Congressional Budget Office

Modeling The Budgetary Cost of FHA’s Single Family Mortgage Insurance

Francesca Castelli, formerly of CBO; Gabriel Ehrlich, Damien Moore, and Jeffrey Perry, all of CBO

September 12, 2014

Presentation for the Inaugural Conference of the Center for Finance and Policy, Massachusetts Institute of Technology

This presentation provides information from Modeling the Budgetary Costs of FHA's Single Family Mortgage Insurance, Working Paper 2014-05 (Congressional Budget Office, September 2014), www.cbo.gov/publication/45711.

1 C O N G R E S S I O N A L B U D G E T O F F I C E

Overview

■ The Federal Housing Administration’s (FHA’s) single-family mortgage insurance program

■ Budgetary costs and the capital reserve account

■ CBO’s statistical modeling and cost projections

2 C O N G R E S S I O N A L B U D G E T O F F I C E

FHA’s Single Family Mortgage Insurance Program

■ The program facilitates access to mortgage credit for borrowers with – Low down payments – Limited or poor credit histories

■ FHA guarantees mortgages against default

■ Borrower pays up-front and annual fees

■ Estimated $1.2 trillion of insurance is in force at the end of fiscal year 2014 (HUD 2013a)

3 C O N G R E S S I O N A L B U D G E T O F F I C E

FHA Share of Purchase Loan Originations

Percentage of Total Market

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 20130

5

10

15

20

25

30

35

4 C O N G R E S S I O N A L B U D G E T O F F I C E

FHA and National Average Serious Delinquency Rates

Percentage of Outstanding Loans

2002 2003 2004 2005 2007 2008 2009 2010 2012 20130

1

2

3

4

5

6

7

8

9

10

FHA

National Average

5 C O N G R E S S I O N A L B U D G E T O F F I C E

Capital Reserve Ratio of the Mutual Mortgage Insurance Fund, Excluding Home Equity Conversion Mortgages

Percent

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013-2

-1

0

1

2

3

4

5

6

7

8

6 C O N G R E S S I O N A L B U D G E T O F F I C E

Budgetary Treatment of Federal Credit Programs: Key Concepts

■ Credit reform subsidy

■ Fair-value subsidy

■ Capital reserve account

7 C O N G R E S S I O N A L B U D G E T O F F I C E

Budgetary Treatment of Federal Credit Programs

■ Federal Credit Reform Act (FCRA) of 1990

■ In each year, the federal budget deficit reflects – Estimates of lifetime costs (credit reform subsidies) of new mortgage

guarantees in that year – Reestimates of costs (subsidy reestimates) of previously issued

mortgage guarantees

■ Credit reform subsidies are present value calculations that use a Treasury rate to discount cash flows

8 C O N G R E S S I O N A L B U D G E T O F F I C E

Credit Reform Subsidy Calculation (Illustration)

■ FHA fee: 175 basis points (bps) up front, 135 bps annually

■ Expected insurance claims: 70 bps annually

■ Annual cash outflow (in basis points):

Year 0 1 2 . . .

Fees −175 −135 −135 . . .

Claims 70 70 . . . _____________ _____________ _____________

Net Cash Flow −175 -65 -65 . . .

Discounted at Treasury Rates −175 plus −455 equals −630, or −6.3% credit reform subsidy

9 C O N G R E S S I O N A L B U D G E T O F F I C E

Fair-Value Subsidies

■ Private mortgage insurers charge annual mortgage insurance premiums – Generally exceed FHA’s fees – Significantly higher than expected losses

■ Private insurers’ fees in excess of losses – Administrative costs – Return on capital (Investors demand a higher return than Treasury

rates to compensate them for market risks.)

■ For FHA – Administrative costs are accounted for outside of subsidies – Market risks are not accounted for in the budget – Taxpayers (and beneficiaries of federal programs) bear market risks

associated with FHA’s guarantees

10 C O N G R E S S I O N A L B U D G E T O F F I C E

Year 0 1 2 . . .

Fees −175 −135 −135 . . .

Claims 70 70 . . . Risk Premium 115 115

____________ ____________ ____________

Net Cost −175 50 50 . . .

Discounted at Treasury Rates −175 plus 300 equals 125, or 1.25% fair-value subsidy

Fair-Value Subsidy Calculation (Illustration)

■ Same cash flows as in the FCRA illustration, but they include a risk premium for credit loss exposure of 115 bps per annum.

■ Annual cash outflow and risk premium charge (in basis points):

11 C O N G R E S S I O N A L B U D G E T O F F I C E

FCRA versus Fair-Value Accounting

■ Fair-value accounting provides a more comprehensive measure of cost than FCRA accounting

■ Disadvantages of FCRA Accounting – Budgetary savings provide incentive to expand credit programs – Makes economically equivalent alternatives to credit programs appear

to be more costly

■ Disadvantages of Fair-Value Accounting – Risk premium is not a cash cost – Cost of market risk is excluded from the estimates of many non-credit

programs, for example, unemployment insurance

12 C O N G R E S S I O N A L B U D G E T O F F I C E

The Capital Reserve Account

■ Part of the system of accounts used to reconcile subsidies with cash flows

■ Can be calculated as the sum of estimated subsidy savings on outstanding cohorts plus accumulated interest

■ Often cited as a measure of program solvency, but FCRA programs have permanent authority to draw funds to pay claims as needed

■ FHA is required to maintain a 2% ratio of capital reserve balance to insurance-in-force (but has not done so since 2009)

■ The balance does not represent resources that can be used to offset future spending

13 C O N G R E S S I O N A L B U D G E T O F F I C E

CBO’s Statistical Modeling

■ Used to project cash flows for FCRA and fair-value calculations

■ Estimated from loan performance records from 1992 through 2009 – Loan characteristics at origination plus quarterly performance data

■ Statistical models follow existing literature – Multinomial logit model for default and prepayment probabilities – Linear regression for loss given default

14 C O N G R E S S I O N A L B U D G E T O F F I C E

Statistical Modeling Variables

■ Borrower credit scores (after 2004)

■ Interest rates

■ Home equity

■ State unemployment

■ Outside source of down payment

■ Geographic location

■ Age of loan

■ Loan amount

15 C O N G R E S S I O N A L B U D G E T O F F I C E

Macroeconomic Projections

02468

1012141618

Ten-Year Treasury Note Rate

02468

1012141618

One-Year Treasury Note Rate

1953 1965 1978 1990 2003 2015 2028 20400

1

2

3

4

5

6

7

Log Federal Housing Finance AuthorityPurchase-Only House Price Index

1953 1965 1978 1990 2003 2015 2028 20400

2

4

6

8

10

12

Unemployment Rate

Mean

95th Percentile

5th Percentile

Percentage Points Percentage Points

Percentage Points1991q1 = 100, Log of Index Level

16 C O N G R E S S I O N A L B U D G E T O F F I C E

Projections of Lifetime Claim Rates

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 20140

5

10

15

20

25

30

35

40

Actual (Through 2013)

Projected

5th Percentile

95th Percentile

Percent of Mortgages

17 C O N G R E S S I O N A L B U D G E T O F F I C E

Projections of Lifetime Prepayment Rates

Percent of Mortgages

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 20140

10

20

30

40

50

60

70

80

90

100

Actual(Through 2013)

Projected

95th Percentile

5th Percentile

18 C O N G R E S S I O N A L B U D G E T O F F I C E

Projections of Loss Given Default

Percent of Unpaid Balances

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 20140

10

20

30

40

50

60

70

80

5th Percentile

95th Percentile

19 C O N G R E S S I O N A L B U D G E T O F F I C E

Estimated FCRA Subsidy Rates

Percentage Points

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014-10

-8

-6

-4

-2

0

2

4

6

8

10

12

14

95th Percentile

5th Percentile

20 C O N G R E S S I O N A L B U D G E T O F F I C E

CBO’s Projections for the Capital Reserve

Office of Management and Budget

Congressional Budget Office

Mean 5th Percentile— Better Outcome

95th Percentile—Worse Outcome

Capital Reserve Contribution, 1992 to 2013 cohorts 3.3 3.1 25.7 −28.0

Total Subsidy Savings, 2014 and 2015 cohorts 22.3 16.4 23.7 8.3

Billions of Dollars

21 C O N G R E S S I O N A L B U D G E T O F F I C E

Projected Fair-Value Subsidy Rates for Purchase Loans for the 2014 Cohort, by FICO Score and Original Loan-to-Value Ratio

Borrower's FICO Score

Loan-to-Value Ratio

500 to 559

560 to 599

600 to 639

640 to 659

660 to 679

680 to 719

720 and Above

Less Than 80 3.9 2.3 2.0 1.2 1.2 0.8 0.3

80 to 90 5.8 4.4 3.7 2.4 2.5 1.8 0.8

90 to 95 2.9 3.5 3.9 2.1 2.4 1.5 0.4

95 to 97 n.a. 2.7 2.2 0.2 0.5 -0.4 -1.4

97 and Above n.a. 3.1 2.8 0.5 0.7 -0.3 -1.2

Percent

Note: n.a. = not applicable.

22 C O N G R E S S I O N A L B U D G E T O F F I C E

Future Modeling Improvements

■ Incorporate more recent performance data (after 2009)

■ Use better information on FHA’s streamline refinances

■ Improve risk premium estimates

■ Find additional ways to quantify uncertainty