The Federal Housing Administration, hit by increasing mortgage-related losses, is in danger of seeing its reserves fall below the level demanded by Congress, according to government officials, in a development that could raise concerns about whether the agency needs a taxpayer bailout.

In the past two years, the number of loans insured by the FHA has soared and its market share reached 23% in the second quarter, up from 2.7% in 2006, according to Inside Mortgage Finance. FHA-backed loans outstanding totaled $429 billion in fiscal 2008, a number projected to hit $627 billion this year.

Rising defaults have eaten through the FHA’s cushion. Some 7.8% of FHA loans at the end of the second quarter were 90 days late or more, or in foreclosure, according to the Mortgage Bankers Association, a figure roughly equal to the national average for all loans. That is up from 5.4% a year ago.

TWI wrote in January about concerns regarding the FHA and its dwindling insurance portfolio. As we noted then, Washington housing consultant Howard Glaser pointed out that with its larger share of the housing market, the FHA was becoming a $2 trillion company without a risk control officer. If that doesn’t make you nervous, it should.

But the bigger issue for the FHA — and for some other government agencies — is the legacy left by the previous two administrations. Beginning, in fact, with former Vice President Al Gore’s Reinventing Government initiative but expanding with a vengeance and an anti-government fervor during the Bush years, the idea of downsizing government reigned supreme. The FHA, like its parent agency, the Department of Housing and Urban Development, was shunted aside, stripped of many of its powers and personnel, left to languish and demoralized. Now a smaller and weakened FHA is supposed to turn on a dime and save the mortgage market. Little wonder the agency is running into problems.

Here’s how Sheila Crowley, president of the National Low Income Housing Coalition, summed things up in January for TWI:

“When you’ve been operating under a belief system that government is the problem and is not helpful, which has been the direction under the Bush Administration, people get demoralized and that makes it harder to get anything done,” she said. “HUD and the FHA have lost a lot of people and they’ve been neglected over the past eight years. There just aren’t enough people left to do everything the government is asking them to do. It’s a pretty hefty assignment to turn them around.”

The FHA has never had to ask for government help since it began in 1934. That may change, if loan defaults keep growing and the insurance fund shrinks even more. If there’s yet another taxpayer bailout, the government won’t need to look far to find someone to blame.

Most striking is that Hope for Homeowners has attracted unexpected backers: Investors who had refused to consider the program’s requirement that they forgive some of a borrower’s mortgage balance if the home is worth less than is owed, known as being underwater, are now trumpeting that provision.

“Institutional investors that own securities backed by mortgages are extremely keen to write down principal in exchange for the borrower refinancing into a Hope for Homeowners loan,” said Tom Deutsch, deputy executive director of the industry group American Securitization Forum.

Investors that were previously unwilling to write down the value of their loans are increasingly on board with the practice — anything to get those loans off the books. A bird in the hand is worth two with a high probability of default, as they say. But there’s something amiss here. If investors believed that they would maximize their return on troubled loans by reducing principle, they would. That is, if they thought that by writing down the principle on a loan they would increase the odds of payment by enough to make the haircut worthwhile, then it would make sense for them to go ahead and do so. And if they were already doing so, then there would be no need for this program.

But clearly there is a need. Investors are only ready to write down principle if that allows them to shed default risk — which means they don’t think that writedowns lead to large reductions in default risk. And they’re probably right. Under this program, there are new borrowers waiting to pick up the loans because Federal Housing Administration is authorized to insure them — up to $300 billion. It kind of looks as though the government is working hard to absorb up to $300 billion in mortgage loan losses from various investors.

Hope for Homeowners seems primarily geared toward providing hope to investors, rather than homeowners. Given the extent to which unemployment is driving defaults in the current climate, a serious effort to stem foreclosures would focus on generous extensions of unemployment benefits, to the exclusion of most everything else.

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With credit remaining tight and banks continuing to restrict lending, it’s been up to the government to keep the mortgage markets moving. And a major player these days is the Federal Housing Administration, a Depression-era insurer of mortgage loans specifically tapped to take on a much larger role as savior of the housing sector and rescuer of homeowners facing foreclosure.

But with the FHA’s share of the mortgage market expected to grow to nearly 50 percent, the agency finds itself facing the same dilemma as its parent, the Department of Housing and Urban Development. Both were shunted aside during the Bush Administration. Like HUD, the FHA doesn’t have enough staff or even up-to-date technology to handle its expanded role. It lowered its loan standards to compete with private lenders during the subprime boom, and problems with fraud continue to plague it, just as it backs more loans than ever.

Illustration by: Matt Mahurin

Even the president of the banking industry’s trade group warned Congress recently that the agency needs to stop predatory lenders from finding their way into FHA lending programs.

Even beyond that, the FHA must turn itself around and operate at its peak, after years of neglect. While the Obama administration tackles the stimulus plan and other urgent problems, government agencies like FHA and HUD, long relegated to the sidelines, are being called on to ramp themselves up and take on greatly expanded tasks. With the financial crisis so severe, the revitalization has to happen immediately – and there’s no Plan B. Getting these agencies back up to speed is an overlooked challenge facing the new White House regime.

Sheila Crowley, president of the National Low Income Housing Coalition, described that challenge as “extraordinary.”

“When you’ve been operating under a belief system that government is the problem and is not helpful, which has been the direction under the Bush Administration, people get demoralized and that makes it harder to get anything done,” she said. “HUD and the FHA have lost a lot of people and they’ve been neglected over the past eight years. There just aren’t enough people left to do everything the government is asking them to do. It’s a pretty hefty assignment to turn them around.”

The view from the private sector isn’t any rosier. “The FHA’s role has been so small until recently that no one’s paid attention to them,” said Robert Eisenbeis, chief monetary economist at Cumberland Advisors money management firm and former director of research at the Federal Reserve Bank of Atlanta. “They’ve been seen as sort of the group that licks the bottom of the bowl. So, no, there’s not a lot of confidence that they can suddenly run the show.”

FHA’s troubles were highlighted recently by HUD Assistant Inspector General James Heist, who told a House Financial Services Committee at a hearing earlier this month that “we have had, and continue to have, concerns regarding FHA’s systems and infrastructure to adequately perform its current requirements… FHA may not be able to handle its expanded workload or new programs that require the agency to take on riskier loans than it has had in its portfolio.”

An audit of FHA’s roster of approved appraisers found 3,480 appraisers with expired licenses and 199 with state sanctions for abuses, Heist said. The agency has just one person assigned to work with the states in complying with new national licensing requirements for mortgage brokers and loan officers. Its computers and software date back to the 1970s and 1980s. Despite the availability of commercial, off-the-shelf software, the agency’s process of approving lenders for its programs remains a largely manual task.

Overall, the FHA needs to increase its staff, increase training for its staff, increase the the oversight of its appraisals and underwriting, and improve the way it vets lenders taking part in its programs, Heist said. The number of FHA lenders approved for its programs jumped by 330 percent over the last year, as credit tightened. But the agency still has problems with continuing to allow lenders with past predatory abuses into its programs, he said.

The “integrity and reliability” of the newer lenders is “unproven,” Heist said, and “in light of the aggressive recent history of this (subprime lending) industry, may pose a risk to the program.”

Howard Glaser, a mortgage industry consultant and former Clinton Administration HUD official, was more blunt. While the agency’s share of the mortgage market will soon approach 50 percent, up from just 3 percent 18 months ago, Glaser said, “the FHA does not have the capacity to handle that kind of volume.” He described the FHA in the near future as akin to a $2 trillion insurance company, without any risk controls.

“They’re the only financial corporation of any note in America that lacks a chief risk officer and a chief credit officer,” he said. “It puts probably many billions of taxpayer dollars at risk.”

That risk also came to light when a Business Week investigation found the same subprime lenders that contributed to the mortgage crisis were finding their way into FHA-backed lending programs, with the agency failing to identify and disqualify them. But the track records of those lenders were easily available – in FHA’s own database, noted Brian Chappelle, a former FHA official and industry consultant.

“There’s no question the FHA needs resources, and that there’s been a loss of career staff and institutional knowledge. That’s a given,” Chappelle said. What’s unknown, he added, is whether the FHA can change its culture to handle its expanded role. “If they have the will, they can do it,” he said.

An HUD spokesman said no one was immediately available for comment. HUD said in a written statement to the House Financial Services Committee that it was closely monitoring loan defaults.

FHA’s expanded role in insuring mortgages is a dramatic contrast to its past.

The agency was created as a New Deal program in the 1930s to help struggling Americans buy homes. In the 1960s, it was brought under HUD, with the goal of increasing home ownership by insuring loans made to underserved populations and borrowers with modest incomes. In the last 15 years, its goal has been to reach mostly urban communities that were subject to redlining, said David Berenbaum, executive vice president of the National Community Reinvestment Coalition.

But as the private sector began about a decade ago to move into the subprime market, FHA’s loan share declined. By the height of the subprime boom, in 2006, FHA’s share of the mortgage market had fallen to 2 percent, according to the agency.

At the direction of former HUD Secretary Alphonso Jackson, and with the support of the White House, the FHA began loosening some of its lending standards to compete with the private market, Berenbaum said. Jackson issued a rule allowing more self-policing for lenders in FHA programs, and he supported raising loan limits. Jackson also maintained that HUD had plenty of resources to deal with the foreclosure crisis, and insisted it wouldn’t be that severe, Berenbaum noted. During his tenure, FHA foreclosures and defaults reached record levels.

Jackson resigned last April over a criminal investigation into charges he steered HUD contracts to business associates and friends. HUD Inspector General Kenneth Donohue in 2007 criticized both Jackson and Brian Montgomery, the current FHA commissioner, for pushing to change FHA lending standards.

Montgomery, who has been asked to remain in his position until a new commissioner is chosen, is a longtime Bush loyalist, a former director of advance for the Bush White House, and an advance man for former president George H.W. Bush. He had no prior housing experience. Montgomery’s predecessor, John Weicher, a conservative economist and now a senior fellow at the Hudson Institute, headed the FHA.

Montgomery, however, surprised critics and won praise from both Democrats and Republicans for being an advocate for his agency and for trying to make it more efficient. But he wasn’t able to do enough, Chappelle said. During Weicher’s tenure, the agency “withered,” he said.

As the mortgage crisis worsened during the last year, Congress and the Bush Administration increasingly turned to the FHA to keep the mortgage market going, encouraging borrowers to refinance into stable, government-backed loans, getting lenders to participate and making more changes to increase the number of eligible borrowers. FHA-backed loans generally have lower downpayment and credit score requirements.

The FHA is funded by mortgage insurance premiums paid by borrowers, which go into a fund to cover losses on mortgages the agency insures. Taxpayers would only have to kick in money if the fund fell too low. But Heist warned the fund has been shrinking recently, down some 40 percent over the last year. The $12.9 billion now in the fund comprises 3 percent of mortgages insured by the FHA, a decline from 6.4 percent last year, and just above the 2 percent ratio required by law, Heist said. About 6.5 percent of FHA-backed loans are in default, he said.

Since it was created in 1934, the FHA has never had to ask for government help to cover its losses.

With its market share rising, the government wants the FHA to keep backing new loans and do a large volume of refinancings as well – something that will require a significant amount of new equipment, resources and staff, Berenbaum said. He and other housing advocates, like Crowley, are counting on the Obama administration to come though with those resources and to rebuild the agency.

As Chappelle pointed out, the agency has come full circle, back to its Depression-era roots as the insurer of home loans in difficult times. The dilemma ahead is whether its recent history will keep it from fulfilling that mission.

But for the past eight years, the government has downsized the FHA and reduced its role. Just like its parent agency, the Department of Housing and Urban Development, the FHA has basically been dismantled by the zeal of anti-government conservatives, and now is expected to turn around and perform at its peak.

This obviously presents some problems, among them a lack of controls in FHA lending programs that are resulting in subprime and predatory lenders getting back into the market,  Mortgage Bankers Association President John Courson told the House Financial Services Committee.

From Courson:

But as we applaud FHA’s turnaround, that increase in volume is a double-edged sword that requires FHA and FHA-approved lenders to be more vigilant than ever about who is allowed to originate FHA loans. Much like you, we are concerned that some unscrupulous lenders may now be turning their attention to FHA and its programs.

Business Week recently called FHA-backed lending programs “the new subprime,” and said unscrupulous lenders are taking advantage of lax oversight to get in on FHA lending. That creates the same problems that got us into this mess in the first place.

If this doesn’t make you nervous yet, it should. As Mortgage Insider’s Matthew Padilla put it, there could be another government bailout coming … of the FHA.

Hopes were high for the program as one possible solution to the economic crisis. It was supposed to be a way to slow down the increasing pace of foreclosures.

As Housing Wire reports, some data is now available on the program’s progress so far. It would be fair to say that a celebration hardly is in order.

In its first two weeks, 42 applications were filed for the program. Not a single one was accepted. The problem seems to be with third-party investors in mortgage-backed securities, who won’t take any losses on their investments. From Housing Wire:

The problem, however, may not be lenders, who say they’re more than willing to begin processing the loans. Instead, the problem sits with third-party investors that have thus far proven unwilling to take the minimum 10 percent haircut required to put borrowers into the program, plus an upfront premium payment–losses are actually far greater for investors who participate, given that the 10 percent figure is based on a current appraisal, and not original LTV.

John Sorgenfrei, president of Florida-based Assurance Home Loan, Inc., said he receives calls from eight to 10 borrowers daily about participation in the program. For the time being, he has been forced to make them wait, as no investors so far have bought into the program.

“I wish I could say we have something in the works,” he said. “We’re waiting for the investors to decide whether it’s going to be a third-party participation or just exclusively held for the lenders.”

Robert Paduano, managing director at Allegro Funding Corp., licensed to operate in 24 states and signed up on the H4H list, also said in an interview that the hold-up on the program has resulted from investors unwilling to accept rewrites on existing loans.

“The [H4H] program is a joke,” he said. “It’s not going to materialize into what we had hoped for because most lenders are unable or unwilling to write down the principal balance to 90 percent because their investors won’t let them.”

There’s a growing list of banks trying to do loan modifications, with JPMorgan, Bank of America, and IndyMac among them. And there’s the program being put together by the Treasury Dept. and the Federal Deposit Insurance Corp. All of them rely on the voluntary participation of lenders and investors, and depend on their willingness to take a losses in return for government guarantees.

Judging by the early returns of the FHA program, and the difficulty in getting other loan modifications through, it’s clear that investors are in the driver’s seat — and that they’re not willing to take any hits.

In the middle of a budget battle in the early 1990s, James Carville, President Bill Clinton’s political adviser, once remarked that he hoped to come back in the next life as the bond market, because it was all-powerful. These days the choice might be investors in toxic mortgage-backed securities, unwilling to give up their double-digit returns — and, apparently, far enough removed from the fluttering of bank-owned signs on millions of empty houses where people once tried to carve out a life, to even care.

When the government bailed out Bear Stearns in March, plenty of people on Main Street complained it wasn’t fair to save an investment bank and do nothing to help homeowners.

Imagine how they feel now.

Each new step the government takes in the private markets — from seizing Fannie Mae and Freddie Mac to providing an $85-billion taxpayer loan to the insurance company AIG — raises the bar for acting on the foreclosure end of the mortgage crisis, in neighborhoods hit hard by falling house prices and failing loans.

Illustration by: Matt Mahurin

It’s not just about fairness anymore. The intervention on Wall Street creates a huge opening, in the view of housing and community activists, to push for the government to take the lead in the housing crisis on Main Street as well — something it’s avoided so far.

Since March, the government has taken control of three major lending institutions. It could restructure mortgage loans on a large scale and send a signal to the private sector to do the same. It could freeze foreclosures until there’s some sort of plan to help homeowners. It could rescue devastated neighborhoods just like it shored up failing investment banks. It could do far more than the little it has been doing. After all, shouldn’t millions of families facing foreclosure also be considered too big to fail?