By Dina ElBoghdady
Washington Post Staff Writer
Wednesday, December 3, 2008

The Federal Housing Administration's fund to cover losses on the mortgages it insures is shrinking, but remains above the point where taxpayers would need to kick in money to cover defaults, according to an independent audit of the agency's financial soundness.

Since its creation in 1934, FHA has been self-sustaining, meaning no public money has been used to cover its mortgage losses. Instead, FHA borrowers pay premiums into an insurance fund to cover defaults and foreclosures.

As of Sept. 30, that fund had an estimated $12.9 billion, a 39 percent drop from $21.2 billion a year ago, according to the audit by Integrated Financial Engineering of Rockville.

"That's a significant drop, and it's occurring at a time when the fund is insuring a lot more mortgages," said Guy Cecala, publisher of Inside Mortgage Finance. "You can easily say it's reason for concern."

The $12.9 billion value represents 3 percent of the mortgages insured by FHA. That's above the 2 percent ratio required by law, but below the 6.4 percent ratio at the same time last year, the analysis found.

Through 2015, the ratio is projected to fluctuate between 2.8 percent and 2.9 percent. If worst-case economic scenarios are factored in, the ratio could dip below 2 percent.

If that happens, Congressional appropriations panels would consider making up the shortfall using taxpayer money.

"The 2 percent threshold is barely maintained," the report concluded.

The biggest problem facing FHA and the lenders it works with is the fallout from plunging home values.

If home prices keep dropping as projected, more borrowers will be vulnerable to foreclosure because they will owe more than their homes are worth. If they suffer a financial blow, such as job loss, they will be more likely to default on their loan because they won't be able to sell or refinance.

"What is uncertain is how much the future default loss will be in the next five to 10 years," said Tyler Yang, president of the auditing firm. "If the housing market recovers, the losses may be less than what is estimated here."

FHA spokesman Stephen O'Halloran said in a statement that the insurance fund "remains on solid ground, even as our business grew significantly in 2008."

The number of FHA-insured loans shot up 225 percent in the first nine months of this year, according to Inside Mortgage Finance, a trade publication. The volume of loans totaled $176 billion during that time, eclipsing the agency's previous one-year high of $165 billion in 2003.

Demand for these once-neglected mortgages surged because they do not require the hefty down payments or stellar credit scores that lenders have come to demand. Also, the amount of money people can borrow on these loans jumped this year, and many homeowners have found them attractive for refinancing.

The fear inside the agency and among those who follow it has been that FHA may not be able to handle its expanded workload or relatively new programs that require the agency to take on riskier loans.

But Brian Chappelle, who oversaw FHA's loan production activities in the mid-1980s, said this year's audit turned out better than he expected.

"Considering the historic collapse of the housing market, the fact that independent, outside auditors say FHA is actuarially sound today and will remain so in the next seven years, I think is a significant achievement," said Chappelle, now a partner at the consulting firm Potomac Partners.