Federal Housing Administration: Proposed Reforms Will Heighten	 
the Need for Continued Improvements in Managing Risks and	 
Estimating Program Costs (20-JUN-06, GAO-06-868T).		 
                                                                 
The Department of Housing and Urban Development's (HUD) Federal  
Housing Administration (FHA) has faced several challenges in	 
recent years, including rising default rates,			 
higher-than-expected program costs, and a sharp decline in	 
program participation. To help FHA adapt to market changes, HUD  
has proposed a number of changes to the National Housing Act that
would raise FHA's mortgage limits, allow greater flexibility in  
setting insurance premiums, and reduce down-payment requirements.
Implementing the proposed reforms would require FHA to manage new
risks and estimate the costs of program changes. To assist	 
Congress in considering issues faced by FHA, this testimony	 
provides information from recent reports GAO has issued that	 
address FHA's risk management and cost estimates. Specifically,  
this testimony looks at (1) FHA's development and use of its	 
mortgage scorecard, (2) FHA's consistent underestimation of	 
program costs, (3) instructive practices for managing risks of	 
new mortgage products, and (4) weaknesses in FHA's management of 
risks related to loans with down-payment assistance.		 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-06-868T					        
    ACCNO:   A55739						        
  TITLE:     Federal Housing Administration: Proposed Reforms Will    
Heighten the Need for Continued Improvements in Managing Risks	 
and Estimating Program Costs					 
     DATE:   06/20/2006 
  SUBJECT:   Housing programs					 
	     Insurance premiums 				 
	     Mortgage programs					 
	     Proposed legislation				 
	     Risk management					 
	     Cost estimates					 
	     Program costs					 

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GAO-06-868T

     

     * Background
     * The Way FHA Developed and Uses TOTAL Limits the Scorecard's
          * Age of Data, Lack of Key Variables, and Lack of Policy for U
          * HUD Could Realize Additional Benefits from an Expanded Use o
     * FHA's Reestimates Reflect Consistent Underestimation of Prog
     * Practices Used by Other Mortgage Institutions Could Help FHA
          * Mortgage Institutions Require Additional Credit Enhancements
          * Before Fully Implementing New Products, Some Mortgage Instit
     * FHA Has Not Implemented Sufficient Standards and Controls to
          * The Percentage of Loans with Down-Payment Assistance in FHA'
          * Stricter Standards and Additional Controls Could Help FHA Ma
     * Observations
     * Contacts and Acknowledgments
          * Order by Mail or Phone

Testimony

Before the Subcommittee on Housing and Transportation, Committee on
Banking, Housing, and Urban Affairs, United States Senate

United States Government Accountability Office

GAO

For Release on Delivery Expected at 2:30 p.m. EDT

Tuesday, June 20, 2006

FEDERAL HOUSING ADMINISTRATION

Proposed Reforms Will Heighten the Need for Continued Improvements in
Managing Risks and Estimating Program Costs

Statement of William B. Shear, Director

Financial Markets and Community Investment

GAO-06-868T

Mr. Chairman and Members of the Subcommittee:

I am pleased to have the opportunity to share information and perspectives
with the committee as it considers issues facing the Department of Housing
and Urban Development's (HUD) Federal Housing Administration (FHA). FHA
provides insurance for single-family home mortgages made by private
lenders and in fiscal year 2005 insured about 480,000 mortgages,
representing $58 billion in mortgage insurance. The insurance program is
supported by the Mutual Mortgage Insurance Fund (Fund), which is financed
through insurance premiums that FHA charges to borrowers. According to
HUD's estimates, FHA's mortgage insurance program is currently a negative
subsidy program, meaning that the Fund is self-financed and currently
operates at a profit. However, the program has faced several challenges in
recent years, including rising default rates, higher-than-expected program
costs, and a sharp decline in program participation due, in part, to
increased competition from conventional mortgage providers.

To help FHA adapt to market changes, HUD has proposed a number of changes
to the National Housing Act that would, among other things, raise FHA's
maximum mortgage limits, give the agency flexibility to set insurance
premiums based on the credit risk of borrowers, and reduce down-payment
requirements from the current 3 percent to potentially zero. However, to
implement this legislative proposal, FHA would have to manage new risks
and accurately estimate the costs of program changes. For example, to set
risk-based insurance premiums, FHA would need to understand the
relationships between borrower and loan characteristics and the likelihood
of default, as well as how the premiums would affect the Fund's financial
condition. Further, reducing the down-payment requirements for certain
borrowers (and thus increasing the loan-to-value ratios) has important
implications for the risks of these loans. Loans with low or no down
payments carry greater risk, partly because the higher the loan-to-value
ratio, the less cash borrowers will have invested in their homes and the
more likely that they may default on mortgage obligations, especially
during times of economic hardship.1

My testimony today discusses four reports that we issued since 2005 that
examined different aspects of FHA's ability to manage risks and estimate
program costs. Specifically, I will discuss (1) FHA's development and use
of a mortgage scorecard to assess the default risk of borrowers, (2) FHA's
consistent underestimation of subsidy costs for its single-family
insurance program and particularly large subsidy reestimate for fiscal
year 2003, (3) practices that could be instructive for FHA in managing the
risks of new mortgage products, and (4) weaknesses in how FHA has managed
risks associated with growth in the proportion of loans with down-payment
assistance.

1Loan-to-value ratio is the loan amount divided by the sales price or
appraised value of the property.

In preparing these reports, we reviewed and analyzed information
concerning FHA's approach to developing its mortgage scorecard and the
scorecard's benefits and limitations; FHA's estimates of subsidy costs and
the factors underlying the agency's subsidy reestimates; steps mortgage
industry participants take to design and implement low- and
no-down-payment mortgage products; and the standards and controls FHA uses
to manage the risks of loans with down-payment assistance. We interviewed
officials at FHA, the U.S. Department of Agriculture, and U.S. Department
of Veteran Affairs (VA); and staff at selected mortgage providers, private
mortgage insurers; Fannie Mae and Freddie Mac; the Office of Federal
Housing Enterprise Oversight; selected state housing finance agencies; and
nonprofit down-payment assistance providers. We conducted this work in
Boston, Massachusetts, and Washington, D.C., from January 2004 through
February 2006 in accordance with generally accepted government auditing
standards.

In summary, our past work identified a number of weaknesses in FHA's
ability to manage risk and estimate program costs:

           o  While generally reasonable, the way that FHA developed and uses
           its mortgage scorecard-an automated tool that evaluates the
           default risk of borrowers-limits the scorecard's effectiveness.
           FHA and its contractor used variables that reflected borrower and
           loan characteristics to create the scorecard, as well as an
           accepted modeling process to test the variables' accuracy in
           predicting default. However, the data used to develop the
           scorecard were 12 years old by the time that FHA began using the
           scorecard in 2004, and the mortgage market has changed
           significantly since then. In addition, the scorecard does not
           include certain key variables that could help explain expected
           loan performance such as the source of the down payment.

           o  FHA's subsidy reestimates reflect a consistent underestimation
           of the costs of its single-family insurance program. For example,
           as of the end of fiscal year 2003, FHA submitted a $7 billion
           reestimate for the Fund, reflecting a reduction in estimated
           profits. Increases in the expected level of insurance
           claims-potentially stemming from changes in underwriting
           guidelines, among other factors-were a major cause of the $7
           billion reestimate.

           o  Some of the practices of other mortgage institutions offer a
           framework that could help FHA manage the risks associated with new
           products such as no-down-payment mortgages. For example, mortgage
           institutions may limit the volume of new products issued-that is,
           pilot a product-and sometimes require stricter underwriting on
           these products. While FHA has utilized pilots or demonstrations
           when making changes to its single-family mortgage insurance, it
           generally has done so in response to a legislative requirement and
           not on its own initiative. Moreover, FHA officials have questioned
           the circumstances under which pilot programs were needed and also
           said that they lacked sufficient resources to appropriately manage
           a pilot.

           o  FHA has not developed sufficient standards and controls to
           manage risks associated with the growing proportion of loans with
           down-payment assistance. Unlike other mortgage industry
           participants, FHA does not restrict homebuyers' use of
           down-payment assistance from nonprofit organizations that receive
           part of their funding from home sellers. However, our analysis of
           a national sample of FHA-insured loans found that the probability
           that loans with seller-funded nonprofit down-payment assistance
           would result in an insurance claim was 76 percent higher than
           comparable loans without such assistance.

On the basis of our findings from the four reports I have summarized, we
made several recommendations designed to improve FHA's risk management and
cost estimates. For example, to improve its assessment of borrowers'
default risk, we recommended that FHA develop policies for updating the
scorecard, incorporate the risks posed by down-payment assistance into the
scorecard, and explore additional uses for this tool.

To more reliably estimate subsidy costs, we recommended that FHA study and
report in the annual actuarial review of the Fund the impact of variables
not in the agency's loan performance models (used in estimating subsidy
costs) that have been found in other studies to influence credit risk. 2
In light of the risks that new mortgage products present and in
recognition of established risk management practices, we also suggested
that Congress consider (1) limiting the initial availability of any new
single-family insurance product it might authorize and (2) directing FHA
to consider using various techniques for mitigating risks for a
no-down-payment product, or products about which the risks were not well
understood.

2Since 1990, the National Housing Act has required an annual and
independent actuarial analysis of the economic net worth and soundness of
the Fund. 12 U.S.C. Section 1711 (g).

FHA has taken actions in response to some of our recommendations. For
example, FHA agreed to consider incorporating a variable for down-payment
assistance in its mortgage scorecard. To more accurately assess subsidy
costs, an FHA contractor is considering the specific variables that we
recommended FHA include in its annual actuarial review and incorporated
the source of down payment in the 2005 actuarial review of the Fund. FHA
also has agreed to improve its oversight of down-payment assistance
lending, including modifying its information systems to document
assistance from seller-funded nonprofits.

While these actions represent improvements in FHA's risk management,
additional improvements will be important if FHA is to successfully
implement some of the program changes HUD has proposed. Accordingly,
consideration of this proposal should include serious deliberation of the
associated risks and the capacity of FHA to mitigate them.

                                   Background

Congress established FHA in 1934 under the National Housing Act (P.L.
73-479) to broaden homeownership, shore up and protect lending
institutions, and stimulate employment in the building industry. FHA's
single-family program insures private lenders against losses (up to almost
100 percent of the loan amount) from borrower defaults on mortgages that
meet FHA criteria. In 2004, more than three-quarters of the loans that FHA
insured went to first-time homebuyers, and more than one-third of these
loans went to minorities. From 2001 through 2005, FHA insured about 5
million mortgages with a total value of about $590 billion. However, FHA's
loan volume fell sharply over that period, and in 2005 FHA-insured loans
accounted for less than 4 percent of the single-family mortgage market,
compared with about 13 percent a decade ago. Additionally, default rates
for FHA-insured mortgages have risen steeply over the past several years,
a period during which home prices have appreciated rapidly and default
rates for conventional and VA-guaranteed mortgages have been relatively
stable.

FHA determines the expected cost of its insurance program, known as the
credit subsidy cost, by estimating the program's future performance.3
Similar to other agencies, FHA is required to reestimate credit subsidy
costs annually to reflect actual loan performance and expected changes in
estimates of future loan performance. FHA's mortgage insurance program is
currently a negative subsidy program, meaning that the present value of
estimated cash inflows to the Fund exceed the present value of estimated
cash outflows. FHA has estimated that the loans it expects to insure in
2007 will have a subsidy rate of -0.37, a rate closer to zero (the point
at which estimated cash inflows equal estimated cash outflows) than any
previous estimate. The economic value, or net worth, of the Fund that
supports FHA's insurance depends on the relative size of cash outflows and
inflows over time. Cash flows out of the Fund for payments associated with
claims on defaulted loans and refunds of up-front premiums on prepaid
mortgages. To cover these outflows, FHA receives cash inflows from
borrowers' insurance premiums and net proceeds from recoveries on
defaulted loans. If the Fund were to be exhausted, the U.S. Treasury would
have to cover lenders' claims directly.

Two major trends in the conventional mortgage market have significantly
affected FHA.4 First, in recent years, members of the conventional
mortgage market (such as private mortgage insurers, Fannie Mae, and
Freddie Mac) increasingly have been active in supporting low- and even
no-down-payment mortgages, increasing consumer choices for borrowers who
may have previously chosen an FHA-insured loan. Second, to help assess the
default risk of borrowers, particularly those with high loan-to-value
ratios, the mortgage industry has increasingly used mortgage scoring and
automated underwriting systems.5 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 such as the
borrower's credit history, property characteristics, and terms of the
mortgage affect future loan performance. As a result of such tools, the
mortgage industry is able to process loan applications more quickly and
consistently than in the past. In 2004, FHA implemented a mortgage scoring
tool, called the FHA Technology Open to Approved Lenders (TOTAL)
Scorecard, to be used in conjunction with existing automated underwriting
systems.

3Pursuant to the Federal Credit Reform Act of 1990, HUD must annually
estimate the credit subsidy cost for its loan insurance programs. Credit
subsidy costs are the net present value of estimated payments it makes
less the estimated amounts it receives, excluding administrative costs.

4Conventional mortgages do not carry government insurance or guarantees.

5Underwriting refers to a risk analysis that uses information collected
during the origination process to decide whether to approve a loan.

HUD's legislative proposal is intended to modernize FHA, in part, to
respond to the changes in the mortgage market. The proposal, among other
things, would authorize FHA to change the way it sets insurance premiums,
insure larger loans, and reduce down-payment requirements. The proposed
legislation would enable FHA to depart from its current, essentially flat,
premium structure and charge a wider range of premiums based on individual
borrowers' risk of default. Currently, FHA also requires homebuyers to
make a 3 percent contribution toward the purchase of a property. HUD's
proposal would eliminate this contribution requirement and enable FHA to
offer some borrowers a no-down-payment product. FHA is subject to limits
in the size of the loans it can insure. For example, for a one-family
property in a high-cost area, the FHA limit is 87 percent of the limit
established by Freddie Mac. The legislative proposal would raise this
limit to 100 percent of the Freddie Mac limit.

  The Way FHA Developed and Uses TOTAL Limits the Scorecard's Effectiveness in
                    Assessing the Default Risk of Borrowers

If Congress authorizes the reforms HUD has proposed, FHA's ability to
assess the default risk of borrowers will take on increased importance
because FHA would be adjusting insurance premiums based on its assessments
of the credit risk of borrowers and insure potentially larger and riskier
mortgages with low or no down payments. A primary tool that FHA uses to
assess the default risk of borrowers who apply for FHA-insured mortgages
is its TOTAL scorecard.

Age of Data, Lack of Key Variables, and Lack of Policy for Updating TOTAL Could
Limit Its Effectiveness

In reports we issued in November 2005 and April 2006, we noted that while
FHA's process for developing TOTAL generally was reasonable, some of the
choices FHA made in the development process could limit the scorecard's
effectiveness.6 FHA and its contractor used variables that reflected
borrower and loan characteristics to create TOTAL, as well as an accepted
modeling process to test the variables' accuracy in predicting default.
However, we also found that:

           o  The data used to develop TOTAL were 12 years old by the time
           FHA implemented the scorecard. Specifically, when FHA began
           developing TOTAL in 1998, the agency chose to use 1992 loan data,
           which would be old enough to provide a sufficient number of
           defaults that could be attributed to a borrower's poor
           creditworthiness. However, FHA did not implement TOTAL until 2004
           and has not subsequently updated the data used in the scorecard.
           Best practices of private-sector organizations call for scorecards
           to be based on data that are representative of the current
           mortgage market-specifically, relevant data that are no more than
           several years old. In the past 12 years, significant
           changes-growth in the use of down-payment assistance, for
           example-have occurred in the mortgage market that have affected
           the characteristics of those applying for FHA-insured loans. As a
           result, the relationships between borrower and loan
           characteristics and the likelihood of default also may have
           changed.

           o  TOTAL does not include certain key variables that could help
           explain expected loan performance. For example, TOTAL does not
           include a variable for the source of the down payment. However,
           FHA contractors, HUD's Inspector General, and our work have all
           identified the source of a down payment as an important indicator
           of risk, and the use of down-payment assistance in the FHA program
           has grown rapidly over the last 5 years. Further, TOTAL does not
           include other important variables-such as a variable for generally
           riskier adjustable rate loans-included in other scorecards used by
           private-sector entities.

           o  Although FHA has a contract to update TOTAL by 2007, the agency
           did not develop a formal plan for updating TOTAL on a regular
           basis. Best practices in the private sector and reflected in bank
           regulator guidance call for having formal policies to ensure that
           scorecards are routinely updated. Without policies and procedures
           for routinely updating TOTAL, the scorecard may become less
           reliable and, therefore, less effective at predicting the
           likelihood of default.

6GAO, Mortgage Financing: HUD Could Realize Additional Benefits from its
Mortgage Scorecard, GAO-06-435 (Washington, D.C.: April 13, 2006). GAO,
Mortgage Financing: Additional Action Needed to Manage Risks of
FHA-Insured Loans with Down Payment Assistance, GAO-06-24 (Washington,
D.C.: November 9, 2005).

To improve TOTAL's effectiveness, we recommended, among other things, that
HUD develop policies and procedures for regularly updating TOTAL and more
fully consider the risks posed by down-payment assistance when
underwriting loans by including the presence and source of down-payment
assistance as a loan variable in the scorecard. In response, FHA agreed to
consider incorporating a variable for down-payment assistance in TOTAL.

HUD Could Realize Additional Benefits from an Expanded Use of TOTAL

Despite potential limitations in the use of TOTAL, HUD still could realize
additional benefits from the scorecard, if, like private-sector lenders
and mortgage insurers, it put TOTAL to other uses. Based on its current
use of TOTAL, FHA lenders and borrowers have seen two added benefits-less
paperwork and more consistent underwriting decisions. However, private
lenders and mortgage insurers put their scorecards to other uses,
including to help price products based on risk and launch new products.
For example, to set risk-based prices, private-sector organizations use
scorecards to rank the relative risk of borrowers and price products
according to that ranking. By increasing their use of scorecards, these
organizations are able to broaden their customer base and improve their
financial performance. Adopting these best practices from the private
sector could generate similar kinds of benefits for FHA, particularly if
FHA were to implement risk-based pricing.

To the extent that conventional mortgage lenders and insurers are better
able than FHA to use mortgage scoring to identify and approve relatively
low-risk borrowers and charge fees based on default risk, FHA may face
adverse selection-that is, conventional providers may approve lower-risk
borrowers in FHA's traditional market segment, leaving relatively
high-risk borrowers for FHA. Accordingly, the greater the effectiveness of
TOTAL, the greater the likelihood that FHA will be able to effectively
manage the risks posed by borrowers seeking FHA-insured loans.

To improve how FHA benefits from TOTAL, we recommended that the agency
explore additional uses for the scorecard, including using it to implement
risk-based pricing of mortgage insurance and to develop new products.
These actions could enhance FHA's ability to effectively compete in the
mortgage market. In response to our recommendations, FHA indicated that it
planned to explore these uses for TOTAL.

FHA's Reestimates Reflect Consistent Underestimation of Program Costs, Primarily
               Because of Higher Claims than Initially Estimated

If implemented, HUD's legislative proposal could affect the Fund's cash
inflows and outflows and, as a result, significantly affect the credit
subsidy costs of the insurance program. For example, changes in FHA's
insurance premiums could affect the revenues FHA receives, and changes in
the composition and riskiness of the loan portfolio (as a result of larger
loans or more loans with no down payments) could affect the size and
number of insurance claims FHA pays.

As previously noted, FHA, like other federal agencies, is required to
reestimate credit subsidy costs annually to reflect actual loan
performance and expected changes in estimates of future loan performance.
FHA has estimated negative credit subsidies for the Fund since 1992, when
federal credit reform became effective. However, as we reported in
September 2005, with the exception of the 1992 reestimate, FHA's subsidy
reestimates have been less favorable than the original estimates.7 In
particular, FHA's $7 billion reestimate for fiscal year 2003 was more than
twice the size of any other reestimate from fiscal years 2000 through
2004.

The $7 billion reestimate for fiscal year 2003 had three main components.
The first component was the $3.9 billion difference between FHA's fiscal
year 2003 estimates of the net present value of future cash flows and the
estimates it made one year earlier. Most of this difference stemmed from
changes in FHA's estimates of claims and, to a lesser extent, prepayments
(the payment of a loan before its maturity date). That is, FHA changed its
estimate of future loan performance based on its observation of actual
loan performance during fiscal year 2003 and revised economic assumptions.
The second component was the $2.1 billion difference between estimated and
actual cash flows occurring during fiscal year 2003. Underestimation of
claims (net of recoveries on claims) and an overestimation of net fees
(insurance premium receipts less premium refunds) for loans made prior to
fiscal year 2003 largely account for the difference. The third component
was an interest adjustment on the reestimate required by Office of
Management and Budget guidance that increased the total reestimate by $1.1
billion.

Several recent policy changes and trends may have contributed to changes
in the expected claims underlying the $7 billion reestimate. For example:

7GAO, Mortgage Financing: FHA's $7 Billion Reestimate Reflects Higher
Claims and Changing Loan Performance Estimates, GAO-05-875 (Washington,
D.C.: Sep. 2, 2005).

           o  Revised underwriting guidelines made it easier for borrowers
           who are more susceptible to changes in economic conditions-and
           therefore more likely to default on their mortgages-to obtain an
           FHA-insured loan.

           o  Competition from conventional mortgage providers could have
           resulted in FHA insuring more risky borrowers.

           o  FHA insured an increasing number of loans with down-payment
           assistance, which generally have a greater risk of default.

           o  FHA's loan performance models did not include key variables
           that help estimate loan performance, such as credit scores, and as
           of September 2005, the source of down payment.

The major factors underlying the surge in prepayment activity that also
contributed to the reestimate were declining interest rates and rapid
appreciation of housing prices. These trends created incentives and
opportunities for borrowers to refinance using conventional loans.

To more reliably estimate program costs, we recommended that FHA study and
report on how variables found to influence credit risk, such as
payment-to-income ratios, credit scores, and down-payment assistance would
affect the forecasting ability of its loan performance models. We also
recommended that when changing the definitions of key variables, FHA
report the impact of such changes on the models' forecasting ability. In
response, FHA indicated, among other things, that its contractor was
considering the specific variables that we had recommended FHA include in
its annual actuarial review and had incorporated the source of
down-payment assistance in the 2005 actuarial review of the Fund.

 Practices Used by Other Mortgage Institutions Could Help FHA Manage Risks from
                        Low- or No-Down-Payment Products

If Congress authorized FHA to insure mortgages with smaller or no down
payments, practices used by other mortgage institutions could help FHA to
design and implement these new products. In a February 2005 report, we
identified steps that mortgage institutions take when introducing new
products.8 Specifically, mortgage institutions often utilize special
requirements when introducing new products, such as requiring additional
credit enhancements (mechanisms for transferring risk from one party to
another) or implementing stricter underwriting requirements, and limiting
how widely they make available a new product.

Mortgage Institutions Require Additional Credit Enhancements, Stricter
Underwriting, and Higher Premiums for Low- and No-Down-Payment Products

Some mortgage institutions require additional credit enhancements on low-
and no-down-payment products, which generally are riskier because they
have higher loan-to-value ratios than loans with larger down payments. For
example, 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. 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).

Mortgage institutions also can mitigate the risk of low- and
no-down-payment products through stricter underwriting. Institutions can
do this in a number of ways, including requiring a higher credit score
threshold for certain products, requiring greater borrower reserves, or
requiring more documentation of income or assets from the borrower.
Although the changes FHA could make are limited by statutory standards, it
could benefit from similar approaches. The HUD Secretary has latitude
within statutory limitations to change underwriting requirements for new
and existing products and has done so many times. For example, FHA
expanded its definition of what could be included as borrower's effective
income when calculating payment-to-income ratios. However, FHA officials
told us that they were unlikely to mandate a credit score threshold or
borrower reserve requirements for a no-down-payment product because the
product was intended to serve borrowers who are underserved by the
conventional market, including those who lack credit scores and have
little wealth or personal savings.

8GAO, Mortgage Financing: Actions Needed to Help FHA Manage Risks from New
Mortgage Loan Products, GAO-05-194 (Washington, D.C.: Feb. 11, 2005).

Finally, mortgage institutions can increase fees or charge higher premiums
to help offset the potential costs of products that are believed to have
greater risk. 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.9 FHA, if authorized to
implement risk-based pricing, could set higher premiums on FHA-insured
loans understood to have greater risk.

We recommended that if FHA implemented a no-down-payment mortgage product
or other new products about which the risks were not well understood, the
agency should (1) consider incorporating stricter underwriting criteria
such as appropriate credit score thresholds or borrower reserve
requirements and (2) utilize other techniques for mitigating risks,
including the use of credit enhancements. In response, FHA said it agreed
that these techniques should be evaluated when considering or proposing a
new FHA product.

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

Some mortgage institutions initially may offer new products on a limited
basis. For example, Fannie Mae and Freddie Mac sometimes use pilots, or
limited offerings of new products, to build experience with a new product
type. Fannie Mae and Freddie Mac also sometimes set volume limits for the
percentage of their business that could be low- and no-down-payment
lending. FHA has utilized pilots or demonstrations when making changes to
its single-family mortgage insurance but generally has done so in response
to legislative requirement rather than on its own initiative. For example,
FHA's Home Equity Conversion Mortgage insurance program started as a pilot
that authorized FHA to insure 2,500 reverse mortgages.10 Additionally,
some mortgage institutions may limit the origination and servicing of new
products to their better lenders and servicers. Fannie Mae and Freddie Mac
both reported that these were important steps in introducing a new
product.

9Fannie 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.

10Under this program, homeowners borrow against equity in their home and
receive payments from their lenders.

We recommended that when FHA releases new products or makes significant
changes to existing products, it consider similar steps to limit the
initial availability of these products. FHA officials agreed that they
could, under certain circumstances, envision piloting or limiting the ways
in which a new product would be available, but pointed to the practical
limitations of doing so. For example, FHA officials told us that
administering the Home Equity Conversion Mortgage pilot program was
difficult because of the challenges of equitably selecting a limited
number of lenders and borrowers. FHA generally offers products on a
national basis and, if they did not, specific regions of the county or
lenders might question why they were not able to receive the same benefit.
FHA officials told us they have conducted pilot programs when Congress has
authorized them, but they questioned the circumstances under which pilot
programs were needed, and also said that they lacked sufficient resources
to appropriately manage a pilot. However, if FHA does not limit the
availability of new or changed products, the agency runs the risk of
facing higher claims from products whose risks may not be well understood.

FHA Has Not Implemented Sufficient Standards and Controls to Manage Risks
  Associated with the Growing Proportion of Loans with Down-Payment Assistance

HUD's legislative proposal would represent a significant change to the
agency's single-family mortgage insurance program and presents new risk
management challenges. In our November 2005 report examining FHA's actions
to manage the new risks associated with the growing proportion of loans
with down-payment assistance, we found that the agency did not implement
sufficient standards and controls to manage the risks posed by these
loans.11

11 GAO-06-24 .

The Percentage of Loans with Down-Payment Assistance in FHA's Portfolio Has Been
Increasing and These Loans Do Not Perform as Well as Similar Loans without
Assistance

Homebuyers who receive FHA-insured mortgages often have limited funds and,
to meet the 3 percent borrower investment FHA currently requires, may
obtain down-payment assistance from a third party, such as a relative or a
charitable organization (nonprofit) that is funded by property sellers.
The proportion of FHA-insured loans that are financed in part by
down-payment assistance from various sources has increased substantially
in the last few years, while the overall number of loans that FHA insures
has fallen dramatically. Money from nonprofits funded by seller
contributions has accounted for a growing percentage of that assistance.
From 2000 to 2004, the total proportion of FHA-insured purchase loans that
had a loan-to-value ratio greater than 95 percent and that also involved
down-payment assistance, from any source, grew from 35 to nearly 50
percent. Approximately 6 percent of FHA-insured purchase loans in 2000
received down-payment assistance from nonprofits (the large majority of
which were funded by property sellers), but by 2004 nonprofit assistance
grew to about 30 percent.

We and others have found that loans with down-payment assistance do not
perform as well as loans without down-payment assistance. We analyzed loan
performance by source of down-payment assistance, using two samples of
FHA-insured purchase loans from 2000, 2001, and 2002-a national sample and
a sample from three Metropolitan Statistical Areas (MSA) with high rates
of down-payment assistance.12 Holding other variables constant, our
analysis indicated that FHA-insured loans with down-payment assistance had
higher delinquency and claim rates than similar loans without such
assistance. For example, we found that the probability that loans with
nonseller-funded sources of down-payment assistance would result in
insurance claims was 49 percent higher in the national sample and 45
percent higher in the MSA sample than it was for comparable loans without
assistance. Similarly, the probability that loans with nonprofit
seller-funded, down-payment assistance would result in insurance claims
was 76 percent higher in the national sample and 166 percent higher in the
MSA sample than it was for comparable loans without assistance. The poorer
performance of loans with nonprofit seller-funded, down-payment assistance
may be explained, in part, by the sales prices of the homes bought with
such assistance. More specifically, our analysis indicated that
FHA-insured homes bought with seller-funded nonprofit assistance were
appraised and sold for about 2 to 3 percent more than comparable homes
bought without such assistance. The difference in performance also may be
partially explained by the homebuyer having less equity in the
transaction.

12The data (current as of June 30, 2005) consisted of purchase loans
insured by FHA's 203(b) program, its main single-family program, and its
234(c), condominium program. The three MSAs were Atlanta, Indianapolis,
and Salt Lake City.

Stricter Standards and Additional Controls Could Help FHA Manage the Risks Posed
by Loans with Down-Payment Assistance

FHA has implemented some standards and internal controls to manage the
risks associated with loans with down-payment assistance, but stricter
standards and additional controls could help FHA better manage risks posed
by these loans while meeting its mission of expanding homeownership
opportunities. Like other mortgage industry participants, FHA generally
applies the same underwriting standards to loans with down-payment
assistance that it applies to loans without such assistance. One important
exception is that FHA, unlike others, does not limit the use of
down-payment assistance from seller-funded nonprofits. Some mortgage
industry participants view assistance from seller-funded nonprofits as a
seller inducement to the sale and, therefore, either restrict or prohibit
its use. FHA has not viewed such assistance as a seller inducement and,
therefore, does not subject this assistance to the limits it otherwise
places on contributions from sellers. However, due in part to concerns
about loans with nonprofit seller-funded, down-payment assistance, FHA has
proposed legislation that could help eliminate the need for such
assistance by allowing some FHA borrowers to make no down payments for an
FHA-insured loan.

FHA has taken some steps to assess and manage the risks associated with
loans with down-payment assistance, but additional controls may be
warranted. For example, FHA has contracted for two studies to assess the
use of such assistance with FHA-insured loans and conducted ad hoc
performance analyses of loans with down-payment assistance but has not
routinely assessed the impact that the widespread use of down-payment
assistance has had on loan performance. Also, FHA has targeted its
monitoring of appraisers to those that do a high volume of loans with
down-payment assistance, but FHA has not targeted its monitoring of
lenders to those that do a high volume of loans with down-payment
assistance, even though FHA holds lenders, as well as appraisers,
accountable for ensuring a fair valuation of the property it insures.

Our report made several recommendations designed to better manage the
risks of loans with down-payment assistance generally, and more
specifically from seller-funded nonprofits. Overall, we recommended that
in considering the costs and benefits of its policy permitting
down-payment assistance, FHA also consider risk-mitigation techniques such
as including down-payment assistance as a factor when underwriting loans
or more closely monitoring loans with such assistance. For down-payment
assistance providers that receive funding from property sellers, we
recommended that FHA take additional steps to mitigate the risks of these
loans, such as treating such assistance as a seller contribution and,
therefore, subject to existing limits on seller contributions. In
response, FHA agreed to improve its oversight of down-payment assistance
lending by (1) modifying its information systems to document assistance
from seller-funded nonprofits and (2) requiring lenders to inform
appraisers when assistance is provided by seller-funded nonprofits. In
addition, HUD has proposed a zero down-payment program as an alternative
to seller-funded, down-payment assistance.

In May 2006, the Internal Revenue Service issued a ruling stating that
organizations that provide seller-funded, down-payment assistance to home
buyers do not qualify as tax-exempt charities. FHA permitted these
organizations to provide down-payment assistance because they qualified as
charities. Accordingly, the ruling could significantly reduce the number
of FHA-insured loans with seller-funded down payments.

                                  Observations

The risks FHA faces in today's mortgage market are growing. For example,
the agency has seen increased competition from conventional mortgage and
insurance providers, many of which offer low- and no-down-payment products
and that may be better able than FHA to identify and approve relatively
low-risk borrowers. Additionally, FHA is insuring a greater proportion of
loans with down-payment assistance. These loans are more likely to result
in insurance claims than loans without such assistance.

To effectively manage the risks posed by FHA's existing products, we have
concluded from our prior work that the agency must significantly improve
its risk management and cost estimation practices. We are encouraged by a
variety of steps FHA has taken to enhance its capabilities in these areas,
such as developing and implementing a mortgage scorecard and improving its
loan performance models. However, FHA needs to take additional steps, such
as establishing policies and procedures for updating TOTAL scorecard on a
regular basis, more fully considering the risks posed by down-payment
assistance when underwriting loans, developing a framework for introducing
new products in a way that mitigates risk, and studying and reporting on
the impact of variables found to influence credit risk that are not
currently in the agency's loan performance models.

HUD's legislative proposal could help FHA serve more low-income and
first-time homebuyers, but also would introduce additional risks to the
Fund. Consideration of this proposal should include serious deliberation
of the associated risks and the capacity of FHA to mitigate them.

Mr. Chairman, this concludes my prepared statement. I would be happy to
answer any questions at this time.

                          Contacts and Acknowledgments

For further information on this testimony, please contact William B. Shear
at (202) 512-8678. Individuals making key contributions to this testimony
included Triana Bash, Anne Cangi, Marcia Carlsen, John Fisher, Austin
Kelly, John McGrail, Andrew Pauline, Barbara Roesmann, Mathew Scire,
Katherine Trimble, and Steve Westley.

(250296)

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Highlights of GAO-06-868T, a testimony before the Subcommittee on Housing
and Transportation, Committee on Banking, Housing, and Urban Affairs,
United States Senate

June 20, 2006

FEDERAL HOUSING ADMINISTRATION

Proposed Reforms Will Heighten the Need for Continued Improvements in
Managing Risks and Estimating Program Costs

The Department of Housing and Urban Development's (HUD) Federal Housing
Administration (FHA) has faced several challenges in recent years,
including rising default rates, higher-than-expected program costs, and a
sharp decline in program participation. To help FHA adapt to market
changes, HUD has proposed a number of changes to the National Housing Act
that would raise FHA's mortgage limits, allow greater flexibility in
setting insurance premiums, and reduce down-payment requirements.
Implementing the proposed reforms would require FHA to manage new risks
and estimate the costs of program changes. To assist Congress in
considering issues faced by FHA, this testimony provides information from
recent reports GAO has issued that address FHA's risk management and cost
estimates. Specifically, this testimony looks at (1) FHA's development and
use of its mortgage scorecard, (2) FHA's consistent underestimation of
program costs, (3) instructive practices for managing risks of new
mortgage products, and (4) weaknesses in FHA's management of risks related
to loans with down-payment assistance.

Recent trends in mortgage lending have significantly affected FHA,
including increased use of automated tools (e.g., mortgage scoring) to
underwrite loans, increased competition from lenders offering low-and
no-down-payment products, and a growing proportion of FHA-insured loans
with down-payment assistance. Although FHA has taken steps to improve its
risk management, in a series of recent reports, GAO identified a number of
weaknesses in FHA's ability to manage risk and estimate program costs
during this period of change. For example:

           o  The way that FHA developed and uses its mortgage scorecard,
           while generally reasonable, limits how effectively it assesses the
           default risk of borrowers.
           o  With one exception, FHA's reestimates of program costs have
           been less favorable than originally estimated, including a $7
           billion reestimate for fiscal year 2003.
           o  FHA has not consistently implemented practices used by other
           mortgage institutions to help manage the risks associated with new
           mortgage products.
           o  FHA has not developed sufficient standards and controls to
           manage risks associated with insuring a growing proportion of
           loans with down-payment assistance.

GAO made several recommendations in its recent reports, including that FHA
(1) incorporate the risks posed by down-payment assistance into its
mortgage scorecard, (2) study and report on the impact of variables not in
its loan performance models that have been found to influence credit risk,
and (3) consider piloting new mortgage products. FHA has taken actions in
response to GAO's recommendations, but additional improvements in managing
risk and estimating program costs will be important if FHA is to
successfully implement its proposed program changes.
*** End of document. ***