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The Federal Housing Administration (FHA) currently insures $658 billion – nearly one quarter –of the national mortgage debt. In California, the FHA is presently insuring over 35% of all home loans, up from just 2% two years ago. As part of its risk assessment protocol, the FHA annually reviews the value of its reserves after subtracting 30 years of projected losses. This fall, the FHA concluded its financial reserves covered 0.5% of the $685 billion of loans it insures, down from 3% last year.

As dire as the trajectory for loan loss reserves appears, the truth might be even worse. A study recently released by economists from the New York Federal Reserve (New York Fed) and New York University (NYU) concludes the FHA significantly understates the amount of risk it has taken on.

A leading culprit for this FHA risk assessment disparity is the method the FHA uses to calculate streamline refinances. Streamline refinancing enables FHA borrowers who are current on their payments to refinance their loans. This liberal standard to support continued homeownership allows for refinancing even if the value of the home is less than the outstanding balance on the loan. As home values began to plummet during the Great Recession, streamline refinances swelled in popularity, growing to 21% of all FHA-backed loans in 2009, up from 6% in 2008.

These high-risk refinance loans spell instant trouble for the FHA if the homebuyer goes into default. When a negative equity home is foreclosed on, the FHA takes a loss equal to the difference between the amount of its real estate owned (REO) resale price and the outstanding unpaid loan amount. The FHA estimates only 1.5% of high-risk streamline refinancing has been made to underwater homeowners. However, the New York Fed and NYU economists estimate 33% of those who received the streamline refinancing are underwater.

All these hugely conflicting negative equity numbers raise a cautionary warning: the California real estate housing market may be on much thinner ice than thought. And if the ice disappears under our collective feet, as we are warned by the New York Fed and NYU economists, who else is there to cast the life preserver if not the taxpayer?

In response to increasing loan insurance losses, the FHA is considering numerous solutions to replenish its insurance fund and remain self-funded, such as:

• raising the minimum required cash down payment to 5% or 10%, up from the current 3.5%;
• increasing its mortgage insurance premium to 2.5% paid upfront by the homebuyers;
• increasing its annual insurance premium to 3%, up from the current 0.5% or 0.55% depending on the borrower;
• reducing the maximum seller contribution to nonrecurring costs to 2%, down from the current 6%; and
• tightening its credit standards to credit score levels consistent with private insurers who issue private mortgage insurance (PMI).

If the FHA takes these steps, they will reduce the level of risk their reserves are exposed to and avoid a taxpayer bailout. However, these protective actions will decrease the number of tenants who can migrate into homeownership. Thus, only legitimate homebuyers can enter the market and tenants-by-nature stay tenants.

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