FHA Hospital Mortgage Insurance Program: Health Care Trends and Portfolio
Concentration Could Affect Program Stability (Letter Report, 02/27/96,
GAO/HEHS-96-29).

Pursuant to a legislative requirement, GAO reviewed the Federal Housing
Administration's (FHA) Hospital Mortgage Insurance Program, focusing on:
(1) factors that could affect the stability of the program's portfolio
and financial performance; (2) FHA 1994 loan loss reserve estimate; (3)
how the program relates to the Department of Housing and Urban
Development's (HUD) mission; and (4) whether FHA has the expertise to
manage the program.

GAO found that: (1) although the Hospital Mortgage Insurance Program has
had a net positive cash flow since its inception, the program faces
financial risks that could affect its future stability; (2) New York
hospitals account for 87 percent of the program's $5 billion in unpaid
principal and have 9 of the 10 largest unpaid principal balances; (3)
New York hospitals unduly rely on FHA mortgage insurance program because
the state's restrictive reimbursement system hinders their ability to
attract private sector capital; (4) state actions and future health care
policy changes and trends could further threaten hospital solvency; (5)
FHA loan loss reserve estimates are unreliable because FHA used
questionable assumptions about default probabilities and loss rates and
did not consider health care market trends; (6) the extent to which the
mortgage program contributes to HUD mission is unclear because HUD does
not routinely measure program outcomes; (7) FHA staff do not have
sufficient health care expertise to manage key program functions and
must rely on Health and Human Services staff experience to monitor
hospitals' financial performance; and (8) hospital officials and program
users are concerned about the length of the program's application and
loan modification processes.

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

 REPORTNUM:  HEHS-96-29
     TITLE:  FHA Hospital Mortgage Insurance Program: Health Care Trends 
             and Portfolio Concentration Could Affect Program
             Stability
      DATE:  02/27/96
   SUBJECT:  Government guaranteed loans
             Hospitals
             Mortgage protection insurance
             Financial management
             Facility construction
             Loan defaults
             Budgetary reserves
             Future budget projections
             Losses
             Health care cost control
IDENTIFIER:  HUD Section 242 Hospital Mortgage Insurance Program
             General Insurance Fund
             Hill-Burton Hospital Construction Program
             New York
             FHA Multifamily Loan Insurance Program
             Medicaid Program
             HHS Credit Watch List
             
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Cover
================================================================ COVER


Report to Congressional Committees

February 1996

FHA HOSPITAL MORTGAGE INSURANCE
PROGRAM - HEALTH CARE TRENDS AND
PORTFOLIO CONCENTRATION COULD
AFFECT PROGRAM STABILITY

GAO/HEHS-96-29

FHA Hospital Mortgage Insurance

(108213)


Abbreviations
=============================================================== ABBREV

  AHA - American Hospital Association
  FHA - Federal Housing Administration
  GAAP - generally accepted accounting principles
  GPRA - Government Performance Results Act
  HHS - Department of Health and Human Services
  HRSA - Health Resources and Services Administration
  HUD - Department of Housing and Urban Development

Letter
=============================================================== LETTER


B-258517

February 27, 1996

The Honorable Alfonse M.  D'Amato
Chairman
The Honorable Paul S.  Sarbanes
Ranking Minority Member
Committee on Banking,
 Housing, and Urban Affairs
United States Senate

The Honorable Jim Leach
Chairman
The Honorable Henry B.  Gonzalez
Ranking Minority Member
Committee on Banking and
 Financial Services
House of Representatives

The Department of Housing and Urban Development (HUD), through the
Federal Housing Administration's (FHA) Hospital Mortgage Insurance
Program, insures loans to finance the renovation or construction of
hospitals that meet certain criteria.  FHA mortgage insurance
protects lenders against losses they might incur if hospitals fail to
make their mortgage payments.  As of August 1995, FHA insured about
$5 billion in outstanding mortgages. 

The Multifamily Housing Property Disposition Reform Act of 1994 (P.L. 
103-233, Apr.  11, 1994), required that we report on three FHA
insurance programs--hospital, nursing home, and retirement service
center--in FHA's multifamily loan insurance portfolio.  This report
provides the results of our evaluation of the Hospital Mortgage
Insurance Program.\1

As agreed with your staff, we (1) identified factors, including those
related to health care market trends, that could affect the stability
of the program's portfolio and obtained information on the program's
financial performance; (2) evaluated the methodology that FHA used to
estimate the program's fiscal year 1994 loan loss reserve; (3)
evaluated the relationship between the purpose of the Hospital
Mortgage Insurance Program and HUD's mission; and (4) determined
whether FHA has the expertise to manage the program. 

To develop our information, we (1) interviewed officials from FHA,
the Health Resources and Services Administration (HRSA) within the
Department of Health and Human Services (HHS), hospitals, health care
and hospital associations, and mortgage and investment banking firms;
(2) analyzed health care data; (3) reviewed program financial data;
(4) reviewed FHA's documentation regarding its 1994 loan loss reserve
methodology; and (5) reviewed applicable program laws, regulations,
and policy statements.  Our review did not include an evaluation of
underwriting criteria, the premium structure of the program, or
whether the program is needed.  (See app.  IV for a detailed
description of our objectives, scope, and methodology.) Our work was
performed between August 1994 and December 1995, in accordance with
generally accepted government auditing standards. 


--------------------
\1 The results of our other studies on the nursing home and
retirement service center insurance programs are provided in a
separate report:  HUD Management:  Greater Oversight Needed of FHA's
Nursing Home Insurance Program (GAO/RCED-95-214, Aug.  25, 1995). 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :1

Since its inception, the program has made a net positive cash
contribution to HUD's General Insurance Fund,\2

according to FHA.  However, the program is currently faced with
potential financial risks that could affect the future stability of
the portfolio.  For example, more than $4 billion or about 87 percent
of the FHA-insured hospital mortgages' unpaid principal balance is
concentrated in New York state with many New York hospitals having
the largest individual unpaid principal balances.  In addition, state
actions, such as the recent decision in New York to reduce hospital
Medicaid spending by about $140 million in one year, could further
strain the financial condition of many of the already financially
weak program hospitals.  Future health care policy changes and
trends, like managed care, that challenge hospitals to control costs
and restructure the way they deliver health care can also threaten
program hospitals' ability to remain solvent. 

Although FHA had a loan loss reserve estimate of $458.25 million as
of September 30, 1994, this estimate is not a reliable measure of
program losses because of methodology limitations.  In estimating the
reserve, FHA used questionable assumptions regarding default
probabilities and loss rates.  For example, FHA had no justifiable
basis for the loss rates it applied to hospitals with a lower than
50-percent probability of default.  In addition, FHA's methodology
did not incorporate health care market trends, a risk factor that can
affect the future viability of program hospitals. 

Our evaluation of the relationship between the purpose of the
Hospital Mortgage Insurance Program and HUD's mission found that
HUD's mission is broad enough to encompass the purpose of the
program.  However, the extent to which the program contributes to
HUD's mission is unclear because HUD does not measure program
outcomes.  Further, FHA's staff has limited expertise in health care
to independently manage key program functions.  FHA relies on HHS'
staff expertise in health care and hospital finance and management to
assess projects' feasibility and monitor hospitals' financial
performance.  We also learned that some program users have raised
concern with the length of the mortgage insurance application
process.  Applications can take more than 1-1/2 years to be approved. 


--------------------
\2 The Hospital Mortgage Insurance Program is part of HUD's General
Insurance Fund, which obtains revenues from insurance premiums and
the proceeds of sales of mortgages and foreclosed properties.  It
incurs expenses for administration, payments of insurance claims, and
costs of maintaining and selling foreclosed properties.  In addition
to the hospital insurance program, this fund's insurance portfolio
supports a variety of multifamily and single-family insured loans. 
These include rental apartments, cooperatives, condominiums, housing
for the elderly, nursing homes, manufactured housing, home
improvement loans, and disaster loans. 


   BACKGROUND
------------------------------------------------------------ Letter :2

In 1968, the Congress added Section 242 to the National Housing Act
establishing the Hospital Mortgage Insurance Program.  In considering
this amendment to the National Housing Act, the House Committee on
Banking and Currency\3

cited a serious shortage of hospitals and the need for existing
hospitals to expand and renovate.  Private lenders seemed reluctant
to provide capital financing at reasonable terms.  The purpose of the
program is to "assist the provision of urgently needed hospitals for
the care and treatment of persons who are acutely ill .  .  .."
Consequently, Section 242 authorized HUD to provide insurance for
hospital mortgages secured from lenders to finance the construction
and renovation of hospitals.\4

Many hospitals need to borrow money from lenders to finance
construction and renovation projects.  Lenders often raise capital by
selling bonds to investors and use the hospitals' mortgage payments
to pay bondholders.  Mortgage insurance, like private bond insurance,
guarantees that bondholders will be paid if the hospital stops making
payments on its loan.  According to the Health Care Financing Study
Group,\5 about 60 percent of hospitals that seek financing require
insurance to enhance their credit because they cannot get a loan on
their own financial strength.  Eighty-three percent of these
hospitals can get private bond insurance but about 17 percent cannot
because private insurers consider them too risky.  Some hospitals
that cannot get private mortgage insurance apply to FHA's hospital
insurance program. 

FHA's Hospital Mortgage Insurance Program staff and HHS' Division of
Facilities Loans staff jointly manage the hospital program.  The
Congress gave HUD statutory responsibility for the program.  The
House Committee on Banking and Currency, in recommending that HUD be
given this responsibility, cited FHA's more than 35 years of
experience with promoting housing construction through its housing
insurance programs.  The Committee was concerned, however, that HUD's
staff did not have specialized knowledge of health care needed to
administer this program.  As a result, the Committee recommended and
the Congress enacted the requirement that a state agency must certify
that a hospital is needed before it can participate in the program. 
Also, the Committee expected HUD to draw upon HHS' hospital expertise
to devise standards for insuring hospitals' mortgages.  Through a
memorandum of agreement, HUD formally delegated authority to HHS to
review and approve proposals for hospitals' mortgage insurance.  HUD
retained authority to make the final insurance commitment and endorse
the mortgage note. 

The Hospital Mortgage Insurance Program requires hospitals to have
the state certify the need for the proposed projects and then meet
underwriting criteria before insurance applications can be approved. 
Since 1988, hospitals have obtained FHA insurance approval to
construct acute care facilities, ambulatory care centers, and
operating rooms and to renovate maternity and emergency departments
and surgical suites.  In addition, hospitals have obtained approval
to purchase equipment, install new computer and fire alarm systems,
and build parking facilities. 

The use of hospital inpatient services, however, has declined over
time.  Current trends indicate a greater focus on cost containment
and delivering health care on an outpatient basis. 


--------------------
\3 Currently the Committee on Banking and Financial Services. 

\4 The Hospital Mortgage Insurance Program supplemented the
Hill-Burton Program.  Under Hill-Burton, HHS, formerly the Department
of Health, Education, and Welfare, made loan guarantees and direct
loans to hospitals for construction and modernization projects. 

\5 The Health Care Financing Study Group is comprised of investment
and mortgage banking firms actively involved in financing health care
facilities throughout the United States, both conventionally and on a
government-supported basis. 


   POTENTIAL FINANCIAL RISKS ON
   THE STABILITY OF THE HOSPITAL
   PROGRAM
------------------------------------------------------------ Letter :3

Overall, the financial performance of the hospital program has
reflected a net positive cash flow from operations over the past 25
years, according to HUD data.  However, in several years, the program
has experienced financial losses.  The bulk of the losses occurred
between 1989 and 1991, when HUD had to pay lenders about $147 million
because of hospital defaults.\6 The current composition of the
program's portfolio with the concentration of insured loans in New
York, changes in state policies, trends in the health care market,
and the probability of future changes in federal health care policies
pose risks that may threaten the future stability of the program. 
Two reasons given in a 1992 HUD study\7 for why some hospitals
defaulted on their loans were changes in the policies and practices
of state and local governments and changes in Medicare and Medicaid
reimbursement. 


--------------------
\6 A default occurs when a hospital has at least one payment
outstanding, the loan is assigned to HUD, and HUD pays a claim. 

\7 Organizational Review of the Hospital Mortgage Insurance Program,
Office of Management and Planning (OMAP), HUD (Washington, D.C.: 
1992), pp.  23-24. 


      THE HOSPITAL PROGRAM
      PORTFOLIO AND ITS FINANCIAL
      PERFORMANCE
---------------------------------------------------------- Letter :3.1

The hospital program has made a positive net contribution of $221
million to HUD's General Insurance Fund, even though there have been
years with negative cash flows (see fig.  1).  Information obtained
from FHA shows that from fiscal year 1969 through 1994, FHA collected
$370 million in premiums and fees and paid $200 million in insurance
claims and $13 million in salaries and other administrative expenses. 
FHA recovered about $64 million of claim payments from mortgage
payments and the sale of the mortgages or properties.  As of
September 30, 1994, 19 hospitals had defaulted;\8 FHA disposed of 10
and retained loan management responsibility for the remaining 9
hospitals.  For these 9 hospitals, the total unpaid principal balance
is $108 million and accrued delinquent interest is $44 million.  (See
app.  I for a description of the hospital program's financial
performance from fiscal year 1969 through 1994.)

   Figure 1:  FHA's Hospital
   Mortgage Insurance Program Cash
   Flow From Operations, Fiscal
   Years 1969-94

   (See figure in printed
   edition.)

Source:  FHA Hospital Mortgage Insurance Program staff. 

As of August 1995, the hospital program portfolio was comprised of
100 projects in 18 states and Puerto Rico (see fig.  2).  The
portfolio has an aggregate unpaid principal balance of about $5
billion.  (See app.  II for individual unpaid principal balances of
FHA-insured hospital projects, by state.)

   Figure 2:  Distribution of
   Hospital Projects and Unpaid
   Principal Balances, by State,
   in the FHA Hospital Mortgage
   Insurance Portfolio, August
   1995

   (See figure in printed
   edition.)

Note:  Numbers within states reflect the number of hospital projects
insured. 

Source:  FHA Hospital Mortgage Insurance Program staff. 

The majority of the hospital program projects, 63 percent, are in New
York.  The unpaid principal balance on mortgages for these projects
is about $4.2 billion or 87 percent of the portfolio's aggregate
unpaid principal balance.  Also, 9 of the 10 largest hospital
mortgages are in New York.  These mortgages account for about $2.4
billion or 50 percent of the portfolio's total unpaid principal
balance.  Included in these mortgages is a $591 million loan, the
largest single loan amount FHA has insured in the history of the
program.  Since 1988, 17 of the 20 projects that FHA insured have
been for New York hospitals.  In addition, as of August 1995, 6 of
the 10 mortgage insurance applications under review by HHS and FHA
were for projects in New York. 


--------------------
\8 One of the 19 hospitals also defaulted on an insured loan obtained
to cover a 2-year operating loss. 


      NEW YORK'S REIMBURSEMENT
      SYSTEM IS A FACTOR IN
      HOSPITALS' RELIANCE ON FHA
      PROGRAM
---------------------------------------------------------- Letter :3.2

The hospital program has become a major financing vehicle for many
New York hospitals.  Several officials stated that New York hospitals
rely on FHA mortgage insurance, in part, because the state's
reimbursement system hinders hospitals' ability to access capital in
the private market.  "New York's restrictive reimbursement system
makes it the most regulated nationwide," according to a Moody's
Investors Service report.\9 Except for Medicare, New York utilizes an
all-payer fixed rate system to reimburse hospitals.  The state
controls all third-party payers' rates of payments by setting a fixed
payment for each hospital based on patient diagnoses.  The
rate-setting system is a regulatory method of budgeting for
hospitals.  The goals of the rate-setting system are cost containment
and access to hospital care.  However, New York state officials said
that this system constrains hospitals' profitability, which weakens
their creditworthiness.  According to a Moody's Investors Service
report, New York hospitals' credit ratings are the weakest in the
nation.\10

In other states, hospitals' credit ratings are generally stronger,
which enables many of them to access capital in the private market. 
These hospitals primarily rely on bond financing backed by their
revenues and projected ability to make loan payments or by commercial
bond insurance instead of FHA's Hospital Mortgage Insurance Program. 
In contrast, private insurers are reluctant to back bond sales to
finance some New York hospital projects because the hospitals are
considered too risky. 


--------------------
\9 Health Care Finance:  Hospital Revenue Bonds, State of New York,
Moody's Investors Service HC71-14 (New York:  1994), p.  3. 

\10 Health Care Finance:  Hospital Revenue Bonds, State of New York,
Moody's Investors Service, p.  1. 


      CONCENTRATION OF INSURED
      PROJECTS IN NEW YORK POSES
      PROGRAM RISKS
---------------------------------------------------------- Letter :3.3

The lack of portfolio geographic diversification and the large
individual unpaid loan balances in New York pose a risk to the
program.  The concentration of the portfolio in New York makes the
program susceptible to New York policies and other factors specific
to the state.  The strength of a portfolio lies in its diversity
because portfolio diversification decreases the risk from losses.  In
addition, a single default of a large loan could lead to insurance
claims that could significantly burden the program.  A 1992 HUD
report stated that the concentration of FHA-insured projects in a
single state and large loan amounts are major controllable risks to
the program that should be avoided or minimized.\11

FHA does not limit the number of projects in a particular state nor
does it cap individual loan amounts it insures as a means of
controlling risks to the program.  The legislation authorizes the
Secretary of HUD to set the terms and conditions under which HUD will
insure projects, but the law does not specifically authorize FHA to
limit the number of projects accepted into the program from a
geographic area or to limit the loan amounts it insures.  In fact, in
1974, the Congress removed existing caps on loan amounts. 

FHA officials stated that they are taking action to diversify the
portfolio by marketing the program to attract hospitals from other
states.  For example, FHA officials reported working with mortgage
bankers to increase program awareness to hospitals outside New York. 
They reported that, as of August 1995, they had received four
applications from hospitals in Illinois, New Jersey, Pennsylvania,
and Puerto Rico.  By expanding the portfolio, FHA also increases the
program's total outstanding mortgage amount.  Officials involved in
the financing of hospital projects told us that hospitals in other
states may not be interested in the FHA program for several reasons,
including the program's high premiums, lengthy application process,
and a lack of program awareness. 

For some future hospital projects, FHA is considering ways to reduce
the risk of financial losses.  For example, FHA is considering a
proposal to establish risk-sharing arrangements with the public and
private sector.  According to FHA officials, the risk-sharing partner
would assume underwriting responsibilities, have an equity position
in the hospital, and share in any losses that result from defaults. 
In an October 1993 report, we noted that HUD terminated FHA's
multifamily housing coinsurance program in January 1990.  The program
enabled FHA to share the risk of insuring a multifamily mortgage with
participating lenders.  However, problems with the program resulted
from deficient conceptual design and failures in administration.\12


--------------------
\11 Organizational Review of the Hospital Mortgage Insurance Program,
OMAP, p.  27. 

\12 Housing Finance:  Expanding Capital for Affordable Multifamily
Housing (GAO/RCED-94-3, Oct.  27, 1993). 


      NEW YORK'S HEALTH CARE
      POLICY AND FUTURE FEDERAL
      POLICY CHANGES INCREASE
      RISKS TO THE PROGRAM
---------------------------------------------------------- Letter :3.4

Changes in state health care policies that reduce hospitals' revenues
can negatively affect the financial stability of hospitals,
particularly the financially weaker hospitals in FHA's hospital
program.  Recent changes in New York's Medicaid policy would reduce
hospitals' patient revenues and could increase program hospitals'
risk of default.  The New York state fiscal year 1996 budget contains
health care cost-cutting measures that are estimated to reduce state
Medicaid hospital spending by $138 million, resulting in an estimated
total hospital revenue loss of $553 million.\13 State analyses of the
reduction in Medicaid spending for individual hospitals estimate that
FHA-insured hospitals will lose $170 million in Medicaid revenue. 
Also, individual program hospitals may lose between 0.31 percent and
4.25 percent of total revenues. 

Some New York hospitals' already marginal operating margins\14 may
deteriorate further as a result of the loss in Medicaid revenue.  Our
analysis of 1994 Health Care Financing Administration data for 52
program hospitals in New York indicates that 49 had negative
operating margins.  The average operating margin for the 52 hospitals
was -5.6 percent.  Our analysis shows that, on average, operating
margins for the 52 hospitals would deteriorate by 26 percent in 1
year because of the state's reduction in Medicaid spending.  Thus,
the ability of some of these hospitals to absorb the cuts and
possible future state Medicaid spending reductions without defaulting
on their FHA-insured loans is questionable. 

In the past, state policy changes have precipitated hospital
defaults.  For example, three hospital defaults in Illinois resulted
in a $27 million loss to the program.  According to a 1992 HUD
report, two of these defaults were caused, in part, by the state
setting a Medicaid reimbursement rate that was too low to cover the
hospital's cost of treating Medicaid patients or the state delaying
Medicaid reimbursement to hospitals.\15

The extent to which New York hospitals are able to reduce expenses
will affect their ability to withstand revenue losses.  According to
FHA, HHS, and New York health care officials, hospitals are expected
to reduce expenses and implement revenue enhancers to mitigate
Medicaid revenue losses and remain viable.  Hospitals with large
Medicaid caseloads are particularly vulnerable to reductions in
Medicaid spending.  Our analysis of 1994 data from 52 New York
program hospitals shows that for about one-third of the hospitals,
their Medicaid inpatient days were greater than 25 percent.\16 Plans
developed by New York program hospitals to respond to the state's
Medicaid cuts include cost-containment measures, such as reducing
staff, salaries, and benefits and revenue enhancement measures, such
as decreasing the length of stay and increasing admissions.  Hospital
and hospital organization officials reported that some hospitals had
already begun taking cost-cutting measures before the budget decision
was made.  In reaction to the cuts, FHA required New York hospitals
awaiting application approval to submit sensitivity analyses on the
impact of the cuts.  In addition, HHS required New York program
hospitals to submit an action plan for responding to the cuts.  After
evaluating the hospitals' responses, FHA and HHS increased their
monitoring efforts for those hospitals identified as most vulnerable
to the cuts. 

In addition to changes in state policies, future changes in federal
health care policies can also restrict hospitals' revenues.  For
example, the Fiscal Year 1996 Congressional Budget Resolution
proposes cumulative Medicare reductions of $270 billion, from current
law projections, over the next 7 years.  In addition, the Budget
Resolution proposes reducing Medicaid outlays by about $180 billion. 
As the congressional debate on deficit reduction continues, other
proposals for containing the cost of federal health care spending on
Medicare and Medicaid could surface. 


--------------------
\13 The total provider loss includes federal, state, and county
Medicaid contributions. 

\14 The operating margin is a commonly used measure of hospitals'
profitability.  It is used to measure profitability on all patient
care operations and is net patient revenue minus operating expenses,
divided by net patient revenue.  Because for many hospitals net
patient revenue does not include all operating revenue, this measure
tends to understate operating profitability. 

\15 Organizational Review of the Hospital Mortgage Insurance Program,
OMAP, pp.  23 and 30. 

\16 Our analysis also shows that one-half of program hospitals had
Medicare inpatient days of 50 percent. 


      TO REMAIN VIABLE, PROGRAM
      HOSPITALS MUST RESPOND TO
      HEALTH CARE DELIVERY TRENDS
---------------------------------------------------------- Letter :3.5

Changes in the delivery of health care can adversely affect the
viability of hospitals that do not take action to successfully
control costs and compete in the marketplace.  One major shift in the
way health care is delivered is the change from a focus on hospital
inpatient care to outpatient care.  From 1983 through 1993, there
were 5.4 million or 15 percent fewer community hospital admissions
nationwide.\17 Over the same period, the average length of stay for
patients admitted to hospitals declined from 7.6 to 7.0 days. 
American Hospital Association (AHA) data show for the same 10-year
period that hospital occupancy rates declined by 10 percent and 522
community hospitals closed--a decline of 9 percent.\18 In contrast,
more dramatic than the decline in inpatient hospital use was the
increase in hospital outpatient visits.  Community outpatient visits
increased about 75 percent over the 10-year period.  This change in
outpatient volume reflects an overall restructuring of the health
care delivery system. 

Some of the factors driving the trends in health care include
advances in technology that allow more care to be delivered in
outpatient settings; changes in reimbursement incentives, such as the
introduction of diagnostic related groups under the prospective
payment system in the early 1980s; and the growth of enrollment in
managed care health plans.  As these trends continue, the need for
hospital acute care beds will continue to decline.  Health care
association representatives cite managed care as a significant trend
facing some hospitals.  Because of the increased enrollment in
managed care plans, hospitals that cannot become a part of a managed
care network or compete in this environment stand to suffer
financially from a loss of market share. 

Understanding the overall impact of these health care trends on the
future need of the program would require further analysis which was
beyond the scope of this review.  Any such analysis should have to
consider, at a minimum, (1) the characteristics of program hospitals
compared with nonprogram hospitals accessing capital, (2) the ability
of program hospitals to obtain financing on the private market
without FHA mortgage insurance, (3) the costs and benefits of the
program including the public good that the program serves, and (4)
the program's underwriting criteria and premium structure. 


--------------------
\17 Community hospitals include institutions that are nonfederal,
short-term, general, and other special hospitals whose facilities are
open to the public.  Not included in this category are hospital units
of institutions, long-term hospitals, psychiatric hospitals, and
alcoholism and chemical dependency facilities. 

\18 According to an AHA report, the decline in the number of
community hospitals was especially rapid between 1985 and 1990,
however, the number of hospital closures has since slowed.  See 94/5
Hospital Statistics:  The AHA Profile of United States Hospitals,
American Hospital Association. 


      MANAGED CARE PENETRATION IN
      NEW YORK COULD AFFECT
      VIABILITY OF PROGRAM
      HOSPITALS
---------------------------------------------------------- Letter :3.6

The growth of managed care in New York can negatively affect some
FHA-insured hospitals' financial condition and, as a result, increase
the risk of financial loss to the insurance program.  In 1993, the
penetration of managed care plans in New York was more than 24
percent.  Also, there is a push in the state for the adoption of
mandatory Medicaid managed care.  Managed care emphasizes health care
cost control, which includes avoiding unnecessary admissions and
lengthy stays. 

Managed care also focuses on cost and utilization control measures. 
However, few New York hospitals have experienced managed care pricing
and utilization controls.  New York hospitals may be at a
disadvantage in a managed care market because they generally have
high lengths of stay.  In addition, according to a Moody's Investors
Service report, "in a managed care market where the key variable is
cost, the generally high-cost urban teaching facilities which are
disproportionately located in New York, will definitely be at a
disadvantage."\19

In addition, these hospitals have large teaching and research costs
and significant fixed costs tied to their large physical plants and
debt loads.  The potential effect on teaching hospitals can be
important to the program because, according to FHA data, the program
insures 44 teaching hospitals of which 34, or 77 percent, are in New
York. 

Hospitals that reduce costs and develop cooperative relationships
with other health care providers may be able to mitigate the negative
financial impact of managed care.  Some program hospitals in New York
and other states are affiliating and forming networks with other
health care providers to reduce costs and increase service area.  For
example, one hospital reduced costs by establishing an affiliate in
which financial and support services were consolidated and shared
within its provider network.  In addition, several hospitals reported
affiliating with community hospitals and physician groups, as well as
developing satellite clinics to broaden their patient base. 

An HHS official stated that, in reviewing hospitals' applications,
HHS considers whether the hospitals are preparing for managed care
and addressing other health care trends.  In addition, according to
an HHS official, HHS examines affiliate contracts and insures that
the contracts are not a drain on the hospitals' finances.  Also,
program hospitals are required to obtain FHA approval for some
mergers and affiliate transactions.  FHA officials also reported that
FHA consultants consider health care trends in their review of
hospitals' applications. 


--------------------
\19 Health Care Finance:  Hospital Revenue Bonds, State of New York,
Moody's Investors Service, p.  2. 


   METHODOLOGICAL FLAWS LIMIT THE
   RELIABILITY OF THE LOAN LOSS
   RESERVE ESTIMATE
------------------------------------------------------------ Letter :4

FHA's loan loss reserve estimate of $458.25 million, as of September
30, 1994, is not reliable because of weaknesses in the methodology
that FHA used to calculate the estimated loan losses.\20 The
assumptions that FHA used to estimate key variables such as default
probabilities and the actual loss rates were not directly linked to
or justified by a detailed documented analysis of loss exposure in
the hospital mortgage insurance portfolio.  In an October 1994 report
we discuss this principle as it applies to depositary
institutions.\21 Further, FHA's methodology did not incorporate some
health care market trends that are likely to impact the future
financial performance of program hospitals.  The net effect of the
methodological flaws on the reserve estimate is unclear because FHA's
default assumptions and their exclusion of market trends could
overstate or understate the loan loss reserve estimate. 

In estimating loan loss reserves, FHA--which is subject to the
Government Corporation Control Act--is required to follow generally
accepted accounting principles (GAAP) for financial statement
reporting purposes.  However, in our October 1994 report, we stated
that this authoritative accounting guidance, established for private
sector institutions, does not provide sufficiently detailed direction
for establishing loan loss reserves.  As a result, our evaluation of
the methodology used by FHA is based on this general GAAP principle
for loss recognition and our experience in applying other principles
in other situations involving the estimation of loan loss
reserves.\22


--------------------
\20 This estimate, calculated on a present value basis, represents
the amount that FHA expects to lose from defaults through 2002 on
hospital loans insured as of September 30, 1994.  The estimate is
about 11 percent of the unpaid principal balance of FHA's insured
hospital portfolio as of this date. 

\21 The report discussed inconsistencies in the use of individual
loan assessments and loss history in establishing loss reserves and
the need to link the loan loss reserve to a detailed documented
analysis of current loss exposure in the loan portfolio.  Depositary
Institutions:  Divergent Loan Loss Methods Undermine Usefulness of
Financial Reports (GAO/AIMD-95-8, Oct.  31, 1994). 

\22 We also considered Statement of Federal Financial Accounting
Standard No.  1, Accounting for Selected Assets and Liabilities,
which provides more detailed guidance on loss reserves than GAAP. 


      ASSUMPTIONS NOT BASED ON
      DETAILED ANALYSIS OF LOSS
      EXPOSURE IN THE PORTFOLIO
---------------------------------------------------------- Letter :4.1

FHA's assumptions regarding default probabilities and loss rates were
not supported by analysis of the loss exposure of each individual
insured loan or other evidence that justified the estimates used. 
Specifically, FHA computed the probability of each program hospital
appearing on HHS' Credit Watch List\23 and then used these
probabilities as proxies to measure the default probability of each
hospital in the portfolio.\24 The probability of a hospital being on
the Credit Watch List, however, is not a valid proxy for estimating
the default probabilities for the entire portfolio because a hospital
appearing on this list is a more common occurrence than a hospital
defaulting.  HHS' data show that from 1984 to 1994 there were on
average 167 hospitals in FHA's portfolio.  During this period, 16
hospitals (or 9.6 percent) defaulted on their loans and there were 82
hospitals on the Credit Watch List (49 percent).  HHS data indicate
that the majority of the default probabilities that FHA used to
calculate the loan loss reserve were higher than the actual default
rate of hospitals in the program.  FHA's approach for measuring
default probabilities resulted in estimates of program hospitals'
default probabilities that ranged from about 3 to 80 percent with the
majority of the default probabilities in the 10 to 40 percent range. 
However, FHA's approach may have underreserved for loans that have
high default probabilities because FHA did not consider the full
unpaid principle balance when applying the loss percentages.\25
Moreover, FHA's use of the Credit Watch List overstates the
hospitals' default probabilities for loans less likely to default. 
FHA officials reported that they preferred to use the Credit Watch
List as an indicator of the probability of default because, in their
view, the Credit Watch List provides a prospective approach to
estimating defaults. 

Regarding the loss rates, FHA applied percentages that were in some
instances arbitrarily set and not linked to documented evidence of
the individual insured loan's likely losses.  For example, FHA
assigned the historical average loss rate of 70 percent to the
hospitals it predicted were most likely to default on their
mortgages\26 (that is, hospitals with estimated default probabilities
of 50 percent or more) and graduated downward the loss rate for
hospitals that had estimated default probabilities lower than 50
percent.\27 The 70-percent loss rate was based on losses HUD
experienced from the sale at foreclosure or property disposition of
eight of the nine hospital mortgages taken into inventory and sold
since 1974.  However, a better method for estimating the loan loss
reserve would be to do a comprehensive analysis of the individual
loss exposure for defaults considered probable--hospital loans with
50 percent or higher default probabilities.  This entails not only
reviewing the financial condition of the hospital, which FHA did, but
considering other factors such as the likelihood of foreclosure
versus FHA continuing to carry the loan.  Further, FHA had no
justifiable basis for the loss rate percentages applied to the
hospitals that had default probabilities lower than 50 percent. 
FHA's rationale was that in the future it could recover more from
disposing of hospitals with default probabilities below 50 percent
because these hospitals are considered to be stronger financially,
based on the hospitals' financial condition in 1994.  FHA arbitrarily
assumed that these hospitals would default later\28 and have a higher
value at the time of sale because they would have a broader patient
base and higher net patient revenue.  We question the validity of
these assumptions because FHA provided no analysis to support the
loss rates applied to hospitals with a lower than 50 percent
probability of default.\29 Because FHA had no basis for the loss rate
percentages used for these categories of loans, it may be misstating
the loan loss reserve estimate. 


--------------------
\23 The Credit Watch List is a listing of hospitals that are in
financial difficulty.  HHS develops the list based on its monitoring
of change in hospitals' financial condition.  The list does not
include hospitals that have defaulted on their loans. 

\24 FHA used regression analysis to estimate the probability of a
hospital appearing on the Credit Watch List.  The analysis was based
on six financial indicators:  liquidity, profitability, capital
structure, liquid assets to liabilities, trends of these indicators,
and a combination of trends and financial indicators.  FHA averaged
the predicted probabilities resulting from these six indicators.  In
effect, the average predicted probability for the hospitals in the
portfolio is the same as the percentage of hospitals on the Credit
Watch List.  FHA assumed that a hospital's average on these
probabilities was a good estimate of the hospital's probability of
default. 

\25 GAAP generally requires that 100 percent of the principle balance
be considered for reserving purposes when default is more likely than
not to occur (that is, defaults that are considered probable).  FHA's
analysis shows that it considered less than 100 percent of the
principle balance in applying reserve percentages for the loans FHA
identified as having high default probabilities.  This practice
understates reserves for loans more likely than not to default. 

\26 According to FHA, losses have averaged 70 percent from the sale
at foreclosure or property disposition of eight of the nine hospital
mortgages taken into inventory and sold since 1974.  Loss data were
not available for the ninth hospital. 

\27 The loss rates were 50 percent for default estimates between 40
and 50 percent, 25 percent for those between 30 and 40 percent, 10
percent for defaults estimates between 20 and 30 percent, and 2
percent for default estimates between 0 and 20 percent. 

\28 FHA assumed that hospitals with default likelihoods of over 80
percent would default in 1995; those between 70-80 percent in 1996;
60-70 percent in 1997; 50-60 percent in 1998; 40-50 percent in 1999;
30-40 percent in 2000; 20-30 percent in 2001; and 2-20 percent in
2002.  FHA officials said that they arbitrarily set the specific
years in which the defaults would occur. 

\29 FHA's underlying assumptions were that some insured loans would
have loss rates equal to the historical average and others would have
loss rates below the historical average.  However, because none of
the insured loans was assumed to have a loss rate above the
historical average, FHA is assuming that future loss rates would be
less than the historical average indicates. 


      HEALTH CARE MARKET TRENDS
      THAT MIGHT AFFECT THE FUTURE
      VIABILITY OF THE PROGRAM
      WERE NOT INCLUDED IN THE
      ANALYSIS
---------------------------------------------------------- Letter :4.2

FHA's loan loss reserve methodology did not incorporate newly
developed events, such as health care market trends, that can affect
the future financial condition of program hospitals.  For example, by
omitting analyses of the potential impact of managed care, the loan
loss reserve did not consider developing events that can impact
program hospitals' revenues.  A reduction in revenue related to
managed care could result in program losses.  Overall, FHA's
exclusion of health care market trends in its methodology may have
understated or overstated the loan loss reserve estimate depending on
the impact that the specific market trend has on the program
hospitals.  While FHA officials acknowledged the importance of health
care trends, they stated that they had not developed an approach to
incorporate such factors into their analysis. 


   PROGRAM PURPOSE RELATES TO
   HUD'S MISSION BUT ACHIEVEMENT
   OF GOALS IS NOT ROUTINELY
   MEASURED
------------------------------------------------------------ Letter :5

HUD's mission is broad enough to encompass the purpose of the
hospital program.  HUD's overall mission includes increasing
opportunities for housing and community development and, through FHA,
providing mortgage insurance for construction projects.  The purpose
of the program is to assist with providing for urgently needed
hospitals.  In the report supporting the establishment of the
hospital program, the House Committee on Banking and Currency cited
FHA's experience with promoting construction through its insurance
programs.  Subsequently, the Congress made providing mortgage
insurance for hospital construction a part of HUD's mission by giving
the department statutory responsibility for the program. 

HUD officials reported that through FHA the program supports the
department's mission because it (1) provides an opportunity for
hospitals to obtain financing for construction and renovation
projects that they may not otherwise obtain in the private market and
(2) promotes one of the department's goals of economic lift by
increasing employment, economic development, and neighborhood
stabilization.  The program also has as one of its specific goals
promoting neighborhood stability and economic lift.\30

Although FHA officials believe that the hospital program is
consistent with HUD's mission, the extent to which the program
accomplishes the department's goals and thereby supports its mission
is not routinely measured.  For example, HUD does not measure the
extent to which local employment increased as a result of the program
or the effect an insured project had on stabilizing a community. 
Performance measurement data would be useful for HUD to determine the
strategic importance of the program to its mission and to evaluate
the extent to which program benefits or outcomes outweigh program
risks. 

Although no legal requirement existed for performance measurement,
the Government Performance Results Act (GPRA) of 1993 requires
federal agencies to submit a strategic plan to the Congress in the
fall of 1997 and an annual performance plan in fiscal year 1999.\31
In response to GPRA requirements, HUD officials stated that HUD
established performance measures for some of its major programs. 
These measures include increasing the number of first-time home
buyers and increasing benefits to low- and moderate-income home
buyers.  However for the hospital program, HUD officials stated that
the agency has not developed performance measures, in part, because
of the program's relatively small size and HUD's lack of data systems
to track specific performance measures. 


--------------------
\30 In addition, FHA also established the following five program
goals:  (1) provide access to capital for facilities that cannot get
conventional financing, (2) make facility modernization and improved
patient care possible, (3) support governmental and market-driven
health care reforms, (4) ease health care costs, and (5) provide
technical assistance to help "turn around" troubled facilities. 

\31 The strategic plan is to contain the agency's mission, long-term
goals and objectives, and strategies for achieving these goals and
objectives.  The annual performance plan is to contain annual
performance goals to gauge the agency's progress toward accomplishing
its longer-term strategic goals and identify the performance measures
the agency will use to assess its progress. 


   FHA PROGRAM MANAGEMENT
   RESPONSIBILITIES SHARED WITH
   HHS STAFF
------------------------------------------------------------ Letter :6

FHA has limited health care expertise to independently manage the
program.  FHA's headquarters staff has overall responsibility but
shares program responsibilities with HHS staff because of HHS'
experience with hospitals and health care.  Managing the program
requires, in part, (1) familiarity with health care regulations,
insurance practices, reimbursement systems, and trends; (2) an
understanding of the indicators of a hospital's financial condition;
and (3) knowledge of the unique construction guidelines that apply to
hospitals.  According to a 1992 HUD report, HHS has staff with skills
and experience in business administration, financial analysis, and
accounting in the health care industry, as well as architects and
engineers who specialize in overseeing the construction of health
care facilities.\32 The majority of the tasks related to managing the
initial phases of the program's loan cycle--loan development and
management--have been delegated to HHS.  FHA has primary
responsibility for managing the latter stages of the program's loan
cycle--loan assignment and property disposition (see app.  III for a
description of each agency's responsibilities during the phases of
the loan cycle). 

A 1992 HUD report shows that FHA and HHS' efforts to manage the
program have produced mixed results.  The report raised some concern
about their past performance in loan development and management and
the management of assigned loans and disposition of HUD-owned
hospitals.  However, the report concluded that, for the most part,
HHS staff had done a good job and HUD's staff was getting more
involved and gaining experience in working with troubled
hospitals.\33

As agreed with your staff, our review did not include an evaluation
of FHA and HHS' performance in program management. 


--------------------
\32 Organizational Review of the Hospital Mortgage Insurance Program,
OMAP, pp.  82-83. 

\33 Organizational Review of the Hospital Mortgage Insurance Program,
OMAP, pp.  15, 22, 37, 43, 45, 52, and 83. 


      LENGTH OF APPLICATION
      PROCESS CRITICIZED
---------------------------------------------------------- Letter :6.1

The hospital and finance agency officials we interviewed raised
concerns about the length of time it takes to get mortgage insurance
applications and loan modifications\34

approved by HHS and FHA.  Our analysis of 12 loan applications
approved since September 1990 shows that the average time from the
date an application was first submitted to HHS to FHA's final
approval was more than 18 months.  In contrast, a Price Waterhouse
study reported that private insurers approve mortgage insurance
applications for health facilities in 2 to 4 weeks.\35 In addition,
according to HUD's 1992 report, the median timeframe for selected
modification approvals was more than 9 months.\36 Several hospital
and finance agency officials said that the application and loan
modification processes are lengthy primarily because of the number of
offices involved in reviewing the applications.  FHA and HHS
officials attribute some of the delay to hospitals not responding to
their questions in a timely manner.  The lengthy approval processes
may hinder hospitals' ability to take advantage of favorable market
interest rates, several officials said.  One hospital reported that
it had to pay an additional 65 basis points\37 on its interest rate
because of the time that elapsed between HHS' recommendation to
approve the application and FHA's final approval. 

FHA recognizes that the approval processes are lengthy and stated
that a reasonable goal for approving applications is 6 months.  FHA
and HHS recently initiated efforts to streamline the application
process.  These efforts include using a team approach to analyze
applications and involving FHA's field staff earlier in the process. 
However, FHA officials stated that their approval timeframes will
generally never match those of private sector insurers because the
hospitals that FHA insures are financially weaker and require closer
screening and evaluation. 


--------------------
\34 Loan modifications are modifying or waiving existing loan terms
and conditions.  These changes include, but are not limited to,
buying or selling equipment, leasing property, and merging or
restructuring the corporation. 

\35 Assessment of Loan Management Procedures to Identify Strategies
to Improve Health Care Facilities' Financial Performance, Price
Waterhouse (1994), p.  13. 

\36 Organizational Review of the Hospital Mortgage Insurance Program,
OMAP, p.  77. 

\37 A basis point is equal to one one-hundredth of one percentage
point, or 0.01 percent. 


   CONCLUSIONS
------------------------------------------------------------ Letter :7

Although the hospital program had made a positive dollar contribution
to the General Insurance Fund as of fiscal year 1994, the
accumulation of more than $4 billion of insured projects and the
large loan amounts in New York pose risks to the future stability of
the program.  The continued buildup in New York may further
exacerbate this risk.  Further, trends in health care and changes in
state and federal health care policies that reduce hospitals'
revenues will impact program hospitals. 

FHA officials are aware of the risks of concentration and health care
changes associated with the current portfolio.  Portfolio
concentration is a controllable program risk for the future.  But the
law that authorizes the Secretary of HUD to set the terms and
conditions under which HUD will insure projects does not specifically
authorize FHA to use as options for diversifying the portfolio,
limiting the number of projects accepted into the program from a
geographic area, or limiting the amounts it insures.  Health care
trends and changes in health care policies are risks beyond FHA's
control.  Hospitals currently in the FHA program must make
adjustments to respond to these changes or they could suffer
significant financial losses.  To reduce the potential financial
losses associated with future insured mortgages, FHA is considering
risk sharing with the public and private sectors.  However, the risk
to the current portfolio remains. 

Flaws in FHA's methodology for estimating loan losses limit the
reliability of FHA's loan loss reserve estimate.  The implications of
health care trends for program hospitals were not factored into FHA's
methodology for estimating potential loan losses.  In addition, the
approach that FHA used to determine default and loss rate assumptions
was not reliable.  FHA did not consider the full loss exposure in
estimating reserves for hospitals that it identified as having high
default probabilities.  As a result of these flaws, the loan loss
reserve estimate could be understated or overstated. 

While FHA has developed performance measures for some of its major
programs in response to GPRA, it has not developed performance
measures for the hospital program.  Performance measures would help
HUD evaluate the program's effectiveness. 


   MATTER FOR CONGRESSIONAL
   CONSIDERATION
------------------------------------------------------------ Letter :8

Given the risks associated with the portfolio's geographic
concentration and the possible implications for the program of
current health care trends, the Congress may wish to explore further
with HUD officials options for reducing the program's risk by, for
example, limiting the program's risk exposure in a particular state
and capping mortgage insurance amounts. 


   RECOMMENDATIONS
------------------------------------------------------------ Letter :9

To improve the reliability of FHA's loan loss reserve estimate,
insure future compliance with federal performance measurement
requirements, and minimize potential financial losses from future
projects, we recommend that the Secretary of HUD

  perform a comprehensive analysis of individual loan loss exposure
     when default is considered probable; link the loan loss reserve
     estimate to documented analyses that justifiably support loss
     rates and default percentages; and consider newly developed
     events, such as health care trends and policy changes, that can
     affect the performance of loans in estimating loan loss
     reserves;

  develop performance measures and begin collecting the data needed
     to track the performance of the Hospital Mortgage Insurance
     Program; and

  pursue risk-sharing arrangements in which a private or public
     entity would share in potential financial losses from hospital
     defaults on future FHA-insured projects only after a thorough
     evaluation of the benefits and drawbacks of risk-sharing
     ventures, taking into account past experiences of FHA's
     multifamily housing programs. 


   AGENCY COMMENTS AND OUR
   EVALUATION
----------------------------------------------------------- Letter :10

On November 22, 1995, we provided a draft of this report to HUD and
HRSA for comment.  Although HRSA did not provide comments, HUD
generally agreed with the report's findings and conclusions.  In
response to our recommendations, HUD reported that it will (1)
incorporate additional data on market trends and health care policy
changes into FHA's loan loss reserve methodology as such data become
available and can be quantified; (2) develop and implement
performance measures for the program in fiscal year 1997; and (3)
conduct front-end risk analysis and incorporate multifamily's
risk-sharing experience into its plans for the hospital risk-sharing
program.  (See app.  V.). 

HUD did not, however, concur with our evaluation of its 1994 loan
loss reserve methodology.  Contrary to what we concluded, HUD stated
that it (1) used the financial position of the hospitals, not their
appearance on the Credit Watch List to predict the probability of
default, (2) based its loss rates on a review of all losses incurred
in foreclosure or property disposition sales since the beginning of
the program, (3) considered the full unpaid principal balance in
estimating the loan loss reserve, and (4) included health care market
trends through its analysis of the current financial condition and
trends in the financial condition of individual hospitals. 


      PREDICTING THE PROBABILITY
      OF DEFAULT
--------------------------------------------------------- Letter :10.1

HUD's comment that FHA used the financial condition of the hospitals,
not appearance on the Credit Watch List, to predict probability of
default is inconsistent with the documentation that FHA provided on
the method used for estimating the program's loan loss reserves. 
FHA's documentation states that financial indicators "were used to
predict the probability that a hospital would appear on HHS' Watch
List." FHA averaged the probabilities estimated by these indicators
to convert "the predictors of appearance on the Watch List to a
likelihood of default." Further, as stated in the report, our review
of HHS data showed that the majority of default probabilities that
FHA used were higher than the actual default rate of hospitals in the
program.  Clearly, FHA did not adjust the predicted probabilities of
default for this difference. 


      DETERMINING LOSS RATES
--------------------------------------------------------- Letter :10.2

Regarding the loss rates, HUD commented that FHA's analysis was based
on all losses incurred in foreclosure and property disposition since
the inception of the program.  HUD also stated that the loss rates
were adjusted downward for mortgages with probabilities of default
lower than 50 percent based on the assumption that hospitals with a
better financial condition would be worth more at foreclosure. 

As discussed in our report, the 70-percent average loss rate that FHA
used for hospitals with high default probabilities was based on
actual losses experienced in the foreclosure or property disposition
of only eight mortgages taken into inventory and sold since 1974. 
Thus, FHA's historical analysis was not statistically significant and
was based on information that was not adjusted for current real
estate market trends.  We believe that FHA's use of this historical
analysis to determine loss reserves for loans where default is
considered more likely than not (that is, hospital loans with
50-percent or higher default probabilities) may overstate or
understate the reserves on these loans.  We believe that individual
loan analysis of mortgages in the current portfolio provides for a
more accurate means to measure loss exposure on loans where default
is considered more likely than not. 

Although as a matter of generally accepted practice, using historical
data may under some circumstances be appropriate for groups of loans
with a lower than 50-percent default probability, FHA arbitrarily
adjusted a questionable 70-percent loss rate downward for such loans
and provided no supporting analysis to justify the resultant loss
rates.  We believe that this analysis was inappropriate for this
group of loans with lower default probabilities.  Therefore, these
loss rates do not provide a reliable basis for estimating FHA's
reserves. 


      ACCOUNTING FOR THE FULL
      UNPAID PRINCIPAL BALANCE
--------------------------------------------------------- Letter :10.3

With respect to accounting for the full unpaid principal balance in
estimating potential losses, HUD stated that it "multiplied the full
unpaid principal balance by the probability of default and then by
the loss rate--a standard approach to factoring the probability of
default into a loss estimate."

However, this approach has the effect of reducing the unpaid
principal balance.  Proper application of GAAP requires 100 percent
of the unpaid principle balance for reserving purposes when default
is more likely than not to occur.  Including default probabilities in
the reserve calculation may be appropriate for loans where default is
not considered more likely than not, but once that threshold has been
determined, the full amount of the loan balance should be considered
in calculating the loss estimate. 


      INCLUDING HEALTH CARE TRENDS
--------------------------------------------------------- Letter :10.4

HUD stated that its methodology reflected current health care market
trends.  We agree that some health care market trends may be
reflected in hospitals' financial statements.  However, some rapidly
evolving health care market trends, such as managed care, may not be
reflected in the hospitals' financial statements that HUD uses
because of the time lag in financial reporting.  FHA's loan loss
reserve methodology does not include a mechanism to identify and
adjust for such trends.  Historical trends should be adjusted to
reflect changes in economic and business conditions, such as managed
care, in order to provide a reasonable estimate of current loss
exposure.  Data on hospitals' utilization rates may be used in
analyzing health care trends. 

HUD also commented on other issues that did not accurately reflect
the information presented in our report.  For example, HUD commented
that we found the program to be "consistent with and contributing
towards the mission of HUD." However, this is not a conclusion of our
report.  Our report cites the statements of HUD officials that the
program supports and is consistent with the Department's mission.  We
concluded that HUD's mission is broad enough to encompass the purpose
of the hospital program, not that it contributes to the mission of
HUD.  (See p.  18.)

HUD also commented that it agreed with our concern that the proposed
federal Medicare and Medicaid cuts could have a "significant adverse
impact on the hospital industry, including some hospitals with
mortgages insured by FHA." Our report does not make a value judgment
about the proposed federal Medicare and Medicaid reductions on the
hospital industry or hospitals in the program.  Instead, we report
that future changes in federal health care policies can restrict
hospital revenues and increase risks to the program.  (See p.  12.)

While HUD commented that our report noted "many urban community and
teaching hospitals need credit enhancement but cannot meet all of the
standards of the private insurers," we did not differentiate among
which types of hospitals need credit enhancement. 

HUD provided additional reasons for the program's concentration in
New York other than the state's reimbursement system.  Despite these
reasons and recent actions taken in efforts to address these risks,
the program's concentration and the large individual unpaid loan
balances in New York continue to pose program risks.  Specifically,
the concentration of the portfolio in New York makes the program
susceptible to New York policies and other factors specific to the
state.  (See p.  10.)

HUD also noted actions that it is initiating to geographically and
economically diversify its portfolio.  According to HUD comments,
these actions include increasing program awareness and developing new
products to meet market demands.  Although we recommended that HUD
pursue risk-sharing arrangements and suggested that the Congress
consider exploring with HUD options for reducing program risks; for
example, by limiting the program's risk exposure in a particular
state and capping mortgage insurance amounts, we do not endorse
expanding FHA's Hospital Mortgage Insurance Program.  By expanding
the program, FHA increases the program's total outstanding mortgage
amount.  In fact, because the overall impact of health care trends
and policy changes is unclear, we stated that to understand the
overall impact of these changes on the future of the program would
require further analysis given its original purpose and the current
composition of the portfolio.  (See p.  13.)


--------------------------------------------------------- Letter :10.5

We are sending copies of this report to appropriate congressional
committees; the Secretary of HUD; the Secretary of HHS; the Director,
Office of Management and Budget; and other interested parties.  We
also will make copies available to others on request. 

Please contact me at (202) 512-7119 if you or your staff have any
questions.  Other major contributors are listed in appendix VI. 

Sarah F.  Jaggar
Director, Health Financing
 and Public Health Issues


FINANCIAL PERFORMANCE OF FHA'S
HOSPITAL MORTGAGE INSURANCE
PROGRAM, FISCAL YEARS 1969-94
=========================================================== Appendix I

                  (Dollars in thousands\a)

                                                  Net cash
                              Net of    Salaries      flow
                            recovery         and      from
          Fees and               and  administra  operatio
Fiscal     premium  Claims   holding        tive    ns for
year        earned    paid    cost\b    expenses  the year
------  ----------  ------  --------  ----------  --------
1969           $11      $0        $0        ($1)       $10
1970           234       0         0        (12)       221
1971         1,255       0         0        (50)     1,205
1972         2,756       0         0        (86)     2,670
1973         4,144       0         0       (133)     4,012
1974         5,028  (26,86        13       (159)  (21,985)
                        7)
1975         5,356       0       991       (169)     6,178
1976         6,186       0     1,935       (243)     7,878
1977         9,117       0     1,990       (337)    10,770
1978        11,502       0     6,262       (363)    17,401
1979        11,150       0     2,582       (378)    13,354
1980        11,253  (12,10     2,407       (418)     1,137
                        5)
1981        13,763       0     2,409       (516)    15,656
1982        15,708       0     1,995       (548)    17,155
1983        18,640       0    12,040       (663)    30,017
1984        20,435       0       298       (673)    20,060
1985        22,369       0     7,061       (869)    28,560
1986        25,373       0     1,317       (876)    25,814
1987        27,385  (5,351     1,308       (898)    22,443
                         )
1988        25,335       0        29       (901)    24,463
1989        22,694  (34,60     1,432       (844)  (11,324)
                        6)
1990        23,450  (21,24     6,118       (872)     7,456
                        0)
1991        24,571  (91,17       803       (883)  (66,687)
                        9)
1992        22,866       0     6,420       (828)    28,458
1993        20,521  (4,202     5,897       (773)    21,442
                         )
1994        19,008  (4,180       474       (714)    14,589
                         )
==========================================================
Total     $370,110  ($199,   $63,781   ($13,207)  $220,953
                      730)
----------------------------------------------------------
Source:  FHA. 

\a These amounts were not adjusted for inflation. 

\b This column includes the amount FHA recovers from mortgage
payments and the sale of the mortgages or properties and the amount
paid in taxes, rent, insurance, maintenance, and other holding
expenses. 


FHA-INSURED HOSPITAL PROJECTS'
UNPAID PRINCIPAL BALANCES, BY
STATE, AUGUST 1995
========================================================== Appendix II

                                                                Unpaid
                                                                princi
                                                                   pal
                                                                balanc
Project                                                              e
--------------------------------------------------------------  ------
Arkansas
----------------------------------------------------------------------
1                                                               $1,365
                                                                  ,254
2                                                               1,235,
                                                                   236
Subtotal                                                        2,600,
                                                                   490

California
----------------------------------------------------------------------
1                                                               1,210,
                                                                   456
2                                                               599,44
                                                                     5
Subtotal                                                        1,809,
                                                                   901

Florida
----------------------------------------------------------------------
1                                                               11,362
                                                                  ,651
Subtotal                                                        11,362
                                                                  ,651

Illinois
----------------------------------------------------------------------
1                                                               6,063,
                                                                   326
Subtotal                                                        6,063,
                                                                   326

Kentucky
----------------------------------------------------------------------
1                                                               9,285,
                                                                   024
Subtotal                                                        9,285,
                                                                   024

Louisiana
----------------------------------------------------------------------
1                                                               2,493,
                                                                   799
Subtotal                                                        2,493,
                                                                   799

Maryland
----------------------------------------------------------------------
1                                                               9,099,
                                                                   451
Subtotal                                                        9,099,
                                                                   451

Massachusetts
----------------------------------------------------------------------
1                                                               151,98
                                                                 6,224
2                                                               30,637
                                                                  ,783
3                                                               27,398
                                                                  ,992
4                                                               6,725,
                                                                   307
5                                                               4,322,
                                                                   184
Subtotal                                                        221,07
                                                                 0,490

Michigan
----------------------------------------------------------------------
1                                                               15,279
                                                                  ,345
2                                                               3,773,
                                                                   294
3                                                               3,137,
                                                                   481
4                                                               922,37
                                                                     8
Subtotal                                                        23,112
                                                                  ,498

Missouri
----------------------------------------------------------------------
1                                                               4,305,
                                                                   135
Subtotal                                                        4,305,
                                                                   135

New Hampshire
----------------------------------------------------------------------
1                                                               2,537,
                                                                   862
Subtotal                                                        2,537,
                                                                   862

New Jersey
----------------------------------------------------------------------
1                                                               83,732
                                                                  ,411
2                                                               58,311
                                                                  ,090
3                                                               31,765
                                                                  ,110
4                                                               20,420
                                                                  ,021
5                                                               16,987
                                                                  ,817
6                                                               16,969
                                                                  ,713
7                                                               5,149,
                                                                   716
Subtotal                                                        233,33
                                                                 5,878

New York
----------------------------------------------------------------------
1                                                               590,79
                                                                 7,000
2                                                               380,24
                                                                 1,760
3                                                               372,43
                                                                 8,614
4                                                               364,19
                                                                 2,332
5                                                               204,57
                                                                 3,918
6                                                               140,97
                                                                 9,861
7                                                               136,55
                                                                 5,425
8                                                               131,41
                                                                 8,238
9                                                               110,11
                                                                 3,928
10                                                              94,763
                                                                  ,000
11                                                              91,896
                                                                  ,764
12                                                              88,735
                                                                  ,802
13                                                              88,678
                                                                  ,093
14                                                              87,755
                                                                  ,400
15                                                              72,560
                                                                  ,788
16                                                              70,722
                                                                  ,167
17                                                              64,465
                                                                  ,065
18                                                              60,866
                                                                  ,708
19                                                              58,959
                                                                  ,262
20                                                              52,714
                                                                  ,233
21                                                              50,420
                                                                  ,949
22                                                              43,470
                                                                  ,870
23                                                              42,298
                                                                  ,615
24                                                              40,740
                                                                  ,246
25                                                              38,213
                                                                  ,163
26                                                              36,501
                                                                  ,710
27                                                              36,030
                                                                  ,000
28                                                              35,091
                                                                  ,398
29                                                              30,720
                                                                  ,000
30                                                              30,580
                                                                  ,690
31                                                              30,081
                                                                  ,568
32                                                              27,242
                                                                  ,060
33                                                              26,940
                                                                  ,025
34                                                              26,633
                                                                  ,787
35                                                              25,750
                                                                  ,401
36                                                              25,124
                                                                  ,360
37                                                              23,062
                                                                  ,692
38                                                              22,089
                                                                  ,824
39                                                              21,143
                                                                  ,165
40                                                              21,028
                                                                  ,658
41                                                              20,430
                                                                  ,852
42                                                              19,908
                                                                  ,217
43                                                              18,726
                                                                  ,104
44                                                              18,223
                                                                  ,927
45                                                              17,171
                                                                  ,818
46                                                              15,597
                                                                  ,580
47                                                              15,593
                                                                  ,213
48                                                              15,557
                                                                  ,416
49                                                              15,449
                                                                  ,366
50                                                              14,857
                                                                  ,896
51                                                              14,664
                                                                  ,349
52                                                              14,088
                                                                  ,396
53                                                              13,929
                                                                  ,748
54                                                              11,860
                                                                  ,561
55                                                              9,385,
                                                                   082
56                                                              9,318,
                                                                   357
57                                                              8,256,
                                                                   858
58                                                              8,253,
                                                                   678
59                                                              7,487,
                                                                   455
60                                                              7,368,
                                                                   244
61                                                              5,411,
                                                                   324
62                                                              5,281,
                                                                   195
63                                                              1,423,
                                                                   221
Subtotal                                                        4,184,
                                                                837,39
                                                                     6

Oklahoma
----------------------------------------------------------------------
1                                                               387,47
                                                                     2
Subtotal                                                        387,47
                                                                     2

Pennsylvania
----------------------------------------------------------------------
1                                                               28,400
                                                                  ,264
2                                                               19,226
                                                                  ,647
3                                                               8,154,
                                                                   756
4                                                               7,578,
                                                                   058
Subtotal                                                        63,359
                                                                  ,725

Puerto Rico
----------------------------------------------------------------------
1                                                               15,782
                                                                  ,102
Subtotal                                                        15,782
                                                                  ,102

Texas
----------------------------------------------------------------------
1                                                               12,286
                                                                  ,708
Subtotal                                                        12,286
                                                                  ,708

Washington
----------------------------------------------------------------------
1                                                               220,09
                                                                     6
Subtotal                                                        220,09
                                                                     6

Wisconsin
----------------------------------------------------------------------
1                                                               8,989,
                                                                   065
2                                                               6,566,
                                                                   419
Subtotal                                                        15,555
                                                                  ,484
======================================================================
Total (100 projects)                                            $4,819
                                                                ,505,4
                                                                    88
----------------------------------------------------------------------
Source:  FHA Hospital Mortgage Insurance Program staff. 


HUD'S AND HHS' RESPONSIBILITIES IN
FHA'S HOSPITAL MORTGAGE INSURANCE
PROGRAM LOAN CYCLE
========================================================= Appendix III

                                                           HHS     HUD
------------------------------------------------------  ------  ------
Development
----------------------------------------------------------------------
Provide applicant guidance and assistance (including         x       x
 preapplication conference)
Conduct initial site visit to hospital                       x       x
Review and approve construction plans, specifications,       x
 and contracts
Engage independent feasibility consultant                            x
Recommend to HUD approval or disapproval of hospital's       x
 application
Make final underwriting determinations, conduct any                  x
 needed legal reviews, issue firm commitment, close
 and initially endorse loan
Conduct preconstruction conference, monitor                  x
 construction work, and process requests for advances
 of mortgage proceeds
Review cost certification, inform lender of maximum          x
 insurable mortgage amount, and process final advance
Arrange final closing and finally endorse mortgage                   x

Loan Management
----------------------------------------------------------------------
Monitor hospital's financial performance by reviewing        x
 financial statements and conducting periodic site
 visits
Receive, review, and recommend to HUD approval or            x
 disapproval of special requests and loan
 modifications (for example, partial release of
 security, transfer of physical assets, bond
 refundings, or major capital projects)
Approve special requests and loan modifications                      x
Conduct site visits to troubled hospitals to determine       x       x
 actions needed to prevent or cure defaults
Review quality and condition of insured hospital loan                x
 portfolio and determine amount of loan loss reserve

Assignment
----------------------------------------------------------------------
Receive/process assignment of loan and pay insurance                 x
 claim
Review assigned hospital's operational performance and       x       x
 financial condition and conduct site visits as needed
Receive, review, and recommend to HUD approval or            x
 disapproval of proposed workout agreements or
 mortgage modifications
Bill for and collect mortgage payments                               x

Disposition
----------------------------------------------------------------------
Analyze hospital's situation, evaluate alternative                   x
 uses, secure appraisal, make decision to foreclose,
 and arrange and hold foreclosure sale
Contract for management services and repairs, as                     x
 needed, to protect asset if HUD is mortgagee-in-
 possession or acquires hospital through foreclosure
 or deed-in-lieu
Develop marketing plan; advertise and sell hospital                  x
----------------------------------------------------------------------
Source:  FHA Hospital Mortgage Insurance Program staff. 


OBJECTIVES, SCOPE, AND METHODOLOGY
========================================================== Appendix IV

The specific objectives of our review were to (1) identify factors,
including those related to health care market trends, that could
affect the stability of the program's portfolio and provide
information on the program's financial performance; (2) evaluate the
methodology FHA used to estimate the program's fiscal year 1994 loan
loss reserve; (3) evaluate the relationship between the purpose of
the hospital mortgage insurance program and HUD's mission; and (4)
determine whether FHA has the expertise to manage the program. 

To identify factors that could affect the stability of the program's
portfolio, we (1) researched the literature and used HUD's 1992
internal report on the hospital mortgage insurance program; (2)
interviewed program officials in FHA and HHS headquarters and field
offices; (3) interviewed senior financial officers from seven
hospitals in New Jersey, New York, Puerto Rico, and Texas;\38 (4)
interviewed representatives from the Health Care Financing Study
Group, New Jersey Health Care Facilities Financing Authority, New
York State Medical Care Facilities Finance Agency, Goldman, Sachs &
Co., Merrill Lynch and Co., AMBAC Indemnity Corp., Municipal Bond
Investors Assurance Insurance Corp., Greater New York Hospital
Association, Healthcare Association of New York State, State of New
York Department of Health, the law firm of Krooth & Altman, and other
state health and hospital organizations that are knowledgeable about
or involved with the program; and (5) convened a panel of investment
bankers and hospital financial officers. 

We used the Health Care Financing Administration's Health Care
Provider Cost Report Information System, the New York State
Department of Social Services Medicaid Provider Ranking List, and the
New York State Department of Health's estimation of Medicaid cost
containment to demonstrate the effect of New York's fiscal year 1996
Medicaid spending reductions on program hospitals.  We calculated
1994 operating margins for 48 of 57 New York program hospitals.  Nine
hospitals did not have 1994 cost report information available or did
not have the state's estimation of Medicaid cost containment.  We
reduced calendar year 1994 net patient revenues by the New York State
Department of Health estimation of Medicaid cost containment.  Two
assumptions of our analysis were that (1) the effects of the proposed
changes on net patient revenue would be the same in each year and (2)
the hospitals took no action to reduce expenses. 

To evaluate the methodology FHA used to estimate its 1994 hospital
loan loss reserve, we reviewed the description of the hospital loan
loss analysis and other related documents.  We evaluated the
methodology and discussed the statistical estimation model and
assumptions FHA used with FHA and HHS officials.  Also, we
interviewed investment bankers and bond insurers to determine
conventional approaches private industry uses in estimating loss
reserves.  As agreed with Committee staff, we did not assess the
accuracy of the estimated amount of the program's loan loss reserve. 

To evaluate the relationship between the purpose of the hospital
program and HUD's mission, we reviewed and analyzed the applicable
laws, regulations, and policy statements related to the Department's
and FHA's missions.  We reviewed the legislative history to determine
the purpose of the program.  We also interviewed FHA officials to
discuss how the program's purpose supports HUD's mission. 

To determine whether FHA has the expertise to manage the program, we
interviewed agency officials and representatives from hospitals and
state health and hospital organizations, as previously mentioned. 
Our review of FHA's expertise to manage the program did not involve
an evaluation of risks to the program resulting from program
management or organization.  Our 1990 report and internal HUD studies
have previously addressed organizational issues.\39

The approach to accomplishing the objectives of this review was
discussed with and agreed to by staff from both the Senate and House
Banking Committees. 



(See figure in printed edition.)Appendix V

--------------------
\38 This was a nonrandom, judgmental sample of states.  Each state
was chosen because it illustrates one or more of the following:  (1)
a high proportion of the program's unpaid principal balance, (2)
several mortgage loans in default, (3) varying health care regulatory
environments, and (4) market trends in diverse geographic areas. 

\39 Financial Audit:  Federal Housing Administration Fund's 1988
Financial Statements (GAO/AFMD-90-36, Feb.  9, 1990); Federal
Managers' Financial Integrity Act Report for Fiscal Year 1991, HUD;
and Organizational Review of the Hospital Mortgage Insurance Program,
Office of Management and Planning, HUD (1992). 


COMMENTS FROM THE DEPARTMENT OF
HOUSING AND URBAN DEVELOPMENT
========================================================== Appendix IV



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)


MAJOR CONTRIBUTORS TO THIS REPORT
AND STAFF ACKNOWLEDGMENTS
========================================================== Appendix VI

MAJOR CONTRIBUTORS

James O.  McClyde, Assistant Director, (202) 512-7152
Madeline M.  Chulumovich
Janina R.  Johnson
Carmen Rivera-Lowitt
Connie Drake Wilson

ACKNOWLEDGMENTS

In addition to those named above, the following individuals also made
important contributions to this report as advisors and technical
assistants:  Linda Calbom, Robert C.  DeRoy, Austin J.  Kelly, Ann
McDermott, Luann M.  Moy, David Patrick Redmon, Mary W.  Reich,
Daynah K.  Shah, and William J.  Carter-Woodbridge. 


*** End of document. ***