“The agency’s misguided policies are disrupting the American dream for the families and neighborhoods they are supposed to help.” — Ed Pinto, The FHA: A home wrecker, Los Angeles Times (12/27/12).
As 2012 came to a close, Ed Pinto at American Enterprise Institute launched a series of attacks on the Federal Housing Administration. Like me, Pinto opposes government intrusion in the economy and is a conservative with a deep devotion to the private sector. AEI was established after WWII to oppose the socialist policies pursued by FDR via the New Deal during the 1930s.
Pinto knows the mortgage sector and worked as chief credit officer for Fannie Mae until the late 1980s. But when he calls the FHA the root of all evil in the U.S. housing sector, he goes too far. Pinto writes:
“Imagine that a federal agency wanted to hurt America’s working-class families on purpose. How would it inflict maximum damage? It might start by aggressively marketing homeownership to marginal borrowers. It would tell them that bad credit scores aren’t a problem. It would push them into homes they can’t afford, saddle them with loans that barely build equity and provide no incentives for fiscal discipline. And when many of these homes go underwater and into foreclosure, it would leave families in financial ruin. In short, such an agency would follow the Federal Housing Administration playbook.”
The FHA is an agency that my colleagues at Carrington know very well. We are an originator of new FHA and nonconforming loans. FHA is also a client in terms of nonperforming loans and rental properties. When we look at Pinto’s critique, some of the recommendations make sense, but others are at odds with reality.
Like many of his colleagues at AEI, Pinto wants to see a withdrawal of the government from the U.S. mortgage sector. The only problem is that banks and private investors, going back to the 1930s, have largely been unwilling to take first lost risk on residential mortgages to any significant extent.
Each of Pinto’s proposals, taken by itself, could be deemed reasonable, but taken together they are inconsistent and unworkable. His recommendations can be summarized as follows:
The FHA should step away from lending that private markets can originate, and instead focus on low-income and first-time borrowers with FICO scores less than 680.
It should stop knowingly lending to people who cannot afford to repay a loan, and achieve a max claim rate of 10%. FHA averaged 10% claims rate between 1983 and 2004. By comparison, Citigroup’s loss rate peaked over 5% in 2010, necessitating an extraordinary government rescue.
The FHA should only engage in responsible lending, which Pinto defines as averaging a 5% claim rate at the portfolio level.
The good news is that the FHA’s loss rates for 2011 and 2012 are roughly in line with Pinto’s recommendations — but only because of the flow of prime mortgages through the FHA. His advice, only lend to high-risk borrowers (low-income and first-time borrowers with less than 680 FICO scores), would inevitably force up FHA claim rates.
This is a key inconsistency in his argument. In order to accumulate loans with an average 5% claim rates, FHA needs to make a lot of loans with expected claim rates below 5%, say 3%. This policy objective would be the equivalent of FHA lending in the prime, 720+ FICO risk bucket, which private markets are increasingly eager to serve. FHA cannot achieve one Pinto principal (5% average claim) without violating another — namely not going after business that the private markets are willing to support.
It is easy for conservatives to criticize the FHA and other government agencies. The hard part is coming up with workable solutions that will not hurt the U.S. economy. As someone who speaks to private investors every day, I believe that Pinto and some of his colleagues at AEI err in thinking that banks and private investors are ready to pick up the slack. This is simply not true — at least not at current, government-subsidized mortgage rates. The true economic cost of a private, 30-year mortgage is not 3%. It is more like double that rate.
Since the start of the subprime crisis and the collapse of government-sponsored enterprises like Fannie Mae and Freddie Mac, agencies such as the FHA have been essential to maintaining the supply of mortgage credit to the U.S. economy. Even as the White House ignored the housing crisis, the FHA helped a lot of Americans refinance out of really bad loans. What would the U.S. housing market look like today had the FHA followed Pinto’s advice?
FHA made it possible for millions of Americans to stay in their homes. By themselves, banks and private investors would never have financed even a fraction of this amount. Remember that 90% of lending volumes today go through the FHA. We at Carrington support a smaller role for government in the mortgage market, but conservatives need to do a reality check. The real challenge is to start a process that expands private participation in the market as the government’s role recedes.
First is higher guarantee fees for FHA and other GSEs, a needed change that is already in process. Why Pinto criticizes increased GSE fees is a mystery to me, especially since a 30-year mortgage with a 3% government guaranteed rate is subsidized by 3-4 points annually. Free market proponents should support higher fees for the GSEs.
To Pinto’s point about a borrower’s ability to pay, FHA should require “skin in the game” in the form of at least 10% down on all mortgages guaranteed by the agency.
Today most banks are writing loans that require 20% down payments, so the market is already moving toward higher down payments. Basel III, which is in draft form and expected to be approved by the U.S. this year, will force even higher equity in bank-originated mortgages.
With the spread between renting and mortgage payments at historically wide levels, people are often better off owning than renting. Requiring higher down payments solves a lot of the problems outlined by Pinto. More skin in the game creates a better alignment between household income and ability to pay. At Carrington, we currently rent a $100,000 house for about $1,000 per month. If a family saves $10,000 and borrows $90,000 via a bank with an FHA guarantee, their monthly mortgage payment would be approximately $500.
With $10,000 worth of “skin in the game,” a family will be more likely to buy a house they can afford, and more likely to repay the loan. Encouraging the same family to buy a $200,000 house with a 3.5% down payment, can set them up for trouble.
If you think about the total amount of loans made through the FHA vs. those that have actually defaulted, I would argue that the FHA is really doing a pretty decent job —particularly when compared to the reckless GSEs like Fannie and Freddie. Pinto and his colleagues at AEI rightly call for the elimination of these two agencies. But I’d like to see someone at AEI write a piece about borrower complicity. How about the real estate agents and bankers? Strange, is it not, that we did not see Ed Pinto or anyone else at AEI complaining about predatory lending when the real estate market was going up?
