1. Is FHA the Next Housing Bailout? Joe Gyourko Martin Bucksbaum Professor of Real Estate, Finance and Business & Public Policy The Wharton School University of Pennsylvania AEI Presentation Washington, D.C. December 9, 2011 1

2. Is FHA the Next Housing Bailout? Yes, in all likelihood Why? – FHA has become much larger and riskier since the housing crisis began – FHA underestimates default risk and future losses on its single-family guarantee portfolio by $50 billion or more – Given its current precarious financial position in which excess reserves equal only 0.12% of its aggregate outstanding single-family insurance- in-force, almost any underestimation of future losses or an adverse economic shock implies its insurance fund will not be able to cover its true losses 2

3. FHA’s Growing Size and Risk It has become a major force in the housing market – Guaranteed 30% of new home purchases in 2010; guaranteed 19% of all home purchases in 2010 – 2011 figures show declines in share, but FHA clearly remains a very important player in the housing market 3

4. FHA’s Growing Size and Risk Typical loan being guaranteed has less than a 5% equity down payment at origination to cushion against price declines – Fraction of single-family portfolio with <5% down payment (see Table 4 in paper) FY2007: 60.2% FY2008: 57.7% FY2009: 60.9% FY2010: 68.2% FY2011: 67.2% – FHA is in the business of insuring greater than 30-to-1 leveraged investments in housing A 3% down payment implies a leverage ratio of 33-to-1 (1/0.03 ~ 33.3) – Given persistent price declines in recent years, majority of FHA’s existing portfolio is underwater (i.e., the typical mortgage FHA guarantees is backed by a home on which there is negative equity; see Table 5 in paper) 4

5. FHA’s Growing Size and Risk Liabilities – Single-family insurance-in-force has more than tripled since FY2007 from $305 billion to just over $1 trillion in FY2011 Current liabilities amount to nearly 7% of aggregate annual national output 5

6. FHA’s Growing Size and Risk Total Capital Resources—Liquid Financial Assets – $28.183 billion at end of FY2011, up slightly from $24.903 billion at end of FY2007 (for single-family guarantee portfolio; see Table 6 in paper) Over the same period during which potential liabilities increased by $704 billion, total capital resources increased by barely $3 billion Thus, liquid capital increased by $1 for every $235 of additional insurance guarantees – FHA has become a much more highly leveraged entity Insurance-in-Force per Dollar of Total Capital Resources (see Table 6 in paper) – FY2007: $12.27 – FY2010: $28.83 – FY2011: $35.81 Implied leverage at FHA has tripled since FY2007 Leverage above 30 is considered very high and extremely risky – That was the level employed by Lehman and Bear Stearns before they failed 6

7. FHA’s Growing Size and Risk Economic Value of the Insurance Fund (single family part) – ‘Excess reserves’ represent resources available to offset any unexpected losses (i.e., those not anticipated by the actuarial model) – Falling over time in absolute amount and as share of insurance-in- force (see Table 6 in paper) FY2007: $21.277 billion FY2010: $5.160 billion FY2011: $1.193 billion – Capital ratios (2% minimum guideline) FY2007: 6.97% FY2010: 0.59% FY2011: 0.12% 7

8. Estimates of Fund Economic Value as End of FY 2011 ($ Millions) ItemEnd of FY 2010 a End of FY 2011 Cash$26,309 Investments4,128 Properties and Mortgages3,292 Other Assets and Receivables12 Total Assets$33,741 Liabilities(2,940) Total Capital Resources$30,801 Net Gain from Investments1,139 b Net Insurance Income in FY 2011(2,440) c Net Change in Properties and Mortgages(868) b Net Change in Accounts Payable85 b Transfer to HECM Account (535) b Total Capital Resources28,183 PV of Future Cash Flows on Outstanding Business(26,990) Economic Value$5,160 d 1,193 Unamortized Insurance-In-Force926,251 d 1,069,354 Amortized Insurance-In-Force879,875 d 1,009,154 a Source: Audited Financial Statements for FY 2010. b Estimated based on unaudited investment income provided by FHA. c Estimated based on unaudited net non-HECM operating cash flow through end of July 2011 provided by FHA and projected net cash flow for the remaining two months d From the FY 2010 Actuarial Review.

9. FHA’s Growing Size and Risk 9

10. The Critical Role of Future Books of Business – Value of Future Insurance Going Forward 10

11. Signs that Future Losses on the Single-Family Guarantee Portfolio Are Underestimated Over-Optimism in the Actuarial Reviews – Every future annual book of business since FY2005 has been estimated to be of positive value to the insurance fund – Contrasts with the predictions of actual losses on existing books in the last two actuarial reviews FY2010: -$25.392 billion FY2011: -$26.990 billion Extreme downside scenarios do not permanently bankrupt the insurance fund FY2010 review: fund recovers from additional 24% decline in house prices Not credible; typical loan being insured has less than 5% equity cushion; price declines of 500% of that amount should result in huge losses that overwhelm the fund 11

12. Underestimation of Future Losses on the Single-Family Guarantee Portfolio Four types of estimation or model errors lead to substantial underestimation of losses to the insurance fund – Improper accounting for unobserved credit risk Complex issue, but very important; probably worth $30+ billion in value Unemployment risk is the biggest factor here – Unrecognized down payment assistance in the FY2009 and FY2010 pools due to the tax credit program for new home buyers Could be worth $10+ billion in added losses, but requires much more research to pin this down – Underestimating negative equity in the insurance portfolio Via use of an inappropriate price index based on the values of homes bought with conventional homes Precise magnitude is unknown, but impact is likely to be large because negative equity is known to be a key trigger of default 12

13. Underestimation of Future Losses on the Single-Family Guarantee Portfolio – Misclassifying streamline refinanced mortgages as prepaying with no future default risk to the insurance fund First pointed out by Aragon, et. al. (2010)  Total underestimation of future losses: ~ $50 billion  Any unexpected deterioration in the underlying house price forecasts will increase future losses above and beyond this figure. FHA anticipates positive price growth beginning in FY2012, escalating to just above 5.5% appreciation in FY2014, before settling down to a long-run price growth rate of just below 3.5% by FY2020. 13

14. Why Doesn’t Increasing Credit Quality in the Borrower Pool Solve the Problem? Credit quality of new borrowers has increased substantially as measured by FICO scores. – % with FICO>=720 July-Sept. 2008: 19.2% July-Sept. 2011: 33.1% – % with FICO<580 July-Sept. 2008: 6.9% July-Sept. 2011: 0.2% Why doesn’t this deal with the issues raised in previous slides? – Because FICO scores are in the model, so loss estimates already are lower because of this increase in borrower quality. Stated differently, those four reasons for underestimation of losses exist independently of the rise in FICO scores – In addition, individual FICO scores can and do fall over time for various reasons (e.g., illness, layoff, divorce), so risk can rise Don’t forget that there was a first time for everyone who ever defaulted, so a high initial FICO score is not a lifetime guarantee of no default 14

15. What To Do? Recapitalize now by $50-$100 billion – Precise amount depends upon financial cushion desired – Could be varied and teamed with fee changes, etc., to generate cash for the fund Why? It’s not legally required. – Single-family mortgage insurance portfolio already has negative economic value if losses estimated properly – Losses tend to escalate when entities become financially weak and begin to take on greater risks to try to bail themselves out This is why sound regulators like the FDIC mandate capital raises or shut down weak banks Downside risk is economically significant when the total liabilities reach the level they have at FHA (i.e., 7% of national output); this makes it financially and fiscally imprudent to run what effectively is a trillion dollar business platform with no financial cushion 15

16. What To Do? – The warning signs of higher future losses are evident Recent sharp rises in modifications and workouts that temporarily cure defaults; is this really effective or just ‘kicking the can down the road’? Increased reliance on future growth to generate sufficient fees to cover losses; ‘even though the past was dark, the future will be bright’ Don’t think this represents an immediate liquidity risk event (i.e., that losses this year would escalate above the $28 billion in total capital resources available), but I could be wrong and such a problem certainly could develop over 2-3+ years – Last, but not least, we need accurate measurement of costs to compare to benefits for proper evaluation of the program Otherwise, the program will become too large and too risky if we keep pretending the costs are very low (and never will be high) 16