Transcript Is FHA the Next Housing Bailout?

Is FHA the Next Housing Bailout?
Joe Gyourko
Martin Bucksbaum Professor of Real Estate, Finance and
Business & Public Policy
The Wharton School
University of Pennsylvania
AEI Presentation
Washington, D.C.
December 9, 2011
1
Is FHA the Next Housing Bailout?
• Yes, in all likelihood
• Why?
– FHA has become much larger and riskier since the housing crisis began
– FHA underestimates default risk and future losses on its single-family
guarantee portfolio by $50 billion or more
– Given its current precarious financial position in which excess reserves
equal only 0.12% of its aggregate outstanding single-family insurancein-force, almost any underestimation of future losses or an adverse
economic shock implies its insurance fund will not be able to cover its
true losses
2
FHA’s Growing Size and Risk
• It has become a major force in the housing market
– Guaranteed 30% of new home purchases in 2010; guaranteed 19% of
all home purchases in 2010
– 2011 figures show declines in share, but FHA clearly remains a very
important player in the housing market
3
FHA’s Growing Size and Risk
• Typical loan being guaranteed has less than a 5% equity down
payment at origination to cushion against price declines
– Fraction of single-family portfolio with <5% down payment (see Table 4 in
paper)
•
•
•
•
•
FY2007:
FY2008:
FY2009:
FY2010:
FY2011:
60.2%
57.7%
60.9%
68.2%
67.2%
– FHA is in the business of insuring greater than 30-to-1 leveraged
investments in housing
• A 3% down payment implies a leverage ratio of 33-to-1 (1/0.03 ~ 33.3)
– Given persistent price declines in recent years, majority of FHA’s existing
portfolio is underwater (i.e., the typical mortgage FHA guarantees is
backed by a home on which there is negative equity; see Table 5 in paper)
4
FHA’s Growing Size and Risk
• Liabilities
– Single-family insurance-in-force has more than tripled since FY2007
from $305 billion to just over $1 trillion in FY2011
• Current liabilities amount to nearly 7% of aggregate annual national output
5
FHA’s Growing Size and Risk
• Total Capital Resources—Liquid Financial Assets
– $28.183 billion at end of FY2011, up slightly from $24.903 billion at
end of FY2007 (for single-family guarantee portfolio; see Table 6 in
paper)
• Over the same period during which potential liabilities increased by $704 billion,
total capital resources increased by barely $3 billion
• Thus, liquid capital increased by $1 for every $235 of additional insurance
guarantees
– FHA has become a much more highly leveraged entity
• Insurance-in-Force per Dollar of Total Capital Resources (see Table 6 in paper)
– FY2007: $12.27
– FY2010: $28.83
– FY2011: $35.81
• Implied leverage at FHA has tripled since FY2007
• Leverage above 30 is considered very high and extremely risky
– That was the level employed by Lehman and Bear Stearns before they failed
6
FHA’s Growing Size and Risk
• Economic Value of the Insurance Fund (single family part)
– ‘Excess reserves’ represent resources available to offset any
unexpected losses (i.e., those not anticipated by the actuarial model)
– Falling over time in absolute amount and as share of insurance-inforce (see Table 6 in paper)
• FY2007: $21.277 billion
• FY2010: $5.160 billion
• FY2011: $1.193 billion
– Capital ratios (2% minimum guideline)
• FY2007: 6.97%
• FY2010: 0.59%
• FY2011: 0.12%
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Item
Estimates of Fund Economic Value as End of FY 2011
($ Millions)
End of FY 2010a
Cash
Investments
Properties and Mortgages
Other Assets and Receivables
Total Assets
Liabilities
Total Capital Resources
Net Gain from Investments
Net Insurance Income in FY 2011
Net Change in Properties and Mortgages
Net Change in Accounts Payable
Transfer to HECM Account
Total Capital Resources
PV of Future Cash Flows on Outstanding Business
Economic Value
End of FY 2011
$26,309
4,128
3,292
12
$33,741
(2,940)
$30,801
1,139b
(2,440)c
(868)b
85b
(535)b
28,183
$5,160d
(26,990)
1,193
Unamortized Insurance-In-Force
926,251d
1,069,354
Amortized Insurance-In-Force
879,875d
1,009,154
a
Source: Audited Financial Statements for FY 2010.
b
c
Estimated based on unaudited investment income provided by FHA.
Estimated based on unaudited net non-HECM operating cash flow through end of July 2011 provided by FHA and projected net
cash flow for the remaining two months
d
From the FY 2010 Actuarial Review.
FHA’s Growing Size and Risk
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FHA’s Growing Size and Risk
• The Critical Role of Future Books of Business
– Value of Future Insurance Going Forward
30
20
10
0
VALUE ($ BILLIONS)
40
50
Value of Future Books of Business Going Forward, FY2005-FY2011
2005
2006
2007
2008
FISCAL YEAR
2009
2010
2011
10
Signs that Future Losses on the Single-Family
Guarantee Portfolio Are Underestimated
• Over-Optimism in the Actuarial Reviews
– Every future annual book of business since FY2005 has been estimated
to be of positive value to the insurance fund
– Contrasts with the predictions of actual losses on existing books in the
last two actuarial reviews
• FY2010: -$25.392 billion
• FY2011: -$26.990 billion
• Extreme downside scenarios do not permanently bankrupt
the insurance fund
• FY2010 review: fund recovers from additional 24% decline in house prices
• Not credible; typical loan being insured has less than 5% equity cushion; price
declines of 500% of that amount should result in huge losses that overwhelm the
fund
11
Underestimation of Future Losses on the
Single-Family Guarantee Portfolio
• Four types of estimation or model errors lead to substantial
underestimation of losses to the insurance fund
– Improper accounting for unobserved credit risk
• Complex issue, but very important; probably worth $30+ billion in value
• Unemployment risk is the biggest factor here
– Unrecognized down payment assistance in the FY2009 and FY2010
pools due to the tax credit program for new home buyers
• Could be worth $10+ billion in added losses, but requires much more research to
pin this down
– Underestimating negative equity in the insurance portfolio
• Via use of an inappropriate price index based on the values of homes bought with
conventional homes
• Precise magnitude is unknown, but impact is likely to be large because negative
equity is known to be a key trigger of default
12
Underestimation of Future Losses on the
Single-Family Guarantee Portfolio
– Misclassifying streamline refinanced mortgages as prepaying with no
future default risk to the insurance fund
• First pointed out by Aragon, et. al. (2010)
Total underestimation of future losses: ~ $50 billion
Any unexpected deterioration in the underlying house price forecasts will increase
future losses above and beyond this figure. FHA anticipates positive price growth
beginning in FY2012, escalating to just above 5.5% appreciation in FY2014, before
settling down to a long-run price growth rate of just below 3.5% by FY2020.
13
Why Doesn’t Increasing Credit Quality in the
Borrower Pool Solve the Problem?
• Credit quality of new borrowers has increased substantially as
measured by FICO scores.
– % with FICO>=720
• July-Sept. 2008: 19.2%
• July-Sept. 2011: 33.1%
– % with FICO<580
• July-Sept. 2008: 6.9%
• July-Sept. 2011: 0.2%
• Why doesn’t this deal with the issues raised in previous slides?
– Because FICO scores are in the model, so loss estimates already are lower
because of this increase in borrower quality.
• Stated differently, those four reasons for underestimation of losses exist independently
of the rise in FICO scores
– In addition, individual FICO scores can and do fall over time for various
reasons (e.g., illness, layoff, divorce), so risk can rise
• Don’t forget that there was a first time for everyone who ever defaulted, so a high initial
FICO score is not a lifetime guarantee of no default
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What To Do?
• Recapitalize now by $50-$100 billion
– Precise amount depends upon financial cushion desired
– Could be varied and teamed with fee changes, etc., to generate cash for
the fund
• Why? It’s not legally required.
– Single-family mortgage insurance portfolio already has negative economic
value if losses estimated properly
– Losses tend to escalate when entities become financially weak and begin
to take on greater risks to try to bail themselves out
• This is why sound regulators like the FDIC mandate capital raises or shut down weak
banks
• Downside risk is economically significant when the total liabilities reach the level they
have at FHA (i.e., 7% of national output); this makes it financially and fiscally imprudent
to run what effectively is a trillion dollar business platform with no financial cushion
15
What To Do?
– The warning signs of higher future losses are evident
• Recent sharp rises in modifications and workouts that temporarily cure defaults; is
this really effective or just ‘kicking the can down the road’?
• Increased reliance on future growth to generate sufficient fees to cover losses;
‘even though the past was dark, the future will be bright’
• Don’t think this represents an immediate liquidity risk event (i.e., that losses this
year would escalate above the $28 billion in total capital resources available), but I
could be wrong and such a problem certainly could develop over 2-3+ years
– Last, but not least, we need accurate measurement of costs to
compare to benefits for proper evaluation of the program
• Otherwise, the program will become too large and too risky if we keep pretending
the costs are very low (and never will be high)
16