Editor's note: A previous version of this article had incorrect FHA loan provisions. The Fool regrets the error.
Think we're beyond the days of people putting little-to-nothing down for home purchases only to later walk away? Think again … and the government is sponsoring it.
For those not familiar with FHA loans, they are loans issued by major banks like Bank of America (NYSE:BAC) and Wells Fargo (NYSE:WFC) as well as smaller mortgage brokers and the origination arms of builders like Ryland (NYSE:RYL) and KB Home (NYSE:KBH). Those loans are then insured against default by the Federal Housing Authority.
The rub is that FHA loans allow borrowers to buy a home with as little as 3.5% down. Plus, qualifying borrowers can use the government's $8,000 tax credit toward closing costs or the down payment (above the 3.5%). Isn't it loans like that that got us into this mess in the first place?
Deeper into the rabbit hole
But wait, it gets worse. With the mortgage market still in disarray and private market insurers like PMI Group (NYSE:PMI) racking up losses, the FHA -- along with Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) -- has been taking on an ever-growing role in the mortgage market. This leaves the insurer taking on an increasing chunk of the riskiest loans in one of the worst housing markets the U.S. has ever seen, not to mention a severe recession.
According to the inspector general of the Housing and Urban Development Department, the increased workload has also left the FHA open to a worrying amount of fraud, which has eaten away at its insurance fund. Currently, the FHA's insurance fund sits at 2% of its insured assets, which is down from 6.4% last year. Two percent is also the minimum level that the agency must maintain.
Worry? Me?
Why should this worry us? Well, for decades the FHA has either generated income from insurance premiums or at least broken even. If it hits hard times, the best outcome is that it goes knocking at Congress' door looking for taxpayer money to shore up its accounts. Some experts have said that taxpayer aid for FHA could reach as much as $100 billion.
But like I said, that's the best-case scenario. With the FHA now insuring a huge chunk of mortgage originations, we could kiss a near-term housing bottom goodbye if the FHA started drastically cutting back its scope to deal with a weak balance sheet. That could mean more housing declines for homeowners, an even worse market for builders, slashed business for banks, and all sorts of other lovely cascading effects.
Choking the green shoots
It seems like everyone wants to talk about green shoots right now. That's fine with me, I love gardening. But what I know about tending a garden is that green shoots won't do you much good if you have weeds hanging around ready to choke them off.
Now don't get me wrong, I'm not some uber-bear here to scare you away from the market. However, I'm also not a bull charging ahead with eyes squeezed shut.
So what am I looking for in this market? Really, it's the same thing that I'm always looking for – high-quality companies at reasonable prices with time-tested businesses and balance sheets strong enough to survive a hurricane. Because of the lurking problems that could foil a quick recovery, though, I'm also taking special care to steer clear of companies that are heavily relying on that quick recovery to be winners.
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