Let me state my conclusion at the start: FHA should be privatized, and if not privatized entirely, vastly scaled back. There are three major reasons why Congress should end taxpayer subsidies to FHA:
1) Today FHA almost entirely duplicates private industry. The FHA’s primary mission today is to compete with a vigorous and healthy private mortgage insurance market. As a general principle of good government, it should not be the role of federal agencies to compete with private industry. FHA was created in the 1930s to fill a market void. That void no longer exists. Nearly half of the mortgage insurance market today is served by the PMIs–a percentage that is rising. At least 60 percent of FHA’s business would be handled by PMIs except for taxpayer subsidies and liberalized lending practices at FHA.
2) FHA has strayed far from its original mandate of serving low-income, first-time home buyers. Increasingly, FHA does not serve low income minority homebuyers. The FHA has aggressively moved into more upscale housing markets. Today, with its $153,000 mortgage cap–up from $67,500 in 1980–FHA is serving wealthier families. These markets are already well-served by the PMIs. Only 18 percent of FHA loan applicants in 1993 were for homes in low or moderate income census tracts. Moreover, in recent years roughly 30 percent of FHA’s business has been mortgage refinancings. In other words, almost one-third of its insurance does not even cover a new home purchase.
3) To compete with private insurers, FHA has been forced to take on riskier loans. On a level playing field, FHA is increasingly incapable of outperforming the efficient PMIs and their wide-range of innovative underwriting services. To retain its market share FHA must resort to questionable underwriting practices that put the taxpayer and homebuyer at great risk. These include the 100 percent guarantee, the higher loan-to-income ratio, a capital reserve on its $348 billion contingent liability that is about one-third the private industry standard, and most importantly, downpayment requirements of as little as 2 and 3 percent.
In sum–and this is the key point–FHA can only compete in the modern mortgage insurance market by putting the taxpayer at ever greater risk of multi-billion dollar losses.
BACKGROUND
I first became involved in the FHA issue some ten years ago when I worked at the Heritage Foundation. When I began investigating the underwriting practices at FHA, I became aghast at FHA’s failure to take prudent measures to protect taxpayers from the very rapid increases in risk (its credit ceiling tripled from about $40 billion to $130 billion from 1980 to 1986) that it was taking on. The study I published in 1986 issued this warning about the FHA:
FHA has become a ticking fiscal time bomb that may soon explode in the taxpayers’ lap. The frightening aspect of this growth in FHA credit is that this agency is failing to take prudent measures to protect itself and the taxpayer against the huge contingent liability the agency carries. Should the economy slide into a deep recession, the FHA could easily be facing multi-billion dollar losses.
The response to this study “How Congress Can Defuse the FHA Time Bomb” was remarkably incendiary. The mortgage bankers and realtors relentlessly vilified me and the study. They said that it was scare-mongering, irresponsible, and baseless hyperbole. They said that FHA was in stellar financial shape. In other words, their view was: Don’t worry; be happy.
Then in 1987 the time bomb exploded. In 1988 the FHA lost a record $1.4 billion. Foreclosures on FHA properties in many states with especially severe real estate slumps more than doubled. Fortunately, one result of all this was that some of FHA’s most irresponsible underwriting practices were ended with sensible reform legislation in 1990.
But the whole incident revealed to me the extent to which this agency has been completely captured by private industry interests. It was telling that not a single low-income advocacy group or any social service organization from minority communities uttered even a word of objection to the study. It was private housing industry groups, allegedly representing the interests of low-income home-buyers and minorities, who howled in protest.
This suggests who the prime beneficiaries of the FHA really are.
DO WE STILL NEED AN FHA?
The subject of this hearing is: What should be FHA’s mission? To answer this, let’s go back to the FHA’s original mission– something the agency has wandered far from. For some 50 years the stated mandate of the FHA has been to complement, rather than supplant the private insurance market. This is how Congress stated the point back in 1948 with the passage of the National Housing Policy Act. “The policy to be followed in attaining the national housing objective hereby established shall be: 1) private enterprise shall be encouraged to serve as large a part of the total need as it can; 2) government assistance shall be utilized where feasible to enable private enterprise to serve more of the total need.”
If we still abided by that mandate then for all intents and purposes, there would be no FHA today. Increasingly, private insurers are becoming capable of serving all of “the total need.”
Today the private sector provides low downpayment mortgages to borrowers who once would have only been served by FHA. Almost half of all mortgage insurance today is provided by the private sector. FHA now only serves 17 percent of the market and about half the insured mortgage market.
FHA has attempted to recapture market share by relaxing its underwriting standards. One of the most disturbing trends at FHA from the taxpayers’ perspective is the decline in the standard downpayment on FHA loans. When FHA was first started its standard policy was to insure 20 year mortgages with 20 percent downpayments. Over the years FHA has continually liberalized these standards–especially in recent years. Even as recently as the mid 1970s the FHA normally required 10 percent downpayment. But from 1977 to 1985 FHA lowered its minimum downpayment requirement three times. And it’s getting worse every year. According to the Department of Housing and Urban Development’s own data, the loan to value ratio of FHA loans continues to climb:
MEDIAN FHA LOAN TO VALUE RATIO
1988 92.8% 1989 93.1% 1990 93.5% 1991 94.7% 1992 95.0% 1993 95.3%
Today the median FHA loan has a downpayment of less than five percent. Why should this be a concern? The answer is that the size of the downpayment is the single most important predictor of loan default. It is much more important than the income of the home purchaser, for example. According to David Maxwell, former chairman of the Federal National Mortgage Association, “The conclusion is inescapable that the most central element in weighing the soundness of a mortgage loan is the amount of the homeowner’s equity.”
The 1990 emergency reforms somewhat lowered the maximum loan- to-value ratio for an FHA insured home to 97.75 percent for homes over $50,000 and 98.75 percent for homes under $50,000. But these ratios are still well above the private industry average of 5 percent downpayment. Worse yet, because the homebuyer is permitted to finance the up-front-mortgage insurance premium, on many FHA insured-homes, the loan to value ratio approaches 100 percent. This creates a perverse incentive system whereby in many cases it is more attractive for a financially-troubled family to walk away from the home, rather than to sell it.
Why do we tolerate such unsound underwriting practices in government? The answer seems to be that the housing industry has come to dominate the FHA agenda. The FHA is a case study of a federal program where the taxpayers’ interest has been subjugated to the special interest. By resorting to liberalized loan insurance practices, the FHA hopes to outcompete the private sector.
DOES THE FHA PROMOTE HOMEOWNERSHIP?
The standard argument for preserving the FHA is that it serves low and moderate income home-buyers who would not otherwise be able to afford a home. This may have been true ten years ago. Today, the argument is increasingly suspect. Here are several reasons why:
1) FHA increasingly does not serve low income home-owners. In 1993 only 18 percent of FHA insurance applicants were purchasing homes from low income census tracts. About 16 percent of PMI loans were from these areas. Federal Reserve Bank economist Glenn Canner recently compared the PMIs with FHA with respect to serving low income areas. He concluded: “The [private] insurance programs seem to have a similar distribution of applicants across neighborhoods grouped by income, but the FHA and VA generally serve a lower- income clientele.”
Also of note: the PMIs were more likely to approve insurance for homes in low income neighborhoods than FHA. PMIs approved 79 percent of such loans in 1993. FHA approved just 73 percent.
Some low-income areas seem to be virtually quarantined by FHA. For example, a recent study found that 94 percent of the mortgages in South Central Los Angeles were conventional mortgages, not FHA. Isn’t South Central precisely the kind of neighborhood that FHA is expected to serve? FHA does not; the private sector does.
2) Low income markets will be well served without FHA. In 1993 the majority of applicants for private mortgage insurance had incomes that were below the median family income for the metropolitan area. In fact the fastest growth area for private insurers is the affordable housing markets. According to a recent article in Mortgage Banking: “The private mortgage insurance industry–comprised of mortgage lenders and mortgage insurance companies working with Fannie Mae and Freddie Mac–have been focusing on the affordable housing market with increasing intensity since 1989, yielding numerous initiatives.…Fannie Mae, for example, which set a goal of $10 billion of affordable loans delivered by 1994, has reached its goal.” Here’s just one example: in 1994 GEMICO insured $1.7 billion under the Community Home Buyer’s program–which is targeted for low income home purchasers.
The PMIs are also experimenting with 5 and even 3 percent downpayment loans to expand in low income markets. (The 3 percent downpayment loans do not allow the financing of the premium, however, as FHA does.) Not surprisingly, even FHA’s strongest allies acknowledge that at least 60 percent of FHA loans would be handled by the PMIs if the FHA were closed down.
3) FHA’s underwriting practices actually harm low-income housing markets. Congress should recognize that there is something much worse than turning a family down for a mortgage, and that is approving a mortgage that a family cannot afford to pay. There is nothing more disruptive to the life of a family than having to lose a home by foreclosing on the mortgage. FHA does no service by pushing families into homes they cannot afford to pay for. But FHA does this routinely through its unjustifiably low downpayment policy and its 100 percent coverage.
The latest FHA budget reveals that total foreclosures soared to 100,000 in 1994. Over the past ten years more than 700,000 families suffered the trauma of losing their FHA-insured homes. These foreclosures cost taxpayers about $5 billion per year. In these cases, the families lost; the taxpayers lost; the neighborhoods lost; only the mortgage bankers won. And they aren’t generally of low income.
One impact of FHA foreclosures is to destroy low income neighborhoods–the very areas that FHA is said to be revitalizing. Gail Cincotta, the head of the National Training and Information Center in Chicago, and a long time slum-fighter, says: “The Number 1 problem in revitalizing neighborhoods is FHA.” She notes that in many low-income neighborhoods, FHA’s default rate is 28 percent. By contrast, private insurers will work with the financially distressed homeowner to refinance the mortgage and make other accommodations to keep the family in the home.
PRIVATIZE FHA
The Mortgage Bankers Association recently published a study suggesting that as many as 150,000 home buyers would be “shut out” of the housing market if FHA were cutback. What MBA did not say is that a great number of these 150,000 loans should never have been originated in the first place. They are unsound loans that have a high risk of default. Tightening FHAs underwriting guidelines to meet private sector standards, or closing down the FHA entirely, will not mean that these families cannot buy a home. It means that they will have to either buy a slightly less expensive home, rather than one they can’t afford, or that they will have to delay a home purchase until they have more equity.
The purpose of government is not to compete with private industry. This is precisely what FHA does today. It serves the same market as private insurers and stays in business only because of its unsound underwriting practices and its direct line of credit to the federal treasury. This direct line of credit creates the illusion that FHA is “profitable.” It is only profitable to the extent that it requires taxpayers to should its $380 billion contingent liability–one that could once again detonate in the taxpayers’ lap.
If FHA cannot be immediately privatized, then Congress should require that it follow the same underwriting standards of private industry. FHA should:
1) Raise the minimum downpayment to 5 percent on all its insured-homes.
2) End the 100 percent insurance coverage on FHA loans. This only encourages mortgage bankers to initiate questionable loans, because all the risk is borne by the taxpayer. FHA should only cover 30 percent of the losses on a foreclosed property.
3) Prohibit borrowers from financing in the mortgage the insurance premium.
4) End FHA refinancing.
5) Lower the ceiling on FHA loans to homes of less than $100,000. The market above $100,000 is already well-served by the private sector. The cross-subsidy argument is spurious. It could be used to justify the FHA insuring $1 million homes. The FHA should be required to make sound loans for low-income homeowners by raising the downpayment threshold. Then, no cross-subsidy would be necessary.
6) Require the FHA to move toward a 4 percent reserve fund on its liability–the private sector industry standard–to protect against taxpayer losses.
7) Immediately close down the FHA multi-family program, which has experienced huge losses, and replace it with a low-income housing voucher program. We should use our affordable housing dollars to empower low-income residents, not mortgage bankers and developers.
