Study Warns of Potential Dangers in FHA Risk-Taking

In recent years, the amount of loans backed by the Federal Housing Administration (FHA) has increased dramatically and now accounts for over a quarter of all home mortgage loans in the United States – a conscious policy decision to avert further declines in housing values.

A recent study suggests that the FHA has failed to properly account for risks on a substantial portion of its insured mortgage loans. Will FHA be the next in line for a taxpayer bailout if borrower default levels continue to rise? An article in The Wall Street Journal discusses the report by seven economists from New York University and the New York Fed:

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.”

This seems to me a risky assumption on the part of FHA officials to operate on the basis that the housing market will rebound and values will rise. The low down payment loans that FHA is known for insuring are usually the first to default when prices fall, and a large number are already underwater:

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.
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