Faced with dwindling reserves at the Federal Housing Administration (FHA), Department of Housing and Urban Development (HUD)Secretary Shaun Donovan said he is "actively looking" at increasing the government mortgage insurance program's premiums and down-payment requirements.

Depending on the magnitude, such changes could make it harder for borrowers to get FHA loans — and as a result could also drive down volumes for a product that has sustained many lenders through the downturn.

It's clear that the FHA needs to do something to replenish its reserves. The agency's long-awaited annual audit, released Wednesday, showed that in the fiscal year that ended Sept. 30 its capital reserve ratio had fallen to 0.53% — well below the congressionally mandated minimum of 2%.

Donovan said he is trying to strike a balance between its need to rebuild cushion and its mission to support the housing market.

"Raising premiums would make loans more expensive to homebuyers, and that will have some negative effects that we need to look at," he said in an interview. "Who does that exclude? Does it threaten the potential recovery that we've seen? On the other hand, it does help to raise our reserves."

Currently FHA borrowers pay an up-front premium of 1.75% of the mortgage amount for home-purchase loans and 1.5% for refinancings. They also pay a monthly premium of 0.5% to 0.55% a year, depending on how much equity the borrower has in the home.

The FHA's minimum down payment is 3.5%; Rep. Scott Garrett, R-N.J., has introduced legislation that would increase it to 5%.

Since the subprime market imploded a few years ago, the FHA has been the only game in town for borrowers who can put down only a small amount, and the agency's volume has surged. In fiscal 2009 the FHA insured almost 30% of all purchase loans and 20% of refinancings.

The agency's losses have mounted as a result of such growth, though HUD tried to downplay the effect on its capital. It emphasized that the capital reserve ratio is a measure of reserves above and beyond what it would need to cover anticipated claims. The FHA's $31 billion of reserves amount to more than 4.5% of its insurance in force; after paying forecasted claims, the FHA would have $3.6 billion left over, HUD said.

Observers are skeptical.

"The assumptions they are using continue to be too optimistic, which is leading to this scenario where they say we still have some capital left," said Ed Pinto, a consultant and a former chief credit officer at Fannie Mae. "I think they will go into the negative."

Donovan reiterated that the insurer would not need a bailout, but said that if the FHA failed to meet its obligations it would have to ask for an additional appropriation from Congress, an action it has never had to take.

Rodney Anderson, the executive director and managing partner of Rodney Anderson Lending Services, a unit of the Dallas lender Everett Financial, said raising premiums would be far preferable to increasing the required down payments.

"Every time FHA tightens its requirements, fewer people qualify to buy a home," he said. "If they raise the down-payment requirement, they could kill 20% of the housing market."

But the cost of FHA insurance has fallen dramatically in the past 20 years from 3.8%, Anderson said. Because the upfront cost is financed into the loan, most borrowers would pay perhaps $12 more per month if the FHA raised premiums, he said.

Pinto, a vocal critic of the FHA, took the opposite view. He said he supported raising the down-payment requirement. "Under this environment it should be 10%."

But Pinto does not support raising premiums, "because at some point you get to diminished returns," he said, "and as you raise the premiums you are getting a less creditworthy borrower," since the stronger ones will go elsewhere. "I think they have reached the point where you can't raise the premium any further."

Howard Glaser, a consultant and former HUD official, said the FHA's capital challenge highlights the government's central role in the housing market today.

"Today is an acknowledgement they are and will continue to be under stress. … A lot of the debate on FHA is less about risk and more about ideology," Glaser said. "What is the proper federal role in the mortgage market? I think today FHA kicks off that debate."

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