Federal Housing Administration: Ability to Manage Risks and	 
Program Changes Will Affect Financial Performance (15-MAR-07,	 
GAO-07-615T).							 
                                                                 
The Federal Housing Administration (FHA) has seen increased	 
competition from conventional mortgage and insurance providers.  
Additionally, because of the worsening performance of the	 
mortgages it insures, FHA has estimated that its single-family	 
insurance program would require a subsidy--that is,		 
appropriations--in fiscal year 2008 in the absence of program	 
changes. To help FHA adapt to the evolving market, proposed	 
changes to the National Housing Act would allow greater 	 
flexibility in setting insurance premiums and reduce down-payment
requirements. To assist Congress in considering the financial	 
challenges facing FHA, this testimony provides information from  
recent reports GAO has issued and ongoing work concerning the	 
proposed legislation that address different aspects of FHA's risk
management. Specifically, this testimony looks at (1) FHA's	 
management of risk related to loans with down-payment assistance,
(2) instructive practices for managing risks of new products, (3)
FHA's development and use of its mortgage scorecard, and (4)	 
FHA's estimation of program costs.				 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-07-615T					        
    ACCNO:   A66864						        
  TITLE:     Federal Housing Administration: Ability to Manage Risks  
and Program Changes Will Affect Financial Performance		 
     DATE:   03/15/2007 
  SUBJECT:   Claims						 
	     Cost control					 
	     Housing programs					 
	     Insurance premiums 				 
	     Internal controls					 
	     Mortgage loans					 
	     Mortgage programs					 
	     Program evaluation 				 
	     Program management 				 
	     Risk management					 
	     Standards						 
	     Lending institutions				 
	     Financial analysis 				 
	     Cost estimates					 
	     Policies and procedures				 
	     HUD Home Equity Conversion Mortgage		 
	     Insurance Program					 
                                                                 
	     Mutual Mortgage Insurance Fund			 

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GAO-07-615T

   

     * [1]Background
     * [2]FHA Has Not Implemented Sufficient Standards and Controls to

          * [3]Loans with Down-Payment Assistance Are a Substantial Portion
          * [4]Stricter Standards and Additional Controls Could Help FHA Ma

     * [5]Practices That Other Mortgage Institutions Use Could Help FH

          * [6]Mortgage Institutions Require Additional Credit Enhancements
          * [7]Before Fully Implementing New Products, Some Mortgage Instit

     * [8]The Way FHA Developed TOTAL Limits the Scorecard's Effective
     * [9]FHA's Current Reestimated Subsidy Costs Are Generally Less F
     * [10]Contacts and Acknowledgments
     * [11]GAO's Mission
     * [12]Obtaining Copies of GAO Reports and Testimony

          * [13]Order by Mail or Phone

     * [14]To Report Fraud, Waste, and Abuse in Federal Programs
     * [15]Congressional Relations
     * [16]Public Affairs

Testimony Before the Subcommittee on Transportation, Housing, and Urban
Development, and Related Agencies, Committee on Appropriations, United
States Senate

United States Government Accountability Office

GAO

For Release on Delivery Expected at 9:30 a.m. EDT Thursday, March 15, 2007
FEDERAL HOUSING ADMINISTRATION

Ability to Manage Risks and Program Changes Will Affect Financial
Performance

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

GAO-07-615T

Madam Chairman and Members of the Subcommittee:

I am pleased to have the opportunity to share information and perspectives
with the committee as it examines issues concerning the financial
performance of 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. In fiscal year 2006,
it insured about 426,000 mortgages, representing $55 billion in mortgage
insurance. According to FHA's estimates, the insurance program currently
operates with a negative subsidy, meaning that the present value of
estimated cash inflows (such as borrower premiums) to FHA's Mutual
Mortgage Insurance Fund (Fund) exceeds the present value of estimated cash
outflows (such as claims).

But, 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, because of the
worsening performance of the mortgages it insures, FHA has estimated that
the program would require a positive subsidy--that is, an appropriation of
budget authority--in fiscal year 2008 if no program changes were made.

To help FHA adapt to market changes, HUD has proposed a number of changes
to the National Housing Act that, among other things, would give FHA
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. Whether under its existing authority or using any
additional flexibility that Congress may grant, FHA's ability to manage
risks and program changes will affect the financial performance of the
insurance program.

My testimony today discusses four reports that we have issued since 2005
on different aspects of FHA's risk management, as well as ongoing work we
are conducting on FHA's proposed legislative changes and the tools and
resources it would use to implement them, if passed. This body of work
addresses a number of issues relevant to FHA's financial performance.
Specifically, I will discuss (1) weaknesses in how FHA has managed the
risks of loans with down-payment assistance, (2) practices that could be
instructive for FHA in managing the risks of new mortgage products, (3)
FHA's development and use of a mortgage scorecard, and (4) FHA's
estimation of subsidy costs for its single-family insurance program.

In conducting this work, we reviewed and analyzed information concerning
the standards and controls FHA uses to manage the risks of loans with
down-payment assistance; steps mortgage industry participants take to
design and implement low- and no-down-payment mortgage products; FHA's
approach to developing its mortgage scorecard and the scorecard's benefits
and limitations; FHA's estimates of program costs and the factors
underlying the agency's cost reestimates; and FHA's plans and resources
for implementing its proposed legislative changes. We interviewed
officials from FHA, the U.S. Department of Agriculture, and U.S.
Department of Veterans Affairs; and staff at selected private mortgage
providers and insurers, Fannie Mae, Freddie Mac, the Office of Federal
Housing Enterprise Oversight, selected state housing finance agencies, and
nonprofit down-payment assistance providers. We conducted this work from
January 2004 to March 2007 in accordance with generally accepted
government auditing standards.

In summary, our work identified a number of weaknesses in FHA's ability to
estimate and manage risk that may affect the financial performance of the
insurance program:

           o FHA has not developed sufficient standards and controls to
           manage risks associated with the substantial 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
           of loans with this type of down-payment assistance resulting in an
           insurance claim was 76 percent higher than comparable loans
           without such assistance. Additionally, the financial risks of
           these loans recently have been realized in effects on the credit
           subsidy estimates. According to FHA, high claim and loss rates for
           loans with this type of down-payment assistance were major reasons
           why the estimated credit subsidy rate--the expected cost--for the
           single-family insurance program would be positive, or less
           favorable, in fiscal year 2008 (absent any program changes).
           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. However, FHA officials have indicated that they would
           institute stricter underwriting standards for any no-down-payment
           mortgage authorized by their legislative proposal.
           o While generally reasonable, the way that FHA developed its
           mortgage scorecard--an automated tool that evaluates the default
           risk of borrowers--limits the scorecard's effectiveness. More
           specifically, FHA and its contractor used variables that reflected
           borrower and loan characteristics to create the scorecard and an
           accepted modeling process to test the variables' accuracy in
           predicting default. But, the data used to develop the scorecard
           were 12 years old by the time that FHA began using the scorecard
           in 2004, and the market has changed significantly since then. In
           addition, the scorecard does not include all the important
           variables that could help explain expected loan performance such
           as the source of the down payment. With competition from
           conventional providers, limitations in the scorecard could cause
           FHA to insure mortgages that are relatively more risky. Our
           ongoing work indicates that FHA plans to use the scorecard to help
           set insurance premiums if legislative changes are enacted.
           Accordingly, any limitations in the scorecard's ability to predict
           defaults could result in FHA mispricing its products.
           o Although FHA has improved its ability to estimate the subsidy
           costs for its single-family insurance program, it generally has
           underestimated these costs. To meet federal requirements, FHA
           annually reestimates subsidy costs for each loan cohort.^1 The
           current reestimated subsidy costs for all except the fiscal year
           1992 and 1993 cohorts are less favorable--that is, higher--than
           originally estimated. Increases in the expected level of insurance
           claims--potentially stemming from changes in underwriting
           guidelines, among other factors--were a major cause of a
           particularly large reestimate that FHA submitted as of the end of
           fiscal year 2003.

           On the basis of our findings from the reports I have summarized,
           we made several recommendations designed to improve FHA's risk
           management. 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 program 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 (the results of which are used in
           estimating and reestimating program costs) that have been found in
           other studies to influence credit risk.^2

           FHA has taken actions in response to some of our findings and
           recommendations. For example, FHA has developed and begun putting
           in place policies for annually updating the scorecard and testing
           additional predictive variables. To more reliably assess program
           costs, an FHA contractor incorporated the source of down-payment
           assistance and borrower credit scores in recent actuarial reviews
           of the Fund.

           While these actions represent improvements in FHA's risk
           management, sustained management attention to the issues that we
           have identified and continued Congressional oversight of FHA will
           play an important role in ensuring that FHA is able to expand
           homeownership opportunities for low- and middle-income families
           while operating in a manner that is financially sound.
			  
			  Background

           Congress established FHA in 1934 under the National Housing Act
           (P.L. 73-479) to broaden homeownership, protect lending
           institutions, and stimulate employment in the building industry.
           FHA's single-family programs insure private lenders against losses
           (up to almost 100 percent of the loan amount) from borrower
           defaults on mortgages that meet FHA criteria. In 2005, more than
           three-quarters of the loans that FHA insured went to first-time
           homebuyers, and about 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 about 5 percent of single-family home purchase
           mortgages, compared with about 19 percent in 2001.^3 Additionally,
           default rates for FHA-insured mortgages have risen steeply over
           the past several years, a period during which home prices have
           generally appreciated rapidly.

           FHA determines the expected cost of its insurance program, known
           as the credit subsidy cost, by estimating the program's future
           performance.^4 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 has estimated negative credit subsidies for the
           Fund from 1992, when federal credit reform became effective,
           through 2007. However, FHA has estimated that, assuming no program
           changes, the loans it expects to insure in fiscal year 2008 would
           require a positive subsidy, meaning that the present value of
           estimated cash inflows would be less than the present value of
           estimated cash outflows. 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. An
           independent contractor's actuarial review of the Fund for fiscal
           year 2006 estimated that the Fund's capital ratio--the economic
           value divided by the insurance-in-force--is 6.82 percent, well
           above the mandated 2 percent minimum.^5 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.^6 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 (loan amount divided by sales price or appraised value),
           the mortgage industry has increasingly used mortgage scoring and
           automated underwriting systems.^7 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.

           Partly in response to changes in the mortgage market, HUD has
           proposed legislation intended to modernize FHA. Provisions in the
           proposal would authorize FHA to change the way it sets insurance
           premiums 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 the property. HUD's proposal
           would eliminate this contribution requirement and enable FHA to
           offer some borrowers a no-down-payment product.
			  
			  FHA Has Not Implemented Sufficient Standards and Controls to
			  Manage Financial Risks of Loans with Down-Payment Assistance

           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.^8 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. According to FHA, high
           claim and loss rates for loans with this type of down-payment
           assistance were major reasons for changing the estimated credit
           subsidy rate from negative to positive for fiscal year 2008 (in
           the absence of any program changes). Furthermore, incorporating
           the impact of such loans into the actuarial study of the Fund for
           fiscal year 2005 resulted in almost a $2 billion (7 percent)
           decrease in the Fund's estimated economic value.
			  
			  Loans with Down-Payment Assistance Are a Substantial Portion of
			  FHAï¿½s Portfolio and Pose Greater Financial Risks Than 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 the 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 percent 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. The corresponding percentages for 2005 and
           2006 were about the same.

           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.^9 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 (e.g.,
           gifts from relatives) 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. This difference in performance may be explained, in
           part, by the higher sales prices of comparable homes bought with
           seller-funded down-payment assistance. 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.
			  
			  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 the financial 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 treated such
           assistance as a seller inducement and, therefore, does not subject
           this assistance to the limits it otherwise places on contributions
           from sellers.

           Concerns about loans with nonprofit seller-funded down-payment
           assistance have prompted FHA and IRS to initiate steps that could
           curb their use. For example, FHA has begun drafting a proposed
           rule that, as described by FHA, would appear to prohibit
           down-payment assistance from seller-funded nonprofits. FHA's
           legislative proposal could also eliminate the need for such
           assistance by allowing some FHA borrowers to make no down payments
           for an FHA-insured loan. Finally, in May 2006, IRS 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. However, FHA officials told us
           that as of March 2007, they were not aware of IRS rescinding the
           charitable status of any of these organizations.

           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) more routinely monitoring the performance of loans with
           down-payment assistance. Also, as previously noted, HUD has
           initiated steps to curb and provide alternatives to seller-funded
           down-payment assistance.
			  
			  Practices That Other Mortgage Institutions Use 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 that other mortgage institutions use
           could help FHA to design and manage the financial risks of these
           new products. In a February 2005 report, we identified steps that
           mortgage institutions take when introducing new products.^10
           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. By adopting such practices, FHA could reduce the
           potential for higher claims on products whose risks may not be
           well understood.
			  
			  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. In
           commenting on our February 2005 report, 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 were underserved by
           the conventional market, including those who lacked credit scores
           and had little wealth or personal savings. However, in the course
           of our ongoing work on FHA's legislative proposal, FHA officials
           indicated that they would likely set a credit score threshold for
           any no-down-payment product.

           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.^11 Our ongoing work indicates that FHA, if
           authorized to implement risk-based pricing, would charge higher
           premiums for loans with higher loan-to-value ratios, all other
           things being equal.

           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.^12 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.

           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. Consistent with these views, FHA officials told us more
           recently that they would not limit the initial availability of any
           products authorized by its legislative proposal. 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.
			  
			  The Way FHA Developed TOTAL Limits the Scorecardï¿½s Effectiveness
			  in Assessing the Default Risk of Borrowers

           A primary tool that FHA uses to assess the default risk of
           borrowers who apply for FHA-insured mortgages is its TOTAL
           scorecard. TOTAL's capabilities are important, because 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 and operate in a financially sound
           manner.

           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.^13 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 had a contract to update TOTAL, the agency did not
           develop a formal plan for updating TOTAL on a regular basis. Best
           practices in the private sector, also 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.

           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, such as including
           the presence and source of down-payment assistance as a loan
           variable in the scorecard. In response, FHA has developed and
           begun putting in place policies and procedures that call for
           annual (1) monitoring of the scorecard's ability to predict loan
           default, (2) testing of additional predictive variables to include
           in the scorecard, and (3) updating the scorecard with recent loan
           performance data.

           We also recommended that HUD explore additional uses for TOTAL,
           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 and
           avoid adverse selection. Our ongoing work indicates that FHA plans
           to use borrowers' TOTAL scores to help set insurance premiums.
           Accordingly, any limitations in TOTAL's ability to predict
           defaults could result in FHA mispricing its products.
			  
			  FHAï¿½s Current Reestimated Subsidy Costs Are Generally Less
			  Favorable than its Original Estimates

           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. In doing so, FHA reestimates subsidy costs for each
           loan cohort.

           As we reported in September 2005, FHA's subsidy reestimates
           generally have been less favorable (i.e., higher) than the
           original estimates since federal credit reform became effective in
           1992.^14 The current reestimated subsidy costs for all except the
           fiscal year 1992 and 1993 cohorts are higher than the original
           estimates. For example, the current reestimated cost for the
           fiscal year 2006 cohort is about $800 million less favorable than
           originally estimated.

           With respect to reestimates across cohorts, our report examined
           factors contributing to an unusually large $7 billion reestimate
           (more than twice the size of other recent reestimates) that FHA
           submitted as of the end of fiscal year 2003 for the fiscal year
           1992 through 2003 cohorts. These factors included increases in
           estimated claims and prepayments (the payment of a loan before its
           maturity date). Several policy changes and trends may have
           contributed to changes in the expected claims. For example:

           o Revised underwriting guidelines made it easier for borrowers who
           were 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 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, HUD
           indicated that its contractor was considering the specific
           variables that we had recommended FHA include in its annual
           actuarial review of the Fund. The contractor subsequently
           incorporated the source of down-payment assistance in the fiscal
           year 2005 actuarial review and borrower credit scores in the
           fiscal year 2006 review.

^1Essentially, a cohort includes the loans insured in a given year.

^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).

^3These figures represent mortgages for owner-occupied homes only.

^4Pursuant to the Federal Credit Reform Act of 1990, HUD must annually
estimate the credit subsidy cost for its mortgage insurance programs.
Credit subsidy costs are the net present value of estimated payments HUD
makes less the estimated amounts it receives, excluding administrative
costs.

^5In fiscal year 2006, the Fund's estimated economic value was $22 billion
and the unamortized insurance-in-force was $323 billion.

^6Conventional mortgages do not carry government insurance or guarantees.

^7Underwriting refers to a risk analysis that uses information collected
during the origination process to decide whether to approve a loan.

^8GAO, Mortgage Financing: Additional Action Needed to Manage Risks of
FHA-Insured Loans with Down Payment Assistance, [23]GAO-06-24 (Washington,
D.C.: Nov. 9, 2005).

^9The 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.

^10GAO, Mortgage Financing: Actions Needed to Help FHA Manage Risks from
New Mortgage Loan Products, [24]GAO-05-194 (Washington, D.C.: Feb. 11,
2005).

^11Fannie 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.

^12Under this program, homeowners borrow against equity in their home and
receive payments from their lenders.

^13GAO, Mortgage Financing: HUD Could Realize Additional Benefits from its
Mortgage Scorecard, [25]GAO-06-435 (Washington, D.C.: Apr. 13, 2006) and
[26]GAO-06-24 .

^14GAO, Mortgage Financing: FHA's $7 Billion Reestimate Reflects Higher
Claims and Changing Loan Performance Estimates, [27]GAO-05-875
(Washington, D.C.: Sep. 2, 2005).

           Madam 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 or [email protected]. Individuals making
           key contributions to this testimony included Barbara Roesmann,
           Paige Smith, Laurie Latuda, and Steve Westley.
			  
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www.gao.gov/cgi-bin/getrpt?GAO-07-615T .

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For more information, contact William B. Shear at (202) 512-8678 or
[email protected].

Highlights of [29]GAO-07-615T , a testimony before the Subcommittee on
Transportation, Housing and Urban Development, and Related Agencies,
Committee on Appropriations, U.S. Senate

March 15, 2007

FEDERAL HOUSING ADMINISTRATION

Ability to Manage Risks and Program Changes Will Affect Financial
Performance

The Federal Housing Administration (FHA) has seen increased competition
from conventional mortgage and insurance providers. Additionally, because
of the worsening performance of the mortgages it insures, FHA has
estimated that its single-family insurance program would require a
subsidy--that is, appropriations--in fiscal year 2008 in the absence of
program changes. To help FHA adapt to the evolving market, proposed
changes to the National Housing Act would allow greater flexibility in
setting insurance premiums and reduce down-payment requirements. To assist
Congress in considering the financial challenges facing FHA, this
testimony provides information from recent reports GAO has issued and
ongoing work concerning the proposed legislation that address different
aspects of FHA's risk management. Specifically, this testimony looks at
(1) FHA's management of risk related to loans with down-payment
assistance, (2) instructive practices for managing risks of new products,
(3) FHA's development and use of its mortgage scorecard, and (4) FHA's
estimation of program costs.

[30]What GAO Recommends

In the reports discussed in this testimony, GAO made recommendations
designed to improve FHA's risk management and estimates of program costs.

Recent trends in mortgage lending have significantly affected FHA,
including growth in the proportion of FHA-insured loans with down-payment
assistance, wider availability of low- and no-down-payment products, and
increased use of automated tools (e.g., mortgage scoring) to underwrite
loans. 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 estimate and manage risk that may affect its financial
performance. For example:

           o FHA has not developed sufficient standards and controls to
           manage risks associated with the substantial proportion of loans
           with down-payment assistance, including assistance from nonprofit
           organizations funded by home sellers. According to FHA, high claim
           and loss rates for loans with such assistance were major reasons
           for the estimated positive subsidy cost (meaning that the present
           value of estimated cash inflows would be less than the present
           value of estimated cash outflows) for fiscal year 2008, absent any
           program changes.
           o FHA has not consistently implemented practices--such as stricter
           underwriting or piloting--used by other mortgage institutions to
           help manage the risks associated with new product offerings.
           Although FHA has indicated that it would impose stricter
           underwriting standards for a no-down-payment mortgage if the
           legislative changes were enacted, it does not plan to pilot the
           product.
           o The way that FHA developed its mortgage scorecard, while
           generally reasonable, limits how effectively it assesses the
           default risk of borrowers. With increased competition from
           conventional mortgage providers, limitations in its scorecard
           could cause FHA to insure mortgages that are relatively more
           risky.
           o FHA's reestimates of the costs of its single-family mortgage
           program have generally been less favorable than originally
           estimated. Increases in the expected level of claims were a major
           cause of a particularly large reestimate that FHA submitted as of
           the end of fiscal year 2003.

GAO made several recommendations in its recent reports, including that FHA
(1) incorporate the risks posed by down-payment assistance into its
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 products. FHA has taken actions in response to GAO's
recommendations, but continued focus on risk management will be necessary
for FHA to operate in a financially sound manner in the face of market and
program changes.

References

Visible links
  23. http://www.gao.gov/cgi-bin/getrpt?GAO-06-24
  24. http://www.gao.gov/cgi-bin/getrpt?GAO-05-194
  25. http://www.gao.gov/cgi-bin/getrpt?GAO-06-435
  26. http://www.gao.gov/cgi-bin/getrpt?GAO-06-24
  27. http://www.gao.gov/cgi-bin/getrpt?GAO-05-875
  29. http://www.gao.gov/cgi-bin/getrpt?GAO-07-615T
*** End of document. ***