By the Numbers
MIP cuts look unlikely while FHA loss risks persist
Brian Landy, CFA | September 24, 2021
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
A healthy insurance fund at the Federal Housing Administration has put a cloud over a Ginnie Mae MBS market concerned about cuts in mortgage insurance premiums. Lower premiums could increase prepayment speeds on Ginnie Mae MBS, stinging investors in a market with most pools priced above par. But roughly 10% of FHA loans are still delinquent, and a wave of expensive loss mitigation could quickly erase the insurance fund’s capital reserves. Lowering premiums too soon would raise the risk that the FHA would need a bailout. HUD Secretary Marcia L. Fudge addressed the issue in March, saying she had no near-term plans to lower premiums. With the high political cost of going hat in hand to Congress, the agency is likely to remain reluctant to lower premiums until most delinquent loans have been cured or liquidated.
A lesson learned in the late 2000s
The FHA experienced significant stress during the late 2000s financial crisis. The FHA insurance fund appeared well capitalized at 7.0% in 2007 but only two years later fell to only 0.5% (Exhibit 1). In 2012 the capital ratio was negative and eventually the FHA received a $1.7 billion appropriation from the Treasury. A few factors contributed to the decline. The financial crisis and recession that started in 2008 drove delinquencies and defaults higher. Home prices fell, which pushed loss severities higher. This increased the forecast of future losses, lowering the NPV of future insurance premiums net of losses.
Exhibit 1. History of the FHA’s insurance fund
The FHA’s loan portfolio exploded in size, jumping from $300 billion in 2007 to $930 billion in 2009. This contributed to the decline since existing capital—typically held in cash and Treasury securities—was spread across a larger portfolio. The FHA builds their capital resources by collecting up-front and annual mortgage insurance premiums from borrowers. But most borrowers include the upfront premium as principal in their loan balance. This means the FHA collects the bulk of the upfront premium late in the payment schedule, or when a loan prepays. The FHA collects little of the upfront premium from loans that default. The FHA also collects annual insurance premiums, but it takes time to build resources. And prior to late 2010, the FHA was only collecting 55 bp per year for annual premiums.
The FHA had little choice but to hike annual insurance premiums to rebuild the integrity of the fund (Exhibit 2). Annual premiums peaked at 135 bp in 2013 before falling to 85 bp in 2015 and remain at that level. Despite the higher premiums, improving home prices and more modest portfolio growth, the insurance fund did not exceed 2008’s capital ratio until 2019 and has not yet matched the level in 2007.
Exhibit 2. Higher premiums stabilized and restored the insurance fund’s capital
The large changes in insurance premiums, while necessary, had many negative effects on borrowers and markets. Borrowers charged the highest premiums were paying more than required to cover their credit risk. Higher premiums may have prevented some borrowers from refinancing when rates dropped. And when premiums finally dropped it created a disruptive prepayment event in the market, which likely hurt pricing of Ginnie Mae MBS and increased mortgage rates for new borrowers.
The capital ratio has increased quickly over the last two years. Perhaps most surprising is that the NPV of future premiums less the NPV of expected losses increased even though seriously delinquent rates reached almost 12% at the peak of the pandemic. The FHA lowered their loss estimates since home prices have been very strong. But there is a lot of uncertainty regarding how the post-pandemic recovery will play out, and it is risky to anticipate lower losses after seriously delinquency rates tripled.
The insurance fund could face hefty losses from the currently delinquent loans (Exhibit 3). The first row assumes every delinquent loan receives a partial claim and does not redefault. This should use roughly $17.4 billion of the FHA’s capital and lower the capital ratio by 1.3% to 4.8%. Subsequent rows assume every delinquent loan is liquidated at a fixed severity. A 30% loss severity would be sufficient to push the capital ratio near the 2% statutory minimum. Loss severities have been roughly 30% to 35% for the last few years and were over 50% in the years following the financial crisis. The FHA has $40 billion of loss reserves allocated, which could defray some of the effect of these claims. But if a lot of loans proceed to liquidation the fund could see a large reduction in capital.
Exhibit 3. The capital ratio might fall
Lowering insurance premiums hastily could put the fund at risk of a capital shortfall, and the political cost of later raising premiums or receiving an appropriation are steep. The NPV of projected insurance premium revenue should fall since new borrowers will pay a lower rate. And the FHA would lose the higher premiums currently paid by borrowers that refinance. It is easy for capital to disappear in a crisis, but difficult to rebuild, especially if borrowers are locked into low insurance premiums. There is no pressing reason to lower insurance premiums, so the FHA can wait to see how loans perform following forbearance. There is also uncertainty about future home prices and loss severities. The next annual report should be released in November and will shed additional light on the state of the fund and the effect of the loans that have already exited forbearance.