Federal Housing Administration: Managing Risks from a New Zero	 
Down Payment Product (30-JUN-05, GAO-05-857T).			 
                                                                 
To assist Congress in considering legislation to authorize the	 
Secretary of the Department of Housing and Urban Development	 
(HUD) to carry out a pilot program to insure zero down payment	 
mortgages, this testimony provides information about practices	 
mortgage institutions use in designing and implementing low and  
no down payment products. It also contains information about how 
these practices could be instructive for FHA in managing risks	 
associated with a zero down payment product--a product for which 
the risks are not well understood. This testimony is primarily	 
based on GAO's February 2005 report, Mortgage Financing: Actions 
Needed to Help FHA Manage Risks from New Mortgage Loan Products, 
(GAO-05-194).							 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-05-857T					        
    ACCNO:   A28557						        
  TITLE:     Federal Housing Administration: Managing Risks from a New
Zero Down Payment Product					 
     DATE:   06/30/2005 
  SUBJECT:   Housing						 
	     Housing programs					 
	     Lending institutions				 
	     Mortgage loans					 
	     Mortgage programs					 
	     Mortgage protection insurance			 
	     Program evaluation 				 
	     Risk management					 
	     Data collection					 
	     Homeowners loans					 
	     Insurance premiums 				 
	     HUD Home Equity Conversion Mortgage		 
	     Insurance Program					 
                                                                 

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GAO-05-857T

United States Government Accountability Office

GAO Testimony

Before the Subcommittee on Housing and Community Opportunity, Committee on
Financial Services, House of Representatives

For Release on Delivery

Expected at 10:00 a.m. EDT FEDERAL HOUSING

Thursday, June 30, 2005

ADMINISTRATION

              Managing Risks from a New Zero Down Payment Product

Statement of William B. Shear, Director Financial Markets and Community
Investment

GAO-05-857T

[IMG]

June 30, 2005

FEDERAL HOUSING ADMINISTRATION

Managing Risks from a New Zero Down Payment Product

                                 What GAO Found

In recent years, many mortgage institutions have become increasingly
active in supporting low and even no down payment mortgage products. In
considering the risks of these new products, a substantial amount of
research GAO reviewed indicates that loan-to-value (LTV) ratio and credit
score are among the most important factors when estimating the risk level
associated with individual mortgages. GAO's analysis of the performance of
low and no down payment mortgages supported by FHA and others corroborates
key findings in the literature. Generally, mortgages with higher LTV
ratios (smaller down payments) and lower credit scores are riskier than
mortgages with lower LTV ratios and higher credit scores.

Some practices of other mortgage institutions offer a framework that could
help FHA manage the risks associated with introducing new products or
making significant changes to existing products. Mortgage institutions
sometimes require additional credit enhancements, such as higher insurance
coverage, and stricter underwriting, such as credit score thresholds, when
introducing a new low or no down payment product. FHA is authorized to
require an additional credit enhancement, but does not currently use this
authority. FHA has used stricter underwriting criteria, but told us it is
unlikely they would use a credit score threshold for a new zero down
payment product. Mortgage institutions may also impose limits on the
volume of the new products they will permit and on who can sell and
service these products. FHA officials question the circumstances in which
they can limit volumes for their products and believe they do not have
sufficient resources to manage a product with limited volumes, but the
potential costs of making widely available a product with risk that is not
well understood could exceed the cost of initially implementing such a
product on a limited basis.

Average Four-Year Default Rates for FHA Insured Loans Originated in 1998,
1999, and 2000 (by LTV)

Source: FY 2003 Actuarial Review of the Mutual Mortgage Insurance Fund.

United States Government Accountability Office

Mr. Chairman and Members of the Subcommittee:

I am pleased to be here today to provide the committee with information
and perspectives as it considers legislation that would authorize the
Secretary of Housing and Urban Development (HUD) to carry out a pilot
program to insure zero down payment mortgages. The Federal Housing
Administration (FHA) at HUD currently insures low down payment mortgages
to homebuyers across the nation. FHA requires homebuyers to make a 3
percent contribution toward the purchase of the home, though some of this
may come in the form of a gift from others. FHA also permits some closing
costs to be financed. My testimony today is primarily based on a report we
completed for this Subcommittee on managing risks associated with low and
no down payment loans, which was issued in February, 2005.1 I will focus
my discussion on the practices mortgage institutions use in designing and
implementing low and no down payment products and how these practices
could be instructive for the FHA in managing risks associated with a zero
down payment product. A substantial body of research indicates that loans
with lower down payments are generally riskier than those with higher down
payments.

To obtain information for our report, we interviewed officials from FHA;
staff at selected conventional mortgage providers;2 private mortgage
insurers; and two government-sponsored enterprises (GSE), Fannie Mae and
Freddie Mac. We obtained information about the standards of low and no
down payment mortgage products they support and the steps they take to
design, implement, and monitor these products. However, we did not verify
that these institutions, in fact, used these practices. We conducted this
work from January through December 2004 in accordance with generally
accepted government auditing standards.

In summary, there are several risk-management practices mortgage
institutions use in designing, implementing, and monitoring low and no
down payment products, and we believe these practices could be instructive
for FHA in managing risks associated with a zero down payment product.

1GAO, Mortgage Financing: Actions Needed to Help FHA Manage Risks from New
Mortgage Loan Products, GAO-05-194 (Washington, D.C.: Feb. 11, 2005).

2Conventional mortgages do not carry government insurance or guarantees.

o  	Mortgage institutions can mitigate the risk of low and no down payment
products by requiring additional credit enhancements such as higher
mortgage insurance coverage. For example, Fannie Mae and Freddie Mac
require higher mortgage insurance for loans with a loan-to-value ratio
(LTV) of great than 95 percent.3 While FHA already will pay up to 100
percent of the losses from a foreclosure on a house, it does have the
authority to share risk but does not currently use this authority.

o  	Mortgage institutions sometimes implement stricter underwriting to
manage the additional risks associated with a new mortgage product. For
example, institutions can require a higher credit score or higher reserves
from the borrower. FHA has made adjustments to its underwriting criteria
on its existing products but FHA officials told us that FHA is unlikely to
mandate a credit score threshold for a zero down payment product.

o  	Mortgage institutions increase fees and charge higher premiums to
compensate for the additional risks associated with a new mortgage
product. For example, Fannie Mae officials stated that they would charge
higher guarantee fees on low and no down payment loans if they were not
able to require the higher insurance coverage. FHA is authorized to make,
and has made, adjustments to its up-front and annual premiums on its
existing products. The administration proposed higher premiums as part of
its 2006 budget proposal for a zero-down payment product.

o  	Mortgage institutions sometimes use pilots or limit the initial
availability of new products to build experience or better understand the
factors that contribute to risk for these products. For example, Freddie
Mac limited the initial availability of its 100 LTV product. Some mortgage
institutions also may limit the origination and servicing of the product
to their better lenders and servicers. However, FHA officials told us they
face challenges in piloting and limiting mortgage products to certain
approved lenders or servicers.

o  	According to officials of mortgage institutions, including FHA, they
also often put in place more substantial monitoring and oversight
mechanisms for their new products and then make changes based on what they
learn. Some mortgage institutions, such as Fannie Mae, told us that they
may conduct rigorous quality control sampling of new acquisitions, early
payment defaults, and nonperforming loans. Depending on the scale of a new
initiative, and its perceived risk, these quality control reviews could

3LTV is a ratio of the loan amount divided by the property sales price or
appraised value of the house.

include a review of up to 100 percent of the loans that are part of the
new product. FHA officials told us they also more closely monitor loans
underwritten under revised guidelines.

In light of the risks that new lending products present and in recognition
of established risk management practices, in our report, we suggested that
Congress consider limiting the initial availability of any new
single-family insurance product it may authorize, including a zero down
payment product. We also suggested that Congress consider directing HUD to
consider using various techniques for mitigating risks for a no down
payment product, or products about which the risks are not well
understood. We recommended that FHA consider using pilots for new products
and for making significant changes to its existing products, regardless of
any new products Congress may authorize. Additionally, we recommended that
FHA explore various techniques for mitigating risks when implementing new
products that have greater risk or for which risk is not well understood,
such as a zero down payment product.

However, during the course of our work, HUD officials told us that they
face challenges in administering a pilot program and they question the
circumstances in which they can limit the availability of a new product.
We believe that HUD needs to further consider piloting or limiting volume
of new or changed products, including a zero down payment product. There
are several available techniques for limiting an initial product that
could help to address HUD's concerns, including limiting the time period
in which it is available. Further we believe that in some circumstances
the potential costs of making widely available a product when the risks of
that product are not well understood could exceed the cost of initially
implementing such a product on a limited basis. To the extent HUD believes
it does not have the authority for exercising the options we describe, we
recommend it seek the authority from Congress.

Background 	Mortgage insurance, a commonly used credit enhancement,
protects lenders against losses in the event of default, and FHA is a
government mortgage insurer in a market that also includes private
insurers. During fiscal years 2001 to 2003, FHA insured a total of about
3.7 million mortgages with a total value of about $425 billion. FHA plays
a

particularly large role in certain market segments, including low-income
and first-time homebuyers. In 2000, almost 90 percent of FHA-insured home
purchase mortgages had an LTV higher than 95 percent. FHA insures most of
its mortgages for single-family housing under its Mutual Mortgage
Insurance (MMI) Fund. To cover lender's losses, FHA collects premiums from
borrowers. These premiums, along with proceeds from the sale of foreclosed
properties, pay for claims that FHA pays lenders as a result of
foreclosures.

In recent years, other members of the conventional mortgage market (such
as private mortgage insurers, government-sponsored enterprises such as
Fannie Mae and Freddie Mac, and large private lenders) have been
increasingly active in supporting low and even no down payment mortgage
products. For example, Fannie Mae and Freddie Mac's no down payment
mortgage products were introduced in 2000; and many private mortgage
insurers will now insure a mortgage up to 100 percent LTV. However, the
characteristics and standards for low and no down payment products vary
among mortgage institutions. Currently, homebuyers with FHA-insured loans
need to make a 3 percent contribution toward the purchase of the property
and may finance some of the closing costs associated with the loan. As a
result, an FHA-insured loan could equal nearly 100 percent of the
property's value or sales price. In recent years, a growing proportion of
borrowers have received down payment assistance, which further helps them
meet the hurdle of accumulating sufficient funds to purchase a home. Based
on our preliminary analysis of FHA-insured loans that had LTVs above 95
percent, use of down payment assistance has grown to over half of such
loans insured during the first seven months of 2005.

When considering the risk of mortgages, a substantial amount of research
GAO reviewed indicates that the LTV ratio and the borrower's credit score
are among the most important factors when estimating the risk level
associated with individual mortgages.4 We also analyzed the performance,
expressed by the percent of borrowers defaulting within four years of
mortgage origination, of low and no down payment mortgages supported by
FHA and others.5 Our analysis supports the findings we found in the
research literature. Generally, mortgages with higher LTV ratios (smaller

4Credit scores are a single numerical score, based on an individual's
credit history, which measures that individual's creditworthiness.

5Mortgage defaults and foreclosures typically occur at the highest rates 4
to 7 years after the mortgages are issued.

down payments) and lower credit scores are riskier than mortgages with
lower LTV ratios and higher credit scores. As can be seen in Figure 1,
when focusing only on LTV for FHA loans, default rates increase as the LTV
ranges increase. In theory, LTV ratios are important because of the direct
relationship that exists between the amount of equity borrowers have in
their homes and the risk of default. The higher the LTV ratio, the less
cash borrowers will have invested in their homes and the more likely it is
that they may default on mortgage obligations, especially during times of
economic hardship (e.g., unemployment, divorce, home price depreciation).

Figure 1: Average Four-Year Default Rates for FHA Insured Loans Originated
in 1998, 1999, and 2000 (by LTV)

Risk assessment is a very important component of issuing and insuring
mortgages, particularly when introducing a mortgage product that has the
risk associated with a higher LTV. To help assess the risks associated
with mortgages, the mortgage industry has moved toward greater use of
mortgage scoring and automated underwriting systems.6 Mortgage scoring is
a technology-based tool that relies on the statistical analysis of
millions of previously originated mortgage loans to determine how key
attributes

6The mortgage industry also uses credit scoring models for estimating the
credit risk of individuals- these methodologies are based on information
such as payment patterns. Statistical analyses identifying the
characteristics of borrowers who were most likely to make loan payments
have been used to create a weight or score associated with each of the
characteristics. According to Fair, Isaac and Company sources, credit
scores are often called "FICO scores" because most credit scores are
produced from software developed by Fair, Isaac and Company. FICO scores
generally range from 300 to 850 with higher scores indicating better
credit history. The lower the credit score, the more compensating factors
lenders might require to approve a loan. These factors can include a
higher down payment and greater borrower reserves.

  Several Practices Mortgage Institutions Use in Designing and Implementing Low
  and No Down Payment Products Could Be Instructive for FHA in Managing Risk of
  a No Down Payment Product

such as the borrower's credit history, the property characteristics, and
the terms of the mortgage note affect future loan performance.

During the 1990s, private mortgage insurers, the GSEs, and larger
financial institutions developed automated underwriting systems. Automated
underwriting systems refer to the process of collecting and processing the
data used in the underwriting process. These systems rely, in part, on
individuals' credit scores or credit history, and they have played an
integral role in the provision of low and no down payment mortgage
products. These systems allow lenders to quickly assess the riskiness of
mortgages by simultaneously considering multiple factors including the
credit score and credit history of borrowers. FHA has developed and
recently implemented a mortgage scoring tool, called the FHA TOTAL
Scorecard, to be used in conjunction with existing automated underwriting
systems. More than 60 percent of all mortgages- conventional and
government-insured-were underwritten by an automated underwriting system,
as of 2002, and this percentage continues to rise.7

According to representatives of mortgage institutions we interviewed, they
use a number of similar practices in designing and implementing new
products. These practices can be especially important when designing and
implementing new products with higher or less well understood risk, such
as low and no down payment products. Some of these practices could be
helpful to FHA in its design and implementation of a zero down payment
product, as well as other new products. More specifically, mortgage
institutions often establish additional requirements for new products such
as additional credit enhancements or underwriting requirements. Although
FHA has less flexibility in imposing additional credit enhancements it
does have the authority to seek co-insurance, which it is not currently
using. FHA makes adjustments to underwriting criteria and to its premiums,
but told us that it is unlikely to use a credit score threshold for a new
zero down payment product. Further, mortgage institutions also use
different means to limit how widely they make available a new product,
particularly during its early years. FHA does sometimes use practices for
limiting a

7Susan Wharton Gates, Vanessa Gail Perry, and Peter Zorn, "Automated
Underwriting in Mortgage Lending: Good News for the Underserved," Housing
Policy Debate, 13, no. 2, 2002.

new product but usually does not pilot products on its own initiative. FHA
officials with whom we spoke question the circumstances in which they can
limit the availability of a program and told us they do not have the
resources to manage programs with limited availability. Finally, according
to officials of mortgage institutions, including FHA, they also often put
in place more substantial monitoring and oversight mechanisms for their
new products including lender oversight. In an earlier report, we made
recommendations designed to improve HUD's oversight of FHA lenders.8

Mortgage Institutions Require Additional Credit Enhancements

Some mortgage institutions require additional credit enhancements-
mechanisms for transferring risk from one party to another such as
mortgage insurance-on low and no down payment products. Mortgage
institutions such as Fannie Mae and Freddie Mac mitigate the risk of low
and no down payment products by requiring additional credit enhancements
such as higher mortgage insurance coverage. Fannie Mae and Freddie Mac
believe that the higher-LTV loans represent a greater risk to them and
they seek to partially mitigate this risk by requiring higher mortgage
insurance coverage on these loans. For example, Fannie Mae and Freddie Mac
require insurance coverage of 35 percent of the claim amount (on
individual loans that foreclose) for loans that have an LTV of greater
than 95 percent and require lower insurance coverage for loans with LTVs
below 95 percent.

Although FHA is required to provide up to 100 percent coverage of the
loans it insures, FHA may engage in co-insurance of its single-family
loans. Under co-insurance, FHA could require lenders to share in the risks
of insuring mortgages by assuming some percentage of the losses on the
loans that they originated (lenders would generally use private mortgage
insurance for risk sharing). FHA has used co-insurance before, primarily
in its multifamily programs, but does not currently use co-insurance at
all.9 FHA officials told us they tried to put together a co-insurance
agreement with Fannie Mae and Freddie Mac and, while they were able to
come to

8GAO, Single-Family Housing: Progress Made, but Opportunities Exist to
Improve HUD's Oversight of FHA Lenders, GAO-05-13 (Washington, D.C.: Nov.
12, 2004).

9According to FHA officials, FHA discontinued the multifamily co-insurance
program after experiencing significant losses. Since then, Congress
provided FHA authority to enter into risk-sharing agreements with GSEs and
housing finance agencies on certain multifamily insurance.

agreement on the sharing of premiums, they could not reach agreement on
the sharing of losses and it was never implemented.

Mortgage Institutions May Require Stricter Underwriting for New Low and No
Down Payment Products

Mortgage institutions also can mitigate risk through stricter
underwriting. For example, mortgage institutions such as Fannie Mae and
Freddie Mac sometimes introduce stricter underwriting standards as part of
the development of new low and no down payment products (or products about
which they do not fully understand the risks). Institutions can do this in
a number of ways, including requiring a higher credit score threshold for
certain products, or requiring greater borrower reserves or more
documentation of income or assets from the borrower. Once the mortgage
institution has learned enough about the risks that were previously not
understood, it can change the underwriting requirements for these new
products. FHA could also benefit from mitigating risk such as through
stricter underwriting. Although FHA has to meet some statutory standards,
it retains some flexibility in how it implements a newly authorized
product or changes an existing product. The HUD Secretary has latitude
within statutory limitations in changing underwriting requirements for new
and existing products and has done this many times.

The requirements in H.R. 3043 that prospective zero down payment loans go
through FHA's TOTAL Scorecard and that borrowers receive prepurchase
counseling are consistent with stricter underwriting. However, in
addressing the final recommendations in our February report, FHA wrote
that is unlikely to mandate a credit score threshold for a new zero down
payment product because the new product is intended to serve borrowers who
are underserved by the conventional market including those who lack credit
scores. Also, FHA wrote that it is unlikely to mandate borrower reserve
requirements since the purpose of a zero down payment product is to serve
borrowers with little wealth or personal savings.

Mortgage Institutions May Mortgage institutions can increase fees or
charge higher premiums to help Increase Fees or Charge offset the
potential costs of a program that is believed to have greater risk. Higher
Premiums For example, Fannie Mae officials stated that they would charge
higher

guarantee fees on low and no down payment loans if they were not able to

require higher insurance coverage.10 FHA could set higher premiums in
anticipation of higher claims from no down payment loans. Within statutory
limits, the HUD Secretary has the authority to set up-front and annual
premiums that are charged to borrowers who have FHA-insured loans. In
fact, in the administration's 2006 budget proposal for a zero down payment
product, it included higher up front and annual premiums for these loans.

Before Fully Implementing New Products, Some Mortgage Institutions May
Limit Their Availability

Some mortgage institutions may limit in some way a new product before
fully implementing the new product. For example, Fannie Mae and Freddie
Mac sometimes use pilots, or limited offerings of new products, to build
experience with a new product type or to learn about particular variables
that can help them better understand the factors that contribute to risk
for these products. Freddie Mac and Fannie Mae also sometimes set volume
limits for the percentage of their business that could be low and no down
payment lending. Fannie Mae and Freddie Mac officials provided numerous
examples of products that they now offer as standard products but which
began as part of underwriting experiments. These include the Fannie Mae
Flexible 97(R) product, as well as the Freddie Mac 100 product.

FHA has utilized pilots or demonstrations as well when making changes to
its single-family mortgage insurance. Generally, HUD has done this in
response to legislation that requires a pilot and not on its own
initiative. For example, FHA's Home Equity Conversion Mortgage (HECM)
insurance program started as a pilot. Congress initiated HECM in 1987; the
program is designed to provide elderly homeowners a financial vehicle to
tap the equity in their homes without selling or moving from their homes
(sometimes called a "reverse mortgage"). Through statute, HECM started as
a demonstration program that authorized FHA to insure 2,500 reverse
mortgages. Through subsequent legislation, FHA was authorized to insure an
increasing number of these mortgages until Congress made the program
permanent in 1998. Under the National Housing Act, the HECM program was
required to undergo a series of evaluations and it has been evaluated four
times since its inception. FHA officials told us that administering this
demonstration for 2,500 loans was difficult because of

10Fannie Mae and Freddie Mac charge fees for guaranteeing timely payment
on mortgage backed securities they issue. The fees are based, in part, on
the credit risk they face.

the challenges of selecting a limited number of lenders and borrowers. FHA
ultimately had to use a lottery to limit loans to lenders.

H.R. 3043 also would mandate that FHA pilot the zero down payment program:
it limits the annual number of zero down mortgages to 10 percent of the
aggregate number of loans insured during the previous fiscal year, and
sets an aggregate limit of 50,000 loans. The appropriate size for a pilot
program depends on several factors. For example, the precise number of
loans needed to detect a difference in performance between standard loans
and loans of a new product type depends in part on how great the
differences are in loan performance. If delinquencies early in the life of
a mortgage were about 10 percent for FHA's standard high LTV loans, and
FHA wished to determine whether loans in the pilot had delinquency rates
no more than 20 percent greater that the standard loans (delinquency no
more than 12 percent), a sample size of about 1,000 loans would be
sufficient to detect this difference with 95 percent confidence. If
delinquency rates or FHA's desired degree of precision were different, a
different sample size would be appropriate.

FHA officials told us they have conducted pilot programs when Congress has
authorized them, but they questioned the circumstances under which pilot
programs are needed. FHA officials also said that they lacked sufficient
resources to appropriately manage a pilot.

Additionally, some mortgage institutions may also limit the initial
implementation of a new product by limiting the origination and servicing
of the product to their better lenders and servicers. Mortgage
institutions may also limit servicing on the loans to servicers with
particular product expertise, regardless of who originates the loans.
Fannie Mae and Freddie Mac both reported that these were important steps
in introducing a new product and noted that lenders tend to take a more
conservative approach when first implementing a new product. FHA officials
agreed that they could, under certain circumstances, envision piloting or
limiting the ways in which a new or changed product would be available but
pointed to the practical limitations in doing so. FHA approves the sellers
and services that are authorized to support FHA's single-family product,
but FHA officials told us they face challenges in offering any of their
programs only in certain regions of the country or in limiting programs to
certain approved lenders or servicers. FHA generally offers products on a
national basis and, when they do not, specific regions of the county or
lenders might question why they are not able to receive the same benefit
(even on a demonstration or pilot basis). However, these officials did
provide examples in which their products had been initially limited to
particular

regions of the country or to particular lenders, including the rollout of
the HECMs and their TOTAL Scorecard.

Mortgage Institutions Establish Enhanced Monitoring and Oversight for New
Low and No Down Payment Products and Make Changes Based on What They Learn

Mortgage institutions, including FHA, may take several steps related to
increased monitoring of new products and subsequently make changes based
on what they learned. Fannie Mae and Freddie Mac officials described
processes in which they monitor actual versus expected loan performance
for new products, sometimes including enhanced monitoring of early loan
performance. Some mortgage institutions, such as Fannie Mae, told us that
they may conduct rigorous quality control sampling of new acquisitions,
early payment defaults, and nonperforming loans. Depending on the scale of
a new initiative, and its perceived risk, these quality control reviews
could include a review of up to 100 percent of the loans that are part of
the new product. FHA officials told us they also monitor more closely
loans underwritten under revised guidelines. Specifically, FHA officials
told us that FHA routinely conducts a review of underwriting for
approximately 6 to 7 percent of loans it insures. According to FHA
officials, as part of the review, it may place greater emphasis on
reviewing those aspects of the insurance product that are the subject of a
recent change.

Fannie Mae and Freddie Mac also reported that they conduct more regular
reviews at mortgage servicer sites for new products. In some cases, Fannie
Mae and Freddie Mac have staff who conduct on-site audits at the sellers
and servicers to provide an extra layer of oversight. According to FHA
officials, they have staff that conduct reviews of lenders that they have
identified as representing higher risk to FHA programs. However, we
recently reported that HUD's oversight of lenders could be improved and
identified a number of recommendations for improving this oversight.11

Conclusions 	Loans with low or no down payments carry greater risk.
Without any compensating measures such as offsetting credit enhancements
and increased risk monitoring and oversight of lenders, introducing a new
FHA no down payment product would expose FHA to greater credit risk. The
administration's proposal for a zero down product included increased
premiums to help compensate for an increase in the cost of the FHA program
which would permit FHA to potentially offset additional costs

11GAO-05-13.

stemming from a new product that entails greater risk or not well
understood risk. The proposed bill also requires that borrowers receive
prepurchase counseling.

Although FHA appears to follow many key practices used by mortgage
institutions in designing and implementing new products, several practices
not currently or consistently followed by FHA stand out as appropriate
means to manage the risks associated with introducing new products or
significantly changing existing products. Moreover, these practices can be
viewed as part of a formal framework used by some mortgage institutions
for managing the risks associated with new or changed products. The
framework includes techniques such as limiting the availability of a new
product until it is better understood and establishing stricter
underwriting standards-all of which would help FHA to manage risk
associated with any new product it may introduce. For example, FHA could
set volume limits or limit the initial number of participating lenders in
the product. Further, changes in FHA's premiums, an important element of
the administration's 2006 budget proposal for a zero down payment product
would permit FHA to potentially offset additional costs stemming from a
new product that entails greater risk or not well understood risk.

However, FHA officials believe that the agency does not have sufficient
resources to implement products with limited volumes, such as through a
pilot program. Yet, when FHA makes new products widely available or makes
significant changes to existing products with less-understood risks, these
products or actions also can introduce significant risks. Products that
would introduce significant risks can impose significant costs. We believe
that FHA could mitigate these risks and potential costs by using
techniques such as piloting. Moreover, FHA told us that it believes that
pilot programs are not needed because the risks of every new year of loans
are assessed annually as part of credit subsidy budgetary transactions and
in its annual actuarial study, and it could terminate the program early in
its life if it identified problems.12 However, because it may take a few
years to determine the risks of a new loan product, early termination
could still

12The Federal Credit Reform Act of 1990 requires that federal government
programs that make direct loans or loan guarantees (including insuring
loans) account for the full cost of their programs on an annual budgetary
basis. Specifically, federal agencies must develop subsidy estimates of
the net cost of their programs that include estimates of the net costs and
revenues over the projected lives of the loans made in each fiscal year.
The Cranston Gonzales National Affordable Housing Act requires an
independent actuarial analysis of the economic net worth and soundness of
FHA's MMI Fund.

expose the government to significant financial risk without some type of
limits on the number of loans insured. If FHA is unsure about its
authority to conduct pilots or concerned about expectations of equitable
distribution of its products, Congress can make clear that FHA has this
authority by requiring a product to be implemented as part of a pilot, or
by explicitly giving the HUD Secretary the authority to establish and
implement pilots for new products.

If Congress authorizes FHA to insure a no down payment product or any
other new single-family insurance products, Congress may want to provide
guidance and clear authority to FHA on this new product. Congress may want
to consider a number of means to mitigate the additional risks that these
loans may pose. Such means may include limiting the initial availability
of such a new product, requiring higher premiums, requiring stricter
underwriting standards, or requiring enhanced monitoring. Such risk
mitigation techniques would serve to help protect the Mutual Mortgage
Insurance Fund while allowing FHA the time to learn more about the
performance of loans using this new product. Limits on the initial
availability of the new product would be consistent with the approach
Congress took in implementing the HECM program. The limits could also come
in the form of an FHA requirement to limit the new product to better
performing lenders and servicers as part of a demonstration program or to
limit the time period during which the product is first offered.

Mr. Chairman, this completes my prepared statement. I would be pleased to
respond to any questions you or other members of the Committee may have at
this time.

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or [email protected]. Contact points for our Offices of Congressional
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testimony. Individuals making key contributions to this testimony also
included Anne Cangi, Bert Japikse, Austin Kelly, Andy Pauline, Susan
Etzel, and Barbara Roesmann.

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