Thanksgiving is usually a time reserved for positive reflection on what has transpired over the last year. In the case of the Federal Housing Administration, the latest actuary report has little to cheer and more to be apprehensive about in the next few years.
The estimates indicate that the economic value of the Mutual Mortgage Insurance Fund dropped below zero to negative $13.5 billion, calling into question whether the FHA would need to take a draw from the U.S. Treasury to infuse the fund. While this day of reckoning had been anticipated for some time, the processes that led us to this point – FHA's role in housing and the actuary assessment of the MMI fund – have important implications for public policy.
One question that emerges is whether FHA can effectively manage through this difficult time. Another is whether the actuary model used to assess the MMI fund is fraught with model risk that calls into question the reliability of the estimates.
The withdrawal of private capital from the mortgage market during the financial crisis was offset by government action to leverage the FHA, along with the government-sponsored enterprises Fannie Mae and Freddie Mac, to provide a countercyclical role in supporting housing finance to avoid an entire collapse of mortgage markets. At the height of the boom, FHA accounted for less than 4% of the mortgage market. Today it accounts for nearly 16%.
Maintaining stability in the market was essential. However, the actuary results underscore real concerns about the FHA that should serve as a wake-up call to policymakers.
While some efforts to upgrade the agency's ability to manage risk on a $1 trillion-plus portfolio have been made over the last few years, the FHA remains woefully under-resourced to handle the ongoing complexity of managing its actual and potential exposures. The Government Accountability Office recognized these deficiencies in a report it published in 2011.
Beyond infrastructure issues, FHA's mission to promote housing has contributed to its downfall in addressing its other mission, to maintain fiscal discipline of the MMI Fund.
For example, part of what dragged the MMI Fund into negative territory was the nonprofit seller-funded Down Payment Assistance loans that have exhibited a high incidence of fraud and losses. Although FHA has abolished these programs, the damage was done and illustrates the kind of policies to promote homeownership that politicians admired at the time and seem to have faded from memory as contributing factors to the crisis.
The actuary report also reveals that FHA relies on a statistically-based automated underwriting scorecard, known as TOTAL, for approving all of its loans. Before and during the crisis, these models were oftentimes overused and, as has been proven, did not hold up well in accurately assessing risk when economic times changed. Old-fashioned underwriting can never be replaced by statistical models and yet we find the agency relying on them more than the GSEs or private lenders do.
This issue of model risk is nowhere better in evidence than with the very model used in developing the MMI Fund estimates. The report notes that the analytical methodology used to estimate economic value changed considerably. Contained in the 235-page report are hundreds of complex mathematical expressions used in the process of simulating each mortgage loan over 100 different possible combinations of home prices and interest rates throughout its life. These valuation models are still in use today by the GSEs in pricing guarantee fees, and by large banks and investors. But as we have seen, the models all missed the mark by a mile in estimating mortgage credit risk in the years leading up to the crisis.
Such models are highly dependent on reliable and accurate loan level data, something that is not a core competency of the Department of Housing and Urban Development generally and FHA specifically. Even so, the valuation exercise is susceptible to considerable sensitivity to any number of factors affecting mortgage losses. Any one of these could materially change the estimates and the report was silent on the level of validation conducted on this new methodology.
In the end, the switch to the new methodology to assess the MMI Fund is probably on the right path, but seems premature given the complexity and differences between it and preceding versions of the model. In-depth and independent validation of the results is required before concluding these estimates of economic value are stable and more accurate than the previous models.
Even so, we know that directionally, the MMI Fund is troubled, suffering from legacy housing policies meant to spur homeownership at the expense of taxpayers and from a host of crippling resource deficiencies that limit the agency's ability to monitor and manage its risk exposures.
We can give thanks for the small cadre of risk resources in place at FHA today, but the agency's cornucopia of policy and infrastructure challenges remains an impediment to sustainable risk management.
Clifford V. Rossi is the Executive-in-Residence and Tyser Teaching Fellow at the Robert H. Smith School of Business at the University of Maryland.