Blog of the Mortgage

Status of the FHA.. Longterm Viability of the Program

February 10th, 2009 10:23 PM

From time to time I'll post updates from our
Consultancy firm: Potomac Partners.
This update was provided early December
by Potomac Partners of Washington D.C. for
those of you that are newer to these mails this
firm is run by former HUD executives and their
information is both market leading and and a firm
indicator of future changes in guidelines
especially on HUD business.
We would like to update you on the following:·

In this update, we provide our assessment of the FHA's recently
published FY 2008 audit that is an independent and up-to-date
analysis of FHA's current and projected financial health. We also
discuss the two key questions about the FHA program:
    * Can FHA continue to handle the increasing volume?
    * Will FHA be the next bailout candidate?
A link to the report is provided at
http://www.hud.gov/offices/hsg/comp/rpts/actr/2008actr.cfm
Overview
As FHA is being called upon to shoulder more of the responsibility
for stabilizing the U.S. housing market (FHA's market share now
exceeds 33%), questions are being asked about FHA's capabilities
to perform such a critical role. At the core of these questions are
concerns about FHA's infrastructure and reservations about the
credit quality of FHA's recent originations and its long-term financial
soundness.
In our view, the FY 2008 audit is encouraging and better than we
expected. It shows, to no one's surprise, the FHA program is not
immune from the impact of widespread house price depreciation.
However, FHA's capital ratio (now 3%) remains above the
Congressionally mandated level of 2% and is expected to exceed
this level throughout the next seven years. In other words, despite
the unprecedented market upheaval, FHA is financially sound and
is expected to remain so.
Another particularly encouraging conclusion in the audit is that the
composition of the FHA book did not deteriorate in FY 2008 as many
had feared because of the influx of poor quality subprime loans.
In fact, FHA's over-all loan characteristics for the FY 2008 book
have improved. While not mentioned in the audit, many lenders on
their own implemented tighter underwriting guidelines for FHA
originations (e.g. minimum credit scores). These actions have been
positive for the program.
At the same time, there are an increasing number of critical articles
expressing concern about FHA's infrastructure and long-term
financial soundness.   You may have seen the recent Business Week
cover story entitled "The Subprime
Wolves Are Back" dated December 1, 2009 ( Link -
http://www.businessweek.com/magazine/content/08_48/b4110036448352.htm?chan=magazine+channel_top+stories )   The
basic premise of the article is that unscrupulous subprime lenders
are entering the FHA program and exposing the taxpayer to billions
of dollar of risk because of FHA's inadequate controls.   Based on
other inquiries from the national press, we expect there will be more
unflattering stories about FHA in the coming weeks and months.
While these stories are troubling and damage FHA's reputation in
Washington, we believe the FHA FY 2008 actuarial review
demonstrates there are not widespread systemic problems in the
program.
Each question mentioned at the outset is discussed below.
Can FHA continue to handle the increasing volume?
Over the last 15 months, FHA has demonstrated it can handle its
volume increase which is now running at 4 x's 2007 levels. Despite
receiving minimal additional resources, there are two reasons why
FHA can handle the volume. First, as you know, FHA approved
lenders can perform all of the loan processing, underwriting, closing
and insuring functions without any HUD review.
Secondly, FHA's technology, despite being 25 years old, remains
resilient and fundamentally sound. With the additional resources
being provided, there is now minimal concern that FHA will not be
able to provide mortgage insurance certificates (MICs) in a timely
manner (barring some unforeseen circumstance) even if FHA
business doubled or tripled from current levels. Quite frankly, our
biggest concern regarding FHA's technology is that future changes,
made with the intent of improving performance, may have the
unintended consequence of impairing FHA's performance.
Will FHA be the next bailout candidate?
There was widespread concern that FHA became the "dumping
ground" for subprime loans when that market collapsed in 2007.
Many press reports have been written questioning FHA's financial
strength. The FY 2008 Actuarial Review provides a current analysis
of the status of the FHA program and rebuts the concern that
there is a systemic problem in the program.
FY 2008 Actuarial Review
Highlights
·         The FHA Mutual Mortgage Insurance (MMI) Fund is actuarially
sound and is projected to remain so over the next seven years.
o   The auditors conclude: "despite the current severe housing
market downturn, the capital ratio is and will remain above 2 percent
in future years".
§ Congressionally mandated level - 2%
o   FHA's capital ratio fell to 3% (from 6.4% in FY 2007).
o   FHA's economic value declined to $12.9 billion from $21.2 billion
(39% drop)
·         The steep decline in house prices is the primary cause for
the decline in economic value and the capital ratio.
·         The encouraging news in the audit is that the composition
of the FY 2008 book of business has improved thereby mitigating
concerns that FHA is being flooded by high risk subprime borrowers.
o   Borrowers with FICO scores above 680 increased from 24% in
FY 2007 to 28% in FY 2008
o   Private data sources (McDash Analytics) indicate that the FICO
score improvement was increasing throughout FY 2008
§ 17% of borrowers had FICO scores above 680 in the first quarter
compared to an estimated 35% in the fourth quarter
o   While not mentioned in the audit, lender restrictions on FICO
scores (i.e. no FICO scores below 580) certainly contributed
significantly to this improvement.
§ 27% of borrowers had FICO scores below 580 in the first quarter
compared to an estimated 5% in the fourth quarter (McDash)
As long as house price changes are close to what the auditor (and
Global Insight, Inc. its economic forecaster) project, FHA should
remain actuarially sound. In the auditor's base case scenario, home
prices are expected to decline 11% during the FY 2008 - 2010
period. (NAR data indicates that existing house prices have
declined 9% nationally in the third quarter 2008 compared with
2007.)
In its extended housing recession scenario with cumulative house
price depreciation in excess of negative 18 percent (what the
auditors call "near depression levels"), the FHA fund's capital ratio
still remains positive throughout the eight years (2008 - 2015) of
the audit and exceeds the 2% capital ratio in 2013.
On a positive note, the audit also confirms the quality of new FHA
originations is exceeding the auditor's expectations in the FY 2007
audit. This continued improvement in the over-all composition of
FHA's portfolio mitigates concerns about possible widespread
deterioration in the quality of recent originations particularly the
2008 book.
Bottom line: If FHA never insures another loan, as of September 30,
2008, the auditors project the FHA fund would have $12.9 billion
remaining after paying all anticipated claims and expenses.   In
other words, the auditors are saying that FHA would have
$12.9 billion to pay unanticipated expenses.
Background
FHA is required by law (Cranston-Gonzalez National Affordable
Housing Act of 1990) to have an independent actuarial analysis of
the economic net worth and financial soundness of the MMI Fund
prepared every year.   An actuarial review is the auditor's projection
of the financial performance of FHA's existing portfolio as of a
particular date (September 30th) based primarily on the historical
experience of the portfolio and future macroeconomic forecasts
(house price and interest rates).
The MMI Fund is the fund in which FHA's basic FHA's section 203
loans are placed. Hope For Homeowner (HFH) loans are placed in a
special fund that does not affect the solvency of the FHA basic
program. However, FHASecure loans are placed in the MMI Fund.
Fortunately, there have been less than 5,000 delinquent
conventional loans insured through FHASecure.
By law, FHA is also required to maintain a 2% capital ratio.
The capital ratio is calculated as:
Capital ratio = Economic Value (Capital) of the Fund
                              Unamortized Insurance In Force (IIF)
The economic value is defined as 1) cash available to the fund 2)
the net present value of all future cash inflows and outflows
expected to result from the outstanding mortgages in the fund
(as of the end of the fiscal year being analyzed).
Analysis
It is not surprising that FHA's economic value and capital ratio have
dropped significantly in light of the current market conditions. FHA,
like every other insurer, investor and financial institution, is not
immune from the impact of house price declines or job losses.
Ø Impact of Housing Market Decline on FHA Economic Value
The three major sources of the decline in FHA's economic value are:
·         Updated economic forecasts:    $ -4.6 billion
The audit states: "The forecasted lower house price appreciation
rate caused the FY 2008 economic value to drop by $4,608 million."
·         Updated loss severity rate:     $-2.2 billion
The audit states: "During the past year, with the weakest housing
market in recent history, REO properties suffered from further
decreases in market value. As a result, REO not disposed until FY
2008 may realize particularly severe loss rates."
·         Changes Due to Demand Forecast: $-2.1 billion
Because of the "severe housing correction", "the performance of
newer books of business, especially those of FY 2006-2009 are
expected to be much worse than those projected in the FY 2007
Review".   The audit states: "The very weak housing market implies
that many newly originated loans will quickly fall into a negative
equity position, thereby resulting in higher projected claim rates
relative to what were estimated in the FY 2007 Review."
Almost $9 billion of decline in FHA's economic value is tied to the
decline in house prices. Below are other quotes from the audit
emphasizing the impact of current market conditions on the status
of the Fund.
The auditors state:
Ø Page v of Executive Summary: "This (lower house price
depreciation) is the single most significant impact on the FY 2008
economic value."
Ø Page 6: "The change in the view of the future housing market
from last year has a large adverse impact on this year's results."
Ø Page 16: "This decrease (capital ratio) is driven mainly by the
significant deterioration of the national housing market."
Ø Page 56: "The house price appreciation rate is the most
important economic factor influencing mortgage insurance claim
rates."
The cornerstone of the audit's economic forecast is the change in
house prices. Using OFHEO National House Price Index, the audit
forecasts future index levels for the next two years as follows:
Year          House Price Index
FY 2008                 387.5
FY 2009                 346.6
FY 2010                 344.9
The auditors predicated their review on a 10.5% drop in the house
price index in FY 2009 and a less than 1% drop in FY 2010. The
audit estimates that the house price index will not exceed the FY
2008 level until FY 2013 when it reaches 393.3.
Ø Improving Composition of FHA's Portfolio
The audit includes encouraging information about the loan
characteristics of FHA's FY 2008 book of business. Specifically, the
initial loan-to-value (LTV) ratio of FHA loans continued to decline in
FY 2008. It is also encouraging that seller funded downpayment
assistance loans were a smaller share of FHA's 2008 business
(17.56%) than was originally thought. Finally, private data sources
indicate that FHA's average FICO score continued to improve in FY
2008.
The audit states: "Revised projections of the composition of the FY
2008 book of business ... increased the FY 2008 economic value by
$659 million." Stated another way, the composition of the FY 2008
book is better than was anticipated in the FY 2007 audit.   The two
principal reasons for the improved performance are:
·         Initial loan-to- value (LTV) has improved
During FY 2008, the percentage of FHA loans with LTVs ratios at or
above 97% is 39%. The high LTV category has dropped steadily
since 2005 when it was 55%. At the same time, "there is a clear
increase in the concentration in LTVs less than 95 percent." Thirty
four percent of the FY 2008 originations had LTVs below 95%. In
FY 2005, only 20% had LTVs below 95%.
·         Improving borrower credit scores
FHA data as well as private data sources indicate that borrower
credit scores improved in FY 2008.   The importance of credit scores
is underscored by the following statement of the auditors: "The
estimation results confirmed that credit history is among the most
influential factors explaining the claim probability among individual
FHA-insured mortgages..."
McDash Analytics Inc. data indicates that there has been a
significant improvement in the quality of FHA borrowers during FY
2008.    For example, borrowers with credit scores above 680 have
improved from 17% in the first quarter of FY 2008 to 35% in the
fourth quarter of FY 2008. Borrowers with credit scores below 580
were 27% of FHA's business in the first quarter and 5% in the fourth
quarter of FY 2008.
Ø What It All Means
All things considered, FHA's portfolio is in reasonably good shape.
The principal cause for FHA's net worth decline was the deterioration
in house prices. Probably more importantly, it was not caused by an
increase in new loans with higher risk characteristics.
Recent government actions as well as those expected early in the
Obama Administration should have a positive effect on the Fund.
For example, the Fed purchase of GSE and Ginnie Mae securities is
having a positive effect on interest rates. Lowering interest rates
increases prepayment speeds which reduces risk to the FHA portfolio.
On a prospective basis, Federal action that addresses the dual
problems of house price declines and increasing delinquencies and
foreclosures will have a positive financial impact on the FHA fund.

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Education Station
Government Loan Programs

Posted by Raoul Badde on February 10th, 2009 10:23 PMPost a Comment (0)