The nationwide decline in house prices has created a vacuum in the U.S. mortgage market. Private financing for home loans has all but dried up and the U.S. government is now guaranteeing almost every new mortgage. Fannie Mae and Freddie Mac have received most of the media’s attention, but policy makers need to focus on the third leg of the housing-support stool: the Federal Housing Administration.

The FHA has some major accounting problems. Left unaddressed, they could spook the markets, lead the FHA to seek a federal cash infusion and further enrage taxpayers. These outcomes can be avoided -- but only if policy makers are more transparent about the risks involved in guaranteeing mortgages.

The FHA provides private lenders with a 100 percent guarantee against defaults on home mortgages that meet certain underwriting criteria, such as a minimum down payment and credit score. Traditionally, the FHA has served first-time homebuyers and low- to moderate-income families who pay an insurance premium for this loan guarantee.

As private-financing options have disappeared, the role of the FHA has grown. Its market share has increased to about 30 percent today from 3-4 percent in 2007. That’s because the agency is now practically the only game in town, accepting borrowers with down payments of as low as 3.5 percent. As the last few years have made clear, sizable down payments -- or “skin in the game” -- are the key to avoiding defaults in the near term and to achieving a stable housing market in the long term.

FHA’s Bottom Line

So how has the FHA fared financially in serving borrowers with low down payments? As the housing bubble burst in 2007, and the number of mortgage-related defaults started to climb, the FHA’s capital reserves declined to $3.5 billion from $22 billion.

This means that the FHA is on the verge of requiring a bailout to support its outstanding mortgage guarantees, which are projected to exceed $1 trillion in 2011.

The credit quality of FHA lending can be improved with better underwriting standards, such as requiring higher down payments and premiums. Unfortunately, it’s difficult to sound the alarm because flawed accounting measures show that new FHA loans will be profitable for the government. As a general rule, each year the government sets insurance premiums high enough to give the appearance that they will more than cover any losses from homeowners who default.

Budgetary Illusion

But no one should take comfort in the FHA’s projected profit. It’s purely a budgetary illusion.

According to the Federal Credit Reform Act of 1990, federal-budget analysts must strip out any costs that the government incurs when it bears market risk in guaranteeing loans, including mortgages. Market risk is the likelihood that loan defaults will be higher during times of economic stress and that those defaults will be more costly. Excluding costs for market risk is particularly irresponsible at a time when foreclosure rates are elevated and doubts remain over whether home prices will fall further.

If the rate of loss on the FHA’s new guarantees ends up higher than expected, that will probably be because the overall economic recovery has stalled. In such a scenario, any entity guaranteeing mortgages -- be it the taxpayer-backed FHA or a private company -- will suffer bigger-than-expected losses.

Taxpayer Risks

Skeptics might dismiss warnings about the FHA’s ballooning market share. They would defend the government’s current accounting rules and argue that the growth in FHA loans (at the expense of private-sector lending) is a perfectly logical policy goal. In their view, the government is a more efficient provider of mortgages because it can borrow at lower interest rates than any private financial institution.

What’s missing from this analysis is that the government enjoys low borrowing costs only because it can shift market risk onto taxpayers.

Put another way, there is only one reason why investors lend to the government at lower rates than they charge private mortgage insurers, even if they all insure identical mortgages: The government can call on taxpayers to repay bondholders if FHA loans result in higher-than-expected defaults. Few taxpayers would choose to bear that risk free of charge.

Rewriting the Rules

Some lawmakers understand this and are working to change the government’s accounting rules to include market risk. At the request of Representative Paul Ryan, a Republican from Wisconsin, the Congressional Budget Office recently took the official budget estimate for new FHA loans and added in the cost of market risk that taxpayers bear in guaranteeing the mortgages.

Under this more comprehensive methodology, the CBO determined that FHA loans would swing to a loss of $3.5 billion from a projected profit of $4.4 billion next year. In a 10-year budget window, this could mean a difference of $50 billion to $70 billion, depending on market conditions.

Accounting issues often seem arcane or even trivial. But the growth in FHA lending has turned a seemingly small problem into a large taxpayer vulnerability. The current accounting rules will also make it harder politically to shift some of the housing market back to the private sector. Congress should own up to the full costs and risks that taxpayers bear to guarantee mortgages.

The last time Congress delayed action in this area, taxpayers got stuck bailing out Fannie and Freddie -- at a cost of more than $160 billion and rising.

(Jason Delisle is a project director at the New America Foundation. Christopher Papagianis is managing director of Economics21 and a former special assistant for domestic policy to President George W. Bush.)

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To contact the writers of this article: Jason Delisle at delisle@newamerica.net and Christopher Papagianis at papagianis@gmail.com.

To contact the editor responsible for this article: Timothy Lavin at tlavin1@bloomberg.net or.