The Mutual Mortgage Insurance Fund: A Study of the Adequacy of Its Reserves and Resources 9780231895644

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THE M U T U A L MORTGAGE

INSURANCE

FUND

Publications

of the Institute

Urban Land

Use and Housing

Columbia

University

for Studies

THE MUTUAL MORTGAGE INSURANCE

FUND

A Study of the Adequacy of Its Reserves and Resources

by

E R N E S T M. F I S H E R

a n d CHESTER

RAPKIN

COLUMBIA UNIVERSITY PRESS, NEW YORK,

1956

Copyright © 1 6 Columbia University Press, New York PUBLISHED IN GREAT BRITAIN, CANADA, INDIA, AND PAKISTAN BY GEOFFREY CUMBERLEGE: OXFORD UNIVERSITY PRESS, LONDON, TORONTO, BOMBAY, AND KARACHI

Library of Congress Catalog Card Number: 56-960) Manufactured in the United States of America

PREFACE

A. STUDY

of the adequacy of the reserves of the Federal Housing Administration was suggested by the President's Advisory Committee on Government Housing Policies and Programs1 and by the Commission on Organization of the Executive Branch of the Government. 2 T h e Federal Housing Administration operates, simultaneously, eleven programs of mortgage and loan insurance. Each of these programs has a separate fund into which fees and premiums collected are credited and to which expenses are charged. T h e amount of insurance in force and the estimated status of each of these funds, except for the Title I Insurance Fund, as of December 31, 1954, are indicated in Section 3 of the Twenty-first Annual Report of the Federal Housing Administration covering insuring operations for the year ending on that day. The largest of the funds covered by the Report in terms of outstanding balance of insurance in force is the Mutual Mortgage Insurance Fund. On December 31 this Fund had outstanding insured balances estimated at $10,458 million. 8 With estimated reserve requirements at $202 million, and reserves of $216 million, this Fund was also in the strongest reserve position of all the funds in operation. The next largest program is represented by the War Housing Insurance Fund, with outstanding insured mortgage balances of $4,543 million, estimated reserve requirements of $195 million, and $109 million in reserves. 1 Recommendations on Government Housing Policies and Programs (Washington,

D. C., Government Printing Office, December, 1953), pp. 10, 39-40, 353-54. 2 Commission on Organization of the Executive Branch of the Government, Herbert Hoover, Chairman, Lending Agencies: A Report to the Congress (Washington, D. C., Government Printing Office, March, 1955), pp. »7-28. 3 Includes $1,009,920 for mortgages insured under Sections 207-10 prior to February J, 1938.

vi

PREFACE

These two programs include, then, over $15,000 million of the total $18,266 million of insurance in force in all eleven programs. T h e Mutual Mortgage Insurance Program, established in 1934, is the oldest of the programs. All of the other mortgage insurance loan programs have been patterned after it. No more insurance is being written under the War Housing Insurance Program, and several of the others are temporary in character. Both the character of risk and the methods employed in establishing and calculating the reserve requirements are alike in all these programs. T h e assumptions upon which the actuarial calculations of reserve requirements are made are similar but vary in detail because of surrounding circumstances. It has not been possible, nor does it appear necessary, to examine all these detailed variations in order to arrive at a judgment with respect to the adequacy of the F H A reserves and resources. In the Twenty-first Annual Report of the Administration some of the variations are given, so that, assuming conclusions with respect to the Mutual Mortgage Insurance Fund are valid, a considered judgment can be arrived at with respect to the other funds by an examination of the materials contained in this Twenty-first Annual Report. This study, therefore, is concerned only with the operations of the Mutual Mortgage Insurance Fund. It examines the history, both legislative and operational, of the System which was established by Congress in 1934 and has been in continuous operation since that date. T h e study was undertaken in the fall of 1954 by the Institute for Urban Land Use and Housing Studies at the suggestion of Dr. James J. O'Leary, Director of Investment Research of the Life Insurance Association of America, and of its Investment Research Committee. T h e Association agreed to provide the necessary funds. Subsequently, the Association was joined by the Mortgage Bankers Association of America, the National Association of Mutual Savings Banks, and the United States Savings and Loan League. T h e Life Insurance Association of America has also made available, whenever requested, the services of Mr. George H. Davis, Associate Actuary. Mr. Davis provided technical assistance through-

vii

PREFACE

out the study. Under his direction, the Statistical Department of the L.I.A.A. made the calculations (reported in Chapter VII) necessary to determine the effect on reserves of variations in the basic assumptions in respect to future income and expenses. We are greatly indebted to the Life Insurance Association of America and to Mr. Davis for this assistance. Without the generous assistance given by the Federal Housing Administration, and particularly by Mr. Allan F. Thornton, Director of the Division of Research and Statistics, Mr. Mortimer Kaplan, Associate Chief, and Mr. Louis O. Shudde, Chief of the Actuarial and Financial Section of this Division, and by Mr. Lester H. Thompson, Comptroller, this study could not have been made. We are grateful to these members of the staff, as well as to the Commissioner, Mr. Norman P. Mason, and Mr. Thomas F. Johnson, Assistant Commissioner, under whose supervision the work of the Division of Research and Statistics is carried on. Throughout the study we have had the valuable counsel of an advisory committee consisting of Mr. L. Durward Badgley, Director of Real Estate and Mortgage Research, T h e Mutual Life Insurance Company of New York; Mr. R. Manning Brown, Jr., Vice President in Charge of Real Estate and Mortgage Loans, New York Life Insurance Company; Mr. Harry Held, Vice President, The Bowery Savings Bank; Dr. James J. O'Leary of the Life Insurance Association of America; Mr. R. B. Patrick, Financial Vice President, Bankers Life Company (Des Moines, Iowa); and Dr. Arthur M. Weimer, Dean of the School of Business, Indiana University. Various members of the Institute's staff contributed to the preparation of this report. Dr. Leo Grebler and Dr. Louis Winnick provided advice and counsel throughout the study, and Dr. Grebler drafted sections of Chapter V. Mr. Ned Shilling and Mr. Robert F. Eggen were research assistants during the later stages and Mr. Shilling prepared the Appendix. Special thanks are due to Mrs. Esther D. Olmstead and Miss Gwladys M. Davies for seeing the report through its various drafts. ERNEST M . March,

1956

CHESTER

FISHER

RAPKIN

CONTENTS I. S T A T E M E N T OF T H E PROBLEM II. BASIC LEGISLATION AND O P E R A T I N G EXPERIENCE 1. Basic Legislation Insurance Benefits Provided Amendments Summary 2. Operating Experience Volume and Characteristics of Mortgages Insured Original Loan-Value Ratio Distribution Reductions in Outstanding Volume Experience with Foreclosed Properties Income, Expenses, and Statutory Reserves

3

8 8 11 13 20 21 21 24 30 36 40

III. CHARACTERISTICS OF INSURED M O R T G A G E S IN FORCE Summary

42 53

IV. T H E FHA METHOD OF C A L C U L A T I N G REQUIRED RESERVES Nature of the Risk 1. Elements in Reserve Valuation Income Items Expense Items 2. Reserve Factors 3. Basic Assumptions Use of Debentures Assumed Future Cycle Pattern Terminations Title Transfer Rates Loss Rates Reserve Requirements as of December 31, 1954

56 57 58 58 58 59 60 61 61 62 66 67 70

X

CONTENTS V. EVALUATION OF FHA METHOD: E X T E R N A L FACTORS 1. Length of Foreclosure and Related Cycles The Foreclosure Cycle Cycles of Residential Construction Conclusions 2. The Record of Mortgage Experience Over-all Foreclosure and Loss Rates Other Variables Possibly Affecting Foreclosure and Loss Rates Period of Loan Origination Contract Interest Rate Amortization Provisions Contract Length Original Loan-Value Ratio Original Amount of Loan Subsequent Increase in Loan Principal Type of Structure Geographic Location Date of Construction Type of Tenancy Geographic Proximity of Property to Mortgagee Age of Loan at Time of Delinquency Period of Property Disposal Summary 3. Change in House Prices VI. EVALUATION OF FHA METHOD: I N T E R N A L FACTORS The Issuance of Debentures Carrying Costs and Settlement Expenses Maintenance Expenses Settlement Expenses Schedule of Anticipated Terminations Summary

VII. EFFECT ON RESERVES OF V A R Y I N G PRINCIPAL ASSUMPTIONS Assumed Rates of Title Transfer and Prepayment

72 72 73 77 80 82 84 87 90 93 93 95 96 98 98 99 100 100 101 101 102 104 106 108 112 11s 118 119 122 123 130 132 134

CONTENTS

Xi

Assumed Rates of Insurance Loss Assumed Rates of Settlement Expenses Assumed Real Estate Cycle Patterns Conclusions VIII. SUMMARY A N D T h e Adequacy Need for Price Prepayment of APPENDIX

RECOMMENDATIONS of the Reserves Index Premiums

137 139 14s 144 146 148 153 154 157

TABLES 1.

Summary of M a x i m u m Provisions for Mortgages Eligible for Insurance under Section 203

2. V o l u m e of Mortgages Insured u n d e r the Provisions of Section 203, by Years, 1935-1954 3. Distribution by L o a n - V a l u e R a t i o of T o t a l N u m b e r of Mortgages and Mortgages on N e w a n d Existing Construction Insured A n n u a l l y under Section 203, 1935-1953 Principal A m o u n t of Mortgages Insured, Estimated Reductions by T e r m i n a t i o n s and A m o r t i z a t i o n of O u t s t a n d i n g Balance of Mortgages Insured, and Estimated O u t s t a n d i n g Balance of Insured Mortgages in Force 5. C u m u l a t i v e N u m b e r a n d A m o u n t of Mortgages T e r m i n a t e d by Prepayment, Foreclosure, Maturity, and O t h e r 6. C u m u l a t i v e and A n n u a l N u m b e r of Properties A c q u i r e d a n d Sold, Cost of A c q u i s i t i o n and O p e r a t i o n of Properties, a n d

18 23

27

4.

N e t Proceeds Received, 1947-1954 N u m b e r of Properties A c q u i r e d , Sold, and o n H a n d , Annually, 1936-1954 8. Income and Expenses of the M u t u a l M o r t g a g e Insurance F u n d , C u m u l a t i v e through 1944, a n d A n n u a l l y , 1944-1954

32 34

37

7.

9.

N u m b e r of Mortgages Insured, Estimated N u m b e r in Force, Estimated Face A m o u n t , and O u t s t a n d i n g Balances of Mortgages in Force, by Year of Endorsement, 1936-1954

38 39

43

10. Estimated O u t s t a n d i n g Balances, Aggregate O r i g i n a l F H A Estimate of V a l u e , a n d Estimated C u r r e n t V a l u e of Properties for Mortgages in Force, by Year of Endorsement, 19361 954 A m o u n t of Estimated O u t s t a n d i n g Balances, Distributed by R a t i o of Estimated O u t s t a n d i n g B a l a n c e to Estimated Current V a l u e , by Year of Endorsement, 1936-1954 12. Percentage of O u t s t a n d i n g Balances R e p r e s e n t i n g M o r e than G i v e n Ratios of O u t s t a n d i n g Balance to Estimated C u r r e n t V a l u e , by Year of Endorsement

45

11.

47

49

TABLES 13. Ratio of Estimated Outstanding Balances to Estimated Current Value, by T e r m of Loan and by Year of Endorsement 14. Distribution of Number of Mortgages in Force by Original Face Amount, by Year of Endorsement 15. Percentage Distribution of Mortgages in Force, by Original Face Amount and by Year of Endorsement, 1936-1954 16. Average Face Amount of Mortgages in Force and of Mortgages Insured, by Selected Years of Endorsement 17. Percentage Distribution by Original Loan-Value Ratio of All Mortgages Insured and of Mortgages in Force, by Year of Endorsement, 1951-1953 18. Mortgage Survivorship T a b l e for Section 203 Mortgages: F H A Experience and Hypothetical Schedule for Phases of Assumed Cycle 19. Assumed Rates of T i t l e Transfer of Insurance Contracts in Force under the Mutual Mortgage Insurance Fund 20. Assumed Insurance Loss per $1,000 of Original Face Amount on a Twenty-Year 85 Percent Mortgage with Mortgage Rating Pattern of 60-100 on Property Acquired during the Unfavorable Phase of the Cycle a i . Estimated Number and Index of Nonfarm Real Estate Foreclosures, Exclusive and Inclusive of H O L C Activity 22. T h e Long Cycle in Nonfarm Real Estate Foreclosures since 1926 23. Long Cycles in Housekeeping Residential Construction 24. Foreclosure and Loss Rates for Samples of Mortgage Loans on Nonfarm 1- to 4-Family Dwellings 25. Foreclosure Rates for Mortgage Loans on Nonfarm 1- to 4-Family Dwellings Made by Life Insurance Companies, Commercial Banks, and Savings and Loan Associations, by Year Made, 1920-1947 26. Percentage of Mortgage Loans on Single-Family Houses Foreclosed by Mutual Savings Banks in Massachusetts, by Period of Loan Origination 27. Loss Rates in Disposal of Foreclosed 1- to 4-Family Dwellings, by Period of Loan Origination 28. Loss Rates in Disposal of Single-Family Dwellings Foreclosed by Mutual Savings Banks in Massachusetts, by Period of Loan Origination

xiii 51 52 52 53

54

65 67

69 75 76 78 85

91

92 92

93

xiv

TABLES

29. Foreclosure and Loss Rates on Samples of Mortgage Loans on 1- to 4-Family Dwellings, by Type of Loan 30. Foreclosure and Loss Rates on Samples of Mortgage Loans on 1- to 4-Family Dwellings, by Contract Length, for Loans Made, 1920-1929 31. Foreclosure and Loss Rates on Samples of Mortgage Loans on 1- to 4-Family Dwellings, by Original Loan-Value Ratios 32. Foreclosure and Loss Rates on Samples of Mortgage Loans on l- to 4-Family Dwellings, by Original Loan Amount 33. Foreclosure and Loss Rates on Samples of Loans Made by Mutual Savings Banks in Massachusetts, 1918-1931, by Increase or No Increase in Principal 34. Foreclosure and Loss Rates on Samples of Loans Made by Mutual Savings Banks in Massachusetts, 1918-1931, by Date of Construction of Building 35. Foreclosure and Loss Rates on Samples of Loans Made by Mutual Savings Banks in Massachusetts, 1918-1931, by Owner and Tenant Occupancy 36. Loss Rates on Foreclosed Nonfarm 1- to 4-Family Mortgage Loans, by Period of Property Disposal 37. Loss Rates on Samples of Loans on l-Family Houses Foreclosed by Mutual Savings Banks in Massachusetts, by Period in Foreclosure Account 38. Hypothetical Projection of Principal Items in the Reserve and Balance Sheet Statement with Respect to a Group of Mortgages Insured in a Single Year 39. Amount of Required Reserves Based upon Various Levels of Assumed Rates of Title Transfer and Prepayment 40. Required Reserve Factors under Various Assumptions as to Title Transfer and Prepayment Rates on Twenty-Year Mortgages Rated 60-100, by Year of Endorsement 41. Amount of Required Reserves Based upon Various Levels of Assumed Insurance Loss Rates 42. Required Reserve Factors under Various Assumptions as to Loss Rates on Twenty-Year Mortgages Rated 60-100, by Year of Endorsement 43. Amount of Required Reserves Based upon Various Levels of Assumed Settlement Expenses

94

95 96 97

99

100

101 103

104

116 136

138 139

140 140

TABLES 44. Required Reserve Factors under Various Assumptions as to Settlement Expenses for Twenty-Year Mortgages Rated 60100, by Year of Endorsement 45. Amount of Required Reserves Based upon Several Assumed Real Estate Cycle Patterns 46. Required Reserve Factors under Various Assumptions as to Number of Depressed Years in the Cycle for Twenty-Year Mortgages Rated 60-100, by Year of Endorsement

XV

141 142

143

CHARTS 1. Amount of Mortgages Insured under Section 303, National Housing Act, from Year to Year, on New and Existing Construction 2. Percentage Distribution of All Mortgages Insured by LoanValue Ratio, 1935-1941 and 1946-1953 3. Percentage Distribution of Mortgages Insured on New Construction by Loan-Value Ratio, 1935-1941 and 1949-1953 4. Percentage Distribution of Mortgages Insured on Existing Construction by Loan-Value Ratio, 1935-1941 and 1946-1953 5. Annual and Cumulative Amount of Mortgages Insured, Estimated Cumulative Reduction in Outstanding Balances on Account of Terminations and Scheduled Amortization, and Estimated Outstanding Balances, 1935-1954 6. Cumulative Number of Mortgages Terminated, 1935-1954, by Prepayment by Supersession, by Foreclosure, Maturity, and Other, and by Prepayment in Full 7. Ratios of Outstanding Balance to Original FHA Estimate of Value and to Estimated Current Value for Mortgages in Force, by Year of Endorsement 8. Distribution of Amounts of Estimated Outstanding Balances by Ratio of Estimated Outstanding Balance to Estimated Current Value 9. Index of Nonfarm Real Estate Foreclosures and Averages for Selected Period 10. Amount of Required Reserves Based upon Various Levels of Assumed Rates of Title Transfer and Prepayment

s1 25 25 26

29

31

44

46 81 136

xvi

CHARTS

u . Reserve Factors by Year of Issue for Various Levels of Assumed Title Transfer and Prepayment 12. Amount of Required Reserves Based on Various Levels of Assumed Insurance Loss Rate 13. Reserve Factors by Year of Issue for Various Levels of Assumed Insurance Loss Rate 14. Amount of Required Reserves Based on Various Levels of Assumed Settlement Expenses 15. Reserve Factors by Year of Issue for Various Levels of Assumed Settlement Expenses 16. Amount of Required Reserves Based on Several Assumed Real Estate Cycle Patterns 17. Reserve Factors by Year of Issue for Various Assumed Real Estate Cycle Patterns

137 138 139 140 141 142 143

THE

MUTUAL MORTGAGE INSURANCE

FUND

CHAPTER

I

Statement of the Problem

S I N C E the establishment in 1934 of the Mutual Mortgage Insurance System by the Federal Housing Administration, there has been constant and genuine concern as to whether the System could become and remain self-supporting. While funds for its inauguration and early operations were supplied and its debentures were guaranteed by the federal government, it has been a perpetual hope of many observers that these actions would not result in any loss to the Treasury.

So far this hope has been realized. Funds advanced by the Treasury have been returned with interest; all expenses and losses have been paid out of earnings, and sizable reserves have been accumulated. But all of these achievements have been accomplished during a period of rising prosperity, defense, war, and postwar activities. In the course of its twenty years of operation, the housing market as a whole has been a rising one. In the midthirties vacancies in housing were high, rents and prices were low, and a large part of the resources for the production of housing was idle. Since then, shortages have developed, rents, prices, and the costs of construction have risen almost continuously, and construction resources have become fully if not over-employed. In such circumstances, no severe test of the whole System could be expected to develop. Before one can be confident that the System can stand on its own feet, it may have to be tested by an unfavorable general economic environment. While it has been eminently successful in a period of economic expansion and rising markets, the question persists as to whether it can pass through a depression of such magnitude as may occur without calling upon the Treasury to

4

STATEMENT OF THE PROBLEM

redeem its debentures when they fall d u e or to advance funds to pay its operating costs. It would have to do so if the reserves it had accumulated and the income it receives currently from fees and premiums, and from property disposals, were insufficient to meet these demands. Obviously, no one can foresee or predict with precision what demands may be made on the Federal Housing Administration's resources. T h e magnitude of such demands depends upon two principal factors: (1) the proportion of insured mortgage balances that mature in claims after foreclosure, and (2) the extent to which the price F H A is able to obtain for properties taken over fails to cover total costs incurred in acquiring the properties, operating them, and disposing of them. F H A ' s liabilities, apart from current operating costs, are limited to the payment of interest on debentures while they are outstanding and the redemption of debentures when they mature. T h e debentures of the Mutual Mortgage Insurance System have a term of twenty years, or one that extends three years beyond the date of maturity of the mortgage on account of which they are issued. T h e major liabilities of the M u t u a l Mortgage Insurance Fund, then, are long term. Whenever such a long-term liability is incurred by the issuance of debentures, an asset is acquired consisting of the property that was security for the mortgage. Aside from operating costs and interest on debentures, the F u n d will suffer a loss only when the price received for a property taken over is less than the amount for which debentures were issued (plus cash settlement) when the property was acquired and any operating deficit incurred while the property is held. A n d the F u n d does not sustain any realized loss until the property is disposed of. T h e r e would not necessarily be, therefore, any drain upon either the cash or the total reserves of the System if a period were encountered when the number of foreclosures and properties acquired multiplied. Such a development would merely cause a change in the balance sheet of the Fund. Liabilities would increase by the amount of debentures issued and assets by the amount at

STATEMENT OF THE PROBLEM

5

which the acquired properties were e n t e r e d on t h e books, plus any reserve established against the properties. D u r i n g the period for which the properties are held a n d the d e b e n t u r e s kept outstanding, F H A would presumably receive income f r o m p r e m i u m s o n account of those insured mortgages which are n o t in default, f r o m interest o n its reserves, a n d f r o m o p e r a t i n g the properties acquired. W h e n a property is sold, it may b r i n g a n e t sale price sufficient to meet all the expenses which have been incurred in taking it over, o p e r a t i n g it, a n d disposing of it, i n c l u d i n g r e d e m p t i o n of d e b e n t u r e s issued. O r , it may be sold at a price that fails to cover all these costs. T h e f u n c t i o n of the reserves of the System is to cover such losses. T h e reserves and resources of the M u t u a l Mortgage Insurance System are deemed to be a d e q u a t e w h e n they are sufficient to cover t h e losses which can be anticipated if F H A should e n c o u n t e r the most severe reversal that can reasonably b e expected to occur. T h e p r o b l e m of j u d g i n g the adequacy of the reserves arises from the fact that there is n o firm basis u p o n which estimates of the m a g n i t u d e of the a m o u n t s involved in each of the m a j o r items indicated above can be made. T h e r e are n o tested probabilities that can be depended u p o n for such estimates. Experience that can be reduced to relevant statistical tables is exceedingly scanty, and the circumstances that are believed to affect or d e t e r m i n e the rate of foreclosure, the rate of loss, the price at which properties can reasonably be expected to be sold, a n d so on, are all different f r o m what they were in the periods covered by the scanty available data. T h e reserves of the M u t u a l Mortgage Insurance System, therefore, c a n n o t be tested for adequacy with a precision a p p r o a c h i n g that with which reserves for the m o r e familiar a n d established types of insurance operation can be appraised. For m a n y of the factors which in the usual insurance operation are k n o w n , F H A has chosen amounts that are not firmly established by experience b u t which, in the light of such experience a n d data as are available, appear to be reasonable a n d w i t h i n the range of probability. N o one knows, for example, what rate of foreclosure may actually

6

STATEMENT OF THE PROBLEM

be experienced in the portfolio of insured mortgages in force. But there are some materials, elsewhere summarized, that indicate the rate which prevailed with respect to home mortgages through the course of the Great Depression of the thirties. T h e rate of foreclosure experienced at that time would be accepted by most reasonable men as one which could be used as an outside limit of a whole range of probabilities. Furthermore, there are few statistical materials that indicate, for example, how aggregate foreclosure rates have been distributed in the past by ratio of original loan to appraised value, or of the outstanding balance of the mortgage to the current value of the property. It is frequently remarked that in the thirties mortgages were foreclosed which represented, for the most part, not over 66% percent of the appraised value of the property when the loan was made, and most of these mortgages were not amortized. Many of the properties encumbered by such mortgages, however, also had junior liens. Can it be anticipated that all insured mortgages on which the outstanding balance represents more than the price which could be obtained for the property in the depths of a decline will be foreclosed? Or will foreclosures be distributed over a wide range of ratio of outstanding balance to market price? And if so, how? On these and other aspects of the major problem, reasonable alternative assumptions have to be made and appraised in order to determine the adequacy of reserves in various hypothetical situations. Similarly, in choosing a rate of loss to apply in foreclosure cases, or any other factor, we have to be content with the assurance that it represents a considered judgment as to what is a reasonable probability. T h e factors thus selected are used in constructing projected schedules of probable income and expenditures, and both of these series are discounted to the present in order to discover whether the present value of the stream of income is at least equal to that of expenditures. If it is not, reserves are established to supply the deficiency. The validity of the estimate of the adequacy of reserves depends upon the reasonableness of the choice of factors used in

STATEMENT OF THE PROBLEM

7

building up the schedules of future income and expenditures. T h i s study begins with an examination of the character of the insurance operation carried on in accordance with the legislation establishing and controlling the Mutual Mortgage Insurance System, of the volume and characteristics of the mortgage loans which have been insured, and of the operating experience of the System with particular reference to the flow of expense and income as affected by terminations and settlement of claims (Chapter I I ) . T h e r e follows an analysis of the major characteristics of the insured mortgages in force as of J u n e 30, 1955, including the distribution of outstanding balances by term of loan, age of loan, original loan-value ratio, ratio of outstanding balance to estimated current value of the property, and so on (Chapter I I I ) . Next, the actuarial method used by the F H A in calculating the reserve position of the Fund is described, and each of the principal factors used in making these calculations is stated (Chapter I V ) . T w o chapters are devoted to an evaluation of the major assumptions underlying the calculation by F H A of its reserve position. One of these deals with external factors, such as the pattern of the foreclosure cycle, loss and foreclosure rates, and the movement of house prices (Chapter V ) . T h e other examines internal factors, such as the use of debentures, the assumptions as to carrying costs and settlement expenses, and FHA's termination schedules (Chapter V I ) . Next, calculations are presented which test the effect upon the reserve position of the Fund of alternative assumptions with respect to several of the important factors which determine the projected flow of income and expense. T h e purpose of these calculations is to ascertain the relative importance to the reserve position of variations from the experience indicated by the factors chosen (Chapter V I I ) . In the final section (Chapter V I I I ) the study is summarized and major conclusions and recommendations are presented.

c h a p t e r

ii

Basic Legislation and Operating Experience i. BASIC LEGISLATION

was established in the summer of 1934 in accordance with the provisions of the National Housing Act approved by the President on June 27. 1 It was in Title I I of this Act that the Administrator was authorized to "provide a system of mutual mortgage insurance," and it is with the provisions of this Title and subsequent amendments, rules, and regulations and with the operations of the Mutual Mortgage Insurance System that this study is concerned. T h e Administrator (subsequent to the Executive Order of February 24, 1942, known as the Commissioner) was "authorized, upon application by the mortgagee, to insure . . . any mortgage offered to him within one year from the date of its execution 2 which is eligible for insurance . . . and to make commitments for the insuring of such mortgages prior to the date of their execution or disbursement thereon. . . ." 3 Such mortgages could cover only properties "upon which there is located a dwelling or dwellings designed principally for residential use for not more than four families. . . ." 4 There were specific limitations prescribed in the Act: T H E

FEDERAL

HOUSING

ADMINISTRATION

1. The mortgage could not exceed $16,000 in principal amount. 2. The amount of the mortgage could not exceed 80 percent of the "appraised value of the property as of the date the mortgage is executed." 3. The mortgage could not have a term in excess of twenty years. 1 Public L a w 479, 7 3 d Cong., approved J u n e 27, 1934, 48 Stat. 1246. 2 T h i s restriction on age of mortgage when presented for insurance was removed by the amendments of 1938. 3 Section 203. 4 Originally, mortgages on larger structures insured under the provisions of Section 207 were also included in the Mutual Mortgage Insurance System, but these were excluded by the amendments of 1938.

LEGISLATION AND

EXPERIENCE

9

Each of these three specific requirements has, since the passage of the Act, been changed by amendment. A n d during practically the whole life of the Federal Housing Administration the regulations have provided for the acceptance of mortgages for insurance up to the maximum permitted by the legislation. 5 A fourth specification was that the mortgage could bear an interest rate " (exclusive of premium charges for insurance) not to exceed 5 per centum on the amount of principal obligation outstanding at any t i m e . . . ." 6 T h e original regulations adopted in late 1934 permitted a maximum interest rate of 5 percent, and in some cases of 5 1 ^ percent. Before any significant volume of business was done, however, the 5i/£ percent rate was eliminated and the maximum interest permitted by regulation has, since J u n e 24, 1935, been not in excess of 5 percent, and since 1939 has been 41^ percent or less. T h e r e were six other characteristics of mortgages eligible for insurance. Each of these represents an attribute expressed in general terms, the specific definition of which was left to the Administrator's discretion. These attributes were as follows: 1. The mortgage must be held by a mortgagee approved by the Administrator as "responsible and able to service the mortgage properly." 2. It must contain or provide for "such initial service charges and appraisal and other fees as the Administrator shall approve." 3. It must contain provisions for complete amortization by "periodic payments by the mortgagor not in excess of his reasonable ability to pay as determined by the Administrator." 4. The mortgage must provide "in a manner satisfactory to the Administrator, for the application of the mortgagor's periodic payments . . . to amortization of the principal of the mortgage." 5. It must "contain such terms and provisions with respect to insurance, repairs, alterations, payment of taxes, default reserves, delinquency charges, foreclosure proceedings, anticipation of ma5 With the exception of the period from the outbreak of hostilities in Korea until April 2 1 , 1953, when maximum amount of mortgage, its term, and the loan-value ratio were controlled by regulation to conform with the provisions of Regulation X promulgated by the Board of Governors of the Federal Reserve System, and the period beginning J u l y 30, 1955, when downpayment requirements were increased by 2 percentage points and term was limited to 25 years. 6 Under certain circumstances the interest rate might be increased to 6 percent per annum "if the Administrator finds that in certain areas or in special circumstances the mortgage market demands it."

10

LEGISLATION

AND

EXPERIENCE

turity, additional and secondary liens, and other matters as the Administrator in his discretion may prescribe. . . ." 6.

It must be executed in connection with a project which the A d ministrator finds to be "economically sound."

These attributes are largely determinate of the soundness of the mortgage. T h e process of analysis of these attributes, therefore, and of selection or rejection of mortgages for insurance constitutes a vital feature of the Mutual Mortgage Insurance program. Banks, insurance companies, and other institutions subject to the inspection and supervision of a governmental agency, charitable or nonprofit organizations that submitted evidence of their responsibility and experience with mortgage investment, and other institutions with substantial capital funds whose principal activity consists of lending or investing in mortgages were either automatically approved by the Administrative Rules and Regulations or could be approved upon application to the Administrator. T h e Administrative Rules and Regulations contain a specific statement of the initial service charges and appraisal and other fees permitted by the Administrator. These have been modified from time to time to meet situations which have developed in the mortgage market. T h e Rules and Regulations have also specified the type of payment schedule which must be included in the mortgage instrument as well as provisions for the allocation of funds between the different items which they are intended to cover. T h e amortization schedule has been for most of the period of F H A operations a single one providing for the payment of a fixed sum, monthly, to interest and principal to amortize the mortgage completely within its term. A standard mortgage form has been promulgated for use in each jurisdiction. It provides, in addition, that the mortgagee shall collect in connection with each monthly payment a sum which it is estimated will accumulate sufficiently to pay insurance, taxes, and assessments when they fall due. For the purpose of determining whether the periodic payments required are not in excess of the reasonable ability of the mortgagor to pay, of deciding whether projects with respect to which mortgages are executed are economically sound, and of classifying

LEGISLATION AND EXPERIENCE

11

mortgages in accordance with the provisions of the Act by their risk, characteristics and terms, the Underwriting Division was established and the Underwriting Manual prepared. This Manual sets forth a system of analysis of each mortgage loan presented for insurance that has become known as the "risk-rating system." It has been recognized that this system has produced some uniformity in the analysis and grading of mortgages according to risk, notwithstanding the fact that this process has been carried on in a large number of field offices that operate under widely varying circumstances.7 T h e National Housing Act also provides for the collection of a minimum premium on the insurance written by FHA " (to be determined in accordance with the risk involved) which in no case shall be less than one-half of 1 per centum per annum of the original face value of the mortgage. . . . " T h e premium established by regulation has always been the minimum permitted by the Act and has been uniform for all mortgages insured. Originally, FHA was authorized to insure mortgages whose aggregate face amount was not over $2 billion, to be divided equally between new and existing construction.8 From time to time, as the current limitation was approached, this amount was increased until the Housing Act of 19549 consolidated the insurance authorization for all titles except Title I, Section 2, with a limit of $20,300 million. In the 1955 amendments to the National Housing Act 10 this authorization was reestablished at $25,500 million for all titles except Title I, Section 2, and Title VIII, Armed Services Housing. INSURANCE BENEFITS PROVIDED

The insurance protection offered to the mortgagee consists of an agreement by FHA to provide certain benefits in case of default T An investigation of variations in underwriting standards from office to office was undertaken in 1955 by the Subcommittee on Housing, Committee on Banking and Currency, and is reported in Progress Report, Report 1281, 84th Cong, 1st Session. 8 The term "new" construction is used in the legislation and regulations to refer to properties on which construction of the principal improvements is begun subsequent to a specified date, usually the date when application for insurance was made. All others are classified as "existing" construction. * Public Law 560,83d Cong., approved August z, 1954, 68 Stat. 590. 10 Public Law 345, 84th Cong., approved August 11, 1955. 69 Stat. 635.

12

LEGISLATION AND EXPERIENCE

and foreclosure of the mortgage. T h e mortgagee could avail himself of these benefits after foreclosure of an insured mortgage in default by transferring the property to F H A and making application for the insurance benefits. Upon the receipt of title the Administrator was authorized to issue to the mortgagee debentures of the Mutual Mortgage Insurance Fund in the amount of the unpaid balance of the mortgage plus any payments made by the mortgagee for insurance and taxes on the property during the period of default. These debentures were to become due and payable "three years after the ist day of July following the maturity date of the mortgage in exchange for which the debentures were issued." Debentures were to "bear interest at a rate determined by the Administrator at the time the mortgage was offered for insurance, but not to exceed 3 per centum per annum." Debentures issued in connection with mortgages insured prior to July i, 1937, 1 1 were "fully guaranteed as to principal and interest by the United States." In addition, it was provided that the Administrator should issue to the insured mortgagee a "certificate of claim" in an amount which, added to the amount of the debentures, would represent "the amount which the mortgagee would have received if, at the time of the conveyance to the Administrator of the property covered by the mortgage, the mortgagor had redeemed the property and paid in full all obligations under the mortgage and those arising out of the foreclosure proceedings." There was to be accrued to the face amount of the certificate of claim an annual increment at the rate of 3 percent. T h e certificate of claim was to be redeemed when the Administrator disposed of the property covered by the mortgage and only to the extent to which the proceeds of the sale of the property were sufficient, after the debentures with accrued interest and any net costs incurred by the Administrator in taking over, managing, and disposing of the property had been paid. If any further proceeds were realized from the sale of the propi i This date was first changed, by a joint resolution in 1937 (Public Resolution 6, 75th Cong., approved February 19, 1937, 50 Stat. 20), to July 1, 1939; and then by the amendments of 1938 (Public Law 424, 75th Cong., approved February 3, 1938, 5it Stat. 8) was stricken out, thus making all debentures guaranteed.

LEGISLATION

AND EXPERIENCE

ig

erty, they were to be "paid to the mortgagor of such property." T h u s the certificate of claim could not become a charge against the general assets or reserves of the Mutual Mortgage Insurance Fund, nor could any profit be realized by the Fund from the acquisition, management, and disposal of properties acquired after foreclosure. Mortgages insured were required to "be so classified into groups that the mortgages in any group shall involve substantially similar risk characteristics and have similar maturity dates." A l l premiums and other income received on account of a given mortgage were to be credited to a group account, and all expenses and losses incurred were to be charged against the group account. In addition, the Administrator was instructed to establish a "general reinsurance account" which was to be "available to cover charges against such group accounts where the amounts credited to such accounts are insufficient to cover such charges." A fund of $10 million was advanced by the Reconstruction Finance Corporation to establish the General Reinsurance Account. In terminating any group account, the Administrator was instructed to transfer from it to the General Reinsurance Account an amount equal to 10 percent of all premiums collected and credited to the group account if such an account were still available as a credit in the group account. After such a transaction had been provided for, any remaining balance in the group account was to be refunded to the mortgagors either when their mortgage was prepaid or when all the mortgages in the group account were amortized and the group account was terminated. T h u s the system was a "mutual" one in the sense that losses and expenses were to be spread over all mortgages insured, reserves were to be established to provide for losses in excess of what could be borne by individual group accounts, and premium payments collected in excess of those required for these purposes were to be refunded to the mortgagors. AMENDMENTS

In 1935 the Act was amended to authorize the collection of a special premium in case of prepayment of the mortgage and can-

14

LEGISLATION AND EXPERIENCE

cellation of the insurance by the mortgagee prior to maturity of the mortgage. 12 T h e amended Act also authorized the collection of such a premium not in excess of what the mortgagee would otherwise have been required to pay if the mortgage had continued to be insured until such maturity date. T h e Rules and Regulations fixed this premium charge at 1 percent of the amount of the original principal of the mortgage, but not more than the aggregate amount of premiums that would otherwise have been paid. From May, 1942, to 1948 this charge was waived as an inducement to prepayment as an anti-inflation measure. 13 Another amendment provided for including in the amount of debentures issued the interest on the unpaid principal balance from the date when foreclosure proceedings were instituted (or the property was otherwise acquired by the mortgagee) to the date of delivery of title to the Administrator. (This subsequently became authority to date debentures as of the date of institution of foreclosure proceedings.) It was specified that the rate of interest to be used in calculating this amount should be the rate provided for in the debentures. T h e next major amendments were approved February 3, 1938. 1 4 These amendments changed the maximum loan-value ratio and the maximum term of mortgages eligible for insurance. They also changed the basis for calculating the minimum premium, removed mortgages on multifamily properties from the Mutual Mortgage Insurance System, and made other significant changes in the operation of the System. On mortgages covering owner-occupied single-family houses on which construction was begun and which were approved for insurance after the date of the enactment of the amendments, or on which construction had been begun after January 1, 1937, and which had not been previously occupied, a maximum loan-value ratio of 90 percent was authorized. 15 A loan in excess of 80 percent, however, could not be insured unless the owner-occupant had paid 12 Public Law 76, 74th Cong., approved May 28, 1935, 49 Stat. 293. 13Ninth Annual Report of the Federal Housing Administration, 1942, p . 9. 14 Public Law .(24, 75th Cong., approved February 3, 1938, 52 Stat. 8. is Section 203(b) (2) ( B ) , 52 Stat. 10. T h i s subsection was repealed by Public Law 475, 81st Cong., approved April 20. 1950, 64 Stat. 48. T h e provision with respect to premiums expired by limitation J u l y 1, 1939.

LEGISLATION AND EXPERIENCE

15

at least 10 percent of the appraised value in cash or its e q u i v a l e n t a n d the principal a m o u n t of the mortgage c o u l d not exceed 90 percent of the first $6,000 a n d 80 percent of an additional $4,000 of value, that is, $5,400 plus 80 percent of the additional value u p to $4,000. Mortgages m e e t i n g the r e q u i r e m e n t s for the loan-value ratio of 90 percent and in the m a x i m u m a m o u n t of $5,400 could also have a longer term, not e x c e e d i n g 25 years; o n all such mortgages accepted for insurance o n or b e f o r e July 1, 1939, the p r e m i u m rate was set b y law at 14 of 1 p e r c e n t per a n n u m on the outstanding balance. T h e a m e n d m e n t w h i c h c h a n g e d the a m o u n t of the insurance p r e m i u m also p r o v i d e d that the p r e m i u m should be calculated o n the basis n o t of the face a m o u n t , as before, b u t on the a m o u n t of the p r i n c i p a l o b l i g a t i o n " o u t s t a n d i n g at any time w i t h o u t taking i n t o a c c o u n t d e l i n q u e n t p a y m e n t s or prepayments." T h e minim u m p r e m i u m authorized was " n o t less than an a m o u n t e q u i v a l e n t to one-half of one per c e n t u m p e r a n n u m nor more than an a m o u n t e q u i v a l e n t to one per cent p e r a n n u m " of this scheduled outstanding balance, except f o r the 90 percent, $5,400 mortgages insured prior to J u l y 1, 1939. T h e a m e n d m e n t also authorized the A d m i n istrator to " r e q u i r e the p a y m e n t of one or m o r e such p r e m i u m charges at the time the m o r t g a g e is insured at such discount rate as he may prescribe not in excess of the interest rate specified in the m o r t g a g e . " In c o n n e c t i o n with the 90 percent, $5,400 mortgages, the Administrator was authorized in settling claims to include in the debentures " a n a m o u n t not in excess of 2 per c e n t u m of the u n p a i d principal . . . but in n o event in excess of $ 7 5 " if default and foreclosure o c c u r r e d b e f o r e the m o r t g a g e had been amortized by at least 10 p e r c e n t of the v a l u e of the property w h e n the mortgage was insured. In 1948, amendments 1 6 were enacted which permitted insurance of a m o r t g a g e representing 90 percent of the value of the property u p to $6,300 (i.e., of the first $7,000 of value) , plus 80 percent of the n e x t $4,000. In addition, the m a x i m u m term of 25 years was permitted on all mortgages u p to $16,000 covering new construc18 P u b l i c L a w 901, 80th C o n g . , a p p r o v e d A u g u s t 10, 1948, 62 Stat. 1268.

i6

LEGISLATION AND EXPERIENCE

tion. On new single-family construction, mortgages up to $5,700 could be accepted for insurance, even though they represented 95 percent of the appraised value of the property, provided the mortgagor was the owner-occupant and paid 5 percent in cash, and such mortgages could have a term of as much as 30 years (Section 203 (b) (2) ( D ) ) . On these mortgages, also, the Commissioner was authorized to include in the amount of debentures issued up to two thirds of the costs of foreclosure, or $75, whichever was greater. Amendments approved April 20, 1 9 5 0 , " authorized insurance of mortgages for 95 percent of the first $7,000 of appraised value of the security plus 70 percent of the next $4,000 of appraised value, provided that the property was a single-family structure, built under F H A inspection, to be owner-occupied and that the owner-occupant had paid at least 5 percent in cash. Or, alternatively, if the property were new construction, to be owner-occupied and a single-family structure, a mortgage up to $6,650 (or $7,600 if the Commissioner found that amount acceptable) plus $950 for each additional bedroom in excess of two, provided the owneroccupant had paid at least 5 percent in cash, could be eligible. T h e maximum term of 30 years was retained. In 1953, the President was given authority to change the basic eligibility requirements. 18 On owner-occupied homes on which application for mortgage insurance was made before construction was begun, the President could authorize insurance of a 95 percent mortgage with a term up to 30 years if the mortgage was not over $12,000 and if the mortgagor had made a cash payment of 5 percent of the appraised value. 19 T h e amendments of 1954 20 increased the eligible mortgage amount on both new and existing homes to $20,000 for 1- and 2-family homes, $27,500 for 3-family properties, and $35,000 for 4-family structures. They also provided that for owner-occupied new construction properties, the mortgage amount might represent IT Public Law 475, 81st Cong., approved April 20, 1950, 6.) Stat. 48. 18 Public Law 94, 83d Cong., approved June 30, 1953. 67 Stat. 121. 18 T h i s provision was repealed by the Housing Act of 1954 (Public Law 560, 83d Cong., approved August 2, 1954, 68 Stat. 590). 20 Public Law 560, 83d Cong., approved August 2, 1954, 68 Stat. 590.

LEGISLATION

AND EXPERIENCE

17

95 percent of the first $9,000 of value (90 percent for existing construction) and 75 percent of the amount in excess of $g,ooo. (At the discretion of the President this amount can be increased to $10,000.) T h e maximum term of the eligible mortgage was fixed at 30 years (or three quarters of the remaining economic life of the property), and the mortgagor must have paid in cash or its equivalent 5 percent of the appraised value. Special terms under Section 203 were authorized for mortgages on owner-occupied homes for victims of major disasters, where the mortgage might be for 100 percent of the appraised value, provided the amount of the mortgage was not in excess of $7,000. Authority for such insurance was previously provided under Title I, Section 8. Special provision was made also for mortgages on homes "in an area where the Commissioner finds it is not practicable to obtain conformity with many of the requirements essential to the insurance of mortgages on housing in built-up urban areas." In such an area the Commissioner could waive the requirement of a 5 percent down payment from the borrower's own resources when the amount of the mortgage was not in excess of $6,650. T h e Commissioner is obliged in such cases also to find that "the project with respect to which the mortgage is executed is an acceptable risk . . ." instead of finding it "economically sound." These amendments also abolished the group accounts and the General Reinsurance Account. In their stead, the General Surplus Account and the Participating Reserve Account were established. T h e Commissioner was instructed to transfer to the General Surplus Account all the assets from the General Reinsurance Account, and to the Participating Reserve Account "from the various group accounts . . . an amount equal to the aggregate amount which would have been distributed [to the mortgagors as of] June 30, 1954, if all outstanding mortgages on such group accounts had been paid in full on such date. . . ." Remaining balances (if any) in the group accounts were transferred to the General Surplus Account. Subsequently, net income and losses were to be credited or charged to the two new accounts "in such manner and amounts as the Commissioner may determine to be in accord with sound actuarial and accounting practice."

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EXPERIENCE

T h e Commissioner was also authorized to distribute to the mortgagor "a share of the Participating Reserve Account in such manner and amount as the Commissioner shall determine to be equitable and in accordance with sound actuarial and accounting practice . . . " when a mortgage was paid and the insurance obligation terminated. Another amendment authorized the insurance of advances made to the mortgagor during the term of the mortgage for the improvement or repair of the property, "pursuant to an 'open end' provision in the mortgage. . . ." T h e amount advanced may be taken into account in determining the amount of the debentures and certificate of claim issued by the Commissioner upon receiving title to the property. T h e amount of advance insured may not exceed the amount by which the original mortgage has been amortized "unless the mortgagor certifies that the proceeds of such advance will be used to finance the construction of additional rooms or other enclosed space as a part of the dwelling." Another limitation on such advances is that they may cover only "such improvements or repairs as substantially protect or improve the basic livability or utility of the property involved. . . ." SUMMARY

T h u s , over twenty years of operation there have been basic changes in the significant characteristics or attributes, in the "eligibility requirements," of the mortgages which the Federal Housing Administration is authorized to insure. Following are the most important of these changes: T h e maximum mortgage amount has increased from $16,000 to $35,000; the maximum loan-value ratio from 80 to 95 percent (and in disaster loans 100 percent) . T h e maximum term has increased from 20 to 30 years. T h e minimum insurance premium has been reduced from i/2 of 1 percent per annum of the original face amount of the mortgage to i/i of 1 per cent of the outstanding balance. Prior to 1954, when the requirements for existing construction were liberalized, changes in the maximum loan-value ratio and in the maximum permissible term limited these requirements to include only new construction, and in some instances to owner-

LEGISLATION AND

EXPERIENCE

21

2,500

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0 CHART I. AMOUNT OF MORTGAGES INSURED UNDER SECTION 203, N A T I O N A L HOUSING A C T , FROM Y E A R TO YEAR, ON N E W AND EXISTING CONSTRUCTION

occupied properties. Insurance benefits have been somewhat enlarged by permitting the inclusion of two thirds of the foreclosure costs, or $75, whichever is greater, and by including in the debentures interest on the outstanding balance from the date of the institution of foreclosure proceedings. All these changes tend to place more strain upon the reserves and resources of the System. On the other hand, the change in treatment of reserve and surplus accounts allows quicker adjustment Of resources to potential liabilities, especially among different groups of insured mortgages. 2. O P E R A T I N G

EXPERIENCE

V O L U M E A N D C H A R A C T E R I S T I C S OF MORTGAGES INSURED

During the span of twenty years F H A , through the Mutual Mortgage Insurance System, has insured over 2,866,000 mortgages with an aggregate face value of over $18,250 million. T h e number and amount of mortgages insured each year are given in T a b l e 2,

22

LEGISLATION

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EXPERIENCE

and diagramed on Chart 1, which shows the distribution between new and existing construction. "New construction" refers to properties approved for insurance prior to the beginning of construction. Beginning with the insurance of 23,397 mortgages in 1935, with an aggregate principal amount of nearly $94 million, the volume of insurance increased rapidly until 1941, when it reached nearly 199,000 mortgages in the amount of nearly $877 million. T h e largest annual increases in the prewar period, both absolute and in percentages, were in 1936, in 1939, and in 1941. T h e increase in 1936, the second year, was in both new and existing construction. Both in 1939 and in 1941 increases were in mortgages on new construction. In fact, from 1938 to 1939 there was some decline in existing construction which was more than compensated for by the increase of $234 million, or over 100 percent, in the volume of new construction. Of the increase of over $140 million in 1941, $132 million was in new construction. Then came World War II. T h e war brought with it the rationing of building materials and the licensing of new construction. Title VI was added to the National Housing Act in order to facilitate the provision of housing in areas in which the authorities considered it essential for the prosecution of the defense and war programs, and during the war and until 1948 practically all the mortgages insured on new construction were insured under the provisions of that Title. 2 1 These operations are not within the scope of this study. However, the volume of loans insured on existing construction increased fairly steadily during this entire period, rising from $183 million covering 46,535 dwelling units in 1941 to $376 million in 1947 covering over 70,000 units. In 1948 total volume practically doubled, rising to $880 million, with the major portion of this volume, $665 million, still covering existing construction. But from 1948 to 1949, the increase in total volume from $880 million to $1,854 million was the most spectacular to this date, and $753 million of this increase was in new construction which covered, in the year 1949, over 132,000 dwelling units. 21 Authority to insure home mortgages on new construction under the provisions of T i t l e VI expired April 30, 1948.

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