The Federal Housing Administration (FHA) is systematically underestimating the default risk of its insured-loan portfolio, possibly to the tune of ‘many tens of billions of dollars’ in future losses, according to a new report.
The report – titled ‘Is FHA the Next Housing Bailout?‘ – is based on the research of Joseph Gyourko, a professor of real estate, finance and public policy at the University of Pennsylvania's Wharton School. The American Enterprise Institute (AEI) has made the report available on its website in advance of the FHA's annual actuarial report to Congress, which is due by Nov 15.
According to Gyourko, the FHA's Mutual Mortgage Insurance Fund (MMIF) is "materially under-reserved by at least $50 billion, with the true figure likely higher."
Although the FHA has tripled its insurance in-force from $305 billion at the end of 2007 to more than $1 trillion through July, the agency has been unable to grow its capital resources at the same pace. The FHA has roughly $30 billion in total liquid capital resources, according to Gyourko.
In the report, Gyourko blames the FHA's artificially low default forecast on the administrative decision to downplay a variable that considers the unobserved credit risk of recent mortgage pools.
‘This leads to dramatically lower forecasts of default – on the order of 50 percent for a typical borrower in the FHA insurance pool,’ the report says. "No theoretical or empirical foundation for this decision is provided, which effectively implies that there will be no more unobserved high credit risk in the future."
In an entry posted on the AEI's "Enterprise" blog, Gyourko wrote that the FHA ‘has simply assumed that unobserved high credit risk on post-2006 insurance pools (i.e., those after the housing bust began) will disappear by 2014.’
The actuarial analysis of the MMIF also fails to consider a number of other risks, he says. For example, the analysis does not control for unemployment risk or negative equity. Just over of FHA-insured loans are tied to borrowers who are under water.
The analysis also incorrectly models streamline refinancings as prepayments that eliminate all default risk to the MMIF. The risk is only eliminated in a refinance transaction when the new loan is a non-FHA product, the report explains. Further, the analysis does not recognize the risk of borrowers who used the $8,000 federal tax credit to fund their down payments.
"Past data indicate that borrowers who do not fund down payments out of their own resources default at rates up to three times higher than other borrowers," Gyourko wrote in the blog. "FHA may have insured one million or more of them.’
To recapitalize the MMIF in a safe manner, the FHA needs between $50 billion and $100 billion, Gyourko says.
On the bright side, the MMIF is safe from an extreme liquidity crisis in the near term, the report states, explaining that its loss estimates will play out over the course of many years.