Debunking the Hysteria Over an Executive Action

It's nice to at last be able to write a post that sheds the light of truth on a financial topic, rather than purely political ones.  I'm done with that - for now - though this one is related somewhat to the political hysteria that continues to grip so much of our nation.

After being inaugurated, President Trump signed several executive orders.  One of them caught the attention of some of my Facebook friends, who shared a post from Sen. Elizabeth Warren that linked an article from the L.A. Times.

Friends, first and foremost, if Elizabeth Warren says it, don't believe it.  It is undoubtedly misinformed sensationalist hyperbole.  Note that Sen. Warren doesn't understand why student loan rates shouldn't be the same as what banks pay the Fed for overnight borrowings.  Anyone who's taken a Money & Banking course in college - or has a modicum of common sense - knows better.  Sen. Warren does not.  I've forgotten more about finance, interest rates and banking than she will ever know.

The executive action in question rescinded one that President Obama made in the waning days of his administration.  Obama's action cut the mortgage insurance premium on FHA loans from 0.85% to 0.60%.  Trump's order rescinded that cut, leaving the insurance premium at 0.85%.

I understand why some people found this alarming.  After all, they haven't the foggiest notion of what the insurance premium is for, why the premium rate is what it is, whether it covers the default risk of an FHA loan, what the default rate is on FHA loans relative to conventional loans, why the FHA default rate is higher ... in other words, they don't understand the issue regarding which they're posting.

That violates The Curmudgeon's Third Rule of Linking or Sharing Articles on Facebook:  "Make sure you truly understand what it says."

But they shared it because Elizabeth Warren posted it, and that satisfies their pre-conceived partisan notions.  Which violates the Curmudgeon's Fourth Rule: "Remember that just because it reinforces what you already believe, that doesn't make it true."

So we're going to break it down, crunch some numbers, and find the truth.  But first, a primer.

FHA - named for the Federal Housing Authority, which administers the program - does not issue mortgage loans.  Rather, it guarantees repayment of loans under the program that are issued by banks, credit unions, mortgage brokers and other traditional lenders.  And since the FHA is taxpayer-funded, if enough borrowers under the program default on the loans to exhaust the FHA's reserves, you and I are on the hook to bail them out.

As we did during the recent housing crisis, to the tune of $1.7 billion.

Under this program, a borrower can make a down payment as low as 3.5%, vs. the 20% required to get a mortgage without paying for mortgage insurance, or the 10% minimum down payment required for a conventional mortgage, which requires borrower-paid mortgage insurance.  Now, pay attention to the numbers, please.

An FHA borrower can qualify with a credit score (a measure of the borrower's creditworthiness based on credit usage and history) as low as 580, which falls into the "Poor" range, and may indicate past defaults and bankruptcies.  The average credit score for FHA borrowers is 679, which falls into the "Fair" range.

So here's the idea behind the program: borrowers whose credit scores wouldn't otherwise qualify them for a mortgage, and who don't have the money to make a 10% down payment, can get a mortgage and buy a home.  It's not a bad idea.  In fact, my first mortgage loan was an FHA loan.  Not all FHA borrowers have low credit scores, they just can't afford a 10% down payment on their first house - at least without mommy-and-daddy money, which many don't have access to.  But on average, FHA borrowers have lower credit scores.

But there's increased risk involved: clearly, given their credit scores, FHA borrowers are more likely to default.  In fact, the FHA default rate today - well after the crisis - is 36% for loans issued at the apex of the crisis in 2007.

Do you get the significance of that?  More than a third of FHA loans granted in 2007 are in default today.  That's a whole lot of risk - risk to be borne by you and me, the taxpayers.  (Even if FHA doesn't exhaust its reserves, our tax dollars still fund it, so either way, we're on the hook for the defaults.)

But the risk doesn't end there.  Since the down payment is smaller, there's a greater risk of not being able to recover the full loan amount, through foreclosure and sale, in the event of a default.  If home prices fall, the value of the home is more likely to fall below the resale value than with a conventional mortgage.  Home prices need only fall by 4% for the house to be underwater, vs. more than 10% for a conventional loan.  And post-housing crisis, people are far more likely to default if their home's value falls below the loan balance than was true prior to the crisis.  (This is now called a "strategic default."  It used to be called "financial irresponsibility.")

Or, if the borrower doesn't take care of the home, in the event of a default and foreclosure, the lender may not be able to sell the loan at market value, which again can result in not being able to recover the full balance of the loan.

So, since the borrower is more risky, said borrower is asked to share in the risk by paying a mortgage insurance premium.  The insurance policy pays the lender back in full if the borrower defaults.  So the lender isn't on the hook, the insurer is - in this case, FHA (which means you and me, the taxpayer).

Okay, let's turn to some numbers.  There's a maximum amount for FHA loans, which prevents the program from being abused by borrowers of more significant means, or by higher-risk borrowers that try to leverage themselves into more home than they're going to be able to afford.  The maximum varies by state and county, based on home prices.  For my home county of Johnson County, KS, the 2017 maximum is $308,200 for a single-family home.  For reference, this is 31% higher than the median price for an existing home in the U.S.  We'll look at the impact of the rescission of President Obama's premium cut on a loan of both values, but first, let's compare the FHA premium to mortgage insurance premiums on conventional loans.

For conventional loans, mortgage insurance isn't required if the borrower puts up at least a 20% down payment.  The logic behind this is that a loan-to-value (LTV) of 80% (100% minus a 20% down payment) affords sufficient protection to the lender that mortgage insurance isn't necessary.  If the borrower makes a smaller down payment (the minimum is 10% for a conventional mortgage), mortgage insurance is required.

Those premiums range from .32% to 1.20%.  Note that the percentage is applied to the principal balance of the loan, as an annual amount.  This amount is divided by 12 and added to the monthly payment.  The premium range above is based on credit score, whether the loan is fixed-rate or adjustable-rate (adjustable-rate loans are riskier as the borrower may default when the rate adjusts upward, resulting in a higher monthly payment that the borrower may not be able to afford), and the down payment (between the 10% minimum and the 20% at which mortgage insurance isn't required).

So the average premium on a conventional loan, with 10% down, is .76%, compared with the pre-Obama executive order rate for FHA loans of .85%.  In other words, if I put 10% down on a home and have a "Good" credit score, I pay only .09% less in mortgage insurance premium than a borrower who puts down 3.5% and has a "Poor" credit score.

That .09% difference isn't nearly enough to make up for the additional risk.  And Obama's order would have meant that more risky borrower, with the "Poor" credit score and who put just 3.5% down, would pay .16% less in mortgage insurance premium than the higher-quality borrower with more skin in the game.

That doesn't begin to cover the additional risk associated with an FHA loan, and thus it puts the taxpayer at risk.  Nor does it make sense: should a driver with a clean driving record pay a lower premium for auto insurance than a driver with a bunch of tickets and accidents on his record, who presents a higher risk of future accidents?

Okay, now to the calculations.  A premium of .85% on the maximum FHA loan amount in Johnson County, KS equates to $218.33 added to the borrower's monthly payment.  A premium of .60% equates to $154.10.  Thus the difference is $64.23.

Or, if we assume a 3.5% down payment on the national median existing home price, the loan balance would be $226,678.50.  On that balance, a .85% premium adds $160.56 to the monthly payment; a .60% premium adds $113.34, for a difference of $47.22.

Folks, if $47 to $64 a month means the difference between being able to buy a home or not, you're probably not ready to be a homeowner.  Save a little more money, or wait until your income is a little higher.  Then you can actually afford a house.

Now, the National Association of Realtors (NAR) stated that rescinding President Obama's order would result in some 40,000 people a year not being able to buy a home (yet).  Looking at the numbers, those are 40,000 people who aren't yet ready to be homeowners.  But note that it's the job of the NAR - a trade association for realtors - to lobby hard for anything that results in realtors making more money by selling more houses, with no regard for what happens to those homeowners, the lenders, the FHA or taxpayers as a result.

Suffice it to say that the NAR's chief economist proclaimed that the housing market was in recovery in 2009, when in fact it was still in free-fall.  Promising news for realtors, but far from the truth.

Also, consider this.  Existing home sales in November 2016 (the most recent data) reached a post-crisis high of an annualized 5.61 million units.  (We use existing home sales because most FHA borrowers don't buy newly-built homes.)  And since most FHA borrowers are first-time buyers (and those are the folks that the sensationalist reports focus on), let's apply to that number the first-time buyer rate of 32% of all home buyers.  That's about 1.8 million first-time buyers a year.

So, if we believe the NAR, just 40,000 of 1.8 million borrowers - about 2% - might not be able to buy a home if the mortgage insurance premium is .85% instead of .60%.  Considering that there are about 122 million Americans who pay federal income tax and are thus on the hook for FHA defaults, I'm okay with that.

The bottom line is that a mortgage insurance premium of .60% for an FHA loan not only is insufficient to cover the increased risk of an FHA loan, it's less than the average mortgage insurance premium paid by borrowers who put down nearly three times as much, and have credit scores more than 100 points higher.  That's not equitable to those borrowers or to taxpayers.

President Obama's intentions were good, but he was attempting to tinker with numbers that he apparently didn't understand, in order to increase homeownership.  The homeownership rate historically trended around 65%, and for good reason: some people just aren't ready to be homeowners (like those who can't afford an extra $47 a month to cover the risk of their own loans).

When politicians attempt to tinker with that natural trend - as Barney Frank, Maxine Waters and Chris Dodd, the architects of the housing crisis, did in the early 2000s - disaster can result.  The trend in homeownership rates is mean-reverting, so when you artificially boost it higher, something will happen to revert it to the mean - defaults and foreclosures, in this instance.  But first, it may revert well below the mean, as happened in the recent crisis.

The Fed recently increased interest rates by .25%.  That will do far more to price would-be homeowners out of the market than holding the FHA mortgage insurance premium at .85%, because it affects ALL homebuyers, not just FHA borrowers.  But no one is calling for Janet Yellen's scalp for raising rates.

Likewise, home prices rose by more than 5% over the past year, and that too will do more to price would-be buyers out of the market than yesterday's executive action, because again, it affects ALL homebuyers.  But nobody's bitching about the housing market regaining strength.

So Elizabeth Warren et al can crow all they want about what a heinous act this is.  But if they understood the math and the risks involved, they might think better.

Know the truth, and the truth shall set you free.