Is the FHA's Insurance Fund Worth a Negative $31 Billion?

FHA May Show Negative Reserves For Mortgage Losses
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Just how deep underwater is the Federal Housing Administration's mortgage insurance fund?

In her Sunday column, Gretchen Morgenson points out that a recent report from the FHA's auditor puts the value of the fund at a negative $13.48 billion. That sounds absolutely horrible. But the truth is that the FHA fund is probably even worse off than that.

The negative $13.48 billion valuation indicated by the auditor's report is an estimate of the gap between mortgage insurance premiums that the auditor expects the F.H.A. will collect in the future and the expected losses from defaults on FHA insured mortgages, combined with the agency's capital.

Under a procedure known as a Monte Carlo simulation, the auditor ran various simulations of 100 equally possible outcomes for the FHA's income stream. It then averaged the net present value of those income streams to produce its base case deficit of a negative $13.48 billion value for the fund.

Predicting future mortgage rates is one of the key elements of this calculation. Perhaps counter-intuitively, the FHA is hurt by lower mortgage rates. When mortgage rates are low, the best borrowers are able to refinance into new, uninsured mortgages and avoid paying FHA insurance premiums. The remaining pool of borrowers is lower quality, driving up the loss rate.

Think of a health insurance pool in which all the healthiest people are able to opt into a different, cheaper plan. The remaining sickly customers become nearly uninsurable. So to figure out the health of the FHA, you really need to get future mortgage rates right.

The FHA auditor to project the future path of the rate on ten year Treasury bonds using projections from Moody's as its guide. Those projections said that rates will rise rapidly from 2013 to 2015 and then level off for the following years. The negative $13.48 billion valuation is based on that scenario.

Moody's projections, however, were made in July of 2012—prior to recent Fed announcements that have made it clear that it intends to keep federal funds rate low until at least mid-2015. On September, the Fed said it had decided "to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015."

Deep in the auditors report, on page 62, it reveals that under this scenario—the scenario anticipated by the Fed itself—the economic value of the fund would fall an additional $17.58 billion, for a negative $31.06 billion. The fund's value stays negative until 2015, when rates are expected to climb again.

Even that may be too sanguine. We do not know for a certainty that rates will climb in 2015. Indeed, the Fed's own language says rates will remain low "at least through mid-2015." They could remain low for even longer than that—which would make the FHA's financial position even worse.