Tuesday, December 4, 2007

More On Taxpayer Bailout of Subprime

UPDATE: Congress is likely to pass the FHA Modernization Act. This will reduce downpayments from 3% to 1.5%, provide for wider use of risk-based premiums by FHA, and raise the maximum loan amount to the "conforming loan" amount for Freddie and Fannie of $417,000.00. The Senate passed this legislation last week and the House passed similar legislation in September. You can get details of the proposed legislation at this summary of the proposed legislation.

On November 13 I wrote an article about the beginnings of a taxpayer bailout of the subprime mortgage mess. I want to add to that article some new information I have found since then. This has nothing to do with the “Paulson” plan, except that his plan seems to be more of a diversion from what is really happening than anything else.

What is really happening? As I wrote in the article referenced above, the Federal Home Loan Banks have increased their exposure to banks by some $183 billion from December 31, 2006 to September 30, 2007. The FHLBanks obtain funds by issuing federally guaranteed securities, so ultimately this is a taxpayer guaranty. Freddie and Fannie have also substantially increased their portfolios over this time period. But there is more.

The FHA is now into the act in a big way. According to this press release yesterday FHA has now refinanced 33,000 subprime loans and plans to refinance another 20,000 by year end. Plans for 2008 are to refinance 240,000 subprime loans. This is all pursuant to the Bush FHASecure Plan. Of course, as with many Bush plans, the name is deceiving. If anything, I believe this plan makes the FHA less secure and more likely to ultimately require a taxpayer bailout.

Granted the FHA program is backed by an insurance fund – the Mutual Mortgage Insurance Fund (the MMI Fund), that is supposed to stand behind these mortgages. The fund is financed with insurance premiums paid by borrowers. The problem is that the health of the fund (which has a capital ratio around 6.4% of outstanding guaranteed loans based on May 31 2007 data that you can find here) depends upon underwriting standards. With all of the buzz around helping subprime borrowers, and based on some observations, I am very concerned that the fund will ultimately be in jeopardy and have to be bailed out by taxpayers. This is based on my reading of the threats to the MMI Fund.

According to this testimony by Basil N. Petrou, Managing Partner, Federal Financial Analytics, Inc. to the Housing and Transportation Subcommittee of the Committee on Banking, Housing and Urban Affairs, United States Senate, June 20, 2006. prepared and presented in consideration of FHA reform proposals in Congress, the primary sources of financial risk are identified as low or no downpayment loans and risk-based premiums.

Regarding risk-based premiums, the report warns that FHA is likely to get it wrong. FHA does not have the ability to accurately determine which borrowers are higher and lower risk thereby justifying a higher or lower premium. The current system of cross subsidization is a key part of why the MMI Fund has been successful (cross subsidization refers to the fact that all borrowers pay the same fee, resulting in higher quality borrowers subsidizing the lower quality borrowers).

Regarding low or no downpayment loans, it warns that such loans could result in high default rates and serious harm to neighborhoods where these loans would be prevalent. Adding to the risk, according to the testimony, would be a declining real estate market. Does this sound familiar? It sounds like the justification now being given by politicians for helping to stem subprime defaults. This testimony lays out the subprime problem quite clearly, and warns that FHA should stay away from these loans.

This reform that was in front of Congress was not passed. The Bush Administration has, however, authorized modifications to the HUD program that allow HUD to utilize risk based premiums. According to a HUD press release:

President George W. Bush today announced that HUD's Federal Housing Administration (FHA) will help an estimated 240,000 families avoid foreclosure by enhancing its refinancing program effective immediately. Under the new FHASecure plan, FHA will allow families with strong credit histories who had been making timely mortgage payments before their loans reset-but are now in default-to qualify for refinancing. In addition, FHA will implement risk-based premiums that match the borrower's credit profile with the insurance premium they pay-i.e., riskier borrowers pay more. This common-sense, risk-based pricing structure will begin on January 1, 2008.
“Common sense” – hummmm. Not according to congressional testimony. I also point out the spin. If riskier borrowers pay more, doesn't that mean "less risky" borrowers pay less?

Does HUD plan to implement these changes? Well, according to the Annual Management Report of The FHA:
This past year has seen an increase in interest rates and a decrease in house price appreciation, leading to the current mortgage credit crunch. Accordingly, FHA will expand its refinance program, FHASecure, to include those individuals and families who are in default as a result of an interest rate reset. With the inclusion of delinquent borrowers under the FHASecure umbrella, the government’s largest mortgage insurance provider will now be able to assist even more troubled homeowners. In addition, FHA will implement risk-based premiums that match the borrower's credit profile with the insurance premium they pay. This administrative risk-based pricing structure will begin in early 2008.
(Again the spin - "a decrease in home price appreciation" isn't really an accurate description of the current housing market.)
What about the downpayment issue? Well, according to the same press release announcing the FHASecure plan:
To qualify for FHASecure, eligible homeowners must meet the following five criteria:
1. A history of on-time mortgage payments before the borrower's teaser rates expired and loans reset;
2. Interest rates must have or will reset between June 2005 and December 2008;
3. Three percent cash or equity in the home;
4. A sustained history of employment; and
5. Sufficient income to make the mortgage payment.

Note the 3% cash or equity in the home. This is not much. If it is cash, it is most likely not equity given the decline in home prices (as opposed to a decrease in appreciation) so you are left with 100% (or higher) loan-to-value. The implementation of these requirements also concerns me. For example, here is what the FHA website says:
To qualify for FHASecure, and include the delinquent loan payments, homeowners wishing to refinance must meet the following requirements:
1. Have a non-FHA insured ARM that has reset;
2. Sufficient income to make the mortgage payment; and
3. A history of on-time mortgage payments before the loan reset.
Homeowners who are current on their conventional mortgages must have sufficient income to make the mortgage payment.
What happened to the “cash or equity” requirement? It isn’t there. Is this an oversight or a reflection of the implementation of this subprime refinance plan? What is this about refinancing delinquent payments? Doesn't this reduce the loan-to-value ratio (making it negative in many cases)? I am cynical, so you know what I think. Here comes the taxpayer bailout. Don't be surprised if sometime in the not too distant future you hear about a MMI Fund taxpayer subsidization plan. Want more? Here is a clip from the Congressional Testimony referred to above:
Key points to consider for FHA reform include:
• As a government program, FHA should serve its targeted borrowers if they are not already being adequately served by the private sector. It is not appropriate for FHA, as a government program, to launch initiatives to expand its “market share.”
• Recent General Accountability Office (GAO) and Department of Housing and Urban Development (HUD) Inspector-General reports, as well as the President’s FY 2007 budget raise serious questions about the Mutual Mortgage Insurance (MMI) Fund’s financial soundness. The most recent available MMI Fund data are for only mid-FY 2005, and these show a serious reduction in the economic value of the fund that undermines its capital adequacy. Mortgage-market trends since then have shown significant weakening, as evident by recent guidance from the federal bank regulatory agencies designed to protect insured depository institutions.
• The FHA should not seek to grow its way out of its current financial problems. Doing so is reminiscent of the actions taken by distressed savings-and-loans during the 1980s.
• The MMI Fund is already taking financial risks. For example, 50% of all FHA loans insured in 2004 had downpayment assistance, with nonprofit organizations that received seller funding accounting for 30 percent of these loans. GAO analysis indicates that these sellers raised the price of their properties to recover their contribution to the seller-funded nonprofit—placing FHA buyers in mortgages that were above the true market value of the house. The Internal Revenue Service (IRS) is curtailing these programs, but the significantly higher claim rates FHA has experienced from these loans will continue for those remaining on its books. Indicative of FHA’s problems is that its delinquency rates are higher than those associated with private subprime loans. Adding yet more risk means potentially profound FHA losses that will heighten the risk of calls upon the taxpayer.
• From a budgetary perspective, the MMI Fund now is only breaking even, but even this is based only on out-dated information. Any shift in the MMI Fund’s financial condition will convert the program into a net cost to taxpayers, increasing the federal budget deficit.

So why didn’t Congress pass this plan? Looks pretty obvious to me. Of course I hope I am wrong and there is no need for a taxpayer bailout of the MMI Fund. Time will tell.

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