Banking on Clues From the FHA

The Federal Housing Administration (FHA) issued the FY 2009 mortgage insurance fund report earlier in November. Many headlines covered reserves dropping below required levels, but the report also includes some insight into how mortgage loans are performing.

The FHA guarantees mortgage loans, but doesn't purchase mortgages like Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) do. The agency is required to maintain a net capital ratio -- reserves above projected loss payouts -- of at least 2%. That ratio is now 0.53%. For taxpayers, that raises concerns that the Treasury could be called on to provide funds. For investors, nothing much changes. The FHA is still guaranteeing mortgages, and if it does run low on funds, the FHA guarantee program is backed by "the full-faith-and-credit of the U.S. government."

Steps have been made to tighten underwriting standards and improve loan quality. For FY2009, the FHA discontinued guaranteeing loans where the seller made the down payment for the buyer. Those loans had default rates as much as three times higher than loans where the buyer put some of his or her money into the deal. Surprise, surprise. Poor loan qualification standards lead to high defaults.

The report does include a mixed bag of mortgage performance statistics that should be of interest to bank investors:

In the fiscal year just ended (2009), FHA guaranteed more than $360 billion in single-family mortgages. That represents a 75-percent increase over FY 2008 activity, and more than four times the volume of insurance commitments made in FY 2007.

The FHA guaranteed nearly 50% of first-time homebuyer loans in the second quarter, a substantial increase over the first quarter and 2008. Higher guaranteed loan volume is a positive for mortgage lenders like Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC), JPMorgan Chase (NYSE:JPM), and Citigroup (NYSE:C). An increase in government guaranteed mortgage paper gives banks more opportunity to hold near-zero-risk assets in portfolio or make an easy sale of the guaranteed paper.

In another bright spot, early payment defaults (90 days past due within six months or origination) are declining. This statistic peaked at 2.65% for loans originated in June 2007, and it's declined to 1.42% for loans originated in January 2009.

The news isn't all rosy for the mortgage industry. The reserve analysis predicts an additional 6%-7% decline before home prices bottom sometime in 2010. In addition, foreclosures continue to increase, both in absolute numbers and as a percentage of insured loans.

Many banking analysts are valuing bank stocks on normalized earnings -- what the banks are expected to earn once-high loan loss rates are behind them. Despite some good news, the FHA Insurance Fund report indicates there'll be quite a wait before those earnings normalize.

More on banks and mortgages:

• The Bank You Need to Buy
• Roundtable: Buy This Bank
• Roundtable: Sell This Bank