Multifamily Housing: Issues Facing the Congress in Assessing HUD's
Portfolio Reengineering Proposal (Testimony, 07/26/96,
GAO/T-RCED-96-231).

GAO discussed the Department of Housing and Urban Development's (HUD)
efforts to reengineer its multifamily rental housing portfolio. GAO
noted that: (1) the portfolio's excessive subsidy costs, high exposure
to insurance loss, and poor physical condition stem from program design
flaws, HUD dual role as loan insurer and rental subsidy provider, and
weaknesses in HUD oversight and management; (3) in 1995, HUD proposed
allowing property owners to set rents at market levels, terminating
Federal Housing Administration (FHA) mortgage insurance, and replacing
project-based rent subsidies with portable tenant-based subsidies; (4)
although the proposal could lower mortgage debt, it would result in
substantial FHA insurance claims; (5) HUD has made several proposal
changes in 1996 due to concerns about the lack of data, effects on
properties and existing residents, and the long-term financial impact on
the government; (6) a 1996 contractor's report confirmed that most
properties have assisted rents that are higher than estimated market
rents and significant maintenance and capital improvement needs; (7) the
study also indicates that most portfolio properties need to have their
debt reduced to continue operating; and (8) reengineering issues
requiring congressional consideration include HUD portfolio management
problems, FHA insurance for restructured loans, project- versus
tenant-based rent subsidies, protection for displaced households,
inclusion of properties with below-market rents, mortgage restructuring,
government financing of rehabilitation costs, and property owners' tax
relief.

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

 REPORTNUM:  T-RCED-96-231
     TITLE:  Multifamily Housing: Issues Facing the Congress in 
             Assessing HUD's Portfolio Reengineering Proposal
      DATE:  07/26/96
   SUBJECT:  Rent subsidies
             Housing programs
             Low income housing
             Cost control
             Fair market value
             Mortgage protection insurance
             Mortgage loans
             Reengineering (management)
             Rental rates
             Rental housing
IDENTIFIER:  FHA Multifamily Mortgage Insurance Program
             HUD Mark to Market Program
             HUD Section 8 New Housing Construction Program
             HUD Section 8 Rental Assistance Program
             HUD Section 8 Substantial Rehabilitation Program
             HUD Section 8 Loan Management Set-Aside Program
             HUD Section 8 Portfolio Reengineering Program
             
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Cover
================================================================ COVER


Before the Subcommittee on Housing and Community Opportunity,
Committee on Banking and Financial Services, House of Representatives

July 26, 1996
10:00 a.m.  EDT

MULTIFAMILY HOUSING - ISSUES
FACING THE CONGRESS IN ASSESSING
HUD'S PORTFOLIO REENGINEERING
PROPOSAL

Statement by Judy A.  England-Joseph, Director, Housing and Community
Development Issues, Resources, Community, and Economic Development
Division

GAO/T-RCED-96-231

GAO/RCED-96-231T


(385645)


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

  HUD - x
  FHA - x
  LLP - x
  HFA - x

============================================================ Chapter 0

Mr.  Chairman and Members of the Subcommittee: 

We are pleased to be here today to testify before this Subcommittee
as it examines proposals to reengineer about 8,600 properties from
the Department of Housing and Urban Development's (HUD) multifamily
rental housing portfolio.  These 8,600 properties, which we refer to
as the insured Section 8 portfolio, are properties that receive
mortgage insurance from HUD through its Federal Housing
Administration (FHA) and that receive Section 8 rental subsidies that
are tied directly to the properties (Section 8 project-based
assistance).  During the past few years, this Subcommittee, HUD, GAO,
and others have given increased attention to the problems affecting
this segment of HUD's portfolio and to identifying possible
strategies for resolving the problems while protecting the interests
of all affected parties--property owners, residents, mortgage
lenders, HUD, state and local housing agencies, and of course, the
federal taxpayer, who will ultimately benefit from the savings or
bear the extra costs that result from the strategy that is adopted. 

In May 1995, HUD proposed a process called "mark-to-market" that was
aimed at addressing these and other problems.  In early 1996, HUD
modified that process in response to stakeholders' concerns and
renamed it "portfolio reengineering." This statement is based on
previous work we have carried out on HUD's multifamily portfolio and
also provides the preliminary results of our work on an assignment
relating to HUD's proposals.  In addition to providing background
information on the insured Section 8 portfolio, this statement
discusses (1) the problems currently affecting the portfolio, (2)
HUD's plans for addressing these problems, (3) a HUD-contracted study
by Ernst & Young LLP that estimates how the properties are likely to
be affected by HUD's reengineering proposal, (4) our preliminary
assessment of Ernst & Young's study, and (5) issues facing the
Congress in deciding how to respond to HUD's proposal.  We are also
providing observations on HUD's portfolio reengineering initiative. 

In summary, we found the following: 

  -- The basic problems affecting the insured Section 8 portfolio are
     high subsidy costs, high exposure to insurance loss, and the
     poor condition of many properties.  These problems stem from one
     or more of several basic causes.  These include (1) program
     design flaws that have contributed to high subsidies and those
     in the insurance program that put virtually all the risk on HUD;
     (2) HUD's dual role as mortgage insurer and rental subsidy
     provider, which has resulted in the federal government averting
     claims against the FHA insurance fund by supporting a subsidy
     and a regulatory structure that has masked the true market value
     of the properties; and (3) weaknesses in HUD's oversight and
     management of the insured portfolio, which have allowed physical
     and financial problems at a number of HUD-insured multifamily
     properties to go undetected or uncorrected. 

  -- In 1995, HUD proposed to address these problems through a
     process it called "mark-to-market." This process would allow
     property owners to set rents at market levels, while HUD would
     reduce mortgage debt if necessary to permit a positive cash
     flow, terminate FHA's mortgage insurance, and replace
     project-based Section 8 subsidies with portable tenant-based
     subsidies.  Although HUD expected the proposal to reduce the
     costs of Section 8 subsidies, lowering mortgage debt would
     result in claims against FHA's insurance fund.  Many questions
     and concerns were raised about the proposal, including (1)
     whether data on the physical and financial condition of
     properties in the portfolio were reliable, (2) how the process
     would affect the properties and existing residents, and (3)
     whether the result would be a net saving or cost to the
     government.  Without this information, it was difficult to
     predict the overall effects of HUD's mark-to-market proposal on
     the properties, their owners, the residents, and the federal
     government.  In response to the concerns, in early 1996 HUD made
     several changes to its proposal but left most of its basic
     thrust intact. 

  -- During 1995, HUD also contracted with Ernst & Young LLP to
     obtain up-to-date information on market rents and the physical
     condition of the properties in the insured Section 8 portfolio
     and to develop a financial model to show how HUD's proposal
     would affect the properties.  Ernst & Young's May 1996 report on
     the Department's proposal indicates that the vast majority of
     the insured Section 8 properties--between 77 and 83
     percent--would need to have their debt reduced in order to
     continue operations.  The data also indicate that between 22 and
     29 percent of the properties in the portfolio would have
     difficulty sustaining operations even if their mortgages were
     totally forgiven.  These projections are based on current data
     on market rents and the physical condition of the properties
     obtained by Ernst & Young.  Furthermore, it is important to note
     that the study's results reflect the provisions contained in
     HUD's mark-to-market proposal prior to the changes that HUD made
     to the proposal in early 1996.  The study also confirms earlier
     data that, for most of the properties subject to portfolio
     reengineering, the assisted rents are higher than the estimated
     market rents.  In addition, the properties in the portfolio were
     found to have significant amounts of immediate deferred
     maintenance and short-term and long-term capital needs. 

  -- Our preliminary analysis of Ernst & Young's financial model
     indicates that it provides a reasonable framework for studying
     the outcomes of portfolio reengineering, such as how many
     properties will need to have their debt reduced.  In addition,
     we did not identify any substantive problems with Ernst &
     Young's sampling and statistical methodology.  We are still
     assessing how the assumptions used in the model affect its
     estimates of the effects of portfolio reengineering.  In
     addition, we are examining data on subsidy and claims costs that
     were developed by Ernst & Young as part of its study, but not
     included in its May 1996 report.  Our preliminary analysis of
     that cost data indicates that the claims costs will be
     substantial--Ernst & Young's data indicate that the average debt
     writedown for properties whose mortgages need restructuring is
     approximately 61 to 67 percent of the insured loans' unpaid
     principal balances at the time of restructuring. 

  -- The Congress will face a number of other key issues in
     considering HUD's portfolio reengineering proposal.  These
     include (1) whether rental assistance should be project-based or
     tenant-based, (2) what protection should be given households
     that could be displaced as a result of reengineering, (3) to
     what extent FHA insurance should be used for restructured loans,
     and (4) to what degree the federal government should finance
     rehabilitation costs.  How these issues are resolved will, to a
     large degree, determine the extent to which the problems that
     have long plagued the portfolio are corrected and prevented from
     recurring and the extent to which the reengineering process
     results in savings to the government. 


   BACKGROUND ON THE PORTFOLIO
---------------------------------------------------------- Chapter 0:1

HUD, through FHA, provides insurance that protects private lenders
from financial losses stemming from borrowers' defaults on mortgage
loans for both single-family homes and multifamily rental housing
properties for low- and moderate-income households.  When a default
occurs on an insured loan, a lender may "assign" the mortgage to HUD
and receive payment from FHA for an insurance claim.  According to
the latest data available from HUD, FHA insures mortgage loans for
about 15,800 multifamily properties.  These properties contain just
under 2 million units and have a combined unpaid mortgage principal
balance of $46.9 billion.\1 These properties include multifamily
apartments and other specialized properties, such as nursing homes,
hospitals, student housing, and condominiums. 

In addition to mortgage insurance, many FHA-insured multifamily
properties receive some form of direct assistance or subsidy from
HUD, such as below-market interest rates or Section 8 project-based
assistance.  HUD's Section 8 program provides rental subsidies for
low-income families.  These subsidies are linked either to
multifamily apartment units (project-based) or to individuals
(tenant-based).  Under the Section 8 program, residents in subsidized
units generally pay 30 percent of their income for rent and HUD pays
the balance. 

According to HUD, its restructuring proposals apply to 8,636
properties that both have mortgages insured by FHA and receive
project-based Section 8 rental subsidies for some or all of their
units.  Data provided by HUD in April 1996 show that, together, these
properties have unpaid principal balances totaling $17.8 billion and
contain about 859,000 units, of which about 689,000 receive
project-based Section 8 subsidies.\2 According to HUD's data, about
45 percent of the insured Section 8 portfolio (3,859 properties,
303,219 assisted units, and $4.8 billion in unpaid loan balances)
consist of what are called the "older assisted" properties.  These
are properties that were constructed beginning in the late 1960s
under a variety of mortgage subsidy programs, to which project-based
Section 8 assistance (Loan Management Set Aside) was added later,
beginning in the 1970s, to replace other subsidies and to help
troubled properties sustain operations.  About 55 percent of the
insured Section 8 portfolio (4,777 properties, 385,931 assisted
units, and $13.0 billion in unpaid loan balances) consists of what
are called the "newer assisted" properties.  These properties
generally were built after 1974 under HUD's Section 8 New
Construction and Substantial Rehabilitation programs and received
project-based Section 8 subsidies based on formulas with automatic
annual adjustments, which tended to be relatively generous to
encourage the production of affordable housing. 

There is great diversity among the properties in HUD's insured
Section 8 portfolio, as illustrated by 10 properties that we studied
in greater depth as part of our current assignment (see app.  I). 
These properties differ in a number of important respects, such as
the amount of their remaining unpaid mortgage debt; the types and
amounts of assistance they receive from HUD; and their financial
health, physical condition, rents, types of residents served, and
surrounding neighborhoods and rental housing markets.  These factors
can influence the effect that HUD's or other reengineering proposals
would have on the properties. 


--------------------
\1 These data do not include "HUD-held" mortgages, which are those
for which HUD has paid an insurance claim and is now, in effect, the
lender.  According to its data, HUD holds mortgages on 1,609
properties that have a combined unpaid principal balance of $5.4
billion. 

\2 For various reasons, HUD chose to exclude from its restructuring
proposals properties with project-based Section 8 assistance that was
provided under its "moderate rehabilitation" program.  HUD estimates
that there are about 167 insured moderate rehabilitation properties
containing about 16,800 units. 


   PROBLEMS AFFECTING THE
   PORTFOLIO
---------------------------------------------------------- Chapter 0:2

The insured Section 8 portfolio suffers from three basic
problems--high subsidy costs, high exposure to insurance loss, and in
the case of some properties, poor physical condition. 

A substantial number of the properties in the insured Section 8
portfolio now receive subsidized rents above market levels, many
substantially above the rents charged for comparable unsubsidized
units.  This problem is most prevalent in (but not confined to) the
"newer assisted" segment of the portfolio, where it stems from the
design of the Section 8 New Construction and Substantial
Rehabilitation programs.  The government paid for the initial
development or rehabilitation of these properties under these
programs by initially establishing rents above market levels and then
raising them regularly through the application of set formulas that
tended to be generous to encourage the production of new affordable
housing.  It has become difficult to continue the high subsidies in
the current budget environment. 

A second key problem affecting the portfolio is the high risk of
insurance loss.  Under FHA's insurance program, HUD bears virtually
all the risk in the event of loan defaults.  A third, closely related
problem is the poor physical condition of many properties in the
portfolio.  A 1993 study of multifamily rental properties with
FHA-insured or HUD-held mortgages found that almost one-fourth of the
properties were "distressed." Properties were considered to be
distressed if they failed to provide sound housing and lacked the
resources to correct deficiencies or if they were likely to fail
financially. 

The problems affecting HUD's insured Section 8 portfolio stem from
several causes.  These include (1) program design flaws that have
contributed to high subsidies and put virtually all the insurance
risk on HUD; (2) HUD's dual role as mortgage insurer and rental
subsidy provider, which has resulted in the federal government
averting claims against the FHA insurance fund by supporting a
subsidy and regulatory structure that has masked the true market
value of the properties; and (3) weaknesses in HUD's oversight and
management of the insured portfolio, which have allowed physical and
financial problems at a number of HUD-insured multifamily properties
to go undetected or uncorrected. 


   HUD'S PLANS FOR ADDRESSING
   PROBLEMS WITH THE PORTFOLIO
---------------------------------------------------------- Chapter 0:3

In May, 1995 HUD proposed a mark-to-market process to address the
three key problems and their causes by decoupling HUD's mortgage
insurance and project-based rental subsidy programs and subjecting
the properties to the forces and disciplines of the commercial
market.  HUD proposed to do this by (1) eliminating the project-based
Section 8 subsidies as existing contracts expired (or sooner if
owners agreed), (2) allowing owners to rent apartments for whatever
amount the marketplace would bear, (3) facilitating the refinancing
of the existing FHA-insured mortgage with a smaller mortgage if
needed for the property to operate at the new rents, (4) terminating
the FHA insurance on the mortgage, and (5) providing the residents of
assisted units with portable Section 8 rental subsidies that they
could use to either stay in their current apartment or move to
another one if they wanted to or if they no longer could afford to
stay in their current apartment. 

Recognizing that many properties could not cover their expenses and
might eventually default on their mortgages if forced to compete in
the commercial market without their project-based Section 8
subsidies, the mark-to-market proposal set forth several alternatives
for restructuring the FHA-insured mortgages in order to bring income
and expenses in line.  These alternatives included selling mortgages,
engaging third parties to work out restructuring arrangements, and
paying full or partial FHA insurance claims to reduce mortgage debt
and monthly payments. 

The proposed mark-to-market process would likely affect properties
differently, depending on whether their existing rents were higher or
lower than market rents and on their funding needs for capital items,
such as deferred maintenance.  If existing rents exceeded market
rents, the process would lower the mortgage debt, thereby allowing a
property to operate and compete effectively at lower market rents. 
If existing rents were below market, the process would allow a
property to increase rents, potentially providing more money to
improve and maintain the property.  HUD recognized, however, that
some properties would not be able generate sufficient income to cover
expenses even if their mortgage payments were reduced to zero.  In
those cases, HUD proposed using alternative strategies, including
demolishing the property and subsequently selling the land to a third
party, such as a nonprofit organization or government entity. 

After reviewing HUD's proposal, various stakeholders raised questions
and concerns about the proposal, including the effect that it would
have on different types of properties and residents, and the
long-term financial impact of the proposal on the government.  In
response to stakeholders' concerns, HUD made several changes to its
proposal and also renamed the proposal "portfolio reengineering." The
changes HUD made included (1) giving priority attention for at least
the first 2 years to properties with subsidized rents above market;
(2) allowing state and local governments to decide whether to
continue Section 8 project-based rental subsidies at individual
properties after their mortgages are restructured or switch to
tenant-based assistance; and (3) allowing owners to apply for FHA
insurance on the newly restructured mortgage loans.  In addition, HUD
stated a willingness to discuss with the Congress mechanisms to take
into account the tax consequences related to debt forgiveness for
property owners who enter into restructuring agreements.  More
recently, HUD has also suggested that action should be deferred on
properties that would not be able to generate sufficient income to
cover operating expenses after reengineering until strategies are
developed that address the communities' and residents' needs relating
to the properties. 

On April 26, 1996, HUD received legislative authority to conduct a
demonstration program to test various methods of restructuring the
financing of properties in the insured Section 8 portfolio.\3
Participation in the program is voluntary and open only to properties
that have rents which exceed HUD's fair market rent (FMR) for their
locality.\4 The purpose of the demonstration is to test the
feasibility and desirability of properties meeting their financial
and other obligations with and without FHA insurance, with and
without above-market Section 8 assistance, and using project-based
assistance or, with the consent of the property owner, tenant-based
assistance.  The demonstration program is limited by law to mortgages
covering a total of 15,000 units or about 2 percent of the total
units in the insured Section 8 portfolio.  An appropriation of $30
million was provided to fund the cost of modifying loans under the
program, which remains available until September 30, 1997.  HUD
believes that this funding level could limit the number of properties
that can be reengineered under the demonstration.  On July 2, 1996,
HUD issued a public notice announcing the program and providing
initial guidance on how it plans to operate the program. 

On May 21, 1996, the Senate Committee on Banking, Housing, and Urban
Affairs issued a Staff Discussion Paper to outline a general strategy
for addressing the problems with HUD's insured Section 8 portfolio. 
Among other things, the staff proposed to continue project-based
Section 8 assistance and to subsidize rents at 90 percent of FMR (or
at higher budget-based rents in certain cases if the FMR-based rents
would not cover the costs of operation).  On June 27, 1996, the
Subcommittee on Housing Opportunity and Community Development held a
hearing on the staff's proposals, and as of mid-July the Subcommittee
was drafting a restructuring bill. 


--------------------
\3 Authority for the demonstration program was provided in Section
210 of HUD's Appropriations Act for 1996 (P.  L.  104-134). 

\4 HUD annually sets "fair market rents" for each metropolitan and
nonmetropolitan area in each state.  These rents represent the cost
of modest rental units of a given size and are used to compute
Section 8 tenant-based rent subsidies. 


   OBJECTIVES AND RESULTS OF ERNST
   & YOUNG'S STUDY
---------------------------------------------------------- Chapter 0:4

In May 1995, when HUD proposed the mark-to-market initiative, the
Department did not have current or complete information on the
insured Section 8 portfolio upon which to base assumptions and
estimates about the costs and impact of the proposal.  For example,
HUD lacked reliable, up-to-date information on the market rents the
properties could be expected to command and the properties' physical
conditions--two variables that strongly influence how properties will
be affected by the mark-to-market proposal.  To obtain data to better
assess the likely outcomes and costs of the mark-to-market proposal,
HUD contracted with Ernst & Young LLP\5 in 1995 for a study on
HUD-insured properties with Section 8 assistance to (1) determine the
market rents and physical condition of the properties and (2) develop
a financial model to show how the proposal would affect the
properties and to estimate the costs of subsidies and claims
associated with the mark-to-market proposal. 

The study was conducted on a sample of 558 of 8,363 properties and
extrapolated to the total population of 8,563 properties identified
by HUD at that time as representing the population subject to its
mark-to-market proposal.\6 The sample was designed to be projectible
to the population with a relative sampling error of no more than plus
or minus 10 percent at the 90-percent confidence level.  A briefing
report summarizing the study's findings was released by HUD and Ernst
& Young on May 2, 1996.  It provides current information on how the
assisted rents at the properties compare with market rents, the
physical condition of the properties, and how the properties are
expected to be affected by HUD's proposal as the proposal existed
while the study was underway.  As such, it is important to note that
the study's results do not reflect the changes that HUD made to its
proposal in early 1996. 


--------------------
\5 The study was conducted by the E&Y Kenneth Leventhal Real Estate
Group. 

\6 Ernst & Young reported that the sample was drawn from a population
of 8,363 properties rather than the HUD-identified population of
8,563 properties because of technical and cost considerations.  As
noted earlier, HUD now believes that 8,636 properties would be
subject to portfolio reengineering. 


      STUDY CONFIRMS EXCESS
      SUBSIDY COSTS AND
      SIGNIFICANT PHYSICAL NEEDS
      AT PROPERTIES
-------------------------------------------------------- Chapter 0:4.1

Ernst & Young estimates that the majority of the properties have
assisted rents exceeding market rents and that the properties have
significant amounts of immediate deferred maintenance and short-term
and long-term capital needs.\7 Specifically, Ernst & Young's study
estimates that a majority of the properties--between 60 and 66
percent--have rents above market and between 34 and 40 percent are
estimated to have below-market rents.  Ernst & Young's data also
indicate a widespread need for capital--between $9.2 billion and
$10.2 billion--to address current deferred maintenance needs and the
short- and long-term requirements to maintain the properties.  The
study estimates that the properties have between $1.3 billion and
$1.6 billion in replacement and cash reserves that could be used to
address these capital needs, resulting in total net capital needs of
between $7.7 billion and $8.7 billion.  The average per-unit cost of
the total capital requirements, less the reserves, is estimated to be
between $9,116 and $10,366. 


--------------------
\7 The study defines capital needs as the cost of improvements needed
to bring properties into adequate physical condition to attract
uninsured market rate financing.  Three categories of capital needs
are defined:  (1) immediate deferred maintenance, the estimated costs
to bring all property operating systems up to market conditions and
lender underwriting standards; (2) short-term capital backlog, the
estimated costs for the expired life of property systems requiring
replacement in 5 or fewer years; and (3) long-term capital backlog,
the estimated costs for the expired life of property systems
requiring replacement in more than 5 years. 


      STUDY INDICATES A
      SIGNIFICANT LEVEL OF DEBT
      RESTRUCTURING WOULD BE
      NEEDED
-------------------------------------------------------- Chapter 0:4.2

Ernst & Young's analysis also indicates that about 80 percent of the
properties would not be able to continue operations unless their debt
was restructured.  Furthermore, for approximately 22 to 29 percent of
the portfolio, writing the existing debt to zero would not
sufficiently reduce costs for the properties to address their
immediate deferred maintenance and short-term capital needs.  The
study estimates that between 11 and 15 percent of the portfolio would
not even be able to cover operating expenses. 

The study was designed to use the information on market rents and the
properties' physical condition gathered by Ernst & Young, as well as
financial and Section 8 assistance data from HUD's data systems, in a
financial model designed to predict the proposal's effects on the
portfolio as a whole.  Specifically, the model estimates the
properties' future cash flows over a 10-year period on the basis of
the assumption that they would be reengineered (marked to market)
when their current Section 8 contracts expire.\8

The model classifies the loans into four categories--performing,
restructure, full write-off, and nonperforming--that reflect how the
properties would be affected by HUD's proposal.  Placement in one of
the four categories is based on the extent to which income from the
reengineered properties would be able to cover operating costs, debt
service payments, deferred maintenance costs, and short-term capital
expenses.  Table 1 shows the results of Ernst & Young's analysis of
how properties would be affected by HUD's proposal. 



                                Table 1
                
                   Effects of Reengineering on HUD's
                      Insured Section 8 Portfolio

                                Percen
                                  t of
Status of loan after            portfo  Costs covered with
reengineering                      lio  reengineered cash flows
------------------------------  ------  ------------------------------
Performing                       17 to  Existing debt, operating
                                    23   expenses, all capital needs
Restructure                      50 to  Restructured debt, operating
                                    58   expenses, all capital needs
Full write-off                   11 to  Operating expenses and some
                                    15   capital needs but no debt
Nonperforming                    11 to  Some operating expenses but no
                                    15   debt or capital needs
----------------------------------------------------------------------
Note:  Capital needs represent immediate deferred maintenance and
short-term (5 years or less) capital needs.  In addition, the
financial model categorizing the loans assumes annual deposits to
replacement reserves. 


--------------------
\8 For properties with more than one Section 8 contract, the model
assumes that the property would be reengineered when the contract
with the earliest expiration date expires. 


   GAO'S ASSESSMENT OF THE MODEL
   AND THE RESULTS
---------------------------------------------------------- Chapter 0:5

We are currently evaluating Ernst & Young's financial model and
expect to issue our report late this summer.  Our preliminary
assessment is that the model provides a reasonable framework for
studying the overall results of portfolio reengineering, such as the
number of properties that will need to have their debt restructured
and to estimate the related costs of insurance claims and Section 8
subsidies.  In addition, we did not identify any substantive problems
with Ernst & Young's sampling and statistical methodology.  However,
our preliminary assessment of the study indicates that some aspects
of Ernst & Young's financial model and its assumptions may not
reflect the way in which insured Section 8 properties will actually
be affected by portfolio reengineering.  Also, some of the
assumptions used in the model may not be apparent to readers of Ernst
& Young's May 1996 briefing report. 

For example, Ernst & Young's assumptions about the transition period
that properties go through in the reengineering process may be overly
optimistic.  During the transition, a reengineered property changes
from a property with rental subsidies linked to its units to an
unsubsidized property competing in the marketplace for residents. 
The model estimates that the entire transition will be completed
within a year after the first Section 8 contract expires.  In
addition, the model assumes that during this year, the property's
rental income will move incrementally toward stabilization over 9
months.  Lenders with whom we consulted on the reasonableness of the
model's major assumptions generally believed that a longer transition
period of 1 to 2 years is more likely.  They also anticipated an
unstable period with less income and more costs during the transition
rather than the smooth transition assumed in the model.  An Ernst &
Young official told us that the 9-month period was designed to
reflect an average transition period for reengineered properties. 
While he recognized that some properties would have longer transition
periods than assumed in the model, he believed that the transition
periods for other properties could be shorter than 9 months. 

In addition, Ernst & Young's May 1996 report does not detail all of
the assumptions used in the firm's financial model that are useful to
understanding the study's results.  In particular, the model assumes
that the interest subsidies some properties currently receive will be
discontinued after the first Section 8 contract expires, including
those in the performing category whose debts do not require
restructuring. 

We are currently examining how the assumptions contained in the Ernst
& Young study affect its estimates of the effects of portfolio
reengineering.  In addition, we are assessing how the use of
alternative assumptions would affect the study's results. 

We also observed that although Ernst & Young's study provided
information on the cost to the government of the portfolio
reengineering proposal, the May report did not provide these
results.\9 We are currently examining Ernst & Young's data and will
provide cost estimates derived from Ernst & Young's model covering
changes in the Section 8 subsidy costs and FHA insurance claims.  Our
preliminary review of this information indicates that the costs of
claims will be significant.  On average, the data indicate that
mortgage balances for the properties needing mortgage
restructuring--including those in the full write-off and
nonperforming categories that would have their mortgages totally
written off--would need to be reduced by between 61 and 67 percent. 
This reduction would result in claims against FHA's multifamily
insurance funds. 


--------------------
\9 According to HUD's Deputy Assistant Secretary for Operations,
Office of Housing, while cost data were developed by Ernst & Young,
HUD never intended that the data be included as a part of Ernst &
Young's report on the results of its study. 


   COMPLEX ISSUES WILL SHAPE THE
   POTENTIAL OUTCOMES OF
   REENGINEERING
---------------------------------------------------------- Chapter 0:6

As we discussed in our testimony before this Subcommittee last year,
the Congress faces a number of significant and complex issues in
evaluating HUD's portfolio reengineering proposal.\10 Since last year
there has been considerable discussion on the issues we noted, but
there is still disagreement on how many of them should be addressed. 
New issues have also been raised.  Key issues include the following. 


--------------------
\10 Multifamily Housing:  HUD's Proposal to Restructure Its Portfolio
(GAO/T-RCED-95-226, June 13, 1995). 


      HOW TO ADDRESS HUD'S
      PROBLEMS IN MANAGING THE
      INSURED SECTION 8 PORTFOLIO
-------------------------------------------------------- Chapter 0:6.1

One key cause of the current problems affecting the insured Section 8
portfolio has been HUD's inadequate management of the portfolio. 
HUD's original proposal sought to address this situation by
subjecting properties to the disciplines of the commercial market by
converting project-based subsidies to tenant-based assistance,
adjusting rents to market levels, and refinancing existing insured
mortgages with smaller, uninsured mortgages if necessary for
properties to operate at the new rents.  However, to the extent that
the final provisions of reengineering perpetuate the current system
of FHA insurance and project-based subsidies, HUD's ability to manage
the portfolio will remain a key concern.  Thus, it will be necessary
to identify other means for addressing the limitations that impede
HUD's ability to effectively manage the portfolio, particularly in
light of the planned staff reductions that will further strain HUD's
management capacity. 


      TO WHAT EXTENT SHOULD FHA
      INSURANCE BE PROVIDED FOR
      RESTRUCTURED LOANS
-------------------------------------------------------- Chapter 0:6.2

An issue with short-term--and potentially long-term--cost
implications is whether HUD should continue to provide FHA insurance
on the restructured loans and, if so, under what terms and
conditions.  If FHA insurance is discontinued when the loans are
restructured as originally planned, HUD would likely incur higher
debt restructuring costs because lenders would set the terms of the
new loans, such as interest rates, to reflect the risk of default
that they would now assume.  The primary benefits of discontinuing
insurance are that (1) the government's dual role as mortgage insurer
and rent subsidy provider would end, eliminating the management
conflicts associated with this dual role, and (2) the default risk
borne by the government would end as loans were restructured. 
However, the immediate costs to the FHA insurance fund would be
higher than if insurance, and the government's liability for default
costs, were continued. 

If, on the other hand, FHA insurance were continued, another issue is
whether it needs to be provided for the whole portfolio or could be
used selectively.  For example, should the government insure loans
only when owners cannot obtain reasonable financing without this
credit enhancement?  Also, if FHA insurance were continued, the terms
and conditions under which it is provided would affect the
government's future costs.  Some lenders have indicated that
short-term (or "bridge") financing insured by FHA may be needed while
the properties make the transition to market conditions, after which
time conventional financing at reasonable terms would be available. 
Thus, the government could insure loans for 3 to 5 years, in lieu of
the current practice of bearing default risk for 40 years.  Finally,
the current practice of the government's bearing 100 percent of the
default risk could be changed by legislation requiring state housing
finance agencies or private-sector parties to bear a portion of the
insurance risk. 


      SHOULD RENTAL ASSISTANCE BE
      PROJECT-BASED OR
      TENANT-BASED
-------------------------------------------------------- Chapter 0:6.3

In addressing the problems of the insured Section 8 portfolio, one of
the key issues that will need to be decided is whether to continue
project-based assistance, convert the portfolio to tenant-based
subsidy, or use some mix of the two subsidy types.  On one hand, the
use of tenant-based assistance can make projects more subject to the
forces of the real estate market, which can help control housing
costs, foster housing quality, and promote resident choice.  On the
other hand, by linking subsidies directly to property units,
project-based assistance can help sustain those properties in housing
markets that have difficulty in supporting unsubsidized rental
housing, such as inner-city and rural locations.  In addition,
residents who would likely have difficulty finding suitable
alternative housing, such as the elderly or disabled and those living
in tight housing markets, may prefer project-based assistance to the
extent that it gives them greater assurance of being able to remain
in their current residences. 


      WHAT PROTECTION SHOULD BE
      GIVEN TO HOUSEHOLDS AT
      REENGINEERED PROPERTIES
-------------------------------------------------------- Chapter 0:6.4

If a decision is made to convert Section 8 assistance from
project-based to tenant-based as part of portfolio reengineering,
decisions must also be made about whether to provide additional
displacement protection for current property residents.  HUD's April
1996 reengineering strategy contains several plans to protect the
residents affected by rent increases at insured properties.  For
example, the residents currently living in project-based Section 8
units that are converted to tenant-based subsidy would receive
enhanced vouchers to pay the difference between 30 percent of their
income and the market rent for the property in which they live, even
if it exceeds the area's fair market rent ceiling.  The residents of
reengineered properties who currently live in units without Section 8
subsidy would receive similar assistance if the properties' new rents
require them to pay more than 30 percent of income.  Such provisions
are clearly important to help limit residents' rent burdens and
reduce the likelihood of residents being displaced, but they also
reduce Section 8 savings, at least in the short run.  The Ernst &
Young study's cost estimates assume that HUD would cover Section 8
assistance costs for existing residents, even if a property's market
rents exceed fair market rent levels set by HUD.  However, it does
not include any costs for providing Section 8 subsidy to residents
who are currently unassisted. 


      TO WHAT EXTENT SHOULD
      PROPERTIES WITH ASSISTED
      RENTS BELOW LOCAL MARKET
      RENTS BE INCLUDED IN
      PORTFOLIO REENGINEERING
-------------------------------------------------------- Chapter 0:6.5

The decision about which properties to include in portfolio
reengineering will likely involve trade-offs between addressing the
problem of high subsidy costs and addressing the problems of poor
physical condition and exposure to default.  On one hand,
reengineering only those properties with rents above market levels
would result in the greatest subsidy cost savings.  On the other
hand, HUD has indicated that also including those properties with
rents currently below market levels could help improve these
properties' physical and financial condition and reduce the
likelihood of default.  However, including such properties would
decrease estimated Section 8 subsidy cost savings.  Although HUD's
latest proposal would initially focus on properties with rents above
market, it notes that many of the buildings with below-market rents
are in poor condition or have significant amounts of deferred
maintenance which will need to be addressed at some point. 


      WHAT PROCESS OR PROCESSES
      SHOULD BE USED TO
      RESTRUCTURE MORTGAGES
-------------------------------------------------------- Chapter 0:6.6

Selecting a mortgage restructuring process that is feasible and that
balances the interests of the various stakeholders will be an
important, but difficult, task.  Various approaches have been
contemplated, including payment of full or partial insurance claims
by HUD, mortgage sales, and the use of third parties or joint
ventures to design and implement specific restructuring actions at
each property.  Because of concerns about HUD's ability to carry out
the restructuring process in house, HUD and others envision relying
heavily on third parties, such as State Housing Financing Agencies
(HFAs) or teams composed of representatives from HFAs, other state
and local government entities, nonprofit organizations, asset
managers, and capital partners.  These third parties would be
empowered to act on HUD's behalf, and the terms of the restructuring
arrangements that they work out could to a large extent determine the
costs to, and future effects of restructuring on, stakeholders such
as the federal government, property owners and investors, mortgage
lenders, residents, and state and local government housing agencies. 
Some, however, have questioned whether third parties would give
adequate attention to the interests of owners or to the public policy
objectives of the housing.  On the other hand, with the proper
incentives, third parties' financial interests could be aligned with
those of the federal government to help minimize claims costs. 


      TO WHAT EXTENT SHOULD THE
      FEDERAL GOVERNMENT FINANCE
      REHABILITATION COSTS
-------------------------------------------------------- Chapter 0:6.7

Who should pay for needed repairs, and how much, is another important
issue in setting restructuring policy.  As discussed previously,
Ernst & Young's study found a substantial amount of unfunded
immediate deferred maintenance and short-term capital replacement
needs across the insured Section 8 portfolio, but particularly in the
"older assisted" properties.  Ernst & Young's data indicate that
between 22 and 29 percent of the properties in the portfolio could
not cover their immediate deferred maintenance and short-term capital
needs, even if their mortgage debt were fully written off.  HUD
proposes that a substantial portion of the rehabilitation and
deferred maintenance costs associated with restructuring be paid
through the affected properties' reserve funds and through FHA
insurance claims in the form of debt reduction.  Others have
suggested that HUD use a variety of tools, such as raising rents,
restructuring debt and providing direct grants, but that per-unit
dollar limits be set on the amount that the federal government pays,
with the expectation that any remaining costs be paid by the property
owners/investors or obtained from some other source. 


      HOW SHOULD HUD ADDRESS THE
      LARGE NUMBER OF PROPERTIES
      THAT WOULD HAVE DIFFICULTY
      SUSTAINING OPERATIONS
-------------------------------------------------------- Chapter 0:6.8

According to Ernst and Young's assessment, between 22 and 29 percent
of HUD's insured portfolio would have difficulty sustaining
operations if market rents replaced assisted rents.  Furthermore,
between 11 and 15 percent of the portfolio would not even be able to
cover operating costs at market rents.  If additional financial
assistance is not provided to these properties, a large number of
low-income residents would face displacement.  While HUD has not yet
developed specific plans for addressing these properties, it appears
likely that different approaches may be needed, depending on a
property's specific circumstances.  For example, properties in good
condition in tight housing markets may warrant one approach, while
properties in poor condition in weak or average housing markets may
warrant another.  Further analysis of these properties should assist
the Department in formulating strategies for addressing them. 


      TO WHAT EXTENT SHOULD THE
      GOVERNMENT PROVIDE TAX
      RELIEF TO OWNERS AFFECTED BY
      PORTFOLIO REENGINEERING
-------------------------------------------------------- Chapter 0:6.9

HUD's portfolio reengineering proposal is likely to have adverse tax
consequences for some project owners.  These tax consequences can
potentially result from either reductions in the principal amounts of
property mortgages (debt forgiveness) or actions that cause owners to
lose the property (for example, as a result of foreclosure).  We have
not assessed the extent to which tax consequences are likely to
result from portfolio reengineering.  However, HUD has stated that it
believes tax consequences can be a barrier to getting owners to agree
to reengineer their properties proactively.  While HUD has not
formulated a specific proposal for dealing with the tax consequences
of portfolio reengineering, it has stated that it is willing to
discuss with the Congress mechanisms to take into account tax
consequences related to debt forgiveness for property owners who
enter into restructuring agreements. 


      WILL THE DEMONSTRATION
      PROGRAM COVER THE FULL RANGE
      OF OPTIONS AND OUTCOMES
------------------------------------------------------- Chapter 0:6.10

The multifamily demonstration program that HUD recently received
congressional authority to implement provides for a limited testing
(on up to 15,000 multifamily units) of some of the aspects of HUD's
multifamily portfolio reengineering proposal.  As such, the program
can provide needed data on the impacts of reengineering on properties
and residents, the various approaches that may be used in
implementing restructuring, and the costs to the government before a
restructuring program is initiated on a broad scale.  However,
because of the voluntary nature of the program, it may not fully
address the broad range of impacts on the properties or the range of
restructuring tools that the Department could use.  For example,
owners may be reluctant to participate in the program if HUD plans to
enter into joint ventures with third-party entities because of
concerns they may lose their properties and/or suffer adverse tax
consequences.  Another potential limitation on the program is that
the funding provided to modify the multifamily loans may not be
sufficient to cover the limited number of units authorized under the
demonstration program. 

How these issues are resolved will, to a large degree, determine the
extent to which the problems that have long plagued the portfolio are
corrected and prevented from recurring and the extent to which
reengineering results in savings to the government. 


   OBSERVATIONS
---------------------------------------------------------- Chapter 0:7

HUD's portfolio reengineering initiative recognizes a reality that
has existed for some time--namely, that the value of many of the
properties in the insured Section 8 portfolio is far less than the
mortgages on the properties suggest.  Until now, this reality has not
been recognized and the federal government has continued to subsidize
the rents at many properties above the level that the properties
could command in the commercial real estate market. 

As the Congress evaluates options for addressing this situation, it
will be important to consider each of the fundamental problems that
have affected the portfolio, and their underlying causes.  Any
approach implemented should address not only the high Section 8
subsidy costs, but also the high exposure to insurance loss, poor
physical condition, and the underlying causes of these long-standing
problems with the portfolio.  As illustrated by several of the key
issues discussed above, questions about the specific details of the
reengineering process, such as which properties to include and
whether or not to provide FHA insurance, will require weighing the
likely effects of various options and the trade-offs involved when
proposed solutions achieve progress on one problem at the expense of
another.  Changes to the insured Section 8 portfolio should also be
considered in the context of a long-range vision for the federal
government's role in providing housing assistance, and assistance in
general, to low-income individuals, and how much of a role the
government is realistically able to have, given the current budgetary
climate. 

Addressing the problems of the portfolio will inevitably be a costly
and difficult process, regardless of the specific approaches
implemented.  The overarching objective should be to implement the
process in the most efficient and cost-effective manner possible,
recognizing not only the interests of the parties directly affected
by restructuring but also the impact on the federal government and
the American taxpayer. 


-------------------------------------------------------- Chapter 0:7.1

As indicated earlier in our statement, we are continuing to review
the results of Ernst & Young's study and other issues associated with
portfolio reengineering, and we will look forward to sharing the
results of our work with the Subcommittee as it is completed. 


GAO'S 10 CASE STUDY PROPERTIES
=========================================================== Appendix I

   Figure 1:  Names and Locations
   of Case Study Properties

   (See figure in printed
   edition.)


*** End of document. ***