FHA Secure

Bush will apparently propose reforms to the Federal Housing Administration (FHA) which would allow the FHA to insure 80,000 more loans, a 50% increase in FHA-insured loans. Assuming an $200,000 loan size for subprime loans originated in 2005-2006, with roughly $30 billion in resets per month over the next year, this works out to around 5% — possibly less — of the subprime ARMs that will reset over the coming year. Relief would occur through a combination of risk-based pricing (premiums are currently set at a flat rate) that would allow FHA to insure riskier loans, and an increase in the FHA loan limit (the maximum is currently $362,000 in high priced areas but is significantly less in many areas. Legislation similar to what he’s discussing is likely to pass out of the Senate Banking Committee this month, and has already passed the comparable House Financial Services Committee. The bills could pass even more quickly with Bush endorsement. Although FHA reform would help some struggling borrowers, it is important to note that FHA is fairly small (it has had low-single digit market share for the last several years, though this is likely to rise). It is also self-financed, and FHA relief is not intended to shift billions of dollars in losses from homeowners or the private sector to the government. We’ve long pointed out that FHA will be a part of the solution, but won’t be the single answer.

· A change in IRS rules — to allow homeowners whose lenders have cancelled a portion of their debt to avoid tax liability on the value of the relief they receive — should encounter minimal resistance and may not even cost too much (under congressional budget scoring conventions) since most people wouldn’t have been able to pay the large tax bill they receive as part of the workout process in any case, and this may be taken into account. Legislation has already been introduced by Democrats in the House and Senate, and has some Republican support. On the margin, the proposal is likely to help a few homeowners avoid foreclosure but looks unlikely to prevent losses broadly.

· The final piece is of the proposal will be a Treasury/HUD project to identify high-default-risk borrowers and encourage lenders/insurers to be flexible in dealing with these borrowers. Essentially, this will be an effort at jawboning the lenders to limit the extent of the credit crunch in this segment of the market. This might be effective, though Congress and federal regulators have already held various ‘lender summits’ to pressure lenders to facilitate loan modification and flexibility in servicing. That said, the Treasury and Department of Housing and Urban Development (HUD) have enforcement powers in other areas, and may be able to bring some indirect pressure to bear to help lenders cooperate.

This is a fairly small step and will provide only incremental relief in itself, but may be the first of several steps the government takes to intervene in the mortgage situation. Politically, this announcement may be intended to avoid the ‘fighting something with nothing’ problem the Bush Administration has faced. In recently denying Fannie Mae its request to raise the cap on its portfolio holdings, the Bush Administration came under increasing pressure to propose some type of alternative solution.

However, although this step is fairly incremental, it does not preclude further steps in the future. Most notably, we expect legislation to reform the housing-related government sponsored entities (GSEs, i.e. Fannie and Freddie) to pass out of the Senate Banking Committee in the next month or so. The GSEs could also become part of the recovery process, as we outlined a few weeks ago. We do not, however, see much chance of a large government sponsored bailout – the government’s role continues to look limited to facilitating liquidity, regulating, and providing limited insurance, but not to shift liability for losses to the government.

In terms of timing, it’s at least a month, and probably at least a couple, until anything could be sent to Bush to sign into law. How fast such reform proposals could move will depend on whether FHA gets wrapped up in a broader package — for instance, GSE and predatory lending legislation to restrict lending practices could also be included — or whether it passes alone. If it gets tangled up in broader matters it will complicate and slows the process but also increases the odds of more aggressive relief than what Bush proposes.