The Federal Housing Administration's default insurance program and public value creation

FHA'S DEFAULT INSURANCE PROGRAM STRATEGICALLY PROVIDES FOR OR CREATES PUBLIC VALUE: A CASE STUDY

This work in writing has as its objective the investigation of whether the Federal Housing Administration's Default Insurance Program (DIP) effective meets the stated purpose of creating public value by encouraging financial institutions to increase lending for mortgages to provide affordable home ownership to those families unable to quality under standard industry criteria.

Theoretical Framework

The theoretical framework for this research is the concept that government security to mortgage lenders creates a situation in which financial institutions are more willing to lend money to low-income homebuyers. In turn, when financial institutions have a greater incentive to lend money to homebuyers who otherwise would not qualify for a mortgage, public value is enhanced via increased homeownership leading to expansion of the nation's economy.

Methodology

The proposed research will be conducted an in-depth literature of the default insurance program by reviewing previous studies, as well as statistical data to determine the value that has been created for the public with regards to the expansion of homeownership and even the expansion of the construction and housing industries.

Case Study Type

The case study structure that will be used for this research will be a linear-analytic approach. This structure is being used because it is most common case study structure, and it allows for the progression from an overview of the issue that is being examined to the analysis of the information and data that are available, and finally to conclusions to be drawn from the analysis that takes place.

Hypothesis

The stated hypothesis in this study is that the default insurance program through the Federal Housing Administration does create value for the public by allowing greater levels of homeownership and allowing for an overall expansion of the housing industry in the United States.

Background of the Study

The work of Quigley (2005) reports that prior to the 1930s depression, "…home mortgage instruments were typically of short terms (3-10 years) with loan-to-value ratios (LTVs) of sixty percent or less. Mortgages were non-amortizable, requiring a balloon payment at the expiration of the term. The onset of the Great Depression engendered a liquidity crisis beginning in 1930, preventing renewal of outstanding contracts. Other borrowers were simply unable to make regular payments. The liquidity crisis affecting new mortgage loans, together with elevated default rates on existing loans, had catastrophic effects upon housing suppliers as well as housing consumers." The following Figure shows the U.S. Housing Starts 1900-2004.

Figure 1

U.S. Housing Starts, 1900-2004 (thousands of units)

Source: Quigley (2005)

The Federal Housing Administration (FHA) was established in 1934 for the purpose of overseeing a program of home mortgage insurance against default." (Quigley, 2005) Proceeds of a fixed premium charged on upaid loan balances funded the insurance which were managed as a mutual fund following revenues being deposited in Treasury securities. This product was diffused across the country and this required standardization on a national level of underwriting procedures. Resulting was a requirement for appraisals and credit histories of borrowers with reported and systematic evaluation of financial capacities. The modern standardized mortgage, according to Quigley (2005) "was born." In the beginning loan amounts were under a restriction of a $16,000 limit however the median price for housing is stated to have been "less than $5,304." (Quigley, 2005) The VA loan program was passed in 1944 as part of the GI bill and it is stated to have "rapidly evolved form a temporary 'readjustment' program to a long-range housing program available to veterans." (Quigley, 29005)

Quigley reports that the provision of these two programs in the form of insurance and mortgage guarantees brought homeownership opportunities to middle class American households in a short space of time." (2005) It is reported that over time the mortgage originations insured by the FHA has experienced a decline from approximately 25% in 1957 to a mere 2% in 2003. Variations in policy are attributed for these differences in rate of mortgage originations over time. The following chart shows the value of FHA & VA Originations/Total Originations 1939-2004.

Figure 2

Value of FHA and VA Originations/total Originations 1939-2004

Source: Quigley (2005)

Literature Review

III. Government Creation of Place and Value

The work of Mark Moore "Creating Public Value: Strategic Management in Government" provides a description of what Moore refers to as a 'strategic triangle' of public value. It is suggested by Moore that corporate strategy can be modified for use in the private sector and make provision of a framework that is useful in the realization of pubic value by managers in the public sector in the integration of substantive judgments of what would serve to be both effective and valuable as well as the integration of an analysis that is comprehensive of political expectations and assessing what is possible in the operations. Moore holds that these specific criteria are the measures that can be used by public managers as to the public value of such actions. Considerations are necessary concerning the legal and political support of the same and the feasibility of their administration and operation.

Moore additionally holds that public administration is required to make the determination of what can be expected from public managers and as well public administration must make identification of resources that serve to provision public managers with the information and tools needed to provide a response to these expectations and for developing more effective methods to provide rapid response to ever-shifting situations thereby exploiting these situations to the advantage of the public. Specifically Moore states "In seeking public value, we come finally to what many believe is the essence of management: the self-conscious, skilled deployment of legal, financial, material, and human assets to produce concrete results" It is suggested by Moore as follows "It is one thing for managers to have visions, and still another for them to mobilize a flow of resources to their enterprises. But the heart of management lies in delivering the envisioned value" (193).

Place is stated to be important to "individuals, to families and to all collectivities of humans." (Kirlin, 1997, p. 167) This is because individuals "live, marry, procreate, learn, work, participate in community affairs, play, worship, and die in specific geographical places. Specific governmental policies shape all these and other facets of life." (Kirlin, 1996, p. 167) Information, values and economic opportunities undoubtedly are influenced by global dynamics, but those factors do not so much reduce the importance of place as change in the way in which governmental actions will be used to enhance the value of place. Living in an open inclusive society." (Kirlin, 1996, p. 167)

Kirlin goes on to state that the types of value created by public and private action are "categorized as related to place, complex systems, or goods and services." (Kirlin, 1996) Kirlin states a belief that the primary function of governments is "increasing the value of place." (1996) Place is stated by Kirlin to be important both economically and politically.

IV. Functions Government Performs for Society

Three functions are performed by government for society:

(1) The first role is "…constituting an effective government";

(2) The second role is political choices that define and protect the character of the community; (3) the third role is 'service delivery'. (Kirlin, 1996, p. 168)

Kirlin states that "advocating the creation of value through governmental action is a useful beginning to what is needed to transform systems of governance." (p. 173) It is reported that the opportunities to create value "can be understood as a matrix defined by two dimensions. One dimension consist of five arenas for governmental action, while the second dimension consists of three types of value that can be created." (Kirlin, 1996, p. 173)

It is reported that the arenas are "social constructions where collective choice and action regarding government are possible." (Kirlin, 1996, p. 173) Arenas are stated to be "locations" defined socially, through which collective choice and action are possible." (Kirlin, 1996, p. 173) Kirlin states that in contrast, "the types of value involve analytical distinctions among the consequences of these choices and actions…" and therefore value distinguishing requires categories of products while distinguishing arena distinguishing requires categories of processes. (Kirlin, 1996,, paraphrased) The five arenas of governmental action are stated to be those of:

(1) constitutional;

(2) jurisdictional and civic infrastructure;

(3) Policy strategy and policy infrastructure;

(4) program implementation; and (5) organizational level/managerial. (Kirlin, 1997, p. 174)

It is reported that 'place' values are inclusive of effectiveness of political structures and civic institutions, individual, property and other rights, competitive position in global markets and the factors that influence the quality of life in an area, such as the environment, housing, affordability, personal safety, mobility, and opportunities for individuals to shape their own destinies." (Kirlin, 1996, p. 175)

Complex functional system values include effectiveness of linkages among public, private, and nonprofit organizations required for successful action in most arenas; extent of access to those structures; and capacity for learning and adaptation." (Kirlin, 1996, p. 175)

Three proposals for creating value are stated to include the following:

(1) standardizing geographical arenas for governmental decision making at national, state, regional, city and neighborhood levels;

(2) establishing a constitutional right to certainty of actions that will comply with governmental policy; and (3) using case managers to deliver social services, perhaps in a capitated system. (Kirlin, 1996, p. 178)

There is stated to be "extreme fragmentation of governmental policy making" and it is reported that the negative consequences arising from this fragmentation include:

(1) inability to achieve coherent coordinated action;

(2) confusing, incomprehensible government;

(3) inaccessible, unaccountable governments;

(4) total governmental expenses that are larger than commonly understood; and (5) Large costs imposed on society to participate in fragmented arenas and to comply with conflicting parties. (Kirlin, 1996, p. 179)

It is reported in a HUD Issue Brief that FHA has "…traditionally been the mechanism used by borrowers who have difficulty obtaining mortgage financing in the private conventional market. It has long been recognized as the major source of funding for first-time, low-income, and minority home buyers. As indicated by the following points, the combination of a strong economy and significant program and policy changes has allowed FHA to expand on its traditional role." (2000) It is stated in the HUD Issue Brief that the share of FHA-insured has increased "from 67% in 1993 to 82% in year 2000." (2000)

FHA has assisted 4.3 million individuals purchase their first home during that same period. It is reported as well that the share of FHA home loans provided to African-American and Hispanic homeowners increased from 67% in 1993 to 82% in year 2000. The share for all minorities increased from 22.5% to 41.8% during this period. (HUD Issue Brief, 2000) FHA insured 21% of all home purchase loans originated in metropolitan areas during 1999 and insured 42% of loans for African-American and Hispanic borrowers. Three out of ten home loans originated in underserved areas. It is reported that FHA has maintained its role in both the low income and minority mortgage market and FHA's share of the mortgage market and while the conventional market has improved its performance in affordable lending no replacement of FHA's important role for providing access to mortgage credit for historically underserved borrowers.

Because FHA insurance is important for these groups and large housing gaps exist there have been various steps taken by HUD to "enhance the usefulness of FHA insurance." (HUD Issue Brief, 2000) Included in these enhancements are:

(1) lower insurance premiums;

(2) higher loan limits;

(3) consolidation and streamlining of loan process to increase speed and improve consistency; and strengthening of the appraisal process.

(HUD Issue Brief, 2000)

FHA has also introduced "automated underwriting through Freddie Mac and Fannie Mae and has been developing and testing its own FHA mortgage scorecard." (HUD Issue Brief, 2000)

The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 is stated to affirmed and strengthen HUD's role as mission regulator for Fannie Mae and Freddie MAC and the government-sponsored enterprises (GSEs) in the secondary mortgage market." The primary responsibility under the 1992 GSE Act has been "the establishment of goals for the GSE's purchase of mortgages for targeted groups of borrowers" including low- and moderate-income families, families living in underserved areas and special affordable families (very low-income families and low-income families in low-income areas)." (HUD Issue Brief, 2000)

The work of Herbert, Haurin, Rosenthal, and Duda (2005) in the work entitled: "Low-Income and Minority Borrowers and Neighborhoods" homeownership rates are presently at "historically high levels for all segments of the U.S. population…" however "dramatic gaps in homeownership rates have been stubbornly present over the last several decades, and even increased somewhat during the decade of the 1990s. As of 2004 the rate of white homeownership was 76% and African-American and Hispanic homeownership rates remained below 50% and the Asian rate was 60%." (Herbert, Haurin, Rosenthal, and Duda, 2005) Understanding the determinants of homeownership rates and gaps is important because homeownerships wisely believed to provide a variety of benefits for both individuals and communities." (Herbert, Haurin, Rosenthal, and Duda, 2005)

It is reported that homeownership "expands individual opportunities to accumulate wealth, enables a family to exert greater control over its living environment, creates incentives for households to better maintain their homes, and may benefit children of homeowners. Homeownership also benefits local neighborhoods because owner-occupiers have a financial stake in the quality of the local community." (Herbert, Haurin, Rosenthal, and Duda, 2005) Federal policy that affects housing is dominated by "indirect off-budget activities -- tax expenditure policies and credit, insurance and guarantee programs -- rather than the direct subsidy of housing production or the payment of shelter allowances to be deserving households." (Herbert, Haurin, Rosenthal and Duda, 2005)

John Alford writes in the work entitled " Defining the Client in the Public Sector: A Social-Exchange Perspective" that those who seek government reform "urge the adoption of a private-sector-style 'customer focus,' but critics see it as inappropriate to the public sector" on the basis that it "devalues citizenship." (2002) According to Alford (2002) there are actually two sets of differences "…between private sector customers and the 'publics' of government organizations." Those two are stated to be:

(1) firstly, that which has to do with 'who performs' the primary functions referred to above -- expressing preferences and receiving goods or services;

(2) the second has to do with the 'nature of those functions. (Alford, 2002)

Each of these in the private sector are stated to be performed by the same individual or the customer however in the public sector they are "…asymmetrically divided between two categories of actors -- the citizenry and clients -- who together constitute the primary distinction in this typology." (Alford, 2002) The government delivers value and that value is "consumed by citizens (who receive public value) and by clients (who receive private value)." (Alford, 2002) Alford reports that the function of stating choices about the value that the government should produce is carried out mainly by the citizenry through the process of political democratic process which is a process that results in the citizenry having the overriding say concerning public and private value. The difference in public and private business is "what they exchange and the type of exchange." (Alford, 2002) It is necessary to understand not only the various types of clients in terms of their expectations and what they have to offer -- and it is this that makes provision of a framework that is useful in tailoring the value created to the group or groups at focus.

FHA has tailored mortgage loans in cohesion with a government default insurance funding for those who meet the qualifications for such mortgage loans. Historically this has been a successful strategy in assisting low- to moderate-income families and minority families in attaining homeownership status and in growing their wealth through building equity in their home. However, this all changed with the recent mortgage loan crisis which has been characterized by subprime loan failure. Subprime loans already put those in these type loans at a deficit in the area of equity building and added to this is the falling prices of homes which further robs the homeowner of equity. Following approximately three decades of progress sit is reported that "real median household incomes will almost certain end the 2000s lower than they started" and additionally, real household wealth is stated to have fallen from $503,500 to $486,600…" (The Joint Center for Housing Studies of Harvard University, 2010) It is furthermore reported that "debt has never been higher relative to home equity…" as following a $8.2 trillion drop in housing wealth since 2005 mortgage debt was at 163% of home equity at the beginning of 2010." (The Joint center for Housing Studies of Harvard University, 2010) The combination of job losses and lower prices on housing the factors that brought first-time homebuyers into the market is attributed to result in poor mortgage loan performance.

At the end of FY 2001 there were 6.6 million FHA-insured single-family loans outstanding at the end of FY 2001. FHA insured over a million single-family mortgage loans in 2001 with seventy percent of those being for purchase of a home and the remaining for refinancing a home. In 2000 FHA insured only 920,000 loans with 92% being for purchase of a home. In the present FHA only insures loans to those who are "able to make a small down payment, have high debt-to-income ratios and/or have tarnished credit.." (Wartel, 2002) The majority of loans insured by FHA are mainly those with very low down payments and which allow the borrower to have 41% total debt payments and credit histories that are less than ideal. Furthermore due to the flexibility in underwriting afforded FHA.

FHA, on the other hand, insures primarily very-low-down-payment loans while allowing the borrower to have total debt payments sometimes as high as or greater than 41% of income and less than ideal credit histories. As a result of its underwriting flexibility, FHA "insures a disproportionate share of mortgages to first-time and minority homebuyers, those with low incomes, and those who live in low-income or high-minority areas." (Wartel, 2002)

First time homebuyers are stated to account for 82% of all home purchase loans that FHA insured during 2000 but less than one-half of all home purchase loans nationwide. The share of FHA-insured home purchase loans to first time buyers is reported to have increase from 1993 to 2000 from 67% and 82% respectively. FHA insured loans are disproportionately provided to borrowers with lower incomes.

Figure 4

FHA Disproportionately Serves Lower Income Borrowers

Source: Wartel (2002)

FHA additionally serves minority borrowers disproportionately and in FY 2000 32.6% of FHA loans were those made to black and Hispanic borrowers compared to only 12.4% of conventional loans during that period. FHA additionally served underserved neighborhoods and 18.2% of FHA loans were insuring in metropolitan areas in 1999 as compared with only 11.3% of conventional conforming loans

Figure 5

FHA Disproportionately Serves Lower Income Borrowers

Source: Wartel (2002)

Underserved Neighborhoods insured by FHA impact can be gauged by examining FHA's market share of loans to groups with lower rates of homeownership…that data reveals that low-income and minority borrowers and borrowers in underserved areas are highly dependent upon FHA for homeownership opportunities. It is also reported that 37% of home loans between 1997 and 1999 can be attributed to FHA facilitated homeownership. In fact it is stated that even critics of the FHA program stated the following conclusion: "…[FHA] is an indispensable provider of homeownership opportunities to low-income and minority borrowers." (Wartel, 2002)

FHA is stated to play a role that is essential in "areas of the country experiencing economic downturn, stabilizing local housing markets. It is reported that it is like that soon the importance of FHA's market stabilizing effect will be seen again. There are challenges faced by FHA with the two primary challenges being those of:

(1) risk management; and (2) operational weakness. (Wartel, 2002)

Studies show that FHA is meeting the credit needs of minority groups better than are conventional lending companies. However findings additionally show that the denial rates for mortgage loans are higher for minority groups than for white individuals in both FHA and conventional loan application decisions. African-American applications for FHA purchase loans are rejected at a rate of 20% however the same group is rejected at a rate of 25.9% when making conventional purchase loan applications. The FHA and conventional purchase loan applications reject rates for Hispanics are stated at 13.9% and 22.5% respectively. Underserved areas however with high minority and low income characteristics are subject to higher mortgage purchase loan denials rates than other areas for both conventional and FHA mortgage purchase loans. FHA mortgage purchase loan denial rates are substantially lower than conventional mortgage purchase loan rates in underserved areas.

SUMMARY AND CONCLUSION

This study has examined the issue of whether FHA insured loans serve to build the wealth of families. The issues surrounding policy decisions and strategies for building homeownership have been examined as well. The stated hypothesis in this study is that the default insurance program through the Federal Housing Administration does create value for the public by allowing greater levels of homeownership and allowing for an overall expansion of the housing industry in the United States.

Findings in this study demonstrate that FHA insured loans do certainly serve to build the wealth of families through creation of value by allowing homeownership at greater levels. FHA insured loans are for the greatest part those with low down payments and in which the total debt payments of the borrower equal or exceed 41% and in which credit histories are less than what would be considered ideal. This study has also found that FHA has historically been the mortgage product utilized by borrowers who are not able to obtain financing for their mortgage in the conventional private market. FHA has been recognized for a very long time as the major funding source for first time low income and minority home buyers.