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The stealth bank bailout via leveraged FHA loans

When David Stevens left his position in the Obama Administration in 2011 as the head of the Federal Housing Administration to go to head the Mortgage Bankers Association, the chief lobbyist for the industry he once regulated, I posted on the revolving door of corporatism, noting how common this sort of thing is. The interesting thing about this is that we now know subsequently what Stevens oversaw before leaving the regulators post for industry because a recent study shows that the FHA insured loans at huge risk in 2009 and 2010 during the height of the crisis. In essence, what were once industry risks became government risks via this stealth bailout via FHA loans, a bailout that continues today. The New York Times reports:

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A new and extensive analysis of 2.4 million loans insured by the Federal Housing Administration in recent years shows a pattern of risky lending that could generate $20 billion in losses and harm thousands of the nation’s most vulnerable borrowers. By ignoring risks in loans it insured in 2009 and 2010, the study concludes, the F.H.A. is imperiling both borrowers and taxpayers who stand behind the agency.

The analysis emerged less than a month after the F.H.A.’s auditor submitted a troubling report on the financial soundness of its insurance fund. In mid-November, the auditor estimated that the fund, which backs $1.1 trillion in mortgages, has a value of negative $13.5 billion. In other words, if it were to stop insuring loans today, the F.H.A. fund could not cover the losses anticipated on loans it has already insured.

The new study of the potential risks in recent F.H.A.-insured loans is illuminating because it provides a level of detail, including where government-backed loans are, that is usually missing from agency analyses. In addition, the report’s loss estimates are somewhat surprising given that the loans it examined were made after the mortgage crisis became evident.

The loan analysis was conducted by Edward Pinto, a resident fellow at the American Enterprise Institute, a conservative organization. But its findings were based entirely on foreclosure estimates made by the F.H.A.’s auditor as well as detailed individual loan data like ZIP codes and borrower credit scores.

Officials at the Department of Housing and Urban Development, which oversees the F.H.A., were briefed on the study’s findings earlier this week.

George Gonzalez, a spokesman for F.H.A., disputed the findings of the analysis. “The assertion that F.H.A. is setting up potential homeowners for failure by insuring 30-year, fixed-rate, fully documented loans for underserved borrowers is not supported by the information presented,” he said. “Selective use of F.H.A. data ignores that F.H.A. has successfully provided access to mortgage financing for millions of creditworthy borrowers for almost 80 years.”

Of course they are going to dispute this. But this is the problem here:

In recent years, the F.H.A. has been increasing its participation in the market. After the mortgage crisis, traditional lenders withdrew from the business and borrowing to buy a home became much more difficult. The F.H.A., as well as Fannie Mae and Freddie Mac, have stepped in to fill that void. While Fannie and Freddie have tightened their loan standards, the F.H.A.’s underwriting requirements have remained liberal.

To receive F.H.A. backing on their loans, borrowers must have a credit score of at least 580 out of a possible 850, and they are required to put down at least 3.5 percent. F.H.A. allows the borrowers whose loans it insures to have a monthly housing debt payment of around 30 percent of their incomes.

Still, 40 percent of the 2010 loans in the F.H.A.’s insurance portfolio were made to borrowers whose total monthly debt payments were greater than 50 percent of their monthly incomes or had a credit store of less than 660, the study found, a dangerous level.

It’s clear now that the FHA is similar to Fannie and Freddie in that those two institutions were thinly capitalised. Sober Look wrote a post we carried here that commented on the 30x leverage at the FHA, noting that Fitch the ratings agency was concerned about the potential for future losses. And we know that as the GSEs  increased risk at the apogee of the housing bubble, their balance sheets imploded as the bubble burst. The cost was hundreds of billions of dollars of losses which taxpayers footed via a nationalisation and bailout of the GSEs.  This is what we should fear with the FHA.

As I have said in the past, the reason that the FHA is taking on the risks is because government is looking to offload risk from bank balance sheets in order to create an environment in which banks can begin to grant more credit to borrowers. Economist Robert Shiller, who predicted the housing bubble, has flagged this in the past. And this has indeed begun. So far then, the plan is working as intended with not just credit increasing but also house prices and mortgage foreclosures, which are at their lowest level in six years. The problem, as Shiller noted back in July is that a scenario in which austerity in the US actually comes to pass will crystallize losses at the FHA and bring the leveraged nature of the FHA and the risk they are taking to light.

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As usual, a lot of things that look good during an economic upturn, look bad when the economy turns down.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.