Driving Off Another Mortgage Cliff

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As a ‘learning experience,' the current recession and its associated housing bust haven't produced many enlightening moments for our policy makers in Washington. Nothing makes that more obvious than the news that delinquencies and foreclosures are rising rapidly among mortgages insured by the Federal Housing Administration, whose reserves have fallen below acceptable levels. The agency's losses, which are almost entirely on loans made after problems with Fannie Mae and Freddie Mac were already apparent in the current bust, may require (guess what) a new taxpayer bailout.

Washington's view of what's happening at FHA falls into two broad categories. On the one hand there are people like FHA commissioner David Stevens who don't seem to think that FHA's current lending practices are risky because the agency isn't lending at so-called sub-prime standards, specifically because the agency doesn't back adjustable rate mortgages and requires documentation from all borrowers to verify their incomes.

Then there are those like Reps. Barney Frank and Maxine Waters, who say they are willing to accept additional risk in FHA loans in order to prop up the housing market and keep lending to people who can't otherwise afford to buy a home right now. Frank and Waters continue advocating giving these borrowers what Washington classifies as "affordable housing" mortgages. Both attitudes, Stevens as well as Frank's and Waters', are troubling when you consider the history of such government-backed lending and what FHA's efforts say about the prospects for sensible reform and restraint.

Congress pushed FHA into the market after Fannie and Freddie, which had usurped much of FHA's mortgage role starting in the early 1990s, went bust. To grease the wheels Washington raised the limits on a mortgage that FHA could approve to a whopping $729,750 per home in some markets. This is what qualifies as "affordable lending" in Washington. In addition, FHA heavily backed mortgages with a down payment amounting to as little as 3.5 percent of the value of the home, which lenders would never approve in the current market without government insurance.

Decades of underwriting experience tell us that these lending practices, that is, big loans made with low-down payments in a volatile market, are very risky. The FHA and the Veterans Administration, for instance, came under similar pressure to lower their underwriting standards and boost lending in the 1950s, after the post-World War II housing boom pushed up prices and put ownership out of the reach of some middle class families. The agencies responded by raising limits on the size of loans they would approve (which Congress allowed the agencies to do) and sharply lowering down payment requirements. From the early 1950s to the mid-1960s the typical down payment on an FHA-backed loan decreased from about 18 percent of the value of a home to just 7 percent, while VA down payments went from an average of about 10 percent to less than 3 percent of the value of the home.

Along the way, foreclosure rates spiked sharply, from about 1 per 1,000 mortgages at both agencies in the early 1950s to about 12 per 1,000 on FHA loans by the mid-1960s, and to 7 per 1,000 mortgages on VA loans, according to a study of foreclosure and delinquency problems in the two programs published in 1971 by the National Bureau of Economic Research.

By contrast, the foreclosure rate on conventional mortgages, where down payment ratios declined only slightly but remained well above FHA and VA rates, went from about 1.6 per 1,000 mortgages in the early 1950s to a mere 2.4 per 1,000 by the early 1960s. "The incidence of [foreclosure] claims was found to decrease sharply with the increases in borrowers' equity," the NBER report observed, stating the obvious.

There's nothing mysterious about why foreclosure rates react this way. A homeowner who has made a small down payment will quickly be sitting on a loan that is "underwater," that is whose value is higher than the value of the home, if home prices decline. For a variety of reasons, ranging from a homeowner who is suddenly out of work or one who was counting on the home he purchased to be a great short-term investment, such homeowners are far more likely to default on their mortgages, studies have shown.

Under these circumstances, all one has to do is look at housing prices to understand just how risky the FHA's low-down payment standard has been in the last two years. Home prices have declined relentlessly every month since August of 2006 through May of 2009 before taking a breather more recently. So it's not surprising that the percentage of FHA mortgages underwater has risen and that, according to one estimate, a fifth of all loans it made last year and a quarter of all loans from 2007 are now classified as having serious problems.

Faced with these troubling signs, the FHA is banking on optimistic projections of rising home prices, which would help to clear up problems with its portfolio in the next few years. But as the economist Robert Shiller observed last week in a New York Times column, a recent uptick in home prices could represent little more than a new wave of short-term speculative buying, what Shiller called "short-run price volatility" that may well be just the equivalent of a brief bear-market rally. If housing market bears are correct, prices could start declining again, and the FHA would be in for a mess of trouble.

Not surprisingly, FHA's backers in Washington, the very same people who defended Fannie and Freddie when critics warned of their increasingly dangerous lending practices, are quick to accept the optimistic view. Waters proclaimed in recent hearings that, "I am feeling very confident about FHA." This is the same Waters who in 2004 told a Congressional hearing that, "We do not have a crisis at Freddie Mac, and particularly at Fannie Mae."

What's even more troubling is that Waters, Frank and other supporters of FHA are willing to take these risks for what amounts to at most a marginal boost in homeownership. In testimony before Congress the FHA administrator, Stevens, and other supporters claimed that its low-down payment loans are necessary to unlock the American dream for those who don't have enough money to put down a conventional down payment. But figures from the last few years suggest that most of these people are not permanently shut out of the mortgage market, that instead, all we do when we subsidize these programs is pull their buying forward.

During the housing bubble, when home ownership rates rose from about 65 percent to 69 percent of households, ownership rates barely budged at all among households led by adults 44 and over, and rose just slightly in households with adults 35-44, according to research by University of Virginia Professor William H. Lucy and researcher Jeff Herlitz. The really big gains came among households headed by someone under 25 years old, where ownership rates rose to 25 percent from 19 percent, and in households led by someone 25 to 29, where ownership rates rose to 41 percent from 36 percent. In other words, it isn't so much that government subsidized loans extend the American dream to those who would be denied, but rather to those who would be denied for a few more years.

None of this is reflected in policy discussions now going on in Washington. It's clear that little about the financial nightmare we've been through has prompted Washington to examine closely the data that's available and reevaluate its long and often disastrous policy of subsidizing home ownership in America at risky and often counterproductive levels.



Steven Malanga is an editor for RealClearMarkets and a senior fellow at the Manhattan Institute

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