Editor: David Reiss
Brooklyn Law School

September 20, 2013

American Dream/American Nightmare

By David Reiss

I will be presenting “How Low Is Too Low? The Federal Housing Administration and the Low Down Payment Mortgage” at the 2013 Meeting of the Canadian Law and Economics Association next week in Toronto. I just came back from an interesting conference at the Cleveland Fed where I was on a panel devoted to the FHA. The other two panelists presented some disturbing findings about default rates for FHA mortgages.

The two panelists were

Edward J. Pinto, Resident Fellow, American Enterprise Institute, How the FHA Hurts Working-Class Families

Joseph Tracy, Executive Vice President and Senior Advisor to the President, Federal Reserve Bank of New York, Interpreting the Recent Developments in Housing Markets

Pinto’s summary is as follows:

The Federal Housing Administration’s mission is to be a targeted provider of mortgage credit for low- and moderate-income Americans and first-time home buyers, leading to homeownership success and neighborhood stability. But is the FHA achieving this mission? This paper reports on a comprehensive study that shows the FHA is engaging in practices resulting in a high proportion of low- and moderate-income families losing their homes. Based on an analysis of the FHA’s FY 2009 and 2010 books of business, the FHA’s lending practices are inconsistent with its mission. The findings indicate: An estimated 40 percent of the FHA’s business consists of loans with either one or two subprime attributes—a FICO score below 660 or a debt ratio greater than or equal to 50 percent (based on loans insured during FY 2012). The FHA’s underwriting policies encourage low- and moderate-income families with low credit scores or high debt burdens to make risky financing decisions—combining a low credit score and/or a high debt ratio with a 30-year loan term and a low down payment. A substantial portion of these loans has an expected failure rate exceeding 10 percent. Across the country, 9,000 zip codes with a median family income below the metro area median have projected foreclosure rates equal to or greater than 10 percent. These zips have an average projected foreclosure rate of 15 percent and account for 44 percent of all FHA loans in the low- and moderate-income zips.

Tracy reported that rates of defaults by households rather than by mortgages gave a truer picture of the FHA’s success because many FHA borrowers would refinance into another FHA loan. Thus, to study defaults by mortgages covers up the real rate of default.

I believe that their studies were preliminary and have not gone through peer review, but both of them reported extraordinary default rates for certain types of FHA mortgages.

Pinto and his empirical work are very controversial so I cannot endorse his findings. But I can say that if he got it only somewhat right about predictable and ridiculously high default rates for some categories of borrowers, the FHA must immediately defend the underwriting of such loans or change its practices. It would be criminal to have predictable default rates in excess of 20% for any population. Such a rate transforms the American Dream of homeownership into an American Nightmare of foreclosure far, far too often.

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