Earlier this year, Joseph Gyourko of the Wharton School proposed phasing out the Federal Housing Administration on the grounds that it can’t really be fixed:
Eliminating FHA will sound extreme to some, given that the agency has existed for over three-quar- ters of a century. I recommend phasing it out for a variety of reasons beyond the facts that it is broke and has not been able to discipline its risk-underwriting process so that substantially more of the borrowers whose mortgages it insures are successful in becom- ing long-term owners. In particular, I fear that FHA cannot be successfully reformed. One of the impor- tant lessons of the collapses of the giant housing gov- ernment-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac is that the incentives of politicians of both parties, of the senior executives of the GSEs, and of the owner-occupied housing industry to underestimate program costs and loss estimates are very strong and extremely difficult to counterbalance over time. There are strong parallels with FHA.
Perhaps even more important is that any govern- ment policy encouraging homeownership should by design target the current FHA system’s core weak- ness, which is the virtual absence of equity anywhere along its chain of operations. FHA itself is grossly undercapitalized, as indicated by its own leverage ratio of over 40 to 1.That is, it has over $40 of out- standing insurance guarantees for every $1 of what it calls total capital resources available to pay off losses. This represents more than a threefold increase from the 12 to 1 ratio in fiscal year 2007. The borrowers whose mortgages it insures are almost as highly leveraged at about 33 to 1 on average, given that the typical down payment is no more than 3 percent. That this business model describes a financial acci- dent waiting to happen is highlighted by the fact that these leverage ratios are higher than those that were employed by Lehman Brothers and Bear Stearns just before those firms collapsed. To be viable, such a business model requires housing prices to never fall. Housing markets are not always so obliging, leaving taxpayers to pick up the bill.
And so Gyourko calls for replacing the FHA with a subsidized savings program aimed at helping low-income borrowers accumulate a 10 percent down payment, a policy he describes as preferable for a number of reasons:
1. It obviates the need for a large bureaucracy to price a complex mortgage guarantee and manage a foreclosure process. A straightforward savings match would be much cheaper to administer.
2. Focusing on borrowers helps ensure that benefits will flow to the intended beneficiaries rather than realtors and homebuilders.
3. The cost of the savings match would be far more transparent than the cost of a mortgage guarantee, which constantly fluctuates. This transparency will make it much easier for policymakers to weigh costs and benefits.
4. It will tend to increase domestic savings.
5. And it will reward low-income households for building assets rather than for taking risky, highly-leveraged gambles.
It’s not clear that Gyourko’s savings match will save the federal government much money in the near-term, as recent changes to the FHA have reduced its cost:
The cost comparison is less favorable for the new subsidy program given recent changes to FHA. Based on FHA’s new upfront insurance premium of 175 basis points and its higher annual fee of 125 basis points, in their 2012 paper, Caplin and colleagues calculate that FHA will roughly break even if cumulative default rates fall much below 14 percent. That is still less than the default rates on recent books of business according to Caplin and colleagues’ paper, but one can imagine better outcomes for FHA as the housing market improves. If this happens, the subsidy program will not be less expensive, but we will still get a much safer and less leveraged housing market with a lower level of defaults and much better outcomes for tens of thousands of borrowers— and for relatively little added net cost.
It doesn’t seem unreasonable to suggest that while Gyourko’s savings match won’t yield savings in the near-term, it might yield savings over the long-term by shielding low-income households from default and by helping them build assets, which will tend to reduce their reliance on transfers.