Study Sees FHA Taking More Risk By Nick Timiraos Wall Street Journal 03-05-2010

Study Sees FHA Taking More Risk By Nick Timiraos Wall Street Journal 03-05-2010

Study Sees FHA Taking More Risk
By Nick Timiraos
The Wall Street Journal
March 5, 2010

The federal government's mortgage-insurance agency is understating how much risk it has taken on, says a group of economists from the New York Federal Reserve and New York University, increasing the likelihood the agency may need taxpayer funds.

The economists warn that the Federal Housing Administration—which has jumped to fill the void left by the collapse of the private mortgage market—is overlooking factors that signal higher losses, according to a working paper released Thursday.

The agency has traditionally turned a profit for the U.S. government. But the economists warn that by underestimating the risks it faces, the FHA has increased the likelihood that it will have to ask Congress for money for the first time in its 75-year history.

The study doesn't say how likely that now is, but "it's hard to imagine that they won't be returning to Congress several times," said Andrew Caplin, one of the authors and an economics professor at NYU. "It's just inconceivable that the loans ... will not cause very large losses."

The FHA says it would need taxpayer money only in a worst-case housing-market scenario.

The economists conclude in their study that the share of borrowers who owe more than their homes are worth may be much higher than the agency forecasts.

The economists estimate that about 40% of mortgages insured by the FHA are worth more than the homes that secure them; as many as 14% of the loans may be for more than 115% of the home's value. The home-price measure used by the FHA puts the latter figure at 6%.

Such underwater borrowers are generally more likely to default if they lose their jobs or have trouble meeting mortgage payments, because they can't easily sell their house.

The FHA, in its annual review, doesn't give an estimate of the share of loans it backs that are underwater, although it does warn that such loans will greatly boost losses.

The economists' study also says the FHA should better account for a higher risk of default among borrowers in areas with high unemployment rates.

"You look at the areas in which they're underwater, you look at the unemployment rate in [those] places, you look at how little was invested upfront, and you know that a lot of these mortgages aren't coming back," Mr. Caplin said.

The FHA's share of the U.S. mortgage market has swelled. The FHA, which doesn't make loans but insures lenders against losses, backs about 25% of all home loans, up from less than 2% three years ago.

Loans backed by the agency are one of the few remaining ways home buyers can make low down payments. The FHA requires a minimum 3.5% down payment, while most private lenders require at least 10%.

FHA officials disagreed with many of the study's conclusions. "It's overstating the flaws," said a senior official who had seen early copies of the report.

The FHA concedes that it faces sharply rising losses as loan defaults mount, and that this is depleting its reserves.

Each year, the agency is required by law to conduct an independent review to estimate the value of its reserves after subtracting 30 years of projected losses. In its latest review last fall, the FHA said its reserves exceed projected losses by $3.6 billion, or about 0.5% of the $685 billion in loans outstanding, down from 3% one year earlier.

The economists' study argues that the agency's situation could be even worse.

The authors say the FHA's review doesn't accurately measure the share of its borrowers who may be underwater because it hasn't properly accounted for a jump in certain refinancing transactions. Those transactions, called streamline refinances, allow FHA borrowers current on their loans to refinance even if the value of the loan equals or exceeds the value of the home.

Streamline refinances, which became popular over the past year as home values plunged, accounted for about 21% of all FHA-backed loans last year, up from 6% the previous year.

The study concludes that at least 33% of borrowers who had a streamline refinance last year were underwater when they refinanced their loans, compared with an estimate of just 1.5% using the FHA's methodology.

"This is one of the world's riskier loans," Mr. Caplin said of extending a loan without knowing how much the collateral backing that loan is worth. "There's no way on earth they would have given you this loan as a new loan today."

Many streamline refinances have helped borrowers who otherwise wouldn't be able to qualify for a refinancing to take advantage of low mortgage rates. The FHA last year tightened rules governing streamline refinances, making them more expensive for borrowers who may be underwater.

FHA officials said the models used by the agency's independent actuary were no different from those used by private financial institutions.

There is "some risk that the FHA portfolio will perform worse than the actuary has predicted because there is uncertainty in any such forecast," said FHA Commissioner David Stevens. "But we stand by the actuarial review's findings as a reasonable assessment of our portfolio today."

The independent actuary that conducts the annual review, Integrated Financial Engineering of Rockville, Md., said its models adequately reflected the risk of streamline refinances and of rising unemployment.

"We did explore different model approaches. The results were virtually identical to what we found," said Tyler Yang, the firm's chief executive.


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