What to do with the Federal Housing Administration.

• Author: Calabria, Mark
• Position: Public Policy - Report

THE FEDERAL Housing Administration (FHA), currently contained within the Department of Housing and Urban Development (HUD), insures lenders against the risk of borrower default. The FHA does not make loans itself, but rather sets guidelines for the mortgages it will insure. Mortgages are originated by the lender and either can be held by the lender on its balance sheet or sold to investors or other financial institutions. Payments from the FHA are made directly to the lender and benefit the borrower only insofar as the presence of the FHA either lowers the cost of borrowing or increases the availability of credit.

Lenders pay premiums to the FHA for this insurance, the cost of which is passed along to the borrower. The basic premise is that, by mutualizing default risk across lenders and borrowers, the FHA creates overall efficiencies that offset the premiums that would exist under a purely private system of mortgage insurance.

The FHA currently backs an activity portfolio of more than one trillion dollars. With an economic value of $2,600,000,000, representing a capital ratio of 0.24%, relatively small changes in the performance of the FHA's portfolio could result in significant losses to the taxpayer. As the taxpayer is, by law, obligated for any losses above the FHA's current capital reserves, these are not losses that can be avoided. Reasonably foreseeable changes to the FHA's performance easily could cost taxpayer tens of billions of dollars, surpassing the ultimate cost of the Troubled Asset Relief Program (TARP) bank bailouts.

The FHA did not create the concept of guaranteeing mortgages against default. The first private mortgage insurance company appears to have been the Title and Guarantee Company of Rochester, N.Y., which opened in 1887. By the time of the stock market crash in 1929, some 37 private mortgage insurance companies operated in the state of New York alone.

The initial years of the Great Depression actually saw an increase in the provision of private mortgage insurance. Private mortgage insurers did not begin failing en masse until 1933, in tandem with the wave of bank failures occurring that same year. As nominal house prices were fiat by 1932, with real prices actually rising, the failure of private mortgage insurance appears to have been more the result of high unemployment and the banking crisis rather than stress in the housing market.

The combined failure of the mortgage insurance industry and the reduction of credit availability from some 4,000 bank failures in 1933 led Congress to pass the National Housing Act of 1934, Title II of which created the FHA. This article will focus solely on the FHA's single-family business, generally referred to as its 203(b) program, authorized in Section 203(b) of the National Housing Act, but the agency also provides insurance for multifamily housing (apartments, co-operatives, and condominiums), manufactured housing, and hospitals.

Although FHA requirements were considered quite radical and risky at the time, the agency's initial loan requirements would be viewed as rather stringent under today's standards. At its inception, the FHA required a minimum down payment of 20% with a maximum loan term of 20 years. The FHA also limited its insurance to loans we today would call "prime"--maintaining credit standards that would have excluded borrowers with poor or marginal credit. FHA loans also were required to have an annual interest rate of 5.5%, along with an annual insurance premium of 0.5%. By comparison, private mortgages that were available during that time generally were priced around four percent or 4.5%, making FHA loans a relatively expensive option.

The FHA also attempted to minimize credit losses via restrictions on the properties and neighborhoods that would be eligible. Property quality restrictions were quite extensive, with the agency maintaining an exhaustive handbook detailing various minimum quality standards that would have to be verified via inspection before FHA insurance was written. The agency, rather than the private sector, also was the creator of mortgage "redlining," a policy by which the FHA refused to write insurance on loans located on properties within communities with high concentrations of racial and ethnic minorities.

Despite its promise to be the heart of the New Deal solution to the housing problems of the Great Depression, the FHA maintained a relatively small role in the U.S. mortgage market, rarely rising beyond 10% of total mortgage debt outstanding during its first decade of operation. Indeed, the agency's market share did not break 15% until the beginning of World War II. During the 1950s and 1960s, the FHA's market share hovered between 15% and 20%.

Due to its relatively low activity and high credit standards, coupled with its higher pricing, the FHA posed little financial threat to the taxpayer during its initial decades. Over its first 20 years, the agency maintained an income of almost $500,000,000 in premiums, with claims payments of only half that amount. With housing prices and employment rising steadily throughout the 1940s and 1950s, the agency was able to maintain a position of financial health and stability, with both defaults and foreclosures remaining low.

The 1960s witnessed a dramatic turn for the FHA, as the program was among many Federal programs that increasingly were seen not simply as a backstop for the market, but as a tool of social engineering. Pres. Lyndon Johnson, in his first State of the Union Address, asked Congress to allow the agency to postpone foreclosure for those homeowners who defaulted due to circumstances beyond their control. The Housing Act of 1964 and the Housing and Urban Development Act of 1968 expanded the reach of the FHA, while adding a mandate to "assist families with incomes so low that they could not otherwise decently house themselves." While it would take some time for these seeds to bear fruit, the FHA entered the 1970s with a mandate to reduce its underwriting standards.

The inflation of the 1970s was not kind to the agency's traditional fixed-rate mortgage product. The FHA's market share, by dollar volume, plunged from more than 24% in 1970 to just six percent by 1976. Its market share remained just above that level for most of the 1980s, while its activity increased along with the rest of the mortgage market as declines in mortgage rates, due to reduced inflation, led to a massive expansion in mortgage lending. However, the FHA was not immune from the mortgage market boom and bust of the late 1980s. It required restructuring and reform. In 1989, for the first time, Congress required annual audited financial statements for the agency and established the Mortgagee Review Board, intended to reduce lender fraud and abuse within the agency.

The 1970s also witnessed the rebirth of the private mortgage insurance industry, which provided direct competition with the FHA. While a number of private mortgage insurance companies went public in the 1960s--the most prominent of which was the Mortgage Guaranty Insurance Corporation--it was not until 1972 that the level of private mortgage insurance issued surpassed that of the FHA. Since that time, private mortgage insurers have maintained a market share comparable to that of the FHA, while presenting no risk to the taxpayer.

During the 1980s, the agency underwent several program expansions that eventually would result in significant costs to the FHA insurance fund and taxpayer. Foremost among these was the reduction of the required down payment from 10% to three percent. Congress also eliminated the agency's maximum interest rate cap...