Is FHA too big to fail?

In the last year or two the concept of “too big to fail” has been applied to certain financial, manufacturing and quasi governmental firms. For example, Barney Frank said last week that he supports the Treasury Department position of supporting Fannie Mae and Freddie Mac due to their importance to the housing market. Given the importance of FHA to the nation’s housing market will it get or need that kind of support? Before answering that question we should first take a look back at the roots of FHA.

Prior to the Great Depression homes were typically financed with large down payments and for a maximum of five years. All that changed with the onset of the Depression and the housing crisis that followed. The passage of the National Housing Act of 1934 provided the foundation for the Federal Housing Administration (FHA) creating a federally backed insurance system to encourage lenders to make loans at more attractive terms than previously available. The idea was that insurance premiums collected from borrowers would provide a pool of funds that would cover future loan losses. The agency poked along until the housing crisis of the mid 2000’s.

During 2006 and into 2007 it was becoming increasingly apparent that alternative loan products were going to be in for a tough ride. These products offered home buyers up to 100% financing and had very liberal qualifying standards. As these products disappeared FHA stepped in and filled the void. With its 3% down payment (now 3.5%) and flexible underwriting standards it started replacing these alternative loan products. Where FHA market share had been historically below 10% and less than 2% in the years during the boom it has now grown to 30%. Because of the increasing volume there is growing concern over FHA’s financial viability.

Recently it was revealed that FHA’s reserve was well below the minimum set by Congress. FHA leadership does not believe that they will have to ask Congress for assistance but it is estimated by the end of 2010 FHA’s portfolio will hit the ONE TRILLION dollar level. The agency’s new chief credit quality executive has expressed his concerns that FHA’s share of the mortgage market is much too high. There are also those that have concerns with FHA’s evaluation of its risk.

Last week a working paper from economists at the New York Federal Reserve and NY University was released suggesting that the FHA may be under estimating the risk it faces. For example, the report is at odds with FHA methodology for determining the number of upside down loans in its portfolio and its measure of the impact of high unemployment. The report expressed concern for “Streamline refinance” loans. This loan represented 21% of FHA loan volume in 2009 and the report authors believe 33% of these homeowners are upside down yet FHA methodology is at 1.5%. How can there be such a large difference?

The gap in risk assessment between FHA and outsiders should come as no surprise to anyone. While the FHA is taking steps to better manage risk by increasing minimum credit scores, lowering the amount sellers can pay towards closing costs, increasing mortgage insurance premiums and so forth the fact is these changes were overdue. Hopefully the changes will mitigate FHA’s risk and subsequent losses in the future. But today FHA is likely facing more losses than it anticipates and is far too important to the fragile housing market so look for it to get the support it needs from the government. Thus it would appear that FHA is too big (important?) to fail.