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FHA's roots.

FHA'S ROOTS

If you review the history, you notice that a risk-based premium for FHA is not a new idea. But neither is it a good one, says one analyst of the home loan program.

Nothing in Washington, D.C. is ever as it appears.

The current debate about a risk-based mortgage insurance premium for the FHA program is an excellent case in point.

Historically, FHA charged all borrowers a uniform premium. However, in the Bush administration's FHA reform package announced by HUD Secretary Kemp on June 6, 1990, a risk-based premium was proposed for the FHA home loan program.

Under that proposal, which subsequently passed the Senate (S. 566) on June 27, 1990, there is .5 percent annual surcharge added to the 3.8 percent upfront mortgage insurance premium for mortgages with loan-to-value (LTV) ratios above 90 percent. The term of the surcharge would vary from 4 to 15 years, depending on the LTV.

A risk-based premium for the FHA program is not a new idea. In fact, two studies in the 1970s (Report of the Task Force on Improving the Operation of Federally Insured or Financed Housing Programs in 1972 and an internal 1977 HUD report entitled Future Role of FHA) recommended the use of a risk-based premium system to reinvigorate FHA lending activity.

Both studies expressed deep concern about the dramatic drop in FHA activity in the 1970s and offered a variety of recommendations including risk-based premiums. The 1977 study concluded its discussion of the premium structure with the following:

While it is impossible to predict

the long-run effect on FHA

volume that would be achieved by an

alteration of this pricing policy

[uniform premium], it appears

that continuation of the single

price scheme will hasten the

declining volume of FHA activity.

What is surprising today, then, is that the risk-based premium concept has been embraced by an administration that has advocated targeting FHA insurance to low- and moderate-income families and others who have sought restrictions on FHA.

At a congressional hearing July 10, 1990, Gregory Barmore, president of the Mortgage Insurance Companies of America, stated:

The administration's proposal

and S.566 recognize also the need

for FHA to better price to the risk

it insures by requiring a small

renewal premium to be paid if the

borrower puts down less than 10

percent. This proposal balances

FHA's social role with its need to

be fiscally responsible because

the premium is based on the risk

of the loan...

The increasing importance of this issue is demonstrated by a statement in the Wall Street Journal on August 1, 1990 attributed to an aide to Secretary Kemp. Mary Brunette, assistant to the secretary for policy and communication, stated that funding levels of various HUD programs were negotiable but the risk-based premium was not.

One might ask, why are advocates of a more-targeted FHA supporting a proposal that, theoretically at least, encourages FHA intervention into the private insurance market? Equally intriguing is the question of why the housing industry does not support this risk-based premium proposal. As is the case with so many issues in Washington, the reasons are not readily apparent. In this article, FHA's mortgage insurance premium will be examined and the reasons for the differing opinions on the concept of risk-based premiums will be analyzed.

History

The Federal Housing Administration was established as part of the National Housing Act on June 27, 1934. Because of the Depression's devastating impact on the nation, FHA's founders recognized that the agency had to operate at no expense to the federal government. Using fundamental insurance principles, FHA's creators realized that the policyholders (homebuyers) would have to cover the costs of program operations and property losses through the payment of insurance premiums.

Toward this end, Section 203(c) of the original Act stated:

The administrator is authorized to

fix a premium charge for the

insurance of a mortgage under this

section (to be determined in

accordance with the risk involved)

which in no case shall be less

than one-half of 1 per centum nor

more than 1 per centum per

annum of the original face value

of the mortgage...

From reading transcripts of hearings and articles on this subject, it appears that the pre-eminent concern in 1934 about the new FHA program was the collection of a premium adequate to withstand any foreseeable adverse circumstances (e.g., high percentage of foreclosures). To accomplish this objective without unfairly penalizing homeowners who used FHA insurance, a mutuality provision was included in the basic program.

Under this concept, the portion of the premium remaining after FHA pays all of its expenses and claim payments is returned to eligible borrowers in the form of a distributive share payment after the mortgage is paid off. This provision enabled FHA to charge a 1 percent premium in 1934 and have a vehicle to return any excess premium amounts to eligible homeowners. The mutuality feature only applies to a specific number of Section 203 subsections, including Section 203(b), and was never authorized for any of the other insurance programs.

There have been relatively few changes to the FHA insurance premium structure over the years. In 1938, the National Housing Act was amended to change the basis for calculating the borrower's monthly premium payment from the original mortgage amount to the outstanding balance of the mortgage. The premium was lowered to .5 percent in 1939 and remained at that level until HUD implemented the one-time mortgage insurance premium structure in 1983. This 3.8 percent upfront premium coincided with .5 percent monthly premium.

Philosophical debate

If the typical thinking about FHA in the 1970s can be characterized by the two studies mentioned earlier, with their concern about FHA's future, the debate in the 1980s shifted 180 degrees. In the decade just closed, the discussion about the FHA program centered on the federal government's proper role in housing. There were some who were concerned about the growth of federal credit and believed housing--through the proliferation of federal loan guaranty programs--was becoming a drain on the economy. FHA became the lightening rod in this debate.

The Reagan administration shared these concerns, and almost from the day it assumed power sought to reduce the role, if not eliminate, the single-family programs of the Federal Housing Administration. Starting with the budget review process in February 1981 in which it proposed phasing out FHA by the middle of the 1980s, the Office of Management and Budget (OMB) offered a variety of proposals to restrict, target and yes, even sell FHA.

The Reagan administration, after having more radical proposals rebuffed, settled on an effort to target FHA insurance. At a Senate Subcommittee on Housing and Urban Affairs hearing in 1982, HUD Secretary Samuel Pierce stated:

We think serving first-time and

inner-city homebuyers is an

appropriate role for FHA... We

propose, first, to direct FHA's

single-family programs to

homebuyers unserved or underserved

by the private sector.

While the Reagan administration's proposals were not well-received by most in the housing industry, private mortgage insurers strongly endorsed this policy shift. At the same hearing in 1982, Robert Waldo, president, Mortgage Insurance Companies of America, reflected the sentiment of his industry when he stated:

All available data demonstrate

that the private mortgage

insurance industry and the FHA

unsubsidized programs now serve

essentially the same market. We

believe, therefore, based on the

capacity we have built since the

inception of the industry 25 years

ago, that a redirection of FHA's

unsubsidized role to areas of the

market not served by private

enterprise would not adversely

impact the availability of housing to

any segment of the market.

Terms like "overlap," "encroachment" and "FHA's complementary role" became the slogans for the Reagan administration and the private insurers in their battle to restrict FHA.

At the same time the Reagan administration was talking about targeting, it also floated a risk-based premium proposal in the mid-1980s. This proposal raised concern because it seemed totally inconsistent with the targeting initiative.

Concern centered on the fact that if FHA was focusing on those borrowers who were not served by the private sector, almost by definition they would be high-risk borrowers with little cash reserves. It follows that these would be the very borrowers unable to bear the financial burden of the higher risk-based premium. The net result would be that underserved borrowers, those that FHA was "targeting" its program toward, would be unable to meet the new cost requirements of a risk-based premium.

To give the reader an idea of the cost of such an approach to the homebuyer, the following passage has been excerpted from a study that was done for MBA by KPMG Peat Marwick in 1987. Peat Marwick stated:

By choosing this approach (risk-based

premium), the FHA would

have to charge premium rates

that vary by as much as 300

percent to 400 percent from the

lowest rate (e.g., low loan-to-value,

high valued home) to the highest

rate (e.g., high loan-to-value,

smaller than average mortgage

amount.)

Applying these criteria, FHA borrowers seeking high-ratio loans of less than $50,000, would likely be charged upfront premiums of exceeding 10 percent. There is little doubt that few borrowers in this category could afford such a premium.

Skeptics saw this proposal as part of the Reagan administration's strategy to shut down FHA. They argued that as the number of mortgages to lower income families was reduced, the percentage of lower-risk borrowers would increase significantly. This development then would give credence to the positions being taken by the administration and the private mortgage insurance industry that there was considerable overlap in the markets served by the FHA program. No formal action was ever taken on this proposal during the Reagan years.

New HUD leadership

When Jack Kemp became HUD secretary, he brought to the department enthusiasm and personal commitment that had been lacking in the previous administration. He acted quickly and decisively to address serious management problems throughout the department.

Kemp's basic goal with regard to the FHA single-family program is to expand homeownership and affordable housing opportunities. His statement to the Senate Subcommittee on Housing and Urban Affairs on June 6, 1990 outlined the Bush administration's proposals to ensure the continued solvency of the FHA program. In that statement, he also gave insight into his view on FHA's future role. During the course of his remarks he said, "Its [FHA] historic and proper mission is to serve low- and moderate-income homebuyers." Further, he stated: "The department is now able to propose a set of changes that will strengthen FHA and make it better able to serve first-time homebuyers in the 1990s."

For all the positive management improvements that Secretary Kemp has implemented at HUD, these statements ring an ominous tone. Philosophically, at least, they appear to be in step with the federal housing policy of the Reagan administration and its powerful Office of Management and Budget (OMB).

Kemp proposals

In his June appearance before the Senate, Secretary Kemp proposed a five-part strategy to ensure FHA's financial solvency and to reach minimum capital standards. The first point in that strategy was the risk-related premium structure noted earlier that has been since passed by the Senate.

The administration's position was articulated in a brochure entitled Facts on FHA Reform. To justify a risk-based premium, the brochure stated:

The actuarial study (Price

Waterhouse) found that by far the best

indicator that a borrower is likely

to default is a low down payment.

Borrowers who put less than 7

percent down account for the

greatest amount of the loss. With

a risk-based premium approach,

the price of FHA insurance

increases only for higher-risk

borrowers. An actuarially sound

single premium system would

increase costs for all borrowers.

This would have the effect of

encouraging less risky borrowers to

seek conventional financing. This

would leave FHA with an even

greater concentration of high-risk

borrowers and, according to Price

Waterhouse, a higher ultimate

default rate than it has now.

Simply put, Price Waterhouse is concerned about adverse selection developing in the FHA program. The 1977 report expressed a similar concern, referring to it as "cream-skimming on the part of the private mortgage insurance industry."

Why a risk-based premium?

In searching for the origins of this proposal, the Price Waterhouse report surely encouraged discussion of this option. While there are wide differences in the commitment to housing shown by Secretary Kemp and his predecessor, the one constant in both the Bush and Reagan administrations has been the dislike for current federal housing policy held by those inside the President's budget office--OMB. OMB Director Richard Darman's budget analogy that compared federal credit programs to "Pac Man" underscores this point. There is little doubt that OMB has seized the opportunity created by FHA's recent financial troubles to further its efforts to gain tighter control over federal credit programs.

There is no question that borrowers with low down payment loans will bear the burden of the higher premium under a risk-based structure. Two FHA statistics underscore the dilemma presented by this proposal. In 1988, 53 percent of all low down payment FHA loans (less than 5 percent down payment) were made on mortgages of less than $60,000 and only 18 percent were made on mortgages exceeding $80,000. The claim rate on loans under $60,000 is 20 percent higher than the claim rate on loans exceeding $80,000. From this data, it is obvious that lower-income families will be the most adversely affected by this proposal. While the differences in the premium structure are relatively modest in the Bush administration's current proposal, the Peat Marwick study demonstrates how much the premium structures can vary under a risk-based structure.

For 56 years, all FHA borrowers have paid the same mortgage insurance premium percentage. By its very nature, charging the same premium to all borrowers produces a type of cross-subsidization in which low-risk borrowers actually "pay" the costs associated with losses produced by borrowers with higher risk. This policy enables FHA to serve first-time homebuyers with lower incomes and/or little cash reserves. Any tampering with the mortgage insurance premium charged FHA borrowers could disrupt the delicate balance that currently allows the program to serve those homebuyers for whom FHA is their only hope and preserve FHA's actuarial soundness.

Although some deserving borrowers no doubt will be excluded, the current administration believes a risk-based premium is necessary to ensure that FHA remains viable in the future because of possible adverse selection.

Because that potential problem has been a factor since the inception of the program, many people question why action is needed today.

It is also interesting to note that the warning raised in the 1977 report to date has proved unfounded. In the last half of the 1980s, FHA insured more mortgages than it did in any comparable period in its history. FHA did more business in 1986-1989 (3,565,800 mortgages) than it did in its first 20 years (2,866,157 mortgages). There is considerable data supporting this view.

Despite all of the problems during the Pierce years, FHA did modernize program operations through the implementation of the direct endorsement program and with deregulation of the FHA administered rate in 1983. These changes rejuvenated industry and public interest in FHA.

If FHA wants to effectively address the issue of adverse selection of borrowers, it must now make policy decisions to attract the needed low-risk borrowers. There is no reason why a borrower making a 10 percent down payment has to meet the same rigorous documentation requirements as those for a borrower making the minimum cash investment. There is no need for these low-risk borrowers to provide both bank statements and pay stubs as well as verification forms. It is duplicative and provides no additional underwriting protection to HUD. Reasonable alternative documentation standards similar to those established by Fannie Mae and Freddie Mac would be an excellent starting point.

No one quarrels with the belief that FHA's first responsibility is to serve the needs of low-, moderate- and middle-income families who are not adequately served by the private sector. Everyone agrees that FHA cannot conduct business in the next decade as it did during the 1980s.

There are two fundamental choices with respect to FHA's premium structure--implementation of a new risk-based premium or continuation of a uniform premium. Those who support the risk-based formula contend that adverse selection may develop in the program and the fund's financial health could suffer as a result. Others maintain that a uniform premium has enabled FHA to best serve lower-income families and that a risk-based premium would hurt the homebuyers who rely on FHA the most.

In weighing the evidence, there is consensus that a risk-based premium will prevent some homebuyers from buying a home because they lack the cash reserves to make a more substantial down payment and the additional income to pay the cost of the higher premium. Economic theory, on the other hand, is the primary basis for the concern about adverse selection of borrowers under the program.

For nearly 60 years, FHA's policy of a uniform premium--with its cross-subsidization principle--has worked remarkably well. FHA has epitomized how a government program can serve a social purpose at no cost to the American taxpayer. While changes must be made to the FHA program to ensure its viability in the 1990s, a risk-based premium should not be one of those changes.

Brian Chappelle is a staff vice president in residential finance and government agency relations at the Mortgage Bankers Association of America, Washington, D.C.
COPYRIGHT 1990 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1990 Gale, Cengage Learning. All rights reserved.

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Title Annotation:risk-based mortgage insurance premium for Federal Housing Administration's loan program
Author:Chappelle, Brian
Publication:Mortgage Banking
Date:Oct 1, 1990
Words:2919
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