Impending FHA bailout justified by saving banks

The FHA has been the lender of last resort during the collapse of the housing bubble. Conventional lending dried up once they realized how lax lending standards became, and how likely it was that borrowers would strategically default and cause more losses. Without the FHA, a Las Vegas style crash of 70% or more would have been common to markets across the country. The banks would have been obliterated.

The FHA insured many of the loans issued as prices declined. Since the FHA down payment is only 3.5%, and since it takes a 6% commission plus closing costs to exit a property, nearly every FHA loan issued over the last 10 years is effectively underwater. The losses are going to be enormous.

The use of the FHA as the lender of last resort will be justified as a necessary act to save the banks. That’s bullshit. The FHA probably did save many of our too-big-to-fail banks, but this was not necessary. We could have let them fail, nationalized them, and recapitalized them with government money later to be sold at a profit. The government basically did this with Citi buying a huge amount of stock at $3 and selling it at $4 after it stabilized. The government took over the GSEs and assumed their liabilities. They currently own most of their worthless stock, but at some point, they may spin these off and recoup some of the losses on stock sales. The FHA has no such resale option.

When the final tally of losses at the FHA come in, everyone will act surprised. Nobody paying careful attention to what the FHA is doing will be shocked. They are absorbing the losses the banks could not by insuring loans with low down payments in a declining market. No private lender or mortgage insurer would do this because the losses would put them out of business. Instead these losses will be absorbed by the US taxpayer — by you.

Bailout concerns mounting for federal housing agency

By Les Christie @CNNMoney January 3, 2012: 4:48 PM ET

NEW YORK (CNNMoney) — Concerns are growing that the Federal Housing Administration will need to be bailed out by taxpayers.

The agency’s latest monthly outlook report revealed a spike in serious delinquencies for FHA-insured loans, posing a further threat to the agency’s already depleted cash reserves.

According to the report, the percentage of loans in the FHA’s portfolio with three missed payments or more rose to 9.3% in November, up from 8.4% in August.

Strategic default will become rampant with FHA borrowers. They are all underwater, and with so little of their own money in the transaction, why wouldn’t they default.

Many of the defaults will come when these people need to move. Most will just stop paying and walk away as if the house were a rental. It basically is a rental. They rented some money from the bank on a property in which they have no equity. When owners have no equity, they are renters of a different sort. They own nothing. (see Money rentership: housing and the new American dream)

“It’s highly likely that the FHA will need a taxpayer bailout over the next three to five years,” said Joseph Gyourko, a real estate professor at the University of Pennsylvania’s Wharton School and author of a report entitled “Is FHA the Next Big Housing Bailout?.”

In November, an independent audit of the FHA’s finances found that losses from mortgage defaults had depleted the agency’s reserve fund to 0.24%, or $2.6 billion, during fiscal 2011 — well below the Congressionally-mandated 2% level. (The ratio measures the net worth of the reserve fund compared with the value of the loans FHA has insured.) In 2006, the reserve fund stood at 7%.

The FHA has $2.6 billion in reserves to cover a multi-trillion dollar portfolio? Yes, they are going to need a bailout, just as I suggested in Predictions for 2012.

… Yet, Wharton’s Gyourko argues that the FHA has underestimated the risk of these more recent loans. Many of the new serious delinquencies were from loans issued in 2009 and 2010 and he projects there will be many more defaults to come.One reason is that many of the borrowers who took out FHA-backed mortgages during this time relied on the First-Time Homebuyer Tax Credit for down payments. A large percentage of these borrowers didn’t have enough cash for the small 3.5% down payment that FHA requires, let alone the money to make their ongoing mortgage payments, he said.

The FHA said that the vast majority of home buyers who claimed the tax credit used their own cash for down payments or borrowed from relatives and are therefore low risk.

If someone at the FHA actually believes that, they are crazy. People who don’t use their own money are the most at risk of default; after all, they aren’t losing their money.

Home prices will also play a key role in whether taxpayers will have to rescue the FHA, said Guy Cecala, publisher of Inside Mortgage Finance, a trade publication.

“Given that most FHA loans are made with a 3.5% down payment, most are underwater within a year after price declines,” he said.

They are effectively underwater immediately after they purchase. It takes a few years of price increases to get them back above water.

Many FHA borrowers are teetering on the edge of foreclosure and further housing price declines will push many of those over, exposing the agency to more losses. “I think there will have to be a bailout over the next couple of years,” said Cecala. …

For all the FHA’s problems, however, it has filled a great need over the past few years, said Cecala. Low-income and first-time home buyers have relied on FHA loans to finance their purchases. Without the backing of the FHA, fewer homes would have been sold and prices would be even lower.

The housing market would be in far worse shape than it is,” he said.

His assessment is accurate. Without the FHA, prices would have cratered everywhere houses were sold. In markets like ours where sales rates are 20% to 30% off historic norms because the inventory is being withheld, perhaps the crash has been delayed but not avoided.

The fact that prices would have been lower if the FHA has not been made the lender (actually insurer) of last resort is not a good justification of the policy — unless, of course, you’re a banker or a loan owner, then you think the policy is great.