting practices in originating FHA loans over a decade.

Wells has argued that the national mortgage settlement waived all liability associated with any false certifications made on loans that are subject to annual reviews by HUD.

That complaint, filed in October, alleges Wells avoided paying $190 million in claims for defaults on 6,320 loans internally identified as containing material violations. The complaint seek treble damages and penalties under the False Claims Act and the Financial Institutions Reform, Recovery and Enforcement Act known as FIRREA.http://www.justice.gov/usao/nys/pressreleases/October12/WellsFargoLawsuitPR.html

Lawyers who represent banks say it is unclear whether the increase in enforcement actions will have a chilling effect on current lending practices.

"At some level, logic would say there would be a fatigue in the industry from having to self-insure a loan," says Clint Rockwell, a partner at BuckleySandler LLP. "If that [FHA] insurance goes away, as a practical matter, market forces would dictate that lenders would be making fewer of those loans."

Originating a mortgage loan these days is like "building a jumbo jet with zero tolerance for error," Rockwell adds. "So the question is, what is the industry's tolerance for that model and whether the FHA product, which is designed for underserved borrowers with a 3.5% down payment, is still viable."

Ed Pinto, a resident fellow at the American Enterprise Institute and former Fannie Mae executive, says a substantial portion of FHA's losses come from loans to borrowers who have "subprime attributes," either because of a Fico score of 660 or less, or a debt ratio of 50% or more.

"When FHA talks about their good book of business, within it is a core of subprime lending," says Pinto, a longtime FHA critic. "FHA should not put a borrower into a loan if underwriting shows a 10% or higher likelihood that the loan would go to foreclosure.

Raising premiums is an option, but Ivy Zelman, the CEO of Zelman Associates, a housing research firm, notes any increase in FHA premiums would further reduce FHA's market share, which declined to 32% in the third quarter from a peak of 49% in the fourth quarter of 2009.

The likely scenario would be an increase in down payment requirements for high-end borrowers, but Zelman says that would have a marginal impact given that only 5% of new home purchases nationwide are above $500,000, and a fraction of such borrowers would opt for FHA financing.

The question of whether FHA will turn to Treasury for additional assistance is not likely to be answered any time soon. The actuarial report being released this week is an independent audit to Congress and even if the FHA's capital reserve turns negative, funding for the agency is driven primarily by the president's budget with some requirements from the Office of Management and Budget.

The Congressional Budget Office also plays a role by independently determining FHA's finances. Either way, FHA will need to bolster the reserves in its accounts by April-May of next year.

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