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Subprime FHA: a sign from Washington [ClearOnMoney]
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Subprime FHA: a sign from Washington

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Commentary

Subprime FHA: a sign from Washington

3 Nov 2009 by Jim Fickett

You might think the recent crisis, in no small part due to a colossal housing bubble, would spur a major rethink of government policy on housing. You would be wrong. It is abundantly clear that the dominant desire in Washington is for more of the same in supporting and stimulating the housing market. The major support mechanisms – tax breaks, mortgage guarantees, and foreclosure mitigation – will continue, the first two for a long time and the third until recovery. This constancy of purpose on the part of the government is one piece of an argument suggesting that 2010 might be a good time to buy property.

Some striking data concerning the Federal Housing Administration (FHA) was recently presented to Congress by Edward Pinto, the former chief credit officer of Fannie Mae from 1987 to 1989. First note that the foreclosure start rate on FHA loans has been rising rapidly (click on graph for larger image):

While foreclosure rates seem to be rising anywhere you look, what is remarkable in this case is the reaction of the lender. Most private-sector lenders, in response to mortgage losses, are now requiring a 20% down payment again or, to put it another way, are requiring the ratio of loan size to home value (LTV) to be under 80%. This provides some protection against a further drop in home values, or costs in collecting on a defaulted mortgage. But Pinto reports that

FHA and … VA … account for over 90% of all the high LTV (>90% LTV) loans being made, most of which have an effective loan-to-value (LTV) in excess of 96%. … Total high LTV lending in the first half of 2009 was equal to 23% of all originations by all lenders. It was only 17% of originations in 2006, a year notorious for its high risk lending.

(FHA and VA - the Department of Veteran Affairs - are grouped together here both because they run similar programs and because the government, in the form of Ginnie Mae, bundles mortgages from both agencies into federally-guaranteed bonds.)

So, after drifting for a moment in astonished wonder, what lesson should we take from this? On the one hand, despite the best educational efforts of the National Association of Realtors, I fail to see why we should all get rich by selling physically-depreciating assets to each other, especially with a 10% transaction tax taken in fees and closing costs. On the other hand, the tax advantages are quite a serious thing. Essentially, the mortgage interest deduction allows one to pay rent out of pre-tax income, and the capital gains exclusion makes this a unique opportunity not to pay tax on the imaginary capital gains produced by inflation. In other words, what really makes housing an interesting investment is the tax treatment. And so an important question is, can a fickle government be relied upon not to change the rules with respect to these tax advantages?

One can certainly see the government conservatorship of Fannie Mae and Freddie Mac (ostensibly private but in reality heavily backed by the taxpayer) as a temporary measure to stabilize the financial system. But what about the following? The extent of intervention is breathtaking, and the talk is not of minimal intervention with a quick exit, but rather of “helping homeowners” and “returning the market to health”. In other words, the sentiment and the actions indicate that the government feels an obligation to back the housing market.

(1) The above-mentioned FHA lending (which can only be described as astonishing).

(2) The market share of Fannie Mae, Freddie Mac, and Ginnie Mae in new mortgage lending: currently 95%.

(Graph produced by the Federal Reserve Bank of San Francisco).

(3) The first-time homebuyer credit, likely to be extended.

(4) The Federal Reserve buying $1.25 trillion in mortgage-backed securities to keep mortgage rates artificially low.

I am reminded of a story concerning the Tacoma Narrows Bridge completed in 1940, nicknamed Galloping Gertie because the wind caused large oscillatory movements in the bridge. (The following bit of the story has wide circulation in the math and engineering community, but I have not verified it.) When the wind caused such large oscillations in the bridge that it collapsed, the governor of Washington declared “We are going to build the exact same bridge, exactly as before.” On hearing of this, the famous engineer Von Karman sent a telegram to the governor stating “If you build the exact same bridge exactly as before, it will fall into the exact same river exactly as before.”

Be that as it may, and whatever the fate of the next cycle in housing, it seems very likely that we can count on the tax advantages continuing. Further, as long as the housing market continues to sag, Congress will be applying their collective creative genius to new interventions. Stay tuned.

I will have more to say about the housing market as time goes on. For two good recent summaries suggesting that we are not yet at the bottom, see Professor Robert Shiller's A Bounce? Indeed. A Boom? Not Yet and the Calculated Risk blog post The Uncertain Housing Outlook.