In its most recent annual report to Congress, November 2020, the Federal Housing Administration (FHA) published its “capital ratio,” a measure of capital reserves to insurance-in-force held within the Mutual Mortgage Insurance Fund (MMI Fund). The figure, standing at 6.1%, was the highest capital ratio reported since 2007 and the sixth consecutive year above the 2% minimum mandated by Congress.
The same report revealed FHA had amassed capital reserves in the amount of $78.9 billion — possibly the highest ever recorded and just $15.6 billion below the amount FHA analysts believe would be needed to maintain the ability to pay mortgage insurance claims in the wake of an adverse credit event similar to the 2008 financial crisis.
In light of the improved capital position of the MMI Fund, mortgage industry trade groups and other stakeholders abruptly called upon FHA to reduce its mortgage insurance premiums (MIPs) which are paid by borrowers to insure the credit risk of both single family forward and reverse mortgages.
The timing of a premium cut, however, in the current environment is in our opinion premature and HUD Secretary Fudge made the correct decision with the March 30 announcement: “we have no near-term plans to change FHA’s mortgage insurance premium pricing.”
While the position of the Fund has strengthened in recent years and continues to do so largely as the result of a robust housing market driven by low inventory, low interest rates, and solid home-price appreciation, there are many reasons to proceed cautiously and to continue to prepare for the unexpected.
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The fiscal year 2020 Annual Report highlighted several data points that are cause for concern: FHA continues to deal with more than 1 million borrowers in mortgage forbearance related to COVID-19, with over 10% of those in forbearance now for a year.
At the end of FY2020, serious delinquencies in the forward book (greater than 90 days past due) were $158 billion, an increase of $117 billion from FY2019. This is a historical high, even surpassing the previous high of $105 billion in FY2012.
How many of these loans ultimately cure is uncertain and will depend on how many are able to resume making mortgage payments or proceed toward other available loss mitigation options including use of a partial claim. As such, the total cost to FHA is unknown at this time and might not be clear for a few years.
By way of example, seller-funded down payment loans prevalent in the early 2000s had a $16.5 billion negative impact on the FHA fund in fiscal year 2016 despite the program’s termination in September 2008, according to an independent actuarial review.
High-risk attributes of loans held in the Forward portfolio, moreover, have been on the rise for years. In fact, the presence of loans with two or more higher credit risk indicators, referred to as risk layering, has been increasing since 2014. Early performance of loans with such risk layering is approximately three times worse than mortgages without it, and as we might expect, the percentage of loans with early payment defaults has gotten significantly worse for mortgages in those recent origination years. The projected lifetime claim rates for recent originations are at the highest level since 2009.
While it is tempting to consider cutting premiums at a time when many in our country are struggling economically, it’s vitally important to understand the sensitivity of the MMI fund to macroeconomic outcomes and the assumptions built into the forecasting models that have been proven to change dramatically, most notably, home price appreciation.
The MMI Fund calculations are such that a modest 1% reduction in home price appreciation lowers the FHA reserves by 1.30 percentage points ($16.9 billion). To illustrate the speed at which underlying assumptions can change, consider the period just before and after the “Great Recession,” when the MMI Fund’s capital ratio stood at 7% in FY2007.
By 2008, the capital ratio had dropped to 3.2%, and, by 2012, it had cratered into negative territory, -1.4%, requiring a $1.7 billion draw on the U.S. Treasury in 2013.
Applying a stress test to the FY2020 portfolio similar to the conditions produced by the Great Recession would, in fact, erase current MMI Fund capital entirely, resulting in a -0.63% capital ratio.
Managing the capital position of the MMI Fund requires a discipline that is much more than achieving or exceeding a minimum capital ratio at a point in time.
Prudent capital management requires that FHA protect the MMI Fund and the American taxpayer from future economic shocks and establish realistic capital reserve benchmarks. Recent history has proven this to be well above the 2% mandated by Congress.
The impact of seemingly small MIP reductions should be understood. Assuming FHA insures 1 million new mortgages a year, the average in recent years, a MIP reduction of 25 basis points (or 1/4th of 1%) would shrink annual revenue by approximately $500 million in the first renewal year alone and trigger a re-calculation of future, reduced revenues.
FHA must also consider the macroeconomic environment in which it is operating, as well as the dynamic market effects of MIP structure on the Fund. In the current environment, a premium reduction, for example, is likely to trigger a round of refinances, further reducing revenues, a key component of the FHAs claims paying capacity, across the broader portfolio during a time of stress.
Taking actions that facilitate increased portfolio prepayments when the ultimate outcome of borrowers in COVID-19 forbearance is unknown might have the effect of a “one-two punch” when those lower premium rate refinances erode FHA’s capital foundation even further.
While any savings for FHA borrowers is welcome, it’s important to note that FHA’s current MIP structure already offers borrowers lower credit costs relative to the GSEs, primarily Fannie Mae and Freddie Mac. The GSEs and FHA function differently in terms of providing mortgage liquidity, but you can make a general comparison between them as to ultimate costs to the borrower.
Over the life of the loan, FHA mortgage insurance provides coverage similar to that of credit-enhancing private mortgage insurance and GSE guarantee fee, only at less cost. A typical FHA borrower with a 665 credit score would save more than $10,000 in credit fees over the first seven years of mortgage life compared to the same loan guaranteed by private mortgage insurance and a GSE.
FHA, a government agency, is largely self-sufficient. It has a fervent obligation to manage the Fund on behalf of the American people in a manner that supports its mission, which is especially to assist low- to moderate-income (LMI), minority, and first-time homebuyers, and seniors.
Additionally, FHA plays an important role within the larger housing finance ecosystem, with the need to both pay claims and possess greater capacity if and when the private market is unable or unwilling to lend without FHA’s support. That is particularly important to how LMI borrowers and seniors fare during tough economic times.
The fact is the MMI Fund is capitalized by borrower-paid MIPs and investments in U.S. Treasuries. The FHA must pay claims and other expenses including property preservation fees from that same fund. In its 87-year history, FHA has needed to draw upon its authority with Treasury just once, which should be a point of pride and motivation for those entrusted with its stewardship. It is not in the interest of the program, homebuyers, the housing market, or the economy to have a repeat of that occurrence, nor should the government facilitate shifting market share away from private capital. Policies should not be adopted that put the Fund into that position.
The housing market thankfully appears to have rolled into 2021 strong, and is expected to remain so, however unexpected that may have been in 2020 during the early days of the pandemic.
Because of its unique mission to serve LMI borrowers, however, it is reasonable for the FHA to expect significant future losses to the MMI Fund due to the current pandemic crisis and heightened concern should home price appreciation stall or reverse course.
The ongoing global pandemic, extended unemployment, and volatile house prices present the potential for material stress on the MMI Fund, especially through the point in time the current forbearance flexibilities are unwound and beyond. In an over-stressed market, combining these risk variables creates a potentially adverse scenario for FHA.
Until the impact of these and other macroeconomic stress conditions are better known, MIP should not be reduced as it could result in future exposure to the taxpayer should the capital ratio not be sufficient to absorb the impacts. The HUD Secretary made the proper decision.
This column does not necessarily reflect the opinion of HousingWire’s editorial department and its owners.
To contact the authors of this story:
Brian Montgomery at Bdmonty1@gmail.com
To contact the editor responsible for this story:
Sarah Wheeler at swheeler@housingwire.com
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