According to a recent Wall Street Journal article approximately 1 in 4 homeowners is now underwater on their mortgage.  5.3 million households now have mortgages which are at least 20% higher than the value of their homes.

This arrangement is not surprising.  In fact it has long been inevitable given the extraordinary amount of debt, extended under lax lending standards, which was layered on overvalued housing. 

What is surprising is that three years after the Housing Bubble popped the Federal Government continues to extend excessive leverage, under lax terms for the purchase of overvalued houses.  Under normal circumstances this would be a recipe for creating foreclosures.  In an environment where housing prices are falling, it is a disaster in a variety of ways.

Government: Consistent and Inept

When the Housing Bubble popped policy makers foolishly decided in favor of a strategy to prop up prices at any cost.  Fannie Mae and Freddie Mac were directed to ignore capital reserve requirements, extend loans on higher priced home purchases and loosen lending standards despite collapsing prices.  Within a matter of months Congress had accelerated the demise of both GSEs and forced a taxpayer bailout which continues to consume productive resources even today.

Undeterred by the failures of Fannie and Freddie, policy makers directed the FHA to fill the void.  In 2006 the FHA financed 2% of mortgages.  Today it accounts for approximately a third of the market.

How the FHA Manufactures Foreclosures

A material down payment is vitally important to regulating prices, preventing inappropriate speculation and avoiding foreclosures.  The reduction or elimination of a material down payment was one of the primary causes of the Housing Bubble.  (See the Down Payments section of The Subprime and Affordable Mortgage Distortion – 11/3/08)

Underwater homeowners result in increased foreclosures.  Foreclosures result in distressed sales which cause housing prices to fall.  Falling housing prices generate more underwater foreclosures.

It is difficult to imagine a more direct way to create incremental and recurring foreclosures than what the Federal Housing Administration is doing. 

The FHA requires a down payment of only 3.5% to purchase a home (a leverage ratio of 27.6x).  Misguided policies which allow the use of an $8,000 homebuyer tax credit to finance closing costs further reduce capital requirements.  The transaction costs associated with selling a home typically exceed 3.5% of a home’s value.  As such, a buyer is functionally underwater immediately upon taking possession of an FHA-financed home.  In an environment where unemployment is high and rising this is a formula for creating foreclosures.

Housing prices have been falling since 2006 and will likely continue to decline in many areas for years to come.  This inevitability is driven by oversupply, lack of demand, falling homeownership, increasing risk, changing expectations, foreclosures, excessive leverage, high unemployment, etc…

In October the median price of a house was down 1.6% relative to September and had declined by 7.1% from a year ago.  At the current pace of depreciation many FHA home buyers are seeing their down payments erode in as little as 2 to 3 months. 

Last year’s FHA-financed home buyers become today’s foreclosures.  Current FHA-financed home buyers will be next year’s foreclosures. 

Dismal Reality

Today one in every six FHA loans is in some stage of default.  A record 3.32% of FHA mortgages are presently in foreclosure.  The Government entity’s insurance reserve ratio has fallen to an all-time low of 0.53% (below its mandated minimum requirement) making a tax-payer bailout inevitable.

The reality is our Government has been and continues to contribute to a self-perpetuating cycle of housing price declines driven by Fannie Mae/Freddie Mac/FHA created foreclosures.  This cycle will continue as long as inappropriate, highly-leveraged mortgages are underwritten on over-valued assets in an environment where prices are falling.

The Government’s coordinated strategy of propping up housing prices has failed miserably.  The policy’s only achievements include lengthening the duration of, and damage from, the housing depression by unnecessarily creating an incremental and recurring source of foreclosures.


As written in Response to WSJ article "First, Let's Stabilize Home Prices" on 10/2/08:

“It was government intervention designed to realize a social agenda that principally contributed to the current problem of overvalued houses.  Proposing further government intervention with the goal of supporting prices at an arbitrary level can not and will not work.  The only solution to our present predicament is to allow the markets to clear.  We must let housing prices reach an equilibrium relative to the supply, demand, credit availability and more conservative mortgage characteristics of the post-bubble economy, as well as the new risk premium perceptions and performance expectations of potential buyers.  Much of the housing gains seen since the late 1990s, when sub-prime and affordability mortgages began to distort the market, will be reversed.

There are steps that the government can take to facilitate the stabilization of the housing market and limit collateral damage to both the credit markets and the broader economy.  Any action which would attempt or have the effect to prop up housing prices at an artificial value, though, is counterproductive.  Such initiatives will only lengthen, deepen and increase the damage caused by the inevitable march to a sustainable equilibrium.  The Japanese have provided us with a useful case study on this subject.  Don’t stand in the way of the markets clearing.  Any government action should be undertaken with a design to facilitate this clearing process and an understanding that substantial economic pain is unavoidable.”