Government Involvement in Housing Market

As noted repeatedly over the last few months, several recent data points suggest the housing market has begun to improve off the unprecedented lows reached in April. Seasonally adjusted housing starts are up 25%, standing inventory of existing homes has been whittled down to 9.4 months (vs. over 11x months at the peak, though well above the 4-6 months indicative of a healthy housing market), and pricing has begun to firm, with the Case Shiller Index posting its first sequential monthly increase since July 2006. Although some regions of the country continue to experience declines (Vegas and Phoenix being amongst the most troubled), the recovery has generally been broad based, with some of the hardest hit markets (southern California, western Florida) demonstrating the strongest hints of recovery.

While a stabilization in the housing market is encouraging, investors must realize how critical the government’s role has been in driving this improvement. Firstly, the $8,000 tax credit for new homebuyers has significantly brought forward demand. This is particularly the case in California where residents also benefited from a $10,000 state-specific tax credit (though the program’s funding was exhausted in July). Further, mortgage rates have been artificially suppressed thanks to the Federal Reserve’s program to buy $1.25 trillion of mortgage-backed securities and up to $200 billion of Fannie & Freddie debt securities by year-end. With a combined $810 billion expended to date on these two programs (see below), the Fed has kept conforming interest rates below 5.5%. Low mortgage rates and 30% peak to trough declines in home prices have resulted in off the charts affordability. However, once these spending programs are exhausted, we are very likely to see mortgage rates creep up. Even a 50-100 bps widening could have a meaningful impact on the housing market, particularly as unemployment moves towards double digits.
Despite the one-time tax credits and government orchestrated effort to suppress mortgage rates, no federal program has been more distortive than the Federal Housing Administration (FHA). Created during the Depression to help minority and poor households realize the promise of homeownership, the FHA has become the government’s vehicle to prop up the housing market. With required downpayments of only 3.5%(much of which will be recouped through the $8,000 tax credit), the FHA has essentially taken the place of subprime in providing financing to at-risk borrowers. In 2006, the FHA insured 2.7% of all loans in the United States. Year-to-date, the agency has provided a government guarantee for 23% of all new mortgages and nearly 40% in August. Many of the public builders suggested in their most recent earnings calls that between 40% and 75% of all their buyers received FHA-insured mortgages last quarter. In fact, when combined with Fannie and Freddie, the government is now insuring close to 90% of all home mortgages and probably close to 100% for all new home buyers (see chart below)!
Several recent articles have highlighted the problems festering in the FHA. In fact, this morning the Washington Post ran an article suggesting that the FHA could breech its minimum capital ratio of 2%. Further, some 7.8% of FHA loans at the end of the second quarter were 90 days late or more, up from 5.4% a year ago. Even more perplexing is that the agency has never operated with a chief risk officer and has only recently sought to fill the position (even AIG Financial Products, Countrywide, and Lehman had chief risk offers!).

While the government will likely continue to support the housing market through the FHA, particularly with the 2010 election around the corner, I would be extremely wary of the headlines suggesting that the housing market is on stable footing. Just as Fannie, Freddie, and later subprime massively distorted the housing market over the last decade, so too has the FHA.
I will continue to report on this organization and Ginnie Mae (the government agency whose primary function is to guarantee mortgage backed securities comprised of FHA-insured mortgages) over the coming weeks and months. While I will also continue to highlight the improving trends in housing, it is always with an eye towards the government’s overarching influence that my enthusiasm will be vastly tempered.