[Senate Hearing 107-]
[From the U.S. Government Publishing Office]



                                                       S. Hrg. 107- 276


    HEALTH OF HUD'S FEDERAL HOUSING ADMINISTRATION'S INSURANCE FUND

=======================================================================

                                HEARING

                               before the

               SUBCOMMITTEE ON HOUSING AND TRANSPORTATION

                                 of the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED SEVENTH CONGRESS

                             FIRST SESSION

                                   ON

      THE FINANCIAL STATUS OF THE DEPARTMENT OF HOUSING AND URBAN 
    DEVELOPMENT'S FEDERAL HOUSING ADMINISTRATION'S MUTUAL MORTGAGE 
                             INSURANCE FUND

                               __________

                             MARCH 19, 2001

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs

                                _______

                  U.S. GOVERNMENT PRINTING OFFICE
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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                      PHIL GRAMM, Texas, Chairman

RICHARD C. SHELBY, Alabama           PAUL S. SARBANES, Maryland
ROBERT F. BENNETT, Utah              CHRISTOPHER J. DODD, Connecticut
WAYNE ALLARD, Colorado               TIM JOHNSON, South Dakota
MICHAEL B. ENZI, Wyoming             JACK REED, Rhode Island
CHUCK HAGEL, Nebraska                CHARLES E. SCHUMER, New York
RICK SANTORUM, Pennsylvania          EVAN BAYH, Indiana
JIM BUNNING, Kentucky                ZELL MILLER, Georgia
MIKE CRAPO, Idaho                    THOMAS R. CARPER, Delaware
JOHN ENSIGN, Nevada                  DEBBIE STABENOW, Michigan
                                     JON S. CORZINE, New Jersey

                   Wayne A. Abernathy, Staff Director

     Steven B. Harris, Democratic Staff Director and Chief Counsel

                Sherry E. Little, Legislative Assistant

              Melody H. Fennel, Professional Staff Member

         Jonathan Miller, Democratic Professional Staff Member

                       George E. Whittle, Editor

                                 ______

               Subcommittee on Housing and Transportation

                    WAYNE ALLARD, Colorado, Chairman

                JACK REED, Rhode Island, Ranking Member

RICK SANTORUM, Pennsylvania          THOMAS R. CARPER, Delaware
JOHN ENSIGN, Nevada                  DEBBIE STABENOW, Michigan
RICHARD C. SHELBY, Alabama           JON S. CORZINE, New Jersey
MICHAEL B. ENZI, Wyoming             CHRISTOPHER J. DODD, Connecticut
CHUCK HAGEL, Nebraska                CHARLES E. SCHUMER, New York

                      John Carson, Staff Director

             Tewana Wilkerson, Deputy Legislative Assistant

                                  (ii)


                            C O N T E N T S

                              ----------                              

                         MONDAY, MARCH 19, 2001

                                                                   Page

Opening statement of Senator Allard..............................     1

Opening statements, comments, or prepared statements of:
    Senator Reed.................................................     2
    Senator Corzine..............................................     3
        Prepared statement.......................................    21

                               WITNESSES

Thomas J. McCool, Managing Director, Financial Markets and 
  Community Investment, U.S. General Accounting Office; 
  accompanied by: Mathew Scire, Stanley Czerwinski, Jay Cherlow, 
  and Christine Bonham...........................................    21
    Prepared statement...........................................    46

                                 (iii)

 
    HEALTH OF HUD'S FEDERAL HOUSING ADMINISTRATION'S INSURANCE FUND

                              ----------                              


                         MONDAY, MARCH 19, 2001

                               U.S. Senate,
  Committee on Banking, Housing, and Urban Affairs,
                Subcommittee on Housing and Transportation,
                                                    Washington, DC.

    The Subcommittee met at 1 p.m., in room SD-538 of the 
Dirksen Senate Office Building, Senator Wayne Allard (Chairman 
of the Subcommittee) presiding.

           OPENING STATEMENT OF SENATOR WAYNE ALLARD

    Senator Allard. I want to call the Subcommittee on Housing 
and Transportation to order. I would like to welcome each of 
you to this hearing of the Housing and Transportation 
Subcommittee. Today's hearing will focus on the health of the 
FHA's Mutual Mortgage Insurance Fund.
    Over the last 2 years, this Subcommittee has heard various 
proposals to spend down the so-called FHA reserve. However, 
before any action is taken, Congress must establish, with the 
help of the General Accounting Office and other accounting 
experts, the safe and the adequate levels of the FHA's 
reserves. Only then should we address a potential surplus.
    FHA provides an important program for first-time low and 
moderate income and minority homeowners. These families should 
not be overcharged FHA premiums. Premiums in excess of an 
amount necessary to maintain an actuarially sound reserve ratio 
in the FHA's Mutual Mortgage Insurance Fund can only be 
characterized as a tax on homeownership.
    On the other hand, Congress, in conjunction with the 
Department of Housing and Urban Development, must ensure that 
FHA stays healthy, so that it can continue to function as an 
important source of homeownership.
    Congress has previously determined that a capital reserve 
ratio of 2 percent of the MMI Fund's amortized insurance-in-
force is necessary to ensure the safety and the soundness of 
the MMI Fund. However, it has never been clear how the Congress 
arrived at that number.
    Last year, the accounting firm of Deloitte & Touche found 
that the capital adequacy ratio of the Fund was 3.66 percent, 
far in excess of the Congressionally mandated goal of 2 
percent. So while it is important for Congress to know the 
capital adequacy ratio, it is just as important to understand 
the implications of the ratio and whether a 2 percent reserve 
is sufficient.
    In order to get a better handle on this issue, I requested 
that the GAO look into the matter. Today, the GAO is releasing 
a report that finds the current reserve is adequate to 
withstand all but the most serious economic scenarios. However, 
GAO also sounds a note of caution. Economic conditions can 
quickly change, thus changing the value of the Fund and the 
level of the reserve.
    I believe that the most prudent course of action is for the 
Congress to increase the reserve requirement to either 2.5 
percent or 3 percent of the insurance-in-force and then direct 
the Department to reinstate distributive shares whenever the 
reserve fund becomes excessive.
    Later this week, I will be introducing legislation that 
would require partial rebates of FHA's mortgage insurance 
premiums to certain mortgagors upon repayment of their FHA-
insured mortgages. My legislation takes the cautious approach 
of providing rebates only when the reserve ratio is in excess 
of 3 percent, or 150 percent of the reserve level mandated by 
Congress. If the reserve ratio drops below 3 percent, 
distributive shares would be suspended. Of course, this rebate 
would be based on sound actuarial and accounting practice, 
since the major reason for the strength in the Fund is the fact 
that we are experienced a near-perfect economy in recent years.
    The FHA's single-family mortgage program was designed to 
operate as a mutual insurance program where the homeowners were 
granted rebates on excess of premiums required to maintain 
actuarial soundness. This rebate program was suspended at the 
direction of Congress in 1990, when the MMI Fund was in the 
red, and with the intent that the payment of distributive 
shares or rebates would resume when the Fund was again 
financially sound.
    With a sufficient capital reserve ratio, it is time to 
resume rebates and return the MMI program to its prior status 
as a mutual insurance fund.
    Our witnesses today will be Mr. Thomas McCool, Managing 
Director of the Financial Markets and Community Investment Team 
at the U.S. General Accounting Office. Mr. McCool is 
accompanied by Jay Cherlow, Christine Bonham, Mathew Scire, and 
Stanley Czerwinski.
    Welcome.
    It is good to see you again, Stan. I look forward to 
hearing from all of you.
    We will go ahead and ask if there are any other statements 
from Members of the Subcommittee.
    Senator Reed.

             OPENING COMMENTS OF SENATOR JACK REED

    Senator Reed. Thank you very much, Mr. Chairman. I am 
looking forward to working with you on this issue and a number 
of other issues as we go forward with this Subcommittee.
    Gentlemen, thank you also for being here today as 
witnesses.
    The FHA's Mutual Mortgage Insurance Fund has proven to be 
very robust over the last several years. It is a source of 
support for the housing sector of our economy. Indeed, the 
FHA's insurance loans go to first-time homebuyers, primarily, 
and also significantly help minority communities, African-
Americans and Hispanics, to be homeowners. All of these are 
very laudatory.
    One interesting aspect of the present economy is the fact 
that so many communities are facing a shortage of affordable, 
decent housing, and we are all trying to find ways in which we 
can increase the housing stock. The FHA's reserve fund might 
provide such a mechanism.
    As you know, and as the Chairman explained, you have looked 
closely at the reserve fund. It is required to maintain a 2-
percent capital ratio. It is doing quite a bit better than that 
at the moment. It is somewhere between 3.2 percent, your 
estimate, and 3.66 percent, the Deloitte & Touche estimate. 
This is a good sign. Now the question is, what can we do with 
this excess surplus, if you will.
    As you know, many Senators, including Senator Kerry, 
Senator Sarbanes, and myself have urged that we take a portion 
of this reserve and use it to capitalize an Affordable Housing 
Trust Fund for building both rental and homeownership housing. 
And given what I see in my State of the dire need for 
affordable, decent housing, I think that is a very important 
priority which we should support.
    My colleague, Senator Allard, has just explained his 
proposal to rebate premiums.
    I look forward to the testimony today, not only to examine 
the soundness of the Fund, but also to be more fully informed 
about the possible use of its proceeds.
    I thank the Chairman for calling this hearing.
    Senator Allard. Thank you.
    Senator Corzine.

           OPENING COMMENTS OF SENATOR JON S. CORZINE

    Senator Corzine. Thank you, Mr. Chairman.
    Mr. McCool, I appreciate you and your staff joining us. 
This is an issue I have a great interest in, mainly along the 
lines that Senator Reed talked about.
    Affordable housing in New Jersey is one of the most 
important topics on our agenda, and certainly, we would like to 
understand the potential use of the Fund for that purpose.
    But I would also make the other observation that we have 
come through a decade of robust economic times and we are now 
facing something that may be slightly more discouraging. One 
wonders about the adequacy of a Fund under different 
circumstances. I certainly want to hear your views with regard 
to it.
    I look forward to the discussions at this hearing and going 
forward, and I thank you for having this hearing, Mr. Chairman.
    Senator Reed. Mr. Chairman, may I make one amendment to my 
statement?
    Senator Allard. Yes, you may.
    Senator Reed. I greeted the gentlemen, which is testimony 
to my poor peripheral vision.
    [Laughter.]
    Welcome, Ms. Bonham.
    [Laughter.]
    Senator Allard. We will go ahead and start the panel.
    Mr. McCool, it is my understanding that you are going to 
give the testimony this morning.

             OPENING STATEMENT OF THOMAS J. McCOOL

                       MANAGING DIRECTOR

           FINANCIAL MARKETS AND COMMUNITY INVESTMENT

                 U.S. GENERAL ACCOUNTING OFFICE

ACCOMPANIED BY: MATHEW SCIRE, STANLEY CZERWINSKI, JAY CHERLOW, 
                      AND CHRISTINE BONHAM

    Mr. McCool. Mr. Chairman, Members of the Subcommittee, we 
are here today to discuss the results of our analysis of the 
financial health of the Mutual Mortgage Insurance Fund of the 
Department of Housing and Urban Development's Federal Housing 
Administration. Through the MMI Fund, the FHA operates a 
single-family insurance program that helps millions of 
Americans buy homes, particularly low-income families and those 
without cash for down payments.
    For most of its history, the Fund was relatively healthy; 
however, in fiscal year 1990 the Fund was estimated to have a 
negative economic value, and its future was in doubt. To help 
place the Fund on a financially sound basis, Congress enacted 
legislation that required the Secretary of HUD to, among other 
things, take steps to achieve a capital ratio of 2 percent by 
November 2000, and to maintain or exceed that ratio at all 
times thereafter. As a result of the 1990 housing reforms, the 
Fund must not only meet capital ratio requirements, it must 
also achieve actuarial soundness; that is, the Fund must 
contain sufficient reserves and funding to cover estimated 
future losses resulting from the payment of claims on 
foreclosed mortgages and administrative costs. However, the 
legislation does not define actuarial soundness.
    The 1990 FHA reforms required that an independent 
contractor conduct an annual actuarial review of the Fund. 
These reviews have shown that during the 1990's, the estimated 
economic value of the Fund, its capital resources plus the net 
present value of future cash flows, grew substantially. You can 
see by the chart in my prepared statement that by the end of 
fiscal year 1995, the Fund attained an estimated economic value 
that slightly exceeded the amount required for the 2-percent 
capital ratio. The gray represents 2 percent of the unamortized 
insurance-in-force and the white represents the value of the 
Fund.
    Since that time, the estimated economic value of the Fund 
continued to grow and always exceeded the amount required for a 
2-percent capital ratio. In the most recent review, Deloitte & 
Touche estimated the Fund's economic value at about $17 billion 
at the end of fiscal year 2000. This represents about 3.51 
percent of the Fund's insurance-in-force.
    Mr. Chairman, you asked us to estimate the value of the 
Fund at the end of fiscal year 1999, given expected economic 
conditions, and compare our estimate to the estimate of the 
value of the Fund reported by HUD for that year. Also, to 
determine the extent to which a 2-percent capital ratio would 
allow the Fund to withstand worse-than-expected economic 
conditions and resulting loan performance. And also, to 
describe some options for adjusting the size of the Fund if the 
estimated capital ratio is different from the amount needed and 
required.
    In summary: First, we estimate that the Fund had an 
economic value of approximately $15.8 billion at the end of 
fiscal year 1999. And this estimate implies a capital ratio of 
3.2 percent of the unamortized insurance-in-force. Although we 
did not evaluate the quality of Deloitte's estimates, which 
were prepared using a different method of analysis, we believe 
that our results and theirs are comparable because of the 
uncertainty inherent in forecasting and the professional 
judgments made in this type of analysis.
    Second, given the economic value of the Fund and the state 
of the economy at the end of fiscal year 1999, a 2 percent 
capital ratio appears sufficient to withstand moderately severe 
economic downturns that could lead to worse-than-expected loan 
performance. Some more severe downturns that we analyzed also 
did not cause the estimated capital ratio to decline by as much 
as 2 percentage points. However, there were certain more severe 
scenarios in which an economic value of 2 percent of insurance-
in-force would not have been adequate. Nonetheless, because of 
the nature of such analysis, we urge caution in concluding that 
the estimated value of the Fund today implies that the Fund 
would necessarily withstand any particular economic scenario 
under all circumstances.
    The third point, Congress and the Secretary of HUD have 
taken and could take a number of steps to influence the 
economic value of the Fund. The impact that these actions have 
on the capital ratio and FHA borrowers is not always certain. 
However, actions that influence the Fund's reserve levels will 
also affect the Federal budget. In short, any proposal that 
seeks to use reserves, if not accompanied by a reduction in 
other spending or an increase in receipts, will result in a 
decline in the Federal budget surplus.
    I am going to go through the three parts of our report.
    First, I am going to spend just a little bit of time 
talking about our estimate of the value of the Fund and the 
comparison with the Deloitte estimate.
    The economic value of the Fund consists of current capital 
resources and the net present value of future cash flows. 
Investments in nonmarketable Treasury securities represent the 
largest component of FHA's current capital resources. 
Estimating the net present value of future cash flows is a 
complex actuarial exercise that required extensive professional 
judgment. Cash flows into the Fund from premiums and the sale 
of foreclosed properties; cash flows out of the Fund to pay 
claims on foreclosed mortgages, premium refunds, and 
administrative expenses.
    If you look at the chart,* you can see the inflows again 
from premiums and sale of properties and the flows out of the 
Fund from paying claims on foreclosed mortgages and premium 
refunds and administrative expenses.
---------------------------------------------------------------------------
    *Attached to prepared statement.
---------------------------------------------------------------------------
    At the end of the fiscal year 1999, the Fund had capital 
resources of $14.3 billion. Using our models and forecasts of 
likely values of economic variables, we estimated that the Fund 
had a net present value of future cash flows of $1.5 billion at 
that time. This yielded an estimated economic value of $15.8 
billion and a capital ratio of 3.2 percent.
    Now these are a little bit different than the numbers for 
1999 that Deloitte came up with. And the primary source of the 
difference had to do with the timing of the estimates. Deloitte 
had to do its estimate before the end of the fiscal year and we 
were able to do ours after the fact, so we had a more accurate 
count of the capital resources, whereas, Deloitte overestimated 
the capital resources by about a billion dollars. Again, part 
of that just reflects the difference in the time when Deloitte 
had to do its estimate versus when we did ours.
    The Fund's economic value principally reflects the large 
amount of capital resources that the Fund has accrued. These 
result from previous cash flows that reflect the robustness of 
the economy, the low-interest rates and high levels of 
employment usually associated with high levels of mortgage 
activity, along with higher premium rates throughout the 
1990's.
    The estimated value of future cash flows also contributed 
to the strength of the Fund at the end of fiscal 1999, and in 
addition, forecasts for the near future show rising housing 
prices and stable interest rates. As a result, our models 
predict low levels of foreclosure and prepayment and a cash 
flow into the Fund from mortgages already in FHA's portfolio at 
the end of the 1999 fiscal year will be more than sufficient to 
cover the cash outflows associated with these loans.
    Now, again, that is a static estimate. It is just a 
comparison between Deloitte's and our estimate.
    I think the more substantive part of our analysis had to do 
with trying to understand this issue of actuarial soundness.
    To provide a framework within which actuarial soundness 
could be assessed, we need to move beyond estimates of the 
capital ratio under expected economic conditions. Instead, we 
believe that to determine actuarial soundness one should 
measure the Fund's ability to withstand worse-than-expected 
conditions, although how much worse is a more difficult 
judgment.
    We generated economic scenarios that were based on economic 
events in the last 25 years. In addition, we generated other 
scenarios that lead to worse-than-expected levels of 
performance in the future. Using the actual historical 
scenarios, we found that the effect on the Fund's estimated 
value was actually fairly minimal. The worst historical 
scenario we tested, which was based on the 1981-1982 national 
recession, lowered the capital ratio by less than four-tenths 
of a percentage point, from about 3.2 to about 2.8 percent. To 
see how the economic value of the Fund would change as the 
extent of adversity increased, we extended regional scenarios 
that were based on historical economic downturns to the Nation 
as a whole.
    We extended the west south central and pacific downturns 
which reduced the capital ratio by about 1 percentage point and 
then we extended the New England downturn to the country as a 
whole, and that reduced the capital ratio by about 2.4 
percentage points, so from about 3.2 to about 0.8.
    In another scenario, we specified falling interest rates 
that would induce refinancing, followed by a recession. And 
again, in this particular scenario, we estimated that the 
capital ratio of the Fund would be reduced from 3.2 to about 
1.4 percent.
    Again, these are all different sets of scenarios, some of 
them more likely than others, obviously. But the idea here is 
to try to see what kind of a stress it might take to actually 
reduce the Fund by either 3 percent or 2 percent or 1 percent, 
whatever the particular level you are trying to test.
    Now, because we are starting from a position where the 
economy is doing very well and the recent historical experience 
has been very good, we were not able to generate, using our 
economic models, foreclosure rates that were in keeping with 
those that were experienced in the 1980's. We wanted to see 
just how the Fund would withstand such foreclosure rates.
    So we tried some alternative scenarios, one in which we 
actually imposed foreclosure rates that were experienced in the 
years 1986 through 1990, for the years 2000 through 2004. When 
we did this--these again were historical foreclosure rates, 
they just did not flow from our economic model, per se--we 
found that the ratio, the capital ratio, would fall from about 
3.2 to about 0.9 percent. Again, that is a fall of over 2 
percentage points.
    An alternative exercise which we did--again, it is not so 
much a stress test as it is kind of a sensitivity analysis--was 
to see what would be the effect of extending certain experience 
to a larger part of the FHA's portfolio. We used the 
southwestern experience, which actually affected about 9 
percent of FHA's portfolio, and we extended it to larger and 
larger parts of their portfolio to see how large an effect it 
would take to actually reduce the capital ratio by 2 percent or 
reduce it, in fact, to zero, in one extreme case.
    As you can see from the graph,* if 36 percent of the FHA's 
portfolio experienced foreclosure rates similar to those in the 
southwest in the late 1980's, that would bring the estimated 
capital ratio down to about 1 percent. If 55 percent of the 
portfolio experienced such foreclosure rates, that would 
actually bring the estimated capital ratio down to zero.
---------------------------------------------------------------------------
    *Attached to prepared statement.
---------------------------------------------------------------------------
    Again, that does not mean that these are likely events. Our 
analysis is just an attempt to show how large an effect you 
would need in order to generate a certain result.
    Now, while we believe that our models make good use of 
historical experience in identifying factors that influence 
foreclosures and prepayments, we also know that there are 
certain limitations.
    Nonetheless, several additional factors lead us to believe 
that Congress and others should apply caution in concluding 
that the estimated value of the Fund today implies that the 
Fund could withstand the economic scenarios that we examined 
under all circumstances.
    In particular, the performance of our model is very 
dependent on the fact that a lot of the loans were originated 
in the fiscal years 1998 and 1999. And as a result, the 
performance of these loans will have an important effect on the 
overall performance of the loan portfolio, but we don't have a 
lot of experience with these loans. They are, obviously, 1 or 2 
or 3 years old. As long as the influences of key predictive 
factors on the probabilities of foreclosure and prepayment have 
not changed, then we can be reasonably confident the estimates 
of the relationships will apply. However, in recent years, 
FHA's competitors in the conventional mortgage market are 
offering to selected homebuyers products that compete with FHA 
for those homebuyers who are borrowing more than 95 percent of 
the value of their homes.
    If these private-sector competitors have attracted some 
less risky borrowers who might otherwise have insured their 
mortgages with the FHA, then the average risk level of FHA's 
loans may have increased. Again, we don't know that is true. 
That is just one possibility, which would imply that we might 
be under-predicting foreclosures in our current model.
    It is also true that there have been changes in FHA's 
insurance program. A number of changes that FHA has made or 
might make in the future could affect the future cash flows 
associated with loans in FHA's portfolio. FHA's loss mitigation 
program might affect cash outflows, depending on whether the 
program succeeds in reducing foreclosures or whether the 
program may result in delayed foreclosures that lead to larger 
losses. We don't know the answer. We just know that this is one 
thing that has changed and therefore could change our model's 
predictions in the future. Also, steps taken by HUD to improve 
the oversight of lenders and the disposition of properties 
could reduce the level of losses to FHA below what we have 
estimated.
    In addition, as we are talking about the existing portfolio 
at the end of 1999, we don't know what is going to happen with 
new loans, either loans that are made in 2000 or loans that are 
made in 2001, or those loans made going forward. Our analysis 
of the ability of the Fund to withstand adverse economic 
conditions requires making the assumption that the adverse 
conditions would not also cause loans insured by FHA after 
fiscal year 1999 to be an economic drain on the Fund. And that 
is again just one of the assumptions we had to make in doing 
our analysis.
    Now, I would like to turn to the last issue which has to do 
with discussing options for drawing on the Fund, which have 
uncertain outcomes, obviously. If Congress or the Secretary of 
HUD believes that the economic value of the Fund is higher than 
the amount needed to ensure actuarial soundness, several 
changes to the FHA's single-family loan program could be 
adopted. The impact that these actions might have on the 
capital ratio and FHA's borrowers is difficult to assess 
without using tools designed to estimate the multiple impacts 
that policy changes often have.
    Although it is difficult to predict the overall impact of a 
change on the Fund's capital ratio and thus on FHA borrowers as 
a whole, different options would likely have different impacts 
on current and prospective FHA-insured borrowers. Some 
proposals would more likely benefit existing and future FHA-
insured borrowers, while others would benefit only future 
borrowers, and still others would benefit neither of these 
groups.
    Because of the difficulty in reliably measuring the effect 
of most actions that could be taken either by Congress or by 
the Secretary of HUD on the Fund's capital ratio, we cannot 
precisely measure the effect of these policies on the budget. 
However, any actions taken by Congress or the Secretary that 
influence the Fund's capital ratio will have a similar effect 
on the budget.
    Last, I want to just talk a little bit about actuarial 
soundness and what it means, and what it doesn't mean.
    Whether actions should be taken to change the value of the 
Fund depends on whether the Fund's capital resources and 
expected revenues exceed the amount needed to meet its expected 
cash outflows under designated stressful conditions; that is, 
whether it is actuarially sound. Assessing whether this 
condition exists requires that the degree of risk the Fund's 
expected to be able to withstand must be specified. If the Fund 
is expected to withstand what Price Waterhouse calls reasonably 
adverse economic downturns, then our results could be construed 
to mean that the Fund is taking in more revenue than it needs. 
Alternatively, if the Fund is expected to never exhaust its 
resources or to be able to withstand stresses such as the Great 
Depression, the current Fund might not be adequate.
    Because we believe that actuarial soundness depends on a 
variety of factors that could vary over time, we also believe 
that a minimum or target capital ratio won't necessarily 
guarantee that the Fund will be actuarially sound over time. We 
believe that to evaluate the actuarial soundness of the Fund, 
one or more scenarios that the Fund is to withstand would need 
to be specified. Then it would be appropriate to calculate the 
economic value of the Fund under the scenarios. As long as the 
estimated economic value is positive and the desired stress 
scenario is used to make that estimate, the Fund could be said 
to be actuarially sound. However, it might be appropriate to 
leave a cushion to account for the factors not captured by the 
model and the inherent uncertainty attached to any forecast. In 
any event, we believe that a single, static capital ratio does 
not necessarily measure actuarial soundness.
    For these reasons, Mr. Chairman, Congress may wish to 
consider taking action to specify criteria for determining when 
the Fund is actuarially sound. Specifically, the Congress may 
want to consider defining the types of economic conditions 
under which the Fund would be expected to meet its commitments 
without borrowing from the Treasury.
    Mr. Chairman, this concludes my statement. We would be 
happy to answer any questions that you or any other Members of 
the Subcommittee might have.
    Senator Allard. Thank you very much. I thought that was a 
very good statement you made and I want to thank you for your 
efforts and diligence in putting together this report.
    Just for Members of the Subcommittee, we have 5 minutes per 
Member. We have a small clock down here. It is a little 
difficult to read, but when the light starts turning orange, 
you have a minute left. When it is green you are okay. And when 
it is red, we ask that you stop.
    I want to start out with just where we are today.
    My memory recalls that back in 1979 or so, we had a reserve 
in the Fund of about 5.3 percent. Frankly, it is quite a bit 
higher than what we are having today. But then in 1990, about 
11 years later, we are running into some deficits in the Fund. 
Would you explain briefly why this should or should not be a 
concern for us today?
    Mr. McCool. Well, I think that it both should and should 
not be a concern. Again, part of it is that the Fund was run 
down over a 10-year period and it had to do with the sequence 
of economic factors. It had to do with very high interest rates 
in the early 1980's and a recession in the early 1980's, 
followed by a number of regional downturns. You have high 
regional unemployment rates, much higher average unemployment 
rates for the economy as a whole than you currently have. So, 
again, you can find a high ratio turn into a lower or negative 
ratio over time if you get the right sequence or concurrence of 
events. But it is also true that the 1980's in particular were 
different than the 1990's have been, in terms of things like 
interest rates and unemployment rates, and at least so far in 
terms of housing price changes.
    Senator Allard. Probably the increase in interest rates had 
as much to do with anybody as to help assure the----
    Mr. McCool. The early 1980's interest rates had a lot to do 
with the later 1980's performance, yes.
    Senator Allard. Last week, the Mortgage Bankers of America 
released data showing that the delinquency rates on FHA loans 
is now 10.46 percent, about 10\1/2\ percent, which is well over 
three times the conventional rate of about 3 percent.
    In my first hearing, I think, as Subcommittee Chairman, we 
looked at those delinquency rates 2 years ago. At that time, we 
were alarmed that the delinquency rate was 8.45 percent and 
that our ARM's, the delinquency rate was 10.46 percent. Two 
years later, both of those figures have gone up, I think, 
rather substantially to 10\1/2\ percent and 12 percent, 
respectively, where the ARM's are 12 percent and the regular 
loans are at 10\1/2\ percent. The trend is now upward and we 
are still in a relatively healthy housing market, at least in 
Colorado.
    What happens in a recession? At what point should we become 
concerned that this could threaten the FHA Fund's actuarial 
soundness?
    Mr. McCool. In particular, in a recession that causes a 
substantial increase in unemployment rates and either a flat or 
potentially a reduction in housing prices, you can get 
increases in foreclosures and delinquencies. And that can have 
an effect on FHA. It depends a lot on how severe the recession 
is, how long it lasts, as to how much an effect it will have.
    Senator Allard. Which is obviously what has been happening 
even before we were in any kind of an economic downturn, with 
these figures that we are looking at.
    Mr. McCool. It is hard to predict and it is hard to--that 
may be true. But we also have to be a little careful about 
changes in delinquency rates on average because part of it can 
also reflect just sort of an aging of the portfolio.
    Senator Allard. Yes.
    Mr. McCool. You did have a lot of new loans in the 
portfolio and generally, new loans don't default. It usually 
takes a few years before they reach the default stage. So it 
could also just be a question of some of those loans moving 
into the peak years for defaults; you need to look at the loans 
on a cohort-by-cohort basis to see if default rates are really 
necessarily increasing.
    Senator Allard. When we talked about the high delinquency 
rates on the ARM's, Mr. Apgar testified in front of our 
Committee at that time and he indicated that they can deal with 
the problem. Have you seen any evidence that would indicate 
they have taken any kind of action on this particular issue 
when you did your audit?
    Mr. McCool. Stan handled that.
    Senator Allard. Mr. Czerwinski, maybe you can answer that.
    Mr. Czerwinski. I remember that hearing very well. We 
talked about how ARM's were very sensitive to interest rates. 
Interest rates were probably one of the key problems in the 
1980's. ARM's combined with interest rates was one of the key 
problems with FHA. And as Tom mentioned, it is an aging of the 
portfolio that is an issue.
    Mr. Apgar promised to reduce the number of ARM's and put 
stricter underwriting standards in place, which they have done. 
If you look at the current portfolio and what is being written 
now, there are much fewer ARM's. That is the good news.
    I think probably what you were picking up in the 
delinquency rates now is that some of these ARM's from the past 
are aging a bit. Interest rates have been coming up. So, we 
still have to work our way through some of the past policies. 
But I don't think you will be seeing that as much in the 
future.
    There is one other issue lurking out there, and that is 
called streamlined refinancing. That is rolling over mortgages. 
And the way FHA has been doing it is to do it without that much 
underwriting requirements. That is the next issue that is 
waiting.
    We talked about ARM's in 1998. In 2001, we are now saying, 
gee, what happened with ARM's? My guess is we may be talking in 
2003 about streamlined refinancing.
    Senator Allard. Thank you.
    I will now go to my Ranking Member, Senator Reed.
    Senator Reed. Thank you, Mr. Chairman.
    Thank you very much, Mr. McCool, for your testimony.
    Is it fair to say that the FHA Fund is performing very well 
when tested against all of your scenarios, that essentially, it 
is in good shape?
    Mr. McCool. In the sense that at least none of our economic 
scenarios brought it down to zero; the Fund still had a 
positive value, even in our more stringent scenarios. So in 
that sense, yes.
    Senator Reed. And you used foreclosure rates from the 
1980's, which were very severe foreclosure rates.
    Mr. McCool. In the one scenario, yes. We used foreclosure 
rates from the 1986 through 1990 period, which were the 
steepest, the worst we have seen in the post-war period, yes.
    Senator Reed. That is really the most extreme test you 
could apply, in terms of foreclosure rates.
    Mr. McCool. Again, given what we have seen in the post-war 
period, yes.
    Senator Reed. And still, the Fund was able to maintain a 
very positive----
    Mr. McCool. It still had a 0.9-percent capital ratio.
    Senator Reed. In your scenarios generally, the assumption I 
think, and this might just be the limitations of modeling, is 
that the FHA managers really can't respond to changes in the 
economy with preventive action or new policies. Is that fair to 
say?
    Mr. McCool. It is fair to say. But it is also true that we 
are looking at a portfolio that is under contract. There is 
only so many things that the FHA can do with those.
    Senator Reed. Right.
    Mr. McCool. They can do more with new business than they 
can with existing business.
    Senator Reed. But in terms of getting out of a precipitous 
decline, trying to get to at least a plateau with new business, 
you can make some policy changes that would presumably help.
    Mr. McCool. You can mitigate it, sure.
    Senator Reed. That is something that I suspect, given the 
limitations of the modeling, that you can't model particularly 
well.
    Mr. McCool. No, we were not modeling that at all in our 
particular scenario.
    Senator Reed. Let me ask again a question about both your 
model and the FHA portfolio. Is there any regional bias in 
terms of the number of, the concentration of loans, in one 
particular geographic region?
    Mr. McCool. I think it is the regional bias of the FHA 
portfolio.
    Mr. Cherlow. I don't know if you could call it a bias. But 
certainly, in certain parts of the country, FHA has a larger 
market share than in other parts of the country.
    Senator Reed. Right. A regional downturn in those areas 
would have a more traumatic effect on the Fund than other 
areas. Is that correct?
    Mr. Cherlow. That is right.
    Senator Reed. And your model compensated for the geographic 
specificity?
    Mr. Cherlow. Our model weights the loans from each region 
according to the share that they are in FHA's portfolio.
    Senator Allard. Where do you have those larger number? 
Where do we have the larger number of FHA loans? Can you 
comment on that?
    Mr. Cherlow. Yes, sir. California, Texas, Florida. Those 
are the three largest States.
    Senator Reed. California, Texas, Florida. California is 
enduring some unusual problems right now in terms of an energy 
crisis, etc. So that that might be sort of a caution to the 
Fund managers.
    You tested 2 percent as a capital ratio, Mr. McCool. There 
has been discussions about legislation that would increase the 
statutory level to 3 percent and then use funds above and 
beyond that for other purposes. Putting aside the purposes, is 
that 3-percent capital ratio level significantly high enough, 
given the fact that the 2 percent level seems to have survived 
all these various tasks?
    Mr. McCool. Again, it depends on what you are trying to 
protect the Fund against. From our analysis, 3 percent would be 
better to protect it against, again, the more extreme 
scenarios, some of which did lower the Fund by more than 2 
percentage points.
    Senator Reed. If the Fund is reduced to 0.9 percent, which 
is your worst-case scenario, would you deem the Fund to be in 
extremis and something that is at risk? Or is that at a level 
sufficient to operate?
    Mr. McCool. It still obviously is solvent.
    Senator Reed. Right.
    Mr. McCool. The question is, what happens next? Do you have 
an additional negative shock? And you could be in more trouble. 
If you have positive shocks, then you might be back over 2 
percent again. So it depends on what happens next.
    Senator Reed. But I guess, for the record, 3 percent is 
better than 2 percent, and 2 percent is okay.
    Mr. McCool. Three percent is safer than 2 percent.
    Senator Reed. Okay.
    Mr. McCool. I would definitely say that.
    Senator Reed. I am not going to get into your modeling 
because I am exhausted my modeling knowledge. Is there a 
comparable private-sector institution that we can look to for 
guidance regarding a loan loss reserve level? And what might 
that be?
    Mr. McCool. There are a number of alternative ways of 
thinking about capital ratios. There are bank capital ratios 
where the regulators impose credit-based capital standards.
    There is, again, not quite private sector, but almost fully 
private sector capital regulations that OFHEO, imposes on 
Fannie Mae and Freddie Mac. And there is the rating agencies 
also that impose their own implicit capital standards on those 
they rate, asking again for much higher capital ratio for a 
triple A rating than for a double A rating and for a single A 
rating.
    There are many different ways that people think about what 
kind of capital reserves you need, depending on risk and how 
you want to measure that risk.
    Senator Reed. In a nutshell, how would this 2 percent 
statutory level rate with those?
    Mr. McCool. Well, it is certainly simpler. And it is not 
clear how risk-based it is. I guess that would be the simple 
answer.
    Senator Reed. Thank you very much, Mr. McCool.
    Thank you, Mr. Chairman.
    Senator Allard. The Senator from New Jersey.
    Senator Corzine. Thank you, Mr. Chairman.
    Pursuing that just a little bit more, Fannie Mae has a 
risk-based system, I presume, that is much more complicated. 
But if my memory serves me correct, it is something like 4 
percent, if I am not mistaken.
    Mr. McCool. Again, there are two different issues. Fannie 
Mae and Freddie Mac have their own modeling approaches and then 
OFHEO, who is their regulator, is to impose a new statutory 
requirement once their role is cleared by OMB, which hasn't 
actually happened yet.
    Senator Corzine. Right.
    Mr. McCool. But I do not actually know what their rule will 
impose on Fannie Mae and Freddie Mac. They have statutory 
requirements that are minimum capital requirements that depend 
on whether something is off balance sheet or on balance sheet. 
I think it is 2\1/2\ percent for on balance sheet and 0.45 
percent for off balance sheet, if my memory serves me 
correctly. Those are not risk-based. Those are just leverage-
based.
    Senator Corzine. Right. Has there been any attempt by 
either yourselves or others to rate or a proxy rating, what the 
Fund would be rated if it were going to outside private 
entities?
    Mr. McCool. We certainly have not, and I do not know that 
anyone else has.
    Mr. Cherlow. Not that I am aware of, sir.
    Senator Corzine. And one of the best tests, at least in the 
experience I have had, is looking at secondary market spreads 
on what packages of FHA, which, I guess, is in Ginnie Mae 
format. Have these spreads widened or tightened? Do you follow 
those through time and seeing whether there is a risk premium 
that is growing or shrinking?
    Mr. McCool. I have not really looked at any trends in 
those, no.
    Senator Corzine. Actually, it might be an interesting 
phenomenon. It tends to track at least how the marketplace in 
general is looking at it.
    I was going to ask some of these regional concentration 
questions. They tend to be the most important in some of the 
valuing of the credit proportions.
    Is there a statutory requirement to be at 2 percent? And 
what are the timeframes that surround when you are out of it 
and you have to get back into it?
    Mr. McCool. The statutory requirement is that the ratio be 
above 2 percent.
    Senator Corzine. Okay.
    Mr. McCool. I am not sure it goes much beyond that in terms 
of specifying what happens if you do not meet that, other than, 
again, things like restricting the Secretary from instituting 
distributive shares or things like that. But there is no real 
enforcement tools, I don't think.
    Mr. Scire. The statutory requirement is a minimum capital 
ratio. And that was put in in the 1990 reforms. The deadline 
was to reach the 2 percent level by 2000.
    Actually, they met the capital ratio well before 2000. But 
it is a minimum capital requirement. The law does not specify 
or define actuarial soundness, which is a trigger for certain 
things that the Secretary can do, such as paying distributive 
shares, which the 1990 reforms discontinued.
    Senator Corzine. A larger risk of default with higher loans 
than smaller loan portfolio?
    Mr. Cherlow. Do you mean larger loans or larger loan-to-
value ratios?
    Senator Corzine. Larger loans. Just the larger end of the 
spectrum of your mortgages.
    Mr. Cherlow. Not generally. In fact, at times it appeared 
that the smallest of the FHA loans were the ones that had the 
largest risk of default, the very small ones.
    But loan-to-value ratio is very important, those loans 
where the borrower is borrowing a larger share of the purchase 
price and therefore, has lower equity. Those tend to be more 
risky.
    Senator Corzine. Do you all have statistics built into your 
model with regard to those kinds of matters?
    Mr. Cherlow. That is right. The model takes into account 
loan size and loan-to-value ratio, as well as other variables.
    Senator Allard. I think a key question for me as we look at 
legislation is whether the 2 percent reserve should be 
increased to 2.5 or 3 percent. Frankly, I feel like we need to 
be conservative. I don't think we need to be ridiculous about 
it. But I do think that we need to err on the conservative 
side.
    There are two scenarios that you had that indicated that 
there would be an increased risk to the Fund. And I might just 
talk about those two briefly.
    The first one, you described a situation where mortgage 
interest rates are falling, which is happening right now. And I 
know that there is an awful lot of refinancing going on in my 
State. I assume that is happening nationwide because of the 
drop in interest rates. I think it is a big inducement for 
borrowers to continue to go into kind of a refinancing mode.
    In your scenario, you describe that then a recession sets 
in. And there is kind of a familiar ring to that. Our economy 
is heading down right now. And under that scenario, you say 
that we totally eliminate the 2 percent reserve, or near total 
elimination. Is it not possible that we may be entering into 
that situation right now?
    Mr. McCool. I think it would depend very much on how large 
and how long a recession we had.
    Senator Allard. Yes.
    Mr. McCool. I am not actually sure about how big the 
recession was that we stressed this system with.
    Mr. Cherlow. The recession we modeled has a fairly 
substantial decline in house prices. Really the most critical 
factor is whether or not people find themselves in a negative 
equity position.
    Senator Allard. Which is not happening right now, at least 
not in my State.
    Mr. Cherlow. Yes.
    Senator Allard. I do not know about other States. Did you 
get any feel for that?
    Mr. Cherlow. No, sir, not yet.
    Senator Allard. Second, you had a scenario which was 
discussed a little bit by my colleague about the foreclosure 
rates from the 1980's being duplicated. That was that 5-year 
period. Now, you described that more than wiped out the 2 
percent reserve. That is a scenario that has happened within 
the past 25 years. It seems to me that we want a reserve that 
will at least sustain us through a period, one that we have 
experienced in recent history. Would you comment on that 
further?
    Mr. McCool. Again, as we have been saying, to a large 
extent, it is up to Congress to decide what stress they want 
the Fund to be able to undergo. It could be a mild stress or a 
stress like the Great Depression. And each one gives you a 
different potential capital ratio or relationship between risk 
and capital, depending on how you want to specify it.
    Senator Allard. You also mentioned the private sector out 
there. They will go and rate soundness, AAA, AA, and A. If you 
were to rate this, where would you rate it?
    Mr. McCool. Well, we are not in the rating business.
    [Laughter.]
    It is a little hard for us to do that.
    Senator Allard. Is there anything we can learn from the 
safety and soundness requirements imposed on banks with the 
FDIC?
    Mr. McCool. As I said, part of it depends on what you are 
trying to achieve. The banks' capital ratios basically are 
effectively 8 percent. But they depend a lot on the extent of 
credit risk that is associated with a particular type of asset. 
And we know that the bank supervisors are undertaking to change 
those standards because they think the current standards are 
too simple and they generate certain types of perverse 
behavior. So, they are trying to move to a system that, again, 
matches capital more with risk.
    Now, again, the other financial institution supervisory 
model that has similarities to the stress test we have been 
talking about is the OFHEO stress test for Fannie Mae and 
Freddie Mac. That involves a very substantial credit stress, as 
well as a very, very large interest rate stress. So, in some 
ways, it is similar to some of the stresses we did, but it also 
has alternative or additional stress factors.
    Senator Allard. And their standard was not just to be 
conservative, but it was almost to the point where it was a 
catastrophic situation. Am I correct?
    Mr. McCool. That is certainly how Fannie Mae and Freddie 
Mac characterize it.
    Senator Allard. Yes. Actually, private mortgage insurers 
also.
    Mr. McCool. Right.
    Senator Allard. They are required by law to hold reserves 
that are in the catastrophic. All we are asking here is just 
that we be very conservative. At least that is kind of been my 
position.
    I guess the fundamental question is why should FHA be 
different? Why should the standard for actuarial soundness be 
lower for a public fund than for a private fund, for example?
    Mr. McCool. Part of it does depend on FHA's role compared 
with the private sector. FHA does have a role to be in the 
market when others pull out. That is what the private sector 
can do. If things get tough, the private sector can decide not 
to play. FHA is supposed to be there to play. Plus the fact is 
that FHA is backed by the Federal Government. So it does have 
that backstop, which the private sector does not have. There 
are similarities, but there are also, I think, some 
differences.
    Senator Allard. Thank you.
    I am going to call on my colleague from Rhode Island now.
    Senator Reed. Thank you, Mr. Chairman.
    Let's go back to the 1980's. Nostalgia calls. As I recall, 
it wasn't just poor economic conditions, but some negligence, 
if not worse, in appraising of properties and lending, et 
cetera, that helped with that precipitous decline. And I note 
that KPMG has just finished an audit contracted by HUD's 
Inspector General that cites improvements in FHA's oversight of 
lenders and appraisers.
    Have you built that into the model going forward, the 
improvement in these oversight measures? One would hope that 
the Fund could now withstand more, and not be in the position 
that it was in the 1980's?
    Mr. Cherlow. One factor that is definitely built in, 
Senator, has to do with what is called the loss rate or the 
amount that FHA loses on each property, what percentage of the 
claim value does it not get back when it sells the property.
    When GAO first began doing this type of work around 1990, 
it was common for the loss rate to be higher--I think we were 
using in those days 42 percent. Nowadays, I think it is more 
like 35 percent. So, in fact, one of the differences between 
the 1980's and now is that FHA has succeeded in reducing its 
loss rate a fair amount.
    Senator Reed. Thank you. In your report, you suggest that 
the Secretary of HUD should develop better tools for assessing 
the impacts that policy changes will have on the volume and 
riskiness of the loans that it insures. And since we are all 
contemplating policy changes here, what are those tools? Might 
you be more specific?
    Mr. McCool. Well, I think there are a number of possible 
tools.
    One of the things that we were suggesting was to try to 
come up with a better sense of how changes, in particular, in 
premia and other financial attributes of FHA, affect the demand 
for FHA loans.
    For example, there is this issue about what would happen if 
you were to raise or lower premiums. And again, right now, 
there is a simple presumption that the level of FHA lending 
either stays the same or increases or decreases in the same 
proportion as the rest of the market does, which is the current 
demand model that Deloitte & Touche uses.
    What we think would be better would be to get a sense of, 
if you change premiums, since you are competing with 
alternatives such as the conventional market, what would be the 
effect on the relative size of FHA compared with the rest of 
the market? In particular, what might be the effect on the risk 
characteristics of that piece that the FHA gets, to be able to 
truly understand the effect of a change in policy.
    Senator Reed. Thank you.
    Deloitte & Touche has done their actuarial study. You have 
done your study. You cited that their study is comparable. What 
does that mean?
    Mr. McCool. What we mean is the results are comparable. We 
did not really do an analysis of Deloitte & Touche methodology. 
That was not what we were attempting to do. Also, our model was 
built to some extent for a different purpose than theirs. We 
were trying not to get into comparing our model to theirs in 
the sense of the mechanics of it. We were just saying that the 
results we came out with in measuring the Fund and the capital 
ratio were, we thought, similar to what Deloitte & Touche came 
out with.
    Senator Reed. What confidence is there in the actuarial 
review that they did?
    Mr. McCool. Well, if they continue to come out with 
estimates that are close to ours, it gives us more and more 
confidence.
    [Laughter.]
    Senator Reed. Thank you.
    Senator Allard. I have a few more questions.
    You have noted that in your report, 40 percent of FHA's 
loans are on new mortgages from 1998 to 1999, and that we have 
no good data on their performance. Should this concern us? And 
is it possible that these loans are riskier than other loans in 
the portfolio?
    Mr. McCool. I think, from our perspective, it simply makes 
us want to be cautious because the portfolio is so loaded 
toward new loans which we have little experience with.
    The question of the relative riskiness again is difficult 
to know. We have heard a lot about the private sector using 
technological tools to do a better job of trying to figure out 
who are the less risky part of the lower end of the mortgage 
distribution. There may be an attempt by the private sector not 
so much to harm FHA, but to make money by offering better terms 
to the less risky part of the low down payment end of the 
mortgage spectrum. As a result, it could be that FHA is left 
with a slightly riskier portfolio. We don't know that. That is 
again something we will need to keep an eye on as these loans 
mature.
    Senator Allard. Is there any information you can give us on 
the potential for this adverse selection?
    Mr. McCool. Whether we have any sense of the magnitude?
    Mr. Cherlow. Right. I would agree with what Mr. McCool 
said. We probably don't have a good sense now of how large an 
effect that might be. Unfortunately, we would have a better 
idea in 2005 what the picture of the Fund at the end of 1999 
is, because then you will have data, but that is rather too 
late to be of a lot of use.
    Senator Allard. Does your report take into account the 
January reduction in premiums that was instituted on the Fund 
by HUD?
    Mr. Cherlow. Not in our estimates because we are just 
looking at the books of business through 1999 and the premium 
change applies to new business. But it is certainly one of the 
factors that we would cite as far as going forward and 
evaluating the actuarial soundness of the Fund. In our model 
and Deloitte's, and Price Waterhouse's in the years before, 
these estimates are not based on new business. They are based 
on existing business.
    Senator Allard. Sure.
    Mr. Cherlow. So what happens to new business, of course, is 
important as well. And with the lower premiums, there is less 
revenue coming in, obviously, to meet the claims.
    Senator Allard. How significant a factor do you think the 
new premiums might be? Can you speculate on that? Minimal? 
Moderate?
    Mr. Scire. HUD estimated that over a 6 year period, it 
would cost $6 billion.
    Senator Allard. Yes.
    Mr. Scire. You might say that estimate is actually 
conservative because it doesn't take into account any change in 
risk and volume or demand for FHA's product. And you would 
expect with a lower insurance premium that they might be able 
to compete better and therefore, attract less risky business. 
But their estimate is based upon what the demand for mortgage 
insurance generally would be in the future.
    Senator Allard. They were looking at a $6 billion cost.
    Mr. Scire. That is right.
    Senator Allard. Do you know how much of that cost was 
allocated just this year, for example?
    Mr. Scire. No, I don't know how much of that would be for 
this year. I know it was over a 6 year period.
    Senator Allard. I think that would be interesting. I would 
be interested if you could make that available, as to how that 
was allocated out over that time period per year.
    Now, your report, then, or the KPMG or the Deloitte & 
Touche audits factor in the anticipated impact of loss 
mitigations by FHA. You haven't done that.
    Mr. Scire. No. HUD estimated that the projected value of 
the MMI Fund in 2006 would be almost $6 billion lower given 
lower premiums that became effective this January. Because this 
is an estimate for a projected value as of a future date, it 
cannot be allocated among the intervening years, without 
establishing projected estimates for those years. Nonetheless, 
assuming--as FHA does--that there is no change in the volume 
and riskiness of loans FHA insures, the difference between the 
value of the Fund under the previous premium structure and the 
value under the new premium structure will increase each year 
in proportion to the volume of business predicted each year 
because the up-front premium being collected for new loans will 
be smaller. However, it is possible that the lower cost of FHA 
mortgage insurance would allow FHA to attract more borrowers 
and less risky borrowers, which would have a favorable effect 
on the economic value of the Fund and thereby partially offset 
the effect of lower up-front premiums. In addition, fewer 
refunds of up-front premiums are likely given that FHA 
shortened the period in which the borrowers are eligible for 
such refunds.
    Senator Allard. Okay. And there is evidence from most 
recent KPMG and Deloitte & Touche audits that the FHA Fund is 
experiencing higher claims and faster prepayments than 
projected in 1999. In fact, the KPMG audit appears to show that 
a reestimate of claims and prepayments hurt FHA's bottom line 
by nearly $4 billion in fiscal year 2000. Have you taken a look 
at these numbers and should they concern us?
    Mr. Scire. Well, I think that that underscores the need for 
looking at the capital ratio again and again over time, and the 
caution that we urge in interpreting that having a 2 percent 
ratio today means that a 2 percent ratio would be sufficient to 
cover moderately severe conditions regardless of what happens 
in the future.
    So, yes, I think that it is something that would give you 
cause for concern.
    Senator Allard. My time has expired.
    Senator Reed. Go ahead.
    Senator Allard. I have just a couple more issue areas that 
I want to cover and then I will be finished.
    Senator Reed. Fine.
    Senator Allard. In your report, you state that one could 
conclude that borrowers during the 1990's overpaid for their 
insurance. Explain why one might interpret a surplus in FHA's 
Fund this way.
    Mr. McCool. I think it is based on the idea of the MMI Fund 
being a mutual insurance fund and the extent to which, if you 
have more than sufficient resources generated to insure, the 
risks against which you are trying to insure, and there is 
something left over, then the idea would be, in a mutual 
insurance fund, you would give some rebates to those people who 
paid.
    Senator Allard. Doesn't this argue in favor of a return to 
distributive shares?
    Mr. McCool. Well, again, that is a policy decision. That 
depends on the total view you have about what the MMI Fund is 
about and what the FHA is about.
    Senator Allard. Under the current regulations, when is the 
Secretary required to reinstitute distributive shares?
    Mr. Scire. Under current regulations, it establishes two 
different accounts--a general surplus account and a 
participating reserve account. The Secretary semiannually is 
supposed to allocate any profits from the Fund to these two 
accounts and to do that taking into account the actuarial 
status of the Fund. And it is from this participating reserve 
account that the Secretary makes distributive shares.
    I believe the short answer to that question is that the 
Secretary is supposed to take into account the actuarial status 
of the Fund before making distributive shares.
    Senator Allard. Would it be reasonable to conclude that if 
the Fund is more than 150 percent above the statutorily 
mandated reserve, that it could be considered actuarially 
sound, particularly in light of the fact of your previous 
arguments, the standards for a public fund might be lower than 
those for a private fund?
    Mr. McCool. As I think I said before, the actuarial 
soundness depends on what you want the Fund to be able to 
withstand. And that is for you in Congress to decide just how 
much risk you want to be able to withstand.
    Senator Allard. Are there any other members of the panel 
that want to make any closing comments?
    Senator Reed. I have one question, Mr. Chairman.
    Senator Allard. Let me call on the Ranking Member.
    Senator Reed. Just one final question. Your analogy to a 
mutual insurance fund as the measure of whether there is 
overpayment by premium payers, does that consciously take into 
consideration the fact that this is a mutual fund that is 
supported by, essentially, the Federal Government? Does that 
make a difference in your analogy?
    Mr. McCool. As I said, it is simply that, when you talk 
about premiums being overpaid, that is the sense in which they 
are overpaid. The members of the mutual organization are paying 
more than is necessary to provide the insurance for themselves. 
This would mean that they necessarily have to get any amount 
repaid or a particular amount repaid.
    Senator Reed. But, conceivably, or hypothetically, this is 
a mutual organization that would never take place unless it was 
supported by the Federal Government. So that there is a very 
large public purpose and public direction here. It is not 
simply a mutual organization.
    Mr. McCool. Right.
    Senator Reed. Thank you.
    Senator Allard. I want to thank the panel, and I want to 
thank the Members of the Subcommittee for their questions. I 
thought this was a very informative hearing.
    I am going to adjourn the hearing.
    [Whereupon, at 2:03 p.m., the hearing was adjourned.]
    [Prepared statements submitted for the record follow:]

              PREPARED STATEMENT OF SENATOR JON S. CORZINE

    Thank you, Mr. Chairman, for holding this hearing and thanks to Mr. 
McCool for appearing here today to help us understand the General 
Accounting Office's report on the FHA's Mutual Mortgage Insurance Fund.
    I am looking forward to hearing about the GAO's findings with 
regard to the Fund's 2 percent capital reserve requirement and the 
Fund's ability to withstand times of economic stress. Given the 
continuing downturn in economic indicators, I hope we will hear some 
encouraging news on that front.
    Additionally, I am looking forward to discussing, in this or other 
hearings, the potential for using any excess FHA MMI receipts to 
promote affordable housing. There is a serious shortage of such housing 
in many parts of the country, and we need to explore all possible ways 
to address the problem.
    Again, Mr. Chairman, I thank you for holding this hearing and I 
look forward to hearing from our witness today.

                               ----------

                 PREPARED STATEMENT OF THOMAS J. McCOOL

     Managing Director, Financial Markets and Community Investment
                     U.S. General Accounting Office

                             March 19, 2001

    Mr. Chairman and Members of the Subcommittee: We are here today to 
discuss the results of our analysis of the financial health of the 
Mutual Mortgage Insurance Fund (Fund) of the Department of Housing and 
Urban Development's (HUD) Federal Housing Administration (FHA). Through 
the Fund, FHA operates a single-family insurance program that helps 
millions of Americans buy homes. The Fund, which is financed through 
insurance premiums, has operated without cost to the American taxpayer. 
Last year, the Fund's economic value appeared to have reached its 
highest level in at least 20 years--prompting proposals to spend some 
of the Fund's current resources or reduce net cash flows into the Fund. 
Concerned about how the soundness of the Fund is measured and proposals 
to spend what some were calling ``excess reserves,'' you requested that 
we analyze the financial health of the Fund.
    Since 1990 the economic health of the Fund has been assessed by 
measuring the economic value of the Fund--its capital resources plus 
the net present value of future cash flows--and the related capital 
ratio--the economic value as a percent of the Fund's insurance-in-
force. For most of its history, the Fund was relatively healthy; 
however, in fiscal year 1990 the Fund was estimated to have a negative 
economic value, and its future was in doubt. To help place the Fund on 
a financially sound basis, Congress enacted legislation in November 
1990 that required the Secretary of HUD to, among other things, take 
steps to achieve a capital ratio of 2 percent by November 2000 \1\ and 
to maintain or exceed that ratio at all times thereafter. The 
legislation also required the Secretary to raise insurance premiums and 
suspend the rebates, called distributive shares, that FHA borrowers had 
been eligible to receive under certain circumstances. As a result of 
the 1990 housing reforms, the Fund must not only meet capital ratio 
requirements, it must also achieve actuarial soundness; that is, the 
Fund must contain sufficient reserves and funding to cover estimated 
future losses resulting from the payment of claims on foreclosed 
mortgages and administrative costs. However, neither the legislation 
nor the actuarial profession defines actuarial soundness.
---------------------------------------------------------------------------
    \1\ The Act defined the capital ratio as the ratio of the Fund's 
capital, or economic net worth, to its unamortized insurance-in-force. 
However, the Act defined unamortized insurance-in-force as the 
remaining obligation on outstanding mortgages--a definition generally 
understood to apply to amortized insurance-in-force. FHA has calculated 
the 2-percent capital ratio using unamortized insurance-in-force as it 
is generally understood--which is the initial amount of mortgages. All 
capital ratios reported here are measured using unamortized insurance-
in-force as it is generally understood.
---------------------------------------------------------------------------
    The 1990 FHA reforms required that an independent contractor 
conduct an annual actuarial review of the Fund. These reviews have 
shown that during the 1990's, the estimated economic value of the Fund 
grew substantially. As figure 1 shows, by the end of fiscal year 1995, 
the Fund attained an estimated economic value that slightly exceeded 
the amount required for a 2-percent capital ratio. Since that time, the 
estimated economic value of the Fund continued to grow and always 
exceeded the amount required for a 2-percent capital ratio. In the most 
recent review, Deloitte & Touche (Deloitte) estimated the Fund's 
economic value at about $17.0 billion at the end of fiscal year 2000. 
This represents about 3.51 percent of the Fund's insurance-in-force--
well above the required minimum of 2 percent.




    Concerned about the adequacy of the minimum 2 percent requirement 
and about proposals to spend what some were calling excess reserves, 
you asked us to determine the conditions under which an estimated 
capital ratio of 2 percent would be adequate to maintain the actuarial 
soundness of the Fund. Specifically, you asked us to: (1) estimate the 
value of the Fund at the end of fiscal year 1999, given expected 
economic conditions, and compare our estimate to the estimate of the 
value of the Fund reported by HUD for that year; (2) determine the 
extent to which a 2-percent capital ratio would allow the Fund to 
withstand worse-than-expected loan performance due to economic and 
other factors; and (3) describe some options for adjusting the size of 
the Fund if the estimated capital ratio is different from the amount 
needed and describe the impact that these options might have on the 
Fund, FHA mortgagors, and the Federal budget.
    In summary:

 We estimate that the Fund had an economic value of about $15.8 
    billion at the end of fiscal year 1999. This estimate implies a 
    capital ratio of 3.20 percent of the unamortized insurance-in-
    force. Although we did not evaluate the quality of the 1999 
    estimates prepared by Deloitte, using a different method of 
    analysis, we believe that Deloitte's estimates and ours are 
    comparable because of the uncertainty inherent in forecasting and 
    the professional judgments made in this type of analysis. Both of 
    these estimates easily exceed the minimum required capital ratio of 
    2 percent that Congress set in 1990.

 Given the economic value of the Fund and the state of the 
    economy at the end of fiscal year 1999, a 2-percent capital ratio 
    appears sufficient to withstand moderately severe economic 
    downturns that could lead to worse-than-expected loan performance. 
    That is, under economic scenarios that we developed to represent 
    regional and national economic downturns that the Nation 
    experienced between 1975 and 1999, the estimated capital ratio fell 
    by only slightly less than 0.4 percentage points. Some more severe 
    downturns that we analyzed also did not cause the estimated capital 
    ratio to decline by as much as 2 percentage points. However, in 
    three more severe scenarios, an economic value of 2 percent of 
    insurance-in-force would not have been adequate. Nonetheless, 
    because of the nature of such analysis, we urge caution in 
    concluding that the estimated value of the Fund today implies that 
    the Fund would necessarily withstand any particular economic 
    scenario under all circumstances.

 Congress and the Secretary of HUD have taken and could take a 
    number of actions to influence the economic value of the Fund. The 
    impact that these actions have on the capital ratio and FHA 
    borrowers is not always certain. However, actions that influence 
    the Fund's reserve levels will also affect the Federal budget. In 
    short, any proposal that seeks to use reserves, if not accompanied 
    by a reduction in other spending or an increase in receipts, will 
    result in a decline in the Federal budget surplus.

    Let me start by describing our estimates of the Fund's economic 
value and capital ratio and how our estimates compare with estimates 
prepared by Deloitte & Touche.

The Fund's Capital Ratio Exceeds 3 Percent
    The economic value of the Fund consists of current capital 
resources and the net present value of future cash flows. Investments 
in nonmarketable Treasury securities represent the largest component of 
FHA's current capital resources. Estimating the net present value of 
future cash flows is a complex actuarial exercise that requires 
extensive professional judgment. Cash flows into the Fund from premiums 
and the sale of foreclosed properties; cash flows out of the Fund to 
pay claims on foreclosed mortgages, premium refunds, and administrative 
expenses. (See figure 2.)




    At the end of fiscal year 1999, the Fund had capital resources of 
$14.3 billion. Using our models and forecasts of likely values of key 
economic variables, we estimated that the Fund had a net present value 
of future cash flows of $1.5 billion at that time. This yielded an 
estimated economic value of $15.8 billion and a capital ratio of 3.20 
percent. Given the inherent uncertainty of these estimates and the 
professional judgments involved, these numbers are comparable to those 
of Deloitte at the end of 1999, when Deloitte estimated that under 
expected economic conditions the capital value was $16.6 billion and 
the capital ratio was 3.66 percent. Much of the difference seems to be 
the result of performing the analyses at different times. Because 
Deloitte performed its analysis before the end of fiscal year 1999, it 
had to estimate the Fund's capital resources and insurance-in-force, 
while we were able to use the year-end values. In its recent estimates 
for 2000, Deloitte noted that in the actuarial review for the fiscal 
year 1999, it had overestimated the Fund's capital resources by about 
$1 billion. However, Deloitte did not restate the economic value and 
capital ratio for 1999; instead it adjusted the starting point for the 
2000 estimate of economic value. If Deloitte had restated the economic 
value and capital ratio for fiscal year 1999, the 1999 values would 
likely have been smaller. Because Deloitte & Touche uses estimates for 
the Fund's capital resources and insurance-in-force, it is difficult to 
compare its estimates of the Fund's economic value and capital ratio 
over time.




    The Fund's economic value principally reflects the large amount of 
capital resources that the Fund has accrued. Because current capital 
resources are the result of previous cash flows, the robustness of the 
economy and the higher premium rates throughout most of the 1990's 
accounted for the accumulation of these substantial capital resources. 
Good economic times that are accompanied by relatively low interest 
rates and relatively high levels of employment are usually associated 
with high levels of mortgage activity and relatively low levels of 
foreclosure; therefore, cash inflows have been high relative to 
outflows during this period.
    The estimated value of future cash flows also contributed to the 
strength of the Fund at the end of fiscal 1999. As a result of 
relatively low interest rates and the robust economy, FHA insured a 
relatively large number of mortgages in fiscal years 1998 and 1999, and 
these loans make up a large portion of FHA's insurance-in-force. 
Because of their low interest rates and because forecasts of economic 
variables for the near future show house prices rising while 
unemployment and interest rates remain fairly stable, our models 
predict that these new loans will have low levels of foreclosure and of 
prepayment. At the same time, we assume that many FHA-insured 
homebuyers will continue to pay FHA annual insurance premiums.\2\ Thus, 
our models predict that cash flowing into the Fund from mortgages 
already in FHA's portfolio at the end of fiscal year 1999 will be more 
than sufficient to cover the cash outflows associated with these loans.
---------------------------------------------------------------------------
    \2\ Most borrowers with FHA-insured loans who received them prior 
to September 1983 were required to pay an annual insurance premium for 
the life of the loan. In addition, most borrowers who received FHA-
insured loans after June 1991 are required to pay an annual insurance 
premium for up to the life of the loan, depending on loan type and the 
initial loan-to-value ratio of the loan. Borrowers who received FHA-
insured loans between September 1983 and June 1991 were not required to 
pay annual mortgage insurance premiums.
---------------------------------------------------------------------------
    The future cash flows are estimates based on a number of 
assumptions about the future, including predictions of mortgage 
foreclosures and the likelihood that those holding FHA-insured 
mortgages will prepay their loans. These predictions are based on 
elaborate models that estimate past relationships between foreclosures 
and prepayments and certain economic variables, such as changes in 
house prices. To the extent that these relationships are different in 
the future, the actual foreclosures and prepayments will differ from 
the estimates. The estimating procedures make many other assumptions, 
and I will describe some of these limitations in greater detail later 
in my testimony.

The Actuarial Soundness of the Fund Depends on the Risks That
Congress Wants the Fund to Withstand
    Although our estimates and the Deloitte's estimates of the Fund's 
capital ratio under expected economic conditions are comparable, we 
cannot conclude on the basis of these estimates alone that the Fund is 
actuarially sound. Instead, we believe that to determine actuarial 
soundness one should measure the Fund's ability to withstand certain 
worse-than-expected conditions. According to our estimates, worse-than-
expected loan performance that could be brought on by moderately severe 
economic conditions would not cause the estimated value of the fund at 
the end of fiscal year 1999 to decline by more than 2 percent of 
insurance-in-force. Some more severe downturns that we analyzed also 
did not cause the estimated capital ratio to decline by as much as 2 
percentage points. However, a few more severe economic scenarios could 
result in such poor loan performance that the estimated value of the 
fund at the end of fiscal year 1999 could decline by more than 2 
percent of insurance-in-force.
    To help determine the Fund's ability to withstand certain worse-
than-expected conditions, we generated economic scenarios that were 
based on economic events in the last 25 years and other scenarios that 
could lead to worse-than-expected loan performance in the future. Under 
each of these scenarios, we used our models to estimate the economic 
value of the Fund and the related capital ratio. (See table 2.) Most of 
the scenarios we looked at had only a small impact on the capital 
ratio. For example, the worst historical scenario we tested, one based 
on the 1981-1982 national recession, lowered the capital ratio by less 
than 0.4 percentage points--about 20 percent of the required 2 percent 
minimum capital ratio. To see how the economic value of the Fund would 
change as the extent of adversity increased, we extended regional 
scenarios that were based on historical economic downturns experienced 
in three States--the west south central downturn based on Louisiana in 
the late 1980's, the New England downturn based on Massachusetts in the 
late 1980's and early 1990's, and the Pacific downturn based on 
California in the 1990's--to the Nation as a whole. In extending the 
west south central and Pacific downturns, the estimated capital ratio 
was about 1 percentage point lower than in the base case. However, our 
models estimate that extending the New England downturn to the country 
as a whole would reduce the capital ratio by almost 2.4 percentage 
points. In another scenario, in which we specify that interest rates 
fall substantially, inducing refinancing, and then a recession sets in, 
leading to increased foreclosures, the estimated capital ratio fell 
substantially, by over 1.8 percentage points.
    In one other scenario, the capital ratio fell by over 2 percentage 
points. In that scenario we assumed that foreclosure rates in 2000 
through 2004 equal foreclosure rates from 1986 through 1990 for 
mortgages originated in the 10-year periods prior to 2000 and 1986, 
respectively.



    Because none of our economic scenarios generated foreclosure rates 
as high as those experienced in the west south central states in the 
late 1980's, we applied these rates directly to our models, assuming 
that for the next 5 years foreclosure rates in most cases would be 
equivalent to those experienced by the west south central states in 
1986 through 1990. Then we varied the proportion of FHA's portfolio 
experiencing these west south central foreclosure rates. As figure 3 
shows, if about 36 percent of the portfolio experiences these rates, 
the estimated capital ratio would be 2 percentage points lower than the 
expected case; and if 55 percent of the portfolio experienced these 
rates, the economic value of the Fund would fall to zero.




    As we have stated in the past, there is considerable uncertainty 
associated with any estimate of the economic value of the Fund because 
of uncertainty about the performance of FHA's loan portfolio over the 
life of the existing loans, which, in some cases, can be for 30 years. 
We believe that our models make good use of historical experience in 
identifying the key factors that influence loan foreclosures and 
prepayments and estimating the relationships between those factors and 
loan performance. In addition, we have relied on reasonable, and in 
some cases conservative, forecasts of economic variables, such as the 
rate of house price appreciation and the unemployment rate, in finding 
that the Fund's economic value in fiscal year 1999 appeared higher than 
necessary to withstand many adverse economic scenarios.
    Nonetheless, several additional factors lead us to believe that 
Congress and others should apply caution in concluding that the 
estimated value of the Fund today implies that the Fund could withstand 
the economic scenarios that we examined under all circumstances. Our 
estimates and those of others are valid only under a certain set of 
conditions, including that loans FHA insured in recent years and loans 
it insured in the more distant past have a similar response to economic 
conditions, and that cash inflows associated with future loans at least 
offset cash outflows associated with those loans. Some specific factors 
beyond those incorporated in our models that could determine the extent 
to which the Fund will be able to withstand adverse economic conditions 
are as follows:

 The performance of recent loans -- Over 40 percent of FHA's 
    loan portfolio at the end of fiscal year 1999 consisted of loans 
    originated in fiscal years 1998 and 1999. As a result, the 
    performance of these loans will have an important effect on the 
    overall performance of FHA's loan portfolio. However, because these 
    loans are so new, we do not have a lot of data yet showing how well 
    they will perform over their lifetimes, which is often 30 years. 
    Our model is based on data on loan performance for loans 
    originating from 1975 through 1999. As long as the influences of 
    key predictive factors on the probabilities of foreclosure and 
    prepayment have not changed much over time, then we can be 
    reasonably confident that the estimates of these relationships 
    generated by our models will apply to these recent loans. However, 
    in recent years, FHA's competitors in the conventional mortgage 
    market--private mortgage insurers and conventional mortgage 
    lenders--are increasingly offering to selected homebuyers products 
    that compete with FHA's for those homebuyers who are borrowing more 
    than 95 percent of the value of their homes. By lowering the 
    required down payment, conventional mortgage lenders and private 
    mortgage insurers may have attracted some less risky borrowers who 
    might otherwise have insured their mortgages with FHA. And this may 
    have increased the average risk of FHA-insured loans in the late 
    1990's. However, because these loans are relatively new, the 
    increased risk would not yet be observable in the data on 
    foreclosures and prepayments. If this effect, known as adverse 
    selection, has been substantial, the economic value of the Fund may 
    be lower than we estimate, and it may be more difficult for the 
    Fund to withstand worse-than-expected loan performance than our 
    estimates suggest.

 Changes in FHA's insurance program--A number of changes that 
    FHA has made or might make in the future could affect the future 
    cash flows associated with loans in FHA's portfolio as of the end 
    of fiscal year 1999 and, therefore, the Fund's economic value, in 
    ways that are not accounted for in our models. For example, if HUD 
    reinstitutes paying distributive shares to borrowers when they pay 
    their mortgages in full or voluntarily terminate their insurance, 
    cash outflows might be higher than our estimates.\3\ FHA's loss 
    mitigation program might either reduce or increase cash outflows, 
    depending on whether the program succeeds in reducing foreclosures 
    or whether the program mainly results in delayed foreclosures that 
    lead to larger losses for FHA in the long run. On the other hand, 
    if FHA's financial counseling program reduces foreclosures for 
    those homebuyers who received such counseling, then losses to the 
    Fund will be less than we have estimated. Steps taken by HUD to 
    improve the oversight of lenders and the disposition of properties 
    could also reduce the level of losses to FHA below what we have 
    estimated.
---------------------------------------------------------------------------
    \3\ Between 1943 and 1990, FHA rebated these so-called excess funds 
to borrowers as distributive shares. In 1990, however, Congress 
suspended the payment of these shares until the Secretary of HUD 
determines that the Fund is actuarially sound. HUD has announced that 
it will resume paying distributive shares. HUD officials said that they 
are developing systems to facilitate the payment of these shares and 
expect to be ready to resume paying them in mid-2001.

 The impact of new loans -- Our models do not look at cash 
    flows associated with loans that FHA would insure after fiscal year 
    1999. Our analysis of the ability of the Fund to withstand adverse 
    economic conditions requires making the assumption that the adverse 
    conditions would not also cause loans insured by FHA after fiscal 
    year 1999 to be an economic drain on the Fund. Since the 1990 FHA 
    reforms, the cash flows associated with each year's loans have been 
    estimated to have a positive economic value, thereby adding to the 
    economic value of the entire Fund. However, during adverse economic 
    times, new loans might perform worse than loans that were insured 
    by FHA during the 1990's. Furthermore, recent and future changes in 
    FHA's insurance program may cause these loans to perform 
    differently from how past experience suggests that they will. If, 
    for example, FHA loosens underwriting standards, future loans may 
    perform worse than past experience suggests. In addition, the 
    recent reduction in up-front premiums could reduce cash inflows 
    into the Fund, although it could also lower the riskiness of the 
    loans that FHA insures. If the newly insured loans perform so 
    poorly that they have a negative economic value, then the loss to 
    the Fund in any of the adverse economic scenarios that we have 
    considered would be greater than what we have estimated. 
    Alternatively, if the newly issued loans have positive economic 
---------------------------------------------------------------------------
    values, then they would contribute to further growth of the Fund.

    Caution also needs to be applied in making changes to FHA's 
insurance program because of the current uncertainty about their impact 
on the Fund. In analyzing the impact of changes in FHA's programs and 
policies on the Fund, it is important to recognize that such changes 
can affect the volume and riskiness of loans that FHA insures. Although 
the models currently used in the annual actuarial reviews of the Fund 
can be used to estimate the direct impact that some policy changes may 
have on the Fund's economic value, these models cannot isolate indirect 
effects on the volume and riskiness of FHA's loans. Accordingly, in our 
report, we recommended that the Secretary of HUD develop better tools 
for assessing the impacts that these changes may have on the volume and 
riskiness of loans that it insures.\4\
---------------------------------------------------------------------------
    \4\ Mortgage Financing: FHA's Fund Has Grown, but Options for 
Drawing on the Fund Have Uncertain Outcomes (GAO-01-460, February 28, 
2001).
---------------------------------------------------------------------------
Options for Drawing on the Fund Have Uncertain Outcomes,
But Any Use of the Fund's Reserves Will Affect the Federal Budget
    Given the recent growth in the economic value of the Fund, several 
proposals have been made to use what some are calling excess reserves 
or take other actions that could result in a change in the value of the 
Fund. If Congress or the Secretary of HUD believes that the economic 
value of the Fund is higher than the amount needed to ensure actuarial 
soundness, several changes to the FHA single-family loan program could 
be adopted. The impact that these actions might have on the capital 
ratio and FHA borrowers is difficult to assess without using tools 
designed to estimate the multiple impacts that policy changes often 
have. However, any actions that influence the Fund's reserve levels 
will also affect the Federal budget. In short, any proposal that seeks 
to use reserves, if not accompanied by a reduction in other spending or 
an increase in receipts, would result in either a reduction in the 
surplus or an increase in any existing deficit.
    Several changes to the FHA's single-family loan program could be 
adopted if the Congress or the Secretary of HUD believes that the 
economic value of the Fund is higher than the amount needed to meet its 
definition of actuarial soundness. For example, actions that the 
Secretary could take that could reduce the value of the Fund include 
lowering insurance premiums, adjusting underwriting standards, and 
reinstituting distributive shares. However, Congressional action in the 
form of new legislation would be required to make other program changes 
that are not now authorized by the statute. These would include such 
actions as changing the maximum amount FHA-insured homebuyers may 
borrow relative to the price of the house they are purchasing and using 
the Fund's reserves for other Federal programs.\5\
---------------------------------------------------------------------------
    \5\ During the 106th Congress, legislation was introduced that 
proposed using the Fund's resources to fund affordable rental housing. 
(See S. 2997.)
---------------------------------------------------------------------------
    Reliably estimating the potential effect of various options on the 
Fund's capital ratio and FHA borrowers is difficult because the impacts 
of these policy changes are complex, and tools available for handling 
these complexities may not be adequate. Policy changes have not only 
immediate, straightforward impacts on the Fund and FHA's borrowers, 
they also have more indirect impacts that may intensify or offset the 
original effect. Implementing these options could affect both the 
volume and the average riskiness of loans made, which, in turn, could 
affect any future estimate of the Fund's economic value. As a result of 
this complexity, obtaining a reliable estimate would likely require 
that economic models be used to estimate the indirect effects of policy 
changes. At this time, however, neither the models used by HUD to 
assess the financial health of the Fund, nor those used by others, 
explicitly recognize the indirect effects of policy changes on the 
volume and the riskiness of FHA's loans. As a result, HUD cannot 
reliably estimate the impact of policy changes on the Fund.
    Although it is difficult to predict the overall impact of a change 
on the Fund's capital ratio and thus on FHA borrowers as a whole, 
different options would likely have different impacts on current and 
prospective FHA-insured borrowers. Some proposals would more likely 
benefit existing and future FHA-insured borrowers, while others would 
benefit only future borrowers, and still others would benefit neither 
of these groups. One interpretation of the higher premiums that 
borrowers paid during the period in which the economic value of the 
Fund has been rising is that borrowers during the 1990's ``overpaid'' 
for their insurance. Some options for reducing the capital ratio, such 
as reinstituting distributive shares, would be more likely to 
compensate these borrowers. The payment of distributive shares would 
benefit certain existing borrowers who voluntarily terminate their 
mortgages. If these policies continued into the future, they would also 
benefit future policyholders. Alternatively, reducing up-front 
premiums, reducing the number of years over which annual insurance 
premiums must be paid, or relaxing underwriting standards would tend to 
benefit only future borrowers.
    Under 1990 credit reform legislation, the FHA's budget is required 
to reflect the subsidy cost to the Government of FHA's loan insurance 
activities for that year.\6\ Credit reform was intended to ensure that 
the full cost of credit activities for the current budget year would be 
reflected in the Federal budget so that Congress and the Executive 
Branch could consider these costs when making annual budget decisions. 
For FHA's Mutual Mortgage Insurance Fund, the subsidy cost is negative; 
that is, the program is operating at a profit. Under credit reform, the 
negative subsidy receipts would be available for appropriation for 
other uses, and a balance would not be permitted to accumulate in the 
liquidating account. However, to accommodate the differing statutory 
requirements of budgeting for the subsidy cost of insuring the loans 
and maintaining a 2-percent reserve, the Office of Management and 
Budget (OMB) and FHA have allowed reserves to accumulate in the Fund in 
the form of interest-bearing Treasury securities. At the end of fiscal 
year 1999, the FHA held nearly $15 billion in Treasury securities. 
These securities represent a claim on the U.S. Treasury to cover future 
losses to the Fund. From the perspective of the U.S. Treasury, these 
securities represent a liability. From the standpoint of the Government 
as a whole, the securities represent a debt owed by one part of the 
Federal Government to another. By investing in nonmarketable Treasury 
securities, FHA makes funds available to other Federal programs. Each 
year that the Fund runs a surplus, the budget surplus for the Federal 
Government, as a whole, is higher than it would otherwise have been if 
FHA had not been insuring profitable loans. When the total Federal 
budget was in a deficit (as it was for most of the 1990's), that 
deficit was lower than it would have been if the Fund had not been 
realizing a surplus at the same time.
---------------------------------------------------------------------------
    \6\ The subsidy cost is the estimated net cost to the Government, 
in present value terms, of FHA-insured loans over the entire period the 
loans are outstanding.
---------------------------------------------------------------------------
    Because of the difficulty in reliably measuring the effect of most 
actions that could be taken either by Congress or the Secretary of HUD 
on the Fund's capital ratio, we cannot precisely measure the effect of 
these policies on the budget. However, any actions taken by Congress or 
the Secretary that influence the Fund's capital ratio will have a 
similar effect on the Federal budget. If Congress or the Secretary of 
HUD adopts policies, such as lowering premiums, paying distributive 
shares, or loosening underwriting standards, that reduce the 
profitability of the Fund, the negative subsidy amount reported in 
FHA's budget submission and the Fund's reserve will both be lower.\7\ 
Some of these policies--lowering premiums and paying distributive 
shares--would affect FHA's cash flows immediately.\8\ Thus, the amount 
of money available for FHA to invest in Treasury securities would be 
lower. Treasury in turn would have less money available for other 
purposes, and the overall surplus would decline. If the amounts of cash 
flowing out of the Fund exceeded current receipts, FHA would be 
required to redeem its investments in Treasury securities to make the 
required payments. Assuming no changes in other spending and taxes, 
Treasury then would be required to either increase borrowing from the 
public or use general tax revenues to meet its financial obligations to 
FHA. In either case, the annual budget surplus would be lower.
---------------------------------------------------------------------------
    \7\ If Congress were to use the Fund's reserves to fund other 
programs, the reserves would be lower, but there would be no effect on 
the negative subsidy amount reported in FHA's budget submissions.
    \8\ Assuming that the volume and the riskiness of FHA-insured loans 
will not change, HUD estimates that the recent reductions in up-front 
premiums combined with the introduction of mortgage insurance 
cancellation policies will lower the estimated value of the Fund by 
almost $6 billion over the next 6 years.
---------------------------------------------------------------------------
    Budgetary scoring for budget control purposes under the 1990 Budget 
Enforcement Act \9\ is required only when a law is enacted; actions 
taken by the Secretary under existing authorities are not scored for 
budget control purposes, even though they may affect the budget surplus 
or deficit. Whether and how the proposals under discussion would be 
scored depend on the exact wording of the new law and is determined by 
OMB for Budget Enforcement Act purposes. However, any action taken by 
Congress or the Administration to reduce FHA's reserves, if not 
accompanied by a similar reduction in other Government spending or by 
an increase in receipts, will result in either a reduction in the 
surplus or an increase in any existing deficit.
---------------------------------------------------------------------------
    \9\ As part of the effort to control Federal budget results, the 
Budget Enforcement Act of 1990, as amended, created controls over laws 
changing or creating mandatory spending (basically entitlements) and 
receipts.
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Actuarial Soundness Should be Defined
    Whether actions should be taken to change the value of the Fund 
depends on whether the Fund's capital resources and expected revenues 
exceed the amount needed to meet its expected cash outflows under 
designated stressful conditions; that is, whether it is actuarially 
sound. Assessing whether this condition exists requires that the degree 
of risk that the Fund is expected to be able to withstand must be 
specified. If the Fund is expected to withstand what Price Waterhouse 
called reasonably adverse economic downturns, then our results could be 
construed to mean that the Fund is taking in more revenue than it 
needs. Alternatively, if the Fund is expected to never exhaust its 
reserves, the current Fund might not be adequate.
    The 1990 reforms did not specify the amount of risk that the Fund 
needed to withstand. Instead, the reforms specified a minimum capital 
ratio and required that the Fund achieve actuarial soundness before the 
Secretary of HUD could take certain actions that might reduce the value 
of the Fund. Because we believe that actuarial soundness depends on a 
variety of factors that could vary over time, setting a minimum or 
target capital ratio will not guarantee that the Fund will be 
actuarially sound over time. For example, if the Fund comprised 
primarily seasoned loans with known characteristics, a capital ratio 
below the current 2-percent minimum might be adequate. But under 
conditions such as those that prevail today, when the Fund is composed 
of many new loans, a 2-percent ratio might be inadequate if recent and 
future loans perform considerably worse than expected.
    We believe that to evaluate the actuarial soundness of the Fund, 
one or more scenarios that the Fund is to withstand would need to be 
specified. Then it would be appropriate to calculate the economic value 
of the Fund or the capital ratio under the scenario(s). As long as the 
estimated economic value of the Fund is positive when the desired 
stress scenario(s) is used to make that estimate, the Fund could be 
said to be actuarially sound. However, it might be appropriate to leave 
a cushion to account for the factors not captured by the model and the 
inherent uncertainty attached to any forecast. In any event, we believe 
that a single, static capital ratio does not measure actuarial 
soundness.
Matters for Congressional Consideration
    For these reasons, Mr. Chairman, Congress may wish to consider 
taking action to specify criteria for determining when the Fund is 
actuarially sound. More specifically, Congress may want to consider 
defining the types of economic conditions under which the Fund would be 
expected to meet its commitments without borrowing from the Treasury.
    Mr. Chairman, this concludes my statement. We would be pleased to 
respond to any questions that you or Members of the Subcommittee may 
have.
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