FHA reserves below limit : Loan defaults take a toll on the housing agency, an audit shows.

The Federal Housing Administration’s cash reserves have shrunk to a level far below what is required by law, and the agency could need taxpayer funding if worst-case scenarios play out, according to an independent audit.

The audit examined the reserves the agency must set aside to deal with unexpected losses in its flagship home-buying program, which has played a key role in supporting the housing market.

As of Sept. 30, those reserves had an estimated value of $3.6 billion, a sharp drop from $12.9 billion a year earlier, the audit found. The current total represents 0.53% of all outstanding single-family-home loans insured by the FHA, down from 3% a year earlier and well below the 2% portion set by law. This is the first time the reserves have fallen under that threshold since 1994.

The FHA does not make loans; it insures the lenders it works with against default if loans go bad. The agency has long self-financed its operation by collecting insurance premiums paid by borrowers.

The default rate on FHA-insured loans climbed in recent years as housing prices tumbled and the economy soured.

The FHA can hike its insurance premiums or increase required down payments to boost reserves to the 2% level.

Should the reserves run out, the government would have to make good on any claims. That would be a first for the FHA since its creation in 1934.

The auditors concluded that the agency would remain self-sustaining under five of six economic scenarios examined, and could possibly even rebuild its financial cushion in the near future.

But under the audit’s most pessimistic assumptions, the reserves would run dry in fiscal year 2011, requiring a $1.6-billion cash infusion from the Treasury. Under this scenario, interest rates plummet to 3% and trigger a significant wave of refinancing, with most of those borrowers refinancing out of FHA-backed loans, depriving the agency of insurance premiums. FHA officials said that scenario was unlikely.

Housing and Urban Development Secretary Shaun Donovan acknowledged that the FHA’s current reserves were too thin.

“It is absolutely critical going forward to build that cushion back up,” he said.

Donovan said newer loans were expected to have much more modest claims, and belong to more creditworthy borrowers than the FHA has served in the past.