The Federal Housing Administration (FHA) insures the mortgages of people who might otherwise have trouble getting a loan, particularly first-time homebuyers and low-income borrowers seeking to purchase or refinance a home. During and just after the 2007–2009 recession, the share of mortgages insured by FHA grew rapidly as private lenders became more reluctant to provide home loans without an FHA guarantee of repayment. FHA’s expanded role in the mortgage insurance market ensured that borrowers could continue to have access to credit. However, like most other mortgage insurers, FHA experienced a spike in delinquencies and defaults by borrowers.
Recently, mortgage borrowers with good credit scores, large down payments, or low ratios of debt to income have started to see more options in the private market. The Congressional Budget Office estimates that the share of FHA-insured mortgages going to such borrowers is likely to keep shrinking as credit standards in the private market continue to ease. That change would leave FHA with a riskier pool of borrowers, creating risk-management challenges similar to the ones that contributed to the agency’s high levels of insurance claims and losses during the recession.
This report analyzes policy options to reduce FHA’s exposure to risk from its program to guarantee single-family mortgages, including creating a larger role for private lenders and restricting the availability of FHA’s guarantees. The options are designed to let FHA continue to fulfill its primary mission of ensuring access to credit for first-time homebuyers and low-income borrowers.
What Is FHA’s Exposure to Risk?
As a guarantor of mortgages, FHA does not lend money directly to borrowers; instead, it insures lenders against borrowers’ default. Under the terms of its insurance, FHA agrees to reimburse the lender for the unpaid balance of the mortgage and any accrued interest if the borrower defaults. To partly offset the costs of that guarantee, FHA charges the borrower an up-front fee and annual insurance premiums.
FHA’s exposure to risk on its mortgage guarantees creates uncertainty about how much they will end up costing the federal government. Those costs vary mainly because of the potential for unexpected changes in FHA’s cash flows because of insurance losses (payments of lenders’ claims minus recovered proceeds from selling foreclosed properties). Costs also vary, to a lesser degree, because of unanticipated changes in the amount of premiums collected and in market interest rates. FHA’s insurance losses are subject to risk because the amount of loss depends on the extent to which economic conditions— and their effect on borrowers—differ from what was predicted when a mortgage was issued.
The cost of FHA’s risk exposure can be measured in various ways. In this report, CBO uses the fair-value estimate of insurance losses, a market-based measure of the cost of the insurance losses generated by the single-family program. For the newly originated mortgages that the program is projected to guarantee in 2018, CBO estimates the fair value of insurance losses at $19 billion over the life of those loans (9 percent of their total dollar amount). Successive years’ cohorts of new guarantees could experience larger or smaller insurance losses over their lifetimes.
What Policy Options Did CBO Analyze?
Many changes have been proposed to reduce the cost of risk to the federal government from FHA’s single-family mortgage guarantees. CBO analyzed illustrative versions of seven policy options, which generally represent the range of approaches that policymakers and others have proposed:
- Guaranteeing some rather than all of the lender’s losses on a defaulted mortgage;
- Increasing FHA’s use of risk-based pricing to tailor up-front fees to the riskiness of specific borrowers;
- Adding a residual-income test to the requirements for an FHA-insured mortgage to better measure borrowers’ ability to repay the loan (as the Department of Veterans Affairs does in its mortgage guarantee program);
- Reducing the limit on the size of a mortgage that FHA can guarantee;
- Restricting eligibility for FHA-insured mortgages only to first-time homebuyers and low- to moderate-income borrowers;
- Requiring some borrowers to receive mortgage counseling to help them better understand their financial obligations; and
- Providing a grant to help borrowers with their down payment, in exchange for which FHA would receive part of the increase in their home’s value when it was sold.
Although some of those approaches would require action by lawmakers, several of the options could be implemented by FHA without legislation. In addition, certain options could be combined to change the nature of FHA’s risk exposure or the composition of its guarantees. CBO did not examine the results of combining options.
What Effects Would the Policy Options Have?
Making one or more of those policy changes would affect FHA’s financial position, its role in the broader mortgage market, and the federal budget. All of the options would improve the agency’s financial position by reducing its exposure to the risk of losses on the mortgages it insures. The main reason for that reduction would be a decrease in the amount of mortgages guaranteed by FHA. CBO projects that under current law, FHA would insure $220 billion in new single-family mortgages in 2018. The options would lower that amount by anywhere from $15 billion to $77 billion (see figure below). Some options would also reduce FHA’s risk exposure by decreasing insurance losses as a percentage of the value of the guaranteed mortgages.
The options would have differing effects on the composition of the portfolio of mortgages insured by FHA. Those changes would affect the expected level of borrowers’ defaults across the portfolio and the number of first-time homebuyers and low-income borrowers who would receive an FHA-guaranteed loan.
The costs or savings associated with the options differ depending on how those effects are measured. The Federal Credit Reform Act of 1990 (FCRA) requires that the impact of the mortgages that FHA guarantees each year be recorded in the federal budget on a present-value basis. That present-value subsidy cost is calculated as the difference between the present values of the insurance losses expected to occur and the fees and premiums expected to be collected on those guarantees over their lifetime. (A present value is a single number that expresses a flow of income or payments in terms of an equivalent lump sum received or paid today.) On a FCRA basis, the $220 billion in new single-family mortgages that FHA is projected to insure in 2018 will be recorded in the budget as producing savings of about $7 billion because the present value of fees and premiums is projected to exceed the present value of insurance losses.
A more comprehensive way to measure the cost of FHA’s guarantees is on a fair-value basis. Fair-value estimates account for the cost of market risk—the risk that taxpayers face because federal payments to cover losses on guaranteed mortgages tend to be high when economic and financial conditions are poor and resources are therefore more valuable. Such estimates reflect the cost that private institutions would assign to similar credit assistance based on market prices. On a fair-value basis, the new single-family mortgages that FHA is projected to insure in 2018 are estimated to cost the government about $5 billion because the estimated market value of insurance losses is projected to exceed the estimated market value of fees and premiums.
The options that CBO analyzed would decrease the budgetary savings that the single-family program shows under FCRA accounting. The reason is that most of the loans that FHA would guarantee under current law but not under the options are projected to provide savings on a FCRA basis in CBO’s baseline. On a fair-value basis, however, the reduction in the volume of guarantees would decrease the program’s cost because those forgone loans are estimated to cost the government money, on average, with market risk taken into account.