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FHA Bailout Looms

Yes, you've heard right: a U.S. Federal Housing Administration (FHA) bailout could be on the way, making the group the latest casualty of the 21st century housing bubble.

An audit released yesterday (Thursday) showed that the FHA, which was set up in 1934 to insure mortgages taken out by low income borrowers during the Depression, has only $2.6 billion in cash reserves to support a mortgage loan guarantee program servicing $1.1 trillion in loans.

"As was the case last year, the new actuarial study shows that FHA is expected to sustain significant losses from loans insured prior to 2009, and thus its capital reserve remains below the congressionally mandated threshold of two percent of total insurance-in-force," a HUD press release stated. "However, the actuaries' report concludes that, barring a further significant downturn in home prices, the MMI Fund will start to rebuild capital in 2012, and return to a level of two percent by 2014 – outpacing last year's prediction."

But critics of the report say that the FHA is underestimating the amount of risk in its loan guarantee portfolio.

Joseph Gyourko, Professor of Real Estate, Finance, and Business & Public Policy at the Wharton School, wrote in a report produced for the American Enterprise Institute, "…the risk of future defaults, and the losses associated with them, is being systematically underestimated. This makes the projections of FHA's main insurance fund value look far rosier than really is the case."

Gyourko continued, "This leaves a quick and substantial economic and housing market recovery as the primary way for FHA to avoid generating substantial losses for American taxpayers…FHA's main insurance program is materially undercapitalized, with the likely amount of capital infusion required being in the $50 billion-$100 billion range, even if there is no unexpected deterioration in housing markets."

FHA Bailout: How We Arrived Here

Traditionally, the FHA was intended to serve low- and moderate-income homebuyers by insuring their mortgages taken out from private lenders. Borrowers pay an up-front insurance premium and monthly insurance premiums that are a part of their mortgage payment thereafter.

The big advantage of an FHA loan is that it required only a small down payment-3.5% until standards were tightened in 2010. Even now, borrowers using FHA insurance need to put down only 10% of the purchase cost of their home instead of the industry-standard 20% or more.

Prior to the collapse of the housing market in 2008, FHA-insured loans accounted for about 5% of all housing loans. In 2010, following the collapse of Fannie Mae and Freddie Mac, the FHA took up much of the slack and, as of 2010, insured fully one-third of all mortgages in the United States.

Loans made between 2005 and 2008 have the highest rate of default and have greatly eroded the FHA's balance sheet. Underwriting standards were tightened beginning in 2009 and, according to the FHA, are profitable. But, even as defaults on mortgages held by banks, Fannie and Freddie have declined, defaults on FHA-insured loans have increased, comparing the first quarter of 2012 to the first quarter of 2011.

Despite the improvement in mortgage lending by banks, many borrowers, even in high-priced housing markets, are choosing FHA financing.

The question is, are today's FHA-insured borrowers choosing to finance their mortgages this way because they want to employ maximum leverage? Or are banks still unwilling to lend even to buyers that would normally be considered to be qualified?

"In the midst of a tough housing market the FHA MMI Fund continues to be actuarially sound," said Acting FHA Commissioner Carol Galante in a statement cited in the HUD press release, "… this past year's endorsements had the highest credit quality ever recorded, and will yield historically high levels of net receipts in the years ahead."

Critics argue that the FHA is in over its head and that the agency cannot possibly rebuild its balance sheet in only two years.

Dan Murphy, general counsel of the Washington, D.C.-based consulting firm BGR Group and HUD's chief of staff during 2001-02, wrote in National Review Online, "Tucked away in President Obama's 2012 budget proposal was a little-noticed provision telling Congress that it may need to provide $688 million to cover the FHA's projected losses this fiscal year. Translation: The FHA will need a bailout for the first time in its 75-year history."

Murphy continued, "Since that proposal came out, the Department of Housing and Urban Development (HUD), which oversees the FHA, has announced a hasty $1 billion settlement with Bank of America for alleged mortgage-market violations. This provided HUD with a Band-Aid to cover the FHA shortfall through October 2012. But the problem has not been solved, merely postponed. Below the radar, FHA is still hemorrhaging money from loan losses."

Right now, the FHA is essentially a political question. The Obama administration is defending the FHA and contends that the housing market would have been much worse without it. Critics argue that the American taxpayer will be on the hook for hundreds of billions of dollars of defaults.

The really tricky part is, assuming the FHA survives the current crisis, how does it go back to being the mortgage insurer of last resort instead of being the first choice for mortgage insurance that it has become today?

But first things first, it's looking increasingly likely that a FHA bailout is inevitable.

Check out what Money Morning financial expert Shah Gilani had to say on the FHA bailout in today's analysis.

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