The FHA and the Role of Government When Markets Fail

February 13th, 2013 at 11:31 pm

Well, well…once again we’re arguing about the role of government.

As he did in his second inaugural address, President Obama’s SOTU address reminded listeners that he twice ran and won on a role for government that goes well beyond that articulated by Gov Romney in the campaign or Sen Rubio in his SOTU rebuttal.

One of the most important fault lines in these debates is government action to correct a failure or serious inefficiency in the market.  If you fail to see such failures, or misdiagnose them—Rubio absurdly blamed the housing bubble and bust on government lending—you risk exacerbating the problem and causing a lot of people a lot of economic pain.

Let me be much more concrete here by talking about the case of the Federal Housing Administration, or FHA.  When the housing bubble burst in late 2007, the private system of housing finance collapsed.  Once gravity reasserted itself and home prices fell by more than half in some of the hardest hit states, banks were stuck holding loans worth cents on the dollar, if that.  They did what they always do in such situations:  they deeply retrenched, flipping from vastly under-pricing risk to becoming hugely averse to taking on any credit risk at all.

The private housing finance market essentially shut down, meaning no liquidity (the once robust—and reckless—market for mortgage backed securities disappeared overnight), no home loans, no refis, and no way forward.  Until, that is, a few government agencies, including the FHA, stepped into the breach.

The FHA’s been around since 1934, not lending directly to homeowners but insuring private mortgages on behalf of less advantaged borrowers—over 30 million since its inception.  It’s always paid for its operations with fees from borrowers and never in its history has it needed any assistance from general government revenues.  That’s because even though it insures the mortgages of lower-income buyers, it’s always had high lending standards.  And contrary to the Republican myth, it held to those standards during the boom, even though that move cost it market share, as private lenders went deep into subprime lending, pushing no-docs and low-docs and other toxicities.

But when the crash hit, the FHA took on more risk than they ever have before, vastly increased their market share, and that led to some real losses.  As recently reported by the WSJ, the FHA may soon “exhaust its reserves and need $16 billion from the US government to cover projected losses.”

And this has brought out predictable attacks, like by Rep Jeb Hensarling ripping into the FHA and claiming that the agency is “morphing into Countrywide” and accusing it of straying “far from its original mission.”

Not so.  In fact, and to the contrary, it was by holding to its mission in the worst housing crash since its inception that the FHA incurred these losses.  As Dave Stevens, former FHA director and now CEO of the Mortgage Bankers Association pointed out, the losses the agency is now facing “are attributable to the critical function it played when the market turned and many private lenders refused to lend. Without FHA to step in, the housing crisis would have been measurably worse.”

In fact, Moody’s Analytics estimates that absent the FHA’s actions, home prices would have fallen another 25% nationally.

And now that the housing market is starting to come back to life—that’s “starting,” as in it’s got a long way back to healthy conditions—the FHA is doing exactly what it should be doing:  getting back to pre-crisis levels of lending standards and market share.

The figure below tells the story quite effectively.  It’s the shares of purchased mortgages utilizing mortgage insurance backed by “primary [or private] mortgage insurance” vs. FHA insurance (the VA also provides mortgage insurance for vets).  You clearly see the private insurance function crashing and the FHA stepping up.  Moreover, you see the FHA already unwinding, as it should be, as the PMI comes back up.

Source: FHA


In addition, as the next figure shows, courtesy of the WSJ, each year that we move further from the crisis, the quality of FHA issuances improves.


Source: WSJ


Former White House housing finance expert Jim Parrott is one of the clearest thinkers I know on these issues, and here’s the way he put it:

As with the GSEs, the FHA’s current market size is not too big because they are lending to people they shouldn’t be lending to, but because the private market is not yet comfortable taking on the credit risk of borrowers who traditionally would have gone to them instead of the FHA. The size of FHA is not a sign of an unhealthy FHA, but of a market that just hasn’t fully recovered.

That’s the key:  to recognize the market dynamics.  To accurately diagnose, as best you can—this is economics, not physics—when the market’s failing and when it’s recovering.  When Keynesian stimulus is needed and when it’s not.  When the safety net needs to ratchet up and when it should fall back.  When staid government housing agencies that have quietly and effectively provided secondary insurance for decades need to get their risk on and when they should get their risk off.

To be fair, it’s of course the case that it’s not just markets that fail but government too.  One reason the FHA is currently over-extended is because Congress nudged them towards a policy called seller-financed down payment assistance, a scheme by which sellers cover the down payment on the home loan, meaning borrowers could get an FHA-backed loan with zero skin in the game, a recipe for highly risky lending.  To their credit, FHA never liked the idea, but Congress resisted ending the program until late 2008.  Were it not for seller-financed down payments, the FHA’s books would be in much better shape (in fact, the losses from that program alone are close to the shortfall noted above).

So you have to pay attention to all these dynamics, to market failure and political overreach.  Of course, if your ideology precludes their recognition, you won’t know what to do when you hit the downturn and a lot of people will suffer for your ignorance.  One interpretation of the President’s two victories is that the majority of the electorate would like to avoid that unnecessary suffering.  I’m with them.

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3 comments in reply to "The FHA and the Role of Government When Markets Fail"

  1. readerOfTeaLeaves says:

    To put in another (background) layer, which has been brilliantly documented by Sen. Elizabeth Warren, in the background of these housing problems were underlying, quiet changes to the usury and banking laws. These changes occurred in the 80s and 90s, while the GOP controlled Congress and had great sway over federal judicial appointments that interpret legislation related to usury and banking.

    By the early 2000s, the economic pressures for housing – in part because it represented access to good schools (and consequent social mobility) – were almost unprecedented. And many families were loaded with debt at usurious rates that had *not* been permitted in the 30s, 40s, 50s, or 60s because we still had usury laws back then.

    But changes to the banking and usury laws preceded the 2000s, and by 2008 ‘finance’ had become about 40% of America’s GDP.

    I’m not defending FHA (which is beyond my knowledge base). Nevertheless, GOP political expediency in smearing federal agencies, without admitting their own culpability in making changes to usury and banking laws that affected economic security for millions of Americans, is a sign of intellectual cowardice. Is the GOP actually incapable of recognizing the linkages between the fact that suddenly banks could change 16+% interest on credit cards, and the fact that ‘finance’ morphed out of proportion to the rest of the economy…?

    Those GOP members — as well as Dems — would be more prudent to examine precisely how ‘finance’ morphed into 40% of America’s GDP by 2008.

    IMVHO, no nation should have 40% of its GDP going to finance; it’s an indictment of our debased American politics that finance has such an outsized an role. Any nation with a finance ratio that high is spending too many resources on smoke, mirrors, interest, and lending fees. Very little of that is economically productive, and it bloats the GDP stats.

    By the early 2000s, debt was about the most profitable sector in America. As near as I can tell, that remains the case, and it’s that underlying issue of a bloated finance sector that the GOP appears to be incapable of examining in any rigorous fashion.

    IMVHO no one has provided a more clear-eyed view of this underlying, deeper problem than Sen. Elizabeth Warren. (And the almost palpable fear that Wall Street and megabanks seem to have for her is quite the ‘tell’ that her analysis reveals their financial tricks as *economically* illegitimate.)

    If the GOP wants to try and score points against the FHA, so be it. They make themselves increasingly irrelevant by failing to grapple with the deeper economic problems, starting with a bloated financial sector, and the role of debt in American life.

  2. R. Nemo says:

    Republicans cant see reality for the ideological lense they look thru. The market is a subset of the state. The state a subset of nature. The PS is not some sacred independent thing. The problem in America is that government has too little control over the market place. This is an historical choice. A bad choice in my view–one that is no longer viable. Things have been allowed to become too volatile for people to have decent lives. Less glitz and more stability would be a good thing. Capitalism is the most wasteful system on earth. Most of what it produces is junk. I could go on for an entire book!

  3. perplexed says:

    Maybe its time to discuss the role that economists have played in the obfuscation of the real story that allows for so many different false memes to be constructed, gain traction and be so difficult to refute. By characterizing the mortgage crisis as a “bubble” or “market failure” or “liquidity crisis” economists provide cover for the criminal and financial fraud that were the “foundation” of the crisis. Economists love to talk about “counterfactuals.” Why are we not not discussing the following counterfactual: if underwriting standards had been adhered to, what would that have done to limit the size of the housing “bubble” and prevent the financial crisis? Did the market for mortgages “fail” or did it just respond to the new information that prior pricing was based on a different “commodity” than what was actually being sold and delivered, and that nobody knew how may or where exactly these defective counterfeits were and who ultimately owned them?

    While derivatives, bank leverage, CDO’s, MBSS’s, and more complex instruments provided ample distractions and certainly exacerbated the crisis, the real crime of fraudulent concealment goes un-prosecuted and the real victims go unaided and continue to be victimized. While its much easier to blame esoteric financial instruments and “government polices,” we continue to ignore the simple explanation that a fraudulent, counterfeit, impostor of the “product” was substituted for the “product” being traded. When the camouflage is cleared away, it is readily apparent that this is no different than substituting “fools gold” for actual gold. While we go to great lengths to develop alternative explanations, the reality is that what we are dealing with is a counterfeiting fraud that is fundamentally no different than what occurs commonly in many industries. Consider the following excerpt from the introduction to the Department of Energy SCI Training manual

    “What does the fashion clothing, shoes and accessories industry have in common with the music and movie industries, the antique furniture industry, the computer software industry, the cat food industry, the auto industry, the aircraft industry, the medical industry and the Department of Energy? All of these entities are plagued by counterfeit products. The purchase of one of the 40 million bogus Swiss made watches sold each year around the world or counterfeited music or movies is one thing, but what about the manufacture and sale of counterfeited cat food, drugs, automobile brakes, airplane parts or components and parts used in a nuclear safety system. When it comes to counterfeit goods, including industrial materials, items, and equipment, no market is immune. Manufacturers of counterfeits violate patents and copyrights, both forms of intellectual property law. The effect of globalization has been that, if anything under the sun can be patented, then anything under the sun can be knocked off at a profit. Knockoff parts are a growing concern in industry: they are inferior in design and reliability. Knockoffs are similar to counterfeit parts, but evade the patent and trademark laws by avoiding actual manufacturer / brand names. Knockoffs are reverse-engineered to look like the OEM products; often labeled/marked with OEM part numbers, and the packaging is almost identical to the OEM design. For the purposes of the training, knockoffs will be categorized as suspect/counterfeit items.
    When counterfeit parts are used there is no traceability of quality or integrity and when a part fails there is no warranty to back it up no liability is incurred. More importantly, counterfeit parts in a system can injure or kill when components and systems fail as a result of the use of counterfeit materials. The worst confirmed accident in the air from counterfeit parts occurred in 1989 on a Convair 580 turboprop charter plane carrying 55 people from Oslo, Norway to Hamburg, Germany. At 22,000 feet over the North Sea, the tail section of the craft began vibrating violently and tore loose. The plane splattered over 3 miles of sea. Everyone aboard died. Norwegian investigators painstakingly dredged up 90 percent of the 36-year old plane and found the cause: bogus bolts, bushings and brackets. The charter company Partnair, went out of business, and the origin of the parts was never determined. (Lubbock Avalanche Journal 1996) The Federal Aviation Administration estimates that 2 percent of the 26 million airplane parts installed each year are counterfeit, which equals approximately 520,000 parts. The June 10, 1996 cover story in Business Week found that bogus airplane parts played a role in at least 166
    U.S. based incidents and malfunctions involving small aircraft during a 20-year period, 1973-1993.”

    Counterfeiting has brought down airliners, sunk ships, and destroyed structures. It has now sent our economy into a tailspin from which we still struggle to recover. It has thoroughly exposed the inadequacy of protections and vulnerabilities to inadequate regulations. But trying to characterize this as something other than the fraud it was creates all kinds of space for alternative, inadequate explanations.