The FHA's reserve fund could be a black hole for U.S. taxpayers

As mortgages continue to sour, the Federal Housing Administration's reserve fund continues to deteriorate. That's not a big surprise. What might be a surprise is the fact that the FHA can get bailout money from the U.S. Treasury without seeking approval from Congress.

An automatic FHA bailout is part of the 1990 law under which the FHA turns over to the Treasury any excess money the agency collects in insurance premiums after it pays out its losses. This excess money goes into an FHA emergency reserve fund. Whenever the FHA needs money, it can draw from the reserve fund. The surprising thing is that there is no limit on the amount that can be withdrawn from the the reserve fund. All FHA loans are backed by the full faith and credit of the government, so if the FHA needs more than the amount of funds in the emergency reserve, it gets it, without the need for Congressional approval.
When the economy was doing well, the FHA built up these emergency reserves. But with the FHA having to back 24% of its loans in default in 2007 and 20% in 2008, the reserve keeps tumbling. Now an audit, which was delayed, is expected to show that the excess money will fall below the legally required 2% of FHA's outstanding loans.

FHA's big problems stem from the housing boom, when private lenders offered more popular products like no- and low-downpayment loans. Only the riskiest borrowers who could not get money from private lenders turned to the FHA. In response, the FHA loosened its lending rules to make new loans. These riskier borrowers are now defaulting on the loans.

The first major draw from emergency reserves happened in 2004, when $7 billion in reserves were transferred back to the FHA from the Treasury to cover losses on loans from 1992 to 2003. In fiscal 2009, the FHA transferred $10.3 billion and by June 30 the emergency fund was at its lowest level in about ten years.

The agency abruptly canceled the release of its audit report a week ago, citing problems with the risk scenarios, according to The Washington Post. Those problems stem from the fact that the independent auditors determined that the risks to the agency were higher than FHA Commissioner David H. Stevens has admitted to publicly. What's being questioned now is whether or not the FHA can rebuild its cash reserves without a bailout from the government.

The FHA's cash reserves are built with the insurance premiums home buyers pay when they close on an FHA loan. Many pay additional monthly premiums as well, depending upon how much they put down on the home.

The FHA essentially has two options to raise cash: 1) a government bailout, or 2) an increase in the insurance premiums borrowers must pay. Stevens, so far, has said he doesn't intend to use either option. Instead, he thinks he can beef up reserves using other tactics:

• He plans to propose that banks and other lenders that do business with the FHA have at least $1 million in capital so they can repay the agency for losses if they were involved in fraud. Currently they only need to have $250,000 in capital.

• He plans to propose that lenders take responsibility for any losses due to fraud committed by mortgage brokers with whom they work.

• He plans to hire a chief risk officer. The FHA has never had a risk officer in its 75-year history.

Even if he does none of these things, an earlier internal audit showed that the agency's reserves will rebound in two or three years, so there may be no need for a government bailout. The internal audit used projections based on future home prices, interest rates and the volume and credit quality of the FHA's business.

The delay in releasing the external audit, done by Integrated Financial Engineering of Rockville, Md., was likely because it showed that internal audits were too optimistic. According to an article in The Washington Post, the outside auditor is running additional scenarios to test the accuracy of its final report. These additional tests would not have been requested unless the new report had concluded that the FHA faced greater risks to its solvency than previously reported.

Congress would need to change the 1990 law in order to stop a potentially continuous drain on the Treasury. Would it even consider doing that during this housing crisis? Right now the FHA funds more than 20% of all mortgages. Private mortgage money has pretty much left the marketplace. If Congress were to pull the plug on FHA loans, the tight mortgage market would get even tighter. So a major change in the agency's financing is unlikely at this time.

Lita Epstein has written more than 25 books including The 250 Questions Everyone Should Ask About Buying Foreclosures.

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