Prepared for the Millennial Housing Commission
FHA Single Family Risksharing
Paper Prepared for the Millennial Housing Commission
Final – June 2002
By
Sarah Rosen Wartell
Consultant
June 2002
Final
Prepared for the Millennial Housing Commission
© Sarah Rosen Wartell for the Millennial Housing Commission
FHA Single Family Risksharing
Paper Prepared for the Millennial Housing Commission
Final – June 2002
Table of Contents
TABLE OF CONTENTS……………………………………………………………………………i
LIST OF ABBREVIATIONS……………………………………………………………………….ii
ABOUT THE AUTHOR……………………………………………………………………………iii
ACKNOWLEDGEMENTS…………………………………………………………………………iv
I. EXECUTIVE SUMMARY ………………………………………………………………...1
II. FHA’S VALUABLE ROLE IN EXPANDING HOMEOWNERSHIP…………………….11
III. CHALLENGES FACING FHA TODAY…………………………………………………..16
A. Growing Risk with Limited Risk Management Capacity…………………………..16
1. Changing Conventional Market Affects FHA’s Portfolio………………….17
2. Evidence of Mounting Risk…………………………………………………20
3. Actuarial Analysis May Be Misleading…………………………………….26
a) Actuarial Review Suggests a Strong Fund………………………….26
b) Certain Changes in Portfolio Not Taken into Account……………..29
4. FHA’s Analytical Tools are Limited in Comparison to Convention
Counterparts………………………………………………………………..31
a) Initial Underwriting………………………………………………...31
b) Portfolio Monitoring………………………………………………..34
c) Servicing……………………………………………………………37
5. Premium Reductions Raise Questions about Whether FHA
Adequately Prices for Risk…………………………………………………38
B. Operational Weaknesses……………………………………………………………39
C. Summary of Challenges ……………………………………………………………42
IV. UNMET ELEMENTS OF FHA’S MISSION: AFFORDABLE AND
SUBPRIME LENDING ……………………………………………………………………43
A. FHA Not Serving the Needs of Affordable Lenders ……………………………….43
1. More and More Players in Affordable Lending ……………………………44
2. Barriers to Using FHA for Affordable Lending ……………………………45
a) Specialized Expertise ………………………………………….……45
b) Cost of FHA Lending ………………………………………………46
c) Inflexibility …………………………………………………………46
d) Discomfort with Level of Credit Risk ………………………….…..46
e) Underwriting Rigidity ………………………………………….…..47
3. Alternative Secondary Market Strategies Used by Affordable Lenders .…..47
a) Large, National Lender ……………………………………………..47
b) State Housing Finance Agency Insurance Fund ……………………48
c) Small, Regional Non-Profit Lender ………………………………...49
B. Subprime Market Problems Go Unaddressed by FHA ……………………………..51
1. The Subprime Market ………………………………………………………51
2. FHA’s Current Role in the Subprime Market ………………………………53
3. Problems in the Subprime Market …………………………………………54
4. Potential for FHA Leadership Role in Subprime Market…………………..58
C. Summary of Unmet Mission ……………………………………………………….60
V. RISKSHARING: COULD IT HELP FHA ADDRESS CHALLENGES
AND SERVE UNMET NEEDS? ………………………………………………………….61
A. From Retail to Wholesale ………………………………………………………….62
B. What is Risksharing? ………………………………………………………………63
1. The Formula for Sharing Losses …………………………………………..63
2. The Formula for Sharing Premiums………………………………………..65
3. Structure of the Risksharing Arrangement ………………………………..66
4. The Assignment of Duties …………………………………………………68 C. The Partner’s Higher Cost of Capital: Lessons from Single-
Family Note Sales …………………………………………………………………69
VI. THE DANGERS OF RISKSHARING ……………………………………………………71
A. Undermining FHA’s Ability to Serve its Public Mission ………………………….71
B. Improperly Aligning Incentives ……………………………………………………72
C. Missing the Target Market …………………………………………………………73
D. Mispricing the Insurance …………………………………………………………..75
E. Picking the Wrong Partners for the Job ……………………………………………76
F. Counterparty Risk ………………………………………………………………….76
G. Inequality of Information and Bargaining Power ………………………………….77
H. Political Factors Shaping Risksharing Agreements ………………………………..77
I. Lessons from Earlier Single Family Risksharing Efforts ………………………….78
J. Summary of Risksharing Dangers …………………………………………………79
VII. A POSSIBLE RISKSHARING STRATEGY ……………………………………………..80
A. General Principles for Risksharing …………………………………………………80
1. Incrementalism ……………………………………………………………..80
2. Experimentation ……………………………………………………………80
3. Broad Goals, Performance Measures, and Programmatic Flexibility ……..80
4. Improve FHA Internal Analytic Capacity …………………………………81
5. Enhancing FHA’s Bargaining Power Through Competition ………………81
B. Guidelines for Specific Risksharing Programs …………………………………….82
1. Gave FHA and its Partner Clearly Identified the Target Market? …………82
2. Does FHA Clearly Understand the Implications for its Existing
Lines of Business and the Conventional Market? ………………………….82
3. Does FHA Have a Reasonable Basis for Performance Expectations? ……..83
4. Have FHA and its Partner Clearly Defined a Secondary Market
Strategy? ………………………………………………………..………….83
5. Has FHA Carefully Aligned Incentives? …………………………………..84
6. Has FHA Built-in Incentives to Encourage its Partner to Achieve
Public Purposes? ……………………………………………………………85
7. Does the Agreement Match Delegated Authorities to the Partner’s
Capacities? ……………………………………………………………….85
8. Is the Product Priced Appropriately? …………………………………….85
9. Does the Agreement Require the Partner to Maintain Separately
Auditable Books? ………………………………………………………..86
10. Does FHA Have a Plan for Managing Counterparty Risk? ……………..86
C. Summary of Risksharing Strategy ……………………………………………….86
VIII. SAMPLE RISKSHARING MODELS …………………………………………………..88
A. An Example of FHA-MI Risksharing: Bringing Risk Management and
Operational Efficiencies to FHA …………………………………………………88
B. An Example of FHA-HFA Risksharing: FHA as Reinsurer Helping Expand
Affordable Lending ………………………………………………………………90
C. An Example of FHA-Non-Profit Intermediary Risksharing: Expanding
Delivery Systems and Innovating Products………………………………………92
D. An Example of FHA-GSE Risksharing: A Potential Way to Rationalize
Subprime Lending ……………………………………………………………….93
E. Summary …………………………………………………………………………96
IX. STATUTORY AUTHORITY FOR RISKSHARING …………………………………..97
A. Current Statutory Authority for Risksharing …………………………………….97
1. Section 244 (Coinsurance) ……………………………………………….97
2. Section 249 (Reinsurance Contracts/Risksharing Demonstration) ………98
B. Alternative Formulation of Risksharing Authority ………………………………100
APPENDIX A: BACKGROUND ON FHA WEAKNESSES …………………………………..103
1. Systems and Technology …………………………………………………………103
2. Exposure to Agency Risk …………………………………………………………104
3. Early Warning and Loss Mitigation Capacity …………………………………….105
4. Management and Disposition of Real-Estate Owned (REO) ……………………..106
5. Reorganization and Streamlining Exacerbate Problems ………………………….108
List of Abbreviations
AU Automated Underwriting
AUS Automated Underwriting Systems
CDFI Community Development Financial Institution
FHA Federal Housing Administration
FY Fiscal Year
GAO U.S. General Accounting Office
GEMICO GE Mortgage Insurance
GSEs Government-Sponsored Enterprises (Fannie Mae and Freddie Mac)
HFAs Housing Finance Agencies
HUD United States Department of Housing and Urban Development
LMI Low- and Moderate-Income
LTV Loan-to-Value Ratio
MGIC Mortgage Guaranty Insurance Corporation
MI(s) Private Mortgage Insurance or Insurer(s)
MIF Massachusetts Insurance Fund
MMI Fund FHA’s Mutual Mortgage Insurance Fund
MRB Mortgage Revenue Bond
NAHA Cranston-Gonzalez National Affordable Housing Act of 1990
NHEMA The National Home Equity Mortgage Association
OMB U.S. Office of Management and Budget, Executive Office of the President
PMI PMI Mortgage Insurance Company
REO Real Estate-Owned (used to refer to property disposition activities)
SHCA Self-Help Community Advantage Partnership Program
ABOUT THE AUTHOR
Sarah Rosen Wartell held a number of positions at FHA from 1993 through 1998: Special Assistant to the FHA Commissioner, Deputy Assistant Secretary for Operations, and Associate General Deputy Assistant Secretary for Housing. In these roles, she focused on legislative, budget, management, and consumer regulatory issues, with a special emphasis on single family housing finance policy. Prior to working at HUD, she practiced law from 1989 through 1993 with the Washington, D.C. firm of Arnold & Porter. From 1998 through 2000, she held a number of posts at the White House’s National Economic Council (NEC), including Deputy Assistant to the President for Economic Policy and Deputy Director of the NEC. She is currently a Visiting Scholar at Georgetown University Law Center.
Acknowledgements
The author would like to thank the following people:
· Millennial Housing Commission Executive Director, Conrad Egan, and Research Director, Eric Belsky, for their interest in my views on FHA and their patience;
· Michael Collins for collegiality, sharing his remarkable knowledge of the single family housing market and other insights, and valuable research assistance;
· Thalia Brown for her excellent statistical and other research assistance and mastery of charts and graphs;
· Brian Bieluch and Edeanna Johnson for professionalism and excellent support in the preparation of this report;
· Judith May, Jim Beavers, John Daly, George Anderson and other HUD employees who shared information and their valuable time;
· Harold Bunce, Deputy Assistant Secretary for Economic Affairs, HUD, for his responsiveness, courtesy, and decades of invaluable economic research and analysis, helping policymakers to understand the implications of their decisions on the people served by HUD and FHA;
· Joe McCloskey, Director of Single Family Asset Management, FHA, who demonstrates that public servants do seek excellence and have the desire and capacity to embrace change; and
· Nic Retsinas, for giving me the extraordinary opportunity to work with him and think about the future of FHA.
3
FHA Single Family Risksharing
Paper Prepared for the Millennial Housing Commission
Final – June 2002
I. EXECUTIVE SUMMARY
Since 1934, the Federal Housing Administration (FHA) has played an essential role in expanding homeownership opportunities for Americans. FHA has allowed lenders to make loans to millions of borrowers who would not qualify for conventional loans. FHA demonstrated the potential of the long-term, fixed-rate mortgage in the 1930s and the home equity conversion mortgage (or reverse mortgage) in the last decade. FHA helped to stabilize regional mortgage markets when private mortgage insurers (“MIs”) withdrew in the mid-1980s. In short, FHA has pioneered new mortgage products, stabilized housing markets, and served borrowers whom the private sector would not or could not serve.[1]
FHA’s role continues to be important today, as detailed in Section II. It is true that the conventional market is doing a better job of offering credit to those with little to put toward a down payment, and a growing subprime market is making more credit available for credit-impaired borrowers. Nonetheless, FHA provides mortgage insurance for hundreds of thousands of purchase money mortgages each year and plays an essential role in providing access to homeownership for first-time homebuyers, African-American and Hispanic borrowers, and residents of underserved areas.
Despite FHA’s continued importance, FHA’s future is a source of concern. A growing number of observers worry about whether FHA will remain a viable tool for meeting the public interest in expanding homeownership.
Section III details some of the significant challenges that FHA faces. FHA operates in a rapidly changing mortgage market where private actors selectively serve portions of the market that they once left to FHA. As a result, the risk that FHA bears may be growing in ways that FHA does not have the systems capacity and analytical tools to measure well. In particular, the actuarial review – the principal tool used by policymakers for assessing the health of the FHA portfolio – may not capture changing loan characteristics that are increasing the risk in the FHA Fund. The issue is not the fact that FHA is insuring riskier loans. That is its mission. Moreover, we should applaud the private sector for serving more low-risk borrowers with affordable lending products. The issue is whether FHA has the tools and the capacity to manage the resulting risk in its portfolio. FHA also faces extraordinary operational challenges. While it has made notable progress in many areas, the gap between FHA and its private sector counterparts continues to grow, as the state of the art for credit insurance operations and risk management improves faster than FHA can advance.
Section IV discusses how, weakened in these ways, FHA is unable to fulfill its mission by responding to emerging needs in affordable and subprime lending. For example, some community-based and portfolio lenders – who are working to provide mortgage credit in underserved areas -- complain of FHA’s inflexibility and bureaucracy. While they need credit enhancement and access to the secondary market, they have turned to more expensive ways to achieve their goals, finding those routes preferable to the limitations of the FHA program. While traditional mortgage bankers continue to originate FHA loans, FHA has not played a significant role in the efforts of the new players in affordable lending over the last decade.
Similarly, FHA is not a resource that anyone mentions in efforts to address problems in subprime lending. The growth of the subprime market has expanded access to credit, but it also has brought expensive borrowing to some consumers who might qualify for less expensive loans. Subprime borrowers include a disproportionate share of lower income and minority borrowers and too many vulnerable elderly, who are too often the victim of predatory practices. Policymakers search for appropriate tools to bring more competition, transparency, responsible practices, and rational underwriting to the troubled parts of the subprime market. A major player of FHA’s size might help pioneer in these areas, but today FHA is playing only an inadvertent role.
Despite these weaknesses and unmet challenges, it is possible that FHA will continue to play an important role in expanding homeownership far into the future. It is also possible that these daunting challenges and a declining perception of FHA's relevance will cripple the agency. In the course of preparing this paper, the author spoke with housing finance experts in state and federal government, non-profit and for-profit firms, lending, credit enhancement, and the secondary market. “Off the record” many of these experts predict a dire future for FHA – one of decreasing relevance in the market, growing insurance claims, increasing restraints on its insurance authority, and even possibly taxpayer losses. There have been concerns and complaints about FHA for almost as long as there has been FHA; still, the author was struck by the pervasiveness and strength of this perception.
If we are to continue to aspire to high levels of homeownership in America, policymakers must ensure that FHA continues to be available to pioneer, stabilize markets, and meet needs that the private sector cannot meet on its own. The Millennial Housing Commission has made revitalizing FHA one of the centerpieces of its prescription for housing policy in the next decade. The Commission proposes that FHA be reorganized as a government corporation, with new resources, authorities, and flexibility to allow it to operate more nimbly in the rapidly changing world of housing finance. The Commission also proposes that, whether in its current structure or reconfigured as a government corporation, FHA find new ways to do business, including through the exploration of single-family risksharing partnerships. The second half of this paper looks at whether single-family risksharing could be an element of a strategy to revitalize FHA and ensure its viability as a potent tool of housing policy.
As described in Section V, the search for partnerships stems from a simple reality: while the government, through FHA, can do some things better than anyone else (particularly, absorb risk), others (lenders, MIs, and reinsurers, housing finance agencies, secondary market institutions, and others) can do many things better than can FHA. If FHA were to rely more on others to do what they can do best, FHA might be more effective at meeting its public purposes. Some describe this transition as going from a retail operation to a series of wholesale programs. In a wholesale model, FHA would give up the operation of many of the day-to-day activities that partners might do better, but retain functions for which government is uniquely suited: providing strategic direction toward public purposes and absorbing risk. The danger of relying upon partners, however, is that they do not inherently share the government’s objectives – either to protect the taxpayers or to achieve public purposes. Risksharing, in theory, could be a way to motivate private entities to serve governmental ends. To do so, however, the risksharing partnership must be designed so that the private partner is rewarded when public purposes are achieved and pays a price when the taxpayers’ experience loss or policy goals are not met.