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Friday, June 28, 2013

Rethinking the (Essentially Insolvent) FHA

The AEI has put out a terrific little (12 page) paper by Joseph Gyourko, who is the Martin Bucksbaum Professor of Real Estate, Finance, and Business Economics & Public Policy at the Wharton School of the University of Pennsylvania, where he chairs the real estate department and is director of the Zell/Lurie Real Estate Center. He is also a research associate at the National Bureau of Economic Research (NBER) and served as codirector of NBER’s special project on housing markets and the financial crisis.

Entitled “Rethinking the FHA”, it calls for “replacing FHA with a new subsidized savings program that provides matches of qualified households’ savings. The goal would be to help those households achieve a 10 percent down payment on the home they wish to purchase.”

This is an approach that I have been thinking about ever since the collapse of the mortgage finance market in 2008.  Why does the federal government provide so much financial support to home ownership?  Is there a better way to do it than the Fannie/Freddie/FHA model which (a) subsidizes households to take on large quantities of debt to buy homes, which (b) drives up housing prices, requiring the next round of buyers to take on yet more debt to buy a house, and (c) leaves the government holding enormous amounts of credit risk from what tend to be among the riskiest household credits in the nation, and (d) multiplies leverage throughout the economy because, not only are the households that issue mortgages left highly leveraged but the government agencies like Fannie/Freddie/FHA that take their credit risk are also highly levered and, on top of that, the holders of the government agencies’ paper are allowed to leverage it at very high ratios because of the government backing?  As Professor Gyourko writes:

 “Recent research projects high default rates—between 15 and 30 percent—among borrowers whose mortgages FHA guaranteed since 2007. Hence,  it is quite clear that very large numbers of program beneficiaries are not successful in becoming stable, long-term owners. FHA’s most recent actuarial review for fiscal year 2012 shows that its Single-Family Mutual Mortgage Insurance Fund is underwater. My own research suggests that even this sobering conclusion by FHA’s actuarial reviewer is too optimistic by tens of billions of dollars.”

 “Both FHA and the borrowers whose mortgages it insures are leveraged by more than 30 to 1. This was always a financial accident waiting to happen: this leverage ratio is on par with those that were employed by Bear Stearns and Lehman Brothers just before their collapses. To be viable, such a highly leveraged business model requires that house values never fall. We have learned the hard way that actual market outcomes are not always so obliging.”

His paper reviews these claims in somewhat more detail, but I don't think there is any real disagreement that the FHA is insolvent, because its underwriting standards are looser and its loans thus have default rates much higher than any private sector lender could sustain.  A typical FHA mortgage has only about a 3% downpayment.  I don't see how the government is serving any public policy interest puttng households into that kind of leveraged position. 

For that reason, I have been thinking along the same lines, that if the government has to be involved in supporting home ownership (which is a political reality after decades of such involvement, regardless of what little economic sense it makes), the best channel is not through the debt but the equity, exactly as Professor Gyourko proposes: give them money to build net worth, not debt that can destroy it.  But giving people 100% of their down payment obviously isn't a sound policy, so the 100% match is a much better way to go.    Or, if someone objects that it's still too hard for poor people to save anything to be matched, I could imagine a small fixed amount like $100 a month and a 100% match of anything above that.  It's also important from an inflation-management perspective that the government subsidy is not freely available for spending generally but sits, outside the economy, in savings vehicles.

The whole paper is only 12 pages and very much worth reading.

Hat tip to Arnold Kling's "askblog" which is also always worth reading.