Normally a small part of the mortgage landscape, the Federal Housing Administration dramatically expanded lending in 2008 when the housing bubble burst and private capital fled.
While progressives hail the FHA's role as key in blunting steep home price declines and providing much needed liquidity to the market, critics argue that the agency's intervention was just another bailout that put taxpayers on the hook, and is now discouraging private lenders from coming back.
To be sure, the FHA took serious losses as home values tanked through 2011, and many were quick to focus on an independent audit in 2012 that cited the possibility of a $16.3 billion shortfall if housing conditions deteriorated. But recent estimates suggest the agency's balance sheet doesn't look nearly as bad as many analysts expected. President Barack Obama's new budget, for example, anticipates that FHA will need to borrow less than $1 billion from the Treasury to cover capital shortfalls next year. If home prices keep rising and defaults keep falling this year as expected, even that deficit could evaporate. An improving financial situation would allow FHA to start rebuilding its capital reserves, which have fallen below the congressionally-mandated 2 percent.
The FHA's footprint in the housing market is also starting to shrink as the housing market rebounds. Back in 2005 and 2006, FHA insured just 3 percent of the mortgage market. That figure zoomed to 29 percent in 2008 as the bubble burst, but last year it fell to just 15.5 percent.
Many critics also overlook a key feature of FHA loans that could help sustain and strengthen the housing rebound over the next several years. While interest rates are at historic lows today – hovering around 4 percent for the past several years – they won't stay that low forever. But that's a non-issue for FHA loans, which are assumable, meaning that if someone wants to buy a home financed with an FHA loan – and they are qualified to assume the current terms of the mortgage – they can take the existing loan instead of having to apply for a new one, potentially at a higher interest rate.
Consider a homeowner that has a 30-year fixed-rate mortgage of 3.75 percent. Now let's say mortgage rates rise to 5.25 percent over the next several years. To a young family looking to buy its first home, assuming an existing loan at a lower interest rate may look very attractive. All things being equal, there is quite the premium built into the value of that home over another comparable house for sale, where a new buyer would have to obtain more expensive financing.
These assumable loans will become more valuable as interest rates rise, improving the quality of FHA's portfolio. That in turn will reduce three risks inherent in mortgage lending: early pre-payment, default and interest rate risk.
Early pre-payment is typically driven by lower rates and thus increased refinancing. We are heading into a higher rate environment, so that risk will be negligible. With the ability to transfer the loan to a new buyer, a borrower has other options besides defaulting (instead of foreclosing, they can sell quicker) if they get in trouble. Interest rate risk is addressed through securitization and that risk is typically transferred to the investors of bonds, unlike when a bank makes a single loan and keeps that loan on its books as rates begin to rise.
It's completely understandable why the conversation on assumable loans was left in the 1980s, when it was quite common. Mortgage rates have been declining for the last 30 years. There is no inherent value in taking over debt with an above-market interest rate. So the assumption feature has no worth in a market where rates are consistently declining.
But those days are over, and when rates start to rise for good, the ability to assume FHA loans may very well take center stage. While there may be some broadening of private capital re-entering the mortgage market when rates do begin to rise, it won't be overlapping the lending population that the FHA aims to serve. With a stated mission to serve first-time homebuyers, minorities and low-to-moderate income families, a vital segment of the homeownership formula, the FHA will have made a fundamental contribution with its lending presence during the crisis, and most likely long after.
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