Federal Housing Administration: Modernization Proposals Would
Have Program and Budget Implications and Require Continued
Improvements in Risk Management (29-JUN-07, GAO-07-708).
In recent years, the Federal Housing Administration (FHA) has
experienced a sharp decline in market share. Also, the agency has
estimated that, absent program changes, its Mutual Mortgage
Insurance Fund (Fund) would require appropriations in 2008. To
adapt to market changes, FHA has implemented new procedures and
proposed the following major legislative changes: raising FHA's
loan limits, allowing risk-based pricing, and lowering
down-payment requirements. GAO was asked to report on (1) the
likely program and budget impacts of FHA's modernization efforts;
(2) the tools, resources, and risk management practices important
to FHA's implementation of the legislative proposals, if passed;
and (3) other options that FHA and Congress could consider to
help FHA adapt to market changes. To address these objectives,
GAO analyzed FHA and Home Mortgage Disclosure Act (HMDA) data and
interviewed officials from FHA and other mortgage institutions.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-07-708
ACCNO: A71689
TITLE: Federal Housing Administration: Modernization Proposals
Would Have Program and Budget Implications and Require Continued
Improvements in Risk Management
DATE: 06/29/2007
SUBJECT: Federal aid for housing
Housing
Housing programs
Lending institutions
Mortgage loans
Mortgage programs
Prices and pricing
Program evaluation
Program management
Proposed legislation
Requirements definition
Risk assessment
Risk management
Strategic planning
Policies and procedures
Program implementation
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GAO-07-708
* [1]Results in Brief
* [2]Background
* [3]FHA Insurance Requirements
* [4]FHA's Mutual Mortgage Insurance Fund
* [5]Trends in the Mortgage Market and Their Impact on FHA
* [6]Legislative Proposals for FHA Modernization
* [7]Modernization Efforts Have Streamlined FHA Processes and Lik
* [8]Mortgage Industry Officials Report That FHA's Recent Adminis
* [9]Raising Loan Limits Likely Would Increase Demand for FHA Loa
* [10]Risk-Based Pricing Could Help Address Adverse Selection but
* [11]Legislative Proposals Likely Would Have a Beneficial Budgeta
* [12]FHA Has Enhanced Tools and Resources Important to Implementi
* [13]Credit Score Information Has Enhanced the Data FHA Would Use
* [14]FHA Has Made Some Improvements to Key Statistical Models, bu
* [15]FHA Has Identified Needed Changes in Information Technology
* [16]FHA Has Sought Limited Staff Increases to Help Implement Pro
* [17]FHA's Prior Risk Management Did Not Always Utilize Common In
* [18]Congress and FHA Could Consider Other Administrative and Leg
* [19]FHA Has Existing Authority to Make More Administrative Chang
* [20]Additional Authorities for Investment in Technology, Pay and
* [21]Alternative Approaches for Providing Federal Mortgage Insura
* [22]Observations
* [23]Agency Comments and Our Evaluation
* [24]Appendix I: Objectives, Scope, and Methodology
* [25]Appendix II: Comments from the Department of Housing and Urb
* [26]Appendix III: GAO Contact and Staff Acknowledgments
* [27]GAO Contact
* [28]Staff Acknowledgments
* [29]Order by Mail or Phone
Contents
Letter 1
Results in Brief 3
Background 6
Modernization Efforts Have Streamlined FHA Processes and Likely Would
Affect Program Participation and Costs 12
FHA Has Enhanced Tools and Resources Important to Implementing Proposals
but Does Not Intend to Mitigate Risks by Piloting New Products 24
Congress and FHA Could Consider Other Administrative and Legislative
Changes to Help FHA Adapt to Changes in the Mortgage Market 33
Observations 39
Agency Comments and Our Evaluation 41
Appendix I Objectives, Scope, and Methodology 44
Appendix II Comments from the Department of Housing and Urban Development
48
Appendix III GAO Contact and Staff Acknowledgments 51
Figures
Figure 1: Proposed Changes to FHA's Loan Limits 11
Figure 2: Impact of Borrower Credit Scores and LTV Ratios on Insurance
Premiums under FHA's Risk-Based Pricing Proposal 18
Figure 3: Impact of FHA's Risk-Based Pricing Proposal on Borrowers'
Premiums, Including First-Time and Low-Income Homebuyers 19
Figure 4: Impact of FHA's Risk-Based Pricing Proposal on Premiums Paid by
Different Racial Groups 20
Figure 5: Impact of FHA's Risk-Based Pricing Proposal on Racial
Distribution of FHA Borrowers 22
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Abbreviations
CBSA core based statistical area
FHA Federal Housing Administration
FTE full-time equivalent
HECM Home Equity Conversion Mortgage
HUD Department of Housing and Urban Development
HMDA Home Mortgage Disclosure Act
IRS Internal Revenue Service
LTV loan-to-value
MHC Millennial Housing Commission
United States Government Accountability Office
Washington, DC 20548
June 29, 2007
The Honorable Richard C. Shelby
Ranking Member
Committee on Banking, Housing, and Urban Affairs
United States Senate
The Honorable Wayne Allard
United States Senate
The Department of Housing and Urban Development (HUD), through its Federal
Housing Administration (FHA), has helped millions of families purchase
homes by providing insurance for single-family home mortgages made by
private lenders. However, FHA's single-family insurance program has faced
several challenges in recent years, including rising delinquency rates and
a sharp decline in the number of participating borrowers, due partly to
increased competition from conventional mortgage providers.^1 As
conventional providers have improved their ability to evaluate risk, FHA
has begun to experience adverse selection--that is, conventional providers
have identified and approved relatively lower-risk borrowers in FHA's
traditional market segment, leaving relatively higher-risk borrowers for
FHA. Furthermore, the agency has estimated that, absent any program
changes, the program would for the first time operate with a positive
subsidy in fiscal year 2008--meaning that the present value of estimated
cash outflows (such as insurance claims) to FHA's Mutual Mortgage
Insurance Fund (Fund) would exceed the present value of estimated cash
inflows (such as borrower premiums). To avoid a positive subsidy in fiscal
year 2008, FHA estimates that it would have to increase slightly the
insurance premiums charged to borrowers.
To adapt to market changes, FHA has implemented new administrative
procedures and proposed legislation designed to modernize its insurance
processes and products. FHA's recent administrative changes include
allowing higher-performing lenders to endorse, or approve, loans for FHA
insurance without prior review by FHA and adopting conventional market
appraisal requirements. The legislative proposals would, among other
things, raise FHA's 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, as we testified in June 2006, weaknesses in FHA's risk management
raise questions about the agency's ability to successfully implement the
proposed legislation.^2 Given these concerns, you asked us to evaluate
FHA's modernization efforts. Specifically, this report discusses (1) the
likely program and budgetary impacts of FHA's modernization efforts; (2)
the tools, resources, and risk-management practices important to FHA's
implementation of the legislative proposals, if passed; and (3) other
options that FHA and Congress could consider to help FHA adapt to changes
in the mortgage market and the pros and cons of these options.
^1The conventional market comprises mortgages that do not carry government
insurance or guarantees. For more information on the decline in FHA's
share of the mortgage market and the factors underlying this trend, see
GAO, Federal Housing Administration: Decline in the Agency's Market Share
Was Associated with Product and Process Developments of Other Mortgage
Market Participants, [30]GAO-07-645 (Washington, D.C.: June 29, 2007).
To determine the likely program and budgetary impacts of FHA's
modernization efforts, we analyzed data collected under the Home Mortgage
Disclosure Act (HMDA) and from FHA's Single Family Data Warehouse
(SFDW).^3 Specifically, we used 2005 HMDA data (the most current
available) to examine the effect of raising loan limits on demand for
FHA-insured loans. We determined the number of additional loans in
different geographic areas that would have been eligible for FHA insurance
under the revised loan limits and, based on FHA's current market share,
estimated the percentage of those loans that FHA might have insured. We
estimated the effects of risk-based pricing on borrowers' eligibility for
FHA insurance and the premiums they would pay by analyzing SFDW data on
FHA's 2005 home purchase borrowers to determine the characteristics of
borrowers that could fall into FHA's proposed pricing categories. We
reviewed recent administrative changes made by FHA and interviewed FHA
officials, several FHA lenders, and mortgage and real estate industry
groups about their effects on loan and insurance processing times and
costs. We also examined the potential budgetary impacts of the legislative
proposals by reviewing the President's fiscal year 2008 budget and FHA's
cost estimates. To evaluate the tools, resources, and risk-management
practices important to FHA's implementation of the proposals, we relied on
our prior work, reviewed information provided by FHA, and interviewed
officials from FHA, private mortgage insurers, and the
government-sponsored enterprises (GSE) Fannie Mae and Freddie Mac.^4 To
determine other options that FHA and Congress could consider, we reviewed
relevant literature and interviewed FHA officials, academic experts, FHA
lenders, and private mortgage insurers. Appendix I contains additional
information on our scope and methodology. We conducted this work in
Washington, D.C., from September 2006 to June 2007 in accordance with
generally accepted government auditing standards.
^2GAO, Federal Housing Administration: Proposed Reforms Will Heighten the
Need for Continued Improvements in Managing Risks and Estimating Program
Costs, [31]GAO-06-868T (Washington, D.C.: June 20, 2006).
^3HMDA requires lending institutions to collect and publicly disclose
information about housing loans and applications for such loans, including
the loan type and amount, property type, and borrower characteristics
(such as ethnicity, race, gender, and income). These data are one of the
most comprehensive sources of information on mortgage lending. Among other
things, FHA's SFDW contains information on the borrower and loan
characteristics of the mortgages FHA insures.
Results in Brief
FHA's modernization efforts, which include completed administrative and
proposed legislative changes, have streamlined the agency's insurance
process and could affect the demand for FHA-insured loans, the cost and
availability of insurance to borrowers, and the budgetary costs of the
insurance program. In 2006, FHA made several administrative changes, such
as allowing higher-performing lenders to approve FHA insurance without
prior review by FHA and simplifying its appraisal process. FHA and
mortgage industry officials with whom we spoke said that these changes
have increased the efficiency of loan and insurance processing, making FHA
products more attractive and, therefore, more likely to be used. For
example, one FHA lender reported a 35 percent decrease in loan processing
times and a 25 percent reduction in operating costs for its FHA business.
In addition to these administrative changes, FHA has proposed legislation
that would grant the agency new flexibilities intended to help address
challenges, such as adverse selection, resulting from innovations and
increased competition in the mortgage market. If passed, the legislative
changes likely would affect borrower participation in the program and the
program's budgetary costs. Based on our analysis of 2005 HMDA data, we
estimate that the number of FHA-insured loans in 2005 could have been from
9 to 10 percent greater had the higher, proposed mortgage limits been in
effect. Although the effect of introducing risk-based premiums on the
demand for FHA-insured loans is especially difficult to estimate,
risk-based pricing would affect the cost and availability of FHA
insurance. Specifically, risk-based pricing would decrease premiums for
lower-risk borrowers and increase them for higher-risk borrowers. Our
analysis of data for FHA home purchase borrowers in 2005 shows that about
43 percent of those borrowers would have paid the same or less than they
actually paid, 37 percent would have paid more, and 20 percent would not
have qualified for FHA insurance based on FHA's plans as of May 2007. (The
same percentages hold true when risk-based pricing is compared with the
higher across-the-board premiums that FHA estimates it would have to
charge to avoid a positive subsidy in fiscal year 2008 absent any program
changes.) The 20 percent who would not have qualified were borrowers with
expected lifetime claim rates more than 2.5 times greater than the average
claim rate. The legislative proposals also would have a budgetary impact,
mostly reflected in subsidy costs. While to be viewed with caution, FHA
has made estimates indicating that the loans it expects to insure in 2008
would result in negative subsidies of $342 million if the major
legislative changes were enacted, rather than requiring an appropriation
of $143 million absent any program changes.
^4Fannie Mae and Freddie Mac are government-sponsored private corporations
chartered by Congress to provide a continuous flow of funds to mortgage
lenders and borrowers by purchasing mortgages from lenders and re-selling
them to investors. They purchase single-family mortgages up to the
conforming loan limit, which for 2006 was set at $417,000.
FHA has taken or planned steps to enhance the tools and resources
important to implementing the legislative proposals--and help address
risks and challenges associated with the proposals--but does not intend to
use a common industry practice, piloting, to mitigate the risks of any
zero-down-payment product it is authorized to offer. To implement its
risk-based pricing proposal, FHA would rely on statistical models that
estimate the performance of loans and its mortgage scorecard, an automated
tool that evaluates the default risk of borrowers. In response to our
prior recommendations, FHA has improved the forecasting ability of its
loan performance models by incorporating additional variables found to
influence credit risk and is in the process of addressing a number of
limitations in its mortgage scorecard that could reduce its effectiveness
for risk-based pricing. For instance, as we reported in April 2006, the
scorecard does not include a number of important variables included in
other mortgage institutions' scorecards, such as the source of the down
payment.^5 FHA also has identified changes in information systems needed
to implement the legislative proposals and has obligated or requested a
total of $11 million for this purpose. To address human capital needs, the
President's fiscal year 2008 budget requests 21 additional staff for FHA
to help analyze industry trends, align the agency's business processes
with current mortgage industry practices, and promote new FHA products.
Although FHA has taken actions to enhance key tools and resources, it
operates in a highly competitive environment in which other market
participants have greater flexibility to hire and compensate staff and
invest in information technology, which enhances their ability to adapt to
market changes. Additionally, the legislative proposals would introduce
new risks and challenges. The proposal to lower down-payment requirements
is of particular concern given the greater default risk of
low-down-payment loans, housing market conditions that could put borrowers
with such loans in a negative equity position, and the difficulty of
setting prices for new products whose risks may not be well understood.
FHA plans to take some steps, such as instituting stricter underwriting
standards, to mitigate these risks and challenges. However, while other
mortgage institutions use pilot programs to manage the risks associated
with changing or expanding their product lines, FHA has indicated that it
does not plan to pilot any zero-down-payment product it is authorized to
offer and lacks the resources to do so. We have previously reported that
Congress may want to consider requiring FHA to limit the initial
availability of any new products and also recommended that FHA itself
consider piloting.
^5GAO, Mortgage Financing: HUD Could Realize Additional Benefits from Its
Mortgage Scorecard, [32]GAO-06-435 (Washington, D.C.: Apr. 13, 2006).
Mortgage industry participants and researchers have suggested a number of
additional administrative and legislative options that Congress and FHA
could consider to help FHA adapt to changes in the mortgage market, but
some changes could have budget impacts and complicate oversight efforts.
Some administrative changes--such as adjusting premiums or even
implementing a more limited form of risk-based pricing--are within FHA's
existing authority. Congress also could consider granting FHA additional
authorities that would increase the agency's operational flexibility. For
example, Congress could allow FHA to invest the Fund's current
resources--that is, negative subsidies that accrue in the Fund's
reserves--in information technology and human capital. However, using the
Fund's current resources would diminish its ability to withstand severe
economic conditions and would also increase the federal government's
budget deficit, all other things being equal. Additionally, Congress could
expressly authorize FHA to offer and pilot new insurance products without
prior congressional approval. Finally, Congress could consider various
alternative approaches to the provision of federal mortgage insurance. For
example, the federal government could continue to provide mortgage
insurance but through a more independent government corporation, implement
risk-sharing arrangements with private partners, or let market forces
determine the future need for federal mortgage insurance by making no
program changes and allowing FHA's role in the mortgage market to increase
or decrease according to market conditions. However, any fundamental
changes to how the federal government provides mortgage insurance also
could require new oversight mechanisms and would require careful
deliberation.
While our report does not make any new recommendations, we make
observations about the need for careful implementation of the legislative
proposals, if passed. While FHA has performed considerable analysis to
support its legislative proposals and has made or planned enhancements to
many of the specific tools and resources that would be important to its
implementation, the proposals present risks and challenges and should be
viewed with caution. Continued management attention to our prior
recommendations, including piloting new products and steps to improve its
mortgage scorecard, could help FHA address these risks.
We provided HUD with a draft of this report. HUD commented that the draft
report provided a balanced assessment but also that the report's concerns
about FHA's risk management and emphasis on the need for piloting zero- or
lower-down-payment products were unwarranted. HUD indicated that it had a
firm basis for anticipating the performance of these products as a result
of its experience with loans with down-payment assistance from nonprofit
organizations funded by home sellers. While we acknowledge that this
experience could inform assessment of how a zero-down-payment product
would perform, the product could be utilized by a different population of
borrowers than seller-funded down-payment assistance loans and may not
perform similarly to these loans. Also, if authorized to offer a
zero-down-payment product in the near future, FHA would be introducing it
at a time when stagnating or declining home prices in some parts of the
country could increase the risk of default. Because of these risks and
uncertainties, we continue to believe that a prudent way to introduce a
zero-down-payment product would be to limit its initial availability such
as through a pilot program. We discuss HUD's comments in the agency
comments section, and the agency's written comments are reproduced in
appendix II.
Background
Congress established FHA in 1934 under the National Housing Act (P.L.
73-479) to broaden homeownership, protect and sustain lending
institutions, and stimulate employment in the building industry. FHA
insures a variety of mortgages for initial home purchases, construction
and rehabilitation, and refinancing. In fiscal year 2006, FHA insured
almost 426,000 mortgages representing $55 billion in mortgage insurance.
FHA's single-family programs insure private lenders against losses from
borrower defaults on mortgages that meet FHA criteria for properties with
one to four housing units. FHA has played a particularly large role among
minority, lower-income, and first-time homebuyers and generally is thought
to promote stability in the market by ensuring the availability of
mortgage credit in areas that may be underserved by the private sector or
are experiencing economic downturns. In fiscal year 2006, 79 percent of
FHA-insured home purchase loans went to first-time homebuyers, 31 percent
of whom were minorities.
FHA is a government mortgage insurer in a market that also includes
private insurers. Generally, borrowers are required to purchase mortgage
insurance when the loan-to-value (LTV) ratio--the ratio of the amount of
the mortgage loan to the value of the home--exceeds 80 percent. Private
mortgage insurance policies provide lenders coverage on a portion
(generally 20 to 30 percent) of the mortgage balance. However, borrowers
who have difficulty meeting down-payment and credit requirements for
conventional loans may find it easier to qualify for a loan with FHA
insurance, which covers 100 percent of the value of the loan. Because the
credit risk is mitigated by the federal guaranty, FHA borrowers are
allowed to make very low down payments and generally pay interest rates
that are competitive with prime mortgages.
FHA Insurance Requirements
Legislation sets certain standards for FHA-insured loans. FHA-insured
borrowers are required to make a cash investment of a minimum of 3
percent. This investment may come from the borrowers' own funds or from
certain third-party sources. However, borrowers are permitted to finance
their mortgage insurance premiums and some closing costs, which can create
an effective LTV ratio of close to 100 percent for some FHA-insured loans.
Congress also has set limits on the size of the loans that may be insured
by FHA. These limits vary by county. The limit for an FHA-insured mortgage
is 95 percent of the local median home price, not to exceed 87 percent or
fall below 48 percent of the Freddie Mac conforming loan limit, which was
$417,000 in 2006. Therefore, in 2006, FHA loan limits fell between a floor
in low-cost areas of $200,160 and a ceiling in high-cost areas of
$362,790. Eighty-two percent of counties nationwide had loan limits set at
the low-cost floor, while 3 percent had limits set at the high-cost
ceiling. The remaining 15 percent of counties had limits set between the
floor and ceiling, at 95 percent of their local median home prices.
FHA's Mutual Mortgage Insurance Fund
FHA insures most of its single-family mortgages under its Mutual Mortgage
Insurance Fund, which is supported by borrowers' insurance premiums. FHA
has the authority to establish and collect a single up-front premium in an
amount not to exceed 2.25 percent of the amount of the original insured
principal obligation of the mortgage, and annual premiums of up to 0.5
percent of the remaining insured principal balance, or 0.55 percent for
borrowers with down payments of less than 5 percent. Currently, FHA uses a
flat premium structure whereby all borrowers pay the same 1.5 percent
up-front fee and a 0.5 percent annual fee.
The Omnibus Budget Reconciliation Act of 1990 requires an annual
independent actuarial review of the economic net worth and soundness of
the Fund. The actuarial review estimates the economic value of the Fund as
well as the capital ratio to see if the Fund has met the capital standards
in the act.^6 The analysis considers the historical performance of the
existing loans in the Fund, projected future economic conditions, loss
given claim rates, and projected mortgage originations. The Fund has met
the capital ratio requirements since 1995, and the single-family mortgage
insurance program has maintained a negative overall credit subsidy rate,
meaning that the present value of estimated cash inflows from premiums and
recoveries exceeds estimated cash outflows for claim payments (excluding
administrative costs). However, in recent years, the subsidy rate has
approached zero.
A few single-family mortgage insurance programs are insured as obligations
under either the General Insurance or Special Risk Insurance Funds. These
programs are Section 203(k) rehabilitation mortgages, which enable
borrowers to finance both the purchase (or refinancing) of a house and the
cost of its rehabilitation through a single mortgage; Section 234(c)
insurance for the purchase of a unit in a condominium building; and
reverse mortgages under the Home Equity Conversion Mortgage (HECM)
program, which can be used by homeowners age 62 and older to convert the
equity in their home into a lump sum payment, monthly streams of income,
or a line of credit to be repaid when they no longer occupy the home.
^6The economic value of the Fund is the value of the Fund's assets minus
its liabilities, plus the net present value of future cash flows of the
outstanding portfolio. The capital ratio is the economic value divided by
the amount of unamortized insurance-in-force (the total initial loan
amounts of outstanding insured loans). The Omnibus Budget Reconciliation
Act of 1990 mandated that the Fund achieve a capital ratio of at least 2
percent by fiscal year 2000 and maintain that level in all future years.
See P.L. 101-508, Section 2105.
Trends in the Mortgage Market and Their Impact on FHA
Two major trends in the conventional mortgage market have significantly
affected FHA. First, in recent years, members of the conventional mortgage
market increasingly have been active in supporting low- and
no-down-payment mortgages, increasing consumer choices for borrowers who
may have previously chosen an FHA-insured loan. Subprime lenders, in
particular, have offered mortgage products featuring flexible payment and
interest options that allowed borrowers to qualify for mortgages despite a
rise in home prices.^7 Second, to help assess the default risk of
borrowers, particularly those with high LTV ratios, the mortgage industry
increasingly has used mortgage scoring and automated underwriting systems.
Underwriting refers to a risk analysis that uses information collected
during the origination process to decide whether to approve a loan, and
automated underwriting refers to the process by which lenders enter
information on potential borrowers into electronic systems that contain an
evaluative formula, or algorithm, called a scorecard. The scorecard
algorithm attempts to measure the borrower's risk of default quickly and
objectively by examining data such as application information and credit
scores. (Credit scores assign a numeric value generally ranging from 300
to 850 to a borrower's credit history, with higher values signifying
better credit.) The scorecard compares these data with specific
underwriting criteria (e.g., cash reserves and credit requirements) to
predict the likelihood of default. Since 2004, FHA has used its own
scorecard called Technology Open to Approved Lenders (TOTAL). FHA lenders
now use TOTAL in conjunction with automated underwriting systems to
determine the likelihood of default. Although TOTAL can determine the
credit risk of a borrower, it does not reject a loan. FHA requires lenders
to manually underwrite loans that are not accepted by TOTAL to determine
if the loan should be accepted or rejected.
Further, as we noted in a recent report, the share of home purchase
mortgage loans insured by FHA has fallen dramatically, from 19 percent in
1996 to 6 percent in 2005, with almost all the decline occurring since
2001.^8 The combination of (1) FHA product restrictions and a lack of
process improvements relative to the conventional market and (2) product
innovations and expanded loan origination and funding channels in the
conventional market--coupled with interest rate and house price
changes--provided conditions that favored conventional mortgages over FHA
products. Conventional subprime loans, in particular, emerged as an
alternative to FHA-insured mortgages but often at a higher ultimate cost
to certain borrowers.
^7Subprime borrowers typically have blemished credit, may have difficulty
providing income documentation, and generally pay higher interest rates
and fees than prime borrowers.
^8 [33]GAO-07-645 .
At the same time, FHA's financial performance has worsened. As we noted in
a recent testimony, one reason for deteriorating loan performance has been
the increase in FHA-insured loans with down-payment assistance from
nonprofit organizations funded by home sellers.^9 Down-payment assistance
programs provide cash assistance to homebuyers who cannot afford to make
the minimum down payment or pay the closing costs involved in obtaining a
mortgage. From 2000 to 2006, the total proportion of FHA-insured home
purchase loans with down-payment assistance from nonprofits (the large
majority of which received funding from property sellers) increased from
about 2 percent to approximately 33 percent.
Legislative Proposals for FHA Modernization
To help FHA adapt to recent trends in the mortgage market, in 2006 HUD
submitted a legislative proposal to Congress that included changes that
would adjust loan limits for the single-family mortgage insurance program,
eliminate the requirement for a minimum down payment, and provide greater
flexibility to FHA to set insurance premiums based on risk factors. HUD's
proposal, as it currently stands, reflects revisions made by the Expanding
American Homeownership Act of 2006, which was passed by the House of
Representatives in July 2006. Specifically, as shown in figure 1, the
proposal would increase the loan limit for FHA-insured mortgages from 95
to 100 percent of the local median home price. It would also raise the
loan limit floor in low-cost areas from 48 to 65 percent of the conforming
loan limit, and the ceiling in high-cost areas from 87 to 100 percent of
the conforming limit.^10 The proposal would also repeal the 3 percent
minimum cash investment requirement and allow FHA to set premiums
commensurate with the risk of the loan.^11 FHA would establish a premium
structure allowing either a combination of upfront and annual premiums or
annual premiums alone, subject to specified maximum amounts.
^9GAO, Federal Housing Administration: Ability to Manage Risks and Program
Changes Will Affect Financial Performance, [34]GAO-07-615T (Washington,
D.C.: Mar. 15, 2007).
^10According to FHA, the existing loan limits are lower than the cost of
new construction in many areas of the country and therefore do not allow
buyers of new homes to use FHA products.
^11The proposal to repeal the 3 percent minimum cash investment
requirement would eliminate the complicated statutory formula used to
calculate down payments. This formula considers multiple variables such as
the average closing costs in the state.
Figure 1: Proposed Changes to FHA's Loan Limits
In addition to these three major changes, the modernization proposal also
contained other provisions, including:
o Permanently eliminating the limit on the number of HECM
(reverse) mortgages that can be insured, setting a single
nationwide loan limit for HECMs, and authorizing a HECM program
for home purchases.^12
o Extending the permissible term of FHA-insured mortgages from 35
to 40 years.
o Moving HECMs, Section 203(k) rehabilitation mortgages, and
Section 234(c) condominium unit mortgages from the General
Insurance and Special Risk Insurance Funds to the Mutual Mortgage
Insurance Fund. Moving the condominium program to the Fund would
simplify the origination and underwriting process for these loans
because they would no longer be subject to more complex
requirements for multifamily housing loans.
^12Under the program, seniors who wished to move from their current home
could get a home purchase loan for a new dwelling and convert that loan
into an HECM in a single transaction.
While FHA's planning has reflected revisions made to its original proposal
by the House of Representatives in the 109th Congress, new bills
introduced in the 110th Congress could further affect FHA's planning.^13
Modernization Efforts Have Streamlined FHA Processes and Likely Would Affect
Program Participation and Costs
FHA's modernization efforts, which include completed administrative and
proposed legislative changes, have streamlined the agency's insurance
processes and likely would affect program participation and costs.
According to FHA and mortgage industry officials with whom we spoke, FHA's
recent administrative changes have resulted in efficiency improvements,
making FHA products more attractive to use. FHA's proposed legislation
would grant the agency new leeway to help address challenges, such as
adverse selection, resulting from innovations and increased competition in
the mortgage market. If passed, the legislative changes likely would have
a number of program and budgetary impacts. For example, we estimate that
raising the FHA loan limits could increase demand for FHA-insured loans,
all other things being equal. The risk-based pricing proposal would
decrease premiums for lower-risk borrowers, increase them for higher-risk
borrowers, and disqualify other potential borrowers. In addition, FHA
estimates that the legislative proposals would have a favorable budgetary
impact.
^13See H.R. 1752, 110th Cong. (2007); H.R. 1852, 110th Cong. (2007); S.
947, 110th Cong. (2007).
Mortgage Industry Officials Report That FHA's Recent Administrative Changes Have
Increased the Efficiency of Loan and Insurance Processing
FHA has taken a number of steps to make the loans it insures easier to
process and bring the agency more in line with the conventional market.
For example, in January 2006, FHA introduced the Lender Insurance Program,
which enables higher-performing lenders to endorse all FHA loans except
HECMs without a prior review by FHA.^14 Prior to that time, all lenders
were required to mail loan case files to FHA for review by contract staff
before the loan could be endorsed for insurance. If the contractor found a
problem with the case file, FHA would mail the file back to the lender for
correction. Under the new program, approved lenders are allowed to perform
their own pre-endorsement reviews and submit loan data electronically to
FHA.^15 If the loan data pass checks for accuracy and completeness, the
lender is able to endorse the loan automatically. As of December 31, 2006,
405 (31 percent) of the 1,314 FHA lenders eligible for the program had
been approved to participate. Between January 1, 2006, and December 31,
2006, 46 percent of FHA-insured loans were endorsed through the program.
In addition to implementing the Lender Insurance Program, FHA revised its
appraisal protocols and closing cost guidelines to align them more closely
with conventional standards. Specifically, the agency simplified the
appraisal process by adopting appraisal forms used in the conventional
market and eliminating the requirement that minor property deficiencies be
corrected prior to the sale of the property. Under the revised procedures,
FHA limits required repairs to those necessary to protect the health and
safety of the occupants, protect the security of the property, or correct
physical deficiencies or conditions affecting structural integrity.
Examples of property conditions that must be repaired include inadequate
access to the exterior of the home from bedrooms, leaking roofs, and
foundation damage. The agency requires the appraiser to identify minor
property deficiencies (such as missing handrails, cracked window glass,
and minor plumbing leaks) on the appraisal form, but no longer stipulates
that they be repaired. These changes went into effect for all appraisals
performed on or after January 1, 2006. In January 2006, FHA also
eliminated its list of "allowable" and "non-allowable" closing costs and
other fees that may be collected from the borrower. The agency made this
change because FHA lenders had advised the agency that home sellers
sometimes balked at accepting a sales contract from a homebuyer wishing to
use FHA-insured financing because its guidelines differed from standard
practice and did not consider regional variations. Lenders may now charge
and collect from borrowers those customary and reasonable costs necessary
to close the mortgage.
^14FHA defines higher-performing lenders as those with 2 years of
acceptable default and claim rates (at or below 150 percent of the
national average). Because FHA is phasing in the Lender Insurance Program,
HECMs are not yet eligible for endorsement through the program.
^15As was the agency's practice prior to the Lender Insurance Program, FHA
will select a sample of each lender's mortgages for post-endorsement
quality checks.
According to FHA lenders and industry groups, these changes have increased
the efficiency of loan processing, making FHA products more attractive to
use. Representatives of a mortgage industry group told us that feedback
from the group's members on the Lender Insurance Program had been
positive.^16 Similarly, the FHA lenders we interviewed stated that the
program had resulted in efficiency improvements, such as reduced
processing times or costs. For example, one large FHA lender estimated
that participating in the program had reduced the time it took to process
an FHA-insured loan by about 35 percent (or 15 to 20 days). The same FHA
lender also estimated that participation in the program had reduced the
operating costs (mostly printing and shipping costs) for its FHA business
by about 25 percent. Additionally, the FHA lenders we interviewed and
representatives of a real estate industry group noted that FHA's revised
appraisal protocols and closing costs had made it easier to originate FHA
loans. Representatives of the industry group noted that the revisions had
shortened the time it took to close an FHA loan, which was important in a
competitive market. Finally, the lenders we interviewed estimated that the
administrative changes had contributed, at least in part, to recent modest
increases in the number of FHA-insured loans they had made.
According to FHA officials, the Lender Insurance Program also has reduced
the time it takes FHA to process insurance endorsements and led to cost
savings. They estimated that it takes FHA from 2 to 3 days to endorse
applications for insurance on loans that are not part of the program. For
loans endorsed through the program, they noted that approval is virtually
instantaneous if the loan passes quality checks. In addition to reducing
insurance processing times, the program has resulted in cost savings for
FHA. During the first year of the program, FHA realized a reduction in
contracting costs of more than $2 million, as its contractors were
required to perform fewer pre-endorsement reviews. FHA also saved more
than $70,000 in mailing costs during the first 9 months of the program.
FHA estimates that contract costs will continue to decline as the program
is expanded to include the HECM program.
^16Although the Lender Insurance Program has streamlined the processing of
FHA-insured loans, the HUD Inspector General has expressed concerns that
the program could increase the risk of fraud because the lenders, rather
than FHA, maintain the records on loans insured through the program.
Raising Loan Limits Likely Would Increase Demand for FHA Loans, but the Effect
of Other Major Proposals on FHA Loan Volume Is Uncertain
Our analysis indicates that raising FHA's loan limits likely would
increase the number of loans insured by FHA by making more loans eligible
for FHA insurance. In some areas of the country, particularly in parts of
California and the Northeast, median home prices have been well above
FHA's maximum loan limits, reducing the agency's ability to serve
borrowers in those markets. For example, the 2005 loan limit in high-cost
areas was $312,895 for one-unit properties, while the median home price
was about $399,000 in Boston, Massachusetts; about $432,000 in Newark, New
Jersey; $500,000 in Salinas, California; and about $646,000 in San
Francisco, California. If the limits were increased, FHA insurance would
be available to a greater number of potential borrowers. Our analysis of
HMDA data indicates that the agency could have insured from 9 to 10
percent more loans in 2005 had the higher mortgage limits been in
place.^17 The greatest portion of this increase resulted from raising the
loan limit floor in low-cost areas from 48 to 65 percent of the conforming
loan limit. In particular, 82 percent of the new loans that would have
been insured by FHA and 74 percent of the dollar amount of those loans in
our analysis occurred in areas where the loan limits were set at the
floor. Only 14 percent of the new loans (22 percent of the dollar amount
of new loans) would have resulted from increasing the loan limit ceiling.
Our analysis also found that the average size of an FHA-insured loan in
2005 would have increased from approximately $123,000 to about $132,000
had the higher loan limits been in place.
The effect of the other major legislative proposals on the demand for
FHA-insured loans is difficult to estimate. Although FHA has not estimated
the effect on demand, FHA officials expect that risk-based pricing would
enable them to serve more borrowers. By reducing premiums for relatively
lower-risk borrowers, FHA expects to attract more of these borrowers.
However, increased premiums for higher-risk borrowers could reduce these
borrowers' demand for FHA products. Additionally, some high-risk borrowers
who previously would have qualified for FHA insurance would not qualify
under risk-based pricing. The effect of lowering down-payment requirements
on demand for FHA-insured loans is also difficult to estimate. FHA expects
a new zero-down-payment product to attract borrowers who otherwise would
have used down-payment assistance from nonprofit organizations funded by
home sellers. However, underwriting restrictions could limit the number of
borrowers who would qualify for the product.
^17Our analysis considered the number of additional loans that would have
been eligible for FHA insurance if the loan limits in 2005 had been raised
to 100 percent of area median income, with a floor in low-cost areas of
$233,773 and a ceiling in high-cost areas of $359,650. For our assumptions
about the share of newly eligible loans that would likely be insured by
FHA, see appendix I.
Developments in the subprime market also may affect the demand for FHA
loans. Since 2001, FHA's share of the mortgage market has declined as the
subprime market has grown. However, relatively high default and
foreclosure rates for subprime loans and a contraction of this market
segment could shift market share to FHA. For example, one major lender we
interviewed said that FHA's continued modernization efforts combined with
a weakening subprime market likely would result in renewed demand for FHA
products as simplified processes make it easier for lenders to originate
FHA-insured loans.
Risk-Based Pricing Could Help Address Adverse Selection but Would Affect the
Cost and Availability of FHA Insurance for Some Borrowers
To help address the problem of adverse selection, FHA has sought authority
to price insurance premiums based on borrower risk, which would affect the
cost and availability of FHA insurance for some borrowers. Currently, all
FHA-insured borrowers pay an up-front premium of 1.5 percent of the
original insured loan amount, and annual premiums of 0.5 percent of the
remaining insured principal balance. Under this flat pricing structure,
lower-risk borrowers subsidize higher-risk borrowers. In recent years,
innovations in the mortgage market have allowed conventional mortgage
lenders and insurers to identify and approve relatively low-risk borrowers
and charge fees based on default risk. As relatively lower-risk borrowers
in FHA's traditional market segment have selected conventional financing,
FHA has been left with more high-risk borrowers who require a subsidy and
fewer low-risk borrowers to provide that subsidy.
Partly due to this trend, the President's fiscal year 2008 budget stated
that, in the absence of risk-based pricing, FHA would need to raise
premiums to avoid the need for a positive subsidy. FHA officials told us
that they would have to raise premiums for all borrowers to 1.66 percent
up front and 0.55 percent annually. Raising premiums for all borrowers
could exacerbate FHA's adverse selection problem by causing even more
lower-risk borrowers to opt for more competitive conventional products
rather than FHA-insured loans, leaving FHA with even fewer lower-risk
borrowers to subsidize higher-risk borrowers. Rather than raise premiums
for all borrowers, FHA has proposed risk-based pricing as a solution to
the adverse selection problem. Under risk-based pricing, some future FHA
borrowers would pay more than the current premiums while others would pay
about the same or less. As previously noted, discounting premiums could
make FHA a more attractive option for relatively lower-risk borrowers.
As of May 2007, FHA's risk-based pricing proposal established six
different risk categories, each with a different premium rate, for
purchase and refinance loans.^18 FHA used data from its most recent
actuarial review to establish the six risk categories and corresponding
premiums based on the relative performance of loans with various
combinations of LTV ratio and credit score. Borrowers in categories with
higher expected lifetime claim rates would have higher premiums than those
in categories with lower claim rates. Premiums would range from 0.75
percent up front and 0.50 percent annually for the lowest-risk borrowers,
to 3.00 percent up front and 0.75 percent annually for the highest-risk
borrowers. Although the premiums that FHA would charge borrowers in the
six risk categories would be more commensurate with the risks of the
loans, lower-risk borrowers would continue to subsidize higher-risk
borrowers to some extent.
If FHA were granted the authority to implement its risk-based pricing
proposal, the agency would publish a pricing matrix that would allow
borrowers to identify their likely premiums based on their credit scores
and LTV ratios. As shown in figure 2, lower borrower credit scores and
higher LTV ratios would result in higher insurance premiums. However, FHA
would use its TOTAL mortgage scorecard to make the final determination of
a borrower's placement in a particular risk category. While TOTAL takes
into account more borrower and loan characteristics than LTV ratio and
credit score (such as borrower reserves and payment-to-income ratio), it
was designed to predict the probability of claims or defaults that would
later result in claims within 4 years of loan origination rather than
lifetime claim rates. Therefore, FHA rescaled the TOTAL scores to reflect
lifetime claim rates. Because of the additional risk characteristics
considered by TOTAL, a borrower's TOTAL score could indicate that a
borrower belongs in a higher risk category than would be suggested by LTV
ratio and credit score alone. FHA has not produced a formal estimate of
how often this would occur, but plans to include this caveat in its
pricing matrix.
^18Different pricing would apply to refinances of existing FHA-insured
mortgages.
Figure 2: Impact of Borrower Credit Scores and LTV Ratios on Insurance
Premiums under FHA's Risk-Based Pricing Proposal
Our analysis of how the proposed pricing structure would affect home
purchase borrowers similar to those insured by FHA in 2005 found that
approximately 43 percent of borrowers would have paid the same or less
while 37 percent would have paid more. As discussed more fully later, 20
percent would not have qualified for FHA insurance had the risk-based
pricing proposal been in effect. These percentages hold true whether
comparing the proposed risk-based premiums to the current premiums of 1.5
percent up front and 0.5 percent annually or the higher premiums of 1.66
percent up front and 0.55 percent annually that, according to FHA, would
be needed to maintain a negative subsidy rate in fiscal year 2008. As
shown in figure 3, risk-based pricing would have had a similar impact on
first-time and low-income homebuyers FHA served in 2005.
Figure 3: Impact of FHA's Risk-Based Pricing Proposal on Borrowers'
Premiums, Including First-Time and Low-Income Homebuyers
Note: We analyzed SFDW data on 2005 home purchase borrowers. The figure
shows how these borrowers would have fared under FHA's risk-based pricing
proposal. Low-income homebuyers are those whose incomes are less than or
equal to 80 percent of the area median income. The figure excludes the
approximately 2 percent of borrowers for whom SFDW did not contain either
an LTV ratio or credit score (the two variables FHA would use to determine
risk-based premiums).
Among FHA's 2005 borrowers, 47 percent of white borrowers and 40 percent
of Hispanic borrowers would have paid the same or less under the new
proposed risk-based pricing structure than they did under the present
pricing structure, while 28 percent of black borrowers would have paid the
same or less. A little more than one-third of borrowers in each racial
category would have paid more (see fig. 4). FHA officials concluded, in
their analysis of an earlier version of the risk-based pricing proposal,
that any disparate impacts of risk-based pricing using consumer credit
scores would be based on valid business reasons. Specifically, they noted
that, although some racial differences do exist in the distribution of
credit scores and LTV ratios, these variables are strongly associated with
claim rates and have become the primary risk factors used for pricing
credit risk in the conventional market.
Figure 4: Impact of FHA's Risk-Based Pricing Proposal on Premiums Paid by
Different Racial Groups
Note: We analyzed SFDW data on 2005 home purchase borrowers. The figure
shows how these borrowers would have fared under FHA's risk-based pricing
proposal. It excludes the 2 percent of borrowers for whom SFDW did not
contain either an LTV ratio or credit score (the two variables FHA would
use to determine risk-based premiums) and the 2.9 percent of borrowers for
whom race was not disclosed. Percentages do not add to 100 due to
rounding.
Risk-based pricing would also affect the availability of FHA insurance for
some borrowers. Approximately 20 percent of FHA's 2005 borrowers would not
have qualified for FHA mortgage insurance under the parameters of the
risk-based pricing proposal we evaluated. FHA determined that the expected
claim rates of these borrowers were higher than it found tolerable for
either the borrower or the Fund. Those borrowers who would not have
qualified had high LTV ratios and low credit scores. Their average credit
score was 584, and their expected lifetime claim rates are more than 2.5
times higher than the average claim rate of all FHA loans.^19 FHA
officials stated that setting risk-based premiums for potential future FHA
borrowers with similar characteristics would require prices higher than
borrowers may be able to afford.
The overall distribution of 2005 FHA borrowers (by income, first-time
borrower status, or race) would not have changed substantially had the
policy not to serve borrowers with these higher expected lifetime claim
rates been in place that year (all other things being equal). If the 20
percent of borrowers with the higher expected claim rates were removed
from FHA's 2005 borrower pool, our analysis found that low-income
homebuyers would have remained about 51 percent of the pool. First-time
homebuyers would have constituted about 78 percent of the pool, compared
with 79 percent when all borrowers are included. Similarly, the overall
racial distribution of borrowers would have changed modestly (see fig. 5).
The percentage of Hispanic borrowers would have remained about 14 percent,
black borrowers would have decreased from 13 to 11 percent, and white
borrowers would have increased from 69 to 70 percent.
^19Additionally, the vast majority of these borrowers (90 percent)
received down-payment assistance from nonprofits, most of which received
funding from property sellers.
Figure 5: Impact of FHA's Risk-Based Pricing Proposal on Racial
Distribution of FHA Borrowers
Note: We analyzed SFDW data on 2005 home purchase borrowers. The figure
shows how these borrowers would have fared under FHA's risk-based pricing
proposal. Percentages do not add to 100 due to rounding.
All other things being equal, implementing the legislative proposals
likely would have had a slightly negative impact on FHA's ability to meet
certain performance measures related to the types of borrowers it serves.
HUD's strategic plan for fiscal years 2006 to 2011 calls for the share of
first-time minority homebuyers among FHA home purchase mortgages to remain
above 35 percent. Our analysis shows that 34 percent of fiscal year 2005
home purchase mortgages were for first-time minority home buyers. Under
risk-based pricing, a slightly lower percentage, 32 percent, would have
been first-time minority home buyers. The strategic plan also calls for
the share of FHA-insured home purchase mortgages for first-time homebuyers
to remain above 71 percent. Our analysis shows that 79 percent of fiscal
year 2005 FHA home purchase borrowers were first-time home buyers. Under
risk-based pricing, 77 percent would have been first-time home buyers.
Legislative Proposals Likely Would Have a Beneficial Budgetary Impact
According to FHA's estimates, the three major legislative proposals would
have a beneficial impact on HUD's budget due to higher estimated negative
subsidies. According to the President's fiscal year 2008 budget, the
credit subsidy rate for the Fund would be more favorable if the
legislative proposals were enacted. Absent any program changes, FHA
estimates that the Fund would require an appropriation of credit subsidy
budget authority of approximately $143 million. If the legislative
proposals were not enacted, FHA would consider raising premiums to avoid
the need for appropriations. If the major legislative proposals were
passed, FHA estimates that the Fund would generate $342 million in
negative subsidies.^20
FHA's subsidy estimates for fiscal year 2008 should be viewed with caution
given that FHA has generally underestimated the subsidy costs for the
Fund. To meet federal requirements, FHA annually reestimates subsidy costs
for each loan cohort dating back to fiscal year 1992.^21 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
higher than originally estimated. As discussed more fully later in this
report, FHA has taken some steps to improve its subsidy estimates.
^20These figures do not reflect FHA's proposals to eliminate the limit on
the number of mortgages insured under the HECM program and move the
program from the General Insurance Fund to the Mutual Mortgage Insurance
Fund. According to FHA's estimates, the HECM program would generate about
$338 million in negative subsidies in fiscal year 2008. Therefore, moving
the HECM program would result in negative subsidies totaling about $680
million for the Fund.
^21Agencies are required to reestimate subsidy costs annually to reflect
actual loan performance and expected changes in estimates of future loan
performance. Essentially, a cohort includes the loans insured in a given
year.
FHA Has Enhanced Tools and Resources Important to Implementing Proposals but
Does Not Intend to Mitigate Risks by Piloting New Products
FHA has enhanced the tools and resources it uses that would be important
to implementing the legislative proposals, but has not always used
industry practices that could help the agency manage the risks associated
with program changes. To implement risk-based pricing, FHA would rely on
historical loan-level data, models that estimate loan performance, and its
TOTAL mortgage scorecard. Although FHA has improved the forecasting
ability of its models by adding variables found to influence credit risk,
the agency is still addressing limitations in TOTAL that could reduce its
effectiveness as a pricing tool. FHA also has identified changes in
information systems needed to implement the legislative proposals and
requested additional staff to help promote new FHA products but faces
long-term challenges in these areas. However, the legislative proposals
would introduce new risks and challenges such as the difficulty of pricing
loans with very low or no down payments whose risks may not be well
understood. While other mortgage institutions use pilot programs to manage
the risks associated with changing or expanding their product lines, FHA
has indicated that it does not plan to pilot any no-down-payment product
it is authorized to offer.
Credit Score Information Has Enhanced the Data FHA Would Use to Implement
Proposals
Mortgage institutions use detailed information on the characteristics and
performance of past loans to help predict the performance of future loans
and price them correctly. Like other mortgage institutions we contacted,
FHA has extensive loan-level data. These data are contained in the
agency's SFDW, which FHA implemented in 1996 to assemble critical data
from 12 single-family systems.^22 SFDW is updated monthly and currently
contains data on approximately 33 million FHA-insured loans dating back to
fiscal year 1975. These data include information on the borrower (such as
age, gender, race, income, and first-time home buyer status) and the loan
(including whether it is an adjustable- or fixed-rate mortgage, the source
and amount of any down-payment assistance, interest rate, premium rate,
original mortgage amount, and LTV ratio).
FHA has added information on borrower credit scores to the loan-level data
that it plans to use to assess risk and set insurance premiums if the
legislative proposals were enacted. Research has shown that credit scores
are a strong predictor of loan performance--that is, borrowers with higher
scores experience lower levels of default. FHA started collecting credit
score data in the late 1990s when it began allowing its lenders to use
automated underwriting systems and mortgage scorecards. Upon approving the
use of Fannie Mae and Freddie Mac's mortgage scorecards in fiscal year
1998, FHA began receiving credit score data for loans underwritten using
these scoring tools. To develop its own mortgage scorecard, FHA purchased
archived credit scoring data for loan origination samples dating back to
1992. Since implementing its TOTAL mortgage scorecard in May 2004, FHA has
collected credit scores on almost all FHA borrowers.
^22These systems contain a wide variety of data that support FHA's
administration of its single-family mortgage insurance program, including
information on mortgage lenders and borrowers and the financial details
and performance of the loans.
FHA Has Made Some Improvements to Key Statistical Models, but Additional
Challenges Remain
FHA would rely on both its loan performance models and TOTAL mortgage
scorecard to set insurance premiums if authorized to implement risk-based
pricing. Although FHA has improved the forecasting ability of its loan
performance models by incorporating additional variables found to
influence credit risk, FHA is still in the process of addressing a number
of limitations in TOTAL that could reduce its effectiveness for risk-based
pricing. The agency's actuarial review contractor developed the loan
performance models to estimate the economic value of the Fund for the
annual actuarial review. The models estimate lifetime claim and prepayment
(the payment of a loan before its maturity date) rates based on factors
such as origination year, age, interest rate, mortgage product type,
initial LTV ratio, and loan amount. FHA used the projected lifetime claim
and prepayment rates from the most recent actuarial review as the basis
for its proposed risk-based insurance premiums.^23
FHA has improved its loan performance models by adding factors that have
been found to influence credit risk. In September 2005, we reported that
FHA's subsidy reestimates, which use data from FHA's loan performance
models, reflect a consistent underestimation of the costs of its
single-family insurance program. We recommended that FHA study and report
the impact (on the forecasting ability of its loan performance models) of
variables that have been found in other studies to influence credit risk,
such as payment-to-income ratios, credit scores, and the presence of
down-payment assistance.^24 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.
^23More specifically, FHA developed index values--the ratio of the claim
and prepayment rates for borrowers in different credit score and LTV ratio
groupings to the claim and prepayment rate for FHA's average borrower.
(FHA used loans with down-payment assistance from seller-funded nonprofit
organizations as a proxy for loans with LTV ratios of 100 percent.) FHA
then applied these index values to the estimated lifetime claim and
prepayment rates for the fiscal year 2008 book of business.
FHA also intends to use TOTAL to determine risk-based premiums, but we
have identified weaknesses in the scorecard that could limit its
effectiveness as a pricing tool. As previously noted, FHA plans to use
TOTAL to make the final determination regarding premium rates if
authorized to implement risk-based pricing. However, we reported in April
2006 that TOTAL excludes a number of important variables included in other
mortgage scoring systems.^25 For example, TOTAL does not distinguish
between adjustable- and fixed-rate mortgages. However, adjustable-rate
mortgages generally are considered to be higher risk than otherwise
comparable fixed-rate mortgages because borrowers are subject to higher
payments if interest rates rise. Unlike the mortgage scorecards of other
institutions, TOTAL also does not include an indicator for property type
(single-family detached homes or condominiums, for example).^26 While
currently a small component of FHA's business, FHA expects that it would
insure more condominium loans if the condominium program were moved to the
Fund, as set forth in its legislative proposal. Additionally, TOTAL does
not indicate the source of the down payment. We have reported that the
source of a down payment is an important indicator of risk, and the use of
down-payment assistance in the FHA program has grown substantially since
2000. Finally, our April 2006 report noted that the data used to develop
TOTAL were not current and FHA had no plans to update the scorecard on a
regular basis.
^24See GAO, Mortgage Financing: FHA's $7 Billion Reestimate Reflects
Higher Claims and Changing Loan Performance Estimates, [35]GAO-05-875
(Washington, D.C.: Sept. 2, 2005). While loan performance models are
critical to subsidy cost estimation, other factors such as assumptions
about the losses per insurance claim and economic conditions also
influence subsidy estimates.
^25 [36]GAO-06-435 .
^26FHA indicated that variables for adjustable-rate mortgages and property
type were not included in TOTAL because the risk associated with them did
not differ significantly in the data sample used to develop the model.
However, the modeling effort may have failed to find significant effects
for these variables because of the small numbers of loans with these
characteristics in the development sample.
Consistent with our recommendations concerning TOTAL, FHA developed
policies and procedures that call for (1) an annual evaluation of the
scorecard's predictive ability, (2) testing of additional predictive
variables to include in the scorecard, and (3) populating the scorecard
with more recent loan performance data. An FHA contractor is helping the
agency to implement these procedures and is scheduled to issue a final
report on its work in August 2007. After receiving the contractor's
report, FHA will decide what changes to TOTAL are necessary. Because the
magnitude of these changes has not yet been determined, FHA does not have
a completion date for this effort. FHA officials indicated that they would
initially implement risk-based pricing using the current version of TOTAL
but would use the updated version when it became available.
FHA Has Identified Needed Changes in Information Technology but Faces Funding
and Implementation Challenges
FHA has identified changes needed in its information technology to
implement the legislative proposals. FHA has divided these changes into
two phases. The first phase consists of simpler changes that it can make
in the short term, such as revising the system used to originate
FHA-insured loans to allow for down payments of less than 3 percent. FHA
also would need to make other changes to the system to support the new
loan limits, such as allowing the loan amount to equal 100 percent of the
conforming loan limit in applicable areas. The second phase includes
modifications to the computer programs that calculate the up-front and
annual insurance premiums to reflect risk-based pricing and revisions
related to the proposed changes to the HECM and condominium programs.
FHA has not yet obtained some of the funding needed to make the technology
changes and does not have estimates for how long it would take to complete
all of the changes. In fiscal year 2006, the agency obligated $2.8 million
of the $10.9 million it estimated was needed to make all anticipated
changes. Specifically, FHA plans to use funds reprogrammed from HUD's
salaries and expense account and other available funds to complete the
first phase of changes. FHA estimates that most of this work could be
completed in a few months. The President's fiscal year 2008 budget
requests an additional $8.1 million to fund the second phase of changes
needed to implement the legislative proposals. However, FHA officials told
us that they did not have an implementation schedule for this phase and
were waiting until the legislative proposals were approved and they had
secured the funding to develop one.
Although FHA officials indicated that they could implement the legislative
proposals after making these minor information technology changes, they
also told us that major systems changes and integration would be needed to
bring FHA's systems up to levels comparable with other mortgage
institutions. Currently, over 40 systems support FHA's single-family
business activity. While a thorough evaluation of large-scale systems
changes was outside the scope of our review, FHA has indicated that its
systems are poorly integrated, expensive to maintain, and do not fully
support the agency's operations and business requirements.^27 For example,
the systems cannot easily share or provide critical information because
they use different database platforms with varying capabilities; some of
the older systems use an outdated programming language; and the creation
of ad hoc systems that do not interface with other systems has resulted in
duplicate data entry. However, FHA has limited resources to devote to the
development of new systems for two main reasons. First, it has to compete
with other divisions within HUD for information technology resources. Of
the approximately $300 million that HUD has requested for information
technology development and maintenance in fiscal year 2008, about 5
percent would be for FHA's single-family operations. Second, FHA spends
what resources it has primarily on systems maintenance. Of the $19 million
that FHA has budgeted for single-family information technology in fiscal
year 2007, FHA officials estimate that $15 million would be devoted to
systems maintenance.
In contrast with FHA, officials from other mortgage institutions with whom
we spoke indicated that they devote substantial resources to developing
new systems and enhancing existing systems that help them price products
and manage risk. To illustrate, officials from one mortgage institution
stated that they had a $15 million annual budget for capital improvements
in information technology. Officials from another mortgage institution
told us that 17 percent of the company's total expenses were related to
information technology and that they recently spent about $15 million to
develop a new system to price a mortgage product for the foreign market.
These and other mortgage industry officials stressed that investments in
state-of-the-art information systems were critical to operating
successfully in the highly competitive mortgage market.
^27These views are consistent with our October 2001 report on FHA's
single-family information systems. See GAO, Single-Family Housing: Current
Information Systems Do Not Fully Support the Business Processes at HUD's
Homeownership Centers, [37]GAO-02-44 (Washington, D.C.: Oct. 24, 2001).
FHA Has Sought Limited Staff Increases to Help Implement Proposals, but Other
Workforce Challenges Remain
According to FHA officials, the legislative proposals would not
fundamentally alter how the agency administers its single-family mortgage
insurance program and, therefore, would not require major increases in
staff above the approximately 950 single-family housing employees it had
as of March 2007. Although implementing the legislative proposals would
require considerable program analysis and monitoring, much of the analysis
required to develop the proposals was performed primarily by staff from
FHA's Offices of Finance and Budget and Single Family Housing with
assistance from several contractors, who will continue to support the
implementation. FHA officials told us that marketing any new products
authorized and explaining program changes to lenders would be their next
major challenge if the legislative proposals were passed. They also noted
that successful implementation would require them to stay abreast of
developments in the mortgage market. Therefore, the President's fiscal
year 2008 budget requests an additional 21 full-time equivalent (FTE)
positions to help promote new FHA products, analyze industry trends, and
align the agency's single-family business processes with current mortgage
industry practices.
Although a detailed assessment of FHA's staffing needs was outside the
scope of our review, a HUD contractor's 2004 workforce analysis suggests
that FHA faces broader challenges that could affect the agency's
operations going forward.^28 The analysis projected that FHA would have 78
fewer FTEs than needed to handle anticipated work demands by fiscal year
2008, assuming hires and transfers equal to the average numbers for 2001
through 2003. In addition to anticipated FTE shortfalls, the report also
identified existing and projected deficits of FHA staff with certain
important competencies such as technical credibility and knowledge of
single-family programs, policies, and regulations.^29 For example, the
consultant projected a difference of 28 percentage points between the
percentage of staff requiring technical credibility and the percentage
that would meet this requirement in fiscal year 2008. FHA officials have
acknowledged the agency's staffing challenges and have developed plans to
address the projected gaps. In fiscal years 2005 and 2006, FHA gained 228
staff through hiring or transfers. However, the contractor had assumed
gains of 362 staff during those years, which means that the projected
fiscal year 2008 shortfall will be worse than originally estimated without
substantial staff accessions in fiscal years 2007 and 2008.
^28LMI Government Consulting for the U.S. Department of Housing and Urban
Development, Strategic Workforce Plan (McLean, Va.: November 2004).
^29The analysis defined technical credibility as demonstrating
programmatic, financial, and technical knowledge and expertise that is
commensurate with the demands of the position and understanding
requirements for the administration of federal grants and loan guarantees.
FHA also faces hiring and salary constraints that other mortgage
institutions do not. FHA's hiring authority is limited by statute and
congressional appropriations. Federal statute (Title 5 of the U.S. Code)
restricts the amounts that FHA can pay staff, and each year's
appropriation determines how many staff it can hire. Further, FHA must
compete with other divisions within HUD for staffing resources and may not
always receive its full request. Other mortgage institutions have greater
flexibility in their ability to hire and compensate staff. For example,
Fannie Mae and Freddie Mac are not subject to federal pay and hiring
restrictions. These restrictions create challenges for FHA as it competes
for qualified staff in the competitive mortgage labor market.
FHA's Prior Risk Management Did Not Always Utilize Common Industry Practices
Such as Piloting, but Some Planned Actions Could Help Address New Risks and
Challenges
Although FHA has not always utilized risk-management practices that other
mortgage institutions use, it plans to take some steps to help address the
new risks and challenges associated with the legislative proposals. In
November 2005, we reported that HUD needed to take additional actions to
manage risks related to the approximately one-third of its loans with
down-payment assistance from seller-funded nonprofits.^30 Unlike other
mortgage industry participants, FHA does not restrict homebuyers' use of
such assistance. Our 2005 analysis found that the probability that these
loans would result in an insurance claim was 76 percent higher than for
comparable loans without such assistance, and we recommended that FHA
revise its underwriting standards to consider such assistance as a seller
contribution (which cannot be used to meet the borrower contribution
requirement).^31 Despite the detrimental impact of these loans on the
Fund, FHA did not act promptly to mitigate the problem by adjusting
underwriting standards or using its existing authority to raise premiums.
However, in May 2007, FHA published a proposed rule that would prohibit
seller-funded down-payment assistance.^32
30GAO, Mortgage Financing: Additional Action Needed to Manage Risks of
FHA-Insured Loans with Down Payment Assistance, [38]GAO-06-24 (Washington,
D.C.: Nov. 9, 2005).
^31We reviewed a national sample of FHA-insured home purchase loans from
2000, 2001, and 2002.
In addition, as we reported in February 2005, other mortgage institutions
limit the availability of or pilot new products to manage risks associated
with changing or expanding product lines.^33 We have previously indicated
that, if Congress authorizes FHA to insure new products, it should
consider a number of means, including limiting their initial availability,
to mitigate the additional risks these loans may pose. We also recommended
that FHA consider similar steps for any new or revised products. However,
in response, FHA officials told us that they lacked the resources to
effectively manage a program with limited volumes. We noted that if FHA
did not limit the availability of new or changed products, the potential
costs of making widely available a product with risks that may not be well
understood could exceed the cost of a pilot program. With respect to its
legislative proposal, FHA officials told us that they do not plan to pilot
or limit the initial availability of any zero-down-payment product the
agency was authorized to offer. They also indicated that they expected
that a zero-down-payment product would perform similarly to loans with
seller-funded down-payment assistance. While the experience of loans with
this type of assistance is informative, a zero-down-payment product could
be utilized by a different population of borrowers and may not perform the
same as these loans.
Nevertheless, if the legislative proposals were to be enacted, FHA plans
to take some steps to help address risks and challenges associated with
(1) managing the risks of no-down-payment loans, (2) setting premiums to
achieve a modestly negative subsidy rate, and (3) modifying oversight of
lenders. First, loans with low or no down payments carry greater risk
because of the direct relationship that exists between the amount of
equity borrowers have in their homes and the risk of default. The higher
the LTV ratio, the less cash borrowers will have invested in their homes
and the more likely it is that they may default on mortgage obligations,
especially during times of economic hardship or price depreciation in the
housing market. No-down-payment loans became common in the conventional
market when rapid appreciation in home prices helped mitigate the risk of
these loans. However, if authorized to offer a zero-down-payment mortgage
in the near future, FHA would be introducing this product at a time when
home prices have stagnated or are declining in some parts of the country.
And because FHA would continue to allow borrowers to finance some portion
of closing costs and up-front insurance premiums, the effective LTV ratio
for loans with very low or no down payments could be greater than 100
percent, further increasing FHA's insurance risk. To mitigate the risks
associated with loans with no down payments, FHA plans to impose stricter
underwriting criteria for such loans:
^32See 72 Fed. Reg. 27048 (May 11, 2007). FHA also has been anticipating a
reduction in the number of loans with down-payment assistance from
seller-funded nonprofit organizations as a result of actions taken by the
Internal Revenue Service (IRS). IRS issued a ruling in May 2006 stating
that these organizations do not qualify as tax-exempt charities,
effectively making loans with such assistance ineligible for FHA
insurance. According to FHA, as of June 2007, IRS had rescinded the
charitable status of three of the 185 organizations that IRS is examining.
^33GAO, Mortgage Financing: Actions Needed to Help FHA Manage Risks from
New Mortgage Loan Products, [39]GAO-05-194 (Washington, D.C.: Feb. 11,
2005).
o FHA would limit the amount of up-front premium and closing costs
that could be financed; therefore, all borrowers would be making
some minimum cash contribution.
o FHA plans to require a minimum credit score of 640 to obtain FHA
insurance on loans with no down payments.^34
o FHA would limit its zero-down-payment product to loans for
owner-occupied, one-unit properties.
Second, FHA's legislative proposal would fundamentally change the way the
agency manages the Fund in that FHA would set premiums to achieve a
modestly negative overall subsidy rate, representing the weighted average
of the subsidy rates for the different risk-based pricing categories. The
President's budget for fiscal year 2008 estimates that the weighted
average subsidy rate would be -0.6 percent (meaning that the Fund would
generate negative subsidies amounting to 0.6 percent of the total dollars
insured for loans originated that year).^35 Achieving a modestly negative
credit subsidy rate would depend on FHA's ability to price new products
whose risks may not be well understood, although risk-based pricing could
help FHA be more precise in setting and adjusting premiums for different
segments of its portfolio. FHA officials told us that they would monitor
the proportion of loans in its two highest-risk categories and consider
raising premiums or tightening underwriting standards if unexpectedly high
demand exposed FHA to excessive financial risk. Fannie Mae, Freddie Mac,
and the four private mortgage insurers we interviewed noted that they
carefully monitor their portfolios to make sure that they do not have too
many loans in any given risk category and take similar steps when they
determine that this is the case.
^34Private mortgage insurers also set credit score thresholds for
zero-down-payment loans.
^35If the HECM program were moved to the Fund, as FHA has proposed, the
weighted average subsidy rate would be -0.82 percent.
Third, FHA may need to modify the way that it oversees lenders if the
legislative proposals were enacted. FHA has indicated that its legislative
proposals would help the agency to expand service to higher-risk borrowers
in a financially sound manner. However, FHA may need to revise its Credit
Watch program if it is to achieve this end. Under Credit Watch, FHA
terminates the loan origination authority of any lender branch office that
has a default and claim rate on mortgages insured by FHA in the prior 24
months that exceeded both the national average and 200 percent of the
average rate for lenders in its geographic area. Because termination
currently is based on how a lender's loans perform relative to other
lenders in its geographic area, lenders that chose to make loans to
higher-risk borrowers could suffer in comparison with lenders that served
only lower-risk borrowers. To encourage lenders to serve borrowers in the
higher-risk categories, FHA officials told us that they would consider
taking into account the mix of borrowers in the various risk categories
when evaluating a lender's performance. Because higher-risk loans can be
expected to incur higher default and claim rates, they stated that FHA
would not want to penalize lenders with larger shares of these loans as
long as the loans were performing within expected risk parameters. FHA
also has improved the accuracy and timeliness of the loan performance data
it uses to evaluate lenders by requiring lenders to update the delinquency
status of their loans more frequently.
Congress and FHA Could Consider Other Administrative and Legislative Changes to
Help FHA Adapt to Changes in the Mortgage Market
Mortgage industry participants and researchers have suggested additional
options that Congress and FHA could consider to help FHA adapt to changes
in the mortgage market, but some changes could have budget and oversight
implications. FHA already has authority to undertake some of these
options. Other options would require additional authorities from Congress
to increase the agency's operational flexibility. Congress also could
consider alternative approaches to the provision of federal mortgage
insurance such as converting FHA to a government corporation or
implementing risk-sharing arrangements with private partners.
FHA Has Existing Authority to Make More Administrative Changes
Although FHA already has made several administrative changes to streamline
the agency's insurance processes, additional administrative changes within
FHA's existing authority could alleviate, to some extent, the need for a
positive subsidy in fiscal year 2008. More specifically, FHA could
exercise its existing authority to raise up-front premiums up to 2.25
percent and, for borrowers with down payments of less than 5 percent,
annual premiums to 0.55 percent.
To moderate the need for a positive subsidy in fiscal year 2008, FHA could
use its existing authority to increase premiums in one of three ways: (1)
FHA could raise premiums for all borrowers, as the President's fiscal year
2008 budget suggests will be necessary; (2) FHA could charge the higher
0.55 percent annual premium to borrowers with lower down payments; or (3)
FHA could implement a more limited form of risk-based pricing than it has
proposed by adjusting premiums within the current statutory limits. HUD's
Office of General Counsel determined in March 2006 that FHA has the
authority to structure premiums for programs under the Fund on the basis
of risk. FHA could implement premium adjustments, either for all or some
borrowers, through the regulation process. However, according to FHA
officials, the current statutory limits on premiums are too low to allow
FHA to implement a risk-based pricing plan that would allow the agency to
set prices high enough to compensate for the expected losses from the
highest-risk borrowers or a new zero-down-payment product. And while
raising premiums for some higher-risk borrowers could improve the Fund's
credit subsidy rate, raising premiums for all borrowers might exacerbate
FHA's adverse selection problem. That is, FHA could lose higher credit
quality borrowers, resulting in fewer borrowers to subsidize lower credit
quality borrowers. This, in turn, could require FHA to raise premiums
again.
Additional Authorities for Investment in Technology, Pay and Hiring, and
Introduction of Products Could Increase FHA's Operational Flexibility
According to mortgage industry participants and researchers, Congress also
could consider granting FHA additional authorities to increase the
agency's ability to invest in technology and staff or offer new insurance
products. First, Congress could grant FHA specific authority to invest a
portion of the Fund's current resources--that is, negative subsidies that
accrue in the Fund's reserves--in technology enhancement. The
congressionally-appointed Millennial Housing Commission (MHC) found that
FHA's dependence on the appropriations process for budgetary resources and
competition for funds within HUD had led to under-investment in
technology, increasing the agency's operational risk and making it
difficult for FHA to work efficiently with lenders and other industry
partners.^36 Because FHA's single-family insurance program historically
has generated estimated negative subsidies, FHA and some mortgage industry
officials have suggested that the agency be given the authority to use a
portion of the Fund's current resources to upgrade and maintain its
technology.
One benefit of this option is that the technology enhancements could
improve FHA's operations. As previously noted, FHA has more than 40
single-family information systems that are poorly integrated, expensive to
maintain, and do not fully support the agency's business requirements.
However, according to FHA, the option would require a statutory change to
allow FHA to use the Fund's current resources to pay for technology
improvements. Also, the Fund is required by law to operate on an
actuarially sound basis. Because the soundness of the Fund is measured by
an estimate of its economic value--an estimate that is subject to inherent
uncertainty and professional judgment--the Fund's current resources should
be used with caution. Spending the Fund's current resources would lower
the Fund's reserves, which in turn would lower the economic value of the
Fund. As a result, the Fund's ability to withstand severe economic
conditions could be diminished. Also, using the Fund's current resources
would increase the federal budget deficit unless accompanied by
corresponding reductions in other government spending or an increase in
receipts.
Second, Congress could consider allowing FHA to manage its employees
outside of federal pay scales. Some federal agencies, such as the
Securities and Exchange Commission, the Office of Thrift Supervision, and
the Federal Deposit Insurance Corporation, are permitted to pay salaries
above normal federal pay scales in recognition of the special skills
demanded by sophisticated financial market operations.^37 The MHC and
mortgage industry officials have suggested that FHA be given similar
authority. This option could help FHA to recruit experienced staff to help
the agency adapt to market changes. Like the authority to invest in
technological enhancement, this option could be funded with the Fund's
current resources but would have similar implications for the financial
health of the Fund and the federal budget deficit.
^36The MHC, established by Congress in 2000, studied the federal role in
meeting the nation's housing challenges and issued a report in 2002, which
included recommendations for a variety of reforms to federal housing
programs. See Meeting Our Nation's Housing Challenges: Report of the
Bipartisan Millennial Housing Commission (Washington, D.C.: May 30, 2002).
Third, Congress could authorize FHA to offer and pilot new insurance
products without prior congressional approval. A variety of new mortgage
products have appeared in the mortgage market in recent years, but FHA's
ability to keep pace with market innovations is limited. For example, the
MHC found that the statutes and regulations to which FHA is subject
dramatically increase the time necessary to develop and implement new
products. The MHC and mortgage industry officials have recommended that
Congress expressly authorize FHA to introduce new products without
requiring a new statute for each. Such authority would offer FHA greater
flexibility to keep pace with a rapidly changing mortgage market. However,
Congress would have less control over FHA's product offerings and, in some
cases, it might take years before a new product's risks were well
understood.
To manage the risks of new products, mortgage institutions may impose
limits on the volume of the new products they will permit and on who can
sell and service those products. Limits on the availability of new or
revised FHA mortgage insurance products are sometimes set through
legislation and focus on the volume of loans that FHA may insure. In a
prior report, we recommended that FHA consider using pilots for new
products and making significant changes to its existing products.^38 Since
FHA officials questioned the circumstances in which they could use pilots
or limit volumes when not required by Congress, we also recommended that
FHA seek the authority to offer new products on a limited basis, such as
through pilots, if the agency determines it currently lacks sufficient
authority. However, FHA has not sought this authority. Furthermore, while
piloting could help FHA manage the risks associated with implementing new
products, FHA officials told us that they lack the resources to manage a
program with limited volumes effectively.^39
37In 1989, the Financial Institutions Reform, Recovery and Enforcement Act
(P. L. 101-73) authorized certain financial regulators to determine their
own compensation and benefits so that they could more effectively compete
in the marketplace for qualified applicants. In 2002, the Investor and
Capital Markets Fee Relief Act (P. L. 107-123) gave SEC similar authority
as those federal banking regulatory agencies. These agencies are permitted
by statute to pay salaries in excess of the Title 5 ceilings.
^38 [40]GAO-05-194 .
Finally, Congress could authorize FHA to insure less than 100 percent of
the value of the loans it guarantees. Unlike private mortgage insurers,
which offer several levels of insurance coverage up to a maximum of 40 or
42 percent (depending on the company) of the value of the loan, FHA
insures 100 percent of the value of the loan. But since most FHA insurance
claims are offset by some degree of loss recovery, some mortgage industry
observers have suggested that covering 100 percent of the value of the
loan may not be necessary. In prior work, we examined the potential
effects of reducing FHA's insurance coverage and found that while lower
coverage would cause a reduction in the volume of FHA-insured loans and a
corresponding decline in income from premiums, it would also result in
reduced losses and ultimately have a beneficial effect on the Fund.^40
However, we also noted that partial FHA coverage could lessen FHA's
ability to stabilize local housing markets when regional economies decline
and may increase the cost of FHA-insured loans as lenders set higher
prices to cover their risk.
Alternative Approaches for Providing Federal Mortgage Insurance Include
Converting FHA to a Government Corporation
The MHC, HUD officials, and other mortgage industry participants have
suggested alternative approaches to provide federal mortgage insurance in
a changing mortgage market. First, since the mid-1990s, several groups
including HUD and the MHC have proposed converting FHA into either an
independent or a HUD-owned government corporation--that is, an agency of
government, established by Congress to perform a public purpose, which
provides a market-oriented service and produces revenue that meets or
approximates its expenditures. Government corporations operate more
independently than other agencies of government and can be exempted from
executive branch budgetary regulations and personnel and compensation
ceilings. Therefore, converting FHA to a corporation could provide the
corporation's managers with the flexibility to determine the best ways to
meet policy goals set by Congress or HUD.
^39FHA officials reported difficulties administering the HECM program
initially as a demonstration for only 2,500 loans because of the
challenges of selecting a limited number of lenders and borrowers.
^40GAO, Homeownership: Potential Effects of Reducing FHA's Insurance
Coverage for Home Mortgages, [41]GAO/RCED-97-93 (Washington, D.C.: May 1,
1997).
This option could have budgetary and oversight implications that would
need to be considered when setting up the new corporation. For example,
Congress would have to determine the extent to which (1) the corporation's
earnings in excess of those needed for operations and reserves would be
available for other government activities and (2) the corporation would be
subject to federal budget requirements. Also, if the corporation were
created outside of HUD, Congress would have to consider whether oversight
of the corporation would require a new oversight institution or could be
performed by an existing organization.
Alternatively, rather than maintaining all the functions of a mortgage
insurer within a government entity, the MHC and private mortgage insurers
have suggested that the federal government could provide mortgage
insurance through risk-sharing agreements with private partners.^41 FHA
already works with partners to conduct various activities related to its
operations. For example, FHA has delegated underwriting authority to
approved lenders, and contractors perform many day-to-day activities (such
as marketing foreclosed properties) that once were performed by FHA
employees. A public-private risk-sharing arrangement would recognize that
government has a better ability to spread risk, while private mortgage
industry participants generally are more flexible and responsive to market
pressures and better able to innovate and adopt new technologies quickly.
There are many different possible ways to structure a risk-sharing
approach, with variables such as the amount of insurance coverage
provided, the number and type of risk-sharing partners, the degree of risk
accepted by each partner, and the roles and responsibilities of the
partners.
Whatever the structure, a risk-sharing approach could result in greater
efficiency and allow FHA to reach new borrowers through new partner
channels. However, risk sharing also could diminish the federal
government's ability to stabilize markets if private partners lacked
incentive to serve markets where economic conditions were deteriorating.
Additionally, implementing risk-sharing arrangements might require more
specialized expertise than FHA currently has among its staff. For example,
careful analysis in both program design and monitoring would be needed to
ensure that FHA's financial interests were adequately protected.
^41FHA has implemented risk-sharing arrangements in its multifamily
insurance program.
Finally, Congress and FHA could elect to make no changes at this time and
allow the private market to play the definitive role in determining the
future need for federal mortgage insurance. The recent decline in FHA's
market share occurred at a time when interest rates were low, house price
appreciation was high, and mortgage credit was widely available. However,
changes in the mortgage market, such as higher interest rates and stricter
underwriting standards for subprime loans, may lead to an increasing role
for FHA in the future or at least a continued role for the federal
government in guaranteeing mortgage credit for some borrowers. Therefore,
even if Congress and FHA were to make no changes at this time, FHA's
market share might increase due to the recent change in market conditions.
Or it might eventually become so small as to indicate that there is no
longer a need for a federal role in providing mortgage insurance. If FHA's
market share continues to decline to such a level, FHA might be eliminated
or critical functions reassigned to maintain a minimal federal role in
guaranteeing mortgage credit.
Making no changes to FHA at this time would acknowledge the substantial
role the private market now plays in meeting the mortgage credit needs of
borrowers. However, some home buyers might find it more difficult and more
costly to obtain mortgages if FHA were eliminated or its functions reduced
and reassigned to another federal agency.^42 And allowing FHA to become
too small could impact the federal government's ability to play a role in
stabilizing mortgage markets during an economic downturn. Also, any option
that might lead to the eventual elimination of FHA's single-family
mortgage insurance program would have broader implications for FHA and its
other programs, such as the multifamily mortgage insurance and regulatory
programs, which this report does not address. Such implications would,
therefore, require further study.
Observations
Recent trends in the mortgage market, including the prevalence of low- and
no-down-payment mortgages and increased competition from conventional
mortgage and insurance providers, have posed challenges for FHA. FHA's
market share has declined substantially over the years, and what was a
negative subsidy rate for the single-family insurance program has crept
toward zero. To adapt to market changes, FHA has implemented new
administrative procedures and proposed legislation designed to modernize
its mortgage insurance processes, introduce product changes, and provide
additional risk-management tools. To its credit, FHA has performed
considerable analysis to support its legislative proposal and has made or
planned enhancements to many of the specific tools and resources that
would be important to its implementation.
^42In 1995, legislation was introduced in the House and Senate (but never
enacted) that proposed to abolish FHA and replace FHA's single-family
mortgage insurance program with a program in which risk would be shared
between qualified mortgage insurers and a Federal Home Mortgage Insurance
Fund within the Department of the Treasury. The federal government would
have provided partial mortgage insurance on some single-family homes (and
would no longer have insured multifamily mortgages).
However, the proposals present risks and challenges and should be viewed
with caution for several reasons. First, FHA has not always effectively
managed risks associated with product changes, most notably the growth in
the proportion of FHA-insured loans with seller-funded down-payment
assistance. In that case, FHA did not use the risk-management tools
already at its disposal to mitigate adverse loan performance that has had
a detrimental impact on the Fund. Second, the proposal to lower
down-payment requirements potentially to zero raises concerns given the
greater default risk of loans with high LTVs, policies that could result
in effective LTV ratios of over 100 percent, and housing market conditions
that could put borrowers with such loans in a negative equity position.
Sound management of very low or no-down-payment products would be
necessary to help ensure that FHA and borrowers do not experience
financial losses. Piloting or otherwise limiting the availability of new
products would allow FHA the time to learn more about the performance of
these loans and could help avoid unanticipated insurance claims. Despite
the potential benefits of this practice, FHA generally has not implemented
pilots, unless directed to do so by Congress. We have previously indicated
that, if Congress authorizes FHA to insure new products, Congress and FHA
should consider a number of means, including limiting their initial
availability, to mitigate the additional risks these loans may pose. We
continue to believe that piloting would be a prudent approach to
introducing the products authorized by FHA's legislative proposal.
Finally, FHA would face the challenge of setting risk-based
premiums--potentially for products whose risks may not be well
understood--to achieve a specific financial outcome, a relatively small
negative subsidy. Because the estimated subsidy rate is close to zero and
FHA has consistently underestimated its subsidy costs, FHA runs some risk
of missing its target and requiring a positive subsidy. Additionally,
limitations we have identified in FHA's TOTAL scorecard, which would be a
key tool used in risk-based pricing, could reduce the agency's ability to
set prices commensurate with the risk of the loans. Accordingly, it will
be important for FHA to continue making progress in addressing these
limitations.
Our recent report on trends in FHA's market share underscores the
challenges that FHA has faced in adapting to the changing mortgage market.
For example, we noted that FHA's share of the market for home purchase
mortgages has declined precipitously since 2001 due in part to FHA product
restrictions and a lack of process improvements relative to the
conventional market. While FHA has taken some steps to improve its
processes and enhance the tools and resources that it would use to
implement the modernization proposals, additional changes may be necessary
for FHA to operate successfully in the long run in a competitive and
dynamic mortgage market. Other mortgage industry participants have greater
flexibility to hire and compensate staff, invest in information
technology, and introduce new products, enhancing their ability to adapt
to market changes and manage risk. A number of policy options that go
beyond FHA's modernization proposals would give FHA similar flexibility
but would have other implications that would require careful deliberation.
Agency Comments and Our Evaluation
We provided HUD with a draft of this report for review and comment. HUD
provided comments in a letter from the Assistant Secretary for
Housing-Federal Housing Commissioner (see app. II). HUD said that the
draft report provided a balanced assessment but also that the report's
concerns about FHA's risk management and emphasis on the need for piloting
lower-down-payment products were unwarranted.
HUD said that it welcomed the draft report's acknowledgement of FHA's
improvements in program administration and risk management but questioned
the report's concerns about FHA's ability to understand and manage risk.
HUD indicated that its proposal to diversify FHA's product offerings and
pricing structure grew out of recognition that FHA was subject to adverse
selection, as evidenced by the loss of borrowers with better credit
profiles and growth in seller-funded down-payment assistance loans. In
addition, HUD listed steps it had taken to curtail seller-funded
down-payment assistance, including publishing a proposed rule in May 2007
that would effectively eliminate seller-funded down-payment assistance in
conjunction with FHA-insured loans. Our draft report cited a number of
improvements in FHA's risk management, such as enhancements to its loan
performance models. However, we continue to believe that our concerns
about FHA's ability to manage risk are warranted. As our draft report
noted, FHA did not take prompt action to mitigate the adverse financial
impact of loans with seller-funded down-payment assistance. Furthermore,
our draft report identified additional steps, such as improvements to
TOTAL scorecard, that would help address the risks and challenges
associated with the legislative proposals.
With regard to piloting, HUD said that pilot programs are appropriate
where a concept is untested but that the concept of zero- or
lower-down-payments was well understood. HUD indicated that it had a firm
basis for anticipating the performance of zero- and lower-down-payment
loans as a result of its experience with mortgages with seller-funded
down-payment assistance. HUD said it used this experience to establish
risk-based insurance premiums and minimum credit scores for zero- and
lower-down-payment borrowers. Additionally, HUD said that it had recently
started to collect 30-day and 60-day delinquency data, giving the agency
the capability to track performance trends for different segments of its
loan portfolio on a monthly basis. HUD stated that, for these reasons, the
risks of zero- or lower-down-payment loans were sufficiently well known or
knowable to not warrant a pilot program.
As our draft report noted, we previously have reported that other mortgage
institutions limit the availability of, or pilot, new products to manage
the risks associated with changing or expanding their product lines and
have recommended that FHA consider adopting this practice. Our draft
report also acknowledged that FHA's experience with seller-funded
down-payment assistance could inform assessment of how a zero-down-payment
product would perform. However, we continue to believe that FHA should
consider limiting the availability of a loan product with no down payment.
In particular, our draft report discussed two factors that indicate the
need for caution in introducing such a product. First, a zero-down-payment
product could be utilized by a different population of borrowers than
seller-funded down-payment assistance loans and may not perform similarly
to these loans. Second, zero-down-payment loans became common in the
conventional mortgage market when rapid appreciation in home prices helped
mitigate the risks of these loans. If authorized to offer a
zero-down-payment product in the near future, FHA would be introducing it
at a time when home prices have stagnated or are declining in some parts
of the country. Because of these risks and uncertainties, we continue to
believe that a prudent way to introduce a zero-down-payment product would
be to limit its initial availability such as through a pilot program.
We are sending copies of this report to the Chairman, Senate Committee on
Banking, Housing, and Urban Affairs; Chairman and Ranking Member,
Subcommittee on Housing and Transportation, Senate Committee on Banking,
Housing, and Urban Affairs; Chairman and Ranking Member, House Committee
on Financial Services; and Chairman and Ranking Member, Subcommittee on
Housing and Community Opportunity, House Committee on Financial Services.
We will also send copies to the Secretary of Housing and Urban Development
and to other interested parties and make copies available to others upon
request. In addition, the report will be made available at no charge on
the GAO Web site at http://www.gao.gov.
Please contact me at (202) 512-8678 or [email protected] if you or your staff
have any questions about this report. Contact points for our Offices of
Congressional Relations and Public Affairs may be found on the last page
of this report. Key contributors to this report are listed in appendix
III.
William B. Shear
Director, Financial Markets and Community Investment
Appendix I: Objectives, Scope, and Methodology
The Ranking Member of the Senate Committee on Banking, Housing, and Urban
Affairs and Senator Wayne Allard requested that we evaluate FHA's
modernization efforts, which include administrative and proposed
legislative changes. Specifically, we examined (1) the likely program and
budgetary impacts of FHA's modernization efforts, (2) the tools,
resources, and risk-management practices important to FHA's implementation
of the legislative proposals, if passed, and (3) other options that FHA
and Congress could consider to help FHA adapt to changes in the mortgage
market and the pros and cons of these options.
To determine the likely program and budgetary impacts of FHA's
modernization efforts, we reviewed FHA guidance on three administrative
changes implemented in 2006: the Lender Insurance Program and revisions to
the agency's appraisal protocols and closing cost guidelines. To determine
the extent to which these administrative changes have affected the
processing of FHA-insured loans, we interviewed representatives of
Countrywide Financial, Wells Fargo, Bank of America, and Lenders One (a
mortgage co-operative representing about 90 independent mortgage bankers).
We selected Countrywide Financial and Wells Fargo because they are large
FHA lenders, Bank of America because it had recently decided to grow its
FHA business, and Lenders One because some of its members make FHA loans.
We also interviewed representatives of three mortgage and real estate
industry groups--Mortgage Bankers Association, National Association of
Realtors, and National Association of Home Builders. To determine how the
Lender Insurance Program has affected the processing of FHA insurance, we
interviewed FHA officials and obtained documentation from them on the
extent of lender participation in the program and its effect on insurance
processing time and costs.
In evaluating the likely program impacts of FHA's proposed legislative
changes, we focused on the proposals to raise FHA loan limits, institute
risk-based pricing of mortgage insurance premiums, and lower down-payment
requirements. To examine the effect of raising loan limits on demand for
FHA-insured loans, we analyzed 2005 HMDA data (the most current
available). Specifically, we analyzed the home purchase loans recorded in
2005 to determine the number of loans in each of 380 core based
statistical areas (CBSA) and used that data to calculate FHA's market
share in each CBSA.^1 (These 380 CBSAs were those for which we had data
and included one aggregate "nonmetro" category.) We then determined the
number of additional loans that, based on their loan amounts, would have
been eligible for FHA insurance in 2005 had the higher proposed loan
limits been in effect. Finally, we estimated the percentage of the
newly-eligible loans in each CBSA that FHA would have insured using the
following range of assumptions: (1) that FHA's market share would have
been approximately the same as it was among all loans in that CBSA under
the actual 2005 loans limits, (2) that FHA's market share would have been
approximately the same as its share of loans with loan amounts ranging
from 70 to 100 percent of the actual 2005 loan limits in that CBSA, (3)
that FHA's market share would have been approximately the same as its
share of loans with loan amounts ranging from 75 to 100 percent of the
actual 2005 loan limits in that CBSA, and (4) that FHA's market share
would be approximately the same as its share of loans with loan amounts
ranging from 80 to 100 percent of the actual 2005 loan limits in that
CBSA.^2
For each of these four scenarios, we calculated the total number and
dollar amount of new loans across all 380 CBSAs that could have been
insured by FHA had the higher loan limits been in effect. All four
assumptions yielded similar results. After arriving at an estimate of an
overall increase in the number of FHA-insured loans, we then determined
the proportions of the increase that would have resulted from raising the
loan limit floor in low-cost areas, raising the loan limit ceiling in
high-cost areas, or raising the limits in areas that fell between the
floor and the ceiling. Finally, we calculated the average FHA-insured loan
amount in 2005, as well as the average loan amount that FHA might have
insured had the loan limits been increased. We assessed the reliability of
the HMDA data we used by reviewing information about the data, performing
electronic data testing to detect errors in completeness and
reasonableness, and interviewing a knowledgeable official regarding the
quality of the data. We determined that the data were sufficiently
reliable for the purposes of this report.
^1We excluded second liens and non-owner-occupied properties from our
analysis because they are not a substantial part of FHA's business. As
defined by the Office of Management and Budget, CBSAs are statistical
geographic entities consisting of the county or counties associated with
at least one core (urbanized area or urban cluster) of at least 10,000
population, plus adjacent counties having a high degree of social and
economic integration with the core.
^2Our analysis was based on an earlier FHA analysis. This analysis assumed
that FHA would achieve a market share for newly eligible loans of (1) at
least 50 percent of FHA's national market share for loans in areas with
median home prices exceeding the 87 percent conforming limit and (2) 75
percent of FHA's current market share in an area that was not constrained
by the 87 percent conforming loan limit.
To estimate the effects of risk-based pricing on borrowers' eligibility
for FHA insurance and the premiums they would pay, we reviewed FHA's
risk-based pricing proposal and interviewed FHA officials regarding their
plans to implement risk-based pricing, if authorized. We then analyzed
SFDW data on FHA's 2005 home purchase borrowers to determine how they
would have been affected by FHA's risk-based pricing proposal. (We focused
on 2005 borrowers because that was the most recent year for which we had
complete data, and we restricted our analysis to purchase loans because
they comprise the bulk of FHA's business.) First, we assigned borrowers to
one of seven categories (FHA's six proposed risk-based pricing categories
and one category for those who would not have been eligible for FHA
insurance) based upon their LTV ratio and credit score. Since FHA does not
currently insure loans without a down payment, we identified borrowers
with down-payment assistance and determined the source and amount of
assistance to approximate borrowers with LTV ratios of 100 percent. We
recalculated the LTV ratio of their loans by adding the amount of their
assistance to the principal balance of their loan. We then examined the
demographic characteristics (race, income, and first-time home buyer
status) of borrowers in each of the six pricing categories, as well as
those borrowers who would no longer qualify for FHA insurance. We assessed
the reliability of the SFDW data we used by reviewing information about
the system and performing electronic data testing to detect errors in
completeness and reasonableness. We determined that the data were
sufficiently reliable for the purposes of this report.
We also interviewed representatives of the following consumer advocacy
groups to obtain their views on FHA's proposed legislative changes: Center
for Responsible Lending, Consumer Action, Consumer Federation of America,
National Association of Consumer Advocates, National Community
Reinvestment Coalition, National Consumer Law Center, and National Council
of La Raza. We examined the potential budgetary impacts of the legislative
proposals by reviewing the President's fiscal year 2008 budget and FHA
cost estimates as shown in the 2008 Federal Credit Supplement. (The
Federal Credit Supplement provides summary information about federal
direct loan and loan guarantee programs, including current subsidy rates
and reestimated subsidy rates.)
To determine the tools, resources, and risk-management practices important
to FHA's implementation of the legislative proposals, we interviewed and
reviewed documentation from FHA officials regarding the agency's plans for
implementing the legislative proposals, if passed. We focused on completed
and planned enhancements to FHA's SFDW data, loan performance models,
TOTAL mortgage scorecard, information technology, human capital, and
risk-management practices. To help us evaluate the need for enhancements
to FHA's tools, resources, and practices, we followed up on our past work
on (1) FHA's development and use of TOTAL, (2) FHA's estimation of subsidy
costs for its single-family insurance program, (3) practices that could be
instructive for FHA in managing the risks of new mortgage products, and
(4) FHA's management of loans with down-payment assistance.^3 To obtain
information on the tools and resources that other mortgage institutions
use to set prices and manage risk, we interviewed Fannie Mae, Freddie Mac,
the Mortgage Insurance Companies of America (the industry group that
represents the private mortgage insurance industry), and four private
mortgage insurance companies--AIG United Guaranty, Genworth Mortgage
Insurance Company, Mortgage Guaranty Insurance Corporation, and PMI
Mortgage Insurance Company.
To determine other options that FHA and Congress could consider and the
pros and cons of these options, we reviewed relevant literature, including
the report of the Millennial Housing Commission,^4 articles discussing
past FHA restructuring proposals,^5 and our past work on various options
for FHA.^6 We also interviewed FHA officials, academic experts, FHA
lenders, and private mortgage insurance companies.
We conducted this work in Washington, D.C., from September 2006 to June
2007 in accordance with generally accepted government auditing standards.
^3See [42]GAO-06-435 , [43]GAO-05-875 , [44]GAO-05-194 , and [45]GAO-06-24
.
^4Meeting Our Nation's Housing Challenges: Report of the Bipartisan
Millennial Housing Commission (Washington, D.C.: May 30, 2002).
^5See, for example, Kerry D. Vandell, "FHA Restructuring Proposals:
Alternatives and Implications," Housing Policy Debate, volume 6, issue 2
(1995).
^6See, for example, [46]GAO/RCED-97-93 .
Appendix II: Comments from the Department of Housing and Urban Development
Appendix III: GAO Contact and Staff Acknowledgments
GAO Contact
William Shear (202) 512-8678 or [email protected]
Staff Acknowledgments
In addition, Steve Westley (Assistant Director), Steve Brown, Laurie
Latuda, John McGrail, Barbara Roesmann, Paige Smith, and Richard Vagnoni
made key contributions to this report.
(250319)
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References
Visible links
30. http://www.gao.gov/cgi-bin/getrpt?GAO-07-645
31. http://www.gao.gov/cgi-bin/getrpt?GAO-06-868T
32. http://www.gao.gov/cgi-bin/getrpt?GAO-06-435
33. http://www.gao.gov/cgi-bin/getrpt?GAO-07-645
34. http://www.gao.gov/cgi-bin/getrpt?GAO-07-615T
35. http://www.gao.gov/cgi-bin/getrpt?GAO-05-875
36. http://www.gao.gov/cgi-bin/getrpt?GAO-06-435
37. http://www.gao.gov/cgi-bin/getrpt?GAO-02-44
38. http://www.gao.gov/cgi-bin/getrpt?GAO-06-24
39. http://www.gao.gov/cgi-bin/getrpt?GAO-05-194
40. http://www.gao.gov/cgi-bin/getrpt?GAO-05-194
41. http://www.gao.gov/cgi-bin/getrpt?GAO/RCED-97-93
42. http://www.gao.gov/cgi-bin/getrpt?GAO-06-435
43. http://www.gao.gov/cgi-bin/getrpt?GAO-05-875
44. http://www.gao.gov/cgi-bin/getrpt?GAO-05-194
45. http://www.gao.gov/cgi-bin/getrpt?GAO-06-24
46. http://www.gao.gov/cgi-bin/getrpt?GAO/RCED-97-93
47. http://www.gao.gov/
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