FHA's cash reserves have dropped well below amount required by law, audit shows

For the first time since 1994, the Federal Housing Administration's cash reserves have shrunk to a point far below what is required by law and could turn negative if worst-case scenarios are factored in, according to an independent audit designed to measure the agency's financial soundness.

The reserve fund, which holds excess cash beyond what the agency needs to cover future losses on its outstanding loans, had an estimated value of $3.6 billion as of Sept. 30, an sharp drop from the $15.82 billion that last year's audit projected it would have by this time.

The $3.6 billion value represents 0.53 percent of the mortgages insured by FHA, well below the 2 percent ratio required by law and the 3 percent ratio maintained by the fund at the same time last year.

If FHA's reserves drop below zero, FHA taxpayer money would automatically flow into that fund from the U.S. Treasury.

Under more pessimistic scenarios, FHA would lose so much in premiums that it would run out of capital in fiscal year 2011, requiring $1.6 billion in borrowing from the Treasury in fiscal year 2012, according to the report submitted to Congress.

The FHA's financial health is in the spotlight because it is playing a key role in supporting the housing market. But as its volume of loans has exploded, its default rate has climbed. The agency attributes the dramatic slide in its reserve fund to hefty losses on loans it insured from 2005 through 2008 -- when home prices declined, the economy soured and unemployment soared.

FHA does not make loans. It insures them against default.

"The story of FHA's financial status at the end of FY 2009 is then the tale of two portfolios," says a report Secretary of Housing and Urban Development Shaun Donovan submitted to Congress on Thursday. "The older portfolio has high rates of delinquencies and is expected to have high rates of insurance claims in the future. The new portfolio, which soon will be larger than the older portfolio, is expected to have more modest claim rates over the life of the loan guarantees."

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.

The FHA also maintains a financing fund, which it uses to pay out claims on defaulted loans, and is separate from the capital reserve, which holds surplus cash. The two funds combined total $31 billion in value, which in theory would be enough to cover an estimated 4.5 percent of outstanding loans, the FHA said in a statement.

However, the ration of loans that the cash reserves alone would cover is barely a quarter of the legally required 2 percent.

"There are real risks to the FHA and we are aggressively addressing those real risks with real reforms," FHA Commissioner David H. Stevens said in a statement.