FHA's mispricing of risk is a major hurdle to housing finance reform

The largest hurdle the US government will face in transferring housing finance into the private sector is its mispricing of risk. The only way for the private sector to even begin taking on some of the mortgage credit risk is to make sure that the gap between private and public terms is sufficiently low to generate interest from private lenders/investors without a massive repricing exercise (discussed here).

For example, mortgage rates for buyers who put down a 20% down payment vs. those who put down say 50% may be quite different in the private markets, while the GSEs would typically price this risk the same way - as a "conforming loan". The one government program that remains ridiculously off-market is the mortgage insurance program managed by the FHA. The average down payment required on a house purchase has been just over 4% - around a 25x leverage.

Source: FHA

This ends up distorting the housing market (pushing prices artificially higher - see recent example) and maintaining a large gap between government sponsored and any privately underwritten pricing of risk. It also continuously puts the taxpayer at risk to borrowers who have very little "skin in the game". The chart below shows the number of FHA dispositions, where the taxpayer becomes the proud owner/seller of houses. Of course in this environment houses are selling well in many areas. What happens if we hit another downturn?

Source: FHA

FHA-sponsored loans represent a form of sub-prime debt, which will have no equivalent in the private market - even if the rates on these loans were to increase dramatically. In order to have any hope of developing a sustainable US housing finance market in the private sector, the FHA needs to start moving closer to terms that private underwriters would want to see (down payment, term, rates, credit score, etc.) or begin phasing out the program altogether. Recapitalizing the FHA with additional taxpayer support, as some politicians have suggested, is exactly the wrong action at this stage.

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