Multifamily Housing: HUD's Portfolio Reengineering Proposal: Cost and
Management Issues (Testimony, 07/30/96, GAO/T-RCED-96-232).

GAO discussed the Department of Housing and Urban Development's (HUD)
proposal to reengineer its multifamily rental housing portfolio,
focusing on: (1) the problems affecting the section 8 portfolio; (2) HUD
plans to address these problems; and (3) how properties will be affected
by the reengineering proposal. GAO noted that: (1) the problems
affecting the insured Section 8 portfolio include high subsidy costs,
high exposure to insurance loss, and the poor condition of many rental
properties; (2) these problems stem from program design flaws that
contribute to high subsidies, and weaknesses in HUD oversight and
management of insured properties; (3) the proposal addresses these
problems by decoupling HUD mortgage insurance and project-based rental
subsidies and subjecting the properties to commercial market forces; (4)
the process would allow property owners to set rent at market levels,
terminate Federal Housing Administration (FHA) mortgage insurance, and
replace project-based Section 8 subsidies with portable tenant-based
subsidies; (5) the vast majority of Section 8 properties need their debt
reduced to maintain operations; (6) it will cost between $6 and $7
billion to reengineer the Section 8 portfolio; and (7) Congress needs to
consider whether rental assistance should be project-based or
tenant-based, the level of protection for displaced households, the
extent of FHA insurance for restructured loans, and the degree to which
the federal government should finance rehabilitation costs.

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

 REPORTNUM:  T-RCED-96-232
     TITLE:  Multifamily Housing: HUD's Portfolio Reengineering 
             Proposal: Cost and Management Issues
      DATE:  07/30/96
   SUBJECT:  Housing programs
             Low income housing
             Federal aid for housing
             Rental housing
             Disadvantaged persons
             Reengineering (management)
             Insurance losses
             Mortgage protection insurance
             Rent subsidies
             Mortgage loans
IDENTIFIER:  HUD Section 8 Substantial Rehabilitation Program
             HUD Section 8 New Housing Construction Program
             HUD Mark to Market Program
             
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Cover
================================================================ COVER


Before the Subcommittee on Human Resources and Intergovernmental
Relations, Committee on Government Reform and Oversight, House of
Representatives

July 30, 1996
10:00 a.m.  EDT

MULTIFAMILY HOUSING - HUD'S
PORTFOLIO REENGINEERING PROPOSAL: 
COST AND MANAGEMENT ISSUES

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

GAO/T-RCED-96-232

GAO/RCED-96-232T


(385640)


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

  HUD - x
  FHA - x
  LLP - x
  FMR - 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 the management and cost implications of 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).  Two years ago, we testified at
a hearing held by this Subcommittee's predecessor concerning the
problems affecting HUD's Section 8 properties, including high Section
8 assistance costs and poor physical conditions at many properties.\1

Subsequently, 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 currently affecting the insured Section 8
     portfolio are much the same as those we discussed 2 years
     ago--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 put
     virtually all the insurance risk on HUD and (2) 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 mark-to-market proposal sought to address these problems
     and their causes by decoupling HUD's mortgage insurance and
     project-based rental subsidies and subjecting the properties to
     the forces and disciplines of the commercial market.  The
     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.  In
     response to various concerns about its mark-to-market proposal,
     in early 1996 HUD made several changes to the 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.  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. 

  -- 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 assumptions used in the model affect its estimates
     of the effects of portfolio reengineering.  Our analysis of the
     cost data that were developed by Ernst & Young as part of its
     study but not included in its May 1996 report indicates that the
     claims costs will be substantial--between $6 billion and $7
     billion on a present value basis.  This amount reflects an
     average debt writedown of approximately 61 to 67 percent of the
     insured loans' unpaid principal balances at the time of
     restructuring for properties whose mortgages need restructuring. 

  -- The Congress will also 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. 


--------------------
\1 Federally Assisted Housing:  Condition of Some Properties
Receiving Section 8 Project-Based Assistance Is Below Housing Quality
Standards (GAO/T-RCED-94-273, July 26, 1994). 


   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.\2 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.\3 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 balance)
consists 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 balance) 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. 


--------------------
\2 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. 

\3 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.  For example, at one of our case study properties, Universal
City in Chicago, Illinois, subsidized rents for the 160 Section 8
units range from $1,017 to $1,469 per month compared to estimated
market rents that the property could command of $520 to $750 per
month.  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.  At one of our case study
properties, Onterie Center, also in Chicago, Illinois, HUD insures a
$49 million mortgage and holds another $26 million in mortgage debt
that was assigned to the Department in 1992 because of continuing
financial difficulties at the property.\4 A third, closely related
problem is the poor physical condition of many of the properties in
the portfolio.  For example, Ernst & Young estimates that one of our
case study properties, Murdock Terrace in Dallas, Texas, has $5.9
million in immediate deferred maintenance and short-term capital
needs.  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 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. 


--------------------
\4 This property includes commercial space and 594 residential units,
119 of which have Section 8 project-based assistance. 


   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 to 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.\5
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.\6 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. 


--------------------
\5 Authority for the demonstration program was provided in section
210 of HUD's Appropriations Act for 1996 (P.  L.  104-134). 

\6 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
would 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\7 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.\8 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 under way.  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. 


--------------------
\7 The study was conducted by the E&Y Kenneth Leventhal Real Estate
Group. 

\8 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.\9 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. 


--------------------
\9 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) the short-term capital backlog,
the estimated costs for the expired life of property systems
requiring replacement in 5 or fewer years; and (3) the 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.\10

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. 

The case study properties we examined reflect the full range of
possible outcomes.  Ernst & Young's model concluded that two of the
case study properties would fall into the performing category, two
were classified in the restructure category, three were full
write-offs, and two were classified as nonperforming.\11


--------------------
\10 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. 

\11 One of our 10 case study properties was dropped from Ernst &
Young's sample prior to their final analysis. 


   MODEL RESULTS INDICATE EVENTUAL
   SECTION 8 SAVINGS BUT HIGH
   CLAIMS COSTS
---------------------------------------------------------- Chapter 0:5

Ernst & Young's model provides estimates of Section 8 subsidy costs
before and after reengineering and the amount of the FHA insurance
claims resulting from writing down the properties' mortgages and
addressing deferred maintenance needs, although in a manner that does
not conform with budget rules or scoring methodology.  The May 2,
1996, briefing report does not present the information gathered in
the study on how portfolio reengineering would affect rental subsidy
and claims costs.  According to the Deputy Assistant Secretary for
Operations, HUD Office of Housing, while the Department plans to use
Ernst & Young's cost data in developing future budget estimates
relating to portfolio reengineering, it never intended that the cost
data be included in Ernst & Young's May 1996 report. 

In the model, claims costs include the amount of debt reduction
needed for the property to sustain operations at market rents and
also include funding for some or all of the immediate deferred
maintenance and short-term capital needs.  However, the claims costs
are limited to a maximum of the unpaid principal balance of the loans
at the time of debt restructuring.  In addition, the claims costs are
based on an evaluation of the loan amount the property could support
using standard financial underwriting criteria without the
continuation of FHA insurance. 

Our analysis of these data indicates that, while Section 8 costs
would decrease over the long-run, there may be little or no aggregate
savings in Section 8 rental assistance costs over the next 10 years
if, as the model assumes, all insured Section 8 properties were
reengineered when their current Section 8 contracts expire.  These
data indicate that, for the period fiscal year 1996 through 2005,
there may be little difference in aggregate Section 8 costs after
reengineering compared with the cost of continuing project-based
assistance at current levels: 

  -- If project-based assistance is continued at current levels
     (including inflation), the costs in present value terms are
     estimated to be between $27.2 billion and $31.0 billion.\12

  -- The cost of Section 8 assistance after reengineering is
     estimated to be between $26.5 billion and $29.8 billion.\13

A primary reason that 10-year Section 8 cost estimates are similar is
that the model assumes that projects will be reengineered when their
current Section 8 contracts expire.  This analysis thus reflects
HUD's contractual obligations, which the Department has repeatedly
indicated that it will not abrogate.  Because many properties with
rents below market have expiring contracts during the first part of
the 10-year period and thus will be reengineered early in the
process, Section 8 costs increase during the early years but then
begin to decrease as more projects with rents above market are
reengineered in the later years.  In fiscal year 2005, when Ernst &
Young assumes that virtually all projects have been reengineered,
Section 8 costs are estimated to be between $1.9 billion and $2.2
billion a year on a present value basis.  The model indicates that
annual savings of between $298 million to $493 million (between 13 to
19 percent) could be achieved with reengineering compared with the
costs of continuing Section 8 assistance at current levels. 

However, we note that Ernst & Young's model does not reflect the
changes that HUD made to its proposal in early 1996.  Some of the
changes offer the potential of additional Section 8 cost savings. 
For example, HUD is proposing to use a proactive approach to
portfolio reengineering and hopes that owners will voluntarily agree
to go through this process (and terminate the Section 8 contracts) in
advance of Section 8 contract expirations.  However, it is not clear
to what extent HUD will be successful in attracting owners to
restructure in advance of the Section 8 contract expirations--or what
additional incentives HUD may have to offer to achieve this goal. 

In addition, HUD now plans to focus initially on reengineering
properties with rents above market.  To the extent that portfolio
reengineering focuses on such properties, Section 8 savings would
increase.  For example, Ernst & Young's data indicate that the
10-year Section 8 costs for properties with assisted rents above
market would be between $21.2 billion and $25.0 billion compared with
between about $18.5 billion and $21.5 billion if the loans for
properties with rents above market were restructured when the Section
8 contracts expire.\14 Furthermore, it is important to note that some
savings would result if, as Ernst & Young's model assumes, mortgage
interest subsidies are terminated as projects are reengineered. 
Ernst & Young estimates that without reengineering, mortgage interest
subsidies would range from between about $841 million to $1.1 billion
over the next 10 years (on a present value basis).  However, it
should be noted that most properties that receive interest subsidies
are believed to have rents that are below market. 

Regarding the FHA insurance claims costs, our analysis of Ernst &
Young's data indicates that FHA claims for mortgage write-downs and
deferred maintenance and other capital costs for properties that need
mortgage restructuring will be substantial.  The mortgage balances
for 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
to 67 percent.  This reduction would result in claims costs against
the FHA multifamily insurance funds.  According to the data, the
10-year costs of claims paid, on a present value basis, would be
between $6 billion and $7 billion.  If HUD's proactive approach were
successful, while Section 8 savings would increase, the claims
amounts related to debt write-down could also be higher than
indicated in Ernst & Young's study because (1) the loans would be
restructured earlier when the unpaid principal balances are higher
and (2) the present value of claims occurring in the earlier years
would be higher.  However, HUD believes that without a proactive
approach, owners will disinvest in the properties.  Such
disinvestment would have an adverse impact on the physical condition,
resulting in higher claims costs at a later date. 

The claims payments estimated in Ernst & Young's study indicate
substantial loan loss rates for the government.\15 For example,
portfolio reengineering claims for properties with assisted rents
greater than market rents are estimated to be between $4.8 billion
and $5.8 billion, and the related unpaid principal balances at the
time of restructuring are between $6.9 billion and $8.1 billion.  The
estimated loss rate would be between 67 and 75 percent.  Table 2
provides claims, unpaid principal balance, and recovery data for the
properties subject to portfolio reengineering. 



                                Table 2
                
                  Impact of Portfolio Reengineering on
                FHA's Insurance Fund, Fiscal Years 1996-
                                 2005\a

                 (Dollars in billions (present value))

Relative value of
assisted rents                            Unpaid principal
before                                    balances at date of     Loss
restructuring        Claims               restructuring           rate
-------------------  -------------------  -------------------  -------
Greater than or      Between $4.8 and     Between $6.9 and      67% to
equal to market      $5.8                 $8.1                     75%
rents

Less than market     Between $1.0 and     Between $2.2 and      40% to
rents\b              $1.5                 $3.1                     51%

======================================================================
Total                Between $6.0 and     Between $9.5 and      61% to
                     $7.0                 $10.8                    67%
----------------------------------------------------------------------
\a All estimates for projects with assisted rents above or below
market rents based on the Ernst & Young sample may be misstated
because the sample did not contain both types of properties in each
of the groups of properties, called strata, from which they sampled. 
Thus, the estimates assume that none of the 510 projects from three
strata containing newer projects had assisted rents below market. 
The estimates also assume that none of the 372 older projects from
two strata were above market. 

\b This estimate may be misstated because no projects with claims
were found among the sampled projects with assisted rent less than
market rent from four strata.  Thus, the estimate assumes that none
of the 985 projects from these strata were projects with assisted
rents less than market rents that resulted in claims.  The 985
projects included 807 newer and 178 older projects. 


--------------------
\12 These and other total cost estimates contained in our statement
are based on a universe of 8,363 properties--the population from
which the sample used by Ernst & Young was selected.  The estimates
contained in Ernst & Young's May 1996 report are based on a
population of 8,563 properties.  The difference reflects properties
that did not have a chance at being included in the sample due to
technical and cost considerations.  In general, the estimates in our
report would increase by about 2 percent if they were applied to
8,563 rather than 8,363 properties.  This assumes that the additional
properties HUD identified are similar to those in the original
population. 

\13 Both estimates assume Section 8 costs increase by 3 percent a
year.  We discounted these costs by 6.75 percent a year to arrive at
a present value estimate. 

\14 All estimates for projects with assisted rents above or below
market rents based on the Ernst & Young sample may be misstated
because the sample did not contain both types of properties in each
of the groups of properties, called strata, from which they sampled. 
Thus, the estimates assume that none of the 510 projects from three
strata containing newer projects had assisted rents below market. 
The estimates also assume that none of the 372 older projects from
two strata were above market. 

\15 The loss rate represents the ratio of claims to the unpaid
principal balances at restructure dates. 


   GAO'S ASSESSMENT OF THE MODEL
   AND THE RESULTS
---------------------------------------------------------- Chapter 0:6

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.  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.  The 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 that 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.  Furthermore, the financial test identifying the loans
that could cover all debt service, operating, and capital needs costs
if market rents replaced assisted rents, assumes that properties that
currently receive interest subsidies would have to pay the full
mortgage interest amount without the benefit of the interest subsidy. 
This assumption would identify fewer performing loans than if the
current debt service requirements were tested for.  We are currently
examining how the assumptions contained in Ernst & Young's study
affect its estimates of the effects of portfolio reengineering.  In
addition, as discussed in appendix II, we also performed sensitivity
analyses to assess the extent to which the use of different
assumptions affects the results of Ernst & Young's study. 

As part of our work evaluating the Ernst & Young model, we also
compared Ernst & Young's data on market rents and deferred
maintenance with information from the three licensed appraisal firms
we retained to assess 10 of the HUD-insured Section 8 properties
included in Ernst & Young's sample.  In 8 out of the 10 cases, the
estimated market rents provided by these appraisers are reasonably
close to (i.e., within 10 percent of) the rents Ernst & Young
developed in their market surveys.  In two instances, however, Ernst
& Young's market rent estimates are more than 20 percent lower than
the market rent estimates of the appraisal firms.  This difference
reflects in large measure a different methodology that Ernst & Young
used in estimating market rents in neighborhoods consisting primarily
of assisted properties--where few, if any, comparable market
properties were identified.  In these cases, Ernst & Young assumed
that since the local neighborhood was essentially maintained by
non-market driven forces, there was no market for unassisted rents in
these neighborhoods other than that controlled by the local housing
authority.  Thus, Ernst & Young based its rent estimates on the rents
subsidized by the local housing authorities.  In contrast, the
appraisers we retained believed that there were comparable properties
that could be used to estimate market rents for the two properties. 

While the information we had on the market rents for our 10 case
studies was generally consistent with Ernst & Young's estimates, the
information on capital needs costs varied widely.  In general, the
Ernst & Young cost estimates were significantly higher.  The
appraisers we retained conducted physical inspections of the
properties but were not tasked with performing engineering studies. 
In contrast, Ernst & Young retained a firm to conduct engineering
studies at the properties.  Officials from Ernst & Young and the
engineering firm said the inspections were not full engineering
studies which would be used in financial underwriting or negotiations
with the owners.  However, the inspections provide preliminary data
that can be used for budgeting purposes.  Because the appraisals
conducted for us were more limited in scope than Ernst & Young's
reviews and thus not directly comparable, we provided the property
owners and managers with the capital needs estimates developed by
Ernst & Young and by the appraisers for their evaluation.  We are
currently examining their responses and the reasons for the
differences in the capital needs estimates. 


   COMPLEX ISSUES WILL SHAPE THE
   POTENTIAL OUTCOMES OF
   REENGINEERING
---------------------------------------------------------- Chapter 0:7

The Congress faces a number of significant and complex issues in
evaluating HUD's portfolio reengineering proposal.  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 restructuring
process results in any net savings to the government.  Key issues
include the following: 

  -- How should HUD's problems in managing the insured Section 8
     portfolio be addressed? 

  -- To what extent should FHA insurance be provided for restructured
     loans? 

  -- Should rental assistance after reengineering be project-based or
     tenant-based? 

  -- What protection should be given to residents of reengineered
     properties to protect them from rent increases or displacement? 

  -- To what extent should properties with assisted rents that are
     below market rents be included in portfolio reengineering? 

  -- What process or processes should be used to restructure
     mortgages? 

  -- To what extent should the federal government finance
     rehabilitation costs? 

  -- What actions should be taken to deal with properties that would
     have difficulty in sustaining operations after portfolio
     reengineering? 

  -- Whether and to what extent should tax relief be provided as a
     part of the reengineering process? 

  -- Will the current demonstration program be sufficient to test the
     range of options for carrying out portfolio reengineering and
     its effects on properties and residents? 

These issues are discussed further in appendix III. 


   OBSERVATIONS
---------------------------------------------------------- Chapter 0:8

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 0:8.1

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 1.1:  Names and
   Locations of Case Study
   Properties

   (See figure in printed
   edition.)


SENSITIVITY ANALYSIS HELPS
EVALUATE THE RANGE OF POSSIBLE
OUTCOMES
========================================================== Appendix II

Any estimates of the outcomes and costs of portfolio reengineering
are likely to be subject to some error because they rely on
predicting the reactions of numerous owners, lenders, and residents. 
In addition, as discussed above, we have identified some limitations
of the model and some assumptions that may not reflect the way in
which insured Section 8 properties will actually be affected by
portfolio reengineering.  To assess the extent to which the use of
different assumptions affects the results of Ernst & Young's study,
we performed sensitivity analyses of Ernst & Young's model using two
sets of revised assumptions that we developed on the basis of our
discussions with multifamily industry officials.  One scenario
reflects assumptions that are more optimistic in terms of the cost to
the government of portfolio reengineering.  The other uses
assumptions that are more conservative or pessimistic.  Both of these
sets of assumptions are intended to reflect the range of potential
outcomes using the same basic policy assumptions used in the Ernst &
Young study.  We recognize that the use of alternative policy
assumptions can produce different outcomes. 

For the optimistic scenario, we used financing terms that the lenders
we consulted believed to be the most favorable that were likely to be
available, assuming that no FHA insurance or other credit enhancement
is provided.  For example, we lowered the range of interest rates
applicable to the restructured loans from a range of 9.75 to 10
percent to a range of 8.75 to 9 percent.  We also revised the debt
service coverage ratios, the loan-to-value requirements, and the loan
amortization periods to reflect the views of the lenders.  In some
cases, our terms, though viewed by lenders as optimistic, are more
conservative than Ernst & Young's.  In addition, a significant
difference between our optimistic scenario and Ernst & Young's
analysis is that we reduced all capital costs used by Ernst & Young
by 25 percent. 

For our pessimistic scenario, we used higher interest rates than
Ernst & Young, set higher standards for debt service coverage ratios
and loan-to-value requirements, and increased the transaction cost
and bad debt expense estimates somewhat.  We also reduced Ernst &
Young's market rent estimates by 5 percent.  We did not adjust the
capital cost estimates used in Ernst & Young's study for this
scenario. 

Under all the scenarios, a substantial number of properties are
likely to do well, and other properties will have difficulty
sustaining operations.  Specifically, using optimistic assumptions,
between 24 percent to 30 percent of properties fall into the
"performing" category, but between 15 percent and 20 percent fall in
the two bottom categories--"full write-off" or "nonperforming." Using
the pessimistic assumptions, between 10 and 14 percent would be
"performing" and between 39 percent and 46 percent would be "full
write-offs" or "nonperforming." The FHA claims costs associated with
portfolio reengineering are estimated to be between $4.9 billion and
$5.9 billion using optimistic assumptions and between $8.2 billion
and $9.4 billion using pessimistic ones.  The Section 8 subsidy costs
are the same as Ernst & Young's using our optimistic assumptions. 
Section 8 subsidy costs decrease somewhat using our pessimistic
assumptions, where we reduced the estimated market rents by 5
percent. 


ISSUES FACING THE CONGRESS IN
ASSESSING HUD'S PORTFOLIO
REENGINEERING PROPOSAL
========================================================= Appendix III

The Congress faces a number of significant and complex issues in
evaluating HUD's` portfolio reengineering proposal.  Key issues
include the following. 


      HOW TO ADDRESS HUD'S
      PROBLEMS IN MANAGING THE
      INSURED SECTION 8 PORTFOLIO
----------------------------------------------------- Appendix III:0.1

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 subsidy, HUD's ability to manage
the portfolio will remain a key concern.  Thus, it will be necessary
to identify other means of 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? 
----------------------------------------------------- Appendix III:0.2

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 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
----------------------------------------------------- Appendix III:0.3

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 properties in housing
markets that have difficulty in supporting unsubsidized rental
housing, such as inner-city and rural locations.  In addition, those
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
----------------------------------------------------- Appendix III:0.4

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
residents affected by rent increases at insured properties.  For
example, 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 property's 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
----------------------------------------------------- Appendix III:0.5

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
----------------------------------------------------- Appendix III:0.6

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
----------------------------------------------------- Appendix III:0.7

Who should pay for needed repairs, and how much, is another important
issue in setting restructuring policy.  As discussed previously, the
Ernst & Young study found a substantial amount of unfunded immediate
deferred maintenance and short-term capital replacement needs across
the insured Section 8 portfolio, 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
----------------------------------------------------- Appendix III:0.8

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
----------------------------------------------------- Appendix III:0.9

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
---------------------------------------------------- Appendix III:0.10

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. 


*** End of document. ***