Federal Housing Update: Loan Growth at the Public’s Expense

This article is a guest post by The Institutional Risk Analyst.

fha_updateWe could not let pass the silly commentary last week in the Big Media regarding the fiscal situation of the Federal Housing Administration, the Federal Home Loan Banks and the other GSEs. The head of the FHA, Commissioner David Stevens, says that the agency is solvent and will have more than sufficient reserves to meet its obligations, primarily guarantees on 37 million first lien mortgages. We disagree.

Last week, in the IRA Advisory Service, we described how Wells Fargo & Co. (NYSE:WFC), in its most recent 10-Q, discloses that it need not bring on balance sheet ANY of the $1.1 trillion in conforming residential OBS exposures that are the subject of the new FASB rule eliminating the “Qualified Special Purpose Entity” designation. Why? Because the loans inside these securitization vehicles are insured by FHA, so goes the thinking of WFC and its auditor, thus the bank has no liability to these entities or the securities they have issued to investors. Pretty neat trick, eh?

Call us provincial, but we have a hard time understanding how WFC can take the position that none of the securitizations issued by Wachovia and WFC are properly reflected on balance sheet. Does WFC really believe that none of the loans underlying these securities will be rejected by FHA? At a minimum, we believe that WFC should show the likely portion of these securitizations that will be rejected by FHA as a liability, especially since the expense of curing such violations of the reps and warranties made at the time of the sale is a cash expense. Maybe our friends at the FASB can add this issue to the list for future study. More, given the past industry practice of substitution of collateral and cash advances to the OBS vehicles followed by WFC and all of the other major players in the industry, we have an equally hard time understanding how any bank can, as a practical matter, still pretend that these vehicles are not de facto controlled by the sponsors.

Eventually the courts and/or the Congress will deal with this issue, but for now the children’s hour continues. But it gets better. If you take the “real,” economic rate of default inside the WFC loan portfolio, say 2x the reported 2.5% annualized defaults at Q3 2009, and attribute it across the $1.1 trillion of conforming RES OBS exposures of WFC alone, we are talking about over $60 billion in realized losses. If you take the standard industry posture that OBS exposures typically underperform the loss rate experience of retained portfolios, the number is more like $100 billion in realized losses from the conforming residential exposures alone. The loss rate experience from WFC’s OBS exposures wipes out FHA reserves two times over — and we are not even talking about Bank of America (NYSE:BAC) and its Countrywide zombie love queen, which has a pile of OBS vehicles around the same order of magnitude as does WFC. And there are thousands of other banks that originate and sometimes sell FHA guaranteed paper.

Now FHA argues that the flow of fees from new guarantees will allow the agency to meet the rising tide of guarantee losses and eventually repay any deficit. OK. What do FHA officials think total realized losses across the 37 million first lien mortgages will be in 2010? Since the FHA has an unlimited ability to borrow from the US Treasury above and beyond any statutory surplus accumulated from guarantee fees, this number could become significant to the bond markets. Or to quote Lita Epstein, writing in Daily Finance: “The FHA’s reserve fund could be a black hole for U.S. taxpayers.”

Josh Rosner of Graham Fisher in New York thinks that the irony in the situation with FHA is that the banks, which have pulled future originations into the present in order to boost current revenue, are now arguably taking greater care of the taxpayer than the FHA is itself. “The realtors are delighted by the strong volumes of new loans written by the banking industry,” Rosner tells The IRA, but adds that the mortgage bankers and even commercial banks are increasingly uncomfortable with what they see in the channel in terms of poor FHA underwriting and risk management standards.

As with low interest rates, debt guarantees and repurchase agreements, the subsidies provided by FHA enable the banks to generate income today, but at a cost to the taxpayer and event the banks tomorrow. And does this mean that WFC, BAC et al are getting away clean on the loans due to the FHA guarantee? Noooo. To our earlier point about the rejection of collateral guaranteed by the FHA, we suspect that the estimated loss rates to FHA illustrated above also will be the minimum hit to the securitization sponsors through the cycle, something that we’ll be addressing in detail in the IRA Advisory Service in coming weeks. Maybe that’s why in all of the disclosure to date from large sponsors such as WFC, BAC the filers indicate that they are still “studying” the matter.

Of note, last week the Federal Deposit Insurance Corporation adopted a proposed Interim Final Rule amending 12 C.F.R. § 360.6 to provide a transitional safe harbor effective immediately for all participations and securitizations in compliance with that rule as originally adopted in 2000. The Interim Final Rule confirms that participations and securitizations completed or currently in process on or before March 31, 2010 in reliance on the FDIC’s existing regulation will be ‘grandfathered’ and continue to be protected by the safe harbor provisions of Section 360.6 despite changes to generally accepted accounting principles adopted by the Financial Accounting Standards Board. GAAP and RAAP remain two different worlds. Stay tuned.

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