“Moral hazard: a situation where one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost.” [1]
The Federal Housing Administration’s (FHA’s) single-family mortgage insurance program is all about moral hazard and is reliant on multiple participants.
First, FHA insures 100 percent of the loss, maintains minimal capital, and is taxpayer-backed. Further, it neither prices for risk nor underwrites for risk layering. This is demonstrated by the fact that the underwriting and pricing for a 30 year term FHA loan with 96.5% LTV with 580 FICO and 46% DTI are effectively the same as for a 30 year term loan with 96.5% LTV with 710 FICO and 36% DTI. The first loan has an AEI mortgage risk index (MRI) of 43 percent versus 17 percent for the second loan. As a result, 88 percent of FHA’s loans are high risk, up from 82 percent in November 2012.
Beyond the moral hazard it presents, FHA’s pricing structure is inherently unfair to borrowers and exposes FHA to adverse selection. [2] This is the exact opposite of the original FHA structure created under the 1934 National Housing Act which prohibited cross-subsidization.
Second, Ginnie, with minimal capital, is free to ignore borrower solvency risk since it is protected by FHA.
Third, mortgage banks or non-bank lenders, [3] like Ginnie Mae, are able to largely ignore borrower solvency risk since it too is protected by FHA. The mortgage banker business model, unchanged for 80 years, is to “originate what they can sell and sell what they originate.” [4] It can largely disregard the inherently risky nature of FHA lending, as long as it complies with FHA’s manufacturing standards. Over the last 2 ½ years nonbank share of FHA loans increased from 27% to 63%, with large bank share shrinking by a commensurate amount. [5] In May 2015 the National Mortgage Risk Index for non-banks FHA loans was 25.1% compared to 21% for large banks.
Fourth, high risk borrowers are misled into thinking they are creditworthy and borrow more than they should. [6] The FHA’s mortgage insurance premium (MIP) reduction in January 2015 provided a text-book case of how the additional buying power created by liberalized credit during a seller’s market, primarily gets absorbed in price, without much increase in accessibility. For April and May 2015, the median price of FHA-insured homes to first-time buyers paying the lower premium went up by about 5% more than GSE- and VA-insured homes. [7] This suggests that half or more of the extra 7% in buying power created by the premium drop was used to purchase either larger, more expensive homes or that prices rose in response to increased demand pressure.
The risks FHA is willing to insure make it the preferred channel for introducing excessive housing finance leverage. This places it in competition with Fannie, Freddie, the VA, and RHS. All of these agencies are effectively exempt from and therefor unconstrained by the Qualified Mortgage Rule. [8] These five agencies account for 85 percent of the mortgage loans made to purchasers of owner occupied loans.
The competition among FHA, Fannie Mae, and eventually Freddie Mac is largely a result of the GSEs still being subject to an affordable housing goals mandate. This mandate was made even more onerous by the Housing and Economic Recovery Act of 2007. All agencies will tend to liberalize underwriting in order to maintain or increase market share. It is this process that will introduce destabilizing risk nationally. However, as was the case prior to the housing crash, this movement out the risk curve may many years.
As has happened time and time again with efforts to liberalize lending terms, the greatest impact will be on lower-income and minority borrowers and neighborhoods.
The National Mortgage Risk Index is well designed to track the growth of moral hazard in real time.
NOTES
[1] http://economictimes.indiatimes.com/definition/moral-hazard
[2] For a detailed analysis of the role risk-based pricing plays in promoting a fair and efficient mortgage market, see Board of Governors of the Federal Reserve System, Report to the Congress on Credit Scoring and Its Effects on the Availability and Affordability of Credit, August 2007, www.federalreserve.gov/boarddocs/rptcongress/creditscore/creditscore.pdf
[3] Mortgage banking subsidiaries of banks are included in the bank grouping.
[4] Evidence of the risk differential between mortgage banks and depository and insurance institutions goes back as far as the late-1950s. FHA’s 1958-1960 claim experience for mortgage bankers was 1.28% compared to 0.57% for banks, thrifts, and insurance companies. Source: McFarland, FHA experience with mortgage foreclosures and property acquisitions, 1963, GPO.
[5] In March 2015, the International Housing Risk Center released its groundbreaking study on the seismic shift in lending away from banks to nonbanks. The study documented that the risk profile of nonbank FHA loans is much higher for nonbanks than for banks. http://www.housingrisk.org/study-shows-seismic-shift-in-lending-away-from-large-banks-to-nonbanks-continued-in-february/
[6]Supra, www.federalreserve.gov/boarddocs/rptcongress/creditscore/creditscore.pdf
[7] The study analyzed over 2½ million loans, controlling for variation in CLTV, FICO, total DTI, seasonality, and property state.
[8] The Qualified Mortgage Rule does not set a downpayment limit, a FICO score minimum, or a maximum debt-to-income ratios (the five governmental agencies mentioned are exempt from the nominal limit of 43 percent).