A ‘Big Mistake’ Is Made

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Thwarting a request from the Federal Housing Administration, Congress, in its housing bill, will not allow the agency to charge higher rates to borrowers with lower credit scores.

In other words, borrowers with weak or little credit history will receive loan insurance at the same terms as people who have decent credit scores, a policy that is doomed to distort the marketplace and undermine the FHA. Hasn’t the nation just learned a pretty convincing lesson about the value of risk-based pricing?

The secretary of housing and urban development, Steve Preston, described the housing bill’s one-year moratorium on risk-based pricing as “a big mistake.” On a conference call earlier this month with reporters, he said the “FHA will have to increase premiums across the board or, alternatively, seek taxpayer funds in October to cover potential losses” when the new fiscal year begins. A third option would be to “cut back on the program at the very time we are an island of hope for hundreds of thousands of Americans.”

His words apparently fell on deaf ears. The head of the FHA, Brian Montgomery, has said, “No insurance company would run their operation that way … and none do.” (He needs a little help with his grammar, but the point is made.) For 74 years, the FHA has been self-sustaining. Now that record is threatened.

What was Congress thinking? A senior policy analyst for the National Association of Realtors, Megan Booth, says, “We were originally supportive of risk-based pricing,” but adds that NAR and many other organizations changed their position when they better understood the FHA’s plan.

The FHA’s proposal to change its pricing also included measures that would make it harder and more expensive for many groups of borrowers to get FHA insurance, she says, and some would be excluded altogether. The FHA later watered down its plan, but the changes still don’t go far enough, according to the NAR.

The FHA argues that it needs risk-based pricing to boost revenues so that it can offset loan losses. Not surprisingly, the absence of sensible pricing is not the only issue confronting the FHA. An even bigger problem is that one-third of its portfolio consists of mortgages made to people who received seller-financed down payments.

The borrowers in these cases have no “skin in the game” and are walking away from their loans at three times the rate of other mortgage holders. NAR and other housing groups say that because the new housing bill no longer requires the FHA to insure these types of seller-financed down payment mortgages, there is no need for the added revenue.

Mr. Montgomery confirmed recently that the FHA is indeed solvent, with a reserve of $21 billion. A recent charge of $4.6 billion and the likelihood of future losses, however, could put the agency’s balance sheet in peril.

A policy analyst with the National Association of Home Builders, David Ledford, says, “The FHA has plenty of reserves currently to cover the loans on its balance sheet.” However, he says the FHA will certainly have to raise prices to cover future losses, or will have to go to Congress for funding.

A spokesman for the Department of Housing and Urban Development, Lemar Wooley, confirms that the most likely approach will be to raise premiums on all borrowers. The risk-based pricing approach would have meant raising prices only for some borrowers.

Opposition to the risk-based pricing initiative came from Senator Dole’s office, inspired perhaps by resistance from private companies in her home state, North Carolina, that are opposed to the FHA becoming more competitive, Mr. Ledford says. A spokesman for Mrs. Dole’s office says the senator’s opposition was a response “to the concerns of North Carolinians and the findings of a GAO report.”

Indeed, the FHA also is running into some headwind on the risk-based pricing approach from the Government Accountability Office. The director of the GAO, William Shear, testifying recently before Congress, challenged the FHA’s risk management capabilities and ability to estimate losses. In particular, he criticized the FHA’s intended use of automated mortgage scoring, broadly used in the industry, to assess default risk, a crucial ingredient in setting risk-based pricing.

Mr. Shear testified that the FHA’s pricing model was based on data that were 12 years old when it was adopted in 2004, and is naturally out of step with current mortgage market trends. This inadequacy and several others gave some in Congress pause in allowing the FHA to change its pricing approach.

Mr. Ledford also says some in Congress are worried that risk-based pricing will disadvantage poor people or minorities. The FHA makes an excellent case, however, that differential premiums are actually in everyone’s best interest, including lower-income consumers.

Studies conducted by the agency indicate that “contrary to conventional wisdom, FHA families with lower incomes actually have higher FICO scores. These are hard-working American families who live within their means and pay their bills on time.”

A senior person at a credit ratings agency, who would speak only on the condition of anonymity, says the FHA is “very mathematically driven. They really know their stuff” in terms of lending criteria.

The FHA’s role in helping solve the housing collapse is growing, making the agency’s soundness even more crucial. For example, its FHASecure program, which was instituted in August 2007, is assisting Americans facing foreclosure. This initiative has benefited some 250,000 families who have been able to refinance with FHA-insured loans to the tune of more than $28.5 billion. Mr. Montgomery projects that by the end of this year, some 500,000 families will be given the opportunity to stay in their homes, making payments on predictable, stable mortgages.

This growth in activity makes the FHA pivotal in helping resolve the mortgage fiasco. During the past several years, due to constraints on the lending procedures of the agency, its market share dwindled. The GAO reports that FHA-insured loans accounted for less than 4% of the single-family market in 2005, down from 13% a decade earlier. The FHA calculates that between 2003 and 2006, the agency lost about 70% of its business. Mr. Montgomery describes the agency as having been “marginalized during the boom, unable to compete because of low loan limits and higher down payment requirements.” Some would say it dodged a bullet just because of the restrictions.

Overall, the FHA will have to clean up its act before Congress will allow it to adopt risk-based pricing. Like Fannie Mae and Freddie Mac, the FHA is saddled with a conflicted mission: It is expected to help Americans secure affordable mortgages while also being self-sustaining by competing effectively with private sector participants. It cannot be hampered by uneconomic restrictions. As Mr. Montgomery says, to his credit, “If we are going to take on riskier loans, we have to protect the taxpayer.” Bravo!

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