HUD Management: FHA's Multifamily Loan Loss Reserves and Default
Prevention Efforts (Letter Report, 06/05/95, GAO/RCED/AIMD-95-100).

In recent years, the number of defaults on Federal Housing
Administration (FHA)-insured loans for multifamily housing has soared.
In 1994, FHA established loan loss reserves of $103 billion for its
multifamily portfolio. This represents the amount that HUD expects to
lose from future defaults on FHA-insured loans. This report evaluates
(1) the methodology that FHA used to set loan loss reserves for its
fiscal year 1993 multifamily portfolio; (2) the relative benefit of
creating a new, actuarially sound insurance fund for all new multifamily
housing insurance commitments; and (3) HUD's current initiatives for
preventing future defaults on FHA's multifamily housing loans.

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

 REPORTNUM:  RCED/AIMD-95-100
     TITLE:  HUD Management: FHA's Multifamily Loan Loss Reserves and 
             Default Prevention Efforts
      DATE:  06/05/95
   SUBJECT:  Budgetary reserves
             Mortgage protection insurance
             Mortgage loans
             Low income housing
             Loan defaults
             Federal aid for housing
             Mortgage programs
             Financial institutions
             Government guaranteed loans
IDENTIFIER:  HUD Section 8 Rental Assistance Program
             Special Risk Insurance Fund
             FHA Multifamily Loan Insurance Program
             
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Cover
================================================================ COVER


Report to Congressional Committees

June 1995

HUD MANAGEMENT - FHA'S MULTIFAMILY
LOAN LOSS RESERVES AND DEFAULT
PREVENTION EFFORTS

GAO/RCED/AIMD-95-100

FHA's Multifamily Loan Loss Reserve

(385426)


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

  FHA - Federal Housing Administration
  GAO - General Accounting Office
  HHS - Department of Health and Human Services
  HUD - Department of Housing and Urban Development
  OCCR - operating cost coverage ratio
  OIG - Office of Inspector General
  SWAT - Special Workout Assistance Team

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


B-260342

June 5, 1995

The Honorable Alfonse 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 (FHA), insures private lenders against
financial losses from borrowers' defaults on mortgages used to
finance multifamily rental properties.  In recent years, the number
of defaults on FHA-insured loans for multifamily housing has grown
significantly, increasing the government's payments to lenders for
insurance claims.  In 1994, FHA established loan loss reserves of
$10.3 billion for its multifamily portfolio as of September 30, 1993. 
These reserves represent the amount that HUD expects to lose from
future defaults on FHA-insured loans. 

This report was prepared to comply with the requirements in Public
Law 103-233, the Multifamily Housing Property Disposition Reform Act
of 1994, for a GAO report on the adequacy of the loan loss reserves
covering FHA's multifamily loan portfolio.  As agreed with your
offices, we evaluated (1) the methodology FHA used to establish loan
loss reserves for its fiscal year 1993 multifamily portfolio, (2) the
relative benefit of creating a new, actuarially sound
(self-sustaining) insurance fund for all new multifamily housing
insurance commitments, and (3) HUD's current initiatives for
preventing future defaults on FHA's multifamily housing loans.  Our
review focused on the loan loss reserve analysis that FHA completed
in 1994 covering its multifamily portfolio as of September 30, 1993. 
FHA's loan loss reserve analysis covering fiscal year 1994 was being
conducted during the latter part of our review and will be reported
in FHA's audited financial statements later this year. 


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

Overall, the methodology that FHA used to estimate its fiscal year
1993 loan loss reserves of $10.3 billion was reasonable and
represents an improvement over prior efforts.  However, the
reliability of FHA's estimate is limited by weaknesses in the
agency's (1) data, (2) use of several factors associated with
default, such as vacancy rates and the physical condition of
properties, and (3) assumptions about the probability of default. 
Although the cumulative impact of these weaknesses on the reliability
of FHA's estimate is difficult to quantify, our analysis of the
impact of only two of the weaknesses shows that FHA's estimate may be
more than a billion dollars higher or lower than the reserves
actually needed to cover future losses from defaults.  While loss
estimates are likely to vary because of the uncertainty associated
with any forecast, the cited weaknesses further increase the
uncertainty of the forecast. 

Creating an actuarially sound insurance fund for all new multifamily
housing commitments would probably have both advantages and
disadvantages.  On the positive side, requiring actuarial soundness
would eliminate the need for appropriations to cover anticipated
losses on new multifamily loans insured by FHA.  These
appropriations, which are required under the Credit Reform Act of
1990 and totaled $188 million for fiscal year 1995, could then be
applied to fund other programs or to reduce the federal budget
deficit.  On the negative side, requiring actuarial soundness might
entail FHA's reducing the amount of mortgage insurance that is
available for higher-risk loans, such as loans to finance the
construction of affordable housing for low-income persons in urban
areas.  Also, because defaults on insured multifamily loans are hard
to predict, FHA would probably have difficulty complying with a
requirement for actuarial soundness. 

To prevent future defaults, HUD is undertaking a number of
initiatives that should, if implemented effectively, strengthen its
ability to manage its multifamily portfolio and help it address
long-standing management deficiencies in its staffing, data systems,
and management controls.  These include using contractors to collect
more complete and current information on the physical and financial
condition of insured multifamily properties in order to help HUD
field offices more quickly identify troubled properties.  However, it
is still too early to determine how effective HUD's initiatives will
be.  Furthermore, HUD has not yet formulated specific plans to
develop data systems that can take full advantage of the new
information it plans to gain through its initiatives. 


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

HUD supports affordable multifamily rental housing for low- and
moderate-income families by providing FHA insurance for loans made by
private lenders.\1 When a default occurs on an insured loan, a lender
may assign the mortgage to HUD and receive payment from HUD for an
insurance claim.  HUD, in effect, becomes the new lender for these
loans, referred to as "HUD-held" loans.  As of September 30, 1994,
FHA's insured multifamily portfolio consisted of 15,147 loans with an
unpaid principal balance of about $45 billion, and the HUD-held
portfolio consisted of about 2,300 loans with an unpaid principal
balance of more than $7 billion. 

FHA's fiscal year 1993 loan loss reserve analysis was a multistep
process that evaluated the risk of default for a sample of insured
multifamily loans on the basis of eight factors, such as net income,
vacancy rate, and the physical condition of the properties.  FHA used
these results to divide the multifamily portfolio into five risk
categories--doubtful, substandard, standard, good, and excellent. 
FHA then calculated loss reserves on the basis of default assumptions
that it developed for each of the five risk categories.\2 (See app. 
I for a detailed discussion of FHA's methodology for estimating the
fiscal year 1993 multifamily loan loss reserves.)

In addition to estimating the losses from anticipated defaults on
loans in its current portfolio, FHA is required, under the Credit
Reform Act of 1990, to estimate the net costs to the government of
insuring new mortgage loans.  The Credit Reform Act was enacted to
better capture the government's cost of extending credit.  It
requires that, for credit instruments--including direct loans, loan
guarantees, and modifications to existing credit instruments--issued
by the government on or after October 1, 1991, budget authority be
provided to cover the government's cost before the loans, guarantees,
or modifications are made.  Through accounting and budgeting changes,
the federal budget now shows whether credit programs represent a cost
to the government (a positive credit subsidy), break even (a zero
subsidy cost), or make a "profit" (a negative credit subsidy).\3
Credit programs have positive credit subsidies when the present value
of the estimated costs to the government (from defaults and
delinquencies, interest rate subsidies, and other payments) is
greater than the present value of the estimated collections (from
payments, including interest and fees).  Conversely, programs have
negative credit subsidies when the present value of the estimated
collections is expected to exceed the present value of the estimated
payments. 

Preventing default is a primary function of HUD loan servicers, who
are responsible for overseeing project owners, management agents, and
lenders to ensure that multifamily properties are maintained in good
financial and physical condition.  HUD's activities for preventing
default include (1) management reviews to determine how a property is
being managed by the owner or management agent, (2) financial
statement reviews to assess a property's current and near-term
financial stability, and (3) physical inspections to determine
whether a property is being maintained in good physical condition. 


--------------------
\1 FHA uses its General Insurance Fund and Special Risk Insurance
Fund to account for claim payments and other cash flows, such as
premium receipts, associated with multifamily insurance programs. 

\2 FHA's loss amounts represent estimates of claim payments minus
recoveries from property sales. 

\3 These calculations are made before administrative costs are taken
into account. 


   FHA IMPROVED ITS METHODOLOGY,
   BUT DATA LIMITATIONS REDUCE THE
   RELIABILITY OF ITS LOSS
   ESTIMATES
------------------------------------------------------------ Letter :3

FHA deserves credit for improving its methodology for estimating its
multifamily loan loss reserves.  Responding to criticism from Price
Waterhouse and others of its previous approach, FHA revised its
methodology for analyzing the risk of default on its fiscal year 1993
multifamily portfolio.  FHA developed the revised process in
conjunction with a working group of outside housing and financial
experts, including representatives from the National Assisted Housing
Management Association, the Mortgage Bankers Association, and the
National Corporation for Housing Partnerships.  Financial and housing
experts with whom we spoke, such as senior officials from Price
Waterhouse and the National Corporation for Housing Partnerships,
believe that the methodology FHA used to estimate its fiscal year
1993 reserves was reasonable and represents an improvement over
earlier approaches.  For example, Price Waterhouse did not express an
opinion on FHA's fiscal year 1992 financial statements because FHA
was unable to reasonably estimate its multifamily loss reserves. 
However, Price Waterhouse was able to express an opinion on FHA's
fiscal year 1993 financial statements.\4

Nonetheless, Price Waterhouse also identified weaknesses, such as
missing data, that reduce the reliability of FHA's loss estimates. 
Other housing and financial experts, such as an executive vice
president from the National Corporation for Housing Partnerships and
the president of Recapitalization Advisors, Inc., a private company,
identified changes that they believe would improve FHA's estimates. 
These include changes in default assumptions and modifications in the
use of certain factors associated with default, such as vacancy rates
and the physical condition of properties.  Overall, we found that the
reliability of FHA's fiscal year 1993 loan loss estimate is reduced
by (1) data limitations, (2) shortcomings in the way several default
factors were used in the analysis, and (3) subjective assumptions
about default that are not linked to historical data.  Although the
impact of these weaknesses is difficult to quantify, their cumulative
effect is that FHA's estimate of $10.3 billion may be more than a
billion dollars higher or lower than the reserves actually needed to
cover losses from defaults.  While loss estimates are likely to vary
because of the uncertainty associated with any forecast, the cited
weaknesses further increase the uncertainty of the forecast. 


--------------------
\4 Price Waterhouse said that FHA's fiscal year 1993 financial
statements present fairly, in all material respects, the financial
position and results of FHA's operations and cash flows in conformity
with generally accepted accounting principles. 


      NUMEROUS DATA LIMITATIONS
      DECREASE THE RELIABILITY OF
      THE ANALYSIS
---------------------------------------------------------- Letter :3.1

Insufficient data on the financial and physical condition of
properties in FHA's multifamily portfolio limit the reliability of
FHA's fiscal year 1993 loan loss reserve estimate.  Because of data
limitations, FHA had to perform its risk analysis on a sample of
properties rather than on all of the properties in its insured
portfolio.  In contrast, financial institutions regularly review
their commercial loans individually to identify troubled or impaired
loans.  (See app.  II for a discussion of GAO's analysis). 

Furthermore, FHA often did not have complete information on the
properties in its sample.  For example, it could not obtain
sufficient information to analyze the condition of 15 percent of the
properties in its sample.\5 In addition, because it could not obtain
complete data for many of the remaining properties, it had to rank
most of the properties in its sample on the basis of an abbreviated
set of risk factors rather than the full set of eight.  Finally,
incomplete data prevented FHA from including information on 3-year
financial trends in its analysis, as it had originally planned.  Such
information is considered an excellent measure of a project's
potential for default. 


--------------------
\5 App.  I provides information on how FHA estimated the risk of
default on these loans (258 out of 1,766) in its loss reserve
analysis. 


      SOME RISK FACTORS DID NOT
      EFFECTIVELY PREDICT DEFAULT
---------------------------------------------------------- Letter :3.2

The reliability of FHA's fiscal year 1993 loan loss reserve estimate
is also limited by risk factors that, as used in the analysis, were
of questionable value in predicting default.  Specifically, the
vacancy rate, management review, and physical inspection factors were
of limited value in characterizing the risk in FHA's multifamily
portfolio. 

For example, FHA used a single overall vacancy rate scale to evaluate
the risk of default for all properties in the multifamily portfolio. 
According to housing industry experts, such as the president of
Recapitalization Advisors, Inc., this approach fails to recognize
that properties in different housing programs may vary in their
ability to withstand vacancies.  According to Price Waterhouse, the
impact of FHA's using the vacancy rate factor was to understate the
loan loss reserve estimate. 

In addition, the management review and physical inspection factors
were often based on properties' scores for other factors because
reports from management reviews and physical inspections were not
available for many of the properties in the sample.  For example,
approximately 75 percent of the properties that remained in the
sample did not have a management review report, approximately 39
percent did not have a physical inspection report, and 35 percent did
not have either a management review or a physical inspection report. 
Furthermore, although assessing a property's physical condition is
important in evaluating the risk of default on a mortgage loan, the
approach FHA used for such assessments may not be adequate to measure
that risk.  Instead of assessing the costs of needed repairs and
maintenance, FHA used subjective evaluations (superior, above
average, satisfactory, below average, unsatisfactory) of physical
conditions that inspectors included in their reports of physical
inspections. 


      FHA USED DEFAULT ASSUMPTIONS
      THAT WERE NOT BASED ON
      HISTORICAL DATA
---------------------------------------------------------- Letter :3.3

The reliability of FHA's 1993 loan loss reserve estimate was further
limited because FHA was unable to test its assumptions about the
probability of default on multifamily loans.  Since FHA has not
divided its loans into risk categories and tracked their performance
over time, it does not have the historical information needed to test
the validity of its assumptions about the rate of default for
properties in each risk category and the time frames during which
defaults are likely to occur. 

FHA's use of untested assumptions introduced further uncertainty into
the loan loss reserve estimate.  Housing industry experts believe
that FHA's assumptions about the rate and the timing of default were
conservative and caused FHA to overestimate the reserves needed to
cover future defaults.  In particular, they pointed to FHA's
assumptions that defaults would occur (1) within 4 years on 100
percent of the properties characterized as "doubtful" and (2) within
5 years on 75 percent of the properties characterized as
"substandard." Small changes in these assumptions have a significant
impact on the final loan loss reserve estimate.  For example,
reducing the default rate from 75 percent to 70 percent for the
properties characterized as "substandard" would lower the reserve
estimate by approximately $350 million. 

During its financial audit of FHA for fiscal year 1993, Price
Waterhouse raised questions about the assumptions used because they
produce estimated default rates that are almost four times as high as
the actual average rate over the past 5 years.  However, FHA
management believes the assumptions are realistic because many
properties in the multifamily portfolio are older properties that
need major repairs, which many owners will be either unwilling or
unable to make.  In addition, FHA management believes the subsidies
needed to keep many of the properties operational will not be
increased and may even be reduced, whereas the loan loss reserve
analysis assumed the continuation of the current subsidies.  In any
event, the assumptions' accuracy cannot be evaluated until FHA
develops a method for tracking the behavior of the loans in its
various risk categories--something it has not yet done. 


      FHA PLANS TO INTRODUCE
      LIMITED CHANGES IN ITS
      METHODOLOGY FOR 1994
---------------------------------------------------------- Letter :3.4

The process FHA is using for its fiscal year 1994 analysis is
substantially the same as for the prior year's, with only a few
exceptions.\6 For example, FHA is attempting to improve the
predictive value of its vacancy rate factor by using different scales
for subsidized and unsubsidized properties.  However, data
deficiencies still preclude the use of 3-year financial trends in
estimating the fiscal year 1994 reserves, and FHA's estimate will
again be based on an analysis of a sample of multifamily properties. 
According to the Deputy Assistant Secretary for Multifamily Housing
Programs, FHA is using a sample for the fiscal year 1994 reserve
analysis so that it can expedite the analysis.  She said the data
limitation that led FHA to use a sample for fiscal year 1993 has been
overcome because FHA now has reliable financial data on most of the
properties in its insured multifamily portfolio.  The Deputy
Assistant Secretary also said that in the future, FHA plans to
analyze all of the insured properties when developing loan loss
reserves. 

FHA has recognized the need to test the accuracy of the factors and
assumptions it uses in its loan loss reserve analysis.  Currently, 48
properties, which were classified as substandard or doubtful in the
fiscal year 1993 analysis, are being reviewed to determine their
condition because field offices have told headquarters that a number
of the properties in the two categories are actually in good
condition.\7 This review could identify problems or limitations
associated with the factors.  Additionally, HUD officials said they
plan to test the accuracy of the default assumptions used in the
analysis by reviewing the loans on which borrowers default in fiscal
year 1995.  These loans would be analyzed according to the current
methodology to determine whether the loan loss reserve analysis would
have identified the loans as being at risk.  Because this review
would not track the performance of loans in the loss reserve sample
over time, it would provide only indirect feedback on the accuracy of
the default assumptions used.  Furthermore, FHA has no immediate
plans to implement this test.  It is not clear at this time what
additional actions, if any, FHA plans to take to test the reliability
of its default assumptions. 


--------------------
\6 The loan loss reserve for fiscal year 1994 will be reported in
FHA's audited financial statements later this year. 

\7 These reviews are being done by the Special Workout Assistance
Teams discussed in the following section on preventing default. 


   A REQUIREMENT FOR ACTUARIAL
   SOUNDNESS COULD HAVE BOTH
   ADVANTAGES AND DISADVANTAGES
------------------------------------------------------------ Letter :4

Currently, FHA is not required to conduct its multifamily loan
insurance program on an actuarially sound (self-sustaining) basis. 
For fiscal year 1995, the Congress appropriated $188 million in
credit subsidies to cover expected losses on new insured loan
commitments.  Requiring new multifamily loan commitments to be made
on an actuarially sound basis would allow these subsidies to be used
for other purposes; however, it could also have some drawbacks and
create implementation problems. 


      CREDIT REFORM ACT REQUIRES
      FHA TO ESTIMATE NEEDED
      SUBSIDY
---------------------------------------------------------- Letter :4.1

To comply with requirements of the Credit Reform Act, FHA must each
year estimate the costs to the government of providing mortgage
insurance for new multifamily loan commitments.  FHA generally
estimates these costs for each program, taking into account the
amount of the mortgage insurance it expects to provide.  First, it
estimates the payments it expects to make over the life of the loans,
primarily to cover the claims against its insurance fund arising from
defaults.  Then, it estimates its collections from mortgage insurance
premium payments and recoveries on loans that have defaulted. 
Comparing the estimated payments with the estimated collections, FHA
then determines whether the program is likely to have a positive or a
negative credit subsidy and calculates the credit subsidy rate.  If
the program has a positive subsidy rate, FHA must request
appropriations to cover the expected cost to the government.\8


--------------------
\8 Although an appropriation is provided each year to cover future
losses expected on each year's portfolio of insured mortgage loans,
these losses are not financed until claims against the Treasury
occur. 


      REQUIRING ACTUARIAL
      SOUNDNESS WOULD FREE FUNDS
      FOR OTHER USES
---------------------------------------------------------- Letter :4.2

A primary benefit of requiring the establishment of an actuarially
sound insurance fund for all new multifamily commitments is that it
would free the funds now used to provide credit subsidies for other
purposes.  For fiscal year 1995, FHA received approximately $188
million in appropriations for credit subsidies on new multifamily
loans.  These credit subsidies were associated with approximately $5
billion in expected loan commitments.  The largest appropriations
were requested for the following purposes:\9

  Approximately $85 million was requested for insured loans to
     for-profit borrowers for new construction or for the substantial
     rehabilitation of rental housing under section 221 (d)(4) of the
     National Housing Act.  According to an FHA multifamily
     development official, most of these insured loans were expected
     to be for the development of market-rate properties, although
     some loans for low-income properties were also expected. 

  Approximately $40 million was requested for risk- sharing
     arrangements with state and local housing finance agencies under
     section 542 (c) of the Housing and Community Development Act of
     1992.  Under these arrangements, housing finance agencies agree
     to take between 10 percent and 90 percent of the risk of loss on
     loans for new construction or for the substantial rehabilitation
     of multifamily properties. 

Appendix III provides additional information on programs for which
FHA received funds to provide credit subsidies in fiscal year
1995.\10

Eliminating the appropriations for mortgage insurance commitments
would allow the funds to be used for other federal programs or for
reducing the federal budget deficit.  According to one congressional
staff member, some funds currently used for credit subsidies might
better be used for subsidies (such as federal rental assistance) that
are more directly targeted to persons with lower incomes. 

Another potential benefit of a requirement for actuarial soundness is
that it could further pressure FHA to reduce the risk of default on
insured multifamily loans by improving its loan underwriting and loan
servicing.  FHA's current and planned actions to reduce defaults on
multifamily loans are discussed later in this report. 


--------------------
\9 FHA officials told us that these requests were based on the
assumption that a planned increase in mortgage insurance premiums
would take effect in January 1995.  Because FHA subsequently decided
to delay this increase, the officials told us that FHA was requesting
a reallocation of the appropriations it received for multifamily
credit subsidies. 

\10 For fiscal year 1995, FHA also planned to approve mortgage
insurance on $3.6 billion in new multifamily loan commitments for
programs that have negative credit subsidies, including insurance on
loans for nursing homes and hospitals and equity take-out loans to
owners of projects that agree to preserve property units for families
with lower incomes. 


      REQUIREMENT FOR ACTUARIAL
      SOUNDNESS HAS POTENTIAL
      DISADVANTAGES
---------------------------------------------------------- Letter :4.3

According to FHA multifamily housing officials and housing experts we
contacted, requiring actuarial soundness for new multifamily loan
commitments could have some disadvantages and could cause some
implementation problems, including the following: 

  It could lead FHA to reduce insurance availability for affordable
     low-income housing as a way to reduce expected losses on
     multifamily loans.  For example, the Director of FHA's Office of
     Insured Multifamily Housing Development believed that a
     requirement for actuarial soundness could cause FHA to reduce
     the number of loans for affordable housing in central cities
     that it insures under section 221(d)(4) of the National Housing
     Act because the risk of default on such loans is generally
     relatively high. 

  It could cause FHA to substantially increase the insurance premiums
     it charges for multifamily loans, which could increase housing
     costs and reduce the demand for FHA insurance.  Increases in
     insurance premiums could also create an "adverse selection"
     problem if borrowers financing "lower-risk" loans decided not to
     apply for FHA insurance because of its increased cost.  The
     overall risk of the loans that FHA insures would then increase,
     and further premium increases might be required. 

  It could create additional pressure for FHA to "cross-subsidize"
     its insured loan origination activities.  In theory, FHA could
     insure more "profitable" loans (i.e., loans with negative credit
     subsidies) or raise its mortgage insurance premiums on such
     loans.  Then, it could use the increased negative credit
     subsidies to offset losses on loans with positive credit
     subsidies.  However, if FHA increased the premiums for
     "profitable" loans, it might receive fewer applications for
     insurance, and its cross-subsidization efforts would be
     frustrated. 

  It could create compliance problems because defaults on multifamily
     loans are difficult to predict.  To ensure that receipts were
     adequate to cover the government's costs of insuring multifamily
     loans, FHA would have to be able to accurately estimate the
     government's future liability for default claims.\11

However, the methodology FHA now uses cannot be relied on to produce
accurate estimates of such claims.  This methodology is based
primarily on historical cash-flow analyses carried out by Price
Waterhouse as part of a 1992 study.  Price Waterhouse initially
attempted to develop econometric models to estimate loan defaults and
prepayments.  However, its attempts were not successful for several
reasons, including the following:  (1) financial variables that
predict loan failure were difficult to forecast; (2) many factors
affecting projects' performance, such as management, were assessed
qualitatively and could not easily be modeled; and (3) key factors
(such as projects' ownership structure and tax considerations) needed
to understand owners' decisions to continue or cease mortgage
payments were not known. 

In spite of the potential problems associated with imposing a
requirement for actuarial soundness, FHA's Deputy Assistant Secretary
for Multifamily Housing Programs told us that FHA was looking at
whether FHA could carry out its future multifamily insurance
activities on a self-sustaining basis.  She also said that FHA was
looking into ways to improve the way it calculates credit subsidies
and sets mortgage insurance premiums. 


--------------------
\11 In our October 1993 report Housing Finance:  Expanding Capital
for Affordable Multifamily Housing (GAO/RCED-94-3), we noted that the
difficulty in accurately determining the price of subsidies
associated with federally supported credit enhancements for
multifamily housing was linked to the lack of data on the performance
of multifamily loans.  We stated that a national data base on the
performance of multifamily housing loans could improve compliance
with requirements of the Credit Reform Act and also help provide
investors with the information they need to consider increasing their
investments in affordable multifamily housing. 


   THE IMPACT OF HUD'S DEFAULT
   PREVENTION INITIATIVES IS
   UNCERTAIN
------------------------------------------------------------ Letter :5

HUD has recognized the need to develop alternative approaches to
prevent default and has undertaken several initiatives to better
manage its multifamily portfolio and correct long-standing
deficiencies in staffing, data systems, and management controls. 
These initiatives are aimed, in large measure, at obtaining the
basic, reliable data about the financial and physical condition of
the properties that are needed for effective oversight.  If
implemented effectively, the initiatives should enable HUD to better
manage its multifamily portfolio.  However, because most are being
planned or are just starting to be implemented, it is too early to
determine their effectiveness.  Furthermore, the effectiveness of
some will depend upon improvements in HUD's multifamily's data
systems. 


      IDENTIFIED MANAGEMENT
      DEFICIENCIES HAVE GONE
      UNCORRECTED FOR MANY YEARS
---------------------------------------------------------- Letter :5.1

Over the last two decades, GAO, Price Waterhouse, and HUD's Office of
Inspector General (OIG) have frequently reported that HUD has not
effectively managed its insured multifamily portfolio.  Since 1987,
HUD itself has reported its multifamily loan servicing as a material
weakness under the Federal Managers Financial Integrity Act (FMFIA). 
Because of inadequate management, a number of insured multifamily
properties provide very poor living conditions for families with low
incomes.  Inadequate management has also contributed to a large
number of past and anticipated defaults on FHA-insured loans. 

Long-standing deficiencies in staffing, data systems, and management
controls have impeded HUD in managing its portfolio.  For example,
HUD does not have enough staff with the proper skills to service its
loans.  As HUD's OIG and HUD staff have repeatedly noted, inadequate
staffing and resources have hampered the performance of fundamental
FHA activities, such as monitoring the insured loan portfolio and
servicing HUD-held mortgages. 

HUD also lacks the data systems it needs to adequately support its
loan-servicing functions.  According to HUD's OIG, HUD's automated
data systems cannot be relied on to provide relevant, timely,
accurate, or complete information on a project's physical or
financial condition or on the project's management.  GAO has also
found that HUD's systems do not adequately support the early
detection of problem loans and the management of actions to correct
loan problems. 

Weaknesses in management controls--including the physical
inspections, financial statement reviews, and management reviews
performed by its field offices--have prevented HUD, according to its
OIG, from consistently identifying and resolving problems that could
lead to insurance claims, excessive rental subsidies, and/or
substandard living conditions.  In addition, field offices have not
adequately followed up with owners and management agents to ensure
that identified problems have been corrected.  Similarly, GAO has
found that although HUD has a wide range of enforcement tools--such
as the option to limit an owner's future participation in HUD
programs--to ensure that owners maintain their properties, HUD uses
these tools sparingly and inconsistently. 


      HUD IS BEGINNING TO
      IMPLEMENT DEFAULT PREVENTION
      INITIATIVES
---------------------------------------------------------- Letter :5.2

HUD is undertaking several initiatives to resolve the weaknesses in
its staffing, data, and management controls and to improve its
ability to prevent defaults in its multifamily portfolio.  Each of
these initiatives has the potential to reduce one or more of HUD's
major weaknesses. 

To reduce the workload of its field office staff and provide them
with current information on the physical condition of the properties
for which they are responsible, HUD has, for several years, allowed
its regional offices to hire contractors to perform physical
inspections.  In February 1994, HUD also hired a contractor to
collect and analyze financial statement data for its insured
multifamily properties and to teach its field office staff how to
interpret the data.  Once these data are collected, HUD plans to use
them in an "early warning system" it is developing to improve its
field offices' ability to quickly detect projects with financial
problems. 

In November 1994, HUD trained and organized a 24-member Special
Workout Assistance Team (SWAT) to help its field offices deal with
troubled insured multifamily properties.  Together, the team members
and field office staff will analyze selected properties, identify
problems, and develop strategies to resolve these problems.  Through
these joint efforts, HUD hopes to improve conditions at 100 to 150
troubled properties during the first year and, as a by-product of the
collaboration, to enhance the training of its field staff.  HUD has
also contracted for the development of a loss mitigation handbook
that will provide further guidance to field offices on diagnosing and
treating projects where a default seems likely. 

HUD has begun to work with various mortgagees to improve its data on
individual projects and to ensure that the mortgagees adequately
carry out their loan-servicing responsibilities.  For example, the
Director of HUD's Office of Multifamily Housing Management said that
HUD is in the process of establishing an electronic linkage with
mortgagees to give it immediate, central access to information on
loan delinquencies and defaults.  Currently, this information is sent
to the field offices in written reports and may arrive too late for
HUD to take effective action.  HUD is also planning to develop
standardized physical inspection requirements for mortgagees so that
it can rely more on their inspections, with the long-term goal of
eliminating the need for HUD to conduct its own inspections.  Some
field offices now consider mortgagees' inspections unreliable. 

In late 1994, HUD began to sell HUD-held mortgages as a way to reduce
the workload of its loan-servicing staff and help to solve its
staffing problems.  Servicing HUD-held mortgages consumes a large
share of staff time and resources.  As these mortgages are sold, FHA
can devote more of its asset management staff and resources to
monitoring its insured mortgage portfolio. 

In addition to these default prevention initiatives, HUD is also
developing a proposal that would "reinvent" the way that FHA carries
out its multifamily activities.  As part of this reinvention, FHA
would be recreated as a government-owned, market-driven enterprise. 
In addition, multifamily properties that receive rental assistance
from HUD (Section 8 subsidies) and have rents above the fair market
rent would be "marked to market"--that is, Section 8 rents would be
lowered to reflect comparable market rents.  For insured multifamily
properties, the mark-to- market proposal also calls for restructuring
the mortgage debt to allow the property to continue to operate at the
new (lower) rents.  Furthermore, the reinvention proposal calls for
phasing out rental assistance that is tied to individual properties
(project-based Section 8 subsidies) and replacing it with rental
assistance that is provided directly to tenants, who could choose
where to live.  Because this proposal is still being drafted, it is
not yet clear what impact it would have on HUD's default prevention
activities. 


      DEFAULT PREVENTION
      INITIATIVES HAVE SOME
      LIMITATIONS
---------------------------------------------------------- Letter :5.3

HUD's initiatives represent a step in the right direction and should
enable HUD to better manage its multifamily portfolio.  However,
because they are still being planned or have just started to be
implemented, it is difficult to assess their full impact or determine
whether they go far enough in addressing HUD's problems. 
Furthermore, they have some limitations, particularly in the area of
data systems.  For example, it is not clear when FHA can expect to
have the basic data systems it needs to support its portfolio
management activities.  In addition, its data systems lack several
key capabilities used by other organizations involved in multifamily
housing.\12 GAO identified a number of these capabilities: 

  Financial statement and physical inspection data are supplied by
     outside parties on electronic media that provide for efficient
     and accurate data collection. 

  Information systems compile data from assessments of projects'
     financial condition, physical condition, and management and
     compare the results against criteria to identify high-risk
     loans. 

  Information systems track progress in implementing corrective
     action plans developed for troubled or potentially troubled
     properties. 

According to loan management officials at these organizations with
multifamily loan portfolios, these capabilities enabled them to
efficiently monitor the quality of the information provided by their
contractors, develop and refine their criteria for potentially
troubled loans, rank all of their loans on the basis of risk for the
purpose of estimating loss reserves, and measure their progress
toward meeting management goals for identifying and resolving loan
problems.  Although HUD does not have specific plans for developing
these capabilities, it does intend to continue developing an early
warning system that will consider data on a project's physical
condition and management as well as financial data. 

The SWAT initiative also has potential limitations.  Given the
limited resources allocated to the effort and the many properties
with physical and financial problems, it is not clear how long this
initiative will take to have an effect on the management of HUD's
insured multifamily portfolio.  A capital needs assessment of the
insured properties, conducted in 1992, showed that about 3,200 had
physical and/or financial problems severe enough to jeopardize
tenants' well-being, impair sound operations, or lead to financial
failure.  At the planned rate of 100 to 150 projects per year, the
teams are likely to be in business for many years, even if they train
HUD field staff to extend their efforts. 

Another potential limitation of these default prevention initiatives
is that most of them will require a sustained commitment to
developing staff and systems and improving portfolio management. 
According to Price Waterhouse, HUD has been unable to fully correct
FHA's problems because its follow-through on planned actions has been
incomplete or spotty.\13 In recent testimony before the House
Committee on Banking, Housing, and Urban Affairs, the Inspector
General also noted with concern that HUD is not making progress in
developing adequate data systems in the multifamily area. 


--------------------
\12 Information was obtained from the Federal Home Loan Mortgage
Corporation, the Federal National Mortgage Association, and the
Massachusetts Housing Finance Agency. 

\13 Price Waterhouse noted that, in some cases, budgetary or
legislative constraints contributed to HUD's inability to follow
through on its plans. 


   CONCLUSIONS
------------------------------------------------------------ Letter :6

FHA deserves credit for improving its loan loss reserve methodology
as well as for planning to (1) rank all of its multifamily properties
on the basis of risk and (2) include the assessment of 3-year
financial trends among the factors it considers in estimating future
reserves.  However, these improvements cannot be implemented before
the fiscal year 1995 loss reserves are established in 1996. 
Consequently, some of the problems that prevented FHA from accurately
and reliably estimating its future losses from defaults for fiscal
year 1993 will also impair its estimate for fiscal year 1994. 
Furthermore, until FHA develops a system for tracking the performance
of loans in its portfolio, it will not be in a position to assess the
accuracy of the default assumptions it used to estimate its loan loss
reserves.  Although FHA plans to test its default assumptions by
retroactively ranking the risks of the loans that fail in 1995, this
action will provide only indirect feedback on the accuracy of the
default assumptions used and will not adequately test the accuracy of
these assumptions.  In addition, FHA has no immediate plans to
implement this test. 

Through its default prevention initiatives, HUD should be able to
better manage its multifamily portfolio and to partially correct its
staffing, data, and management control weaknesses.  However, HUD's
initiatives have some limitations, particularly in the area of data
systems.  Although HUD is taking steps to collect better data on its
multifamily portfolio, it has not yet developed specific plans for
incorporating analytical and tracking capabilities into its data
systems that will allow it to gather data through electronic media on
the financial and physical condition and on the management of the
multifamily projects in its portfolio, take corrective actions, and
monitor the progress of its corrective actions. 


   RECOMMENDATIONS
------------------------------------------------------------ Letter :7

To estimate its loan loss reserves more reliably, we recommend that
the Secretary of HUD direct the Deputy Assistant Secretary for
Multifamily Housing to establish a process for tracking the
performance of its multifamily projects to obtain the data needed to
test the accuracy of its assumptions about default.  In addition, to
obtain the information it needs to manage its multifamily portfolio
effectively and to measure its performance, we also recommend that
the Secretary direct the Deputy Assistant Secretary to develop
specific plans for incorporating capabilities into its data systems
that will allow it to (1) gather data through electronic media on the
financial and physical condition and on the management of the
multifamily projects in its portfolio, and (2) track the progress of
projects in implementing actions to prevent default. 


   AGENCY COMMENTS AND OUR
   EVALUATION
------------------------------------------------------------ Letter :8

On March 2, 1995, we provided a draft of this report to HUD. 
Responding on April 14, 1995, HUD agreed with our assessment that its
fiscal year 1993 loan loss reserve estimate was imprecise; however,
it maintained that highly precise loan loss reserve estimates are not
achievable because of the many uncontrollable events and lengthy time
frames involved.  We agree that loss estimates are likely to vary
because of the uncertainty associated with any forecast, but we
believe that the weaknesses cited in this report further increased
the uncertainty of HUD's fiscal year 1993 estimate.  HUD also stated
that samples may be used appropriately in developing loan loss
reserves.  Our report does not assert that HUD's loan loss
methodology was flawed because a sample was used.  Our point is that
the use of a sample reduces the reliability of FHA's loan loss
reserve estimate and that this increased uncertainty should be
recognized. 

HUD also stated that the shortcomings we identified in the fiscal
year 1993 reserve estimate have been addressed in calculating the
1994 estimate.  While we recognize that HUD has taken some steps to
overcome weaknesses in its fiscal year 1993 estimate, its fiscal year
1994 estimate will not address all of the problems we identified. 
For example, data deficiencies still preclude the use of 3-year
financial trend data, and management reviews and physical inspection
reports, as used in the analysis, still may not be adequate to
measure the risk of default.  We note that HUD's response does,
however, anticipate methodological changes in the future. 
Specifically, FHA reported that it would hire a large certified
public accounting firm to review its present methodology and to
recommend and develop an enhanced model for estimating its fiscal
year 1995 loan loss reserves. 

Finally, HUD disagreed with our assessment that the use in the
analysis of subjective default assumptions reduced the reliability of
the estimate.  HUD stated its preference for "relevant judgment-based
data over objective nonrelevant data," defining historical default
data as nonrelevant and suggesting that GAO supports the use of
historical data alone in estimating future defaults on loans.  HUD's
response misinterprets our position.  Our report never suggests that
HUD base its loan loss reserve estimate on unadjusted historical
data.  However, in our view, prudence would dictate the use of
objective, historical data on defaults as a benchmark, adjusting
these data as necessary to reflect current and/or changing
conditions.  Furthermore, the reliability of the loss estimates would
be enhanced if HUD would test the validity of its assumptions about
the rate of default for properties in each risk category and the time
frames during which defaults are likely to occur by comparing these
assumptions with actual performance over time.  Consequently, we
believe that our recommendation that HUD test the accuracy of its
default assumptions by establishing a process for tracking the
performance of FHA's multifamily projects is still valid.  In its
comments, HUD does not indicate what steps, if any, it will take in
response to this recommendation. 


---------------------------------------------------------- Letter :8.1

We conducted our review from August 1994 to May 1995 in accordance
with generally accepted government auditing standards.  (See app.  IV
for a discussion of our scope and methodology.)

We are sending copies of this report to appropriate congressional
committees, the Secretary of Housing and Urban Development, the
Director of the Office of Management and Budget, and other interested
parties.  We will make copies available to others upon request. 

Please contact me at (202) 512-7631 if you or your staff would like
additional information on this report.  Major contributors to this
report are listed in appendix V. 

Judy A.  England-Joseph
Director, Housing and Community
 Development Issues


METHODOLOGY FOR FHA'S FISCAL YEAR
1993 MULTIFAMILY LOAN LOSS RESERVE
ANALYSIS
=========================================================== Appendix I

The Federal Housing Administration (FHA) established its fiscal year
1993 loan loss reserves by (1) evaluating the risk of default for a
sample of multifamily projects on the basis of a set of factors, (2)
using these results to divide the multifamily portfolio into five
risk categories, and (3) calculating loan loss reserves on the basis
of default assumptions for each of the five categories.  To estimate
the loan loss reserves, FHA divided its insured multifamily portfolio
into two groups:  multifamily rental properties (including coinsured
properties) and hospitals.  While the analyses for the two groups of
projects were similar, FHA separated the hospitals from the rest of
the portfolio because (1) factors that affect the financial
performance of hospitals do not necessarily affect the financial
performance of multifamily rental properties and vice versa and (2)
staff from the Department of Health and Human Services (HHS), not FHA
staff, are responsible for monitoring the financial performance of
the hospitals in FHA's multifamily portfolio. 


   SAMPLE SELECTION
--------------------------------------------------------- Appendix I:1

FHA based its analysis on a sample of 1,766 multifamily projects. 
FHA allocated sample projects to each of 12 multifamily programs on
the basis of each program's share of the total balance of the
multifamily portfolio.  For example, the section 221(d)(4) program
had an unpaid principal balance of $15.5 billion as of April 30,
1994, equivalent to 45.84 percent of the multifamily portfolio's
unpaid principal balance.  FHA therefore allocated 45.84 percent of
the sample projects--or 809 projects--to the 221(d)(4) program.  FHA
selected individual projects for inclusion in the sample by applying
a random selection process to the projects in each program. 

In addition to analyzing the 1,766 multifamily projects in the
sample, FHA intended to analyze all existing coinsured projects in
its multifamily portfolio.  However, data limitations allowed FHA to
include only 388 coinsured projects whose unpaid principal balances
totaled approximately $3.08 billion (approximately 90 percent of the
coinsured dollars in FHA's multifamily portfolio).  FHA also selected
34 hospitals whose unpaid principal balances totaled approximately
$1.84 billion.  The hospitals were identified through a hospitals
"Credit Watch List" maintained by HHS and represented hospitals
identified by HHS staff and others as being financially unsound. 


   DEFAULT RISK FACTORS
--------------------------------------------------------- Appendix I:2

Projects in the sample were evaluated against a series of weighted
performance indicators designed to measure the risk of default for
each project.  FHA set performance standards for each of the
indicators and compared financial, physical, and management
information for each project with the standards.  Projects
accumulated risk points through a comparison with FHA's
standards--fewer points were assigned for good performance, and more
points were assigned for poor performance.  Table I.1 lists the
indicators, their computations, and their weights. 

Many of the projects in the sample did not have all of the
information needed for ranking.  Therefore, FHA specified that, in
order to be ranked, a project had to have information for two of the
following three financial indicators:  (1) the operating cost
coverage ratio (OCCR), (2) the current ratio, and (3) the reserve for
replacement per unit.  FHA believed that two of these three ratios
could adequately capture the risk of default for a project.  The
remaining information, while of value in the analysis, was not
considered to be vital to "risk rank" a project.  To derive a total
score for projects with incomplete data, FHA imputed their scores on
the basis of the points assigned for known financial indicators.  For
example, a subsidized project that received 20 risk points for three
financial indicators with a weight of 40 points would receive 50
percent of the points for each of the remaining, unknown risk
indicators. 



                               Table I.1
                
                  Performance Indicators Used in FHA's
                   Fiscal Year 1993 Loan Loss Reserve
                                Analysis

                                  Weight
                                  (point
Indicator                             s)  Formula
--------------------------------  ------  ----------------------------
Operating cost coverage               15  Total revenue
 ratio                                     Total revenue ï¿½(profit/
                                           loss + depreciation) +
                                           principal due + reserve for
                                           replacement deposit
                                           required
Reserve for replacement per unit      15  Reserve for replacement
                                           account balance
                                           Total project units
Current ratio                         10  Current assets
                                           Current liabilities
Vacancy rate                          10  Vacancy rate
                                           Total rental revenue
Subsidy rate                           5  Tenant assistance payments
                                           +
                                           flexible subsidy
                                           payments\a
                                           Total revenue
Net income                             5  Net profit/loss
                                           Total revenue
Physical inspection                   15  Based on evaluation summary
Management review                      5  Based on evaluation summary
----------------------------------------------------------------------
Note:  Projects were scored on a scale of 80 rather than 100 points
because FHA could not use 3-year trends in its analysis.  FHA
originally planned to allocate 20 points for 3-year trends. 

\a Flexible subsidy payments are FHA funds used to restore or
maintain the physical and financial soundness of troubled projects. 

FHA determined that 258 loans in its sample did not have the minimum
data required for evaluation.  These were put in an unranked category
and dropped from the initial steps of the analysis because FHA could
not determine their risk of default. 


   DEFAULT RISK CATEGORIES
--------------------------------------------------------- Appendix I:3

FHA used the total points accumulated by each project to place it in
one of five risk categories.  The risk categories corresponded to the
relative risk of default for the projects.  Projects that compared
favorably with FHA's standards for each of the risk factors
accumulated few risk points and were therefore assigned to categories
characterized as having little risk of default.  Conversely, projects
that generally did not compare favorably with FHA's standards
accumulated more risk points and were assigned to categories that
carried a greater risk of default.  Table I.2 provides the risk
categories and their cutoff points. 



                               Table I.2
                
                Fiscal Year 1993 Default Risk Categories


                                            Unsubsidized
Risk category                                         \a  Subsidized\a
------------------------------------------  ------------  ------------

Excellent                                          0 -15         0 -16
Good                                              16 -29        17 -32
Standard                                          30 -44        33 -48
Substandard                                       45 -59        49 -65
Doubtful                                          60 -75       66 -80\
----------------------------------------------------------------------
\a Projects were scored on a scale of 80 rather than 100 points
because FHA was not able to include 3-year trends in its analysis. 
FHA originally planned to allocate 20 points for the 3-year trends. 
Unsubsidized projects were scored on a scale of 75 points because
they could not be given a score for their subsidy per unit. 

FHA described projects in the five risk categories as follows: 

  Excellent--affords strong protection for FHA; is managed well and
     is in excellent condition; risk of default and risk of loss in
     the event of default appear remote. 

  Good--presents an acceptable level of risk; is better than industry
     peers; risk of default and risk of loss in the event of default
     are considered remote. 

  Standard--does not currently expose FHA to a substantial degree of
     risk but does have deficiencies or potential weaknesses that may
     expose FHA to an increased risk of loss in the future. 

  Substandard--has identified weaknesses that jeopardize repayment
     under the current terms; risk of default and risk of loss seem
     reasonably possible to probable. 

  Doubtful--has all the weaknesses inherent in a project classified
     as substandard but the weaknesses are more severe, increasing
     the likelihood of loss to FHA to a high level; intense vigilance
     by FHA required to minimize loss. 

In assigning the projects to risk categories, FHA made adjustments
for projects with distinct characteristics that warranted special
consideration--loans on which borrowers had already defaulted or that
lenders had elected to assign to FHA, new loans, and projects that
were ranked as standard or better but had OCCRs below 0.95.\1 FHA
determined that any loans on which borrowers had already defaulted or
that lenders had decided to assign to FHA would initially be removed
from the sample and automatically ranked as doubtful, since default
and loss were virtually assured.  New endorsements were also removed
from the sample and ranked as excellent, since, for new loans,
default was not expected.  Any project that had been ranked as
standard or better but that had an OCCR of 0.95 or below was demoted
to the doubtful category, since the low OCCR meant that the project
did not generate sufficient revenues to cover its operating costs. 

To characterize the risk of default for the projects in its sample,
FHA reintroduced the 258 unrankable projects to the analysis.  FHA
assumed that the unrankable projects shared the same characteristics
as the ranked projects and distributed the dollars associated with
the unranked projects among the five categories according to the
distribution of those that had been ranked. 


--------------------
\1 The OCCR measures the ability of a project's revenues to cover the
project's costs.  An OCCR of 0.95 means that the revenues cannot meet
the costs of the project. 


   PROJECTING THE RESULTS OF THE
   SAMPLE TO THE ENTIRE
   MULTIFAMILY PORTFOLIO
--------------------------------------------------------- Appendix I:4

After assigning the sample projects and their unpaid principal
balances to the five risk categories, FHA projected the results of
the sample to its multifamily portfolio.  This was done program by
program.  Thus, for the sample, 19.45 percent of the unpaid principal
balance in the section 207 program was ranked as good.  FHA applied
the 19.45 percent to the unpaid principal balance for the entire
section 207 program, which was approximately $507.2 million, to
conclude that approximately $98.6 million of the program's unpaid
principal balance was good and posed virtually no risk of default. 
Table I.3 shows the distribution of FHA's multifamily portfolio
(minus hospitals) among the five risk categories. 



                               Table I.3
                
                    Distribution of the Multifamily
                  Portfolio Among Five Risk Categories

                         (Dollars in thousands)

                                                Percent of portfolio's
Risk category                          Value  unpaid principal balance
------------------------  ------------------  ------------------------
Doubtful                         $ 4,547,763                    11.52%
Substandard                       10,388,661                     26.32
Standard                           8,140,585                     20.63
Good                               8,886,293                     22.52
Excellent                          7,503,480                     19.01
======================================================================
Total                            $39,466,782                   100.00%
----------------------------------------------------------------------

   CALCULATING EXPECTED LOSSES
   USING DEFAULT ASSUMPTIONS
--------------------------------------------------------- Appendix I:5

After distributing the unpaid principal balance for the entire
multifamily portfolio among the five risk categories, FHA calculated
the amount it would lose through defaults and, hence, the reserves it
would need to cover these losses.  FHA subjected the dollars in each
of the five categories to a set of assumptions that varied from one
category to another.  Specifically, FHA made assumptions about the
following: 

  Default potential--FHA assumed that the likelihood that borrowers
     would default on loans for projects in various categories would
     range from 100 percent of the projects in the doubtful to 0
     percent of the projects in the good and excellent categories. 

  First default--FHA assumed that borrowers would begin to default in
     the first year after the analysis regardless of category. 

  Years of default--FHA assumed that the period of time during which
     borrowers would default would range from 4 to 6 years, depending
     on the project's category. 

  Asset recovery rate--FHA assumed that it would recover an average
     of 24 percent of the unpaid principal balance for any project
     whose mortgagee defaulted regardless of the project's category. 

  Years to recovery--FHA assumed that it would take 3 years after a
     mortgagee defaulted to recover any part of a project's unpaid
     principal balance. 

  Cost of capital-- For discounting purposes, FHA assumed that the
     cost of capital would be 7.0 percent annually. 

Table I.4 displays the assumptions that FHA used to predict losses
from defaults on multifamily properties.  FHA's final estimate of
losses from defaults on these properties was approximately $9.4
billion.\2



                               Table I.4
                
                     Assumptions Used to Determine
                     Multifamily Base Loss Reserves

                                      Substand  Standa          Excell
Input assumptions           Doubtful       ard      rd    Good     ent
--------------------------  --------  --------  ------  ------  ------
Default potential               100%       75%     20%      0%      0%
First default\a                    1         1       1       1       1
Years of default                   4         5       6       3       3
Asset recovery rate              24%       24%     24%     24%     24%
Years to recovery                  3         3       3       3       3
Cost of capital                   7%        7%      7%      7%      7%
----------------------------------------------------------------------
\a The year in which the first default will occur.  FHA's model
treated fiscal year 1993 as year 0. 


--------------------
\2 This is in net present value terms.  According to FHA's model, the
"undiscounted" base reserve estimate is approximately $10.6 billion. 


      LOAN LOSS RESERVES FOR
      HOSPITALS
------------------------------------------------------- Appendix I:5.1

To establish loan loss reserves for hospitals, FHA modified the
methodology it used for the multifamily rental properties in its
portfolio.  As noted earlier, FHA, in consultation with HHS staff,
identified 34 hospitals with the potential for default.  HHS and FHA
estimated the likelihood of default for each hospital, expressed as a
percent, on the basis of their familiarity with the financial
condition of each hospital.  FHA then calculated the amount it could
expect to lose in the event of default for any of the 34 hospitals. 
This amount was a standard 70 percent across all hospitals and was
based on historical loss rates from prior defaults on hospital loans
and sales.  By combining the two numbers for each hospital, FHA
estimated a combined loss rate.  By applying the loss rate to the
unpaid principal balance for each hospital, FHA determined the
dollars for each hospital that could be considered at risk.  By
summing the at-risk unpaid principal balances for the 34 hospitals,
FHA calculated the hospitals' total expected loss.\3 FHA then reduced
this sum by 10 percent to roughly take into account the probability
that defaults on loans for hospitals would occur within 5 to 10
years.  FHA's final estimate of losses from defaults on hospital
loans was approximately $402 million.\4


--------------------
\3 For any given hospital, the dollars at risk from default are
meaningless.  This is not the amount FHA would lose if a default were
to occur.  However, when the dollars are summed for all hospitals,
the result provides FHA with an estimate of potential losses across
the portfolio. 

\4 This is in net present value terms.  According to FHA's model, the
"undiscounted" loan loss reserve estimate for the hospitals portfolio
is approximately $472 million. 


   PORTFOLIO LOSS RESERVES
--------------------------------------------------------- Appendix I:6

FHA established $505 million in portfolio reserves to cover four
contingencies:  (1) defaults on new loans, (2) defaults on loans for
projects characterized as good or excellent, (3) unexpected natural
disasters, and (4) administrative expenses associated with settling
claims on defaults.  FHA had ranked all new loans as excellent
because it assumed that, for new loans, defaults would not occur. 
However, recognizing that defaults might occur on some of these
loans, FHA estimated a required reserve of $135 million.  Likewise,
FHA recognized that defaults could also occur on loans for projects
ranked as good or excellent, and it therefore estimated $170 million
in reserves to cover losses from such defaults.  FHA established
reserves of $50 million to cover unforeseen losses from natural
disasters, since these could not be taken into account in the
analysis.  FHA estimated that $200 million would be necessary to
cover the expenses associated with settling claims from defaults. 
FHA felt that if its estimates of defaults were accurate, it would
need increased staffing or contractor support to process the
potential increase in claims during the coming years. 


   RESULTING TOTAL RESERVE
   ESTIMATE
--------------------------------------------------------- Appendix I:7

Through its fiscal year 1993 analysis, FHA estimated that it would
need approximately $10.3 billion in reserves to cover defaults on
loans in its multifamily portfolio.  As table I.5 shows, this amount
consisted of the following elements: 



                               Table I.5
                
                   Elements of Total Reserve Estimate

                         (Dollars in billions)

Reserves                                                        Amount
--------------------------------------------------  ------------------
Base loss reserves (excluding hospitals)                          $9.4
Hospitals loss reserves                                            0.4
Portfolio loss reserves                                            0.5
======================================================================
Total                                                          $10.3\a
----------------------------------------------------------------------
\a This figure is in net present value terms.  According to FHA's
model, the "undiscounted" loan loss reserve estimate is approximately
$11.6 billion. 


ANALYSIS OF THE EFFECT OF SAMPLING
ERROR ON FHA'S LOAN LOSS RESERVE
ESTIMATE
========================================================== Appendix II

To determine the effect of sampling error\1 on FHA's loan loss
reserve estimate, we first estimated (1) the percent of the total
unpaid principal balance\2 in each of the five risk categories used
in the loan loss reserve analysis and (2) the sampling error
associated with each of these estimates.  We then tested the
sensitivity of FHA's loan loss reserve to uncertainty about the exact
percent of the unpaid principal balance that belonged in each risk
category. 

For each of the 12 housing programs whose loans FHA sampled, we used
the sampled loans to estimate the percent of the total unpaid
principal balance in each risk category.\3 We also developed an
overall estimate of the percent of the unpaid principal balance in
each risk category, using the September 30, 1993, unpaid principal
balance of $34.6 billion that FHA used in its loan loss model.  We
calculated the sampling error for each of these estimates.  On the
basis of these estimates, provided in table II.1, we determined that
there is uncertainty about the percent of the $34.6 billion unpaid
principal balance that belongs in each risk category.  Given sampling
error, we estimate for example, that 5.28 ï¿½ 1.37 percent (or between
3.91 percent and 6.65 percent) of the $34.6 billion is in the
doubtful category while 29.76 ï¿½ 3.32 percent (or between 26.44
percent and 33.08 percent) is in the substandard category. 



                                    Table II.1
                     
                      Estimated Percent of Unpaid Principal
                             Balance in Risk Category


              Unpaid
           principal              Substandar
Program    balance\a    Doubtful           d    Standard        Good   Excellent
--------  ----------  ----------  ----------  ----------  ----------  ----------

207             $507       19.13       22.02       39.41       19.44
                         (25.35)     (25.41)     (26.76)     (18.96)          \b
207           $1,847       12.10       21.20       30.46       25.81       10.44
 Conv.                    (9.37)     (11.14)     (14.77)     (12.49)     (10.87)
220           $1,212        1.81       13.16       20.67       27.52       36.85
                          (2.47)     (13.06)     (11.34)     (13.85)     (17.70)
221             $727        9.36       74.46       13.03        3.15
 Conv.                   (10.71)     (16.19)     (11.63)      (4.04)          \b
207/          $2,603        2.24       30.72       22.11       32.09       12.84
 223F                     (3.93)     (14.21)     (12.30)     (13.34)      (8.29)
221D4        $15,601        4.64       25.81       21.99       27.89       19.68
 MRKT                     (1.86)      (5.43)      (3.80)      (4.07)      (3.42)
221D3         $2,182        0.42       26.79       21.97       31.33       19.49
 MRKT                     (0.79)     (12.08)      (9.30)     (14.13)      (9.45)
221D3           $823                   60.21       24.39       15.39
 BMIR                         \b     (26.05)     (20.05)     (18.18)          \b
231             $593        6.35       34.77       24.42       14.46       20.00
                         (11.58)     (23.12)     (21.82)     (12.73)     (16.82)
232           $3,095        7.45       17.30       23.58       24.26       27.41
                          (6.24)      (7.83)     (10.87)     (11.62)      (9.93)
236           $5,327        6.71       45.17       24.34       19.64        4.14
                          (3.40)      (7.74)      (6.55)      (5.86)      (2.23)
Other            $65                   50.11       43.98        5.91
                              \b     (43.53)     (41.82)     (11.71)          \b
================================================================================
Total        $34,583        5.28       29.76       23.11       25.49       16.36
                          (1.37)      (3.32)      (2.73)      (2.84)      (2.20)
--------------------------------------------------------------------------------
Note:  The estimated percent of the unpaid balance in each risk
category represents the estimate that GAO based on FHA's April 30,
1993, sample.  The sampling error, shown in parentheses, represents
GAO's estimate of the sampling error at the 95-percent confidence
level. 

\a Dollars in millions as of September 30, 1993. 

\b None of the sampled loans fell into this category. 

Using the estimates in the above table, we tested the sensitivity of
FHA's loan loss reserve estimate to uncertainty about the exact
percent of the unpaid principal balance that belonged in each risk
category.  We repeatedly calculated a loan loss reserve, varying the
percent of the unpaid principal balance falling into each risk
category.\4 The average loan loss reserve estimate based on 10,000
repetitions was $7.35 billion.\5 After we eliminated the 250 (2.5
percent) lowest estimates and the 250 (2.5 percent) highest
estimates, the remaining 95 percent of the estimates ranged between
$6.68 billion and $8.02 billion.  The difference of about $0.67
billion between (a) the $7.35 billion average estimate and the $6.68
billion optimistic estimate and (b) the $7.35 billion average and the
$8.02 pessimistic estimate is a measure of the sensitivity of the
estimate to sampling error in the estimated percents of the unpaid
principal balance falling into each risk category. 


--------------------
\1 When probability samples are used to make estimates, each estimate
has a measurable precision or sampling error, which may be expressed
as a plus/minus figure.  A sampling error indicates how closely we
can reproduce from a sample the results that we would obtain if we
were to take a complete count of the universe using the same
measurement methods.  By adding the sampling error to and subtracting
it from the estimate, we can develop upper and lower bounds for each
estimate.  This range is called a confidence interval.  Sampling
errors and confidence intervals are stated at a certain confidence
level--in this case, 95 percent.  For example, a confidence interval,
at the 95-percent confidence level, means that in 95 out of 100
instances, the sampling procedure we used would produce a confidence
interval containing the universe value we are estimating. 

\2 The amounts used by FHA in its loan loss reserve analysis differ
from those we derived using FHA's loss reserve data base.  We found
that our results agreed with FHA's until we made FHA's adjustment for
the operating cost coverage ratio (see app.  I).  We asked FHA about
the discrepancy.  An official said that they had made their
adjustment manually and could inadvertently have missed some sampled
loans that should have been moved to the substandard category. 

\3 As noted in appendix I, FHA's 1993 loan loss reserve analysis was
based upon a sample of properties under 12 FHA multifamily housing
programs.  FHA's analysis also included coinsured properties and
hospitals.  Because FHA attempted to select all coinsured properties
and all hospitals on whose loans defaults were likely, the latter two
groups were not subject to sampling error. 

\4 We varied the percent of the unpaid principal balance falling into
a risk category by generating random variates from a normal
distribution whose mean and standard deviation were equal to the
percents and standard errors estimated from the sample. 

\5 As noted earlier, this estimate applies only to the 12 programs
from which FHA drew its sample.  The total loan loss reserve estimate
of $10.3 billion includes, among other things, amounts for the
coinsured and hospital portfolios that are not subject to sampling
error. 


CREDIT SUBSIDY RATES FOR SELECTED
FHA MULTIFAMILY MORTGAGE INSURANCE
PROGRAMS
========================================================= Appendix III

                                                               Subsidy
Program                                                          rates
------------------------------------------------------------  --------
Risk-sharing arrangements with state and local housing           8.13%
 finance agencies involving new construction [section              and
 542(c)]\a                                                       6.39%
Risk-sharing arrangements with state and local housing           1.77%
 finance agencies involving existing projects [section
 542(c)]
Risk-sharing arrangements with government-sponsored              1.77%
 enterprises or other qualified entities [section 542(b)]
New construction or substantial rehabilitation of rental        12.68%
 housing with for-profit borrowers [section 221(d)(4)]
Acquisition or refinancing of existing rental properties         3.20%
 [section 223(f)/207]
New construction or substantial rehabilitation of               29.84%
 cooperative or rental housing involving nonprofit
 borrowers
 [section 221(d)(3)]
Insurance to cover operating losses for insured or HUD-held     29.84%
 properties
 [section 223(d)]
Sales of HUD-held mortgages                                      3.08%
Refinancing of insured loans [section 223(a)(7)]                 3.08%
----------------------------------------------------------------------
Note:  The credit subsidy rates reflect the FHA mortgage insurance
premium structure that was in place as of December 1994. 

\a The credit subsidy rate used depends on the amount of risk assumed
by the housing finance agency. 


SCOPE AND METHODOLOGY
========================================================== Appendix IV

To evaluate the methodology FHA used to develop fiscal year 1993 loan
loss reserves for its multifamily loan portfolio, we reviewed FHA's
loan loss reserve analysis, as well as the examination of FHA's loan
loss reserve methodology that Price Waterhouse conducted for its
fiscal year 1993 FHA financial statement audit.  We discussed FHA's
loss reserve methodology with FHA officials, including the Deputy
Assistant Secretary for Multifamily Housing Programs and the FHA
Comptroller; senior officials with Price Waterhouse responsible for
the FHA financial audit; and multifamily housing industry experts,
including a senior vice president with the National Corporation for
Housing Partnerships and the president of Recapitalization Advisors,
Inc., a private company.  We tested the sensitivity of FHA's estimate
to adjustments in default assumptions and discussed the validity of
these assumptions with officials from FHA and multifamily housing
industry advisers.  Additionally, to determine the effect on the loan
loss reserve estimate of FHA's use of a sample, we performed a
statistical analysis of FHA's sample and extrapolated the results to
the multifamily portfolio.  (See app.  II for a detailed discussion
of our analysis of the effect of sampling error on FHA's estimate.)

To determine the costs and benefits of requiring that new multifamily
commitments be made on an actuarially sound basis, we discussed
budgetary and programmatic issues with FHA officials, including the
Deputy Assistant Secretary for Multifamily Housing Programs and the
Director of the Office of Insured Multifamily Housing Development, as
well as with officials from Price Waterhouse and the Congressional
Budget Office. 

To evaluate the Department of Housing and Urban Development's (HUD)
initiatives for preventing defaults on multifamily housing loans, we
discussed FHA's current initiatives for preventing defaults with FHA
officials, such as the Deputy Assistant Secretary for Multifamily
Housing Programs and the Director of the Office of Multifamily
Housing Management, and with multifamily managers in the HUD's
Jacksonville, Minneapolis, San Francisco, and Washington, D.C.  field
offices.  We also discussed these initiatives with officials of other
institutions that underwrite multifamily mortgages, including the
Federal National Mortgage Association, the Federal Home Loan Mortgage
Corporation, and the National Housing Partnership. 

HUD provided written comments on a draft of this report.  These
comments are presented and evaluated in our report and are reproduced
in appendix V. 




(See figure in printed edition.)Appendix V
COMMENTS FROM THE DEPARTMENT OF
HOUSING AND URBAN DEVELOPMENT
========================================================== Appendix IV



(See figure in printed edition.)


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix VI

RESOURCES, COMMUNITY, AND ECONOMIC
DEVELOPMENT DIVISION, WASHINGTON,
D.C. 

Jim Wells
Richard A.  Hale
Christine M.B.  Fishkin
Cheryl L.  Kramer
Dennis G.  Coleman
Karen E.  Bracey
Patrick B.  Doerning

ACCOUNTING AND INFORMATION
MANAGEMENT DIVISION, WASHINGTON,
D.C. 

David G.  Gill
Laura B.  Triggs
James R.  Hamilton

RELATED GAO PRODUCTS

Multifamily Housing:  Status of HUD's Multifamily Loan Portfolios
(GAO/RCED-94-173FS, Apr.  12, 1994). 

Multifamily Housing:  Information on Selected Properties Owned by HUD
(GAO/RCED-94-163FS, Apr.  11, 1994). 

Multifamily Housing:  Impediments to Disposition of Properties Owned
by the Department of Housing and Urban Development (GAO/T-RCED-93-37,
May 12, 1993).