Who Decided 417:1 Leverage is a Good Idea?

Amongst all the good news in the housing market, here’s something interesting: even though there is a massive push to limit leverage in financial instruments controlled by private parties, Congress allows politically connected entities to drink from a different punch bowl.  Today’s example of poor risk control?  The FHA, better known as the Federal Housing Administration.  Congress mandates that the FHA maintains at least 2% of their outstanding liabilities (they insure home mortgages) in the form of cash reserves.  For those keeping score at home, that’s an implied leverage of 50:1.  Fifty to one would be bad enough – but FHA’s reserves actually sit at just .24% of their $1.1 Trillion in insured mortgages.

What is the FHA?

The Federal Housing Administration was founded in 1934 ostensibly to backstop the underwriting of home mortgages (they don’t issue, just insure) and improve stability in the housing market.  Historically, the FHA has insured a small amount of outstanding mortgages in the market – previously around 2% of mortgages, but more recently 33% of the market since the bubble burst.  You see, nature abhors a vacuum, as does Congress – with Fannie Mae and Freddie Mac choking on their own mortgage liabilities, the FHA has stepped in to fill the void in mortgage backstopping.  That’s a problem because even though Freddie and Fannie continue to suck money out of the taxpayers, the FHA still claims that it is an entirely self-funded operation (“the only self-funded government program!”).  Of course, that’s because that other ‘government entity which self funds’, the quasi-independent USPS and the FHA also have implicit backstops – if they get in trouble, Uncle Sam will step in the back them up.  Don’t be naive – that $1.1 Trillion in potential liabilities would be tossed on the Government’s books no matter how much this site (and you) complain.

Recently, the FHA has actually tried to swim in the Fannie and Freddie swimming pool of prime loans.  FHA’s average mortgage now is attached to a borrower with a 700 credit score as opposed to a 620, which was their number just a few years ago.  Their exposure has also swelled to $1.1 Trillion from $305 Billion in 2007.  As our colleague Madhaus at Burbed alerted us to this year – prime mortgages might be the next bomb to drop.  Why, you may ask?  Two words: ‘strategic default‘.

A Graph of Stupid Historical Leverage

Here’s a graph of a few relevant leverages!  Remember: Greece (2010 EOY Data) and Long Term Capital Management were bailed out.  MF Global wasn’t.  It’s up to you to decide if $1.1 Trillion in potential liabilities is too big to fail.

The Next Bubble to Pop?

FHA has moved towards fiscal sanity, starting with their increase in insurance rates in 2011 (they are increasing rates again soon): 1.1% or 1.15% annually (until a mortgage has 20% equity and has matured for 60 months).  Previously it was 0.85% or 0.90%.  Of course, refinancing wipes an insurance paying loan from the books if prices do increase at a rate where 20% equity is reached before 60 months – so even the new terms might not be the magic ticket.  Remember that a bailout can be long and drawn out like it is proving to be with Fannie Mae and Freddie Mac – it doesn’t have to be one huge payment.

The problem is that the FHA is still a very good deal for borrowers – one that, combined with the programs offered by some cities, can still let a borrower purchase a house with only one percent down.  Don’t believe me?  Check out this program from CalHFA as an example – it creates a loan subordinate to the FHA backed mortgage, allowing a borrower to borrow up to 99% of a house’s cost.

How did Canada ever achieve their high home-ownership rates when their government housing entities are so much smaller than ours (pdf)? Is FHA the next bailout?  Discuss!


  1. says

    As for FHA – 417 leverage with no hedge whatsover is pretty irrational.  Obviously there’s the implied backstop that pretty much makes their balance sheet irrelevant as it is limited only to the government’s ability to borrow…which doesn’t seem all that limited.  FHA will get “bailed out” by an American refinancing program alongside increasing FHA premiums.  The burden is paid by well-capitalized banks holding MBS to the homeowner, who will pay higher FHA premiums but a lower total mortgage bill due to refinancing.  Just my take.

    As far as Canada, it’s magic. Even still, there’s definitely going to be a correction in Canadian homes. Canada has the highest price to rent ratio in the world, which implies that current investment is made under the assumption of rising rents.  The Economist says Canada’s real estate is 76% more expensive than long-run average based on price to rents, and 32% more expensive based on incomes.  By contrast, American real estate is 12% undervalued relative to historical rent averages, and 25% undervalued relative to historical housing prices to income ratios.

    As for why Canadians are more likely to own homes, who knows.  Right now, it looks like a much better idea to rent a Canadian home than purchase one.

    • says

      I like that – Canada is magic. Especially Vancouver.

      But seriously, it’s hard to explain Canada’s homeownership in the context of what we’ve seen, well, everywhere else in the world. Either they’re the next shoe to drop, or the influx of money through their immigration programs (very lax for business owners, for example) are actually keeping them afloat.

      • says

        That’s a good point about business owners, since it seems that there’s a large Chinese interest in Canadian housing.  Maybe also full recourse loans have a bit to do with it – you can’t just walk away, and so you never have the a massive surge in foreclosures after a bubble.

        • says

          Do you remember that song “The Impression That I Get” by the Mighty Mighty Bosstones? There is one part that goes “I’m not a coward, I’ve just never been tested. I’d like to think that if I was,
          I would pass.”

          Canada hasn’t (yet) been tested – it’s easy to say something is working on the way up, but when the music stops hopefully they can arrest major problems on the way down.

          • says

            Hey guys, as a Canuck I’ll chime in.  One of the key reasons is that much of our population is still pretty rural and stable in terms of home prices.  Another reason we can invest more in our houses is because of the subsidized schooling situation (less student loans, and less saving for our kids), and our health care is free.  This leaves us to take bad situation in strike, when they can be crippling in the States (cancer etc.).  Finally, the markets in Toronto and Vancouver completely skew the numbers.  There is definitely the same speculation going on there that plunged the States into chaos.  The only reason their might be a slightly softer landing is that there actually are a lot of foreign people with money that want to live in those cities, so the speculation crash might not go as deep.  The rest of Canada (save Quebec) is likely to stay pretty as is.  The oil patch isn’t going anywhere, and the prairies are the definition of a diverse economy.  I predict housing will drop by at least 30% in Vancouver and TO, but everywhere else will stay pretty even.  The weird rent stats are mostly a result of the condo surge combined with crazy rent controls and renters rights – it’s just so much easier to turn apartment buildings into condos and lock in massive profits.

          • says

            Thanks for the reality check – most of the stuff I read is about foreign buyers in Vancover, and million dollar ranches. It seems suspiciously like where I live (except minus the popped bubble!)

  2. freeby50 says

    In my mind it doesn’t really matter.

    THe FHA is a part of the US government.  

    Our government has tons of debt and I don’t mind if they don’t let cash sit idly doing nothing.   Worst case they have to bail out the FHA and that would be with borrowed money anyway.

    Would we rather that they have $2 billion sitting in cash or that they borrow $2 less?

    BTW,FHA mortgage insurance works differently than private loan PMI.   So I don’t think a refinance just makes that cost disappear as easily.  FHA has an “up front” mortgage insurance that you pay as part of the purchase.

    • says

      The last insurance worked like so (not sure after the recent/upcoming insurance change):

      1% upfront premium – almost impossible to recapture
      1.1 – 1.15% insurance annually, paid monthly, up until 22% equity in the home. Also, requires a minimum of 60 months.

      That’s where I was saying a refinance was worth it – to counteract the annual insurance payments if you have reasonable equity before 60 months is up.

      And yes, it’s like if Scrooge McDuck made piles of money in different sections of his pool – it’s all the same thing. I see it as a good deal for a home-buyer and cheap leverage, and combined with low rates and a potentially bottoming market I’d think you’d see even more first time buyers coming out of the woodwork.

  3. says

    Hmmm….couple this with the problem that I’m reading about this morning: rents are outpacing wage inflation. It’s becoming more difficult to rent a house. That’ll make it difficult for congresspeople to justify eliminating 1 percent down mortgage programs.

    • says

      Maybe they’ll make it 0% down? You know, when a Government policy doesn’t have the intended effect, make the policy more lax?

  4. says

    Sometimes it’s just as scary to ask the question “what if there isn’t an immediate reprocussion.” In politics, results justify the means and the risk taking only increases until there’s a problem. If the FDA works as a life-raft once, what will it be used for in the next housing crisis?

    • says

      If the FDA worked in housing? We’d probably get a housing triangle saying where to avoid or get calories and which building materials are safe to eat.

      Seriously, though – things will work, until they don’t. Even though Fannie and Freddie seem to show what happens when there is too much leverage, that won’t stop politicians apprehensive about another election season from using the FHA for short term gains and ignoring the inevitable hangover.