Unsafe leverage building up (again!)

Here’s an interesting piece re the systemic risk being created by FHA loans.

For those just joining us: FHA is a program through which the federal government insures banks against losses on loans for 1-4 unit properties, allowing banks to make loans up to 97.5% of the purchase price and to people with beat-up credit.

During the worst days of the recession, in 2009-2011, FHA was incredibly important. It was the only way a lot of people could buy and, if you used it correctly, was an incredible source of leverage. (For example: I have clients – hi N&J – who bought a duplex is Echo Park with 5% down and have probably made $200-250k on their $35k investment in a few years.)

At the time, I was a big cheerleader for the FHA program. The reason was pretty simple: Using lots of leverage is always pretty risky, but it’s least risky when prices are low.

As prices have increased over the past few years, it has become riskier and riskier to loan up to 95-97.5% LTV, because the chance of a price drop putting the home underwater is high.

FHA was a great lender of last resort during this past crisis. But, now that those loans are risky and there is private capital in the marketplace, the government should absolutely not be in the business of making very high-leverage loans to people with bad credit.

Let private capital take that risk (and be compensated for it!), not the taxpayers.