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A Built-In Bailout For FHA

One troubled underwriter hit hard by the subprime mortgage crisis won’t be asking for a government bailout, because it is part of the government.

The Federal Housing Administration (FHA), created in 1934, insures mortgages, protecting lenders from defaults. Homeowners who receive FHA-backed mortgages pay insurance premiums in addition to their monthly mortgage payments, allowing the FHA to cover the cost to lenders when homeowners are unable to meet their obligations.

Given that business model, you would expect the FHA to be pretty picky about what mortgages it is willing to insure, checking thoroughly to make sure that homebuyers have the financial resources to pay for the homes they buy.

Instead, the agency’s Web site proffers the promise of “low down payments,” “low closing costs,” and “easy credit qualifying.” The FHA has no qualms about backing mortgages with down payments as low as 3.5 percent of the purchase price.

This may sound eerily similar to the practices of those evil lenders who took advantage of an unsuspecting public by luring people into mortgages they couldn’t afford. That’s because it is.

In fact, the FHA lighted the way into the mortgage crisis. While the housing market as a whole was still flourishing, the FHA’s finances started to deteriorate as the number of mortgages it had insured which went into default skyrocketed. At that time, private lenders were offering attractive deals, featuring little or no down payment, to reasonably low-risk borrowers. The FHA could not compete with these boom-era bargains, so it started opening its doors to less credit-worthy borrowers. As a result, it started to see more defaults.

The FHA boasts that it is “the only government agency that operates entirely from its self-generated income and costs the taxpayers nothing.” In 1992, the FHA even established an emergency fund to help it get through difficult times without having to turn to Uncle Sam. Each year, it deposited its surplus money with the Treasury. But, for the past seven years, the FHA has been drawing down that fund. The fund is still in the black, holding about $3.6 billion as of Sept. 30, but this is only about one-quarter of the reserves it is required by law to maintain.

It is likely the FHA will soon exhaust the fund entirely. But if it does, it won’t stop drawing money from the Treasury.

While policymakers are weary of granting bailouts, this time they will not have a choice to refuse, because the FHA does not need to ask permission before it takes the money it needs. The mortgage insurance program is backed by the full faith and credit of the U.S. government, meaning that the government is basically a co-signer on all FHA loans. Marvin Phaup, a former budget analyst at the Congressional Budget Office and now a budget expert at Pew Charitable Trusts, explained, “It is absolutely a myth that they [the FHA] would have to go to Congress for money. The FHA has permanent authority to get money from the Treasury.”

As private lenders tighten their standards, the FHA, with its direct pipeline to the U.S. Treasury, is keeping its money spigot open in an attempt to prop up the housing industry and dilute its own existing pool of bad loans. In the short term, the FHA’s offers of low down payments and easy credit attract a broader spectrum of people to the housing market. This keeps houses from sitting empty and provides new business for the construction industry.

But, unless these new homeowners can truly afford the long-term costs of home ownership, the FHA’s easy credit ensures that defaults will continue and that the American taxpayer will be on the line for debts that neither homeowners nor the FHA can pay.

That gurgling sound you hear is your tax dollars going down the drain.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.

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