The FHA Single-Family Insurance Program Performing a Needed Role in the Housing Finance Market

by Housing and Urban Development

THE GSEs’ FUNDING OF AFFORDABLE LOANS:
A 2004-05 UPDATE
Harold L. Bunce
December 2012
Office of Policy
Development
and Research
Housing Finance
W O R K I N G P A P E R S E R I E S
U.S. Department of Housing and Urban Development
Working Paper No. HF-019
THE GSEs’ FUNDING OF AFFORDABLE LOANS:
A 2004-05 UPDATE
Harold L. Bunce
Office of Policy
Development
and Research
Housing Finance
W O R K I N G P A P E R S E R I E S
U.S. Department of Housing and Urban Development
Working Paper No. HF-019
THE GSEs’ FUNDING OF AFFORDABLE LOANS:
A 2004-05 UPDATE
Harold L. Bunce
December 2012
Office of Policy
Development
and Research
U.S. Department of Housing and Urban Development
Working Paper No. HF-019
The FHA Single-Family Insurance Program:
Performing a Needed Role in the
Housing Finance Market

Edward Szymanoski

William Reeder

Padmasini Raman

John Comeau

Housing Finance
W O R K I N G P A P E R S E R I E S
December 2012
U.S. Department of Housing and Urban Development | Office of Policy Development and Research

The FHA Single-Family Insurance Program: Performing a Needed Role in the Housing Finance Market

The FHA Single-Family Insurance Program:

Performing a Needed Role in the

Housing Finance Market

Office of Policy Development and Research
Executive Summary

Introduction
In laying out the Federal Housing Administration’s (FHA’s)
mission in the single-family mortgage market and in presenting
its historical role in meeting immediate and emerging chal
lenges over its history, this paper serves as a useful foundation
for considering FHA’s future role in housing finance as both
institutional and regulatory reforms are debated. The paper
focuses on the historical and ongoing role of FHA mortgage
insurance in sustaining access to mortgage credit, stabilizing
housing markets, and expanding sustainable homeownership
opportunities. In so doing, it provides useful facts, descriptions
of policies undertaken, and information that can inform de
bates about FHA’s appropriate role going forward. In perform
ing its historical role, FHA has insured more than 41 million
mortgages since its inception in 1934.
The paper is organized into four sections and an appendix.
The first section provides a historical overview of FHA’s role in
stabilizing housing markets, setting market standards, provid
ing information, and addressing market failures such as credit
rationing. The second section shows how this role provides
improved opportunities for low-wealth (often newly formed)
households to access affordable, sustainable homeownership.
The third section describes some significant challenges that
FHA has faced over the years and the steps it has taken to meet
these challenges. Throughout the current crisis, FHA has bor
rowed from lessons it learned in the past. The fourth section
examines FHA’s response to the current housing crisis: FHA has
stabilized declining markets by maintaining access to federally
guaranteed mortgage credit in the face of a severe curtailment
of private capital in the market, and it has assisted distressed
homeowners to keep their homes. Finally, the appendix reviews
key questions and policies that will inform the future role of
FHA, including questions related to the costs and benefits of
FHA’s countercyclical role, pending regulatory and institutional
reforms that could affect underwriting standards in the conven
tional mortgage market.
Historical Overview of FHA’s Role
Before the government’s involvement in the 1930s, the recorded
homeownership rate was never higher than 48 percent. Financial
markets were highly volatile with financial panics every 10 to
20 years and frequent depressions. Mortgage loans were difficult
to obtain. Substantial downpayments for first-lien mortgages
were in the neighborhood of 50 percent, and second- and third-
lien financing at high interest rates were commonplace. In 1934,
with new mortgage credit frozen, residential construction stalled,
and a serious nationwide decline in construction employment,
Congress authorized FHA mortgage insurance with the aim of
getting the building trades and private credit back to work.
Initially, FHA was intended to revitalize the housing industry
and make home financing attainable for a much larger share of
American families in the face of national recession. It has since
extended this role to help soften the effects of local or regional
downturns and increase homeownership opportunities for lower
wealth, minority, and first-time buyers. Studies show that profit-
maximizing conventional lenders do not raise prices just when
lending becomes riskier in areas experiencing economic down
turns; instead, they tighten underwriting to ration the number
of mortgages made in such an area. FHA, on the other hand,
maintains its presence in all markets, providing stability and
liquidity in markets experiencing recession. By addressing the
tendency of the private marketplace to ration credit, FHA has
always brought a great deal more stability to mortgage markets
and extended the opportunity for homeownership to a much
broader segment of the population.
It should be noted that mortgage loan limits rather than bor
rower income limits have been the principal method of target
ing FHA’s insurance activities over its history. This has the
effect of focusing FHA insurance activity on specific segments
of the housing market, and it helps maintain stability in credit
flow to these market segments. Temporary expansion of FHA’s
loan limits in the current housing crisis has extended FHA
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The FHA Single-Family Insurance Program: Performing a Needed Role in the Housing Finance Market

access to a broader segment of the housing market, thereby
leveraging FHA’s ability to provide stability to the distressed
housing market.
In its early days, FHA also took on the task of developing and
building the national infrastructure to operate an economically
sound insurance program across the United States. FHA rede
fined mortgage underwriting standards to allow a much broader
segment the population to qualify for mortgage finance, and it
created new uniform construction and appraisal standards in
the building and finance industries so that the FHA mortgage
contract was readily tradable across the country. Another im
portant role of FHA was to make information available to the
market on the performance of relatively high loan-to-value
ratio (LTV) mortgage lending (compared with the low LTV
loans before the Great Depression). By the mid-1950s FHA had
demonstrated the feasibility of such lending, given the sound
underwriting and appraisal standards it pioneered. The upshot
of this was a rebirth in the 1950s of the private mortgage insur
ance (PMI) industry, which originally operated for a time before
the Great Depression wiped it out. By 1970, the system of thrifts,
commercial banks, FHA-insured lending, PMI-insured conven
tional lending, and access to private capital via secondary market
support from Ginnie Mae (a government agency) and Fannie
Mae (a government-sponsored enterprise [GSE]) had helped to
raise the national homeownership rate from its 1930 measure
of 46 percent to 63 percent.
FHA Offers Opportunities for Low-
Wealth Families
To a large extent, FHA does not compete with conventional
lenders. FHA focuses on homebuyers who, in comparison
with those typically served in the conventional market, have
lower wealth and pose moderately higher risks, yet are deemed
creditworthy. FHA addresses the credit market imperfections
that prevent households from accessing the type and level of
housing consumption best suiting their needs and budget. As
a result, and as an ancillary benefit to addressing these market
imperfections, FHA provides opportunities for newly formed
lower wealth households that wish to buy a home that meets
their family’s needs at a time when their children are young and
can still experience the full range of benefits from homeownership.
To illustrate the above, the Office of Policy Development and
Research at the U.S. Department of Housing and Urban Devel
opment (HUD) has compared characteristics of FHA and GSE
(Fannie Mae and Freddie Mac combined) first-time homebuyer
loans (the latter restricted to those falling below FHA loan limits)
for selected origination years to gain understanding of how
FHA has been used by first-time homebuyers in relation to the
(prime) conventional market. The vast majority of FHA home
purchase loans over the past 15 years have been made to first-
time homebuyers. Except for the peak housing boom years,
first-time homebuyers tended to rely more heavily on FHA
financing—by two to three times as much—than on GSE con
ventional financing, and that reliance has grown dramatically in
the past 2 years. For younger homebuyers using FHA—those
under age 35—FHA’s first-time buyer percentage has been con
sistently 80 to 90 percent; for those over age 35, 60 to 80 per
cent; and, overall, nearly 80 percent. Among FHA’s first-time
buyers, nearly 70 percent have been below age 35—consistent
with the notion that FHA provides greater opportunities than
the conventional market to families starting out.
FHA has also long been known to serve a disproportionately
larger number and share of minority homebuyers, particularly
African-American and Hispanic buyers. For example, in 2001,
FHA served more than twice as many minority first-time buyers
(about 220,000) than Fannie Mae and Freddie Mac combined
(about 100,000). During the peak boom years, when many
minority homebuyers chose subprime or other nontraditional
conventional loans, the FHA minority first-time buyer counts
dipped below those of the GSEs; however, since the crisis be
gan, FHA has returned to serving a disproportionate number of
minority first-time buyers.
FHA Has Overcome Challenges in Its
History
Over its history, FHA has faced challenges regarding its financial
condition or its relegation to small niche status in the market
place. Three such challenges and FHA’s responses are discussed:
(1) in 1989, FHA faced a severe financial crisis and a large port
folio of unsound legacy business insured over many prior years;
(2) large market shifts between 2001 and 2006 during the
runup of the housing bubble called into question the continu
ing relevance of FHA in the market; and (3) poor performance
during the 2000s from home purchase mortgages with down-
payment gifts provided by nonprofit organizations in which the
gift funds were contributed by the homesellers involved in the
specific transactions, and possibly financed by inflated house
values.
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1. It may not be widely known, but FHA faced a severe financial
crisis once before in its history during the administration of
George H.W. Bush. The accounting firm of Price Waterhouse
was commissioned in 1989 to conduct an independent actu
arial review (the first of many such annual reports) of FHA’s
Mutual Mortgage Insurance (MMI) Fund, the principal
ac-counting fund used by FHA to insure its home mort
gages. The Price Waterhouse analysis found that FHA was
underpricing its mortgage insurance and had been doing so
for a decade. Price Waterhouse attributed a sharp decline
in the MMI Fund’s net worth during the 1980s, primarily
to the lower rates of inflation and house price appreciation
in the 1980s compared with the 1970s. The 1980-to-1982
recession years and the economic problems in the energy-
producing states generated particularly large losses; losses
due to lax management also were a contributing factor, but
the underlying trend in house price appreciation was cited
as the fundamental problem.
During 1990, Congress and the Bush administration con
sidered various policy proposals to shore up the MMI Fund.
The policy debate in 1990 centered on how best to balance
the public purposes of FHA with policies designed to improve
its financial soundness. The Cranston-Gonzales National
Affordable Housing Act (NAHA) of 1990 was ultimately en
acted to restore the MMI Fund to actuarial soundness (along
with other legislation enacted in 1989 to improve manage
ment effectiveness). The NAHA established a new actuarial
soundness standard for FHA—a target level of capital of at
least 2.0 percent of insurance-in-force (aggregate balance on
insured loans in FHA’s portfolio). But it was understood at
the time that this target was designed only to enable FHA to
withstand a moderate recession—not a severe downturn as
has occurred since 2007. The law requires FHA to operate in
an actuarially sound manner, but it does not require FHA to
hold reserves that would make it able to withstand a severe
economic event.
Two years after the initial Price Waterhouse study and after
the implementation of NAHA and other reforms, the fiscal
year (FY) 1991 actuarial review of the MMI Fund found
that the capital ratio of the fund had continued to fall. Price
Waterhouse estimated the FY 1991 capital ratio to have
declined to negative 0.2 percent (-0.2 percent) of insurance
in-force. NAHA and other reform measures adopted to reduce
MMI Fund risks and to raise premiums were too new to offset
the factors causing losses from the legacy business. That
finding, however, did not mean that FHA needed a bailout.
Rather, the 1991 actuarial review itself predicted future
capital ratios would rebound, because the reforms would
improve the performance of newly insured loans and the
economy would recover. Price Waterhouse predicted the
MMI Fund would meet its long-run capital ratio target of
2.0 percent by year 2000, and history shows that the fund
actually achieved the 2.0 percent goal in FY 1995.
2. Large market share fluctuations during the decade of the
2000s also posed a challenge for FHA. Unlike a profit-
motivated private insurer or lender, FHA does not actively
seek to maximize market share. The extreme fluctuations
observed in FHA’s market share since 2000, however, have
given rise to questions regarding FHA’s appropriate role in
the market. In particular, FHA had gone for more than a
decade from capturing about 10 to 15 percent of the home
purchase market—the approximate share it had for many
years leading up to the new millennium—to less than
5 percent of the market during the boom years immediately
preceding 2007 and rebounding to around 30 percent from
mid-2008 forward. Although many believe the current 30
percent home purchase share represents too large a footprint
for the FHA in the long term, there is less clarity about
whether the very low (below 5 percent) precrisis share is
the appropriate level for FHA going forward. The low FHA
shares during the boom years occurred at a time when
predatory and subprime lenders offering high-risk or high-
cost alternative mortgage products attracted large numbers
of homebuyers who might otherwise have chosen more
sustainable FHA financing.
Subprime underwriting criteria were “liberal to nonexistent”
back then, and the high cost of these loans was often masked
by short-run mortgage payments (before teaser rates adjusted)
that were lower, giving borrowers the perception that the
loan was affordable. A disproportionate share taking these
products were minority homebuyers; thus, the declines in
FHA market share were greatest for African American and
Hispanic homebuyers. After the crisis hit, minority home-
buyers were disproportionately affected by the dramatic
tightening of conventional mortgage credit, and FHA’s share
of minority homebuyers has increased above the levels
observed at the start of the decade.
FHA did not follow the market’s lead into teaser rate adjustable-
rate mortgages (ARMs), low-documentation loans, or “piggy
back” second liens. If FHA were to have extended itself into
these products, it would likely have incurred large losses once
home prices began to fall that could have undermined FHA’s
ability use its institutional capacity to assume a countercyclical
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role during the crisis. Although FHA is likely to sustain large
losses on the loans it did insure during the precrisis boom
years of 2005 to 2007—in part, because it may have been
adversely selected during those years when the GSEs, in re
sponse to HUD affordable housing goals, were also extending
credit to borrowers not typically served by the prime conven
tional market—FHA did avert even greater losses by staying
principally with its traditional line of business.
3. Although FHA did not follow the market’s lead into the non
traditional loan products, it did insure a group of loans that
proved to be high risk: loans with downpayment gifts from
nonprofit or charitable organizations in which the gift funds
were ultimately replenished from a donation to the organiza
tion by the seller of the home. Often the borrowers who re
ceived the seller-funded downpayment gifts had weak credit
histories as well. The combination of low or zero equity in
a property often sold at an inflated sale price (sellers would
recoup their donations through raising asking prices) to a
buyer with weak credit history resulted in a group of loans
that, on average, had a frequency of mortgage insurance
claims that was two to three times the average for other
comparable FHA loans.
In 1996, FHA published guidance for mortgagees on the
acceptable sources of the homebuyer’s required investment
(downpayment) beyond the homebuyer’s own cash savings.
Nowhere did FHA extend permission to obtain downpayment
funds from the seller of the property—a practice expressly
prohibited by conventional lenders. In the 1990s, however,
some charitable organizations, which are permissible sources
of downpayment gifts, began to circumvent the FHA restric
tion on gifts from sellers in various ways, including the estab
lishment of a fund that provides the “gift” to the homebuyer
that is replenished by the homeseller through a “charitable
donation” to the organization after the sale is completed.
As early as 1999, FHA took steps to prohibit the funding of
downpayment gifts in which the source of the funds directly
or indirectly comes from the seller of the property. Ultimately,
the elimination of the seller-funded downpayment gifts
would be accomplished through statutory prohibition of
the practice. The passage of the Housing and Economic
Recovery Act (HERA) on July 30, 2008, finally terminated
seller-funded downpayment assistance effective for loans
underwritten on or after October 1, 2008. The practice,
however, did result in large losses for FHA, as documented
in FHA’s MMI Fund actuarial reviews.
FHA Response to the Crisis
Beginning in 2007, FHA began to focus on its countercyclical
role as conventional credit dramatically tightened in response
to the rise in delinquencies and foreclosures among subprime
mortgages and the drop in home prices. Home prices continued
falling for 33 consecutive months through early 2009, and the
FHA played a major part in the government’s efforts to slow
this trend and stabilize prices. Mark Zandi, chief economist at
Moody’s Analytics, offered this assessment of FHA’s role during
the crisis:
The FHA had been virtually dormant during the housing
bubble, but it made about one-third of all U.S. mortgage
loans in the period after the bust. Without such credit,
the housing market would have completely shut down,
taking the economy with it. The effort took a toll on the
agency’s finances, but so far the FHA has avoided turning
to taxpayers for help, making it one of the few housing-
related enterprises—public or private—that have not.
As home prices peaked and began to decline, and as delinquen
cies and foreclosures increased, lenders withdrew credit from
the conventional mortgage market. The sheer volume of delin
quent mortgages and foreclosure filings, along with numerous
failures of mortgage lenders beginning in 2007, created a situ
ation in which markets were in a self-perpetuating spiral with
declining home prices and rising mortgage defaults; that is,
defaults and foreclosures in the subprime sector led to falling
home prices and tighter underwriting by conventional lenders,
which, in turn, affected the prime sector and caused further
home price declines. Arguably, FHA’s response to the crisis was
one of many actions taken by the federal government to help
break the home price downward spiral. FHA’s response con
sisted of (1) enabling home purchases, (2) enabling mortgage
refinances, and (3) helping homeowners keep their homes.
The increase in FHA’s home purchase market share starting in
2008 is due to three principal factors: (1) the tightening of pri
vate credit, (2) FHA keeping its underwriting standards fairly
constant, and (3) the temporary increases in FHA’s loan limits
enacted by Congress. In 2006, FHA was authorized to insure
loans of up to $200,160 in all markets and up to $363,790 in
high-cost markets. In 2008, the Emergency Economic Stabi
lization Act (EESA) and, later, HERA granted FHA temporary
authorization to insure mortgage loans of up to $271,050 in
all markets and up to $729,750 in high-cost areas. The result
was that, during FY 2006, as the crisis was about to begin, FHA
insured 314,000 home purchase loans, but, by FY 2009, it had
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increased it volume of home purchase loans to 996,000 during
a year in which the overall home purchase market was consid
erably smaller.
Not widely known is the fact that FHA also provided support
for the refinance segment of the housing market during the crisis.
Beginning in 2007, FHA stepped in to enable growing numbers
of homeowners facing interest rate resets from expiring teaser
rates on conventional ARMs to avoid large payment shocks. These
conventional-to-FHA “product refinances” helped hundreds of
thousands of borrowers who met FHA’s standard underwriting
criteria to convert conventional mortgages facing (or that already
had received) monthly payment increases into far more sustain
able FHA loans. In addition to providing help to homeowners
with unsustainable conventional loans, FHA also enabled bor
rowers with existing FHA loans to refinance through its stream
lined FHA-to-FHA refinance programs. Because FHA already
holds the default risk on the loan, it is not taking on new risk
with a streamlined rate or term refinance of the loan (with no
cash out other than to cover closing costs), even if the loan
were to be under water, or if the borrower’s credit history had
deteriorated.
The exhibit from the paper shown below illustrates FHA’s
response to the crisis in terms of market shares by loan type
(purchase or refinance).
Although FHA’s expansion of mortgage credit has been and
continues to be critical to housing markets, the FHA’s support
for the market during the crisis also includes help for distressed
homeowners. Although not as widely recognized as the U.S.
Department of the Treasury’s Home Affordable Modification
Program for conventional loans, FHA has actually extended loss
mitigation aid to more than 1.4 million distressed homeowners
with existing FHA loans since the second quarter of 2009.
Finally, any discussion of FHA’s countercyclical role during
the current crisis should consider the costs incurred by FHA in
performing this role. Loans FHA insured during the 2005-to
2009 period are likely to suffer the most (in terms of lifetime
performance) from the recent national housing recession. These
loan vintages contained high shares of seller-funded downpay
ment gifts, which historically have performed much worse than
other FHA loans. These vintages also were underwritten when
home prices were near or at their peak in mid-2006, which was
followed by 33 consecutive months of decline in national price
levels, creating the greatest potential for significant negative
equity. FHA’s relatively low market shares during these boom
years with high-loss potential, helped mitigate the impact of
these loan vintages on FHA itself, however. Also, in certain
states such as California, for which falling home prices were
especially severe, FHA had even more limited exposure due
FHA Is Known To Have Ramped Up Its Support for Home Purchases; Less Well Known Is Its Support for Refinances
During Crisis
FHA as Share of Quarterly Mortgage Originations by Type (percent)
45
40
35
30
25
20
15
10
5
0
Purchase
2003 Q1 2003 Q3 2004 Q1 2004 Q3 2005 Q1 2005 Q3 2006 Q1 2006 Q3 2007 Q1 2007 Q3 2008 Q1 2008 Q3 2009 Q1 2009 Q3 2010 Q1 2010 Q3 2011 Q1 2011 Q3 2012 Q1
Refinance Combined
Sources: Mortgage Bankers Association and the U.S. Department of Housing and Urban Development
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to precrisis loan limits that restricted origination volumes. As
a result of FHA’s countercyclical activity, however, the high
origination volumes insured between 2009 and 2012 now con
stitute about 78 percent of FHA’s insured loan portfolio, and
although the bulk of these loans have better risk characteristics
than is typical for FHA, they will nevertheless be entering their
peak default periods during 2013 through 2017.
Appendix
The authors hope that this paper serves as a useful foundation
for considering FHA’s future role in housing finance as both
institutional and regulatory reforms are debated. FHA’s history
has shown that the public policy debate after FHA’s financial
crisis of the 1980s was driven by balancing the dual objectives
of carrying out FHA’s purpose and mission with maintaining
and improving its financial soundness. In the current environ
ment, FHA is still helping to mend the ailing housing market.
Looking forward to a time when that objective will have been
substantially accomplished, there are numerous policy questions
to be addressed. Some questions involve balancing the costs
and benefits of FHA assuming a countercyclical role when
future market distress may occur at the same time that it is
meeting the other aspects of its mission. This and other ques
tions about FHA’s institutional role are integral to the policy
debate framed by the White Paper on Reforming America’s
Housing Finance Market that was jointly released by the De
partment of the Treasury and HUD in February 2011.
In addition, there are questions related to regulatory reforms
now under consideration that are likely to impact FHA’s role
going forward. These are the Qualified Mortgage rule, the Qual
ified Residential Mortgage rule, and Basel III capital rules for
financial institutions. If, in the context of these reforms, FHA
continues its tradition of serving creditworthy, lower wealth
households not well served by the conventional market, its rel
ative size and role could depend significantly on how the rules
are interpreted and implemented.
Other considerations may also affect the future size of the FHA
market. Specifically, demographic trends, which recently have
shown a decline in the rate at which individuals form households
and a sharp drop in immigration, may suppress the number of
FHA’s major historical client group, first-time homebuyers.
The appendix provides background information on these issues
to help frame the discussion of the relevant policy questions to
be addressed regarding the future role of FHA.
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Introduction

Since the advent of the Great Depression, government has been
involved in fine tuning the balance between public and private
support for the system of home mortgage finance in the United
States. Today, government guaranties or support are in evidence
at every important link between sources of capital and mort
gage lending. Commercial bank and thrift mortgage lenders are
linked with loanable funds through federal deposit insurance.
Many banks and thrifts are eligible for membership in the
Federal Home Loan Bank system, through which they can
access below-market-rate loans for financing housing. Other
mortgage lenders, such as mortgage companies, banks, and
thrifts, are linked to capital markets with either Ginnie Mae’s
federally guaranteed securities or Fannie Mae’s and Freddie
Mac’s (government-sponsored enterprise [GSE]) agency status.
The Federal Housing Administration’s (FHA’s) home mortgage
insurance program, however, is the only generally accessible
federal government guaranty linking mortgage borrowers with
mortgage lenders (Bunce et al., 1995).
1, 2
FHA is a government agency housed in the U. S. Department
of Housing and Urban Development (HUD). FHA insures
private lenders against loss on mortgage loans that meet FHA
underwriting standards, enabling those lenders to provide
mortgages to creditworthy borrowers who are unable to meet
more stringent conventional lending standards and might
otherwise be denied access to the capital markets. The various
FHA portfolios include mortgages on single-family residential
properties, multifamily apartments, hospitals, assisted-living
facilities, and nursing homes.
In laying out FHA’s mission in the single-family mortgage mar
ket and its historical role in meeting immediate and emerging
challenges during its history, the authors’ hope that this paper
serves as a useful foundation for considering FHA’s future role
in housing finance as both institutional and regulatory reforms
are debated. To that end, the paper provides useful facts on
FHA’s historical and ongoing role, descriptions of policies un
dertaken, and information that can inform debates about FHA’s
future. In performing its historical role, FHA has insured more
than 41 million such mortgages since its inception in 1934.
The paper is organized into four sections and an appendix. The
first section provides an historical overview of FHA’s role in
stabilizing housing markets, setting market standards, provid
ing information, and addressing market failures such as credit
rationing. The second section shows how this role provides
improved opportunities for low-wealth (often newly formed)
households to access affordable, sustainable homeownership.
The third section features some significant challenges that
FHA has faced over the years and the steps it has taken to
meet these challenges. Throughout the current crisis, FHA has
borrowed from lessons it learned in the past. Its response to
the current housing crisis is described in the fourth section:
FHA has stabilized declining markets by maintaining access
to federally guaranteed mortgage credit in the face of a severe
curtailment of private capital in the market, and has assisted
distressed homeowners to keep their homes. Finally, the ap
pendix reviews key questions and policies that will inform the
future role of FHA, including questions related to the costs and
benefits of FHA’s countercyclical role, pending regulatory and
institutional reforms that could affect underwriting standards in
the conventional mortgage market.
3
1
This and subsequent paragraphs, where noted, closely follow Bunce et al. (1995: 9-2, 9-3).
2
Other government-guaranteed mortgage programs like those of the U.S. Department of Veterans Affairs or the Rural Housing Service are limited to veterans or
households meeting specific income and geographic location criteria.
3
The FHA Mutual Mortgage Insurance (MMI) Fund Actuarial Review for fiscal year 2012 was released on November 16, 2012, and showed that the capital reserve
ratio of the MMI Fund had fallen below zero to negative 1.44 percent. Because this paper was written before the release of the Review, however, it does not discuss
these results.
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Section I. Historical Overview of FHA’s Role

Before the government’s involvement in the 1930s, the re
corded homeownership rate was never higher than 48 percent.
4
Financial markets were highly volatile with financial panics
every 10 to 20 years and frequent depressions.
5
Mortgage
loans were difficult to obtain, and homebuyers had to provide
their own mortgage default “insurance” for lenders in the
form of substantial downpayments in the neighborhood of 50
percent or second and third loan financing at interest on the
order of 18 to 20 percent (see Semer et al., 1976a: 10–11).
In addition, homebuyers had to bear most of the interest rate
risk with short-term, high-interest balloon mortgages. Even
with the limited development of private mortgage insurance
(PMI), primarily in New York State, homebuyers were unable
to reduce downpayments below 33 percent and this insurance
proved worthless when difficult economic times came (Rapkin
et al., 1967: 23–27). The purely private system of mortgage
finance, under which lenders and investors bore the full weight
of default losses and faced variable economic conditions,
limited consumer access to mortgage credit and sustainable
homeownership (Bunce et al., 1995: 9-2).
The complete and extended collapse of the housing economy,
including both its home financing and home building sectors
through the early years of the Great Depression, provided
a dramatic and incontrovertible demonstration of just how
ineffectual private sector institutions unaided by government
were at mitigating the effects and rebounding from economic
disaster (Semer et al., 1976a: 3). In an effort to restore the
supply of credit to mortgage lending and employment in the
housing industry, President Hoover convened the President’s
Conference on Home Building and Home Ownership to bring
about a system of Home Loan Discount Banks. These institu
tions were created with passage of the Federal Home Loan Bank
Act of 1932. The Home Owner’s Loan Act of 1933 quickly
followed and established the Home Owner’s Loan Corporation,
created to refinance home mortgages in default or foreclosure
or to help owners to recover homes lost through foreclosure or
forced sale (see Semer et al., 1976a: 4–6).
In 1934, however, with new mortgage credit still frozen, resi
dential construction stalled at less than one-tenth of the units
built in 1925, and a decline in construction employment to
fewer than 150,000 people nationwide with an equivalent loss
in employment in the production of materials and equipment
for home construction (Semer et al., 1976a: 8–9), Congress
authorized the Federal Housing Administration (FHA) mortgage
insurance with the aim of getting the building trades and private
credit back to work. Speaking in support of the legislation, Fed
eral Emergency Relief Administrator, Harry L. Hopkins, stated:
The building trades in America represent by all odds
the largest single unit of our unemployment. Probably
more than one-third of all the unemployed are identified,
directly and indirectly, with the building trades…. Now,
a purpose of this bill, a fundamental purpose of this bill,
is an effort to get these people back to work…. There
has been no repair work done on housing since 1929….
And, finally, we believe it is essential that we unloose
private credit rather than public funds in the repairing of
those houses and the building of new houses … (Semer
et al., 1976a: 9).
FHA mortgage insurance served as a credit enhancement that
could be used by borrowers to access lender financing and ac
tuate the borrower’s demand for newly constructed or existing
homes. Whereas other financing institutions, such as Federal
Home Loan Banks, federal deposit insurance, or subsequent
government sponsored entities, such as the Federal National
Mortgage Association (Fannie Mae), connected lenders to loan
able funds, FHA mortgage insurance connected borrowers to
lenders facilitating the borrower’s demand for and connection
to those funds.
Initially, FHA insurance was intended to revitalize the housing
industry and make home financing attainable for a much larger
share of American families in the face of national recession. It
has since assumed the same role helping to soften the effects of
local or regional downturns or negative effects on less advan
taged groups to restore healthy housing market activity.
Studies have shown that lenders can more easily vary conven
tional underwriting standards (whereas the FHA has relatively
fixed underwriting standards), which leads to nonprice ration
ing by conventional lenders in response to local differences
4
By comparison, the U.S. Census Bureau reported the 2011 homeownership rate for the nation at 66.1 percent.
5
See figures 30-2 and 34-1 in Lipsey and Steiner (1975: 586–587; 662).
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The FHA Single-Family Insurance Program: Performing a Needed Role in the Housing Finance Market

in economic conditions or other perceived risks. That is,
profit-maximizing lenders do not only raise prices when lend
ing becomes riskier in areas experiencing economic downturns,
instead, they tighten underwriting to ration the number of mort
gages made in such an area. FHA, on the other hand, maintains
its presence in all markets, providing stability and liquidity in
markets experiencing recession. Credit rationing in the conven
tional lending market is considered a market failure in the par
lance of economists, and FHA’s ability to address this failure is
the key justification for FHA’s historical and current role in the
market. That is to say, the FHA, by addressing the tendency of
the private marketplace to ration credit, has always brought a
great deal more stability to mortgage markets and extended the
opportunity for homeownership to a much broader segment of
the population than was or would have been true in its absence.
The FHA, by addressing the tendency of the private mar
ketplace to ration credit, has always brought a great deal
more stability to mortgage markets and extended the op
portunity for homeownership to a much broader segment
of the population.
FHA is able to extend credit to those creditworthy borrowers
who are not adequately served by conventional lenders and
do so in an actuarially sound manner (which is a statutory
requirement for FHA) because FHA has a lower cost of capital
than conventional lenders. According to Bunce et al. (1995)
“FHA’s federal guaranty is the principal reason it can serve a
more risky clientele” (Bunce et al., 1995: 9-6). Private lenders
or insurers must earn a profit sufficiently large to attract the
capital necessary to satisfy their shareholders. Because serving
riskier borrowers involves a greater risk of failure, private
lenders/insurers would have to maintain both larger reserves
of capital and a larger profit margin to secure the capital in
that riskier use. They go on to say “the freedom from having
to earn a private risk-adjusted profit is FHA’s principal cost
advantage….” In addition FHA can make mortgage finance
available to some borrowers by cross-subsidizing their losses
with surplus premium income from lower risk FHA borrowers,
who are themselves too risky for private lenders and insurers”
(Bunce et al., 1995: 9-6).
The original FHA mortgage insurance contracts enabled bor
rowers to obtain financing with a minimum 20-percent down-
payment. The maximum mortgage was limited to $16,000,
which enabled families to purchase a $20,000 home with a
minimum downpayment. Thus FHA originally served a large
portion of the market as the typical home’s price at the time
was about $5,300. By charging borrowers a small premium
and insuring the full mortgage amount, thereby protecting
lenders from default losses, the FHA encouraged acceptance
of long-term, lower downpayment, self-amortizing (all interest
and principal repaid over the life of the loan), level-payment
mortgages, bringing homeownership within the reach of many
more families with lower upfront and monthly payments
(Reeder et al., 1987: 2).
Note that mortgage loan limits rather than borrower income
limits have been the principal method of targeting FHA’s insur
ance activities during its history. This eligibility requirement
has the effect of focusing FHA insurance activity on specific
segments of the housing market, and helps maintain stability in
credit flow to these market segments. Introducing the idea of
federally backed mortgage insurance was only the beginning.
Next came the nuts and bolts issues of developing and building
the national infrastructure to operate an actuarially sound
insurance program across the United States. In addition to
redefining mortgage underwriting standards to allow for a
much broader segment of American households to qualify for
mortgage finance, FHA created new uniform construction and
appraisal standards to be used by private sector practitioners in
the building and finance industries so that the FHA mortgage
contract was readily traded across the country ensuring that
homebuyers would have access to the lowest cost funds avail
able nationally rather than locally (Semer et al., 1976a: 11–12).
In addition to redefining mortgage underwriting stan
dards to allow for a much broader segment of American
households to qualify for mortgage finance, FHA created
new uniform construction and appraisal standards to be
used by private sector practitioners.
Over time, the mortgage terms were gradually liberalized on
lower value homes with an increase to a 90-percent maximum
loan-to-value ratio (LTV) and 25-year repayment term for
newly constructed homes mortgaged for less than $5,400 or up
to $8,600 if the mortgage did not exceed the sum of 90 percent
of the first $6,000 in value and 80 percent of the value between
$6,000 and $10,000 (Semer et al., 1976a: 21).
Early on (as has been the continued practice), race was not
explicitly regarded as a factor in FHA’s mortgage insurance
operations. Although as noted in section III, lenders of the time
generally held the belief that it was unwise to invest mortgage
funds in certain areas of cities (characterized by blight, low in
come, and minority residents), and FHA’s earliest underwriting
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The FHA Single-Family Insurance Program: Performing a Needed Role in the Housing Finance Market

manuals reflected similar policies for evaluating older urban
neighborhoods. By administrative decision in 1950, however,
FHA actively took steps to address existing explicit racial
discrimination in the market as the agency ceased insuring
any more mortgages on real estate subject to covenants against
ownership or occupancy by members of certain races. In 1962,
President Kennedy issued Executive Order 11063 making
FHA- and U.S. Department of Veterans Affairs-insured housing
and related properties subject to Equal Opportunity in Housing
requirements despite industry reaction that such action would
lead lenders and homebuyers alike to shun FHA financing in
favor of conventional financing which was not yet subject to
equal opportunity requirements. No significant shift away from
FHA materialized and in 1968 all housing and related transac
tions became subject to Fair Housing law under Title VIII of the
Civil Rights Act (Semer et al., 1976a: 15). By 1970, the system
of thrifts, commercial banks, FHA-insured lending, and Fannie
Mae had helped to raise the homeownership rate from its 1930
measure of 46 to 63 percent (Semer et al., 1976a: 26).
More recently, FHA introduced major underwriting changes in
1995 designed to expand the shares of first-time and minority
homebuyers that it served. For example, it recognized more
sources of income (for example overtime or part-time employ
ment income if certain conditions were met) in qualifying a
borrower, enabled borrowers to use rent and utility payments
to establish their credit quality, and permitted debt-to-income
and payment-to-income ratios above FHA’s limits if the lender
could identify factors that compensated for the additional risk
assumed.
6
As a result of these changes, first-time homebuyers
increased from about 60 to 80 percent of FHA’s home purchase
business, and its share of minority homebuyers increased from
about 25 to 35 percent. Homeownership rates for the nation
as a whole and for racial and ethnic minority households, for
which the rates have historically lagged behind those of White
households, rose each year thereafter through 2002, achieving
a nationwide peak of 69.0 percent by 2004.
Another important role of FHA was to make information
available to the market on the performance of relatively high
LTV mortgage lending (as compared with the low LTV loans
before the Great Depression). By the mid-1950s FHA had
demonstrated the feasibility of such lending given the sound
underwriting and appraisal standards it pioneered. The upshot
of this demonstration was a rebirth of the PMI industry in the
late 1950s.
Another important role of FHA was to make information
available to the market on the performance of relatively
high LTV mortgage lending.
The PMI industry grew so that by the mid-1990s it, together
with other conventional market institutions, was serving an
annual volume of homeowners that was approximately equal
to that served by FHA (Bunce et al., 1995: 9-2). As the PMI
industry grew in size and strength, however, so did efforts to
legislatively limit access to FHA. Between 1970 and 1995, no
fewer than five major efforts were made to reassess FHA’s role
(and in some cases other government support) in the mortgage
finance system, with a focus on the extent to which it could
shift its business to conventional mortgage lending with private
insurers (HUD PD&R, 1987, 1977; McKenna and Hills, 1982;
President’s Private Sector Survey on Cost Control, 1983; United
States and Linowes, 1988).
7
Each effort argued that FHA was
serving borrowers that conventional-market providers could
have served as well or better—that is, substantial “overlap”
existed between conventional and FHA borrowers. None of
these efforts ever empirically established significant overlap
between FHA and conventional lending, however, and each
ultimately concluded that FHA had a continuing role so long as
it complemented rather than competed with the conventional
market.
Some of the calls to limit FHA also included proposals to
replace its full insurance coverage with partial or limited
insurance, or to remove its full faith and credit backing of
the United States’ government, or for its privatization (that is,
outright elimination). These calls have often been accompanied
by claims that FHA was incapable of keeping up with the
technological changes in mortgage finance and the efficiencies
of private market delivery systems.
FHA and Ginnie Mae have led the way in demonstrating
the viability of many technical innovations.
Such claims, however, often fail to recognize that FHA uses the
same private lender and servicer delivery system that conven
tional mortgage providers use. FHA and/or Ginnie Mae (the
government-owned analog to the government-sponsored enter
prises [GSEs]) have in many cases led the way in demonstrating
the viability of technical innovations. Early on FHA demonstrated
6
See mortgagee letter 95-7 at http://portal.hud.gov/hudportal/HUD?src=/program_offices/administration/hudclips/letters/mortgagee.
7
This and the following discussion closely follow Bunce et al. (1995: 9-2 to 9-4).
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The FHA Single-Family Insurance Program: Performing a Needed Role in the Housing Finance Market

the value of the long-term, fixed-rate, self-amortizing mortgage
and paved the way for the modern mortgage lending industry
with development of minimum property construction and
appraisal standards. Indeed, FHA demonstrated the viability
of mortgage insurance, and Ginnie Mae pioneered the use of
mortgage-backed securities, which were quickly adopted by
the conventional market. Moreover, FHA pioneered lower
downpayments, higher payment-to-income ratios, graduated
payment mortgages, the 1- to 5-year adjustable-rate mortgage,
underwriting guidelines for borrowers with nontraditional
credit histories, and Home Equity Conversion Mortgages (reverse
mortgages) for elderly homeowners (Bunce et al., 1995: 9-3).
In addition, FHA has worked with industry to develop an
automated credit underwriting capacity for FHA lending and
continues to provide publically available data on which gov
ernment, industry, and academe rely for analysis and under
standing of mortgage credit markets inclusive of prepayment
and default.
8
Looking forward, FHA may continue to play a
significant role in developing standards and guidelines in the
industry to address unique or specific challenges.
Claims that the conventional mortgage market is fully capable
of assuming FHA’s role and delivering equal or better service
on at least the same scale depends on the ability of the conven
tional market to make similar loans to similar borrowers—that
is to say, the existence of overlap between conventional and
FHA-insured loan products and borrowers. Bunce et al. (1995)
developed a comparative analysis of 1993 FHA and GSE loan-
level data that revealed that, in fact, GSE and FHA products
or borrowers overlapped very little and that FHA continued
to offer homeownership opportunities to a large, creditworthy
segment of households that was not otherwise available.
9
Subsequent academic papers analyzing data from later periods
have found a modest degree of overlap but nevertheless con
firm distinct populations. Rodda et al. (2005) found that only
about 10 percent of FHA-insured loans have risk characteristics
similar to GSE-purchased loans and that, when compared with
GSE-purchased loans, FHA-insured loans are characterized by
lower borrower credit scores and higher LTVs (that is, lower
downpayments), and they are more targeted to lower income
and minority borrowers.
10
Nonetheless, analysts have argued that some continuing over
lap may be essential for maintaining FHA’s ability to carry out a
market stabilization role, maintaining its institutional capacity
to expand if necessary. Pennington-Cross and Yezer concluded
that, for FHA to continue its important purposes of regional
stabilization, information production, and insuring equal credit
opportunity, it must maintain “a substantial FHA presence in
national mortgage markets … even if that means substantial
competition between FHA and conventional mortgage lend
ing” (Pennington-Cross and Yezer, 2000: 370). As discussed
in section IV, FHA’s countercyclical role during the housing
crisis from 2007 forward relied on its institutional capacity to
expand, and many of the loans FHA has insured in this role
would have qualified for conventional financing in the precrisis
environment, although given the tightening of conventional
underwriting, postcrisis overlap between FHA and the conven
tional market has likely remained small.
8
FHA is in the process of updating its internal technology systems, which are admittedly antiquated. As described previously, FHA relies on private lender and

servicer systems for underwriting and servicing its portfolio with additional information stored on internal technology systems.

9
This section closely follows Bunce et al. (1995: 6-8 to 6-26 and 7-1 to 7-23).

10
See Pennington-Cross and Nichols (2000: 2; 307–336), Pennington-Cross and Yezer (2000: 2; 357–372), and Rodda et al. (2005: 1–108).

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The FHA Single-Family Insurance Program: Performing a Needed Role in the Housing Finance Market
Section II. FHA Offers Opportunities for Creditworthy Low-

Wealth Families
To a large extent, the Federal Housing Administration (FHA)
does not compete with conventional lenders. FHA focuses its
home purchase business on a lower wealth, moderately higher
risk, yet creditworthy clientele than is served by conventional
lenders. FHA also is more accepting of compensating factors
that demonstrate a borrowers’ ability and willingness to make
timely mortgage payments to offset risk characteristics that
might be unacceptable to conventional lenders. FHA’s insur
ance products and underwriting are designed to accommodate
creditworthy households that present higher risk characteristics
related to economic climate and/or their location, asset and
income circumstances, or other demographic characteristics. As
a result, FHA serves a much higher fraction of households that
are first-time buyers, and may also have minority status, live
in neighborhoods characterized by lower incomes, minority
concentrations, or center-city locations.
Under the credit-rationing paradigm, households not
meeting conventional underwriting standards are more
apt to use FHA.
As discussed in section I, the conventional mortgage lending
industry has traditionally tightened underwriting standards to
ration the number of mortgages and limit exposure in areas
or to groups in locations where lending is perceived to have
become riskier, whereas FHA as a matter of policy has not. As
a result of the nonprice credit-rationing policy, households that
at one time may have qualified for a conventional mortgage
loan of a given size might later fail to qualify for that loan,
making FHA the only viable alternative. Credit rationing in
the conventional mortgage market has been widely recognized
in academic literature. A paper by Ambrose et al. is one of the
more recent studies to have examined the effects of location-
specific variation in credit risk on FHA market share. These
authors conclude that strong evidence shows that the conven
tional mortgage lenders employ a nonprice credit-rationing
paradigm (Ambrose, Pennington-Cross, and Yezer, 2002: 2;
1–28). Thus, households not meeting conventional underwrit
ing standards are more apt to use FHA because the range of
service provided by FHA extends well beyond that available
from these lenders. FHA insures lenders against loss up to
100 percent, and this deep coverage gives lenders the level of
comfort they need to make loans to homebuyers in higher risk

neighborhoods and localities. Without that level of comfort,
lenders do not merely charge more; rather, they limit access to
credit through more stringent underwriting and/or substantially
higher downpayments. The credit-rationing model was widely
used by the industry before the recent house price boom when
significant segments of the conventional market adopted risk-
based pricing, especially in the subprime sector where loosened
(or outright abandoned) underwriting standards prevailed and
risks were priced (albeit mispriced in many instances). Since
the crisis, the industry has returned to prudent underwriting
and, arguably, to credit rationing, to the extent that credit tight
ening might be considered excessive (Goodman et al., 2012).
In addition, FHA has traditionally offered more lenient
underwriting thresholds than the prime conventional market,
making it possible for borrowers purchasing modest homes
(below area median price) to obtain a larger mortgage and bet
ter house for a given income, asset level, and/or credit rating.
Bunce et al. (1995) calculated that a 1993 homebuyer could,
under FHA downpayment rules, purchase a given home with
approximately 30 percent less cash than would be required
with private mortgage insurance (PMI). Put another way, were
the homebuyer with given cash assets required to use PMI, he/
she would be limited to a home priced 30 percent below the
one available with FHA. FHA has also been more flexible than
conventional lenders with its income-qualification rules, al
lowing for variations in the qualifying ratios when appropriate
compensating factors were identified. Stretching payment to
income ratios from 28 to 33 percent is equivalent to reducing
the income required to finance a home by 15 percent below
what would be required by conventional lenders at the standard
28-percent ratio or increasing the value of the home available
to a homebuyer of given income by an equivalent 15 percent.
Finally, FHA is substantially more tolerant of past borrower
credit history problems or lack of established credit history.
Pennington-Cross and Nichols (2000: 318) found that FHA
FICO credit scores in 1996 were on average substantially below
that for conventional loans, 665.7 versus 716.6. FHA is also
more apt to insure mortgages in areas with greater uncertainty
about the stability of borrower credit or collateral values.
Again, FHA’s greater acceptance of compensating factors that
demonstrate a borrower’s willingness to repay helps to offset
some of these risks.

12
Housing Finance Working Paper Series

0
200
400
600
800
1,000
1,200
30
20
10
0
40
50
60
70
80
90
100
1995 1997 1999 2001 2003 2007 2008 2009 2010
Count (thousands)
Share (percent)
FTHB percentage among FHA purchase loans
Total FHA purchase loans (right scale)
0
200
400
600
800
1,000
1,200
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
1995 1997 1999 2001 2003 2007 2008 2009 2010
Ratio (FHA to GSE)
Number (thousands)
Ratio of FHA to GSE first-time buyers
Number of FHA FTHB Number of GSE FTHB
The FHA Single-Family Insurance Program: Performing a Needed Role in the Housing Finance Market

An ancillary benefit of the above underwriting differences be
tween FHA and conventional lenders is the greater opportunity
that FHA extends to families to move into better homeowner
ship situations and begin to build a middle class life at roughly
similar times in the family lifecycle as more advantaged house
holds. Some argue that FHA does not really increase home
ownership, it merely accelerates it by an estimated 5 years or
so (Goodman and Nichols, 1997: 184–202). That, however,
is an important benefit that FHA provides as a corollary to its
primary mission to address the credit market imperfections
from credit rationing. In other words, for newly formed house
holds that wish to buy a home that meets their needs at a time
when their children are young and can still experience the
full range of benefits from homeownership, FHA provides the
opportunity to access credit earlier.
For newly formed households that wish to buy a home at
a time when their children are young and most able to
benefit from owning a home, FHA provides the opportu
nity to access credit earlier.
The Office of Policy Development and Research has examined
characteristics of FHA and government-sponsored enterprise
(GSE) first-time homebuyer loans (the latter being restricted to
those falling below FHA loan limits for purposes of comparison)
for selected origination years from 1995 through 2010 to
gain understanding of how FHA has been used by first-time
homebuyers in relation to the (prime) conventional market.
11
Most FHA purchase loans made during the past 15 years were
to first-time homebuyers. For younger homebuyers—those
younger than 35 years old—FHA’s first-time buyer percentage
has consistently been 80 to 90 percent; for those older than 35,
60 to 80 percent; and overall 70 to 80 percent. Exhibit II-1A
shows both the number of FHA and GSE first-time homebuy
ers by selected year and the ratio of FHA first-time buyers to
GSE first-time buyers. It shows that except for the time of the
housing boom and right up to the housing and financial crisis,
first-time homebuyers tended to rely more heavily on FHA
financing—by 2 to 3 times as much—as compared with GSE
conventional financing. That reliance has grown dramatically
during the crisis years. Exhibit II-1B shows the consistently
high percentage of FHA buyers—approximately 70 to 80
percent—who are first-time buyers. In contrast, since 2006, a
much lower percentage—approximately 35 to 40 percent—of
GSE homebuyers have been first-time buyers.
Exhibit II-2A shows that the distribution of FHA first-time
buyers grouped by age of borrower is fairly consistent across
Exhibit II-1A. First-Time Homebuyers Rely More on
FHA Than on Conventional Market
Number of FHA and GSE First-Time Buyers by Year and
Ratio of FHA to GSE First-Time Buyer Mortgages for
Selected Years
1 1 1 2 2 2 2 2 2
995 997 999 001 003 007 008 009 010
3.5 1,200
3.0
1,000
2.5
800
2.0
600
Number (thousands)
Ratio (FHA to GSE)
1.5
400
1.0
200
0.5
0.0 0
Ratio of FHA to GSE first-time buyers
Number of FHA FTHB Number of GSE FTHB
Note: Analysis restriced to GSE loans within FHA loan limits.

Sources: U.S. Department of Housing and Urban Development and Federal

Housing Finance Agency (government-sponsored enterprise public-use

database)

Exhibit II-1B. FHA Home Purchase Loans Are
Predominately to First-Time Buyers
Percentage Share of First-Time Homebuyers and Total
Count of FHA Purchase Loans
1 1 1 2 2 2 2 2 2
995 997 999 001 003 007 008 009 010
Count (thousands)
100 1,200
90
80
1,000
70
800
60
Share (percent)
60050
40
400
30
20
200
10
0 0
FTHB percentage among FHA purchase loans
Total FHA purchase loans (right scale)
Source: U.S. Department of Housing and Urban Development
11
The definition of a first-time homebuyer includes individuals who have had no ownership in a principal residence during the 3-year period before purchase of the
property. For a complete definition, see http://portal.hud.gov/hudportal/HUD?src=/program_offices/housing/sfh/ref/sfhp3-02. FHA data are from the U.S. Department
of Housing and Urban Development (HUD); GSE data come from the Federal Housing Finance Agency and HUD public use databases. GSE public use data for 2005
were not available at the time this paper was written.
13
Housing Finance Working Paper Series

1997 2001 2007 2008 2009 2010
< 21 21–25 25–30 30–35
Borrower age
35–40 40–55 55–99
0
5
10
15
20
25
30
Percent of total first-time buyers
0
< 21
1997 2001 2007 2008 2009 2010
21–25 25–30 30–35
Borrower age
35–40 40–55 55–99
5
10
15
20
25
30
Percent of total first-time buyers
The FHA Single-Family Insurance Program: Performing a Needed Role in the Housing Finance Market

the selected years and stable since the start of the housing
crisis. Between 60 and 70 percent of FHA first-time buyers are
below age 35—which is consistent with the notion that FHA
provides greater opportunities than the conventional market
to families starting out. The conventional market, as shown in
related exhibit II-2B and as measured by GSE first-time buyer
loans within FHA loan limits, has consistently fewer first-time
buyers younger than age 35 (only 50 to 60 percent) with the
Exhibit II-2A. 60 to 70 Percent of FHA First-Time
Buyers Under Age 35; Post-Crisis Age Trend Stable
First-Time Homebuyers by Age Group and Selected Year
Percent of total first-time buyers
30
25
20
15
10
5
0
< 21
1997
21–25
2001 2007 2008 2009 2010
25–30 30–35
Borrower age
35–40 40–55 55–99
Source: U.S. Department of Housing and Urban Development
Exhibit II-2B. 50 to 60 Percent of GSE First-Time Buyers
Under Age 35; Post-Crisis Average Age Rising
First-Time Homebuyers by Age Group and Selected Year
0
5
10
15
20
25
30
Percent of total first-time buyers
< 21 21–25 25–30 30–35 35–40 40–55 55–99
Borrower age
1997 2001 2007 2008 2009 2010
Note: Analysis restricted to GSE loans within FHA loan limits.
Sources: U.S. Department of Housing and Urban Development and Federal
Housing Finance Agency (government-sponsored enterprise public-use
database)
trend since the start of the housing crisis being toward older
first-time buyers, as underwriting has tightened in the conven
tional sector.
Exhibit II-3 compares the incomes of FHA first-time homebuy
ers with those in the conventional (GSE) market. The chart
displays the means of FHA and GSE first-time buyer incomes
as a percentage of area median income for selected origination
years. The chart shows that relative incomes of FHA first-time
buyers are approximately 10 to 20 percent below the relative
incomes of conventional first-time buyers for every year except
2007 and 2008 when the difference narrowed to less than 10
percent below conventional first-time buyer incomes.
Exhibit II-4 shows the income qualifying advantage FHA has
offered these lower income first-time buyers. The exhibit plots
the mean ratio of the individual buyer’s loan amount divided
by the buyer’s income for FHA first-time buyers and the similar
ratio for conventional GSE first-time buyers. One can see that
in the preboom years FHA first-time buyers had greater pur
chasing power than GSE first-time buyers. That is, the FHA
buyers qualified for and got mortgage loans that were 10 to 15
percent larger relative to income than the conventional buyers
and this advantage was eroding through the boom years and
was gone in the post-crisis years.
12
Exhibit II-3. First-Time Buyers Served by FHA Have
Lower Incomes Than Those Served in Conventional
Market
First-Time Homebuyer Incomes as Percent of Area Median
Income for Selected Loan Origination Years
1995 1997 1999 2001 2003 2007 2008 2009 2010
120
110
100
90
80
70
60
FHA FTHB income to AMI GSE FTHB income to AMI
Note: Analysis restricted to GSE loans within FHA loan lImits.
Sources: U.S. Department of Housing and Urban Development and Federal
Housing Finance Agency (government-sponsored enterprise public-use
database)
12
One partial explanation for the perceived erosion of the FHA buyer’s purchasing power advantage is that the distributions of FHA and GSE first-time buyers were
becoming more similar as traditional FHA buyers shifted to the GSE conventional market financing during the boom period (because it was easier to income-qualify
for a conventional loan in that period and possibly because of GSE affordable housing goals), followed by a shift of traditional GSE conventional buyers to FHA as
the GSEs tightened credit, and FHA loan limits were temporarily raised.
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FHA has long been known to serve a disproportionately larger
number and share of minority African-American and Hispanic
homebuyers. Exhibit II-5 shows that before the financial and
housing crisis, FHA served far more minority (African-American
or Hispanic) buyers than did the conventional GSE market. During
the peak boom years, when many minority homebuyers chose
subprime or other nontraditional conventional loans, the FHA
minority first-time buyer counts dipped below those of the GSEs.
Exhibit II-4. FHA Provided First-Time Homebuyers With
Greater Purchasing Power Than GSE Conventional
Market Before Crisis; Not So After Crisis
Ratio of Original Unpaid Principal Balance to Borrower
Income for Selected Years
1995 1997 1999 2001 2003 2007 2008 2009 2010
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
FHA FTHB UPB to income GSE FTHB UPB to income

250
Sources: U.S. Department of Housing and Urban Development and Federal
Housing Finance Agency (government-sponsored enterprise public-use
database)
Exhibit II-5. FHA Serves More Minority First-Time
Buyers Than Conventional (GSE) Market; Peak Boom
Years Exception
First-Time Buyers by Selected Year
1995 1997 1999 2001 2003 2007 2008 2009 2010
Number (thousands)
200
150
100
50
FHA FTHB minority count GSE FTHB minority count
0
Sources: U.S. Department of Housing and Urban Development and Federal
Housing Finance Agency (government-sponsored enterprise public-use
database)
Finally, FHA has long served a higher proportion of first-
time buyers purchasing homes in underserved areas because
(1) FHA has traditionally served more first-time homebuyers
(see exhibit II-1A), and (2) a higher proportion of its first-time
buyers purchase homes in underserved areas. Exhibit II-6
shows that FHA has consistently helped 43 percent or more of
its first-time homebuyers to purchase homes in underserved
areas, by contrast to the GSE conventional market where first-
time purchases in underserved areas accounted for approxi
mately 32 percent of their first-time homebuyer business. More
recently, the proportions of first-time FHA homebuyers in
underserved areas have both increased modestly and continued
to exceed the comparable proportions for GSE conventional
first-time buyers; however, the gap between the relative shares
has narrowed considerably—falling from an average 11 per
centage points to roughly 5 percentage points.
Thus, FHA’s mission of providing increased opportunities for
less advantaged, creditworthy families, although tested during
the boom years, proved to be critical to stabilizing the market
after the crisis began. The differences between FHA and prime
conventional homebuyers have narrowed somewhat since 2003
because of easier income qualification of conventional buyers
in the boom period, and possibly to the GSE affordable housing
goals.
13
Differences also narrowed as formerly conventional
Exhibit II-6. Higher Percentage of FHA’s First-Time
Buyer Homes in Underserved Areas Than GSE First-
Time Buyer Homes; Post-Crisis Differential Has
Narrowed
First-Time Buyers in Underserved Areas as Percent of Total
First-Time Buyers by Year

1995 1997 1999 2001 2003 2007 2008 2009
60
50
40
30
20
10
0
FHA FTHB underserved area GSE FTHB underserved area
Note: Underserved areas are defined as census tracts characterized by high
proportions of low- and moderate-income and minority households or high
proportions of very low-income residents.
Sources: U.S. Department of Housing and Urban Development and Federal
Housing Finance Agency (government-sponsored enterprise public-use
database)
13
More detail on the GSE housing goals is provided in section III.
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buyers shifted to FHA as conventional credit standards tightened
after 2006 and FHA loan limits were temporarily raised. The
narrowing differences notwithstanding, FHA’s home purchase
business continues to be more focused on less-advantaged home-
buyers than the conventional market. FHA has served and con
tinues to serve a much higher fraction of households that are
first-time buyers, have lower incomes and/or minority status,
or live in lower income, minority, center-city, or underserved
areas. Both its level and proportion of first-time business relative
to GSE conventional first-time business has grown dramatically
in the years after 2007 helping to stem the most negative effects
of the credit crunch across the country. More on FHA’s role in
addressing the housing crisis will be presented in section IV.
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Section III. FHA Has Overcome Challenges in Its History

During its history, the Federal Housing Administration (FHA)
has faced challenges that could have affected its financial insol
vency or potentially relegated it to small market niche status
in the market place. FHA has repeatedly met these challenges
and has righted itself financially and reaffirmed its traditional
mission. This section discusses three such challenges: (1) in
1989, FHA faced a severe financial crisis and a large portfolio
of unsound legacy business insured over many previous years;
(2) large market shifts between 2001 and 2006, during the
runup of the housing bubble, called into question the continu
ing relevance of FHA in the market; and (3) poor performance
during the 2000s from home purchase mortgages with down-
payment gifts provided by nonprofit organizations, wherein the
gift funds were contributed by the homesellers involved in the
specific transactions, and possibly financed by inflated house
values. The manner in which FHA overcame each of these chal
lenges is addressed in this section.
III-1. Through Improved Risk Man
agement and Other Reforms, FHA
Emerged From a Financial Crisis
During the 1990s
Brief History of the FHA Financial Crisis in 1990
It may not be widely known, but FHA was faced with a severe
financial crisis during the administration of President George
H.W. Bush. The accounting firm of Price Waterhouse was com
missioned by the General Accounting Office (GAO) in 1989
to conduct an independent actuarial review (the first of many
such annual reports by Price Waterhouse and other indepen
dent firms) of FHA’s Mutual Mortgage Insurance (MMI) Fund,
which is the principal fund used by FHA to insure its home
mortgages. Before 1989, FHA had conducted internal actuarial
analyses, but this was the first independent audit of FHA’s
financial strength undertaken in a comprehensive manner,
including construction of statistical models to predict future
claims and prepayments. Price Waterhouse’s fiscal year (FY)
1989 study stated that the FHA was still solvent, but not
The public policy debate in 1990 centered on how best
to balance the public purposes of FHA with policies
designed to improve FHA’s financial soundness.
actuarially sound, which meant that new business coming
through the door would ultimately pay out more in insurance
claims than the premium revenues it would collect, further
eroding FHA’s finances. During 1990, Congress and the Bush
administration considered various policy proposals to shore
up the MMI Fund. The Cranston-Gonzales National Affordable
Housing Act (NAHA) was ultimately enacted to restore the
MMI Fund to actuarial soundness.
The public policy debate in 1990 centered on how best to
balance the public purposes of FHA with policies designed to
improve FHA’s financial soundness (Weicher, 1992).
How did this situation come about? As discussed previously
in this paper, FHA originally helped supply mortgage credit
to a broad segment of the housing market, thereby increasing
demand for housing. FHA accomplished this objective through
a statutory nationwide limit on the principal mortgage amount
with no upper limit placed on the homebuyer’s income. The
original FHA mortgage limit in 1934 was $16,000 nation-
wide—well above the $5,300 median home price at the time
according to Jaffee and Quigley (2010). FHA also insured what
was then an unusual form of mortgage instrument: a fixed-rate
self-amortizing mortgage over a long term (20 years at the
time) to maturity.
14
Insurance was funded by the proceeds of a
fixed premium (0.5 percent) charged annually on unpaid loan
balances. These revenues were deposited in Treasury securities
and managed as a mutual insurance fund. Of significance,
default insurance was offered on what were dubbed “economi
cally sound” self-amortizing mortgages with terms as long as 20
years and with loan-to-value ratios (LTVs) of up to 80 percent.
Over time, the terms of FHA mortgages were gradually liberal
ized as experience provided evidence of the soundness of the
long-term, fixed-rate mortgage. By the time FHA got into finan
cial trouble in 1989, it was insuring 30-year mortgages with
downpayments as low as 3 percent on mortgages of $50,000
14
Before the Great Depression, the typical home mortgage took the form of a balloon rollover with a short term, typically 5 to 10 years. Longer term loans were
considered too risky by lenders, especially for nonamortizing loans for which the balance owed does not decline.
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or less (although loans above $50,000 required downpay
ments of 3 percent of the first $25,000, and 5 percent on the
remainder.) FHA’s mortgage ceiling was raised and restructured
to be set by market area (county or metropolitan area) with
a statutory minimum of at least $67,500, and higher levels
permitted for high-cost areas up to 95 percent of the area’s
median-priced home, with a legislated maximum of $90,000
in 1980, which remained at that level until raised to $101,250
in 1987.
15
Despite these loan-limit increases from the original
level established in 1934, home price inflation outpaced
FHA’s loan limits, and FHA became increasingly focused on
the lower value segment of the market. At the time, FHA also
permitted homebuyers to finance their closing costs as part of
the mortgage, a practice that was unique in the industry, and
which also increased FHA’s risk profile.
16
Finally, the long-time
FHA premium of 0.5 percent annually on the outstanding loan
balance was replaced in 1983 by a one-time upfront payment
of 3.8 percent of the original loan balance, and this amount
could be financed in the mortgage and partially refunded if the
borrower prepaid the loan without an insurance claim. This
premium structure, although designed to be revenue neutral,
actually increased FHA’s risk because it raised effective LTVs
and required large sums to be refunded during periods of high
refinance activity.
Laws enacted during the 1950s and 1960s changed FHA’s
original underwriting standard of insuring only “economically
sound” loans to a more flexible “reasonable risk standard.” The
more flexible standard was needed to extend FHA insurance
authority to special purpose and subsidized home mortgage
insurance programs targeted to lower income households,
declining areas, and other special groups (see Vandell, 1995).
Economic soundness was a requirement of the original Housing
Act. From its inception, FHA was influenced by the existing
customs and practices of the mortgage-lending industry, which
likely spilled over into its early interpretation of the require
ment (Semer et al., 1976b: 175). Conventional lenders of the
time likely gave tacit, if not explicit, agreement to the notion
that it was unwise to invest mortgage funds in certain areas of
cities (especially transitional neighborhoods characterized by
blight, low income and minority residents). Thus FHA’s early
policy may have inadvertently promoted redlining practices
and may have accelerated post-World War II (WWII) suburban
sprawl.
17
As discussed in section I, however, in the 1950s and
1960s, FHA, and later the U.S. Department of Housing and
Urban Development (HUD), which became the parent agency
of FHA in 1965, moved strongly to turn this situation around.
Redlining was prohibited. Also, as noted previously, Congress
had directed FHA and HUD to implement a series of special
purpose and subsidized home mortgage insurance programs
targeted to lower income households, declining areas, and
other special groups.
According to Semer et al. (1976b: 177), the programs to serve
lower income households and those in declining areas were not
implemented with as much care and management oversight
as they should have been. As a result, some cities (such as
Detroit in the early 1970s) experienced high FHA default and
foreclosure rates soon afterward (Semer et al., 1976b; Vandell,
1995). As noted by Weicher (1992: 136) when GAO released
the findings of its 1989 study of FHA, HUD had been “front
page news for months, with revelations of influence peddling
and favoritism in awarding contracts in certain programs, fraud
in others, and substantial losses in several relatively small FHA
insurance programs in other funds.”
Although these changes increased the inherent risk of FHA’s
business, and large losses had occurred for a time in the 1960s
and early 1970s, the post WWII era was generally a period of
expansion, and as a result the MMI Fund’s reserves continued
to grow. This situation began to change during the 1980s.
The initial Price Waterhouse analysis found that the net pres
ent value of FHA’s entire book of business plus cash reserves
through 1989 was $3.1 billion, about 1 percent of its insurance
15
The nationwide high-cost conforming loan limit for Fannie Mae and Freddie Mac was set at a higher amount than the high-cost market area ceiling for FHA.
Specifically, the conforming loan limit was established at $93,750 in 1980 and going forward was indexed to the annual house price change in the conventional
market. FHA’s minimum and high-cost ceiling were not similarly indexed and required statutory authority to change.
16
Typical closing costs averaged 2.5 to 3.0 percent of the sales price for FHA buyers in 1989, which meant that a homebuyer making the minimum downpayment
on a typical $65,000 home could have only $900 equity in the home—about 1.4 percent and far lower than even today’s FHA downpayment requirements permit.
To calculate: assume 3 percent closing costs, making the sum of purchase price plus closing cost $66,950; compute borrower downpayment as 3 percent of first
$25,000 ($750), plus 5 percent of the remainder (.05 x $41,950 = $2,098) for a total of $2,848; subtract this downpayment from 66,950 and the homeowner may
finance a mortgage of $64,100 (to the nearest $100)—effectively leaving the buyer with only $900 equity.
17
Excerpts from FHA (1938) established criteria for rating economic viability of property locations and neighborhoods, including those that assessed lower viability
to older neighborhoods with low growth as “accelerating the transition to lower class occupancy,” and required an assessment of the quality of development near the
property location “to determine whether incompatible racial and social groups are present, for the purpose of making a prediction regarding the probability of the
location being invaded by such groups.” See FHA (1938: ¶ 909 and 937).
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in force (aggregate loan balances).
18
This decline was significant
in the course of a decade—Price Waterhouse calculated that
in 1979 the MMI Fund had an economic value of $3.4 billion,
which was 5.3 percent of the insurance in force at the time. The
MMI Fund was projected to lose money on each year’s book of
business (loan vintage) from 1980 through 1989. In short, FHA
was underpricing its mortgage insurance, and had been doing
so for a decade (Weicher, 1992).
Price Waterhouse attributed the sharp decline in the MMI Fund’s
net worth during the 1980s primarily to the lower rates of infla
tion and house price appreciation in the 1980s compared with
that of the 1970s. The 1980–1982 recession years and the eco
nomic problems in the energy producing states in the late 1980s
generated particularly large losses, but the underlying trend
in house price appreciation was the fundamental problem. In
addition, the fund was insuring an increasingly risky book of
business, and a contributing factor was “past poor management
practices and lax monitoring” (Weicher, 1992: 138).
Considerable policy debate existed over how to restore the
financial strength of FHA, to make administrative reforms to
reduce fraud and abuse, and to improve management practices.
Changes addressing these issues were enacted in several key
pieces of legislation in 1989 and 1990.
• Administrative reforms were enacted by the Housing and
Urban Development Reform Act of 1989,
19
which included
establishment of (1) a Mortgagee Review Board, to enforce
lender compliance with FHA rules and standards; (2) the
Offices of the Chief Financial Officer and FHA Comptroller,
to improve agency financial accountability; (3) improved
management practices such as annual audited financial state
ments; and (4) elimination of private investor-owners from
the FHA single-family program. (Investor loans had been a
key source of abuse leading to high losses by FHA.)
• Reforms directly addressing FHA’s MMI Fund soundness
were enacted by the NAHA of 1990
20
and included (1) the
development of an actuarial standard of financial soundness;
(2) modification of minimum equity requirements; (3) changes
in the pricing of insurance premiums; and (4) revisions to

policies regarding distributive shares, which were a form of
dividends FHA paid to some borrowers whose loan cohorts
had experienced low losses.
• Governmentwide reforms were enacted by the Federal
Credit Reform Act of 1990,
21
which instituted a more
realistic picture of the cost of U.S. government direct loans
and loan guarantees. The credit subsidy cost of direct loans
and loan guarantees is the net present value of the estimated
long-term cost to the government for these credit activities.
Beginning in FY 1992, this calculation of credit subsidy
cost for loan guarantees such as FHA mortgage insurance
occurs at the time a new loan guarantee is made and when
the previous-year loan guarantees are annually re-estimated
to reflect any changes in the cost of the subsidy. This law
ended previous practices of cash accounting that tended to
make the budget effect of loan guarantees appear positive
in the early years when premium revenues were high and
losses were low, but had adverse budget effects in later years
when the opposite situation prevailed.
Through these legislative changes, FHA took the following
steps to shore up its finances: (1) shed high-risk loans (by
eliminating investor loans, a major source of fraud and abuse);
(2) raise the mortgage insurance premium (to raise revenues)
while simultaneously restructuring it (to reduce effective LTVs),
and stop distributive share refund payments; (3) implement
systematic risk management and better monitoring practices;
and (4) tighten underwriting through limits on the financing of
closing costs (to reduce effective LTVs).
The steps that FHA took in the 1990s are very similar to steps
that FHA has taken to shore up its finances during the current
crisis. Clearly FHA’s current capital reserves have eroded as a
result of the housing crisis beginning in 2007, which is well
documented in its recent MMI Fund actuarial reviews. The risk
management steps FHA has taken since 2007 include (1) shed
ding its riskiest loans (banning high-risk downpayment gifts);
(2) raising mortgage insurance premiums; (3) instituting better
management practices (including establishment of Office of Risk
Management, more frequent reporting to Congress on MMI
Fund condition, and expanding loss mitigation interventions
18
This net present value calculation is defined as the economic value or economic net worth of the Fund. It is a net asset position, after booking a liability for loan
loss reserves. Those loan loss reserves are to be sufficient for paying all projected future insurance claims, after accounting for expected future premium revenues.
The projection of loan loss reserves assumes no new business is booked to provide any additional resources.
19
P. L. 101–235.
20
P. L. 101–625.
21
P. L. 101-508.
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for defaulted borrowers); and (4) modest tightening of under
writing requirements (including minimum consumer credit
scores and higher downpayments on low-credit-score loans).
Again, similar to the 1990s experience, FHA took these post
2007 steps while balancing the goals of financial stability and
public mission to maintain mortgage liquidity in all markets
and provide service to creditworthy borrowers who would
otherwise not be served in a period of severe credit tightening
by the conventional market.
Pre-1991 Legacy Business Gradually Replaced by
Better Performing Loans and Improved Economic
Forecasts
Two years after the initial Price Waterhouse study, and after
the implementation of NAHA and other reforms, the FY 1991
actuarial review of the MMI Fund
22
found that the capital ratio
of the Fund had continued to fall. Price Waterhouse estimated
the FY 1991 capital ratio to have declined to negative 0.2
percent (-0.2 percent) of insurance in force as improved econo
metric models predicted higher losses among FHA’s legacy
(pre-NAHA) business compounded by slightly less favorable
economic forecasts. NAHA and other reform measures adopted
to reduce MMI Fund risks and to raise premiums were too
new to offset the factors that were reducing the economic value
of the legacy business. That finding, however, did not mean
that FHA needed a public bailout. Rather, the 1991 actuarial
review predicted future capital ratios would rebound as both
the reforms and the economy would recover, and that the MMI
Fund would meet its long-run capital ratio target of 2.0 percent
by year 2000. That is precisely what occurred, as exhibits III-1
and III-2 show, although the 2.0-percent capital target was
achieved much sooner than predicted in 1995.
NAHA Target Ratio: Designed To Withstand a
Moderate (Not Severe) Housing Downturn
The 1990 policy debate over the appropriate level of capital
for FHA resulted in a long-term target of at least 2.0 percent
of insurance in force. It was understood at the time, however,
that this target was designed only to enable FHA to maintain
positive capital during a moderate recession—not a severe
downturn as has occurred since 2007. Again, a review of the
historical record sheds light on the thinking behind this target.
The law requires FHA to operate in an actuarially sound
manner, but it does not require FHA to hold reserves that
would make it able to maintain positive capital during a
severe economic event.
The NAHA legislation actually established two target capital
ratios for FHA during its recovery: a 2-year target of 1.25 per
cent, and a more conservative long-term target of 2.0 percent
for the year 2000 forward. Price Waterhouse’s FY 1990 actuarial
review of the MMI Fund concluded that the fund’s net worth
should be at least 1.25 percent of its insurance in force: “The
Exhibit III-1. FHA Quickly Recovered After 1991 Reforms
FHA MMI Fund Economic Values and Capital Ratios by Fiscal Year of Actuarial Review, FY 1989–2004
Fiscal Year of Insurance-In-Force Economic Value Capital Ratio NAHA Target Capital Ratio
Actuarial Review (millions of dollars) (millions of dollars) (percent) (percent)
1989 263,963 3,133 1.19 —
1990 304,216 (2,674) – 0.88 —
1991 327,811 (669) – 0.20 —
1992 325,912 1,405 0.43 1.25
1993 316,527 4,554 1.44 1.25
1994 335,073 6,682 1.99 1.25
1995 345,278 7,086 2.05 1.25
1996 370,484 9,397 2.54 1.25
1997 400,850 11,258 2.81 1.25
1998 419,575 11,360 2.71 1.25
1999 454,184 16,637 3.66 1.25
2000 482,732 16,962 3.51 2.00
Note: Capital ratio is economic value as a percentage of insurance-in-force.
Source: U.S. Department of Housing and Urban Development
22
This report was submitted to FHA on December 31, 1992.
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Exhibit III-2. FHA Exceeded 1991 Projections for
Captial Ratio, Meeting 2.0 Percent Statutory Target for
FY 2000 in FY 1995
FHA MMI Fund Capital Ratio Projections From the 1991
Actuarial Review Compared With Actual Capital Ratios
From Subsequent Reviews
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
4.0
3.0
2.0
1.0
0.0
– 1.0
1997 projected capital ratio Actual capital ratio
Source: U.S. Department of Housing and Urban Development
1.25 percent is not a desired ratio, but a minimum ratio….
As we saw in the 1980’s when the capital ratio declined from
5.3 percent to one percent, far more than 1.25 percent capital
could be needed.”
This minimum capital percentage was derived from Price
Waterhouse’s simulation of FHA’s legacy book of business
under adverse (moderate recession) economics, and represents
the capital level the MMI fund would needed to stay solvent in
a hypothetical situation in which no new business is written.
23
The report goes on to say, “Any analysis of the MMI Fund
must recognize that FHA’s public purpose can be, and often is,
at odds with its statutory requirement to be sound…. While
reliance on the Treasury to cover catastrophic conditions might
be appropriate in the most severe circumstances, we believe
that, given current statutory requirements, MMI must (at a
minimum) maintain enough equity to withstand, on its own,
moderately severe economic conditions.”
The law requires FHA to operate in an actuarially sound
manner, but it does not require FHA to hold reserves that
would make it able to maintain positive capital during a severe
economic event.
III-2. FHA Met the Challenge Posed by
Market Shifts From 2001 to 2006
FHA’s Market Share Fluctuations Before and After
Crisis
Large market share fluctuations during the decade of the 2000s
also posed a challenge for FHA. Unlike a profit motivated
private insurer or lender, FHA does not actively seek to maxi
mize market share—that is not consistent with FHA’s mission.
The extreme fluctuations observed in FHA’s market share
since 2000, however, have given rise to questions as to FHA’s
appropriate role in the market. In particular, FHA had gone
more than a decade from capturing about 10 to 15 percent of
the home purchase market—the approximate share it had for
many years leading up to the new millennium—down to below
5 percent during the boom years immediately preceding 2007,
and rebounding to about 30 percent from mid-2008 forward.
24
See exhibit III-3, which illustrates quarterly FHA market shares
leading up to the crisis and in response.
25
Although many policy analysts believe the current 30-percent
share represents too large a footprint for the FHA in the long
term, less clarity exists about whether the very low (below
23
The moderate recession scenario that Price Waterhouse modeled to reach its conclusion was (1) lower house-price appreciation (than consensus scenario) by
2 percentage points, (2) lower interest rates by 1.5 percentage points, and (3) higher unemployment rates by 3 percentage points. These adverse conditions were
assumed to occur during the first 2 years in the forecast and are gradually phased out by the 5th year, after which the assumptions return to the consensus forecast.
In contrast, the post-2006 housing downturn was far more severe.
24
These shares are in terms of loan counts, not aggregate principal balance. Because FHA average loan sizes are typically smaller than those in the conventional
market, FHA shares by loan balance would be lower.
25
Immergluck (2009), Vandell (1995), and others provide a historical summary of FHA’s market shares going back to the agency’s inception. Some estimates refer to
FHA’s share of all mortgage originations and others refer to shares of home purchase loans or even home sales, so caution is warranted in making intertemporal com
parisons. We summarize some of the findings here to give a longer historical perspective on FHA market shares. From 1935 to 1939, FHA-insured loans accounted
for 23 percent of all single-family mortgage lending, growing to 45 percent during the years 1940 to 1944. When the Veterans Administration loan guaranty program
was introduced after WWII to serve returning veterans, the FHA share dropped significantly. During the 1950s the private mortgage insurance (PMI) industry re
emerged after its demise in the Great Depression, which gradually reduced FHA’s shares further. In 1970, FHA loans still accounted for nearly 30 percent of single-
family loans. With the increase in PMI activity along with the increasing presence of Fannie Mae (1968) and Freddie Mac (1972)—which by their founding charters
required a credit enhancement such as PMI for loans with LTVs above 80 percent—FHA’s market share had fallen to the 5- to 10-percent range during the 1980s
(except for a few years after 1985, when FHA shares spiked as private insurers retreated from the market in response to the recession in the energy-producing states).
FHA’s share rebounded in the 1990s to between 10 and 15 percent, partly in response to underwriting changes in the mid-1990s intended to increase homeowner
ship rates for low- and moderate-income borrowers and minorities. It remained in this range until the advent of the boom preceding the 2007 crisis.
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Exhibit III-3. FHA Shares of the Home Purchase Market Hit Record Lows in 2005, Followed by a Dramatic Turnaround
FHA as Share of Quarterly Home Purchase Mortgage Originations (percent)
45
40
35
30
25
20
15
10
5
0
2003 Q1 2003 Q3 2004 Q1 2004 Q3 2005 Q1 2005 Q3 2006 Q1 2006 Q3 2007 Q1 2007 Q3 2008 Q1 2008 Q3 2009 Q1 2009 Q3 2010 Q1 2010 Q3 2011 Q1 2011 Q3 2012 Q1
Sources: Mortgage Bankers Association and U.S. Department of Housing and Urban Development
5 percent) precrisis share is the appropriate level for FHA going
forward, or if FHA would more appropriately return to the
pre-2002 share in the 10- to 15-percent range to adequately
perform its mission. That is, the low FHA shares during the
boom years may also be an anomaly because those shares oc
curred at a time when predatory and subprime lenders offering
high-risk or high-cost alternative mortgage products attracted
large numbers of homebuyers who might otherwise have
chosen more sustainable FHA financing. In 2008, Bloomberg
Business Week noted the following:
For much of the real estate boom, the Federal Housing
Authority [sic] sat frustrated on the sidelines. Hand
cuffed by congressional limits on the cost and size of its
loans, the original government buyer of mortgage loans
couldn’t compete with private firms in the subprime
game. As a result, the agency’s share of the loan market
dwindled from its long-term average of 18 percent to
less than 2 percent by 2007. “We were marginalized,”
FHA Commissioner Brian Montgomery said in July (der
Hovanesian, 2008).
FHA growth during the boom years was also constrained, as
noted by Bloomberg, by congressional limits on the maximum
loan size FHA could insure. For example, house-price growth
across the United States outpaced the growth of the FHA loan-
limit ceiling leading into the crisis. From 1999 to mid-2005,
the national median existing house price rose by 62 percent.
By contrast, the FHA national loan-limit ceiling and floor
rose by only 50 percent. In high-growth, high-cost states like
California, the constraint was especially binding. According to
the California Association of Realtors, the median-priced home
in California increased by 252 percent during the 1999-to
2005 period. With house prices growing faster than the FHA
loan-limit ceiling, the portion of the housing market that FHA
was even eligible to serve declined rapidly in high-cost areas.
This decline is clearly illustrated by the fact that FHA mortgage
endorsements in California declined from 127,000 in FY1999
to less than 5,000 in FY2005. After the bust in 2007, loan ceil
ings for both FHA and the government-sponsored enterprises
(GSEs) were raised temporarily in several pieces of legislation
designed to broaden the ability of these agencies to provide a
backstop to the market which was experiencing severe credit
tightening. These loan-limit increases, which will be discussed
further in the next section, leveraged the subsequent rebound
in FHA’s market share.
In addition to the loan-limit constraints FHA faced going into
the crisis, and subsequent statutory expansions to these limits,
the shifting market shares observed during this decade were
also highly affected by underwriting standards. As noted in sec
tion I, lenders can more easily vary conventional underwriting
standards, whereas the FHA has relatively fixed underwriting
standards, which leads to nonprice rationing by conventional
lenders in response to local differences in economic conditions
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The FHA Single-Family Insurance Program: Performing a Needed Role in the Housing Finance Market
(Ambrose, Pennington-Cross, and Yezer, 2002). That is, lend
ers do not only raise prices when lending becomes riskier in
areas experiencing economic downturns, instead, they tighten
underwriting to ration the number of mortgages made in such
an area. FHA, on the other hand, maintains its presence in all
markets, providing stability and liquidity in markets experienc
ing recession.
Because FHA charges a mortgage insurance premium, many
homebuyers who can qualify for conventional lending without
mortgage insurance or with less costly private mortgage insur
ance choose conventional mortgages when the local economy is
robust. When the local or national economy is weak, however,
conventional lenders or private insurers tighten underwriting
and reduce their exposures in these markets, and FHA home
purchase mortgage market shares increase as FHA continues to
provide liquidity.
Thus, in good times, FHA home purchase mortgage market
shares often decline as lenders loosen underwriting standards.
This tendency was especially evident during the boom years

(2002–2006) preceding the 2007 downturn as FHA home
purchase mortgage market shares, especially those for racial
and ethnic minority borrowers, fell dramatically.
During the boom years, conventional lenders also competed
with FHA on product type variations in addition to price.
26

Many offered a range of nontraditional (often high-risk and
high-cost subprime) loan products along with expedited under
writing decisions. These subprime loan products increasingly
appealed to homebuyers who were facing ever-increasing home
sales prices.
A disproportionate share of homebuyers taking these products
were racial or ethnic minorities. Exhibit III-4, which uses data
reported by lenders under the Home Mortgage Disclosure Act
(HMDA) because that is the only readily available source of
racial and ethnic composition of conventional mortgage origi
nations, shows how the shifts in market share were greatest for
African American and Hispanic homebuyers.
27
After the crisis
hit, minority homebuyers were disproportionately affected by
the dramatic tightening of conventional mortgage credit.

Exhibit III-4. Changes in FHA Shares for Minority Home Purchase Market Were More Pronounced Than for Other
Groups
FHA as Share HMDA Reported Home Purchase Mortgage Originations by Race/Ethicity of Borrrower (percent)
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
60
50
40
30
20
10
0
Year of loan origination
All loans White alone Hispanic or LatinoBlack or African American alone
Note: One- to four-unit (single-family) home purchase loan originations: first-lien, owner- and nonowner-occupant borrowers, including manufactured housing. The data
are not adjusted for different coverage of FHA loans relative to convential loans; hence, FHA shares may be slightly overstated. For more details about coverage HMDA
levels, see “A Look at the FHA’s Evolving Market Shares by Race and Ethnicity,” U.S. Housing Market Conditions, Q1 2011.
Source: Home Mortgage Disclosure Act
26
FHA was also restricted in many markets by low loan limits.
27
When selecting HMDA data records for exhibit III-4, the criteria were to include only reported one- to four-unit (single-family) home purchase loan originations
that were secured by first-lien mortgages, representing both owner- and nonowner-occupant borrowers, and including purchases of manufactured housing.
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Jaffee and Quigley (2010) attribute the decline in FHA loans
during the boom years to subprime lending, predatory lend
ing, and the failure of the FHA to keep up with the lending
industry technology. They point to advances in underwriting
technology, contract (mortgage product) innovation, and
growth in private mortgage securitization, in addition to GSE
competition.
Thus to some, it appeared that FHA had been relegated to a
small niche role by a nonprime conventional market that used
new technologies to (1) design products that would appeal to
FHA’s traditional borrowers, (2) render faster credit underwrit
ing and pricing decisions, and (3) pass along the risk through
complex securitization structures. It also appeared that the
prime conventional market contributed to the decline in FHA
market share because of increased efforts by the GSE to lend to
FHA’s former clientele in part attributable to HUD’s affordable
housing goals for the GSEs.
Shift Toward the Nonprime Sector. The observations by
Jaffe and Quigley with regard to the shift toward the nonprime
sector was shared by the Government Accountability Office in
a 2007 report on FHA market share (GAO, 2007). The GAO
report also suggested this shift to nonprime resulted in a dete
rioration in FHA’s risk profile. Specifically, the GAO noted—
The decline in FHA’s market share was associated with
a number of factors and has been accompanied by
higher ultimate costs for certain conventional borrowers
and a worsening in indicators of credit risk among FHA
borrowers. More specifically, (1) FHA’s product restric
tions and lack of process improvements relative to the
conventional market and (2) product innovations and
expanded loan origination and funding channels in the
conventional market—coupled with interest rate and
house price changes—provided conditions that favored
conventional over FHA-insured mortgages. In contrast to
FHA-insured loans, the majority of conventional subprime
loans had higher ultimate costs to borrowers, partly be
cause their initial low interest rates could increase sub
stantially in a short period of time. (GAO, 2007a:5)
In comments to Jaffee and Quigley, Wachter (2011) notes that
subprime mortgages are designed for borrowers with impaired
credit records. Unlike FHA insured (and GSE guaranteed)
mortgages, subprime mortgages “price” the risk. For borrow
ers who meet the risk thresholds of the FHA (and similarly
the GSE portion of the conventional market), a more or less
uniform mortgage rate is charged for accepted loans. That is,
FHA’s risk-based pricing is limited, and lower risk borrowers
(who, as noted by Bunce et al., 1995, are relatively lower risk
among all FHA borrowers, but are generally too risky for the
prime conventional market) cross-subsidize higher risk bor
rowers. That has been FHA’s business model over its history.
For much of its history, the conventional market did not price
risk either—rather it generally followed a credit-rationing
paradigm to manage risks—until the advent of the past decade.
With new risk-based pricing and product development tech
nologies available in the market, FHA’s continued reliance on
cross-subsidies would arguably drive FHA’s better risks (based
on a combination of borrower and loan characteristics) to the
portion of the conventional market where risks are “priced”
at the loan level, leaving FHA with a dwindling book of ever
riskier loans. The key question sparked by FHA’s huge drop
in market share in mid-decade was whether FHA’s insurance
model of cross-subsidization had been rendered obsolete.
Alternatively, would FHA’s full embrace of the new market
paradigm based on the new technologies and product mix con
tribute to pro-cyclical swings, in effect negating one of FHA’s
main missions of promoting market stability?
During the boom, subprime underwriting criteria were “liberal
to nonexistent” and the high cost of these loans was often
masked by short-run mortgage payments (before teaser rates
adjusted) that were lower, giving borrowers the perception
that the loan was affordable (Wachter, 2011). The reality was
that the subprime loans being made both lacked suitability
for borrowers, and at the same time were not fully pricing the
high level of risk the products entailed. According to Wachter
(2011) subprime loans were much higher risk than FHA loans
without bearing sufficiently higher return (to investors) to
cover the risk. Thus the experience in the nonprime market
during the boom years preceding 2007 does not make the case
that FHA’s model of cross-subsidization is obsolete.
Shift Toward the Prime Sector. To better understand the
shift toward the prime conventional sector that FHA may have
experienced up until the housing crisis began in 2007, it is
helpful to present a brief history of the affordable housing goals
that HUD had established for the GSEs. Until 2009 HUD had
been the mission regulator for Fannie Mae and Freddie Mac,
and a major aspect of this regulation involved setting minimum
percentage-of-business goals for the GSEs’ mortgage purchases.
These housing goals measured the enterprises’ respective levels
of support for very low-income and low- and moderate-income
lending and lending in underserved geographic areas. The
main objective of the housing goals was to increase GSE invest
ment in underserved areas and GSE financing of underserved
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borrowers in return for the many cost advantages afforded the
enterprises through their public charters. The housing goals
also intended to encourage Fannie Mae and Freddie Mac to
introduce new affordable lending programs in underserved
areas and to make prudent adjustments in their mortgage
purchase standards that recognize the special circumstances of
low-income families and others who have found it difficult to
access credit in the conventional mortgage market. Through
a rulemaking process, HUD periodically established specific
targets for these goals since the passage of the Federal Housing
Enterprises Financial Safety and Soundness Act (FHEFSSA) of
1992 and until the passage of the Housing and Economic Re
covery Act (HERA) in 2008, which transferred the housing goal
function to the newly formed Federal Housing Finance Agency.
As noted by Weicher (2010), a major policy issue regarding the
setting of GSE goals was whether these enterprises should “lead
the market” or continue to “lag the market” as had historically
been the case. Leading the market means the fraction of an
enterprise’s mortgage purchases for a given year that qualify
for one of the goals would be greater than the corresponding
fraction for the entire conventional mortgage market (including
GSE loan purchases plus loans originated by portfolio lenders,
community-based lenders, and FHA/U.S. Department of Veterans
Affairs, but excluding subprime loans classified as “B and C”).
The housing goals set by HUD during 1993 through 2004
required the GSEs to raise their share of business for each goal
category relative to past performance, but these goals could be
met while the enterprises continued to lag the market. In its
November 2004 GSE Rule, however, HUD increased the goal
percentages for 2005 to 2008 to levels that were designed to
bring the GSEs’ performance to the upper end of HUD’s market
range estimates for each goal, consistent with the FHEFSSA
requirement that HUD should consider the GSEs’ ability to
lead the market. Because HUD had to project the size of goal
qualifying shares in the market to set the goals, actual market
goal-qualifying percentages would vary from the ex-ante HUD
projections. Weicher (2010) shows that in 2005 and 2006, it
was still possible for the GSEs to meet the goals and lag the
market (as ex-post actual market goal-qualifying shares came in
above the HUD projections) but in 2007 and 2008, for two of
the three main goals (low- and moderate-income, and special
affordable) the goal targets exceeded the actual market levels.
Both Fannie Mae and Freddie Mac responded to the higher
housing goals over the years by expanding their suites of mort
gage products targeting low- and moderate-income buyers. As
noted by GAO (2007b),
These products, in combination with the historically
low interest rates, made it easier for homebuyers to
purchase homes in a period of strong house price ap
preciation. For example, to serve the lower-income
and minority populations targeted by their affordable
housing goals, the GSEs developed products featuring
underwriting criteria that allowed for higher risks, such
as Freddie Mac’s Home Possible
®
Mortgage, which al
lows qualified borrowers to make no down payment. As
the GSEs worked to meet their goals, their market share
among lower-income and minority borrowers grew
over much of the 10-year period we examined [1996 to
2005], while FHA’s fell (GAO, 2007a: 11).
Consistent with these observations, research by An and Bostic
(2008) found a significant negative relationship between the
change in the GSE and FHA shares of the overall mortgage
market using data at the census tract level over a period span
ning 1996 through 2000, and these authors attribute the shift
to the HUD affordable housing goals. Unfortunately similar
research covering the period of 2005 to 2008 is not available.
This key period corresponds to a dramatic loss of FHA market
share to the nonprime market and the previously mentioned
HUD policy decision to raise the housing goals to levels corre
sponding to meeting or leading the market. The market shares
for both FHA and the GSEs ultimately declined after 2002,
however, which suggests that the main driver of FHA market
share declines may have been to the nonprime sector.
FHA’s Response to the Changing Market
FHA did not participate in exotic mortgages with low initial
teaser rates used to qualify borrowers who might not be able
to afford the fully indexed rate after the expiration of the
initial rate period. FHA also did not loosen its underwriting to
permit less than full documentation loans, nor did it permit
“piggy-back” structures that use second mortgages to fund
downpayments, nor did it permit prepayment penalties.
28
To compete successfully in the boom years leading up to the
crisis, FHA might have offered the teaser rate adjustable-rate
28
The one truly high-risk product that FHA permitted until it was prohibited by law by HERA were loans with downpayment gifts from nonprofit organizations that
were funded by the sellers of the property.
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mortgages (ARMs) that were at the center of the subprime crisis
and arguably a major source of the growth in subprime and
resulting loss of FHA market share. Alternatively, it may have
extended mortgage insurance to mortgages that contained other
exotic features. It may be that the growth of teaser rate ARMs,
in particular, enabled the subprime sector to outcompete the
FHA, because these loans were initially more affordable (while
the teaser rate was in effect) in a period of rising housing
prices, when other loans were not. Of course, FHA would not
likely have offered such loans because they would not likely
meet a standard of suitability (and may not have been permit
ted under existing statutory or regulatory authorities of FHA),
but if the FHA were to have extended itself into these products,
Wachter (2010) suggests it would likely have required im
mediate taxpayer support for FHA and a bailout after the boom
ended, undermining the ability for FHA to assist the struggling
mortgage market and borrowers in distress during the crisis.
29
FHA … did not change course from [its] fundamental
mission in response to shifting market shares.
Thus, FHA met the challenge posed by the market shifts that
caused its market share to decline by continuing to offer its
traditional line of business. To the extent advances in technology
were a causative factor, note that FHA embraces technological
advances where appropriate to better serve the public through
more efficiently meeting its basic mission with soundly under
written mortgages, but it did not change course from that fun
damental mission in response to shifting market shares in a period
in which the capital markets had a high appetite for mortgage
product with little regard for its underlying credit risk.
Although both Jaffee and Quigley (2010) and GAO (2007a)
have suggested that the loss of FHA market share during the
precrisis boom years may have resulted in adverse selection and
a higher overall risk profile for FHA, the decision by FHA to
maintain relatively consistent underwriting ultimately put the
agency in a better position to respond to the severe tightening
of credit after 2006, and the result was a dramatic shift of
market share back to FHA starting in 2008. Furthermore, a
review of FHA’s MMI Fund actuarial review for FY 2007 does
not indicate a dramatic increase in FHA’s portfolio risk charac
teristics in the10 years preceding 2008.
30
III-3. FHA Eliminated High-Risk Seller-
Funded Downpayment Gift Mortgages
Although FHA did not follow the market’s lead into teaser rate
ARMs, low documentation loans, or piggy back second liens, it
did offer one loan product which proved to be high risk: loans
with downpayment gifts from nonprofit or charitable organiza
tions where the gift funds were ultimately replenished to the
organization by the seller of the home.
Starting in 2000, the share of loans with gift letters from
nonprofit, religious, or community entities increased rapidly.
Most of these gifts from nonprofit organizations involved funds
which were supplied by contributions from the homesellers
involved in the specific transactions, and possibly financed
by inflated house values, as noted in a 2007 report by GAO.
31
This concentration reached about 10 percent by FY 2003 and
increased dramatically to more than 20 percent in FY 2005. As
a share of home purchase loans, the concentrations peaked at
more than 30 percent between 2005 and 2007.
Often the borrowers who received the seller-funded downpay
ment gift had weak credit histories as well. The combination
of low or zero equity in a property often sold at an inflated sale
price to a buyer with weak credit history resulted in a group of
loans that on average had a frequency of mortgage insurance
claims that was two to three times the average for other compa
rable FHA loans.
29
For further discussion of how FHA resisted the temptation to preserve market share by relaxing underwriting as other providers raced to the bottom, see Van
Order and Yezer (2011) and Reeder and Comeau (2008: 9–11).
30
Specifically, the 2007 actuarial report noted the distribution among FHA’s initial LTV categories shifted after 1998, with increased percentages of FHA’s business
comprising loans with LTV of 97 percent or higher. For example, the percentages of FHA’s loans endorsed during FY 2005–2007 falling in the 97-percent-or-above
category were 55.5, 49.3, and 42.3, respectively, compared with 22.9 in 1998. (One explanation for the post 1998 jump is that FHA instituted downpayment
simplification guidance in 1998 that replaced a cumbersome formula for maximum LTV. The formula change resulted in maximum LTVs for some loans that
formerly would have fallen in the 95- to 97-percent category rising to 97 percent. See FHA Mortgagee Letter 98-29. Partially offsetting this increase in the highest
LTV category, however, the years following 1999 also showed a corresponding decrease in loans with LTVs between 95 and 97 percent, with the overall effect being
that roughly equal percentages of FHA’s loans (42 percent) had LTVs less than 95 percent in 2007 and in 1998, with somewhat lower percentages in this lower risk
category during the intervening years.
31
The seller made a donation to the nonprofit or charitable organization in an amount equal to the downpayment gift plus a small additional amount that would be
retained by the organization. The downpayment gift often came from a fund operated by the organization, and this fund would be replenished by the donation from
the seller after the sale had been completed. Often, sellers would recoup their donations through raising asking prices for the home by an equal amount. The GAO
did an analysis and found that seller-funded downpayment contributions may have inflated selling prices by about 2 to 3 percent. See GAO (2007b).
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FHA Never Intended To Permit Seller-Funded
Downpayments
Back in the mid-1990s, the National Housing Act required
homebuyers to pay a minimum contribution (generally at
least 3 percent) of the cost of acquisition of a property for
the mortgage to be eligible for insurance by FHA. The statute
and the implementing regulations were originally silent about
permissible and/or impermissible sources of the mortgagor’s
investment. Then legislation was enacted in 1996 to permit
family members to provide gifts and loans to other family mem
bers. FHA followed with guidance published in handbooks and
mortgagee letters a broad range of other permissible sources
of the mortgagor’s investment beyond the homebuyer’s own
cash savings. These sources included the aforementioned gifts
and loans from family members, but also extended permissible
sources to include the borrower’s employer, government agen
cies, and charitable organizations. Nowhere did FHA extend
permission to obtain downpayment funds from the seller of the
property.
Nowhere did FHA extend permission to obtain downpay
ment funds from the seller of the property.
The prohibition of seller provision of downpayment funds is
widely accepted in the conventional lending sector as well.
FHA permitted limited amounts of seller contribution for
other borrower charges such as closing costs, with instructions
for appraisers to adjust the property value downward dollar
for-dollar for excess seller contributions (see FHA Mortgagee
Letter 2005-2).
32
The statutory minimum contribution by the
borrower, however, clearly was never intended to be permitted
to come from the seller. Downpayment gifts from relatives,
employers, government, or most charitable organizations were
considered to come from parties not participating directly in
the sales transaction.
In the 1990s, however, some charitable organizations began to
circumvent the FHA restrictions in various ways, including the
establishment of a fund that provides the “gift” to the homebuyer.
As noted previously, the fund is immediately replenished by
the seller providing through a “charitable donation” or a “ser
vice fee” to the nonprofit from the proceeds of the sale of the
home, and the seller does so only if the homebuyer is using
the charitable organization’s downpayment assistance program.
In September 1999, FHA published a proposed rule to estab
lish standards regarding the use of gifts by charitable or other
nonprofit organizations as a source of an FHA’s mortgagor’s
investment in the mortgaged property.
33
Specifically, the
standards would provide that gifts could not be made from
funds that the organization received, directly or indirectly,
from the seller of the property. Arguments were made that the
seller donation to the charitable or nonprofit organization after
the consummation of the sale did not constitute a gift from
the seller, however, and therefore the gift was to be treated
as coming from the organization. FHA eventually withdrew
the proposal in January 2001 as HUD received 1,871 public
comments of which only 21 favored the rule, and especially
after litigation opposing the ban was successful. Thus, FHA was
thwarted in its initial attempt to prohibit this type of downpay
ment gift, which was known to contribute to elevated mortgage
insurance claim rates.
In 2006, FHA approached the problem from a different
perspective. By this time the share of FHA home purchase
loans with seller-funded downpayment gifts was exceeding 30
percent and these loans were experiencing cumulative claim
rates that were two to three times the rate for other comparable
FHA loans. FHA consulted with the Internal Revenue Service to
obtain clarification from the tax authorities on the eligibility of
organizations offering this type of downpayment gift to qualify
for nonprofit status under section 501(c)(3) of the IRS code.
FHA issued Mortgagee Letter 2006-13 to clarify that eligible
sources of the borrower’s contribution included gifts from
charitable organizations and nonprofits, but only those that
were “exempt from income taxation under section 501(a) of
the Internal Revenue Service Code (IRC) of 1986 pursuant to
section 501(c)(3) of the IRC.”
34
At the same time, IRS issued its Bulletin 2006-21, which stated
that the manner in which an organization receives funding for
its downpayment gifts matters regarding the organization’s
eligibility for tax-exempt status under section 501(c)(3). The
IRS bulletin states that in cases in which the organization relies
on sellers and other real estate-related businesses that stand to
32
http://portal.hud.gov/hudportal/HUD?src=/program_offices/administration/hudclips/letters/mortgagee.
33
Docket No. FR-4469-P-01, published September 14, 1999.
34
http://portal.hud.gov/hudportal/HUD?src=/program_offices/administration/hudclips/letters/mortgagee.
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benefit from the transactions, that organization would not qual
ify under 501(c)(3). Although it appeared that the combined
effects of Mortgagee Letter 2006-13 and IRS Bulletin 2006-21
would be to curtail the practice of seller-funded downpayment
gifts, the result was that high volumes of these loans were still
being endorsed following the IRS announcement. It appeared
that removal of 501(c)(3) status from the organizations in
volved was not easily accomplished and that the organizations
likely revised their business models sufficiently to argue that
they remained in compliance with section 501(c)(3) as clarified
by Bulletin 2006-21.
FHA Received Statutory Relief in 2008
Ultimately the elimination of the seller-funded downpayment
gifts would be accomplished through statutory prohibition of
the practice. The passage of HERA on July 30, 2008 finally
terminated seller-funded downpayment assistance for loans
underwritten on or after October 1, 2008. Specifically section
2103 of HERA stated in no case shall the funds required for
the borrower’s minimum cash contribution consist, in whole
or in part, of funds “provided by the seller or any other person
or entity who stands to benefit from the transaction” and that
the prohibition applies to funds that may have been provided
“during or after closing of the property sale.”
Although a surge of these loans was observed immediately
before the effective date of the HERA prohibition which spilled
over as cases endorsed for FHA insurance immediately after
that date, the endorsement of seller-funded downpayment as
sistance loans decreased rapidly soon thereafter. By the second
quarter of FY 2009, these loans accounted for less than 1 per
cent of total endorsements. The steep decline in seller-financed
downpayment assistance in FY 2009 and later years will have a
significant effect in reducing losses on future FHA loans.
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Section IV. Response to the Crisis: FHA Keeps Credit Flowing
and Helps Distressed Homeowners
The years since 2000 have been very challenging for the
Federal Housing Administration (FHA), requiring it to make
and implement policy decisions in response to rapidly chang
ing market conditions, and more recently to assume a major
countercyclical role. In the previous section, we saw how FHA
did not succumb to pressures to compete with the subprime
sector on product types in a “race to the bottom” that would
have proved to be very risky for FHA, despite its market share
dropping to historic lows in the years just before the start of
the crisis in 2007. Beginning in 2007, FHA began to focus 
on its countercyclical role as conventional credit dramatically
tightened in response to the rise in delinquencies and foreclo
sures among subprime mortgages and the drop in home prices.
Home prices continued falling for 33 consecutive months
through early 2009, and the FHA played a major part in the
government’s efforts to slow this trend and stabilize prices (see
exhibit IV-1). Mark Zandi, chief economist at Moody’s Analyt
ics, offered this assessment of FHA’s role during the crisis.
The FHA had been virtually dormant during the housing
bubble, but it made about one-third of all U.S. mortgage
loans in the period after the bust. Without such credit,
the housing market would have completely shut down,
taking the economy with it. The effort took a toll on
the agency’s finances, but so far the FHA has avoided
turning to taxpayers for help, making it one of the few
housing-related enterprises—public or private—that
have not (Zandi, 2012).
An important component of FHA’s mission is “…to stabilize
credit markets in times of economic disruption” (HUD, 2012a).
During the years leading up to the housing bubble (roughly
2000–2006), FHA continued to keep its underwriting standards
and product mix roughly constant. As detailed in this section,
however, the rest of the market was fueled during this time by
rising house prices, loose underwriting standards and exotic
mortgages that proved ultimately to be unsustainable. As a
result, FHA’s market share and loan volumes declined during
this period. After the bursting of the housing bubble and the
collapse of the private-label securities (PLS) sector through which
many of the exotic mortgages were financed, FHA focused on
its stabilization role in the credit and housing markets in many
ways. FHA enabled homeowners with unsustainable conventional
loans to refinance into more suitable FHA loans, and offered
sustainable financing for new home purchases. It helped FHA
borrowers reduce monthly payments with streamlined refinances.
Exhibit IV-1. Home Prices Peaked in Mid-2006 and Began a 33-Consecutive-Month Decline Through April 2009
Index Value (Jan 2000 = 100)
Jan-03Apr-03
Jul-03
Oct-03Jan-04Apr-04
Jul-04
Oct-04Jan-05Apr-05
Jul-05
Oct-05Jan-06Apr-06
Jul-06
Oct-06Jan-07Apr-07
Jul-07
Oct-07Jan-08Apr-08
Jul-08
Oct-08Jan-09Apr-09
Jul-09
Oct-09Jan-10Apr-10
Jul-10
Oct-10Jan-11Apr-11
Jul-11
Oct-11Jan-12Apr-12
Jul-12
210
200
190
180
170
160
150
140
130
S&P/Case-Shiller
Index
Source: Standard & Poor’s
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FHA also enhanced its loss-mitigation strategies and its reten
tion and nonretention alternatives for distressed borrowers
facing foreclosures.
IV-1. Rising Home Prices Minimized
FHA’s Role
In the 1990s nonbank mortgage lenders emerged to operate
without many of the regulations governing traditional banks.
Many of the new lenders specialized in loans to borrowers
who could not qualify for traditional mortgages because of
poor credit or low incomes and supplied/sold the mortgages to
mortgage-backed security (MBS) issuers.
35
The issuers passed
the risk on to investors around the world who at the time were
eager to buy MBS carrying higher yields than those offered by
safer investments such as U.S. Treasury bonds (Knowledge@
Wharton, 2007). Following the burst of the dot-com stock
market bubble in early 2000, U.S. GDP growth began to slow
and the Federal Reserve began cutting interest rates to stimulate
the economy. After the terrorist attacks on September 11,
2001, the Federal Reserve cut interest rates six more times
between 2001 and 2003 (Federal Reserve Bank of New York,
2012). Mortgage lending peaked in 2003, driven by a surge in
refinancing as the Federal Reserve cut interest rates to excep
tionally low levels.
After 2003, home prices rose and private sector underwriting
standards declined. Exceptionally low rates of returns on sav
ings accounts and stock market decline led many households
and investors to turn to housing attracted by higher returns
and low borrowing costs (Zandi, 2012). Low Treasury bond
yields attracted both domestic and foreign investors to the
higher yielding agency MBS and PLS. PLS traditionally played
a very minor role in funding home mortgages, with a market
share of just more than 2 percent in 1990, yet, at the home
price peak in 2006, PLS issuers accounted for more than 20
percent of the home mortgage market (Federal Reserve Board,
2012a). As demand for mortgaged backed securities grew,
traditional mortgage originators evolved from underwriters of
portfolio mortgages to financial intermediaries in an originate
to-distribute business model. Without a vested stake in the
performance of the mortgages the underwriters originated,
prudent underwriting was subordinated to increasing volume
and generation of loan processing fees. Similarly, PLS securitiz
ers, driven by fees associated with the securitization and sale of
PLS put little emphasis on prudent underwriting, which made
FHA underwriting requirements less attractive and reduced the
demand for FHA insured loans.
FHA’s reluctance to relax its underwriting standards and
expand its product mix resulted in a decline in market
share at the peak of the housing bubble. FHA’s institu
tional capacity enabled it to step in when private capital
withdrew after the bursting of the bubble, however.
Rising home prices obscured the riskiness of the mortgages
pooled in PLS or being purchased by the government-sponsored
enterprises (GSEs) as borrowers extracted equity gains with
more highly levered affordable payment refinancing (often with
new introductory teaser rates) or purchased new, second, or
investment homes (Reeder and Comeau, 2008: 9–11).
During this period, FHA kept its underwriting standards fairly
constant which led to a sharp decline in market share of origi
nations as borrowers were attracted to subprime and Alt-A
mortgage loans with their minimal qualifying requirements and
documentation standards.
36
As underwriting standards contin
ued to be relaxed, exotic mortgages products such as 3-27 and
2-28 hybrid adjustable-rate mortgages (ARMs), interest-only (IO)
mortgages, and payment option ARMs with negative amorti
zation features permeated the market posing risks that were
often poorly understood by borrowers and investors alike.
37
FHA’s reluctance to relax underwriting standards resulted in
endorsements contracting as housing prices peaked, but FHA
35
Asset-backed securities vary in type of financial assets that back the securities. ABS differed from agency (Ginnie Mae, Fannie Mae, Freddie Mac) mortgage-backed
securities in that the types of mortgage collateral backing them were often subprime or low-documentation mortgages that did not conform to agency underwriting
standards.
36
At the peak of the bubble in 2004–2006, some private sector underwriters issued SISA (stated-income, stated assets), NINA (no income, no assets), and NINJA
(no income, no job or assets) mortgages where borrowers did not have to show any proof of the income, assets, or employment that would be used to make their
monthly mortgage payments.
37
Alt-A mortgages and payment option-ARMs were originally designed for borrowers who were self-employed and thus were unable to document income from an
outside employer or who had income that was variable and thus variable payments would enable them to adjust mortgage payments to match seasonal income. The
products may be useful in such specialized situations, however, during the relaxed underwriting of the past crisis these mortgage products were often used to qualify
borrowers for a larger, more expensive home than their income could support, an untenable situation that overextended borrowers and put them at risk of losing
their home.
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The FHA Single-Family Insurance Program: Performing a Needed Role in the Housing Finance Market

retained the institutional capacity necessary to expand and
provide countercyclical support when private capital withdrew
from the market.
At the start of the first decade of the 2000s, FHA originations
counted for more than 14 percent of mortgaged home purchases;
by the middle of the decade FHA’s share had fallen to less than
5 percent before growing to more than 30 percent of mort
gaged home purchase originations by the end of the decade.
38
IV-2. The Housing/Economic Contrac
tion: FHA Helps Stop the Downward
Spiral
As home prices peaked and began to decline, delinquencies
increased and lenders withdrew credit from the conventional
mortgage market in two ways: by lenders tightening underwrit
ing standards and by the closure or bankruptcy of mortgage
lenders.
Tightening of underwriting standards by lenders is discussed
further in this section (see exhibit IV-11, showing the sharp
increase in the net share of senior loan officers reporting tighter
underwriting conditions after late 2006).
Between 2007 and 2010, the Federal Deposit Insurance Cor
poration was appointed the receiver of 325 failed banks, a
huge increase from their receivership count of 24 failed banks
between 2000 and 2004. Fear in financial and housing markets
reached a crescendo in September 2008 with the bankruptcy
of Lehman Brothers, the fourth largest U.S. investment bank
at the time, and the conservatorship of the GSEs, Fannie Mae
and Freddie Mac, which were precipitated by rising losses on
mortgage loans as defaults and foreclosures rose to historically
high levels. Market turmoil and stress were very high as shown
by the sharp increases in the delinquency and foreclosure levels
in exhibit IV-2.
In other words, housing and mortgage markets were in a
self-perpetuating downward home-price and rising default
Exhibit IV-2. Market Stress Levels Evidenced by Rapid Rise in Delinquency and Foreclosure
U.S. First-Lien Mortgage Performance, Percent of Active Loans
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
In foreclosure
Delinquent
0
2
4
6
8
10
12
Source: LPS Applied Analytics
38
Calendar year home purchases by loan count. Source: FHA
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spiral (summarized by exhibit IV-3), which provided the
impetus for federal actions and policies that were intended
to break this self-perpetuating spiral. FHA’s countercyclical
role providing increased mortgage credit flows to counteract
the overtightening of underwriting standards is a crucial
component of these federal actions. FHA (and GSE) loan limits
were temporarily increased by the passage of several pieces of
legislation during 2008 and 2009 intended to support housing
and economic recovery (specifically the Emergency Economic
Stabilization Act [EESA] of 2008, the Housing and Economic
Recovery Act [HERA] of 2008, and the American Recovery
and Reinvestment Act [ARRA] of 2009) which extended FHA
access to more homebuyers and enabled more borrowers in the
conventional market to use FHA to refinance into lower interest
rates, reducing monthly payments. In addition to extending
access to more homebuyers and existing homeowners seeking
to refinance, FHA was also key in the successful temporary
surge in homebuying and associated temporary price increase
(which helped stem the free fall of prices) from the First-Time
Homebuyer Tax Credit program in 2009 and 2010. Further
more, FHA improved its loss mitigation policies and strategies
to assist about 1.4 million distressed homeowners with existing
FHA mortgages to retain their homes. Finally, FHA took steps
to shore up its finances and risk management process so that
it could balance its mission objectives with its requirement to
operate in an actuarially sound manner.
Exhibit IV-3: Self-Perpetuating Home Price and Default
Spiral

Falling home prices
Defaults increase
Fewer new
homebuyers gain
approval
Lower housing demand
Falling home prices
Overextended
homeowners unable
to refinance
Defaults increase
Reduced mortgage credit and
tightening of underwriting standards
IV-3. FHA Maintained Access to Credit
During the Crisis
The boom and bust in home prices and the ensuing mortgage
credit crunch highlighted the importance of maintaining access
to credit for not only homebuyers, but also homesellers. Sup
port for falling home prices requires that sellers be able to find
buyers who can access credit under reasonable terms.
The bust also stressed the need to maintain credit with sound,
but not overly restrictive, underwriting standards. By not
loosening underwriting standards and by not originating
unsustainable mortgages such as option ARMs and loans with
less than full documentation during the runup of the housing
bubble, FHA played an important role as a standard bearer of
sound underwriting. Yet, unlike the conventional market, FHA
did not subsequently severely tighten its underwriting stan
dards after the bubble burst, which could have exacerbated the
downward spiral in home prices and defaults and reinforced
the market instability shown in exhibit IV-3. Indeed even as
credit standards tightened significantly in the conventional
market each quarter from the first quarter of 2007 through
the second quarter of 2010, FHA, with modest tightening of
underwriting requirements was able to play a countercyclical
role, increasing originations from 528 thousand in 2007 to
1.98 million in 2009 (Federal Reserve Board, 2012b).
As noted above, to balance its countercyclical role during the
crisis with its requirements to remain actuarially sound, FHA
did take deliberate steps to adjust underwriting standards and
pricing to reduce its highest risk loans and bolster the adequacy
of FHA’s Mutual Mortgage Insurance (MMI) Fund and capital
reserves. The actions taken by FHA to shore up its financial
condition include the following:
1. Eliminated high-risk seller-funded downpayment gift loans.
2. Raised mortgage insurance premiums.
3. Raised minimum cash contribution from homebuyers from
3 to 3.5 percent as required by HERA.
4. Instituted better management practices, including establish
ment of the Office of Risk Management and more frequent
reporting to Congress on MMI Fund condition.
5. Expanded loss mitigation interventions for defaulted bor
rowers, which in addition to helping borrowers retain their
homes, also mitigates FHA losses.
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6. Modest tightening of underwriting requirements, including
establishment of a minimum consumer credit score,
increased downpayment requirements on certain higher
risk loans (those with low credit scores), and limiting seller
contributions to closing costs.
39
Although FHA did take the above steps to improve its financial
condition, the agency also resisted pressure from critics to
make substantial increases to downpayment requirements,
thereby maintaining access to low-downpayment loans when
others were exiting this segment.
Exhibit IV-5 (which appears later in this section) provides
a detailed breakout of the types of loans FHA was insuring
leading up to the crisis (during fiscal years [FY] 2004 through
2006) and their cumulative claim (foreclosure) rates, which pro
vide a partial measure of the relative performance of each group
of loans insured. Exhibit IV-6 (which follows exhibit IV-5)
shows a detailed breakout similar to that in exhibit IV-5 but
showing FHA’s response to the crisis in FY 2007 through 2009.
The tables clearly show the volumes of poor-performing loans
with high-risk downpayment gifts that FHA had been trying
to end declined rapidly after the legislative relief of 2008, and
volume of new home purchase business, conventional-to-FHA
refinances, and FHA-to-FHA refinances rose rapidly after 2006.
FHA Enabled Refinances
Not widely known is the fact that FHA provided support for
the refinance segment of the housing market during the crisis.
Beginning in 2007, FHA stepped in to enable growing numbers
of homeowners facing large interest rate resets from expiring
teaser rates on conventional ARMs to avoid large payment shocks.
These conventional-to-FHA “product refinances” helped
hundreds of thousands of borrowers who met FHA’s standard
underwriting criteria to convert conventional mortgages facing
(or which already had received) monthly payment increases
into far more sustainable FHA loans. Cagan (2007), who
examined more than 8 million conventional ARMs originated
between 2004 and 2006, found that given interest rate levels
prevailing as of the time of his analysis, 39 percent would face a
payment increase of between 25 and 50 percent on initial reset,
10 percent would face a payment increase of 51 to 99 percent,
and 15 percent would face a payment increase of 100 percent
or more (Cagan, 2007). If the borrower had sufficient equity
and credit quality to qualify for an FHA loan, he/she could have
refinanced into a fixed-rate FHA loan at a much lower payment
than the fully indexed ARM rate. This advantage was somewhat
negated after 2007 as policies by the Federal Reserve and other
factors brought mortgage rates down to historic lows, reducing
the potential for large payment shocks for conventional ARMs.
Nevertheless, during 2007-2009 in particular, conventional-to-
FHA refinance volumes rose rapidly. Because these loans were
fully underwritten to FHA standards, their early performance
has not been materially different than FHA’s other fully under
written loans in the same years (see exhibits IV-5 and IV-6 later
in this section).
The FHA’s countercyclical support enabled borrowers
with unsustainable conventional mortgages to refinance
into fixed-rate FHA mortgages.
In addition to providing help to homeowners with unsustainable
conventional loans, FHA also enabled borrowers with existing
FHA loans to refinance through its streamlined FHA-to-FHA
refinance programs. Streamline refinancing, which was an
option for FHA borrowers that existed before the crisis, became
increasingly important during the crisis as a way for FHA bor
rowers who might not otherwise qualify to take advantage of
lower interest rates to reduce monthly payment burdens. The
idea underlying a streamline refinance is that FHA, which al
ready held the default risk on the loan, would not be taking on
new risk if it insured a rate or term refinance of the loan (with
no cash out other than to cover closing costs), even if the loan
were underwater, or if the borrower’s credit history had dete
riorated. A rate or term refinance involves either a reduction in
the mortgage rate (to reduce monthly payment) or a change of
the loan term (for example, from 30-year to 15-year—provided
the new monthly payment does not exceed previous monthly
payment) without the borrower taking any cash away from the
39
Mortgagee Letter 10-29 restricted maximum financing to borrowers with a credit score of 580 or higher, maximum financing equal to 90 percent loan-to-value
ratio for borrowers with a credit score of 500 to 579, and made borrowers with a credit score below 500 ineligible for FHA insurance. According to Fair Isaac, from
2005 to 2011 Americans with credit scores of less than 500 represented 6.3 to 7.3 percent of the U.S. population. Thus, after tightening its underwriting guidelines,
FHA financing remained available for approximately 93 percent of the U.S. population. Mortgagee Letter 10-29 reaffirmed that applicants with nontraditional
credit history or insufficient credit (either of which could cause the applicant to have no credit score available) remain eligible for maximum financing if they meet
the underwriting guidance in HUD Handbook 4155.1 4.C.3. Mortgagee letters can be accessed at http://portal.hud.gov/hudportal/HUD?src=/program_offices/
administration/hudclips/letters/mortgagee.
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transaction. As such, the original loan would not be required
to be reunderwritten to approve the new streamline refinance
loan.
40
As explained previously, FHA’s enabling of refinances was piv
otal in arresting the self-perpetuating home price and default
spiral shown in exhibit IV-3. The volumes of conventional-
to-FHA refinances ranged from a low of 33,581 in 2005 and
increased in each of the next 4 years, reaching 468,644 refi
nances in 2009.
41
FHA-to-FHA refinances, including streamline
refinances, also increased during this period from 124,902 in
2005 to 367,802 in 2009.
Although overall market origination volumes declined in
2007 and 2008, the total number of FHA originations increased
by more than 29 percent in 2007 and 166 percent in 2008.
Exhibit IV-4 shows FHA quarterly market shares (in terms of
loan count) and clearly shows the ramping up of FHA market
shares for both purchase and refinance mortgages, with FHA
purchase loan shares being especially high after 2007 compared
with the years preceding the peak of home prices. The graph
also shows that FHA’s market share of refinances increased
sharply after Q3 2007, reflecting the ramp up in conventional-
to-FHA refinances that FHA offered in its countercyclical role.
As noted previously, in “normal” times, borrowers prefer con
ventional refinances but because conventional refinances were
not available to many borrowers owing to tight underwriting
standards, these borrowers turned to FHA refinances.
FHA Enabled Home Purchases
As discussed above, FHA maintained its traditional role of
helping finance home purchases, especially to first-time home-
buyers. Home Mortgage Disclosure Act (HMDA) data show
that with the decline in home purchase demand from 2005
to 2011 (with 2011 home purchase lending being 67 percent
below 2005 levels; see Avery et al., 2012), the count of HMDA
reporting institutions also declined such that in 2011 there
were fewer reporting institutions than in any of the previous
10 years. This decline, along with the tighter underwriting
conditions (explained subsequently in this section) meant that
many households were unable to qualify for conventional home
purchase loans. As a result, FHA home purchase share rose
dramatically as shown in exhibit IV-4.
Exhibit IV-4. FHA Is Known To Have Ramped Up Its Support for Home Purchases; Less Well Known Is Its Support
for Refinances During Crisis
FHA as Share of Quarterly Mortgage Originations by Type (percent)
45
40
35
30
25
20
15

10

5
0
Purchase
2003 Q1 2003 Q3 2004 Q1 2004 Q3 2005 Q1 2005 Q3 2006 Q1 2006 Q3 2007 Q1 2007 Q3 2008 Q1 2008 Q3 2009 Q1 2009 Q3 2010 Q1 2010 Q3 2011 Q1 2011 Q3 2012 Q1
Refinance Combined
Sources: Mortgage Bankers Association and U.S. Department of Housing and Urban Development
40
In some streamline refinance cases for which financed closing costs bring the new loan balance above a stated threshold (with no other cash out), a new appraisal
would be required. Thus, exhibits IV-6 and IV-7 (which appear later in this section) show breakouts for streamline refinances with or without new appraisals. In
either case, new mortgage credit underwriting is not involved.
41
To date, these conventional to FHA refinances over the period from 2007 to 2009 have performed better than standard and streamline FHA refinances.
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Several laws temporarily expanded FHA loan limits
along with those of the GSEs up to a high cost ceiling of
$729,750. In October 2011, the high cost ceiling was
rolled back to $625,500, but in November 2011, the
FHA ceiling was restored to $729,750, making it higher
than that of the GSEs.
The increase in FHA’s home purchase market starting in 2008
is due both to the withdrawal of private credit and to the
increase in FHA’s loan limits. Loan limits have risen rapidly in
recent years: in 2006, FHA could insure loans up to $200,160
in all markets and up to $363,790 in high-cost markets. Several
laws addressing economic recovery (EESA, HERA, and ARRA)
temporarily expanded FHA loan limits along with those of the
GSEs based on percentages of local median home price up to
a high cost ceiling of $729,750. In October 2011, the high
cost ceiling was rolled back to $625,500, but in November
2011, FHA ceiling was restored to $729,750, making it higher
than that of the GSEs. Thus, in 2012 FHA can insure loans up
to $271,050 in all markets and up to $729,750 in high-cost
areas whereas the GSEs are now limited to $417,000 in most
markets and $625,500 in high-cost areas. HERA also directed
the Federal Housing Finance Agency to move the GSEs to a
county-based system of loan limits like FHA while raising the
standard (outside areas at the floor or ceiling) from 95 percent
of median house prices to 115 percent. Thus, starting in 2008
FHA began insuring single-family mortgages of up to $729,750
and supporting broader segments of the housing market (in
cluding jumbo conforming) and reminiscent of the early days
of FHA in the midst of the Great Depression when the loan
limit was set at $16,000 at a time when average the home price
was in the neighborhood of $5,000.
42
With this raising of loan limits, a greater percentage of FHA
loans endorsed since 2007 have been above the 2007 loan
limits—that is, in the “jumbo conforming space.” For instance,
whereas 7.7 percent of FHA’s endorsements in 2008 were
above the old 2007 limits, this share increased to 12.8 percent
in 2009 and 14.0 percent in 2011. Increased loan limits at
a time of falling house prices has meant that FHA’s market
share of originations had increased to 29.8 percent of purchase
originations in 2011:
43
a measure perhaps of the countercyclical
role that it has played in the ongoing housing crisis.
Exhibits IV-5 and IV-6 are illustrative of FHA’s ability to
respond to the market in a relatively short time with the help
of Congress. Exhibit IV-5 shows that going into the crisis FHA
was at low volumes, and had large portions of its business
in high-risk downpayment gift loans that were performing
very poorly. Exhibit IV-6, however, shows that after the crisis
began, FHA succeeded in eliminating the high-risk gift loans,
increased its overall volume (purchase and refinance), and
enabled product refinances (conventional to FHA) with the
latter performing no worse than FHA’s ordinary refinance
business. This illustration provides another example of FHA’s
ability to address market challenges, which was also discussed
in a historical context in section III.
FHA Helps Homeowners Keep Their Homes
Although FHA’s expansion of mortgage credit was critical to
housing markets, the FHA’s support for the market extends
beyond extension of credit to new FHA loans: FHA is the direct
policy lever available to policymakers and has been used to
test out policy programs to address the crisis. Although not
as widely recognized as the U.S. Treasury’s Home Affordable
Modification Program (HAMP) for conventional loans, FHA has
actually extended loss mitigation aid to more than 1.4 million
distressed homeowners with existing FHA loans since the
second quarter of 2009 (see exhibit IV-7).
FHA’s loss mitigation actions include, amongst other actions,
the FHA Home Affordable Modification Program (FHA
HAMP), which is not to be confused with the Treasury’s HAMP
for conventional loans. FHA-HAMP is available to existing
FHA-insured borrowers who meet eligibility requirements
to avoid foreclosure by permanently reducing their monthly
mortgage payment through the use of a partial claim, which
in effect writes down the principal on the first lien, and
establishes a silent second lien for the amount of the partial
claim. The Helping Families Save Their Homes Act of 2009
provided FHA the authority to pay a partial claim of up to 30
percent of the unpaid principal balance as of the date of default
in combination with a loan modification. In addition to FHA
HAMP, FHA has encouraged its approved servicing lenders to
make greater use of its existing loss mitigation programs, which
have ramped up in volume considerably since the crisis. These
42
On November 18, 2011, President Obama signed into law the Consolidated and Further Continuing Appropriations Act, PL-112-55, which extended FHA’s
authorization to insure loans of up to $271,050 in all markets and up to $729,750 in high-cost areas through December 31, 2013.
43
See exhibit IV-11.
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Table IV-5. FHA Single-Family Insurance Program: Entering the Crisis
FHA Had Low Volumes and Was Seeking To Stop Insuring Purchase Loans With High-Risk, Seller-Funded Downpayment Assistance (Gifts From Nonprofits),
Data as of July 2012
FY 2004 FY 2005 FY 2006
Type of
FHA Mortgage
Downpayment
Gift Source
Total
Insured
Case Count
Percent of
FY Insured
Cases
Claim
Rate to
Date
(percent)
Total
Insured
Case Count
Percent of
FY Insured
Cases
Claim
Rate to
Date
(percent)
Total
Insured
Case Count
Percent of
FY Insured
Cases
Claim
Rate to
Date
(percent)
First-time buyer No gift 234,430 24.4 6.8 127,744 24.9 9.1 113,220 26.6 10.6
Nonprofit/government 128,571 13.4 19.4 96,507 18.8 21.4 85,435 20.1 21.7
Relative/employer 91,241 9.5 8.6 55,831 10.9 11.3 50,229 11.8 12.6
Subtotal 454,242 47.3 10.7 280,082 54.7 13.8 248,884 58.5 14.8
Other home purchase No gift 81,911 8.5 5.7 43,643 8.5 8.0 39,803 9.4 10.0
Nonprofit/government 31,517 3.3 15.6 20,998 4.1 17.6 17,895 4.2 18.7
Relative/employer 18,440 1.9 8.4 9,121 1.8 10.4 7,416 1.7 12.8
Subtotal 131,868 13.7 8.4 73,762 14.4 11.0 65,114 15.3 12.7
Conventional-to-FHA No gift 56,351 5.9 6.6 33,247 6.5 8.5 60,114 14.1 11.3
refinance* Nonprofit/government 138 0.0 41.3 164 0.0 29.3 99 0.0 25.5
Relative/employer 206 0.0 13.1 170 0.0 18.8 184 0.0 12.5
Subtotal 56,695 5.9 6.7 33,581 6.6 8.7 60,397 14.2 11.3
FHA-to-FHA refinance No gift 26,104 2.7 4.4 11,825 2.3 6.9 14,696 3.5 12.2
(nonstreamline)* Nonprofit/government 1 0.0 0.0 0 0.0 0.0 2 0.0 50.0
Relative/employer 41 0.0 0.0 15 0.0 0.0 24 0.0 12.5
Subtotal 26,146 2.7 4.4 11,840 2.3 6.8 14,722 3.5 12.2
Streamline refinance N/A 221,275 23.0 5.5 90,663 17.7 8.0 26,014 6.1 9.7
(no appriasal) N/A 70,208 7.3 7.8 22,399 4.4 12.3 10,360 2.4 14.8
Streamline refinance
Subtotal 291,483 30.3 6.0 113,062 22.1 8.9 36,374 8.5 11.2
(with appriasal)
Total insured cases 960,434 100.0 8.6 512,327 100.0 11.8 425,491 100.0 13.6
* Some nonstreamiline refinances require a cash contribution to pay closing costs, buy out the ownership interest of another party (such as a divorce situation), or pay off the old first- and second-lien mortgage balances, which
may come from a gift.
Note: Fiscal years begin on October 1 of previous calendar year and run through September 30.
Source: U.S. Department of Housing and Urban Development
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The FHA Single-Family Insurance Program: Performing a Needed Role in the Housing Finance Market
Table IV-6. FHA Single-Family Insurance Program: Response to the Crisis
FHA Volume Rises (Countercyclical Role), High-Risk Loans With Nonprofit Gifts Become Ineligible in 2008, and Homeowners Refinance out of High-Risk Conventional
Loan Products Into FHA, Data as of July 2012
FY 2007 FY 2008 FY 2009
Type of
FHA Mortgage
Downpayment Gift
Source
Total
Insured
Case Count
Percent of
FY Insured
Cases
Claim
Rate to
Date
(percent)
Total
Insured
Case Count
Percent of
FY Insured
Cases
Claim
Rate to
Date
(percent)
Total
Insured
Case Count
Percent of
FY Insured
Cases
Claim
Rate to
Date
(percent)
First-time buyer No gift 98,302 23.1 10.1 240,999 22.2 5.7 548,034 29.9 1.7
Nonprofit/government 81,495 19.2 19.6 170,575 15.7 12.2 45,773 2.5 7.1
Relative/employer 41,673 9.8 11.8 80,711 7.4 7.0 187,872 10.3 2.2
Subtotal 221,470 52.1 13.9 492,285 45.3 8.2 781,679 42.7 2.2
Other home purchase No gift 33,995 8.0 8.7 87,474 8.0 5.7 174,202 9.5 1.9
Nonprofit/government 16,534 3.9 18.2 37,142 3.4 11.7 9,916 0.5 7.8
Relative/employer 6,395 1.5 12.1 14,753 1.4 7.3 29,754 1.6 2.4
Subtotal 56,924 13.4 11.8 139,369 12.8 7.4 213,872 11.7 2.3
Conventional-to-FHA No gift 107,403 25.3 11.1 356,512 32.8 8.2 466,590 25.5 2.9
refinance* Nonprofit/government 60 0.0 0.0 54 0.0 16.7 24 0.0 4.2
Relative/employer 276 0.1 15.9 914 0.1 11.5 2,030 0.1 3.7
Subtotal 107,739 25.4 11.1 357,480 32.9 8.2 468,644 25.6 2.9
FHA-to-FHA refinance No gift 16,483 3.9 11.5 31,438 2.9 7.4 38,231 2.1 3.0
(Nonstreamline)* Nonprofit/government 0 0.0 28.6 3 0.0 0.0 1 0.0 0.0
Relative/employer 21 0.0 0.0 45 0.0 16.7 133 0.0 2.3
Subtotal 16,504 3.9 11.5 31,486 2.9 7.4 38,365 2.1 3.0
Streamline refinance N/A 14,905 3.5 12.5 51,482 4.7 10.9 280,265 15.3 5.1
(no appriasal) N/A 7,182 1.7 14.4 15,290 1.4 10.2 49,172 2.7 4.1
Streamline refinance
Subtotal 22,087 5.2 13.1 66,772 6.1 10.7 329,437 18.0 5.0
(with appriasal)
Total insured cases 424,724 100.0 12.8 1,087,392 100.0 8.2 1,831,997 100.0 2.9
* Some nonstreamiline refinances require a cash contribution to pay closing costs, buy out the ownership interest of another party (such as a divorce situation), or pay off the old first- and second-lien mortgage balances, which
may come from a gift.
Note: Fiscal years begin on October 1 of previous calendar year and run through September 30.
Source: U.S. Department of Housing and Urban Development
Housing Finance Working Paper Series
37

The FHA Single-Family Insurance Program: Performing a Needed Role in the Housing Finance Market
Exhibit IV-7. FHA Has Role in Helping Distressed Homeowners
Cumulative Mortgages Receiving Aid Since April 1, 2009 (millions)
Apr-09 Jun-09
Aug-09 Oct-09 Dec-09 Feb-10
Apr-10 Jun-10
Aug-10 Oct-10 Dec-10 Feb-11
Apr-11 Jun-11
Aug-11 Oct-11 Dec-11 Feb-12
Apr-12 Jun-12
0
1
2
3
FHA loss mitigation HAMP modifications
Note: Data exclude trial modifications.

Sources: U.S. Department of the Treasury and U.S. Department of Housing and Urban Development

loss-mitigation programs include special forbearance, partial
claim (intended to bring loan arrearages current and limited to
1 year of principal and interest payments), and loan modifica
tions (non-HAMP).
44
A promising recent FHA initiative is the expanded use of dis
tressed note sales through FHA’s Distressed Asset Sales Program
beginning in 2010. This initiative includes a new pilot started
in 2012, the Neighborhood Stabilization Loan Sales initiative, for
which Departmental policies around future sales are still being
refined. Under FHA’s distressed asset sale programs, seriously
delinquent loans (notes) are sold competitively to investors (ei
ther for-profit or nonprofit) at a market-determined price gen
erally below the outstanding principal balance. FHA processes
an insurance claim, removes the FHA insurance, and transfers
the note to the investor. For some note sales, the investors are
not restricted in how they resolve the loan default. In others,
including the Neighborhood Stabilization initiative, restrictions
are placed on the investor. Restrictions, when applied, gener
ally have included a prohibition on starting foreclosure on any
properties for a minimum of 6 months, giving the new loan
servicer time to work through loan retention options. Because
the loans are sold for less than the unpaid balance, the investor
has the ability to reduce the loan principal, or otherwise modify
the loan terms while still being able to earn a reasonable return
on the initial investment. The Neighborhood Stabilization Loan

Sales initiative is designed to help stem the flow of distressed
properties hitting distressed markets and therefore requires
that no more than 50 percent of the loans in the pool be sold
as vacant REO properties, which provides an incentive for the
investor to offer some REO properties in the pool for rent when
home retention was not possible.
FHA Disproportionately Serves Racial and Ethnic
Minority Borrowers
Historically, FHA endorsements have been provided to minority
and low-income households that struggled to secure conven
tional market financing. At the home price peak in 2006, many
subprime lenders targeted racial and ethnic minority commu
nities and, accordingly, FHA’s minority market share declined.
As home prices declined and defaults rose, however, FHA re
emerged as a critical source of financing for minorities seeking
homeownership. As shown graphically in exhibit III-4, and with
additional detail in exhibit IV-8, FHA’s 2006 home purchase
market share was 5.3 percent overall and among Black and His
panic borrowers was 8.0 percent, and 5.1 percent, respectively.
In 2009, FHA’s home purchase market share overall reached a
high of 37.3 percent and in 2010 FHA’s home purchase market
share to Black and Hispanic borrowers, reached 59.6 and 59.3
percent, respectively. Although minority households were dis
proportionately hurt by the foreclosure crisis and minority

44
In addition to the listed loss mitigation programs which help FHA borrowers remain in their homes, FHA also has other loss mitigation programs—preforeclosure
sale, and deed-in-lieu of foreclosure—which help borrowers who are unable to retain their homes through one of the other options.
38
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The FHA Single-Family Insurance Program: Performing a Needed Role in the Housing Finance Market

Exhibit IV-8. FHA Home Purchase Mortgage Originations as Share of All Home Purchase Originations by Race/Ethnicity
Year
Count Percent
Black Hispanic Black Hispanic Total
2011 64,658 117,402 53.5 54.0 30.7
2010 83,743 134,745 59.6 59.3 36.2
2009 87,203 145,337 58.8 58.4 37.3
2008 83,846 107,857 46.2 39.7 25.5
2007 40,113 36,084 13.5 8.8 7.0
2006 35,648 35,155 8.0 5.1 5.3
homeownership rates declined, the losses would have been far
worse without the support provided by the FHA through its
home purchase, refinance, loss mitigation, and other activities.
Since 2009 to date, nearly 60 percent of homes pur
chased by Black and Hispanic buyers were financed with
FHA loans.
FHA Kept Low-Downpayment Loans Available
FHA has also traditionally played a large role in low-downpayment,
high loan-to-value ratio (LTV) mortgage lending for home pur
chases. As house prices declined and mortgage losses rose, FHA
was pressured to restrict low downpayment homeownership
programs. The FHA resisted this pressure and continued to
provide support for qualified creditworthy households seeking
homeownership but lacking the significant assets often re
quired for downpayments on conventional loans. Whereas the
FHA chose to maintain its low downpayment loan programs
for creditworthy borrowers, it sought to shore up its finances
and to protect the MMI Fund by adjusting mortgage insur
ance premiums and downpayment requirements for higher
risk, low-FICO borrowers. Mortgagee Letter 10-29 restricted
maximum financing to borrowers with a credit score of 580 or
higher, maximum financing equal to 90 percent LTV for bor
rowers with a credit score of 500 to 579, and made borrowers
with a credit score below 500 ineligible for FHA insurance.
45
Exhibit IV-9 shows that leading up to the home price peak,
FHA’s market share of borrowers making a downpayment of
4 percent or less declined from 71 percent in 2001 to 26 per
cent in 2007. Yet by 2009 at the height of the credit contraction,
the FHA endorsed nearly 79 percent of mortgage loans with
a downpayment of 4 percent or less. The graph also shows
that FHA’s support for the market was not limited to low
downpayment borrowers as FHA’s purchase share of the for
merly prime 5- to 19-percent downpayment market segments
were also more than 50 percent in 2009 and 2010. Without
FHA’s continued commitment to low-downpayment home
purchase lending, the pool of qualified borrowers would have
shrunk, further reducing demand for homes, further depressing
home prices, and putting additional stress on housing markets
nationwide.
Without FHA’s continued commitment to low-downpayment
home purchase lending, the pool of qualified borrowers
would have shrunk, further reducing demand for homes.
FHA’s Role in Recent Years
During 2004–2007, the PLS sector of the market grew in share
and became the preferred conduit for securitizing loans made
to “weak borrowers” or those with lower FICO, high LTV and
additional risk layers, such as IO and low or no documentation.
These years saw the proliferation of subprime and Alt-A loans.
Exhibit IV-10 (taken from Goodman et al., 2012) shows the
“loosening” of underwriting standards between 2004 and 2007
and the subsequent tightening of these underwriting standards
in the market.
46
Between 2004 and 2007, whereas underwriting
standards loosened considerably in the PLS sector, they loos
ened only slightly in FHA/U.S. Department of Veterans Affairs
(VA) or in the GSE space. Exhibit IV-11 shows the origination
volume by year, holder of risk and key loan characteristics.
45
http://portal.hud.gov/hudportal/HUD?src=/program_offices/administration/hudclips/letters/mortgagee.
46
In exhibit IV-11, tighter standards are associated with higher average origination FICO credit scores, lower average LTV ratios, lower share of originations with
ARMs, and lower share of originations with IO features.
39
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The FHA Single-Family Insurance Program: Performing a Needed Role in the Housing Finance Market
Exhibit IV-9. FHA Purchase Origination Market Share by Downpayment Percentage and Vintage Year
Percent of Market Originations in Category
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
60
50
40
30
20
10
0
70
80
90
4 or less 5–9 10–14 15–19 20–24 25–30
Source: LPS Applied Analytics
In additional to the individual risk characteristics such as
those illustrated in exhibit IV-11, another symptom of loose
underwriting is the layering of risk. For instance, many loan
products originated during the housing bubble had multiple
risk features: many borrowers obtained low/no documentation
loans that also had high LTVs or second liens attached. Other
risk layering features included the presence of IO options
wherein the loan is essentially nonamortizing and the most
risky of these loan products were the IO ARMs with a short
initial period of 2 or three years after which interest rates rose
sharply. Note that exhibit IV-10 does not reflect the favorable
pricing in the nonagency sector for risk-layered loans (includ
ing low/no documentation, Alt A and stated income/stated
assets) which were the mainstay of the PLS sector. The PLS
sector priced these risk-layered loans very favorably and such
loans proliferated during the peak of the housing bubble.
Underwriting standards remained roughly constant in
FHA/VA/USDA programs through the housing boom and
the bust unlike the pro-cyclical trend in the PLS market.
With the collapse of the PLS sector, some of these risk-layered
loans did make their way into the GSEs in 2007 but this trend
was reversed by the tightening of underwriting standards at the
GSEs: origination FICOs dipped for the GSEs and originating
LTVs inched up (the origination LTV at FHA/VA actually
dipped and origination FICOs declined in 2007). The share of
Refinances increased sharply in 2007 as some of the borrowers
of these risk-layered PLS loans sought refinances into loans
with the FHA/VA and the GSEs. This increase in FHA refinance
share is evident in exhibit IV-5 under “Conventional to FHA
Refinances” and represents one of the countercyclical roles
played by FHA (and the GSEs) during the credit crisis—that
is, product refinances which typically benefited consumers
who were faced with large rate resets after the expiration of
teaser rates. Through most of 2007, as the PLS sector dried
up in terms of market share, it was the GSEs that gained most
of the market share. By the end of 2007, however, the GSEs
had tightened their credit underwriting requirements after
realizing that their gain in market share was coming in the
form of risk layered loans that would ultimately have higher
loss severity. Thus, from 2008 onwards, the Ginnie Mae (that
is combined FHA/VA/U.S. Department of Agriculture) share
40
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The FHA Single-Family Insurance Program: Performing a Needed Role in the Housing Finance Market
Exhibit IV-10. Origination Volumes by Year, Holder of Risk, and Selected Loan Characteristics
Issue
Balance ($ M) Orig. FICO Orig. LTV
Year
Portfolio FHA/VA PLS FHLMC FNMA Portfolio FHA/VA PLS FHLMC FNMA Portfolio FHA/VA PLS FHLMC FNMA
2001 8,027 237,472 237,663 140,193 195,791 698 656 690 714 708 73.7 95.7 73.6 74 74.3
2002 17,476 258,643 351,107 350,103 483,890 722 655 690 721 715 68.3 95.8 72.6 70.8 71.5
2003 55,387 315,345 545,060 679,158 1,139,018 729 658 686 730 723 68.5 95 73.3 68.1 68.4
2004 70,613 174,183 809,647 349,172 510,354 725 650 677 721 718 72.2 95.8 76.6 71.2 71.2
2005 117,146 126,043 1,101,897 373,965 483,878 725 653 680 725 721 72.9 96 77 71.5 71.7
2006 183,366 112,430 1,000,064 346,611 468,775 720 654 679 725 720 73.6 96.1 77.7 72.6 72.9
2007 218,094 136,728 357,809 427,708 606,776 720 643 703 723 718 75 95.3 75.5 74.3 75.2
2008 105,208 380,911 1,352 339,015 530,635 741 667 736 740 737 70 95.3 71.3 71.4 72.3
2009 56,206 603,455 362 458,641 774,847 753 696 764 761 756 67.3 95.6 56.1 67.1 67.4
2010 74,407 484,259 414 372,725 594,935 765 707 773 760 762 65.4 95.6 58.9 69.5 68.4
2011 76,519 359,915 836 297,591 550,008 766 709 770 761 761 66.3 95.1 64 69.9 69.4
Issue
% Refi % ARM % IO
Year
Portfolio FHA/VA PLS FHLMC FNMA Portfolio FHA/VA PLS FHLMC FNMA Portfolio FHA/VA PLS FHLMC FNMA
2001 67 25 64 63.8 63.3 29 3.4 37 5.9 5.1 2.8 0.1 4 0 0.1
2002 70.6 32.5 68 74.6 70.1 28.5 7.2 49 8.4 9.5 1.8 0.1 12 0 0.4
2003 70 49.4 68 81.3 78.1 30.9 5.7 55 7.6 10.2 6.8 0 17 0 1
2004 46.3 35 55 60.4 58.2 59.1 11.9 73 14.4 21.9 27.9 0 32 0.2 5.1
2005 44.2 31 52 56 54.2 63.3 7.2 73 16.2 22 36.6 0 38 7 10.3
2006 46.5 30.6 54 47.2 49.1 33 3.2 68 19.9 16.7 26.3 0.1 34 16.6 15.7
2007 48.6 36.6 60 51.3 50.6 34.9 2 57 18.1 10.3 30 0.6 45 22.6 15
2008 57.2 39.5 56 59.1 58.8 44.3 2.1 63 8.6 7.9 26.1 0 60 7.1 5.5
2009 65.8 47.7 80 80.2 77.5 34 2.3 87 0.8 2.9 18.6 0 69 0.2 0.9
2010 73.1 42.4 64 78.9 77.2 27.4 6.2 17 4.4 6.3 8.9 0 17 0.4 1.3
2011 68.5 41.5 55 78.4 76.5 26.8 8.2 14 8.6 6.6 10.7 0 14 0.1 0.7
41
Source: Case-Shiller
®
, 1010 data, Amherst Securities as reported in Amherst Mortgage Insight, May 30, 2012
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The FHA Single-Family Insurance Program: Performing a Needed Role in the Housing Finance Market

Exhibit IV-11. Senior Loan Officers Reporting Tighter Underwriting Conditions
Net Change in Percent
2003 Q3 1990 Q31991 Q31992 Q31993 Q31994 Q3 1995 Q3 1996 Q3 1997 Q3 1998 Q3 1999 Q3 2004 Q3 2000 Q3 2001 Q3 2002 Q3 2005 Q3 2006 Q3 2007 Q3 2008 Q32009 Q3 2010 Q32011 Q3
– 10
– 20
0
10
20
30
40
50
60
70
80
All mortgages Prime mortgages only

Source: Federal Reserve Board
of market securitization rose from 4.7 percent of originations
to 19.6 percent in 2008 to 21.8 percent in 2011. As noted in
the May 30, 2012 Amherst Mortgage Insight, “However, in
government lending programs, lending standards remained
roughly constant, and much more activity has gravitated to
these programs” (Goodman et al. 2012: 4).
These lending standards were consciously kept at a near-
constant level to serve the market even in times of market
turmoil and were crucial to the countercyclical role played
by the government agencies. Another critical component that
helped this role was the raising of the conforming loan limit in
2008 for FHA and GSEs, as noted previously in this section.
Tighter Credit Underwriting After 2008
As seen in exhibit IV-10, originating FICOs have been rising
for all sectors after 2008 with the originating LTVs falling for
the GSEs and portfolio loans indicating the tightening of their
underwriting. Through these years, the originating LTV for
FHA/VA stayed steady in the 95-percent range indicating that
it has now effectively become the sole source of high LTV loans
and for borrowers with low credit scores.
This tightening of credit standards is evident in other data as
well. The Federal Reserve survey of senior loan officers shows
that banks tightened underwriting standards every quarter
from late 2006 through mid-2010 with very little easing since
then. Exhibit IV-10 shows the dramatic tightening of credit
in 2007 and 2008, which peaked with 74 percent of senior
loan officers reporting tighter underwriting conditions on
prime mortgages.
47
Although underwriting conditions have
not become tighter since then, they nevertheless remain tight:
The July 2012 survey reports that “lending standards for most
categories of loans remained at least somewhat tighter, on bal
ance, than the middle of their respective ranges since 2005.”
48
Thus, in 2012, the housing market is faced with historically
low interest rates and high housing affordability (as measured
47
The “net change” represented in exhibit IV-11 is the fraction of banks that tightened standards minus the fraction that reported having eased standards. Thus,
negative net changes imply that more banks reported having eased standards than tightened standards.
48
The July 2012 Senior Loan Officer Opinion Survey on Bank Lending Practices, accessed on 9/28/2012 from http://www.federalreserve.gov/boarddocs/snloansurvey/
201208/fullreport.pdf, p.7: “With respect to loans to households, a majority of the banks reported that lending standards for all five categories of residential mortgage
loans included in the survey (prime conforming mortgages, prime jumbo mortgages, subprime mortgages, nontraditional mortgages, and HELOCs) were at least
somewhat tighter than the middle of the range that those standards have occupied since 2005, whereas smaller but still significant fractions of domestic banks also
reported that standards were tighter than the midpoint for prime credit card, subprime credit card, auto, and other consumer loans.”
42
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The FHA Single-Family Insurance Program: Performing a Needed Role in the Housing Finance Market
by the NAR’s housing affordability index) and yet remains
anemic as evidenced by housing market activity (sales and
prices). Policymakers and legislators are faced with the daunt
ing task of healing housing markets while reforming them. The
White Paper on Reforming America’s Housing Finance Market
that was released by Treasury and the U.S. Department of
Housing and Urban Development in February 2011 endorsed
“returning FHA to its traditional role as targeted lender of
affordable mortgages” (U.S. Treasury and HUD, 2011: 14). The
White Paper recommends “a reformed and strengthened FHA”
that will ensure that “creditworthy first-time home borrowers
and families with modest income can access a mortgage” (U.S.
Treasury and HUD, 2011: 19).
Finally, any discussion of FHA’s countercyclical role during
the current crisis should consider the costs incurred by FHA
in performing this role. Loans FHA insured during the 2005 to
2009 period are likely to suffer the most (in terms of lifetime
performance) from the recent national housing recession.
These loan vintages contained high shares of seller-funded
downpayment gifts, which historically have performed
much worse than other FHA loans. These vintages also were
underwritten when home prices were near or at their peak in
mid-2006, with the subsequent 33-consecutive-month declines
in national price levels creating the most potential for nega
tive equity. FHA’s relatively low market shares during these
high-loss boom years, however, has helped mitigate the effect
of these loan vintages on FHA. In certain states like California,
for which falling home prices were especially severe, FHA had
even more limited exposure because of lower precrisis loan lim
its that restricted origination volumes. In addition to precrisis
loan vintages, the surviving FHA mortgages originated between
2009 and 2012 will enter their peak default periods during
2013 through 2017. As FHA stepped up its countercyclical
role, and the relatively high volumes of FHA originations in the
2009-2012 period, which has resulted in about 78 percent of
the entire MMI Fund concentrated in mortgages in these loan
vintages as of 2012, the MMI Fund is expected to realize high
claim losses in the next several years.
43
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The FHA Single-Family Insurance Program: Performing a Needed Role in the Housing Finance Market
Appendix. Key Questions on Future Role of FHA

The authors hope that this paper serves as a useful foundation
for considering the Federal Housing Administration’s (FHA’s)
future role in housing finance as both institutional and regula
tory reforms are debated. FHA’s history has shown that the
public policy debate after FHA’s financial crisis of the 1980s
was driven by balancing the dual objectives of carrying out
FHA’s purpose and mission and maintaining and improving
its financial soundness. In the current environment, FHA is
still engaged in helping to mend the ailing housing market.
Looking forward to a time when that objective will have been
substantially accomplished, numerous policy questions remain
to be addressed. Some questions involve balancing the costs
and benefits of FHA assuming a countercyclical role when
future market distress may occur at the same time it is meeting
the other aspects of its mission. This and other questions
about FHA’s institutional role are integral to the policy debate
framed by the White Paper on Reforming America’s Housing
Finance Market that was jointly released by the Departments
of Treasury and Housing and Urban Development in February
2011 (U.S. Treasury and HUD, 2011).
FHA is a valuable direct policy lever and has been used to
address credit market imperfections, market failures and
to provide countercyclical support. It has helped address
market imperfections by providing increased homeownership
opportunities to creditworthy low- and moderate-income
families, minority households and first-time homebuyers that
the conventional market was unable to serve. FHA has also
expanded access to credit in all regional markets and smoothed
regional variations that might have surfaced otherwise. FHA
has demonstrated innovative processes in mortgage finance
such as underwriting borrowers with nontraditional credit
that have since become more mainstream practices. As, the
paper has detailed in sections III and IV, FHA has provided
significant countercyclical support with regional recessions
(such the oil patch recession of the 1980s) and the national
housing bubble in recent years. (Regional recessions have been
more common than national ones and FHA has been a valuable
policy instrument in mitigating them). Furthermore, FHA has
applied the lessons it has learned in the past to the actions it
has taken in dealing with the current crisis: both to protect its
fiscal health and also to support its dual mission of bolstering
the housing market during tough times and providing access
to homeownership for underserved populations. Although the
final accounting for the cost of actions taken to deal with the
current crisis is still to be determined, FHA and policymakers
will likely seek answers to the following questions.
• What is the cost of the current level of countercyclical
support being provided? Is it appropriate given the benefits
secured?
• In the future, are other institutional structures possible that
will support/augment/replace this role? Should FHA’s coun
tercyclical role be confined to segments of the market such
as the underserved populations? How might FHA interact
with private mortgage insurance (PMI) companies and
other institutions in the future: should operations overlap
considerably as in the past or very little? Is this overlap to be
addressed via regulation or through pricing?
• Will FHA need to become active in developing standards,
innovating new guidelines, and providing information
on loan performance to the industry, such as identifying
creditworthy borrowers among households whose credit was
impaired during the crisis?
• How will regulatory reform affect these discussions? What is
the appropriate “credit box” for Qualified Mortgages (QMs)
that balances the responsible lending standards (in terms of
taking ability to repay into consideration) with availability of
credit? How will the market react to the cumulative effect of
these reforms?
• How will demographic trends affect FHA’s role and market
share? Demographic trends such as slowing down in the rate
of household formation may reduce the demand from first
time buyers who have traditionally relied heavily on FHA
financing. The State of the Nation’s Housing Report from the
Joint Center for Housing Studies at Harvard University notes
“a sharp slowdown in average annual household growth in
2007-2011 to 568,000 in 2011 which is less than half the
pace in the first half of the 2000s or even the 1.15 million
average in the late 1990s” (Joint Center for Housing Studies
of Harvard University, 2012: 6). The Report notes that two
causative factors: a decline in the rate at which individuals
(especially those younger than age 35) form households
(or headship rates) and a sharp drop in immigration which
could contribute to a decrease in first-time homebuyers, a
traditional FHA constituency.
44
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The FHA Single-Family Insurance Program: Performing a Needed Role in the Housing Finance Market

As the Treasury/HUD White Paper has pointed out, the
current housing crisis has exposed deep flaws in our housing
finance system. The White Paper does not rule out a dramatic
transformation in the role of government in the housing market
as it offers three options for the housing finance system. These
options offer widely different degrees of government support
and along with different associated costs and benefits.
Option 1: A privatized system of housing finance with the gov
ernment insurance role limited to the FHA, U.S. Department of
Agriculture (USDA), and U.S. Department of Veterans Affairs
(VA) assistance to narrowly targeted groups of borrowers.
Option 2: A privatized system of housing finance with as
sistance from the FHA, USDA and VA for narrowly targeted
groups of borrowers and a guarantee mechanism to scale up
during times of crisis.
Option 3: A privatized system of housing finance with FHA,
USDA and VA assistance for low- and moderate-income bor
rowers and catastrophic reinsurance behind significant private
capital.
As policymakers debate and choose among these options, they
will be making difficult trade-offs between providing broad
access to mortgages for all households with risks to taxpayers
and market stability and resiliency. Another set of difficult
trade-offs will be involved in the phasing of these reforms: en
suring housing market recovery will need to be balanced with
long-term reform of the entire housing finance structure.
In addition, questions emerge related to regulatory reforms that
are under consideration which are likely to affect FHA’s role
going forward. These reforms are detailed in the Qualified Resi
dential Mortgage (QRM) proposed rule, the QM proposed rule,
and Basel III capital proposed rules for financial institutions.
The outcomes of these rulemakings could affect how and at
what price the conventional market will be able to serve future
homebuyers of varying credit risk profiles. If FHA continues to
perform its traditional role of serving those creditworthy, lower
wealth households not well served by the conventional market,
these rules could affect the size of the potential FHA market.
All three proposals are expected to be finalized in the near fu
ture and the final provisions of each rule may be quite different
from those contained in the proposed rules. This appendix will
discuss the challenges, concerns and reactions to the proposed
rules because the final rules have not yet been published. It
is likely (and hoped) that the concerns raised here will be ad
dressed in the final rules.
QRM or “Skin in the Game” Rules
The Dodd-Frank Act requires issuers to retain 5 percent of the
credit risk on loans they securitize (that is, they retain some
“skin in the game”) unless the loan is a QRM in which case
those loans are exempt from the 5-percent requirement. FHA/
VA/USDA loans and government-sponsored enterprise (GSE)
loans while the GSEs are in conservatorship are exempt from
the 5-percent requirement.
49
Six federal agencies that have been
charged with jointly issuing the QRM rule (the Federal Deposit
Insurance Corporation [FDIC], Federal Housing Finance Agency
[FHFA], the Federal Reserve Board, the U.S. Department of
Housing and Urban Development, the Office of the Comptrol
ler of Currency and the Securities and Exchange Commission)
issued their proposed QRM rule in 2011, have received comments
and have not yet announced plans to issue the final rule.
50
The
consensus is that the regulators will likely finalize the QRM
after the final Qualified Mortgage or QM rule is issued.
The proposed QRM definition is a closed-end loan with the
following characteristics.
• A maximum loan-to-value ratio (LTV) of 80 percent for
purchase loans, 75 percent for rate and term refinances, and
70 percent for cash out refinances.
• A maximum front-end and back-end Debt-to-Income or DTI
ratio of 28 and 36, respectively.
• On any debt, the borrower cannot be 30 days past due,
never 60 days past due in the past 24 months, or have any
bankruptcy, repossession, foreclosure, deed-in-lieu, short
sale or judicial judgment on any debt in the past 3 years.
• Points and fees on QRM cannot exceed 3 percent of the loan
amount.
• The loan cannot have negative amortization, a balloon term,
term longer than 30 years and in the case of an adjustable-
rate mortgage (ARM), rate increases are capped at 2 percent
age points per year and 6 percentage points over the life of
the loan.
49
Note that GSE loans could continue to be exempt from risk retention requirements should regulators decide so. 

50
See “Credit Risk Retention, Proposed Rule.” 76 Federal Register 24090-24186.29. April 2011.
45
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These rules, as proposed would restrict a large share of the
recent mortgage market from QRM designation. An FHFA
study showed that only 19.8 percent of GSE loans made
from 1997 to 2009 would have been QRM-eligible (Federal
Housing Finance Agency, 2011). Only 30.5 percent of GSE
loans made in 2009 (a year of very tight credit underwriting
at the GSEs) would have been QRM-eligible. One argument in
favor of a restrictive QRM designation is to require nearly all
securitizations to involve retained risk by the issuer (that is, for
most to retain “skin in the game”) with only a small fraction of
securities involving very safe mortgages being exempt. Many
have suggested preference for a less restrictive QRM definition,
however, expanding LTVs to 90 or even 95 percent to capture
more of the market (Moody’s Analytics, 2011). Consumer
advocates such as the Center for Responsible Lending have
pointed out that even allowing LTVs to expand to 90 percent
(with PMI) will still adversely affect borrowers, especially low-
and moderate-income and minority households (Center for
Responsible Learning, 2012b).
Many industry participants, consumer advocates (including the
Coalition for Sensible Housing Policy) and trade groups have
argued that instead of the 10-15 basis point increase antici
pated in the analysis of the proposed QRM rule, interest rates
would actual increase by 80-185 basis points for non-QRM
loans. If the higher estimates of effect on mortgage rates are
correct, a narrow definition of QRM may severely restrict the
securitization of nongovernment mortgage loans.
Proposed Regulatory Change: QM
51
When a lender originates a QM loan under the requirements
set forth in the proposed QM rule,
52
they are making a reason
able and good-faith determination, based on verified and
documented information, that at the time the loan is closed,
the consumer has a reasonable ability to repay it according to
its terms, including all applicable taxes, insurance (including
mortgage insurance) and assessments. The QM provisions ap
ply to nearly all mortgage loans
53
—whether securitized or held
in portfolio, whether held by private entities or by government
or government sponsored entities.
Under the proposed QM rule, lenders can comply with the
ability-to-repay requirement in four ways.
1. By originating a mortgage loan after considering and
verifying eight factors.
54
2. By originating a QM loan: The proposed rule offers two
alternative approaches to protecting lenders from liability
when they originate a QM loan—”a legal safe harbor” and
a “rebuttable presumption” from liability for QM loans.
55
The CFPB is expected to adopt one of these approaches in
the final rule. Under the legal safe harbor approach, legal
safe harbor would be available only for a mortgage that
met certain specific conditions.
56
Under the rebuttable
presumption of compliance, in addition to the requirements
listed for safe harbor, the lender is also required to consider
and verify the borrower’s employment status, monthly
payment for any simultaneous mortgage(s), borrower’s
current debt obligations, monthly DTI ratio or residual
income and borrower’s credit history.
3. By originating a “balloon payment QM” for small lenders
operating predominantly in rural or underserved areas that
will be holding the loan in portfolio.
4. By refinancing a “nonstandard” mortgage into a “standard
mortgage” with certain restrictions.
51
The regulatory landscape discussion here relies heavily on the detailed discussion provided in Canfield Press L.L.C. (2012). 

52
See Regulation Z, Truth in Lending, Proposed Rule, 76 Federal Register 91. pp. 27390-27506.
53
The proposed rule excludes HELOCs, time shares, and reverse loans. Subordinate closed-end loans are covered.
54
The eight factors are (1) the borrower’s current or reasonably expected income or assets, other than the value of dwelling that secures the loan; (2) the borrower’s
current employment status if current income from employment is used to determine ability to repay the loan; (3) the loan payment based on the fully indexed-rate
and on fully amortizing payments that are substantially equal; (4) the borrower’s monthly payment on any simultaneous mortgage loan that the lender knows—or
has reason to know—will be made, and for HELOCs, the payment is based on the amount of credit drawn at the closing of the QM loan; (5) the borrower’s monthly
payment for mortgage-related obligations; (6) the borrower’s current debt obligations; (7) the borrower’s monthly debt-to-income ratio or residual income; and
(8) the borrower’s credit history.
55
By definition, “the safe harbor approach” ensures that the lenders face minimal putback or litigation risk if the loan is originated per QM rule. The rebuttable
presumption approach on the other hand has some built-in litigation risk but provides the basis with which the lender can defend their decision.
56
(1) Does not include negative amortization, interest-only payments, or balloon payments or have a loan term exceeding 30 years; (2) total points and fees that
generally do not exceed 3 percent of the loan amount (with alternative thresholds proposed for smaller loans); (3) lender considered and verified borrower income or
assets; and (4) where the underwriting is based on the maximum interest rate in the first 5 years, takes all mortgage-related obligations into account (including taxes
and insurance) and that uses a payment schedule that fully amortizes the loan over its term.
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The Dodd-Frank Act provides for “enhanced damages” for
violation of the ability-to-pay requirements by expanding the
statute of limitations from 1 to 3 years and permits borrowers
to assert the ability-to-pay violations as a defense to foreclo
sures even after the 3-year limit.
Although both legal-safe-harbor and the rebuttable-presumption
approach provide the borrower the opportunity for judicial
review of a claim that the ability-to-repay standard was not
satisfied, a significant difference exists between the two. As
industry experts have pointed out, within a litigation context,
only the stated standard or factors of safe harbor can be applied
by the court, and only this approach would minimize litigation
risk and put-back risk (whereby the loan originator may be
required to repurchase a defaulted loan previously removed
from its balance sheet and put into a mortgage-backed security
pool) to the lender/originator. By definition, the rebuttable
presumption inherently has some litigation and put-back risk
built into it and is viewed less favorably by industry and trade
groups. On the other hand, some consumer advocates have
argued that adopting a safe-harbor provision is contrary to the
spirit of the Dodd-Frank Act and that the absence of legal con
sequences for creditors would provide for the same conditions
that led to the financial crisis in the first place.
Additionally, industry and trade groups
57
have pointed out that
an undefined or vaguely defined rebuttable-presumption stan
dard could have a significant effect on the cost and availability
of credit as the costs of defending against future litigation or
of carrying a put-back loan on balance sheet are likely to be
passed on to borrowers in the form of higher rates and fees
and of additional disclosures.
58
Furthermore, these sources
say lenders are likely to reduce their exposure to such risks by
tightening credit standards to stay well inside of those estab
lished by the QM rule and thus will face reduced incentives to
originate non-QM loans.
In March 2012, a coalition including the Center for Responsible
Lending, the Consumer Federation of America, the Leadership
Council on Civil Rights and Human Rights and The Clearing
house Association jointly presented a “term sheet” to the CFPB
in an effort to forge a compromise that defined the terms under
which the borrower could rebut the presumption compliance
with QM rules (The Clearing House, 2012). Despite this
attempt at compromise, a comment letter (American Bankers
Association, 2012) from 23 industry and trade groups has
stated that establishing a rebuttable presumption of compliance
would “force lenders to retreat to far more conservative lending
standards” and called for the inclusion of a legal safe harbor.
Consumer advocates such as the Center for Responsible Lend
ing, the Consumer Federation of America and the Leadership
Council on Civil Rights and Human Right have explained
why their position on the proposed QM has changed: their
comment letter from July 29, 2012 contains extensive analysis
of data from various sources that shows that “low-wealth,
low-income and minority consumers will be at greater risk of
being excluded from the QM market unless creditors can apply
a bright line standard which is easily measured, understood,
and can be applied at scale across underwriting platforms and
organizations” (Center for Responsible Lending, 2012a: 3).
The CFPB is set to issue its final rule at the end of 2012.
Whether that rule is based on safe harbor or as a rebuttable
presumption, it is very likely that non-QM loans, which by def
inition are also non-QRM (QRM is a subset of QM), are unlikely
to be originated because they will face significantly higher capital
retention requirements. If non-QM loans are originated by
some lenders, the loans would likely involve premium pricing
because of their higher litigation and put-back risks. Establish
ing the appropriate “credit box” for QM is important.
59
Without
such definition, lenders will likely use the more restrictive QRM
definition as the de facto QM definition. The current QRM
proposal is quite narrow requiring for instance, a 20-percent
downpayment for purchase loans and would exclude large
segments of the current mortgage market. Additionally, unless
this box is wide and broad, critical market segments (likely
low-income, low-wealth and minority borrowers) will be either
excluded or will be able to get a mortgage only at much higher
interest rates and costs than might otherwise be possible.
Proposed Basel III Capital Standards
Regulatory capital requirements such as those under the Basel III
Accord are intended to ensure that banks retain a sufficient
cushion to absorb losses during times of economic stress. Regu
lators determine the amount of capital required for different
57
See the ABA’s comments, for instance, at http://www.aba.com/aba/documents/news/QMletter41312.pdf.

58
Goodman et al. (2012) estimate that each violation of the “ability to repay” statute could cost the lender $70,000–$100,000.

59
The term “credit box” refers to a graphic representation of the range of risk levels over multiple credit risk factors, often depicted as a rectangular “box.” One

example would be a credit box showing acceptable ranges of LTV on one dimension and debt-to-income ratio on the other.
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types of assets using a risk-weighting scheme, with low-risk
assets (such as government securities) having little or zero
capital requirements, whereas assets that represent greater risk
require a larger capital cushion. Thus, these risk weights also
provide a policy lever by which regulators indirectly influence
the type of activities banks elect to engage in.
In 1988, the Basel Committee developed a new capital frame
work (Basel I) that was designed to make minimum capital
requirements uniform across member countries and to take the
riskiness of the bank’s portfolio into account in setting capital
requirements. A minimum capital requirement of 8 percent
was established in all member countries (including the United
States) and bank assets were divided into broad categories with
a risk weight for each asset category. For instance, in the Unit
ed States, commercial loans are risk weighted at 100 percent
risk, residential mortgages at 50 percent, GSE backed securities
at 20 percent and government obligations (such as Ginnie Mae
securities) are given a 0-percent weight.
In 2004, the Basel Committee agreed to a new capital frame
work, (Basel II), but before Basel II was actually used by any
U.S. banking institutions, the financial crisis hit and the Basel
Committee determined that refinements were needed. Basel III
rules were released in December 2010 and implementation of
Basel III in the United States requires the three Federal Banking
agencies to issue proposed regulation. The OCC, the FDIC
and the Federal Reserve Board began the process by issuing
proposed regulations in the summer of 2012 that both com
munity and regional banking organizations and the very largest
international banks will be required to adopt. In general, the
Proposed Risk Weights for Residential Mortgage Exposures
a
proposed rules will increase the capital needed for residential
mortgage finance. Although a complete analysis of the proposal
is beyond the scope of this paper, consider the following
examples where the proposed rules directly affect mortgage
financing and—
60
• Increase the risk weight for residential mortgages held in
portfolio.
• Increase the risk weight assigned to mortgage servicing
rights.
• Double the capital required to be held against undrawn
home equity lines of credit (unless banks retain the right to
cancel the line at any time).
• Increase the regulatory burden on banking institutions for
holding private-label securities relative to other types of
securities.
Consider the risk weight for residential mortgages held in port
folio. Currently, prudently underwritten residential mortgages
are assigned a risk weight of 50 percent, implying that the
bank has to hold only one-half the capital for such a residential
mortgage as for a commercial loan. Under the proposed Basel
III rules, all mortgages belong in one of two categories and are
further subdivided based on LTV. Category 1 mortgages have
lower capital charges than Category 2 loans.
61
The table in this appendix summarizes the proposed risk
weights and the significant increase in risk weights for
Category 2 loans.
Loan-to-Value Ratio (%) Category 1 Residential Mortgage Risk Weight (%) Category 2 Residential Mortgage Risk Weight (%)
≤ 60 35 100
>60 and ≤80 50 100
>80 and ≤90 75 150
≥90 100 200
a
See page 33, Table 5 in the news release at http://www.occ.treas.gov/news-issuances/news-releases/2012/nr-ia-2012-88b.pdf.
60
See Natter (2012) and K&L Gates (2012).
61
Category 1 loans must be a first mortgage, must have a term not exceeding 30 years, cannot have a balloon payment or a negative amortization feature, cannot
allow for deferment of principal payments, and must be underwritten using documented and verified income and after considering all the borrower’s obligations
(including taxes, insurance, and assessments). Furthermore, the creditor must have made a reasonable determination that the borrower can repay the loan using
the maximum allowable interest rate in the first 5 years and if the loan is an ARM, the interest-rate adjustments are capped at 2 percent per year and no more
than 6 percent over the life of the loan. Category 2 is a catchall category for all mortgage loans that are not Category 1 loans. Moreover, PMI does not count when
determining LTV because PMI providers have varying financial strengths.
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According to the proposed rule, the current risk based capital
treatment for residential mortgage exposure that is uncondi
tionally guaranteed by the U.S. government or its agencies will
be maintained. That is, residential mortgages unconditionally
guaranteed by the U.S. government would retain their risk
weighting of zero and conditionally guaranteed loans (such
as those guaranteed by the GSEs) will retain a risk rating of
20 percent. This treatment means that under the new proposed
rules, the capital requirements on a loan with nongovernment
mortgage insurance will become much higher. In certain
market segments such as high-LTV lending, this treatment may
have the consequence of raising the cost of loans with PMI (as
banks/originators pass on the extra cost of holding capital on
to borrowers) and therefore leaving FHA with a higher share of
these loans. Further, some industry experts have cautioned that
the effect of these rules (if enacted in current form) in conjunc
tion with regulations to be issued under the Dodd-Frank Act
could adversely affect the origination of loans by private capital
and its subsequent securitization in certain market segments
such as high-LTV segments.
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