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The Government’s Overleveraged Housing Bet

Wednesday, November 16, 2011

There is every reason to believe that FHA’s losses are underestimated by at least $50 billion, and that up to $100 billion is needed to properly recapitalize the agency.

The Federal Housing Authority (FHA) is a federal government agency tasked with the inherently risky business of insuring the mortgages of first-time home buyers and those who cannot afford to make significant down payments. Given the high risk they take on, one would expect a conservative, well-capitalized operation. Unfortunately, FHA has quadrupled its insurance portfolio during a time of consistently falling house prices without any material increase in capital resources. This week FHA released its risk analysis for fiscal year 2011. It makes for depressing reading.

FHA’s main insurance fund guaranteeing single family mortgages remains dangerously undercapitalized. It is supposed to maintain capital reserves against unexpected future losses equal to 2 percent of the $1 trillion in insurance guarantees it has provided for borrowers with single-family homes. Presently, it only has 0.12 percent in such reserves. This is the third consecutive year in which it is in violation of its main capital requirement.

What’s more, FHA’s new risk analysis has corrected none of the deficiencies noted in my recent AEI report and by others. These deficiencies include underestimating the extent of negative equity in its insurance portfolio, incorrectly evaluating the risk of its mortgages that refinance, ignoring the added risks posed by borrowers who funded their down payments out of the stimulus’s $8,000 tax credit program (rather than from their own resources) authorized in 2009, and making other decisions that give false hope about how large future defaults and insurance losses will be. Hence, there is every reason to believe that losses are still being underestimated by at least $50 billion, and that up to $100 billion is needed to properly recapitalize the agency.

FHA has quadrupled its insurance portfolio during a time of consistently falling house prices without any material increase in capital resources.

Furthermore, FHA remains dangerously overleveraged at over 30-to-1: It has only about $30 billion in liquid capital to back just over $1 trillion in outstanding insurance guarantees on its single family mortgage portfolio. That is a ridiculously small amount of capital for such a risky business, and a serious government would not allow such overleveraging to continue.

It is worth remembering that FHA’s business model shares key risk traits with the now infamous CDO-squared (collateralized debt obligations-squared or CDO2) securities that were among the first to fail in the recent financial crisis. For those not familiar with those securities, a CDO2 essentially was backed by a pool of high loan-to-value mortgages with little or no home equity cushioning them against losses in the event house prices declined. Because all the loans shared the same weakness (little or no equity cushion), they were all susceptible to any economy-wide shock that lowered house prices or raised unemployment. When house prices fell by a modest amount at the beginning of the crisis, all the loans went underwater, making all of them more likely to default.

Investment professionals call what happened the result of correlated or concentrated risk. The pooling of highly leveraged assets (mortgages in this case) means that a decline in house prices will negatively affect all the assets in the pool, not just a few. There is no diversification of risk with this structure. Indeed, the risk is concentrated. And default risk is positively correlated across the different mortgages in the sense that if one defaults, it is likely that the same fate will befall many others at the same time. Why? Because they share the same weakness (little or no equity), which leaves them susceptible to the same economic shock.

Deficiencies include underestimating the extent of negative equity in its insurance portfolio and incorrectly evaluating the risk of its mortgages that refinance.

While FHA obviously is not issuing CDO2 securities, it shares the same financial weaknesses. It guarantees pools of highly leveraged assets, most of which have little or no equity cushion, leaving them more likely to fail en masse if house prices fall further. Over half the existing pool is already underwater, so there is little more diversification of risk here than there was in CDO2 bonds.

In sum, we have been to this movie before, and it ends badly—very badly, in fact. Not to recognize this risk is dangerous, and it is that inability to face up to what we have done (and continue doing) that is most depressing about the most recent FHA report.

Facing up to that reality leads to two policies: (a) recapitalize FHA immediately, commensurate with the high risk it is bearing; and (b) develop a multi-year plan to reduce FHA’s scale to a more manageable level. For those wondering why we should not drastically shrink FHA now, the answer is that it is too risky to do so given existing weakness in the broader economy and housing markets specifically. This is a terrible situation to have put ourselves in, but that is another reality we have to face.

Joseph Gyourko is the Martin Bucksbaum Professor of Real Estate, Finance, and Business & Public Policy at the Wharton School, University of Pennsylvania.

FURTHER READING: Edward J. Pinto writes “Senate Undermines Obama—and the Country—on Housing” and “Government Housing Policy: The Sine Qua Non of the Financial Crisis.” Peter J. Wallison, Alex J. Pollock, and Edward J. Pinto reveal “Principles for Reforming the Housing Finance Market.” Michael Barone discusses “Replacing Property as a Source of Wealth Creation.”

Image by Rob Green | Bergman Group

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