Mortgage Financing: Actuarial Soundness of the Federal Housing
Administration's Mutual Mortgage Insurance Fund (Testimony, 03/20/2001,
GAO/GAO-01-527T).

Through the Mutual Mortgage Insurance Fund, the Federal Housing
Administration operates a single-family insurance program that helps
millions of Americans buy homes. Last year, the Fund's economic value
appeared to have reached its highest level in the last 20
years--prompting proposals to spend some of the Fund's current resources
or reduce net cash flows into the Fund. This testimony discusses (1) the
financial health of the Fund under different economic scenarios and (2)
the impact of proposals to reduce the size of the Fund. GAO determined
that under several scenarios it tested, the Fund would be able to
withstand moderately severe economic downturns. However, in three more
scenarios GAO tested, the Fund would not be able to maintain its
actuarial soundness. Because of the professional judgment and
uncertainty involved in these analyses, GAO urges caution in using these
estimates to determine that the Fund would withstand any particular
economic scenario under all circumstances. Congress and the Secretary of
Housing and Urban Development have taken and could take a number of
actions to influence the economic value of the Fund. However, those
actions will affect the federal budget and, if not accompanied by
spending reduction efforts in other areas of the government, the federal
budget surplus will decline.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GAO-01-527T
     TITLE:  Mortgage Financing: Actuarial Soundness of the Federal
	     Housing Administration's Mutual Mortgage Insurance Fund
      DATE:  03/20/2001
   SUBJECT:  Funds management
	     Mortgage loans
	     Mortgage programs
	     Risk management
	     Economic analysis
	     Econometric modeling
	     Mortgage protection insurance
IDENTIFIER:  Mutual Mortgage Insurance Fund

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GAO-01-527T

MORTGAGE FINANCING

Actuarial Soundness of the Federal Housing Administration's Mutual Mortgage
Insurance Fund Statement of Thomas J. McCool, Managing Director Financial
Markets and Community Investment United States General Accounting Office GAO
Testimony Before the Subcommittee on Housing and Community

Opportunity, Committee on Financial Services House of Representatives

For Release on Delivery Expected at 2: 00 p. m., EST Tuesday March 20, 2001
GAO- 01- 527T

GAO- 01- 527T 1

Madam Chairwoman 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.

The 1990 FHA reforms required that an independent contractor conduct an
annual actuarial review of the Fund. These reviews have shown that during
the 1990s, 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.

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.

GAO- 01- 527T 2

Figure 1: Comparison of Estimated Economic Value and 2 Percent of Insurance-
in- Force, 1989- 2000

Source: GAO analysis of Price Waterhouse (now PricewaterhouseCoopers) and
Deloitte & Touche data.

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 insurancein- 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 judgements 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

GAO- 01- 527T 3

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 fig. 2.)

GAO- 01- 527T 4

Figure 2: Cash Flows of the Mutual Mortgage Insurance Fund

Refinancedor sold! Refunds of

up- front premiums if

mortgage terminated voluntarily within 7 years

Sold! FHA

Administrative expenses

HUD- owned house

Previously foreclosed

Proceeds from sale of foreclosed

property FHA- insured

mortgage Insurance

premiums (up- front and annual)

Lender Claims on

foreclosed properties MMI

Fund

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 judgements 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

GAO- 01- 527T 5

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 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 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.

Table 1: Estimates of Capital Ratios for FHA's Mutual Mortgage Insurance
Fund by GAO and Deloitte & Touche, End of FY 1999

Dollars in millions Estimate

Total capital resources

Future cash flows

Economic value

Unamortized insurance- inforce Capital ratio

(percent)

GAO $14,326 $1,484 $15,810 $493,990 3.20 Deloitte 15,331 1,306 16,637
454,184 3.66 Source: GAO analysis and Actuarial Review of MMI Fund as of FY
1999, Deloitte & Touche.

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 1990s 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 prepayment. At the same time, we
assume that many FHA- insured homebuyers will continue to pay FHA annual
insurance premiums. 2 Thus, our

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.

GAO- 01- 527T 6

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.

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 FHAinsured 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 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- 82 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 1980s, the New England
downturn based on Massachusetts in the late 1980s and early 1990s, and the
Pacific downturn based on California in the 1990s- 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.

GAO- 01- 527T 7

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.

GAO- 01- 527T 8

Table 2: Capital Ratios Under Expected and More Severe Economic Scenarios in
Selected Locations Scenario Description

Capital ratio for scenarios in one

region (percent) Capital ratio for

national scenarios (percent)

Expected economic conditions

Unemployment and interest rates vary as DRI forecasts; house price growth is
adjusted for constant quality and slower growth a

NA 3.20 Historical regional downturns West south central downturn

House prices and unemployment rates change as they did in Louisiana from
1986 through 1990.

3.06 2.31 New England downturn House prices and unemployment

rates change as they did in Massachusetts from 1988 through 1992.

3.14 0.81 Pacific downturn House prices and unemployment

rates change as they did in California from 1991 through 1995.

2.89 2.16 Other national scenarios 1981- 82 Recession For each state, house
prices,

unemployment rates, and interest rates change as they did from 1981 through
1985.

NA 2.81 Induced refinancing followed by a recession

Mortgage interest rates fall, inducing borrowers to refinance, and then a
recession sets in, with a rising unemployment rate and falling house prices.

NA 1.37

GAO- 01- 527T 9 Rising interest rate

scenario Mortgage and other interest rates

from 2000 through 2004 are higher than under expected economic conditions.

NA 3.36 Scenario with foreclosure rates from the 1980s

Foreclosure rates in 2000 through 2004 equal foreclosure rates from 1986 to
1990 for mortgages

originated in most recent 10- year period.

NA 0.92

a Standard and Poor's DRI is a private economic forecasting company. Source:
GAO analysis.

Because none of our economic scenarios generated foreclosure rates as high
as those experienced in the west south central states in the late 1980s, 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 high 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.

Figure 3: Capital Ratios Resulting From Applying the Average 1986- 90
Foreclosure Rates in the West South Central Census Division to Varying
Proportions of FHA's Insurance Portfolio in 2000- 04

Note: West south central mortgages made up 9 percent of FHA's portfolio in
1999. This analysis does not change foreclosure rates for streamline
refinanced or adjustable rate mortgages because there are little data on
these

GAO- 01- 527T 10 products for the 10- year period prior to 1986. The west
south central Census division includes Arkansas, Louisiana,

Oklahoma, and Texas. Source: GAO analysis.

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 1990s. 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

GAO- 01- 527T 11

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.

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
1990s. 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 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.

4 Mortgage Financing: FHA's Fund Has Grown, but Options for Drawing on the
Fund Have Uncertain Outcomes (GAO-01- 460, Feb. 28, 2001).

GAO- 01- 527T 12

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 single- family loan program could be adopted if
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 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 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

5 During the 106 th Congress, legislation was introduced that proposed using
the Fund's resources to fund affordable rental housing (see S. 2997).

GAO- 01- 527T 13

been rising is that borrowers during the 1990s “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, 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, 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 1990s), that deficit was lower than it would have
been if the Fund had not been realizing a surplus at the same time.

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

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. 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 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.

GAO- 01- 527T 14

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.

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 are 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.

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 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.

GAO- 01- 527T 15

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, Madam Chairwoman,
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.

Madam Chairwoman, this concludes my statement. We would be pleased to
respond to any questions that you or Members of the Subcommittee may have.

Contact and Acknowledgments

For further information regarding this testimony, please contact Thomas J.
McCool at (202) 512- 8678. Individuals making key contributions to this
testimony included Nancy Barry, Jay Cherlow, and Mathew Scire.

GAO- 01- 527T 16

Related GAO Products Mortgage Financing: FHA's Fund Has Grown, but Options
for Drawing on the Fund Have Uncertain Outcomes (GAO- 01- 460, Feb. 28,
2001). Mortgage Financing: Financial Health of the Federal Housing
Administration's Mutual Mortgage Insurance Fund (GAO/ T- RCED- 00- 287,
Sept. 12, 2000). Mortgage Financing: Level of Annual Premiums That Place a
Ceiling on Distributions to FHA Policyholders (GAO/ RCED- 00- 280R, Sept. 8,
2000).

Single- Family Housing: Stronger Measures Needed to Encourage Better
Performance by Management and Marketing Contractors (GAO/ T- RCED- 00- 180,
May 16, 2000, and GAO/ RCED00- 117, May 12, 2000).

Single- Family Housing: Stronger Oversight of FHA Lenders Could Reduce HUD's
Insurance Risk (GAO/ RCED- 00- 112, Apr. 28, 2000). Homeownership:
Information on Single- Family Loans Sold by HUD (GAO/ RCED- 99- 145, June
15, 1999).

Homeownership: Achievements of and Challenges Faced by FHA's Single- Family
Mortgage Insurance Program (GAO/ T- RCED- 98- 217, June 2, 1998).

Homeownership: Results of and Challenges Faced by FHA's Single- Family
Mortgage Insurance Program (GAO/ T- RCED- 99- 133, Mar. 25, 1999).

Homeownership: Management Challenges Facing FHA's Single- Family Housing
Operations (GAO/ T- RCED- 98- 121, Apr. 1, 1998). Homeownership: Information
on Foreclosed FHA- Insured Loans and HUD- Owned Properties in Six Cities
(GAO/ RCED- 98- 2, Oct. 8, 1997). Homeownership: Potential Effects of
Reducing FHA's Insurance Coverage for Home Mortgages (GAO/ RCED- 97- 93, May
1, 1997). Homeownership: FHA's Role in Helping People Obtain Home Mortgages
(GAO/ RCED- 96- 123, Aug. 13, 1996).

GAO- 01- 527T 17

Mortgage Financing: FHA Has Achieved Its Home Mortgage Capital Reserve
Target (GAO/ RCED- 96- 50, Apr. 12, 1996). Homeownership: Mixed Results and
High Costs Raise Concerns about HUD's Mortgage Assignment Program (GAO/
RCED- 96- 2, Oct. 18, 1995).

Mortgage Financing: Financial Health of FHA's Home Mortgage Insurance
Program Has Improved (GAO/ RCED- 95- 20, Oct. 18, 1994).

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