Government of Pakistan launched the Naya Pakistan Housing Program (NPHP) with the intention to build 5 million housing units. No one believes the 5 million number not even the government. But it helps the government to remain in the news headlines. The government has no idea how to go about it as it has been proven time and again that local bureaucracy does not have the capacity to deliver on the housing promises. The job has become more difficult for the current government after it agreed to the latest IMF program as one, a significant slowdown is expected in the rate of growth of the economy, two, construction costs of material and interest rates have risen significantly, and three, soaring inflation has reduced the capability of low-income buyers to afford the housing units.
Furthermore, the carrot and stick approach that the government is employing with the banks to encourage them to offer mortgages to low income groups to buy these so far un-built housing units is not showing any signs of working. The government dangled, in front of the banks, a carrot of low regulatory reserve requirements and lower taxes on interest income derived from mortgages offered to low-income borrowers. The banks refused to bite. The stick of imposition of fine, which the now sacked finance minister threatened the banks with, didn’t make them budge either. A clear case of market failure.
If you want to read more on how the government is failing at NPHP, you cannot do worse than read the three papers (1. Optimising the Naya Pakistan Housing Policy Opportunity, 2. Low Cost Housing: Just Out of Reach? and 3. Mortgage Market Design for Low-Cost Housing Units in Pakistan) I co-wrote on this subject. The papers are a bit jargon heavy. For the tl;dr version, please read this cover story Can the Naya Pakistan Housing Programme Work? in the weekend magazine EOS of Pakistan’s daily DAWN which summarizes the three paper in a general public friendly language.
While continuing to read up on affordable housing, I came across Devon Zuegel’s post Subsidizing Suburbia (recommended reading) on the US Federal Housing Agency (FHA) and I went down a rabbit hole of books, papers and blogpost to research FHA further. We think Fannie Mae, Freddie Mac, securitization, MBS etc. is what makes the US housing finance market so vibrant when in fact it is FHA that laid the foundation, growth and sophistication of both US housing and US housing finance. This post summarizes my research into the history and workings of FHA. It does not consider if an FHA like agency is replicable in Pakistan or what are the legal/constitutional/financial pre-requisites of creating such an agency in Pakistan.
From 1928 to 1933, residential property construction fell by 95%. In 1930, there were 150,000 non-farm foreclosures, followed by an additional 200,000 non-farm foreclosures in 1931. President Herbert Hoover convened President’s National Conference on Homebuilding and Homeownership in 1931. Over 40 specialists attended the conference joining its various working committees. The conference made four recommendations:
- Creation of long term amortized mortgages
- Reduction of interest rates on mortgages
- Government aid to private sector for creating housing for low-income households
- Reduction of construction costs for housing
Liberal economist Richard Eby tried to mollify businessmen that members in his committee (one of several working committees at the conference) were “unanimous in their opposition to the construction of homes with public funds”. But those in real estate business were more worried about their own survival than with any particular political ideology. Republican Secretary of Interior, Ray Lyman Wilbur went as far as to say that if private capital did not invest in technically innovative large scale residential building operations to take on the housing challenge then “housing by a public authority is inevitable”. Such a heretical statement from Republican administration in 1931 didn’t cause a ripple is an indication of how low the confidence was in the private sector and its capability to make it through the crisis. National Association of Home Builders (NAHB) took the position that private builders cannot build affordable homes without government support.
By now, Hoover was ready to experiment. On July 22, 1932, Hoover signed into law the Federal Home Loan Bank Act which created Federal Home Loan Bank (FHLB). FHLB established a credit reserve for mortgage lenders to increase the supply of credit in the housing market. FHLB received 41,000 applications from homeowners but due to bureaucratic red tape, only 3 were approved. The economic conditions continued to worsen with additional 250,000 non-farm foreclosures in 1932. By the spring of 1933, half of all mortgages in United State were underwater with foreclosure rate reaching 1,000 per day. The act and the bank failed to revive the housing market.
Unlike Hoover’s short-lived FHLB, two innovation of FDR’s New Deal, Home Owner’s Loan Corporation (HOLC) and the Federal Housing Authority (FHA), have had a permanent and lasting impact on the housing market. HOLC was created on June 13, 1933 through Home Owners’ Loan Act of 1933. HOLC refinanced tens of thousands of mortgages in danger of defaults and/or foreclosure. It even gave low-interest loans to permit homeowners to recover homes lost to foreclosure. Between July 1933 and June 1935, HOLC provided $3 billion for over a million mortgages.
“Probably no single measure consolidated so much middle-class support for a new deal [than the creation of HOLC]”.
HOLC is important because it introduced, perfected and proved in practice the feasibility of self-amortizing mortgage with equal payments throughout the life of the mortgage. HOLC used long term bonds to acquire mortgages in default and then rewrote these mortgages on more affordable terms. Before 1929 in the US, typical term of a mortgage loan was between 2 to 11 years. Saving and Loans (S&Ls) provided mortgages for 11 years. Mortgages issued by insurance companies had a term of 6 to 8 years and commercial banks 2 to 3 years. Naturally, the loans had not fully amortized by maturity forcing the homeowner to arrange a renewal/refinance at maturity leaving him at the whims of the market. Under HOLC, loans were fully amortized and repayment period was extended to 15 years thereby reducing monthly payments. What is now a norm in housing finance_ fixed-rate, long term, self-amortizing, and low down payment mortgage_ was virtually non-existent before the mid-1930s and HOLC.
Aside from a large number of mortgages that HOLC refinanced for long term at low-interest rates, HOLC systematized appraisal methods across the country using questionnaires relating to income, occupation, age, ethnicity, type of construction, price range, sales demand, etc. Appraisals were being carried out before HOLC too but HOLC created a formal uniform system that was implemented by individuals only after intensive training. It single-handedly improved the appraisal methodology in US.
Federal Housing Agency
No agency has had a more lasting impact on homeowners, builders, and mortgage lenders than FHA. It was created as FDR wanted at least one program that stimulated private sector to build without government spending. FHA was established through the National Housing Act on June 27, 1934. The primary purpose of the legislation, however, was the alleviation of unemployment which stood at about quarter of total workforce in 1934 and particularly high in construction industries as “fundamental purpose of this bill, is an effort to get the people back to work”. It was intended “to encourage improvement in housing standards and conditions, to facilitate sound home financing at reasonable terms, and to exert stabilizing influence on housing market” as per Mariner Eccles, special assistant to Treasury Secretary Henry Morgenthau Jr. drafted the National Housing Act 1934 which led to creation of FHA.
Title II of the National Housing Act 1934 authorized FHA to “provide a system of mutual insurance” by creating Mutual Mortgage Insurance Fund (MMIF) for both mortgage on single family homes and on apartment projects having at least 5 units.
FHA (followed be Veterans Administration (VA) in 1944) is a government run mortgage insurer. It doesn’t actually lend money to home buyers but insures the mortgages made by private lenders as long as loan meets strict size and underwriting standards. In exchange for this protection, agency charges upfront and annual fees, the cost of which is passed on to the borrower. FHA induces lenders who have money to invest it in residential mortgages by insuring them against losses on such loans with the full weight of US Treasury behind the contract. With FHA insurance, mortgage lenders were protected from default; if the borrower’s failed to keep up with their mortgage payments, the FHA would cover the unpaid balance of the loan.
FHA runs at no cost to government using insurance fees as its sole source of revenue. In the event of severe market downturn, FHA has unlimited line of credit from US Treasury though it never has to draw on these funds.
The underwriting criteria for financing single family homes were following
- Fully amortizing mortgage with fixed rate of 5.5%
- Minimum down payment of 20% appraised value
- Maximum term of 20 years
- Maximum mortgage amount $16,000
- Insurance premium of 0.5%
Eccles described the mechanism of federal guarantees for private loans as a device that “avoided any direct encroachment by the government on the domain of private business, but which used the power of government to establish conditions under which private initiative could feed itself, and multiply its benefits”. Evidence for FHA’s success was that private capital started moving back into residential housing construction. In 1934, starts were up for the first time in 8 years. Steagall National Housing Act of 1938 further eased the underwriting criteria
- For homes costing no more than $6,000, maximum LTV increased to 90% from 80%
- For loans between $6,000 and $10,000, maximum LTV increased to 90% for first $6,000 and 80% for remainder
- Mortgage term increased to 25 years
- Insurance premium reduced from 0.5% to 0.25%
- Interest rate reduced from 5.5% to 5%
This led to a revolution in housing finance by:
- Allowing higher LTV loans. In 1920s, Savings and Loans (S&Ls) held one half of US mortgages and required almost 20% down payment. FHA allowed lenders to lend at LTV of 90%.
- Reducing foreclosures. From a high of 250,000 non-farm units in 1932, foreclosures went down to only 18,000 in 1951.
- Establishing minimum standards of home construction.
- Reducing interest rates. The bankers did not face the risk of loans default. As a result, interest rates on the mortgages fell by two or three percentage points by freeing the lender from the costs of default and foreclosure.
Mortgage loan limits rather than borrower income limits have been the principal method of targeting FHA insurance activities during its history. This has the effect of focusing FHA insurance on specific segments of the market. The design standards such as a requirement that bathrooms not be accessed through bedrooms tended to limit FHA insurance to existing dwelling but that was fine for New Deal administrators who were more interested in stimulating new construction.
FHA did much more than issue mortgage insurance. FHA required that the mortgage, the property, and the borrower meet certain requirements to receive insurance. The agency insisted that all mortgages meet its requirements of physical quality. FHA developed strict standards towards the type of properties on which it would insure mortgages. The agency also applied standards based on the location, ethnic and racial composition of the community in which the property was located. The underwriting standards included the mandate that the neighborhood be “homogenous” (racially segregated).
Many features of FHA were designed to introduce greater prudence rather than more liberal standards to broaden the base of home ownership. FHA required strict appraisal, new standards of construction and design, and escrow of tax and insurance payments.
FHA’s Impact on construction and construction finance industry
FHA revolutionized the scale at which suburban developers worked. Home loans become so desirable that lenders actively sought bigger and bigger projects to bankroll. As soon as the development was approved by FHA for mortgage insurance, lenders eagerly advanced cash to builders to get the housing units built. Savvy developers found themselves commanding virtually unlimited capital, very little of which they had to supply themselves, which enabled construction in US at a scale previously unknown at US. Where a typical builder in 1920s would have only one or two homes under construction at a given moment, post WWII firm would enact 100 at a time.
Once able to secure working capital, builders increased the size of their operations. Growth brought more profits. Medium size builders tended to expand while large builder grew larger still. These results weren’t coincidental. FHA “made a commitment to provide moderate cost housing production through large scale build operations”. FHA believed that mass construction leads to efficiencies, thus actively directed away federal loans from small builders and explicitly favored gigantic “operative builders” who “assume responsibility for the product from plotting and development of land to disposal of completed units”.
Another way FHA helped modernize and subsidize the industry was by providing builders with research services, something which even the largest builder could rarely afford on their own. Thus FHA established design standards, projected demand in different areas, and undertook planning studies to make sure that proposed housing was coordinated with utilities, transportation, and schools.
Costs decreased as a result of FHA coordination by 13% in 1940 compared to 3 years earlier. “Probably the most important factor in this decline was a shift of FHA financing from houses catering to high income classes to medium-priced dwellings”.
Secondary Mortgage Market
FHA insured mortgages led to the creation of secondary market in mortgages. Whereas S&Ls financed mortgages out of their deposits, FHA mortgages were also financed by non-depository institutions. Individual brokers and independent mortgage companies would use borrowed funds to finance FHA insured mortgages. They would then sell these mortgages to other institutions mostly insurance companies and Fannie Mae (from 1930s to 1940s, life insurance companies were dominant investors in FHA mortgages. Thereafter, Fannie Mae became more important).
FHA’s Impact on suburban design
FHA’s minimum construction standards reduced statistical probability that the unit will suffer from structural and mechanical defects. The standards were innovative in two respects. One, these standards were objective, uniform and in writing and two, they were enforced by actual on-site inspection at various fixed stages of the new housing units. Since WWII, many private builders have built housing to FHA standards even if they don’t take FHA loans. This is because many buyers will not buy a house if it does not meet FHA standards. A developer might sell just a few houses in subdivision through FHA but only if whole division met federal standards. As a result, FHA ideas quickly became the standard among US housing.
FHA set up structures to reward certain activities. For example, FHA wanted to encourage particular type of land use patterns that the agency believed would help safeguard residential property values such as uniform setback of houses from streets, cul-de-sac roads, and residential neighborhoods separated from commercial districts. Developers generally complied because those whose plan conformed to agency standards were able to get an advance commitment that FHA would insure mortgages for all the homes they built. Such a commitment made it easier and cheaper for developers to secure funding since lenders were sure beforehand that such sales will be quick and profitable. In this way, the agency was able to influence planning standards throughout the country.
Even the most modest of FHA insured tracts supplied shelter that met or exceeded standards of adequate ventilation, running water and flush toiled which seemed impossible at mass level in 1920s at an affordable price. This was possible only because of massive federal support of road construction and financial market reorganization.
Construction starts and homeownership
The above changes resulted in a significant increase in the number of families that can qualify for and afford a mortgage and be on a pathway to homeownership. Starting from 93,000 housing units in 1933, starts rose to 332,000 in 1937, 399,000 in 1938, 458,000 in 1939, 530,000 in 1940 and 619,000 in 1941. After WWII, the numbers became even larger. By 1972, FHA had helped around 11 million families to own houses and another 22 million to improve their properties. From 1934 to 1972, homeownership rate went from 44% to 63%. Almost one-fourth of new house in US during 1940-1960s received FHA subsidy with high point of 40.7% of households in 1955.
Despite steps to make FHA program accessible to home buyers of more modest means, for the first two decades, it was oriented towards new construction and only a small proportion of loans were given to low priced properties and high-risk borrowers. However, by 1970s, the prices of FHA insured loans and incomes of homeowners with those loans were below the overall median.
There was downside as well. FHA led to decay of inner cities. This happened because one, FHA preferred single family homes as opposed to multifamily buildings, two, and the loans for repair of existing structures were small and for a short duration and three, FHA instituted a neighborhood rating mechanism which rated houses located in existing racially or ethnically diverse neighborhood negatively compared to new suburban subdivisions. The result was a move of white middle-class homeowners to suburbs. So on one side, FHA helped millions of white middle class and low middle-class households to become owners in racially homogenous cookie-cutter suburban neighborhoods, and on the other hand, it led to death of inner cities and limited funding to multi family or mixed use or non-standard house financing. To put it bluntly, FHA deemed properties located in predominantly black neighborhoods too risky to warrant mortgage insurance.
From its inception till 1954, FHA insured 2.9 million mortgages with aggregate principal of $18.3 billion or an average of $6,300 per property. Through Dec 31, 1954, FHA foreclosed on 9,253 properties. FHA acquired 5,712 of these properties and paid insurance claims on them. Of the 5,712, 5,282 had been disposed off by Dec 31, 1954, with a net loss of $3 million or average of $562 per property acquired and disposed off. From its inception till June 30, 1954, MMIF had income of $494 million and expenses of $246 million.
FHA in 21st Century
During economic downturns in an area, conventional lenders not only increase prices (interest rates) they also engage in credit rationing i.e. reduce the number of mortgages underwritten. FHA by maintaining positions in all markets provides liquidity and stability in markets experiencing recession. Credit rationing in conventional lending is considered market failure in economic parlance. FHAs ability to address this failure is a key justification for FHA’s historical and current role in the market.
During normal economic times, FHA focuses on borrowers with low down-payment loans namely first time home buyers and low and middle-income families. During market downturns, lenders rely on FHA to keep mortgage credit flowing, meaning agency’s business tend to increase. Through this countercyclical support, agency is critical to providing stability to US housing market.
In the late 1990s and early 2000s, mortgage market changed considerably. New subprime mortgage products backed by Wall Street capital emerged, many of which competed with standard mortgages insured by FHA. These products were poorly underwritten and were easier to process than FHA backed loans often translating into far better compensation for the originators. This gave lenders the motivation to steer borrowers toward higher risk and higher cost products even when they qualified for safer FHA loans.
As private subprime market took over the market for low down payment borrowers in mid 2000s, the agency saw its market share plummet. In 2001, FHA insured 14% of home purchase loans. By 2005, that number had decreased to 3%.
We know the rest of story. When bubble burst in 2008, Wall Street stopped supplying mortgage. FHA picked up the slack and by 2011 backed roughly 40% of all home purchase loan in US.
By playing a counter-cyclical role, FHA ensured middle-class families still continued to buy homes. It backed 4 million loans since 2008 and helped another 2.6 million families lower their monthly payments by refinancing.
Moody’s Analytics estimated that if FHA had stopped business in Oct 2010, by end of 2011, mortgage interest rates would have doubled, construction activity would’ve plunged by more than 60%, new and existing homes sales would have dropped by third, and home prices would have fallen another 25% from already depressed levels. A second collapse would have sent US into double-dip recession, GDP would’ve declined by 2% and another 3 million job losses with unemployment rate up to 12%.
“[Obama admin] empowered FHA to ensure that household could find mortgages at low interest rates even during the worst phase of financial panic,” wrote Mark Zandi, chief economist at Moody’s Analytics in Washington Post.
“Without such credit [i.e. FHA], housing market would have completely shut down, taking the economy with it.”Mark Zandi, Moody’s Analytics in Washinton Post