The upbeat outlook in the Trump administration’s budget on the Federal Housing Administration’s fiscal position has reportedly renewed calls for a cut to FHA insurance premiums charged to homebuyers.
The reduction was originally pushed through by the Obama administration in its waning days, but the effort was suspended indefinitely by the Trump administration upon taking office. This was the right decision then, and it continues to be the right decision. Any premium reduction would have a pernicious effect on the purchasing power of first-time, low-income homebuyers and would endanger FHA’s mutual mortgage insurance fund.
The suspended reduction would have been on top of an even larger cut made in 2015, which had a number of unintended consequences. At the time, the agency claimed that the premium drop would result in 250,000 new first-time buyers over the next three years and save each FHA buyer $900 annually. In new research by the AEI Housing Center, we along with our colleagues found that home prices went up by about 2.5% for FHA borrowers — that is because a portion of the premium drop pushed home prices higher due to the supply-constrained seller's market. FHA's premium cut increased buying power but did nothing to increase supply.
In an odd, yet predictable twist, prices also went up for non-FHA buyers in neighborhoods with FHA-insured sales. After all, it is one housing market where borrowers, no matter the financing, compete for houses. This caused the non-FHA buyers, who did not receive the benefit of lower premiums, to largely offset the price increase by buying a home of lesser quality — perhaps a smaller home, a smaller lot or a home in a different location. They were the clear losers.
We estimate that about 500,000 of these non-FHA borrowers were first-time homebuyers. Each of these non-FHA homebuyers paid approximately $6,200 extra per house, a total extra payment of about $3.1 billion. From a cost-benefit perspective, this averages to an incredible $180,000 for each of the new FHA first-time buyers that the reduced premiums attracted.
The big winners were the realtors who received hundreds of millions of dollars in higher commissions from higher prices. The increase in commissions from the 2015 cut averaged about $325 per sale. If you multiply that by the over 1.22 million home sales in tracts with high FHA concentration in 2015, you get a windfall of almost $400 million per year — not a bad return on the tiny fraction spent on lobbying.
Economic principles, ironically first described by Ernest Fisher, the FHA’s first chief economist in the 1930s, gave us reasons to be doubtful of the FHA’s predictions: Liberalizing credit when the inventory of homes for sale is tight fails to bring in a lot of new buyers, and increased buying power in a sellers’ market drives prices higher as buyers compete over a limited supply of houses.
In 2015, the FHA ignored the fact that the nation was already two and a half years into a seller’s market — defined by the National Association of Realtors as a market with less than a six-month supply of homes for sale at the current selling pace.
We also found that even though FHA’s loan volume increased substantially in the first year after the 2015 premium cut, only about 17,000 were new first-time buyers, far short of FHA’s prediction. The rest were borrowers poached from other federal agencies or buyers who purchased homes unrelated to the premium drop.
With the national seller’s market now in its 65th month and levels of supply even lower than around the time of the last cut, a premium reduction would again hurt homebuyers, stoking even more demand. That is especially the case since it would be combined with continued credit easing from the federal guaranty agencies.
These misguided policies beget a vicious cycle until prices and debts reach an unsustainable level. By 2007-2008, these policies had caused a financial crisis and ultimately hurt homeowners who were unprepared for the decline in prices. Today, we are again seeing the same phenomenon. For the last five years, homes in the bottom-third price tier have more than doubled — a much faster price increase than those in the top-third tier. In the last year alone, low-tier prices were up 10.8%, while top-tier prices were up 4.8%.
It is this continuing boom in home prices, particularly for entry-level homes, that makes another premium cut a danger to the FHA’s insurance fund. The longer this upward trend continues, the greater the risk of a serious house price correction, a correction that would pose a substantial threat to FHA and taxpayers.
Rather than continued credit easing that further fuels the boom and benefits realtors, the FHA and the other federal guaranty agencies should be acting counter-cyclically by tightening credit.