It's as bad as many thought. The results of the Federal Housing Administration's (FHA) annual independent audit were released yesterday after being delayed for about a week. The Federal mortgage insurer's cash reserves have fallen to 0.53%, well below the 2% limit set by Congress.

If you’re a regular reader of this blog you'll know that we've been documenting the FHA's troubles for most of the year, and have at times referred to them as The New Subprime, and the probable recipient of the “Next Taxpayer Bailout.

For months now, even the FHA knew its 2009 levels weren't going to clear the 2% mark, but Federal officials continue to down-play the audit's results:

Administration officials said the losses, while large, come as the FHA is helping to heal the housing market. That reserve account is playing exactly the role that Congress intended it to, said Shaun Donovan, secretary of Housing and Urban Development.

Mr. Donovan, whose agency oversees the FHA, also played down the idea that the FHA would need a federal subsidy, except under the most severe economic scenarios. That is because the FHA still has around $30 billion in capital to pay for losses.

While agencies like HUD continue to push aside the idea that the FHA will require a bailout, the fact is: the current housing market depends so heavily on the insurer that the contrary is more likely to happen.

There's No Going Back Now

Washington is doing everything in its power (i.e. extending the homebuyer tax credit, Fed programs to keep rates low) to generate new demand for housing.

When the housing market collapsed and conforming-loan requirements became even more strict, borrowers turned to the lax lending standards available with FHA financing. The administration’s book of business increased by 75% in fiscal year 2009. Due to their massive market presence, one could argue that the FHA is keeping marginal buyers in the market in order to support housing. Letting the agency falter might destabilize any foundation that has been built so far.

It Could Only Get Worse

With default rates of 24% and 20% expected for FHA loans insured in 2007 and 2008, respectively, there’s no reason to believe that these types of figures won’t exist for 2009.

From the WSJ:

The FHA has been particularly exposed to the economic downturn, because it allows borrowers to finance purchases with down payments as low as 3.5%. In a declining housing market, that means borrowers could soon end up owing more than their homes are worth, and raises the risk of default when borrowers face job loss or other hardships. More than half of all FHA-insured loans outstanding had an initial loan-to-value of 95% or more.

Should the FHA Change?

We’re not surprised that officials at both HUD and the FHA are mum on the possibility of a taxpayer bailout given current consumer sentiment. A proposal by one New Jersey lawmaker designed to reduce the number of underwater homeowners was to raise the FHA’s downpayment requirement to 5%.

Market conditions aren’t about to change anytime soon. It’s very difficult for borrowers (especially in this economic climate) to save as much as 10% to 20% for a downpayment on a Fannie or Freddie loan. Why would they when they could get financing for as little as 3.5% down on an FHA-backed loan? Should the FHA correct its lending model to keep pace with the current market? If it wants to remain solvent, it may have to do so.

FHA Commissioner David Stevens says changing would be a mistake: the “biggest mistake” that the agency could make would be to “overcorrect.”

What do you think — is it time for the FHA to change?

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