Time for Renovation at the FHA?

Addressing rising defaults on home loans, President Bush recently noted several proposals of ways the federal government might be able to help. One key proposal: modernize the Federal Housing Administration.

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MELISSA BLOCK, host:

From NPR News, this is ALL THINGS CONSIDERED. I'm Melissa Block.

Wall Street cheered today as Federal Reserve policymakers moved decisively to address concerns about the economy's health. The Dow shot up more than 300 points after the Fed cut short-term interest rates by half a percentage point. Many Fed watchers had expected a less aggressive quarter-point cut. David Wyss is chief economist for Standard & Poor's.

Mr. DAVID WYSS (Chief Economist, Standard & Poor's): They're obviously concerned about the health of the overall economy, but they're also very concerned about the health of financial markets. Any central bank has to worry about the smooth functioning of financial markets because if they stop functioning smoothly, the central bank loses all control over the economy.

BLOCK: Wyss points out that the U.S. has had a long period where the economy and the financial markets have been doing very well. But he says the markets got extremely complacent about risk.

Mr. WYSS: With the rising foreclosures and delinquencies in the subprime market, they got reminded that risk is still a four-letter word. And now, they're reacting in the opposite direction by refusing to touch anything the least bit risky, and that's threatening to freeze up financial markets generally, not just the mortgage markets, but also things like commercial paper and corporate lending.

BLOCK: That's David Wyss of Standard & Poor's.

Even though the Fed moved more aggressively than most expected, it's not at all clear that the medicine will work. People who watch the housing market expect the foreclosure problem to get worse before it gets better, and a rate cut will do little to solve problems with loans that have been packaged into securities.

In the troubled subprime market, an estimated 2.2 million borrowers have mortgages that are going to reset by the end of next year. The adjustable rates on their loans will adjust upwards. And for many of those 2 million plus borrowers, the new monthly mortgage bill will be impossible to pay. The federal agency that has been sent to the rescue is a venerable legacy of President Franklin Delano Roosevelt's New Deal. And today, the House of Representatives passed a measure to expand its reach.

Here's my co-host, Robert Siegel.

ROBERT SIEGEL, host:

On August 31st, President Bush announced a response to the subprime mortgage meltdown.

President GEORGE W. BUSH: We're going to work to modernize and improve the Federal Housing Administration. That's known as the FHA. The FHA is a government agency that provides mortgage insurance to borrowers through a network of private sector lenders.

SIEGEL: And its roots are in a mortgage crisis far more severe than what we're seeing now.

(Soundbite of music)

SIEGEL: In the Great Depression of the 1930s, when a mortgage was a short-term loan - no amortization schedule, just a big payoff due at the end of three or five years - almost half of all mortgages were facing foreclosure. So, President Franklin Roosevelt created a federal agency to insure new long-term mortgages.

(Soundbite of FHA ad)

Unidentified Man: This program is presented by the Federal Housing Administration to tell you how you may obtain the benefits of the National Housing Act. One payment each month takes care of the mortgage, interest, taxes, fire and hazard insurance. And at the end of 12, 15 or 20 years, the home you are buying will be yours free and clear, without any strings attached. It's the modern way to home ownership. And now, the orchestra will play "You Saved My Life."

(Soundbite of song "You Saved My Life")

SIEGEL: The FHA probably did save the dream of home ownership for middle-class Americans. The theory of the agency remains the same to this day. If you want to buy a home but your income or credit history makes you look like a risky prospect to a lender, the FHA will insure the bank against the chance of your falling behind and defaulting on the loan. An FHA insured loan would charge you a monthly insurance premium. But if after a few years you made your payments and you prove yourself credit-worthy, then the premiums would stop. The FHA uses the premiums it collects to pay banks the cost of bad loans they insure.

For all its history and successes, the FHA, of recent years, has been a bit player on a stage dominated by subprime lenders. One reason - it demanded so much paperwork and was so slow to modernize its offices, people figured it slowed down a home purchase. Also, real estate prices in recent years have zoomed past the limits for FHA-insured loans. So the FHA has practically disappeared from pricey real estate markets like San Francisco.

Another reason for the eclipse of the FHA is that it requires a 3 percent down payment. And again, with house prices so high, that's looked like too high a hurdle for many borrowers who could get a nothing-down subprime loan instead. Of course, the partially hidden cost of that loan was the interest rate reset down the road, when it would go up.

Mr. BRIAN MONTGOMERY (Federal Housing Commissioner, U.S. Department of Housing and Urban Development): And that's the main difference between FHA and the subprime, is we price for the risk with an insurance premium, whereas in most of the subprime world, they price the risk in the interest rate.

SIEGEL: That's Brian Montgomery, who runs the agency out of the Department of Housing and Urban Development. The FHA now plans to help tens of thousands of homeowners who, in the past, would not have been eligible to refinance with an FHA insured loan. If they can't make the 3 percent down payment, they could pay less, but pay bigger premiums than others. That's called a risk-based premium structure, and it'll be something new for FHA. And homeowners who have fallen behind on their subprime mortgages can now try to refinance with an FHA-insured mortgage.

Mr. MONTGOMERY: We had a strict requirement that they had to be current. But what we were hearing and finding from a lot of our lenders, that they are hearing from a lot of borrowers who had now fallen behind because of the reset of their interest rate. They had a good payment history for the first two years or three years under the teaser rate. But then as the interest rate reset, they now became delinquent because their payments went up so much. So we think that this is a role FHA should play.

SIEGEL: One reading of the problems that you are addressing is that private lenders were making loans to risky borrowers and the FHA wasn't doing that because it wasn't modern enough - it hadn't changed enough to be there for people. Another reading is the FHA wasn't making those loans because it wasn't so reckless as to be making loans to those people. Which is more true?

Mr. MONTGOMERY: Well, you're actually right on both accounts. In today's mortgage marketplace, where time is money, yes, FHA, for many years, was the slowest game in town. And for realtors and brokers - and even buyers who were interested in closing soon and getting a loan - unfortunately, many of them were steered away from FHA. Well, we moved to fix all those problems. But we also, since we are FHA, we were very, very mindful that we have no intention of making homeowners out of people who aren't ready to buy a home.

(Soundbite of conference)

Unidentified Woman: So what's probably more compliant (unintelligible) that you find out...

SIEGEL: In San Antonio, Texas, Brian Montgomery's agency held a conference earlier this month, training mortgage lenders in the ways of the FHA.

(Soundbite of conference)

Unintelligible Woman: Acceptable basically (unintelligible)? You have a deficiency, the loan was still acceptable...

SIEGEL: For these lenders, like Anthony Golbert of Gatewood Mortgage in Houston, subprime loans were the biggest game in town until this year.

Mr. ANTHONY GOLBERT (Lender, Gatewood Mortgage): I've seen an increase in people inquiring about getting financing for homes through FHA when they knew or they found out that they couldn't get it on a conventional basis. If they could, the interest rate was much higher and the terms, not as attractive, and the cost was more. So basically, the alternative will be for a lot of people who can afford to be in a home, will be FHA because that subprime or that, you know, 100 percent financing stuff, that's all out the window now.

SIEGEL: Leonor Ramirez of Gold Financial in San Antonio was also at the conference, getting trained in what is now the biggest game in mortgage lending.

Ms. LEONOR RAMIREZ (Loan Officer, Gold Financial Services): It's just been a big change for us, going from - leaving the subprime lending, now just focusing on FHA. So it's a totally new market for me to go.

SIEGEL: Can this attempt to rev up an old New Deal housing agency succeed in the 21st century? Anthony Pennington-Cross teaches real estate economics at Marquette University in Milwaukee.

Dr. ANTHONY PENNINGTON-CROSS (Real Estate Economics, Marquette University): What's going to happen if we have a bunch of borrowers who are in trouble in the subprime market and they start getting FHA-insured loans? It may be perfectly fine - and it would be perfectly fine if the borrowers that come from subprime into FHA look a lot like current FHA borrowers in terms of their credit risk profiles. And if that's true, then I think there'll be no real hiccups in bringing in a large swath of subprime borrowers.

SIEGEL: But, what if a lot of the borrowers who make this switch have much riskier credit histories? What if they are the very people the FHA commissioner says are not ready to buy a home?

Dr. PENNINGTON-CROSS: Then we're introducing a series of borrowers that will increase the overall risk of this insurance fund.

SIEGEL: Pennington-Cross says that for the FHA to step up to the plate, it has to do two things: modernize procedures, hire more and better staff, and do more risk-based pricing. Although, he admits, higher premiums for higher risk borrowers presents both positives and negatives.

Dr. PENNINGTON-CROSS: The positive is you can make those loans. The negative is you're charging probably poorer borrowers. And those who were - need help, you're charging them the most.

SIEGEL: And that negative aspect of the FHA plan rankles the chairman of the House Financial Services Committee, Democrat Barney Frank of Massachusetts.

Representative BARNEY FRANK (Democrat, Massachusetts; Chairman, House Financial Services Committee): A hardworking woman making $45,000 a year and trying very hard to support herself and her kids and paying her mortgage, would pay more to the federal government for mortgage insurance than I would.

SIEGEL: But let's say that's a risk-based premium.

Rep. FRANK: Yes. And risk-based premiums...

SIEGEL: It's insurance, and she's a bigger risk?

Rep. FRANK: Yes. And in the outset, you don't know any different. But after she had shown for several years that she was not a bigger risk, why should she pay more than I? Now, I understand that a private sector entity would have to do that. But we're the federal government. So what we're saying is this: yes, you can charge someone like that more at the outset. But if after three years she's made all of her payments, you refund the extra, because there was no reason in the world why the federal government should charge someone who is the working class level more if she's made her payments.

SIEGEL: And Barney Frank says many subprime mortgage borrowers can't even think about refinancing their loans until the government persuades the institutions that hold their mortgages - banks, investment funds - to forgive a prepayment penalty that can easily be half a year's interest on 80 percent of the balance of the loan. For a balance of $300,000 at 8 percent, that's $9,600.

Rep. FRANK: To sell into the secondary market - this is where prepayment has come in - when people buy a security in the secondary market, they want some assurance that they're going to have that income through a number of years. So, if you want to make these securities saleable in the secondary market, we are told, you have to have prepayment penalties. Because when you sell someone the security, you say, guess what? These people are going to be paying you this high interest rate and they can't get out from under. That's why the prepayment penalty has become the focus, and trying to get people out from under the prepayment penalty so they can refinance is the key to saving some of them -obviously, not all of them.

SIEGEL: Barney Frank and many congressional Democrats support a more robust federal approach to this problem, but he welcomes the FHA plan as a belated recognition by the White House that the mortgage market failed.

So, how much can the FHA actually accomplish? Well, the head of the FHA says of those 2.2 million borrowers who were looking at costly resets, some are speculators who've just been out to flip a condo, some were borrowing for a second home, and some will work out their problems with their lenders without any special help. He says that leaves 600 to 900,000 households that will risk delinquency or default over the next couple of years, and that FHA might be able to help about half of them.

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