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On February 11, 2011, the Treasury Department, along with the Department of Housing and Urban Development (HUD) released a white paper to Congress outlining the administration's proposals for reforming the housing finance market. The plan calls for private markets to serve as the primary sources of mortgage credit and bear the burden for losses, while requiring financial institutions to adhere to more conservative underwriting standards that require homeowners to hold more equity in their homes. The plan also calls for restructuring the government's long-term role in the housing finance system and ensuring access to quality, affordable housing for the underserved.
The white paper lays out three different reform options. In the first option, the government creates a reinsurance program that guarantees mortgagebacked securities (MBS) during a crisis. Under this approach, a group of private mortgage companies provides guarantees for MBS that meet certain strict underwriting criteria. The government charges a premium for its reinsurance that is used to offset losses, guarantees only the MBS after the mortgage entities take losses, and does not backstop the entities' debt. In this model, the federal government still provides the backstop for the private guarantors.
In a second option, the government stays out of the mortgage market almost entirely, retaining the Federal Housing Administration (FHA) in support of housing programs for low-income households. A third option also reduces the government's role, but maintains a guarantee mechanism that expands in down markets to serve as a backstop if private capital withdraws.
Despite their substantial differences, all three proposals retain a significant role for the FHA. Indeed, in the recent crisis, the FHA played a major countercyclical role in mortgage lending; its share of purchase mortgage loans increased from 4 percent of the market in 2005 to more than 23 percent in June 2010 (U.S. Department of Housing and Urban Development 2010a).1 For this reason, it is vital that discussions surrounding mortgage finance reform consider what role the FHA will play in the new regime.
The goal of this article is to make two points relevant to assessing what role the FHA should play. First, when the national housing market declines, the federal government typically supports mortgage lending and, since the FHA is part of the federal government, it will in all likelihood play a major role in this effort. Second, one of the FHA's missions is to lend to lowand moderate-income households, and it does this partly by allowing for low down payments. When house prices drop, many of these loans will end up with negative equity, that is, a borrower will owe more than his house is worth, and it is well documented that negative equity is the most important factor in default. Consequently, the FHA's exposure to risk will increase. Whether countercyclical mortgage lending by the federal government is good policy is an open question and one that I do not take a stand on. Nevertheless, it should be clear that if such a lending policy permits low down payments during a declining housing market, the costs of such a policy may be significant.
The next section provides a brief description of the FHA and its Mutual Mortgage Insurance fund (MMI fund). Section 2 illustrates the risks to countercyclical lending by providing estimates of negative equity in a sample of FHA-endorsed mortgages from Florida. Florida is not representative of the rest of the country; indeed, its housing market is in significantly worse shape than many other states, but it is a useful case study because house price dynamics are very strong there and the availability of public house price data allows me to estimate county-level price indexes. Section 3 concludes with a discussion of policy implications.
1. THE COUNTERCYCLICAL ROLE OF THE FHA AND READING THE TEA LEAVES OF RISK IN THE MMI FUND
Background on the FHA
The FHA provides mortgage insurance on loans made by FHA-approved lenders for single-family and multifamily homes, including manufactured homes, along with hospitals. …