Will Taxpayers Have to Bail Out the FHA?

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Government officials testifying before Congress on Thursday staunchly denied that the Federal Housing Administration (FHA) is destined to be the next financial institution to require a taxpayer bailout.

But at least one critic testified that the agency is about to burn through its cash reserves in the next 24 to 36 months and will require a federal bailout to survive.

Former Fannie Mae (NYSE: FNM) executive Edward J. Pinto predicted at a hearing in front of a House Financial Services panel that the FHA will incur $40 billion in losses, rendering it unable to cover its bad loans without taxpayer help.

Pinto, a real estate finance consultant who served as Fannie Mae's chief credit officer from 1987 to 1989, testified that an annual audit conducted by the FHA showing it will not need government assistance is based on underlying assumptions that are "overly optimistic."

But FHA Commissioner David Stevens assured lawmakers that his agency would not need a bailout and that it was doing a good job managing its risks. He characterized Pinto's assertions as "completely unfounded."

Money Morning Contributing Editor Shah Gilani recently made a similar argument.

"In an era of increasingly stringent lending standards, the FHA's standards are laughably lax," Gilani said in a recent Money Morning editorial. "The almost inevitable insolvency of the FHA could rapidly undermine the fragile recovery of the U.S. economy. And it could plunge stock prices and bank viability to new lows."

The Second Housing Bubble

After the housing bubble burst, banks and other mortgage companies reacted by tightening their lending standards by requiring down payments of as much as 20% and proof of income. Now, with the economic slump and the unemployment rate soaring close to the 10% mark, many borrowers simply can't get a loan.But the FHA has stepped up to the plate, providing insurance that enables borrowers to qualify for loans with down payments as low as 3.5% and offering other incentives to stabilize the market.

Faced with few other options, homebuyers are flocking to the government agency.

So far in 2009, the FHA has backed nearly 2 million mortgages worth at least $328 billion, and is insuring about 6,000 loans a day, four times the amount in 2006. It insured 21.5% of all new mortgages last year, up from fewer than 6% in 2007.

Originally created during the Great Depression to help lower-income and first-time buyers purchase homes, the agency now insures roughly 5.4 million single-family home mortgages, with a combined value of $675 billion.

But many of the borrowers who took loans from the FHA in 2007 and last year are now defaulting, the agency acknowledged. Stevens admitted during his testimony that one out of five loans insured last year – and as many as 24% of those from 2007 – have problems, including foreclosure.

The loans made in those two years are performing "far worse" than newer loans, dragging down the whole portfolio, Stevens of the FHA said in an interview with The New York Times.

The total number of FHA mortgage holders in default is 410,916, up 76% from a year ago, when 232,864 were in default, according to agency data.

Congress Eyes Loan Defaults

According to Money Morning's Gilani, what makes the situation at the FHA particularly troubling is that loans that are FHA-insured are pooled and packaged into mortgage-backed securities (MBS) by the Government National Mortgage Association, more commonly known as Ginnie Mae.

Ginnie Mae securities are the only mortgage-backed securities backed by the full faith and credit of the U.S. government.

"The FHA and its mortgage-backed securities "factory" – Ginnie Mae – have taken up where Fannie and Freddie left off, and are now the dumping ground for toxic mortgages," said Gilani.

The issue is serious enough to get the attention of Congress.

Some fearful lawmakers want to rein the agency in before a repeat of the Fannie Mae and Freddie Mac bailout. On the other hand, but others are afraid tighter regulations on the FHA could kill the housing recovery, which is only just starting to stabilize.

The defaults are simply the price we have to pay to get the housing market moving again, according to U.S. Rep. Barney Frank D-MA, who serves as the chairman of the House Financial Services Committee.

"I don't think it's a bad thing that the bad loans occurred," he said. "It was an effort to keep prices from falling too fast. That's a policy," Frank told The Times in an interview.

But because of their low initial investment, some critics say these borrowers are more apt to simply walk away if they are hit by a job loss or by another drop in home values.

To some members of Congress the risk is too high.

"I'm concerned that the private market for loans with little or no money down has shifted directly onto the books of the federal government," said U.S. Rep. Ed Royce, R-CA. "We need to make certain that taxpayers are not again on the hook for the failures of Washington."

Whatever their position, everyone acknowledges that unless there's improvement in the loan portfolio, losses at the FHA could more than wipe out the agency's $30 billion of cash reserves, which have fallen to below its Congressionally mandated minimum of 2%, from over 6% two years ago.

Legislators Propose Reforms

One possible solution, backed by lawmakers like U.S. Rep. Scott Garrett R-NJ, is to raise the minimum down payment on FHA loans to 5%. That would make it more likely borrowers would stay in their homes and not let them fall into foreclosure.

But FHA Commissioner Stevens said that raising the minimum down payment would be an overreaction based more on emotion than facts, and could threaten the recovery in the housing market. He cited figures showing a person wanting to buy a $300,000 house, would need to come up with an additional $4,500 for a down payment.

"All that's going to do is retard recovery," Stevens said, pointing out that the FHA moderates risk by requiring borrowers to document their incomes and insures only standard, 30-year fixed-rate mortgages.

In order to further reduce risk, Stevens testified he will appoint the agency's first chief risk officer and wants to raise lender capital requirements from $250,000 to at least $1 million, leaving fewer losses to land on the FHA ledger.

The data from the audit also project that the reserves will rebound to the required level within two to three years as a result of the recovery in the housing prices, Stevens said

Those measures plus tighter reviews of loan applications should allow the agency to rebuild its reserves without more government funding, he said.

"We're not going to need a taxpayer bailout," he said. "It's a fact."

After the hearing, U.S. Rep. Maxine Waters D-CA, the subcommittee's chairwoman, gave Stevens's presentation a thumbs-up.

"I am feeling very confident about FHA," Waters told The Washington Post. "I think it's going to be able to continue to be a major source of support for home mortgages."

But Gilani strongly disagrees.

"Obama & Co. are making an all-or-nothing bet that the U.S. economy will recover and bail out the housing market before the final bill for this ill-advised gambit comes due," he said. "When this bubble bursts – and it will – U.S. taxpayers will be on the hook for more than $1 trillion in government-guaranteed debt."

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