As the Federal Housing Administration is being asked to shoulder more responsibility for stabilizing the U.S. housing industry, questions are being asked about its capacity to perform such a critical role. At the core of these questions is a concern about the agency's financial soundness.
Two recent reports, the Mortgage Bankers Association's National Delinquency Survey for the third quarter of 2008 and the FHA's actuarial review for fiscal 2008, provide valuable insight into the state of the FHA program.
The MBA survey shows that FHA loan performance is holding up reasonably well, in contrast to the steady deterioration of prime and subprime loans. The agency's delinquency rate is unchanged from the third quarter of 2007, while the delinquency rates have risen 122 basis points for prime loans and 372 basis points for subprime loans. The current percentage of FHA loans in the foreclosure process (2.32%) is below its median quarterly percentage for the last six years (2.34%), while the percentage of prime and subprime loans in foreclosure set a record in the third quarter of calendar-year 2008. The agency is clearly benefiting from the fact that it did not permit "stated income" or investor loans.
Since it could be argued that the FHA's spike in volume is masking its delinquency and foreclosure problems, the independent actuarial review is a better indicator of its long-term solvency. This review provides an up-to-date assessment of whether the FHA has adequate reserves to cover future losses from loans in its portfolio.
The actuarial review concludes that "despite the current severe housing market downturn, the capital ratio is and will remain above 2% (its congressionally mandated level) in future years." The FHA's capital ratio did fall to 3% (from 6.4%) in fiscal 2008 and its economic value (capital) declined from $21.2 billion to $12.9 billion. But, said another way, after paying all expected claims and expenses, the FHA would have $12.9 billion to cover unanticipated losses.
Another important actuarial finding is the improved quality (loan characteristics) of the fiscal 2008 book. That component of the economic value was actually increased by $659 million. This finding mitigates the concern that the FHA became the "dumping ground" for subprime loans when that market collapsed in 2007.
However, high-risk loans were insured by the FHA in the latter half of 2007. The experiences of three top 10 lenders document this problem. One top 10 lender's average FHA FICO score dropped from 634 to 614 in the third quarter of 2007 compared with 2006. Another's average FICO score fell to 586 in November 2007. At a third, 22% of borrowers in November 2007 applications had FICO scores below 560. In response to this deterioration, mortgage lenders on their own, particularly the large purchasers of FHA loans, significantly tightened underwriting guidelines.
Their actions have contributed to a dramatic improvement in FHA FICO scores. FHA data shows that the average FICO score was 648 for loans insured in February 2008 and increased to 683 by September. One top 10 lender's percentage of FHA loans with FICO scores below 580 fell from 31% in the first quarter of fiscal 2008 to 7% in the fourth quarter.
Why would lenders take such actions when they have 100% FHA insurance? Unlike alternative-A and subprime products, in which the risk was mispriced and the value of the loan was in its "origination" and sale in the secondary market, the ultimate economic value of an FHA loan is in the monthly servicing fee (an annuity-like payment) on a performing loan. In short, long-term performance matters in the FHA program.
This fact, coupled with the consolidation of servicing and the growth of third-party originations, provides a built-in economic "check and balance" in the FHA program that mitigates risk for the insurance fund and the American taxpayer. In 2009 these large servicers, in effect, will "invest" an estimated $4 billion to purchase FHA servicing (e.g. servicing release premiums). To ensure the profitability of this investment, they are imposing their own underwriting and lender eligibility requirements when they believe the FHA's criteria are too lenient.
As recent press reports have noted, there is no guarantee that all lenders will act responsibly in the FHA program. Also, the FHA's public database is showing troubling increases in early-default rates, particularly on refinance transactions. For these reasons, the new FHA leadership should heed the actions of the lending community and undertake a thorough and ongoing review of the agency's credit policies and risk management operations and make appropriate changes. By refining its automated underwriting system, tightening guidelines on high-risk products and targeting lenders with poor performance earlier in the process, the FHA can make an excellent start in addressing the concerns about its program operations.
The FHA will not be immune from the impact of further house price depreciation and job losses. As the fiscal 2008 actuarial review concludes, the risk in the FHA program "is driven mainly by the significant deterioration of the national housing market."
To fulfill its public purpose, the FHA cannot avoid this economic risk. The challenge for the new administration is balancing this risk with prudent credit management. The FHA must have in place the underwriting and risk management policies to manage and mitigate this risk to the extent possible.