Policy Documents

FHA Loans Create Substantial Risk for Taxpayers

Matthew Glans –
January 23, 2009

The subprime crisis has spawned numerous calls for tightening the credit market and banking regulations, in a market that is already highly regulated. As is true in most times of crisis, temptations abound to create new rules to “fix” the market and prevent future catastrophe.

Politicians and the public have placed the blame largely on the mortgage and lending industries. As the real estate bubble burst, many predatory lenders suffered the consequences of their own ill-conceived loans.

The irony is that the subprime crisis emerged largely from manipulation and regulation of the credit system by various government institutions and programs, including the Federal Reserve, Fannie Mae, Freddie Mac, the Community Reinvestment Act, and the Federal Housing Administration. Many of the financial problems the country is currently facing emerged as a direct result of the government attempting to intervene and artificially stimulate the economy.

Legislators should consider the following points when addressing the expansion of the Federal Housing Administration:

Government is creating additional risk for future taxpayers

With the expansion of the Federal Housing Administration (FHA), the government is taking on additional risk. Instead of allowing the private market to correct itself and fix the root causes of the crisis, the government is assuming the risk of individual buyers at taxpayer expense. This places the FHA at increased risk of failure due to the volatile nature of lower-priced mortgage loans. The growing number of FHA-backed loans should concern every taxpayer, as this expansion creates all risk and no reward for American taxpayers.

Loan contracts always should be mutually agreed upon by lenders and borrowers

Individual lenders and borrowers ought to be permitted to work out loan arrangements, without government interference. The government’s direct involvement in housing agreements limits the ability of consumers and lenders to reach a sound financial agreement through the market process. The end result will be loans that are influenced by politics, not based on sound fiscal decisions, exacerbating rather than solving the problems of the current crisis.

Further stimulus will lead to another housing boom-and-bust cycle

The most troubling aspect of FHA expansion is the risk of creating another artificial housing bubble. The collapse of the last bubble, created in large part by the Federal Reserve’s manipulation of interest rates, has created a credit crunch that is crippling our economy. The expansion of FHA raises eerie parallels to the last bubble and creates the potential for a repeat of the last crisis—a mistake we should not attempt to repeat. History has demonstrated quite clearly that when markets are artificially supported by government manipulation through subsidies, regulation, and price controls, these markets tend to collapse, leaving in their wake significant damage not easily repaired.

FHA expansion prevents long-term housing industry stability

The recent expansion in federal power over the housing market began with the expanded use of the discount window, continued in the bailouts of Bear Stearns, and grew exponentially with the creation of the Troubled Asset Relief Program (TARP), the long-predicted bailout of the financial industry. These new policies are at their core an extension of existing interventionist policies. A sound recovery will come only through the establishment of a long-term policy that practices government restraint and a return to sound market fundamentals.

The current plan to address the mortgage crisis by using government tax dollars to absorb toxic assets and assume a greater share of risk in lending agreements takes few steps forward and a giant leap backwards. The goal of the plan is to create a more active role for the government in private lending agreements, spending billions of dollars to prop up a market that is currently highly unstable and risky. Using taxpayer money to support an ailing system is both fiscally and morally irresponsible.

Additional stimulus won’t solve a problem created by government stimulus

Supporters have tried to portray these bailouts as a rescue for homeowners, but they are in fact more harmful than helpful, ignoring the root causes of the crisis. Too many solutions from the government today simply involve throwing taxpayers’ money at a problem. This wrongheaded macroeconomic “leadership” is bad public policy and harmful to the economy. Moving government tax revenue into an already-bloated housing market will prolong the housing bubble that emerged as a result of previous government stimulus through a dramatic lowering of interest rates.

The following articles address some of these concerns and examine the expansion of the Federal Housing Administration from a free-market perspective.

Congress Mulls Mortgage Guarantees; Critics See More Harm than Good Likely
http://www.heartland.org/policybot/results.html?articleid=23453
This article from Heartland’s Budget & Tax News examines the FHA expansion prior to its approval, focusing on the primary beneficiaries of the changes and possible effects on the market and economy.

Anatomy of a Train Wreck: Causes of the Mortgage Meltdown
http://www.heartland.org/policybot/results.html?articleid=23863
Stan J. Liebowitz of the Independent Institute examines the root causes of the mortgage crisis, including the role of the FHA in the collapse.

A Non-Prescription for Confronting the Sub-Prime Crisis
http://www.heartland.org/policybot/results.html?articleid=22841
Eli Lehrer and John Berlau of the Competitive Enterprise Institute (CEI) examine proposals to combat the subprime crisis and come to the conclusion that the best course of action may be no action.

The Subprime FHA
http://cei.org/gencon/019,06195.cfm
In an essay written before the FHA reforms became law, John Berlau of CEI examines the risk FHA loans pose to taxpayers and considers the effects the reforms could have on the mortgage meltdown.

The Dodd-Shelby Housing Bill: A Bad FHA Refinance Plan Hijacks Good GSE Reforms
http://www.heritage.org/Research/Economy/wm1941.cfm
David John of The Heritage Foundation examines one of the proposals being made to reform and expand the FHA, looking especially on how the bill might affect the federal government’s efforts to reform Fannie Mae and Freddie Mac.

H.R. 5830, the Frank–Dodd FHA Refinance Plan, Is Still the Wrong Policy for the Housing Mess
http://www.heritage.org/research/economy/wm1918.cfm
In his second article on the topic, John examines specific shortcomings with the plan, and in general any expansion of the FHA. He advises against hasty reforms as part of an effort to “do something,”

FHA-Backed Loans: The Next Subprime Crisis?
http://www.msnbc.msn.com/id/27844894/
This article examines the risk that an increase in the number of FHA loans could present for the housing market. The authors warn about the dangers of exposing taxpayers to another artificial housing bubble and the growing risk being posed by unscrupulous lenders.

Nothing in this document is intended to influence the passage of legislation, and it does not necessarily represent the views of The Heartland Institute. For further information on this and other topics, visit The Heartland Institute’s Web site at http://www.heartland.org and PolicyBot, Heartland’s free online research database.

If you have any questions about this issue or The Heartland Institute, contact Heartland Institute Legislative Specialist Matthew Glans at 312/377-4000 or mglans@heartland.org.