(Ann Schnare is an economist specializing in housing and mortgage finance. She was former senior vice president for corporate relations at Freddie Mac and vice president, Housing Economics and Financial Research. She also served as chair of the Center for Housing Policy. Opinions expressed are her own)
By Ann Schnare
WASHINGTON D.C. (Reuters.com) — If you like what’s happened to Fannie Mae and Freddie Mac, you’ll love what could come next. With estimates putting the cost of a potential bailout to these government-sponsored mortgage giants at more than $25 billion, Washington is boosting its commitment to one of the riskiest segments of the mortgage business, rather than paring it back.
While Fannie and Freddie mainly serve middle-class borrowers who’ve been relatively slow to default on their loans, another entity, the Federal Housing Administration, caters to first-time buyers and those with poor credit, the same people that private lenders shepherded into the now notorious “subprime” market.
Now that subprime lending has all but ground to halt, the FHA is riding to the rescue, helping thousands of aspiring, but risky homebuyers secure financing they wouldn’t otherwise be able to get. As a result the FHA’s share has swelled to 10 percent of all new loans, up from just 4 percent at the height of the housing boom. Moreover, the recent Housing Bill will expand the FHA’s mandate significantly, permanently increasing the size of loans it is allowed to guarantee and creating a new program designed to help troubled subprime borrowers refinance into more affordable loans.
While FHA’s policy goal — providing low-income borrowers with affordable mortgages - is laudable, these developments should give taxpayers pause. The mortgage market, we now know, is risky business. And that goes equally for giants like Fannie and Freddie and with large, experienced staffs and Wall Street investment banks with complex computer models. With billions of taxpayer money at stake, is it really wise to ask the FHA — chronically under-funded, buffeted by the whims of politicians, delegated too little authority — to succeed where they have failed? While the general consensus appears to be yes, as there are few, if any viable alternatives, efforts to expand the role of FHA need to be accompanied with appropriate and meaningful reform, including greater autonomy and greater access to private sector tools and expertise.
The FHA traces its roots back to the New Deal. It was established in 1934 to provide a reliable, low cost source of financing for American homeowners. Like Fannie and Freddie, the FHA doesn’t issue loans, but through its sister agency Ginnie Mae, guarantees mortgages made by private lenders like Wells Fargo and Chase. FHA loans carry the explicit backing of the U.S. government, not just an implied backing like its two better-known cousins. That means American voters get cheaper interest rates, but if they default, taxpayers are on the hook.
While it was originally targeted to middle class, first-time homebuyers, FHA has evolved over time to serve borrowers with poor or non-existent credit. In this sense FHA loans are similar to subprime mortgages. However, while FHA mortgages require relatively little money down - typically about 3 percent — they have none of the toxic features of subprime loans such as pre-payment penalties, high interest-rate resets, negative amortization, or the ability to qualify on “stated” income.
The last FHA audit, conducted a year ago, found the program to be financially sound. But market conditions have deteriorated substantially since that time, and FHA loans are suffering from some of the same problems that have plagued other parts of the mortgage market. Roughly 13 percent of FHA loans are in arrears, 5.6 percent are more than 90 days past due, and 2.4 percent have actually entered foreclosure. While the foreclosure rate is considerably better than the one for subprime loans, currently about 11 percent, it’s twice as bad as the 1.2 percent foreclosure rate on “prime” loans to borrowers with solid credit, the kind that Fannie and Freddie guarantee.
As FHA becomes more important, it is critical to ensure that the Agency has the requisite money and manpower to perform its tasks. At present, FHA is light years behind the industry in its risk management systems, and its ability to attract and retain qualified staff. As one example, senior executive salaries at FHA are subject to federal pay scales and capped at $172,200, while Fannie and Freddie CEOs each earned more than $14 million last year. FHA must also rely on Congress to legislate any significant program or policy change, limiting its ability to respond to evolving market conditions. While the new housing bill contains some provisions for “modernization,” FHA has a long way to go.
FHA will also need to find a way to isolate itself from the type of political meddling that has hampered its effort thus far to manage its risk. Most recently, for example, Congress refused the Department’s requests to charge riskier borrowers a higher rate, and it took years to terminate a popular downpayment assistance program with known performance problems, but with some politically influential friends. If Congress wants to subsidize mortgages that’s a fine policy decision, but such actions need to be explicit.
The turmoil in the mortgage market has forced many private sector participants into retreat, leaving most of the remains to government and government-sponsored enterprises. While Fannie and Freddie have absorbed much of new lending activity, FHA is also growing by leaps and bounds. This situation is likely to continue for a while. Like it or not, it will be up to federal regulators, Congress, and the incoming Administration to clean up the mess that was left in the wake of the subprime crisis.
GSE reform is now on its way to becoming a reality. However, while FHA reform has long been a priority for policy wonks, it has received little support in Congress or elsewhere. Bipartisan recommendations from the Congressionally-mandated Millennium Housing Commission have largely gathered dust. These and other proposals to change the status quofor example, making FHA an independent, government-owned agency with expanded authorities, creating risk-sharing agreements with the private sector, and moving FHA into a reinsurance role—need to be reexamined. Now is the time to give the agency the tools it will need to do its job. The taxpayers should demand no less.