The Mission of the Federal Housing Administration

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Thank you Chairman Mack for the opportunity to testify on themission of the Federal Housing Administration.

Let me state my conclusion at the start: FHA should beprivatized, and if not privatized entirely, vastly scaled back.There are three major reasons why Congress should end taxpayersubsidies to FHA:

1) Today FHA almost entirely duplicates private industry. TheFHA's primary mission today is to compete with a vigorous andhealthy private mortgage insurance market. As a general principleof good government, it should not be the role of federal agenciesto compete with private industry. FHA was created in the 1930s tofill a market void. That void no longer exists. Nearly half of themortgage insurance market today is served by the PMIs--a percentagethat is rising. At least 60 percent of FHA's business would behandled by PMIs except for taxpayer subsidies and liberalizedlending practices at FHA.

2) FHA has strayed far from its original mandate of servinglow-income, first-time home buyers. Increasingly, FHA does notserve low income minority homebuyers. The FHA has aggressivelymoved into more upscale housing markets. Today, with its $153,000mortgage cap--up from $67,500 in 1980--FHA is serving wealthierfamilies. These markets are already well-served by the PMIs. Only18 percent of FHA loan applicants in 1993 were for homes in low ormoderate income census tracts. Moreover, in recent years roughly 30percent of FHA's business has been mortgage refinancings. In otherwords, almost one-third of its insurance does not even cover a newhome purchase.

3) To compete with private insurers, FHA has been forced to takeon riskier loans. On a level playing field, FHA is increasinglyincapable of outperforming the efficient PMIs and their wide-rangeof innovative underwriting services. To retain its market share FHAmust resort to questionable underwriting practices that put thetaxpayer and homebuyer at great risk. These include the 100 percentguarantee, the higher loan-to-income ratio, a capital reserve onits $348 billion contingent liability that is about one-third theprivate industry standard, and most importantly, downpaymentrequirements of as little as 2 and 3 percent.

In sum--and this is the key point--FHA can only compete in themodern mortgage insurance market by putting the taxpayer at evergreater risk of multi-billion dollar losses.

BACKGROUND

I first became involved in the FHA issue some ten years ago whenI worked at the Heritage Foundation. When I began investigating theunderwriting practices at FHA, I became aghast at FHA's failure totake prudent measures to protect taxpayers from the very rapidincreases in risk (its credit ceiling tripled from about $40billion to $130 billion from 1980 to 1986) that it was taking on.The study I published in 1986 issued this warning about theFHA:

FHA has become a ticking fiscal time bomb that may soon explodein the taxpayers' lap. The frightening aspect of this growth in FHAcredit is that this agency is failing to take prudent measures toprotect itself and the taxpayer against the huge contingentliability the agency carries. Should the economy slide into a deeprecession, the FHA could easily be facing multi-billion dollarlosses.

The response to this study "How Congress Can Defuse the FHA TimeBomb" was remarkably incendiary. The mortgage bankers and realtorsrelentlessly vilified me and the study. They said that it wasscare-mongering, irresponsible, and baseless hyperbole. They saidthat FHA was in stellar financial shape. In other words, their viewwas: Don't worry; be happy.

Then in 1987 the time bomb exploded. In 1988 the FHA lost arecord $1.4 billion. Foreclosures on FHA properties in many stateswith especially severe real estate slumps more than doubled.Fortunately, one result of all this was that some of FHA's mostirresponsible underwriting practices were ended with sensiblereform legislation in 1990.

But the whole incident revealed to me the extent to which thisagency has been completely captured by private industry interests.It was telling that not a single low-income advocacy group or anysocial service organization from minority communities uttered evena word of objection to the study. It was private housing industrygroups, allegedly representing the interests of low-incomehome-buyers and minorities, who howled in protest.

This suggests who the prime beneficiaries of the FHA reallyare.

DO WE STILL NEED AN FHA?

The subject of this hearing is: What should be FHA's mission? Toanswer this, let's go back to the FHA's original mission--something the agency has wandered far from. For some 50 years thestated mandate of the FHA has been to complement, rather thansupplant the private insurance market. This is how Congress statedthe point back in 1948 with the passage of the National HousingPolicy Act. "The policy to be followed in attaining the nationalhousing objective hereby established shall be: 1) privateenterprise shall be encouraged to serve as large a part of thetotal need as it can; 2) government assistance shall be utilizedwhere feasible to enable private enterprise to serve more of thetotal need."

If we still abided by that mandate then for all intents andpurposes, there would be no FHA today. Increasingly, privateinsurers are becoming capable of serving all of "the totalneed."

Today the private sector provides low downpayment mortgages toborrowers who once would have only been served by FHA. Almost halfof all mortgage insurance today is provided by the private sector.FHA now only serves 17 percent of the market and about half theinsured mortgage market.

FHA has attempted to recapture market share by relaxing itsunderwriting standards. One of the most disturbing trends at FHAfrom the taxpayers' perspective is the decline in the standarddownpayment on FHA loans. When FHA was first started its standardpolicy was to insure 20 year mortgages with 20 percentdownpayments. Over the years FHA has continually liberalized thesestandards--especially in recent years. Even as recently as the mid1970s the FHA normally required 10 percent downpayment. But from1977 to 1985 FHA lowered its minimum downpayment requirement threetimes. And it's getting worse every year. According to theDepartment of Housing and Urban Development's own data, the loan tovalue 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 fivepercent. Why should this be a concern? The answer is that the sizeof the downpayment is the single most important predictor of loandefault. It is much more important than the income of the homepurchaser, for example. According to David Maxwell, former chairmanof the Federal National Mortgage Association, "The conclusion isinescapable that the most central element in weighing the soundnessof 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 homesover $50,000 and 98.75 percent for homes under $50,000. But theseratios are still well above the private industry average of 5percent downpayment. Worse yet, because the homebuyer is permittedto finance the up-front-mortgage insurance premium, on many FHAinsured-homes, the loan to value ratio approaches 100 percent. Thiscreates a perverse incentive system whereby in many cases it ismore attractive for a financially-troubled family to walk away fromthe home, rather than to sell it.

Why do we tolerate such unsound underwriting practices ingovernment? The answer seems to be that the housing industry hascome to dominate the FHA agenda. The FHA is a case study of afederal program where the taxpayers' interest has been subjugatedto the special interest. By resorting to liberalized loan insurancepractices, the FHA hopes to outcompete the private sector.

DOES THE FHA PROMOTE HOMEOWNERSHIP?

The standard argument for preserving the FHA is that it serveslow and moderate income home-buyers who would not otherwise be ableto afford a home. This may have been true ten years ago. Today, theargument is increasingly suspect. Here are several reasons why:

1) FHA increasingly does not serve low income home-owners. In1993 only 18 percent of FHA insurance applicants were purchasinghomes from low income census tracts. About 16 percent of PMI loanswere from these areas. Federal Reserve Bank economist Glenn Cannerrecently compared the PMIs with FHA with respect to serving lowincome areas. He concluded: "The [private] insurance programs seemto have a similar distribution of applicants across neighborhoodsgrouped by income, but the FHA and VA generally serve a lower-income clientele."

Also of note: the PMIs were more likely to approve insurance forhomes in low income neighborhoods than FHA. PMIs approved 79percent 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 mortgagesin South Central Los Angeles were conventional mortgages, not FHA.Isn't South Central precisely the kind of neighborhood that FHA isexpected to serve? FHA does not; the private sector does.

2) Low income markets will be well served without FHA. In 1993the majority of applicants for private mortgage insurance hadincomes that were below the median family income for themetropolitan area. In fact the fastest growth area for privateinsurers is the affordable housing markets. According to a recentarticle in Mortgage Banking: "The private mortgage insuranceindustry--comprised of mortgage lenders and mortgage insurancecompanies working with Fannie Mae and Freddie Mac--have beenfocusing on the affordable housing market with increasing intensitysince 1989, yielding numerous initiatives....Fannie Mae, forexample, which set a goal of $10 billion of affordable loansdelivered by 1994, has reached its goal." Here's just one example:in 1994 GEMICO insured $1.7 billion under the Community HomeBuyer's program--which is targeted for low income homepurchasers.

The PMIs are also experimenting with 5 and even 3 percentdownpayment loans to expand in low income markets. (The 3 percentdownpayment loans do not allow the financing of the premium,however, as FHA does.) Not surprisingly, even FHA's strongestallies acknowledge that at least 60 percent of FHA loans would behandled by the PMIs if the FHA were closed down.

3) FHA's underwriting practices actually harm low-income housingmarkets. Congress should recognize that there is something muchworse than turning a family down for a mortgage, and that isapproving a mortgage that a family cannot afford to pay. There isnothing more disruptive to the life of a family than having to losea home by foreclosing on the mortgage. FHA does no service bypushing families into homes they cannot afford to pay for. But FHAdoes this routinely through its unjustifiably low downpaymentpolicy and its 100 percent coverage.

The latest FHA budget reveals that total foreclosures soared to100,000 in 1994. Over the past ten years more than 700,000 familiessuffered the trauma of losing their FHA-insured homes. Theseforeclosures cost taxpayers about $5 billion per year. In thesecases, the families lost; the taxpayers lost; the neighborhoodslost; only the mortgage bankers won. And they aren't generally oflow income.

One impact of FHA foreclosures is to destroy low incomeneighborhoods--the very areas that FHA is said to be revitalizing.Gail Cincotta, the head of the National Training and InformationCenter in Chicago, and a long time slum-fighter, says: "The Number1 problem in revitalizing neighborhoods is FHA." She notes that inmany low-income neighborhoods, FHA's default rate is 28 percent. Bycontrast, private insurers will work with the financiallydistressed homeowner to refinance the mortgage and make otheraccommodations to keep the family in the home.

PRIVATIZE FHA

The Mortgage Bankers Association recently published a studysuggesting 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 isthat a great number of these 150,000 loans should never have beenoriginated in the first place. They are unsound loans that have ahigh risk of default. Tightening FHAs underwriting guidelines tomeet private sector standards, or closing down the FHA entirely,will not mean that these families cannot buy a home. It means thatthey will have to either buy a slightly less expensive home, ratherthan one they can't afford, or that they will have to delay a homepurchase until they have more equity.

The purpose of government is not to compete with privateindustry. This is precisely what FHA does today. It serves the samemarket as private insurers and stays in business only because ofits unsound underwriting practices and its direct line of credit tothe federal treasury. This direct line of credit creates theillusion that FHA is "profitable." It is only profitable to theextent that it requires taxpayers to should its $380 billioncontingent liability--one that could once again detonate in thetaxpayers' lap.

If FHA cannot be immediately privatized, then Congress shouldrequire that it follow the same underwriting standards of privateindustry. FHA should:

1) Raise the minimum downpayment to 5 percent on all itsinsured-homes.

2) End the 100 percent insurance coverage on FHA loans. Thisonly encourages mortgage bankers to initiate questionable loans,because all the risk is borne by the taxpayer. FHA should onlycover 30 percent of the losses on a foreclosed property.

3) Prohibit borrowers from financing in the mortgage theinsurance 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 theprivate sector. The cross-subsidy argument is spurious. It could beused to justify the FHA insuring $1 million homes. The FHA shouldbe required to make sound loans for low-income homeowners byraising the downpayment threshold. Then, no cross-subsidy would benecessary.

6) Require the FHA to move toward a 4 percent reserve fund onits liability--the private sector industry standard--to protectagainst taxpayer losses.

7) Immediately close down the FHA multi-family program, whichhas experienced huge losses, and replace it with a low-incomehousing voucher program. We should use our affordable housingdollars to empower low-income residents, not mortgage bankers anddevelopers.

Stephen Moore

Subcommittee on Housing Opportunities and Community Development
Committee on Banking, Housing and Urban Affairs
United States Senate