Mortgage Financing
Actions Needed to Help FHA Manage Risks from New Mortgage Loan Products Gao ID: GAO-05-194 February 11, 2005The U.S. Department of Housing and Urban Development (HUD), through its Federal Housing Administration (FHA), insures billions of dollars in home mortgage loans made by private lenders. FHA insures low down payment loans and a number of parties have made proposals to either eliminate or otherwise change FHA's borrower contribution requirements. GAO was asked to (1) identify the key characteristics of existing low and no down payment products, (2) review relevant literature on the importance of loan-to-value (LTV) ratios and credit scores to loan performance, (3) report on the performance of low and no down payment mortgages supported by FHA and others, and (4) identify lessons for FHA from others in terms of designing and implementing low and no down payment products.
FHA and many other mortgage institutions provide many low and no down payment products with requirements that vary in terms of eligibility, borrower investment, underwriting, and risk mitigation. While these products are similar, there are some important differences, including that FHA has lower loan limits, allows closing costs and the up-front insurance premium to be financed in the mortgage, and permits the down payment funds to come from nonprofits that receive funds from sellers. FHA also differs in that it does not require prepurchase counseling. A substantial amount of research GAO reviewed indicates that LTV ratio and credit score are among the most important factors when estimating the risk level associated with individual mortgages. GAO's analysis of the performance of low and no down payment mortgages supported by FHA and others corroborates key findings in the literature. Generally, mortgages with higher LTV ratios (smaller down payments) and lower credit scores are riskier than mortgages with lower LTV ratios and higher credit scores. Some practices of other mortgage institutions offer a framework that could help FHA manage the risks associated with introducing new products or making significant changes to existing products. Mortgage institutions may impose limits on the volume of the new products they will permit and on who can sell and service these products. FHA officials question the circumstances in which they can limit volumes for their products and believe they do not have sufficient resources to manage a product with limited volumes. Mortgage institutions sometimes require additional credit enhancements, such as higher insurance coverage; and sometimes require stricter underwriting, such as credit score thresholds, when introducing a new low or no down payment product. FHA is authorized to require an additional credit enhancement by sharing risk through co-insurance but does not currently use this authority. FHA has used stricter underwriting criteria but this has not included credit score thresholds.
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Director: Team: Phone:GAO-05-194, Mortgage Financing: Actions Needed to Help FHA Manage Risks from New Mortgage Loan Products
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Report to the Chairman, Subcommittee on Housing and Community
Opportunity, Committee on Financial Services, House of Representatives:
February 2005:
Mortgage Financing:
Actions Needed to Help FHA Manage Risks from New Mortgage Loan
Products:
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-05-194]:
GAO Highlights:
Highlights of GAO-05-194, a report to the Chairman, Subcommittee on
Housing and Community Opportunity, Committee on Financial Services,
House of Representatives
Why GAO Did This Study:
The U.S. Department of Housing and Urban Development (HUD), through its
Federal Housing Administration (FHA), insures billions of dollars in
home mortgage loans made by private lenders. FHA insures low down
payment loans and a number of parties have made proposals to either
eliminate or otherwise change FHA‘s borrower contribution requirements.
GAO was asked to (1) identify the key characteristics of existing low
and no down payment products, (2) review relevant literature on the
importance of loan-to-value (LTV) ratios and credit scores to loan
performance, (3) report on the performance of low and no down payment
mortgages supported by FHA and others, and (4) identify lessons for FHA
from others in terms of designing and implementing low and no down
payment products.
What GAO Found:
FHA and many other mortgage institutions provide many low and no down
payment products with requirements that vary in terms of eligibility,
borrower investment, underwriting, and risk mitigation. While these
products are similar, there are some important differences, including
that FHA has lower loan limits, allows closing costs and the up-front
insurance premium to be financed in the mortgage, and permits the down
payment funds to come from nonprofits that receive funds from sellers.
FHA also differs in that it does not require prepurchase counseling.
A substantial amount of research GAO reviewed indicates that LTV ratio
and credit score are among the most important factors when estimating
the risk level associated with individual mortgages. GAO‘s analysis of
the performance of low and no down payment mortgages supported by FHA
and others corroborates key findings in the literature. Generally,
mortgages with higher LTV ratios (smaller down payments) and lower
credit scores are riskier than mortgages with lower LTV ratios and
higher credit scores.
Some practices of other mortgage institutions offer a framework that
could help FHA manage the risks associated with introducing new
products or making significant changes to existing products. Mortgage
institutions may impose limits on the volume of the new products they
will permit and on who can sell and service these products. FHA
officials question the circumstances in which they can limit volumes
for their products and believe they do not have sufficient resources to
manage a product with limited volumes. Mortgage institutions sometimes
require additional credit enhancements, such as higher insurance
coverage; and sometimes require stricter underwriting, such as credit
score thresholds, when introducing a new low or no down payment
product. FHA is authorized to require an additional credit enhancement
by sharing risk through co-insurance but does not currently use this
authority. FHA has used stricter underwriting criteria but this has not
included credit score thresholds.
Average Four-Year Default Rates for FHA Insured Loans Originated in
1998, 1999, and 2000 (by LTV):
[See PDF for image]
[End of figure]
What GAO Recommends:
GAO suggests that Congress consider limiting any new no down payment
product it may authorize. GAO recommends that HUD, among other things,
consider piloting new or changed products and that HUD establish a
framework for when and how to pilot products. In written comments, HUD
stated that it had considered these actions, including piloting, but
instead adopted an alternative solution. However, it is not clear under
which circumstances HUD would consider piloting.
www.gao.gov/cgi-bin/getrpt?GAO-05-194.
To view the full product, including the scope and methodology, click on
the link above. For more information, contact William B. Shear at (202)
512-8678 or shearw@gao.gov.
[End of section]
Contents:
Letter:
Results in Brief:
Background:
Characteristics and Standards of Low and No Down Payment Products Vary
by Mortgage Institution:
Research Shows LTV Ratio and Credit Score Are Important When Estimating
Risk of Individual Mortgages:
Our Analysis Indicated That Mortgages with Higher LTV Ratios and Lower
Credit Scores Pose Greater Risks:
Several Practices Mortgage Institutions Use in Designing and
Implementing Low and No Down Payment Products Could Be Instructive for
FHA:
Conclusions:
Matters for Congressional Consideration:
Recommendations for Executive Action:
Agency Comments and Our Evaluation:
Appendixes:
Appendix I: Scope and Methodology:
Appendix II: Papers Identified in Literature Search and Included in
Analysis:
Appendix III: Comments from the Department of Housing and Urban
Development:
Appendix IV: GAO Contacts and Staff Acknowledgments:
GAO Contacts:
Staff Acknowledgments:
Tables:
Table 1: Eligibility Limitations of FHA Compared with RHS, VA, and
Selected Products of Fannie Mae and Freddie Mac:
Table 2: LTV Calculations for FHA, RHS, VA, Fannie Mae, and Freddie
Mac:
Figures:
Figure 1: Evolution of Low and No Down Payment Products:
Figure 2: Percentage of Home Purchase Mortgages with a LTV Ratio Higher
Than 95 Percent for HUD (FHA), VA, Fannie Mae, and Freddie Mac for
Loans Originated in 2000:
Figure 3: Percentage of Loans with LTV Ratios of 95 Percent or Higher
That Fannie Mae and Freddie Mac Purchased, 1997-2000:
Figure 4: Four-year Relative Default Rates by LTV Ratio for FHA-Insured
Mortgages (1992, 1994, and 1996):
Figure 5: Four-year Relative Default Rates by Credit Score for FHA-
Insured Mortgages (1992, 1994, and 1996):
Figure 6: Four-year Relative Default Rates by LTV Ratio and Credit
Score for FHA-insured Mortgages (1992, 1994, and 1996):
Figure 7: Four-Year Relative Default Rates by LTV Ratio for
Conventional Mortgages (1997, 1998, and 1999):
Figure 8: Four-Year Relative Default Rates by Credit Score for
Conventional Mortgages (1997, 1998, and 1999):
Figure 9: Four-Year Relative Default Rates by LTV Ratio and Credit
Score for Conventional Mortgages (1997, 1998, and 1999):
Abbreviations:
ARM: adjustable rate mortgage:
FASAB: Federal Accounting Standards Advisory Board:
FHA: Federal Housing Administration:
GSE: government-sponsored enterprise:
HECM: Home Equity Conversion Mortgage:
HUD: U.S. Department of Housing and Urban Development:
LTV: loan-to-value:
MMI: Mutual Mortgage Insurance:
OFHEO: Office of Federal Housing Enterprise Oversight:
RHS: Rural Housing Service:
USDA: U.S. Department of Agriculture:
VA: U.S. Department of Veterans Affairs:
Letter February 11, 2005:
The Honorable Bob Ney:
Chairman:
Subcommittee on Housing and Community Opportunity:
Committee on Financial Services:
House of Representatives:
Dear Mr. Chairman:
Every year, the U.S. Department of Housing and Urban Development (HUD),
through its Federal Housing Administration (FHA), insures billions of
dollars in home mortgage loans made by private lenders, very often with
low down payments. FHA mortgage insurance helps homebuyers with limited
funds to obtain a home mortgage. Homebuyers with FHA-insured loans need
to make a 3 percent contribution toward the purchase of the property
and may finance some of the closing costs associated with the loan. As
a result, an FHA-insured loan could equal nearly 100 percent of the
property's value or sales price--commonly called loan-to-value (or LTV)
ratio.[Footnote 1] In recent years, various mortgage industry
participants, such as lenders, private mortgage insurers, and
government-sponsored enterprises (the Federal National Mortgage
Association [Fannie Mae] and the Federal Home Loan Mortgage Corporation
[Freddie Mac]) have begun to support mortgage products that require
very little or no down payment. Among these products, some allow third-
party provision of gift down payment assistance. Recently, in a HUD
contractor study of a national sample of FHA loans, of those loans that
received down payment assistance, 29 percent received assistance from a
nonprofit down payment assistance provider. In addition, the FHA and
others have proposed eliminating the borrower contribution requirement
for FHA-insured loans. At the same time, the mortgage industry has
moved toward greater use of automated systems assessing the risk level
of mortgages. These automated underwriting systems rely, in part, on
individuals' credit scores or credit history, and these systems have
played an integral role in the provision of low and no down payment
mortgage products.[Footnote 2]
In light of recent changes in the composition of FHA-insured mortgage
products and the proposal to eliminate the borrower contribution
requirement for FHA-insured mortgages, you asked us to evaluate low and
no down payment lending. Specifically, this report examines (1) the key
characteristics and standards of mortgage products--supported by FHA
and others--that require low or no down payments; (2) what published
research indicates about the importance of variables such as LTV ratios
and credit scores in estimating the risk level associated with
individual mortgages; (3) the performance of low and no down payment
mortgages supported by FHA and others; and (4) what lessons FHA might
learn from others that support low and no down payment lending in terms
of designing and implementing such products.
To address the objectives we interviewed officials at FHA, the U.S.
Department of Agriculture (USDA), and U.S. Department of Veterans
Affairs (VA); and staff at selected conventional mortgage
providers[Footnote 3]; private mortgage insurers; two government-
sponsored enterprises (GSE); the Office of Federal Housing Enterprise
Oversight (OFHEO); selected state housing finance agencies; and
nonprofit down payment assistance providers. We reviewed descriptions
of low and no down payment mortgage products supported by selected
mortgage industry participants and compared the standards used by these
entities. To determine what published research indicates about the
variables that are most important when estimating the risk level
associated with individual mortgages, we reviewed recent and relevant
papers that we identified through a systematic search of economic
literature. To describe the low and no down payment performance of
loans supported by FHA and others, we examined the relationship among
mortgage performance, LTV ratio, and credit score using 4-year default
rates for a special research sample of over 400,000 mortgages insured
by FHA during 1992, 1994, and 1996 and for all conventional loans
originated in 1997, 1998, and 1999 and purchased by Fannie Mae or
Freddie Mac. We chose these years because, for FHA, these data are the
only significant data set of FHA-insured loans that includes credit
scores and that had at least 4 years of loan performance activity. For
Fannie Mae and Freddie Mac, in 1997, these institutions began
purchasing an increasing number of loans with the highest LTV ratios;
loans originated after 1999 would have less than 4 years of experience
to analyze. The GSEs provided us data that they considered to be
proprietary. We did not disclose information that could be considered
proprietary, but this did not limit our overall findings. We assessed
the reliability of the FHA, Fannie Mae, and Freddie Mac data by
discussing the data with knowledgeable FHA officials and Fannie Mae and
Freddie Mac officials; reviewing recent audit reports that evaluated
the information systems at each entity; and comparing the data with
similar publicly available data. We determined that the data are
sufficiently reliable to use in our analysis of the performance of low
and no down payment mortgages. To determine what lessons FHA might
learn from others that support low and no down payment lending, we
obtained testimonial information from mortgage industry participants
about the steps they take to design and implement low and no down
payment lending products. We did not verify that these institutions, in
fact, used these practices.
We performed our audit work from January 2004 to December 2004 in
accordance with generally accepted government auditing standards.
Appendix I provides a full description of our scope and methodology.
Results in Brief:
FHA and other mortgage institutions provide products that enable
homebuyers to purchase homes using little of their own funds. While
similar, the products offered by FHA and others have important
differences in terms of eligibility, borrower investment, underwriting,
and risk mitigation. With respect to eligibility, for example, FHA loan
limits are lower than those in the conventional market. In terms of
borrower investment, FHA's product differs from others in that it
allows some of the closing costs and the up-front insurance premium to
be financed in the mortgage. Although FHA requires a 3 percent borrower
contribution, it can come from sources other than the borrower. Many
conventional low and no down payment products also permit down payment
funds to come from others but generally stipulate that down payment
funds, either directly or indirectly, cannot come from an interested or
seller-related party. FHA also does not permit down payment funds to
come directly or indirectly from sellers but does permit nonprofits
that receive contributions from sellers to provide down payment
assistance to homebuyers. With respect to underwriting, many mortgage
institutions use automated systems to some extent. These systems allow
lenders to quickly assess the riskiness of mortgages by simultaneously
considering multiple factors including the credit score and credit
history of borrowers. With respect to risk mitigation, FHA differs from
conventional mortgage institutions that provide low and no down payment
products. For example, while FHA does not require prepurchase
counseling, some institutions require borrowers to receive counseling
for their no down payment products. Additionally, some mortgage
institutions require higher private mortgage insurance coverage on
their no down payment products. While FHA already provides nearly 100
percent insurance, it does have the authority to share risk but does
not currently use this authority.
A substantial body of economic research indicates that LTV ratio and
credit score are among the most important factors when estimating the
risk level associated with individual mortgages. We reviewed 45
economic research papers that examined multiple factors that could be
important; of these, 37 examined if LTV ratio was important. Almost all
of these papers (35) found the LTV ratio of a mortgage important when
estimating the risk level associated with individual mortgages. For
example, one study found that the default rates for mortgages with an
LTV ratio above 95 percent are three to four times higher than default
rates for mortgages with an LTV ratio of 90 to 95 percent. Of the 45
papers we reviewed, 19 examined whether credit score was important. All
but one of these papers found the borrower's credit score important
when estimating the risk level associated with individual mortgages.
For example, one study found that a mortgage with a credit score of 728
(indicating an applicant with excellent credit) had a default
probability of 1.26 percent, while the default probability of a
mortgage with a credit score of 642 was more than two times higher--
3.41 percent. The research also indicated that additional factors--such
as characteristics of the borrower, mortgage, and property--may help in
estimating the risk level associated with individual mortgages.
Our analysis of FHA and conventional mortgage data indicated that,
generally, mortgages with higher LTV ratios (smaller down payments) and
lower credit scores are riskier than mortgages with lower LTV ratios
and higher credit scores.[Footnote 4]For example, FHA-insured mortgages
with LTV ratios greater than 80 percent and low credit scores (below
660), had a default rate above the FHA average default rate.[Footnote
5] There is a similar relationship for conventional mortgages. For
example, conventional mortgages with LTV ratios greater than 80 percent
and credit scores below 700 had a default rate above the conventional
average default rate.
FHA and other mortgage institution officials report using a number of
similar practices in designing and implementing low and no down payment
products but FHA does not typically follow some practices that could
help it to manage the risks associated with introducing new products or
making significant changes to existing products. Mortgage institutions
we spoke with, such as Fannie Mae, Freddie Mac, and the private
mortgage insurers, told us they often initially analyze the risk of
products that are similar to those they are considering by both using
internal data and data they acquire externally. For example, Freddie
Mac officials said that Freddie Mac obtained external loan data when
they purchased loans through a structured transaction to provide
insight into low and no down payment lending when designing its low and
no down payment products.[Footnote 6] These loans had characteristics
of loans they were considering purchasing on a routine basis. FHA
officials also said they have purchased loan performance and other data
when designing a new product or studying changes to an existing product
but rely more heavily on internal data. Mortgage institutions also
sometimes require additional credit enhancements or stricter
underwriting when introducing a new low or no down payment
product.[Footnote 7] FHA has the authority, but does not currently
require an additional credit enhancement, and has made adjustments to
mortgage underwriting features but this has not included credit score
thresholds such as those used by other mortgage institutions.[Footnote
8] FHA does adjust premiums. In implementing new products, mortgage
institutions may impose limits on the volume of the new products they
will permit and on who can sell and service these products. Fannie Mae
and Freddie Mac officials described new low and no down payment
products that they first introduced as part of a pilot or with certain
limits on how many of the new products they would commit to purchase.
However, limits on the availability of new or revised FHA mortgage
insurance are sometimes set:
through legislation and focus on the volume of loans that FHA may
insure.[Footnote 9] FHA officials questioned the circumstances in which
they can use pilots or limit volumes when it is not required by
Congress and told us that they lack the resources to effectively manage
a program with limited volumes. Finally, mortgage institutions,
including FHA, establish enhanced monitoring and oversight for new low
and no down payment products and revise new products as they improve
their understanding of these products. In addition to reviewing routine
data on the characteristics and performance of all loans, some
institutions may regularly review the underwriting of all loans within
a new product line as compared with a sample of loans for their
established products (for which they better understand performance).
FHA typically reviews a sample of loans for a new product and says that
they make changes to products based on their acquired understanding.
This report includes matters for congressional consideration and
recommendations to HUD. We suggest that Congress consider limiting the
initial availability of any new single-family insurance product it may
authorize. We recommend that FHA consider using pilots for new products
and for making significant changes to its existing products and that,
when doing so, FHA develop a framework for when to use pilots and how
they should be implemented. We also recommend that FHA explore various
techniques for mitigating risks when implementing new products that
have greater risk or for which risk is not well understood.
We provided a draft of this report to HUD, Fannie Mae, Freddie Mac,
USDA, and VA. We received written comments from HUD, which are
discussed later in this report and reprinted in appendix III. We also
received technical comments from HUD, Fannie Mae, and USDA which have
been incorporated where appropriate. VA did not have comments on the
draft. HUD stated that in developing its proposed zero down payment
product, it considered all of the items that we recommended they
consider including piloting. However, it is not clear under what
circumstances HUD believes piloting or limiting the availability of a
changed or new product would be appropriate or possible. During the
course of our work, HUD officials told us that they face challenges in
administering a pilot program because of the difficulty of selecting
only a limited number of lenders and borrowers. HUD officials also held
that they may not have the authority to limit products and that they
lacked sufficient resources to adequately manage products as part of a
pilot or with limited volumes. We believe that HUD needs to further
consider piloting or limiting volume of new or changed products. There
are several available techniques for limiting an initial product,
including limiting the time period in which it is available. Further we
believe that in some circumstances the potential costs of making widely
available a product with risk that is not well understood could exceed
the cost of initially implementing such a product on a limited basis.
We therefore recommend that HUD consider a wide range of options for
mitigating risk, including piloting or limiting the volume of new or
changed products. To the extent HUD believes it does not have the
authority for exercising the options we describe, it should seek the
authority from Congress.
Background:
Mortgage insurance, a commonly used credit enhancement, protects
lenders against losses in the event of default. Lenders usually require
mortgage insurance when a homebuyer has a down payment of less than 20
percent of the value of the home. FHA, VA, the USDA's Rural Housing
Service (RHS), and private mortgage insurers provide this insurance. In
2003, lenders originated $3.8 trillion of single-family mortgage loans,
of which more than 60 percent were for refinancing. Of all the insured
loans including refinancings originated in 2003, private companies
insured about 64 percent, FHA insured about 26 percent, VA insured
about 10 percent, and RHS insured a very small number. Private mortgage
insurers generally offer first loss coverage--that is, they will pay
all the losses from a foreclosure up to a stated percentage of the
claim amount.[Footnote 10] Generally, these insurers limit the coverage
that they offer to between 25 percent and 35 percent of the claim
amount. The insurance offered by the government varies in the amount of
lender incurred losses it will cover. For example, VA guarantees losses
up to 25 percent to 50 percent of the loan, while FHA's principal
single-family insurance program insures almost 100 percent.[Footnote
11] FHA plays a particularly large role in certain market segments,
including low-income and first-time homebuyers. During fiscal years
2001 to 2003, FHA insured a total of about 3.7 million mortgages with a
total value of about $425 billion. FHA insures most of its mortgages
for single-family housing under its Mutual Mortgage Insurance Fund. To
cover lenders' losses, FHA collects insurance premiums from borrowers.
These premiums, along with proceeds from the sale of foreclosed
properties, pay for claims that FHA pays lenders as a result of
foreclosures.
Fannie Mae and Freddie Mac are government-sponsored private
corporations with stated public missions chartered by Congress to
provide a continuous flow of funds to mortgage lenders and borrowers.
Fannie Mae and Freddie Mac purchase mortgages from lenders across the
country and finance their mortgage purchases through borrowing or
issuing mortgage-backed securities that are sold to investors. They
purchase single-family mortgages up to the "conforming loan limit,"
which for 2005 was set at $359,650.[Footnote 12] Their purchase
guidelines and underwriting standards have a dominant role in
determining the types of loans that primary lenders will originate in
the conventional conforming market.
Members of the conventional mortgage market (such as private mortgage
insurers, Fannie Mae, Freddie Mac, and large private lenders) have been
increasingly active in supporting low and no down payment mortgage
products. Many private mortgage insurers will now insure a mortgage up
to 100 percent of the value of the housing being purchased. Fannie Mae
and Freddie Mac, working together with the private mortgage insurers,
have become more aggressive in developing high LTV products that target
low-and moderate-income or first-time homebuyers while also developing
high LTV products designed for use by borrowers across the income
spectrum. Figure 1 shows the history of the introduction of low and no
down payment mortgage products at three LTV levels. FHA and VA have
been backing low and no down payment mortgages for many years, and
Fannie Mae and Freddie Mac permitted conventional lenders to sell them
mortgages with an LTV of 97 percent in 1994 and 1998, respectively.
Freddie Mac and Fannie Mae's no down payment mortgage products were
introduced in 2000.
Figure 1: Evolution of Low and No Down Payment Products:
[See PDF for image]
[End of figure]
As shown in figure 2, a greater proportion of the FHA-insured and VA-
guaranteed mortgage loans had low down payments than was the case for
loans purchased by Fannie Mae and Freddie Mac. Further, the number of
loans FHA insured in 2000 that had LTVs greater than 95 percent
exceeded the total number of loans with such LTVs that were guaranteed
by VA and purchased by Fannie Mae and Freddie Mac combined.
Figure 2: Percentage of Home Purchase Mortgages with a LTV Ratio Higher
Than 95 Percent for HUD (FHA), VA, Fannie Mae, and Freddie Mac for
Loans Originated in 2000:
[See PDF for image]
[End of figure]
While relatively few loans purchased by Fannie Mae or Freddie Mac had
low or no down payments, in recent years the GSEs have purchased
relatively more of these loans than in the past. As shown in figure 3,
both Fannie Mae and Freddie Mac, during the years 1997-2000, acquired a
higher proportion of mortgages with a high LTV than in previous years.
To do this, they increased the number of product options available to
borrowers with limited down payment funds.
Figure 3: Percentage of Loans with LTV Ratios of 95 Percent or Higher
That Fannie Mae and Freddie Mac Purchased, 1997-2000:
[See PDF for image]
[End of figure]
The mortgage industry is increasingly using mortgage scoring and
automated underwriting. During the 1990s, private mortgage insurers,
the GSEs, and larger financial institutions developed automated
underwriting systems. Mortgage scoring is a technology-based tool that
relies on the statistical analysis of millions of previously originated
mortgage loans to determine how key attributes such as the borrower's
credit history, the property characteristics, and the terms of the
mortgage note affect future loan performance. Automated underwriting
refers to the process of collecting and processing the data used in the
underwriting process. FHA has developed and recently implemented a
mortgage scoring tool, called the FHA TOTAL Scorecard, to be used in
conjunction with existing automated underwriting systems. More than 60
percent of all mortgages were being underwritten by an automated
underwriting system, as of 2002, and this percentage continues to
rise.[Footnote 13] The mortgage industry also uses credit scoring
models for estimating the credit risk of individuals--these
methodologies are based on information such as payment patterns.
Statistical analyses identifying the characteristics of borrowers who
were most likely to make loan payments have been used to create a
weight or score associated with each of the characteristics. According
to Fair, Isaac and Company sources, credit scores are often called
"FICO scores" because most credit scores are produced from software
developed by Fair, Isaac and Company.[Footnote 14] FICO scores
generally range from 300 to 850 with higher scores indicating better
credit history. The lower the credit score, the more compensating
factors lenders might require to approve a loan. These factors can
include a higher down payment and greater borrower reserves.
Characteristics and Standards of Low and No Down Payment Products Vary
by Mortgage Institution:
The characteristics and standards for low and no down payment mortgage
products vary among mortgage institutions. Standards to determine a
borrower's eligibility differ from lender to lender. For example, one
mortgage institution might have a limit on household income where
another might not. Each of these mortgage products requires some form
of borrower investment. Most mortgage institutions use automated
systems to underwrite loans but differ on how they consider factors
such as the borrower's credit score and credit history. Finally,
mortgage institutions also try to mitigate the increased risk
associated with these products by employing tools like prepurchase
counseling and greater insurance coverage.
Eligibility Standards Are Not Uniform throughout the Mortgage Industry:
Each mortgage institution we studied limits in some way the mortgages
or the borrowers that may be eligible for their low and no down payment
products, but the specific limits and criteria differ among
institutions. Fannie Mae and Freddie Mac are constrained in the size of
the mortgages they may purchase. Specifically, the Housing and
Community Development Act of 1980 requires a limit (conforming loan
limit) on the size of mortgages that can be purchased by either Fannie
Mae or Freddie Mac. In 2005, the conforming mortgage limit for Fannie
Mae and Freddie Mac is $359,650 for most of the nation.[Footnote 15]
FHA is also limited in the size of mortgages it may insure. The FHA
loan limit varies by location and property type, depending on the cost
of homes in an area and the number of units in a property. Thus, FHA's
loan limit may be as high as 87 percent of the conforming loan limit,
or $312,895 in 2005; or as low as 48 percent of the conforming loan
limit, or $172,632 in 2005. In addition, FHA also has higher limits in
Alaska, Hawaii, Guam, and the U.S. Virgin Islands because these are
considered to be high cost areas. Although VA does not have a mortgage
limit, lenders generally limit VA mortgages to four times the VA
guaranty amount, which is now set at 25 percent of the conforming loan
limit. Since the maximum guaranty currently is legislatively set at
$89,913, VA-guaranteed mortgages will rarely exceed $359,650.
Moreover, while FHA does not restrict eligibility to borrowers with
certain income, other mortgage institutions may limit eligibility by
borrower income and other measures. Most state housing finance agencies
target their low and no down payment products to first-time
homebuyers.[Footnote 16] Some mortgage institutions providing
affordable low and no down payment products also limit the loans to
households with income at or below area median levels. For example,
USDA's RHS, in its section 502 Guaranteed Loan program, does not
guarantee loans to individuals with incomes exceeding 115 percent of
the area median income or 115 percent of the median family income of
the United States. We also found that Web sites of many state housing
finance agencies show that their mortgage products include income
limits as well as sales price limits and in some cases designated
"targeted areas" within a state.[Footnote 17] Table 1 illustrates some
of the major similarities and differences in the eligibility criteria
of FHA and other mortgage institutions.
Table 1: Eligibility Limitations of FHA Compared with RHS, VA, and
Selected Products of Fannie Mae and Freddie Mac:
Eligibility criteria: Borrower type;
FHA: N/A[A];
RHS: Resident in rural-designated area;
VA: Veteran or active duty;
Fannie Mae MyCommunity-Mortgage program™: N/A;
Freddie Mac Affordable Gold programs: N/A.
Eligibility criteria: Income;
FHA: N/A;
RHS: Cannot exceed 115 percent of area median income or the median
family income of the U.S;
VA: N/A;
Fannie Mae MyCommunity-Mortgage program™: Cannot exceed 100 percent of
area median income[B,C];
Freddie Mac Affordable Gold programs: Cannot exceed 100 percent of area
median income[B,C].
Eligibility criteria: Property type;
FHA: 1-4 unit, owner-occupied;
principal residence[D];
RHS: 1-unit, owner-occupied principal residence;
VA: 1-4 unit, owner-occupied principal residence;
Fannie Mae MyCommunity-Mortgage program™: 1-4 unit, owner-occupied
principal residence;
Freddie Mac Affordable Gold programs: 1-unit, owner-occupied principal
residence.
Eligibility criteria: Mortgage type;
FHA: Up to 30-year fixed rate or adjustable rate mortgages (ARM);
RHS: 30-year fixed rate;
VA: Up to 30- year fixed rate or ARMs;
Fannie Mae MyCommunity-Mortgage program™: Up to 30 years fixed rate or
ARMs;
Freddie Mac Affordable Gold programs: Up to 30-year fixed rate.
Legend:
N/A = not applicable:
Sources: HUD, VA, USDA, Fannie Mae, and Freddie Mac.
[A] While FHA does not set specific requirements for the type of
borrower, it tends to serve low-income and first-time homebuyers.
[B] Can be higher in high cost areas.
[C] Waiver of income limit may apply in targeted areas.
[D] Under certain circumstances FHA may insure loans on second
residences, investment properties, and properties owned by nonprofits
and state and local governments.
[End of table]
Fannie Mae and Freddie Mac affordable mortgage products primarily
target low-to-moderate income and first-time homebuyers. Freddie Mac
and RHS allow a borrower to purchase a home containing one unit, while
FHA, VA, and Fannie Mae allow a borrower to purchase properties that
have up to four units with one mortgage. VA stipulates that if the
veteran must depend on rental income from the property to qualify for
the mortgage, the borrower must show proof that he or she has the
background or qualifications to be successful as a landlord and have
enough cash reserves to make the mortgage payments for at least 6
months without help from the rental income. With regard to mortgage
type, many mortgage institutions permit 30-year fixed-rate mortgages.
Some also permit adjustable rate mortgages (ARM).
Most Low and No Down Payment Products Require Some Form of Borrower
Investment:
Most low and no down payment mortgage products require some form of
borrower investment, either a borrower contribution or cash reserve, as
a way of reducing risk and assuring that the borrower has a stake in
the property. Low down payment products offered by FHA, Fannie Mae,
Freddie Mac and private insurers require a cash investment of at least
3 percent from the borrower. No down payment mortgage products offered
by VA, RHS, Fannie Mae, Freddie Mac, and some private insurers require
either no down payment or a minimum amount (such as $500 in Fannie
Mae's MyCommunityMortgage program).
Many institutions permit down payment assistance. FHA stipulates that
the gift donor may not be a person or entity with an interest in the
sale of the property, such as the seller, real estate agent or broker,
builder, or entity associated with them. FHA mortgagee letters state
that "gifts from these sources (seller, builder, etc.) are considered
inducements to purchase and must be subtracted from the sales price."
However, FHA allows nonprofit agencies that may receive contributions
from the seller to provide down payment assistance to the borrower. In
contrast, Fannie Mae, Freddie Mac, and some of the private insurers
generally do not allow down payment funds, either directly or
indirectly, from an interested or seller-related party to the
transaction. Fannie Mae and Freddie Mac officials told us that such
seller-related contributions could contribute to an overvaluation of
the price of the property.
Even where borrowers pay no down payment they very often must pay a
minimum percentage of closing costs from their own funds.[Footnote 18]
FHA requires that borrowers pay 3 percent of the total loan amount
toward the purchase of the home. This contribution may be used for down
payment or closing costs. Thus, FHA borrowers may finance closing
costs, within limits. FHA borrowers may also finance their insurance
premium. Unlike FHA, some mortgage institutions do not allow financing
of the closing costs and the insurance premiums in the first mortgage.
VA generally allows payment of all closing costs to be negotiated while
restricting those that may be charged to the borrower. VA allows
borrowers to finance their insurance premium, called the funding fee.
In the section 502 Guaranteed Loan program for RHS, borrowers may pay
closing costs but they are not required to do so and may be allowed to
finance the closing costs and their insurance premium, called the
Guarantee Fee.[Footnote 19] Freddie Mac in its no down payment product
requires a 3 percent borrower contribution to be used for closing
costs, financing costs, or prepaids and escrows, all of which can come
from gifts or property seller contributions.
FHA, RHS, VA, Fannie Mae, and Freddie Mac differ somewhat in terms of
their maximum allowable LTV ratios and how they calculate this ratio.
LTV ratios are important because of the direct relationship that exists
between the amount of equity borrowers have in their homes and the
likelihood of risk of default. The higher the LTV ratio, the less cash
borrowers will have invested in their homes and the more likely it is
that they may default on mortgage obligations, especially during times
of economic hardship.
The Omnibus Budget Reconciliation Act of 1990 (Pub. L. No. 101-508),
established LTV limits for FHA-insured mortgages of 98.75 percent if
the home value is $50,000 or less, or 97.75 percent if the home value
is in excess of that. However, because FHA allows financing of the up-
front insurance premium, borrowers can receive a mortgage with an
effective LTV ratio of close to 100 percent.
In table 2, we calculate the effective LTV ratio for selected low and
no down payment products. The example assumes a $100,000 purchase price
(appraisal value) and a 30-year fixed-rate mortgage. It also assumes
average closing costs of about 2.1 percent of sales price. FHA has a
formula to calculate the maximum loan amount based on a percentage of
the purchase price of the home. FHA does not have a down payment
requirement but instead has what FHA calls a minimum cash investment
requirement. This investment requirement can be used to pay either the
down payment and in some cases the closing costs. Not shown are the
actual out-of-pocket expenses to the borrower which could vary based on
the individual transaction and whether the investment requirement was
split among the closing costs and down payment, as well as whether the
borrower opted to finance their up-front premium.[Footnote 20]
Table 2: LTV Calculations for FHA, RHS, VA, Fannie Mae, and Freddie
Mac:
Mortgage elements: Purchase price;
Government: FHA[A] 203b: $100,000;
Government: USDA 502 guaranteed program: $100,000;
Government: VA zero down: $100,000;
Conventional: Fannie Mae and Freddie Mac 100 LTV products: $100,000.
Mortgage elements: Loan amount before up-front insurance;
Plus up-front insurance premium/fee;
Government: FHA[A] 203b: Loan amount before up-front insurance:
$97,750[B]; Plus up-front insurance premium/fee: +$1,466[C] (1.5%);
Government: USDA 502 guaranteed program: Loan amount before up-front
insurance: $100,000; Plus up-front insurance premium/fee: +$2,000[D]
(2%);
Government: VA zero down: Loan amount before up-front insurance:
$100,000; Plus up-front insurance premium/fee: +$2,150[E] (2.15%);
Conventional: Fannie Mae and Freddie Mac 100 LTV products: N/A.
Mortgage elements: Total mortgage;
Government: FHA[A] 203b: $99,216[F];
Government: USDA 502 guaranteed program: $102,000;
Government: VA zero down: $102,150;
Conventional: Fannie Mae and Freddie Mac 100 LTV products: $100,000.
Mortgage elements: Effective LTV ratio[G];
Government: FHA[A] 203b: 99.2%;
Government: USDA 502 guaranteed program: 102%;
Government: VA zero down: 102%;
Conventional: Fannie Mae and Freddie Mac 100 LTV products: 100%.
Sources: HUD, VA, USDA, Fannie Mae, and Freddie Mac.
[A] This is the existing FHA mortgage insurance product that requires
the least amount of a down payment. This product is not a "no down"
mortgage product.
[B] We are assuming, for this example, that the mortgage is in a state
with average closing costs of above 2.1 percent of sales price. In this
case, the maximum mortgage (not including a financed up-front insurance
premium) would be $100,000 x 97.75 percent.
[C] Up-front insurance premium = $97,750 x 1.5 percent = $1,466.
[D] Guarantee fee = $100,000 x 2 percent = $2,000. Loans can be
guaranteed up to 102 percent LTV if doing so is necessary to allow the
2 percent guarantee fee to be financed by the borrower. A 100 percent
LTV threshold may only be exceeded to allow the guarantee fee to be
financed. If a borrower chooses not to finance the guarantee fee, loans
are limited to 100 percent LTV. Closing costs are allowed but closing
costs may not be financed if the borrower is already financing the
guarantee fee such that they have reached the maximum allowed LTV of
102 percent, not including closing costs.
[E] Funding fee = $100,000 x 2.15 percent = $2,150.
[F] The borrower is required to pay 3 percent (of the contract sales
price--called a minimum cash investment requirement) toward closing
costs and down payment.
[G] Calculation = total mortgage / purchase price.
[End of table]
In addition, some of the affordable conventional mortgage products
allow for subordinate financing in the form of secondary mortgages to
pay for a down payment and/or closing costs. These secondary mortgages
allow for a total effective LTV of up to 105 percent.
Some Underwriting Standards Differ between FHA and Other Mortgage
Institutions:
When underwriting mortgages, FHA and other mortgage institutions
require that lenders examine a borrower's ability and willingness to
repay the mortgage debt. Lenders for low and no down payment mortgages
may use automated underwriting systems examining the borrower's credit
score or creditworthiness, qualifying ratios, and cash reserves. In
some cases, they use manual underwriting to accommodate nontraditional
credit histories. By screening the majority of applications with
automated systems, underwriters have more time to review special cases
with manual underwriting.
Many mortgage institutions use credit scores in assessing mortgage
applicants through their automated underwriting systems. For standard
products, institutions tend to rely on automated underwriting, which
develops a mortgage score based on various factors including credit
score and, based on this, they make a decision on the loan. However, in
some instances, mortgage institutions set credit score minimums for
some low and no down payment products. In some instances, these credit
score minimums exist within the automated underwriting system. In other
instances, the credit score minimums exist only in products that are
underwritten using manual underwriting. FHA does not require a credit
score minimum, nor do VA and RHS. These three governmental agencies
examine the overall pattern of credit behavior rather than rely on one
particular credit score. All three agencies allow a good deal of
judgment and interpretation on the part of the underwriters in
determining the creditworthiness of the prospective borrower. Fannie
Mae does not use externally derived credit scores for its loan products
that use automated underwriting but instead relies on the credit
history of the borrower. Based on a review of Web sites of private
mortgage insurers, products with no down payment that are insured by
these private mortgage insurers have minimum credit score requirements
ranging from 660 to 700. Individual low and no down payment products
that use credit score minimums use a variety of cutoff scores. Many
mortgage industry sources consider borrowers with credit scores of 720
or higher as having excellent credit. One study that focused on issues
related to homeownership and cited extensive interviews with leading
experts in government and industry found that mortgage applicants with
scores above 660 are likely to have acceptable credit.[Footnote 21] On
the other hand, for applicants with FICO scores between 620 and 660,
mortgage institutions typically perform more careful underwriting,
scrutinizing many factors. FICO scores under 620 indicate higher risk
and are unlikely to be approved by conventional lenders unless
accompanied by compensating factors.
Some of these mortgage institutions may, under some circumstances,
accept a lower credit score, if the borrower provides additional
compensating factors (such as 2 months cash reserve) that would
indicate a lower risk on the part of the borrower. Mortgage
institutions might also accept a lower credit score if they were
receiving additional compensation for the risk, such as a mortgage
originator receiving a higher interest rate or a mortgage insurer
getting a higher insurance premium. Some mortgage institutions state in
their underwriting guidance that FICO scores together with the LTV
determine in part the borrower's minimum contribution. For example, one
private mortgage insurer allows borrowers with credit scores equal or
greater than 700 to have a minimum borrower contribution of 0 percent
on a 100 LTV loan. For this same insurer, a borrower with a credit
score between 660 and 699 would have a minimum borrower contribution of
3 percent on a 100 LTV loan.
Many mortgage institutions use two qualifying ratios as factors in
determining whether a borrower will be able to meet the expenses
involved in homeownership. The "housing-expense-to-income ratio"
examines a borrower's expected monthly housing expenses as a percentage
of the borrower's monthly income, and the "total-debt-to-income ratio"
looks at a borrower's expected monthly housing expenses plus long-term
debt as a percent of the borrower's monthly income. Lenders who do
business with Fannie Mae or Freddie Mac place more emphasis on the
total-debt-to-income ratio. Total debt includes monthly housing
expenses and the total of other monthly obligations, such as auto
loans, credit cards, alimony, or child support. The guidelines for
manual underwriting are discussed below; automated underwriting systems
weight the qualifying ratios, as well as numerous other factors, in
assessing the borrower's ability to meet the expenses involved in
homeownership.
Unless there are compensating factors, FHA monthly housing-expense-to-
income ratio is set at a maximum of 29 percent, while the monthly
"total-debt-to-income ratio" is, at most, 41 percent of the borrower's
stable monthly income. The requirements set by Fannie Mae, Freddie Mac,
and the private insurers on the monthly housing expense-to-income ratio
vary greatly. Some have set lower thresholds, such as Freddie Mac,
which uses as a guideline that the monthly housing expense-to-income
ratio should not be greater than 25 percent to 28 percent, with
exceptions for some products. Others, such as some private insurers,
have set higher thresholds than FHA has set, such as 33 percent.
Some mortgage institutions set thresholds on the "total-debt-to-income"
ratio that are lower than FHA's threshold. Conventional mortgages that
are manually underwritten to Fannie Mae or Freddie Mac standards are
set at a benchmark total-debt-to-income ratio of 36 percent of the
borrower's stable monthly income, compared with FHA's 41 percent.
However, Fannie Mae and Freddie Mac state that they occasionally
specify a higher allowable debt-to-income ratio for a particular
mortgage loan if compensating factors are present.[Footnote 22]
Cash reserves represent the amount of funds a borrower has after
closing on the loan. Generally the reserves required of borrowers are
expressed in terms of the numbers of monthly mortgage payments they may
comprise. Conceptually they represent the ability of the borrower to
repay the mortgage out of accumulated funds. Many mortgage institutions
including FHA consider it a compensating factor that reduces the risk
of delinquency. FHA, unlike conventional lenders who do business with
the GSEs and the private insurers, does not require cash reserves for
its low down payment product. VA and RHS also do not require cash
reserves. Generally the GSEs and the private insurers with whom we
spoke required cash reserves of either 1 or 2 months of monthly
mortgage payments for low and no down payment products.
Mortgage Institutions Use Various Risk Mitigation Tools:
Some of the mortgage institutions we spoke with used various tools to
mitigate risk. For example, most mortgage institutions offering
affordable low and no down payment mortgages to first-time homebuyers
require prepurchase counseling, and some require postpurchase
counseling. These include lenders working with Fannie Mae, Freddie Mac,
private insurers, and state housing finance agencies. Homeownership
counseling for first-time homebuyers takes a variety of forms. There
are counseling programs administered by government agencies, lenders,
nonprofit organizations, and the private insurers, among others. These
programs are delivered through many different avenues including
classroom, home study, individual counseling, and telephone. The
content of the counseling programs also varies significantly across
each of these administrative and delivery mechanisms, as does the
timing of the counseling--which can be either prior to closing or
postpurchase (when the borrower becomes delinquent on a payment).
More specifically, Freddie Mac in each of its Affordable Gold products
(intended for first-time homebuyers who generally earn 100 percent or
less of area median income) requires that at least one qualifying
borrower in the transaction must receive prepurchase counseling.
Lenders must document the organization that administered the counseling
and how the counseling was delivered. Freddie Mac exempts those
borrowers who have cash reserves after closing equal to at least two
monthly mortgage payments from the counseling requirement. Similarly,
Fannie Mae in its MyCommunityMortgage, requires prepurchase counseling
for first-time homebuyers when they are purchasing a one-unit property.
If they are purchasing a two to four unit property, landlord counseling
is required. Fannie Mae also requires postpurchase counseling for
borrowers under certain low down payment programs who become delinquent
on their payments early in the mortgage.
Some private insurers require pre-and postpurchase counseling, but some
only recommend it. For example, two private insurers require pre-and
postpurchase counseling with all of its affordable low and no down
payment products, and they provide most of this counseling themselves.
On the other hand, another private insurer recommends, but does not
require, prepurchase counseling for first-time homebuyers in its low
and no down payment products. However, this insurer's underwriting
guidance states that prepurchase counseling is considered a positive
underwriting factor. It also recommends postpurchase counseling,
particularly for borrowers who are experiencing financial difficulties
but have a good chance of overcoming their financial problems and
maintaining homeownership.
FHA, unlike most low and no down payment mortgage institutions serving
affordable first-time homebuyers, does not require prepurchase
counseling. VA also does not require prepurchase counseling, but
considers it to be a compensating factor in improving creditworthiness.
RHS encourages lenders to offer or provide for homeownership counseling
and lenders may require first-time homebuyers to undergo such
counseling if it is reasonably available in the local area.
FHA, VA, RHS, and the private insurers also differ in the amount of
insurance or guaranty they provide to protect lenders against the
losses associated with mortgages that go to foreclosure. While FHA
essentially protects against almost 100 percent of the losses
associated with a foreclosed mortgage, VA, RHS and the private insurers
protect against a portion of the loss.[Footnote 23] Private insurers
generally provide protection to lenders for only a portion of losses.
This protection is usually expressed as a percentage of the claim
amount. For example, an insurer may provide insurance coverage of 30
percent. This means that the insurer will cover losses up to 30 percent
of the claim amount. In exchange for offering this insurance, the
insurer charges borrowers a premium.
Some of the insurers with whom we spoke, as well as the GSEs, noted
that they require higher insurance coverage for mortgages with lower
down payments. For example, one insurer said that the amount of
insurance coverage tends to be 35 percent for no down payment
mortgages, in contrast to 30 percent for low down payment mortgages.
Private insurers noted that they charge higher premiums or require more
stringent underwriting when they provide higher insurance coverage. For
example, one private insurer stated that its monthly premium rates to a
borrower increase about 15 percent for every 5 percentage point
increase in insurance coverage between 20 and 35 percent.
Research Shows LTV Ratio and Credit Score Are Important When Estimating
Risk of Individual Mortgages:
Economic research we reviewed indicated that LTV ratios and credit
scores are among the most important factors when estimating the risk
level associated with individual mortgages.[Footnote 24] We identified
and reviewed 45 papers that examined factors that could be
informative.[Footnote 25] Of these, 37 examined if the LTV ratio was
important and almost all of these papers (35) found the LTV ratio of a
mortgage important and useful. Nineteen research papers evaluated how
effective a borrower's credit score was in predicting loan performance,
and all but one reported that the credit score was important and
useful.[Footnote 26] In addition, a number of the papers reported that
other factors were useful when estimating the risk level. For example,
characteristics of the borrower--such as qualifying ratios--were cited
in several of the papers we reviewed. Finally, other research evaluated
additional factors; however, we identified very few papers that
investigated the same variables or corroborated these findings.
Collectively, the research we reviewed appeared to concur that
considering multiple factors was important and useful in estimating the
risk level of individual mortgages. For example, some of the papers (7)
reported that considering LTV ratio and credit score concurrently was
important and useful when estimating the risk level of individual
mortgages.[Footnote 27]
LTV Ratio Helps Estimate Risk of Individual Mortgages:
Many studies found that a mortgage's LTV ratio was an important factor
when estimating the risk level associated with individual mortgages. In
theory, LTV ratios are important because of the direct relationship
that exists between the amount of equity borrowers have in their homes
and the likelihood of risk of default. The higher the LTV ratio, the
less cash borrowers will have invested in their homes and the more
likely it is that they may default on mortgage obligations, especially
during times of economic hardship (e.g., unemployment, divorce, home
price depreciation). And, according to one study, "most models of
mortgage loan performance emphasize the role of the borrower's equity
in the home in the decision to default."[Footnote 28] We identified 45
papers that examined the relationship between default and one or more
predictive variables; of these, 37 examined if LTV ratio was important
and useful. Almost all of these papers (35) determined that LTV ratio
was effective in predicting loan performance--specifically, when
predicting delinquency, default, and foreclosure. Several papers
reported that there was a strong positive relationship between LTV
ratio and default. Specifically, one paper reported that the default
rates for mortgages with an LTV ratio above 95 percent were three to
four times higher than default rates for mortgages with an LTV ratio
between 90 to 95 percent.[Footnote 29] Another paper found that, at the
end of 5 years, the cumulative probability of default risks for
mortgages with an LTV ratio less than 95 percent was 2.48 percent;
however, the cumulative probability of default for mortgages with an
LTV ratio greater than or equal to 95 percent was 3.53
percent.[Footnote 30] While the majority of the empirical research
found that LTV ratio mattered, 4 of the research efforts did not find
that LTV ratio is important when estimating the risk level associated
with individual mortgages.[Footnote 31] For example, one paper found
that, for subprime loans, delinquency rates were relatively unaffected
by the LTV ratio.[Footnote 32] Generally, subprime loans are loans made
to borrowers with past credit problems at a higher cost than
conventional mortgage loans. Additionally, some (7) research efforts
examined the relationship between the LTV ratio and severity (losses),
and all found that there was a positive relationship between the LTV
ratio and severity. For a detailed list of the economic research that
addresses the relationship between LTV ratio and mortgage performance,
see appendix II.
Credit Score Helps Estimate Risk of Individual Mortgages:
Despite the relatively recent use of credit score information in the
mortgage industry, several studies found that credit score was an
important and useful factor when estimating the risk level associated
with individual mortgages.[Footnote 33] In general, credit scores
represent a borrower's credit history. Credit histories consist of many
items, including the number and age of credit accounts of different
types, the incidence and severity of payment problems, and the length
of time since any payment problems occurred. The credit score reflects
a borrower's historic performance and is an indication of the
borrower's ability and willingness to manage debt payments. Of the 45
papers we reviewed, 19 evaluated how effective a borrower's credit
score was in predicting loan performance. Eighteen research efforts
evaluated how effective a borrower's credit score was in predicting
delinquency, default, and foreclosure; all of these efforts found that
a borrower's credit score was important. Generally, the papers reported
that higher credit scores were associated with lower levels of
defaults. Specifically, one study found that a mortgage with a credit
score of 728 (indicating an applicant with excellent credit) had a
default probability of 1.26 percent, while a mortgage with a credit
score of 642 had a default probability of 3.41 percent--or more than
two times higher.[Footnote 34] Additionally, four research efforts
examined the relationship between credit score and severity (losses),
and three reported that there was a negative relationship between
credit score and severity. For example, one study found that credit
scores were also helpful in predicting the amount of losses resulting
from foreclosed mortgages. In particular, the paper reported the loss
rate for defaulted mortgages with high credit scores was lower than
foreclosed mortgages with low credit scores.[Footnote 35] For a list of
the economic research, that we reviewed, that addresses the
relationship between credit score and mortgage performance, see
appendix II.
Other Factors May Help in Estimating the Risk of Individual Mortgages:
Many of the papers we reviewed identified factors that, in addition to
LTV ratios and credit scores, were important and useful determinants of
credit risk for home mortgages. Of these, the most widely analyzed
factor--accumulation of equity in the home--was a subject of 26 studies
we reviewed. Some factors were the subject of far fewer papers. Yet
other factors were the subject of a single paper only. The most widely
assessed factors included borrower characteristics such as accumulation
of equity in the home, qualifying ratios, and income.[Footnote 36]
Additionally, characteristics of the area in which the property was
located included variables such as unemployment rates and income
levels. Finally, characteristics of the mortgage included variables
such as mortgage age and term of the mortgage (e.g., 15 year vs. 30
year). The extent to which the authors agreed on the importance of the
other factors varied. For example, nearly all of the papers that looked
at equity accumulation (a factor which is not known at the time of loan
origination), the unemployment rate of the area in which the property
is located, and mortgage age, found that these factors were important.
However, the research was less certain as to the importance of
qualifying ratios and income. That is, several of the papers found that
the qualifying ratios and income were important in estimating risk;
however, some found that qualifying ratios and income were not an
important factor.
The economic research we reviewed also indicated that considering
factors in combination was helpful in estimating the risk level of
individual mortgages. Of all 45 papers we reviewed, more than half
conducted multivariate analyses. For example, seven studies found that
using credit score information in combination with the LTV ratio was
helpful in estimating the risk level of individual mortgages.
Specifically, one study found that the "foreclosure rate is
particularly high for borrowers with both low credit scores and high
LTV ratios--almost 50 times higher than that for borrowers with both
high credit scores and low LTV ratios."[Footnote 37] Other studies
examined several aspects of a mortgage concurrently. For example, in
one study, the authors controlled for certain loan characteristics,
such as credit history and LTV, and they found that borrower income is
useful in estimating risk levels of mortgages.[Footnote 38] In another
study, the authors controlled for house price appreciation (10 percent)
and unemployment rates (8 percent) and examined loan performance--after
15 years--in terms of LTV ratio and a borrower's relative income.
Regardless of income, default was higher for zero down payment
mortgages. Specifically, under these conditions, the authors reported
that zero down payment mortgages of borrowers with incomes below 60
percent of the metropolitan statistical area's (MSA) median level would
have cumulative default rates about twice as high as mortgages that
required a 10 percent down payment made to borrowers with similar
incomes. Similarly, the zero down payment mortgages of borrowers with
incomes greater than one-and-a-half times the MSA's median level would
have cumulative default rates about 50 percent greater than mortgages
that required a 10 percent down payment made to borrowers with similar
incomes.[Footnote 39]
Our Analysis Indicated That Mortgages with Higher LTV Ratios and Lower
Credit Scores Pose Greater Risks:
Consistent with studies we reviewed, our analysis of FHA and
conventional mortgage data indicated that mortgages with high LTV
ratios (smaller down payments) and low credit scores generally are
riskier than mortgages with low LTV ratios and high credit
scores.[Footnote 40] For example, FHA-insured mortgages with LTV ratios
greater than 80 percent and low credit scores (below 660) had a default
rate above the FHA average default rate. Similarly, conventional
mortgages with LTV ratios greater than 80 percent and somewhat low
credit scores (below 700) had a default rate above the conventional
average default rate. While this analysis is useful in determining the
extent to which LTV ratios and credit scores can help predict the risk
level associated with individual mortgages, care should be taken when
comparing the FHA with the conventional relative default. In
particular, the relative default rates are derived from different
calendar years (that is, a sample of FHA mortgages insured in 1992,
1994, and 1996 and conventional mortgages originated in 1997, 1998, and
1999 and purchased by Fannie Mae or Freddie Mac). Also the average
default rate for FHA-insured mortgages is higher than the average
default rate for conventional mortgages.
FHA-Insured Mortgages with Higher LTV Ratios and Lower Credit Scores
Are Riskier Than Other FHA-Insured Mortgages:
When considering LTV alone, FHA-insured mortgages with higher LTV
ratios (smaller down payments) generally perform worse than FHA-insured
mortgages with lower LTV ratios. As figure 4 illustrates, our analysis
indicates that the incidence of default increases as LTV ratios
increase. When considering the LTV ratio alone, the default rate for
sampled FHA-insured mortgages, with an LTV of 70 percent or less, is no
more than half the average FHA default rate. In contrast, the default
rate for mortgages with LTV ratios greater than 90 percent, as a group,
surpasses the average FHA default rate. For the highest LTV ratio
group--greater than 97 to 100 percent--the default rate for these
mortgages is about 1.75 times the average FHA default rate.
Figure 4: Four-year Relative Default Rates by LTV Ratio for FHA-Insured
Mortgages (1992, 1994, and 1996):
[See PDF for image]
Note: Because of the sensitive nature of the data, we have chosen to
illustrate relative 4-year default rates for each LTV ratio and credit
score category. These relative 4-year default rates are defined as
follows: the 4-year default rate for each category, divided by the
average 4-year default rate for a sample of mortgages insured by FHA in
1992, 1994, and 1996. For example, if the 4-year default rate for a
particular LTV ratio and credit score category was 3 percent, and the 4-
year default rate for all FHA mortgages sampled was 2 percent, the
relative 4-year default rate for this category would be 3 divided by 2,
or 1.5 times the average 4-year default rate. To generate the average 4-
year default rate, we merged mortgage volume and performance data for
the sample of FHA mortgages insured in 1992, 1994, and 1996. Loan data
are measured in dollars.
[End of figure]
FHA-insured mortgages with lower credit scores generally perform worse
than FHA-insured mortgages with higher credit scores, regardless of LTV
ratio. As figure 5 illustrates, our analysis indicated that the
incidence of default increases as credit scores decrease. Considering
the credit score, the default rate for sampled FHA-insured mortgages
with credit scores 700 and above is no more than half the average FHA
default rate for all sampled mortgages. The default rate for mortgages
with a credit score below 660, as a group, surpasses the average FHA
default rate. For the lowest credit score group--less than 620--the
default rate for these mortgages is almost twice the average FHA
default rate.
Figure 5: Four-year Relative Default Rates by Credit Score for FHA-
Insured Mortgages (1992, 1994, and 1996):
[See PDF for image]
Note: For description of relative default rates, please see note with
figure 4.
[End of figure]
As expected, FHA-insured mortgages with both high LTV ratios (smaller
down payments) and low credit scores generally perform worse than
mortgages with both low LTV ratios and high credit scores. Our analysis
indicates that the incidence of default increases as LTV ratios
increase and credit scores decrease. As figure 6 illustrates, mortgages
with lower LTV ratios and higher credit scores (those at the bottom of
the figure) have lower default rates than mortgages with higher LTV
ratios and lower credit scores (at the top of the figure). FHA-insured
mortgages with LTV ratios greater than 80 percent and low credit scores
(below 660) had a default rate above the FHA average default rate. FHA-
insured mortgages, with LTV ratios greater than 90 percent and credit
scores below 620, had a default rate more than double the FHA average.
Figure 6: Four-year Relative Default Rates by LTV Ratio and Credit
Score for FHA-insured Mortgages (1992, 1994, and 1996):
[See PDF for image]
Notes: For description of relative default rates, please see note with
figure 4.
We do not present relative default rates for categories with fewer than
1,000 observations as the performance information may not be reliable
when there are too few observations. In the figure, these instances are
noted as "N/A." For a more detailed description of our analysis, see
appendix I.
[End of figure]
Conventional Mortgages with Higher LTV Ratios and Lower Credit Scores
Are Riskier Than Other Conventional Mortgages:
Generally, the performance relationships that exist for FHA-insured
mortgages also exist for conventional mortgages originated in the late
1990s. As figure 7 illustrates, our analysis indicates that
conventional mortgages with higher LTV ratios (smaller down payments)
generally perform worse than conventional mortgages with lower LTV
ratios. When considering LTV ratio alone, the default rate for the
group of conventional mortgages with LTV ratios below 80 percent was no
more than half the average conventional default rate. Generally, the
default rates then increase with higher categories of the LTV ratio. In
fact, the default rate for conventional mortgages with an LTV ratio
greater than 90, but less than 97 percent, as a group, is more than
twice the average conventional default rate. One notable exception to
this general pattern is that conventional mortgages in the highest LTV
ratio category (that is, greater than 97 to 100 percent) appear to have
a lower risk of default than do conventional mortgages in some of the
lower LTV ratio categories. According to GSE officials, this may be
explained by a number of possible factors. The GSEs had just begun to
purchase an increasing number of mortgages with very high LTV ratios
during the late 1990s and the GSEs took steps to limit the risks
associated with these mortgages. For example, some of these loans were
part of negotiated deals with individual lenders. These negotiated
transactions may have required the use of manual underwriting and
minimum credit scores, and the GSEs may have used specific servicers
for these loans. GSE officials told us that lenders and servicers
operating as part of negotiated deals with them tend to be more
conservative in their approach to these loans. GSE officials also told
us that the borrowers during this time period would have been the very
best segment of the applicant pool. Agency officials indicate that, for
more recent loans where volumes are higher and lenders are reaching
deeper into the applicant pool, default rates on loans in these
categories are higher than they were in the 1997-1999 period and are
now consistent with the relationship we would expect between LTV and
default rates. We discuss these practices in greater depth later in the
report.
Figure 7: Four-Year Relative Default Rates by LTV Ratio for
Conventional Mortgages (1997, 1998, and 1999):
[See PDF for image]
Note: Because of the sensitive nature of the data, we have chosen to
illustrate relative 4-year default rates for each LTV ratio category.
These relative 4-year default rates are defined as follows: the 4-year
default rate for each category, divided by the average 4-year default
rate for all conventional mortgages originated in 1997, 1998, and 1999
and purchased by Fannie Mae or Freddie Mac. For example, if the 4-year
default rate for a particular LTV ratio category was 3 percent, and the
4-year default rate for all conventional mortgages sampled was 2
percent, the relative 4-year default rate for this category would be 3
divided by 2, or 1.5 times the average 4-year default rate. To generate
the average conventional 4-year default rate, we combined Fannie Mae
and Freddie Mac mortgage volume and mortgage performance data; we also
combined the sample data for mortgages originated in 1997, 1998, and
1999. Loan data are measured in dollars.
[End of figure]
When considering credit score alone, conventional mortgages with lower
credit scores generally perform worse than conventional mortgages with
higher credit scores. As figure 8 illustrates, our analysis indicates
that the incidence of default generally increases as credit scores
decrease. The average default rate for mortgages with credit scores of
740 and higher is no more than 20 percent that of the average default
rate for conventional loans and loan performance declines for each
lower category of credit score. In fact, the default rate for mortgages
with a credit score below 700, as a group, surpasses the average
default rate. Ultimately, the average default rate for the lowest
credit score category (below 620) is more than 4 times the average
conventional default rate.
Figure 8: Four-Year Relative Default Rates by Credit Score for
Conventional Mortgages (1997, 1998, and 1999):
[See PDF for image]
Note: For description of relative default rates, please see note with
figure 7.
[End of figure]
As expected, conventional mortgages with both high LTV ratios (smaller
down payments) and low credit scores generally perform worse than
mortgages with both lower LTV ratios (larger down payments) and higher
credit scores. Our analysis indicates that the incidence of default
generally increases as LTV ratios increase and credit scores decrease.
As figure 9 illustrates, mortgages with lower LTV ratios and higher
credit scores (those at the bottom of the figure) have much smaller
default rates than mortgages with higher LTV ratios and lower credit
scores (at the top of the figure). Specifically, as a group, mortgages
with LTV ratios greater than 80 percent and credit scores below 700
have default rates greater than the average conventional default rate.
Further, conventional mortgages with LTV ratios greater than 80 percent
and credit scores below 660 had a default rate more than twice the
conventional average.
Figure 9: Four-Year Relative Default Rates by LTV Ratio and Credit
Score for Conventional Mortgages (1997, 1998, and 1999):
[See PDF for image]
Notes: For description of what we mean by relative default rates,
please see note with figure 7.
We do not present relative default rates for categories with fewer than
3,000 mortgages as the performance information may not be reliable when
there are too few observations. In the figure, these instances are
noted as "N/A." For a more detailed description of our analysis, see
appendix I.
[End of figure]
One notable exception to this general pattern is that the group of
conventional mortgages with the highest LTV ratios (that is, greater
than 97 to 100 percent) appears to have a lower risk of default than do
the group of conventional mortgages with lower LTV ratios for loans
originated during these years. For example, of conventional loans with
credit scores of 740 and higher, those that had LTV ratios greater than
97 percent, as a group, performed better than those with LTV ratios
greater than 90 to 97 percent. Similarly, of conventional loans with
credit scores below 620, those with the highest LTV ratio performed
better than those with LTV ratios greater than 90 to 97 percent. This
anomaly, where the highest LTV mortgages appear to perform better than
the lower LTV loans, may reflect that the GSEs had just begun to
purchase an increasing number of mortgages with very high LTV ratios in
the years we analyzed and that the GSEs took steps to limit the risks
associated with these mortgages. Likewise, lenders may perform more
rigorous underwriting when first originating a new loan product.
While this analysis is useful in determining the extent to which LTV
ratios and credit scores are helpful in predicting the risk level
associated with individual mortgages insured by FHA and for mortgages
purchased by the GSEs during specific years, there are several reasons
why care should be taken when comparing the FHA with the conventional
relative default rates. The relative default rates are derived from
different years (that is, FHA mortgages insured in 1992, 1994, and
1996; and conventional mortgages originated in 1997, 1998, and 1999 and
purchased by Fannie Mae or Freddie Mac). Also, the actual average
default rate for FHA-insured mortgages is higher than the actual
average default rate for conventional mortgages. Finally, the
distribution among LTV categories for FHA-insured loans and
conventional loans differs. Generally, over half of the loans that the
GSEs purchase have LTV ratios at or below 80 percent. In comparison,
loans insured by FHA generally have LTV ratios greater than 95 percent.
Several Practices Mortgage Institutions Use in Designing and
Implementing Low and No Down Payment Products Could Be Instructive for
FHA:
Mortgage institutions we spoke with used a number of similar practices
in designing and implementing new products, including low and no down
payment products. Some of these practices could be helpful to FHA in
its design and implementation of new products. When considering new
products, mortgage institutions focused their initial efforts on
identifying other products with similar enough characteristics to their
new product so that data on these products could be used to understand
the potential issues and performance for the proposed product. Some
mortgage institutions, including FHA, said they may acquire external
loan performance data and other data when designing new products.
Moreover, mortgage institutions often establish additional requirements
for new products such as additional credit enhancements or underwriting
requirements. FHA has less flexibility in imposing additional credit
enhancements but it does have the authority to seek co-insurance, which
it is not currently using. FHA makes adjustments to underwriting
criteria and to its premiums, but is not currently using any credit
score thresholds. Mortgage institutions also use different means to
limit how widely they make available a new product, particularly during
its early years. FHA does sometimes use practices for limiting a new
product but usually does not pilot products on its own initiative, and
FHA officials question the circumstances in which they can limit the
availability of a program and told us they do not have the resources to
manage programs with limited availability. According to officials of
mortgage institutions, including FHA, they also often put in place more
substantial monitoring and oversight mechanisms for their new products
including lender oversight, but we have previously reported that FHA
could improve oversight of its lenders.
Mortgage Institutions Initially Analyze the Risk of Products Similar to
the Product They Are Seeking to Develop:
Mortgage institutions, such as Fannie Mae, Freddie Mac, the private
mortgage insurers, and FHA first identify what information, including
data, they already have that would allow them to understand the
performance of a potential product. When these institutions do not have
sufficient data, they may purchase external data that allows them to
conduct their own analysis of loans that are related to a type of loan
product that they are considering. For example, Freddie Mac purchased
structured transactions of Alt A and subprime loans in order to learn
more about the underwriting characteristics and performance of high LTV
and low credit score loans.[Footnote 41] Freddie Mac officials reported
that these data were very helpful to them in considering how to best
structure some of their high LTV products. Moreover, the accounting
standards related to the Federal Credit Reform Act of 1990, which
requires federal agencies to estimate the budget cost of federal credit
programs, suggest that federal agencies making changes to programs
should consider external sources of data. FHA officials told us that
FHA has purchased such loan performance data. According to FHA
officials, FHA relies more heavily on data that it has collected
internally from the approximately 1 million loans it endorses each year
and its single-family data warehouse, which contains data on
approximately 30 million loans. FHA officials stated that, when
possible, they use these internal data to create a proxy for how a loan
product with certain characteristics might perform. FHA officials said
they used these data to create a "virtual zero down loan" when FHA was
considering how it might implement a proposed no down payment product.
The mortgage institutions with whom we spoke noted that any loan
performance data they develop or produce when implementing new products
are also used to enhance their automated underwriting systems. The data
improve the statistical models used in their automated underwriting
systems. In May 2004, FHA implemented a statistical model for
evaluating mortgage risk that may be used in lenders' automated
underwriting systems, called the FHA TOTAL Scorecard. In developing the
TOTAL Scorecard, FHA purchased external data (credit score data), which
they merged with their existing FHA data to try to better understand
the loan performance of FHA-insured loans.
Mortgage Institutions Require Additional Credit Enhancements or
Stricter Underwriting for New Low and No Down Payment Products:
Some mortgage institutions require additional credit enhancements--
mechanisms for transferring risk from one party to another--on low and
no down payment products and set stricter underwriting requirements for
these products. Mortgage institutions such as Fannie Mae and Freddie
Mac mitigate the risk of low and no down payment products by requiring
additional credit enhancements such as higher mortgage insurance
coverage. Fannie Mae and Freddie Mac require credit enhancements on all
loans they purchase that have LTVs above 80 percent. Typically, this
takes the form of private mortgage insurance. Fannie Mae and Freddie
Mac also require higher levels of private mortgage insurance coverage
for loans that have higher LTV ratios. For example, Fannie Mae and
Freddie Mac require insurance coverage of 35 percent for loans that
have an LTV greater than 95 percent. This means that, for any
individual loan that forecloses, the mortgage insurer will pay the
losses on the loan up to 35 percent of the claim amount. Fannie Mae and
Freddie Mac require lower insurance coverage for loans with LTVs below
95 percent. Fannie Mae and Freddie Mac believe that the higher-LTV
loans represent a greater risk to them and they seek to partially
mitigate this risk by requiring higher mortgage insurance coverage.
Although FHA is required to provide up to 100 percent coverage of the
loans it insures, FHA may engage in co-insurance of its single-family
loans. Under co-insurance, FHA could require lenders to share in the
risks of insuring mortgages by assuming some percentage of the losses
on the loans that they originated (lenders may use private mortgage
insurance). FHA has used co-insurance before, primarily in its
multifamily programs, but does not currently use co-insurance at
all.[Footnote 42] FHA officials told us they tried to put together a co-
insurance agreement with Fannie Mae and Freddie Mac and, while they
were able to come to agreement on the sharing of premiums, they could
not reach agreement on the sharing of losses and it was never
implemented.
FHA could also benefit from other means of mitigating risk such as
stricter underwriting or increasing fees. Fannie Mae officials also
stated that they would charge higher guarantee fees on low and no down
payment loans if they were not able to require the higher insurance
coverage. Fannie Mae and Freddie Mac charge guarantee fees to lenders
in exchange for converting whole loans into mortgage-backed securities,
which transfer the credit risk from the lender to Fannie Mae or Freddie
Mac. Within statutory limits, the HUD Secretary has the authority to
set up-front and annual premiums that are charged to borrowers who have
FHA-insured loans. In fact, in the administration's 2005 budget
proposal for a zero down payment product, it included higher premiums
for these loans. The Secretary has the authority to establish an up-
front premium, which may be up to 2.25 percent of the amount of the
original insured principal obligation of the mortgage. Within statutory
limits, the Secretary may also require payment of an annual premium.
Under the Administrative Procedures Act, the Secretary would generally
follow a process in which the change to premiums would include issuing
a proposed rule, receiving public comments, and then issuing a final
rule.
Additionally, mortgage institutions such as Fannie Mae and Freddie Mac
sometimes introduce stricter underwriting standards as part of the
development of new low and no down payment products (or products about
which they do not fully understand the risks). Institutions can do this
in a number of ways, including requiring a higher credit score
threshold for certain products, or requiring greater borrower reserves
or more documentation of income or assets from the borrower. Freddie
Mac officials stated that they believed limits on allowing ARMs or
multiple-unit properties were also reasonable, at least initially. Once
the mortgage institution has learned enough about the risks that were
previously not understood, it can change the underwriting requirements
for these new products to align with its standard products. Although
FHA sometimes has certain standards set for it through legislation,
there exists some flexibility in how it implements a newly authorized
product or changes to an existing product. The HUD Secretary has
latitude within statutory limitations in changing underwriting
requirements for new and existing products and has done this many
times. Examples included the decrease in what is included as borrower's
debts and an expansion of the definition of what can be included as
borrower's effective income when lenders calculate qualifying ratios.
In the context of the new zero down product, the Federal Housing
Commissioner at HUD has stated that all loans being considered for a
zero down loan would go through FHA's TOTAL Scorecard, and borrowers
would be required to receive prepurchase counseling.
Before Fully Implementing New Products, Some Mortgage Institutions May
Limit Their Availability:
Fannie Mae and Freddie Mac sometimes use pilots, or limited offerings
of new products, to build experience with a new product type or to
learn about particular variables that can help them better understand
the factors that contribute to risk for these products. Freddie Mac and
Fannie Mae also sometimes set volume limits for the percentage of their
business that could be low and no down payment lending. Fannie Mae and
Freddie Mac officials provided numerous examples of products that they
now offer as standard products but which began as part of underwriting
experiments.[Footnote 43] These include the Fannie Mae Flexible 97®
product, as well as the Freddie Mac 100 product. FHA has utilized
pilots or demonstrations as well when making changes to its single-
family mortgage insurance but generally does this in response to
legislation that requires a pilot and not on its own initiative. One
example in which FHA might have opted to do a pilot, or otherwise
limited volumes, for a product is with allowing nonprofit down payment
assistance. Concerns have been raised about the performance of FHA
loans that have down payment assistance. FHA might have benefited from
setting some limits on this type of assistance such that they could
study its implications before allowing its broader use.
FHA's Home Equity Conversion Mortgage (HECM) insurance program is an
example of an FHA program that started out as a pilot. HECM was
initiated by Congress in 1987 and is designed to provide elderly
homeowners a financial vehicle to tap the equity in their homes without
selling or moving from their homes. Homeowners borrow against equity in
their home and receive payments from their lenders (sometimes called a
"reverse mortgage"). Through statute, HECM started out as a
demonstration program that authorized FHA to insure 2,500 reverse
mortgages. Through subsequent legislation, FHA was authorized to insure
25,000 reverse mortgages, then 50,000, and then finally 150,000 when
Congress made the program permanent in 1998. Under the National Housing
Act, the HECM program was required to undergo a series of evaluations
and it has been evaluated four times since its inception. FHA officials
told us that administering this demonstration for only 2,500 loans was
difficult because of the challenges of selecting only a limited number
of lenders and borrowers. FHA ultimately had to limit loans to lenders
drawn through a lottery.
The appropriate size for a pilot program depends on several factors.
For example, the precise number of loans needed to detect a difference
in performance between standard loans and loans of a new product type
depends in part on how great the differences are in loan performance.
If delinquencies early in the life of a mortgage were about 10 percent
for FHA's standard high LTV loans, and FHA wished to determine whether
loans in the pilot had delinquency rates no more than 20 percent
greater that the standard loans (delinquency no more than 12 percent),
a sample size of about 1,000 loans would be a sufficient size to detect
this difference with 95 percent confidence. If delinquency rates are
different, or FHA's desired degree of precision were different, a
different sample size would be appropriate. FHA officials with whom we
spoke told us they could use pilots or otherwise limit availability
when implementing a new product or making changes to an existing
product, but they also questioned their authority and the circumstances
under which they would do so. FHA officials also said that they lacked
sufficient resources to be able to appropriately manage a pilot.
Some mortgage institutions may also limit the initial implementation of
a new product by limiting the origination and servicing of the product
to their better lenders and servicers, respectively. Mortgage
institutions may also limit servicing on the loans to servicers with
particular product expertise, regardless of who originates the loans.
Fannie Mae and Freddie Mac both reported that these were important
steps in introducing a new product and noted that lenders tend to take
a more conservative approach when first implementing a new product. FHA
officials agreed that they could, under certain circumstances, envision
piloting or limiting the ways in which a new or changed product would
be available but pointed to the practical limitations in doing so. FHA
approves the sellers and services that are authorized to support FHA's
single-family product. FHA officials told us they face challenges in
offering any of their programs only in certain regions of the country
or in limiting programs to certain approved lenders or servicers. They
generally offer their products on a national basis and, when they do
not, specific regions of the county or lenders may question why they
are not able to receive the same benefit (even on a demonstration or
pilot basis). These officials did, though, provide examples in which
their products had been initially limited to particular regions of the
country or to particular lenders, including the rollout of the HECMs
and their TOTAL Scorecard.
Mortgage Institutions Establish Enhanced Monitoring and Oversight for
New Low and No Down Payment Products and Make Changes Based on What
They Learn:
Mortgage institutions, including FHA, may take several steps related to
increased monitoring of new products and then make changes based on
what they learn. Fannie Mae and Freddie Mac officials described
processes in which they monitor actual versus expected loan performance
for new products, sometimes including enhanced monitoring of early loan
performance. FHA officials told us they also monitor more closely loans
underwritten under revised guidelines. Specifically, FHA officials told
us that FHA routinely conducts a review of underwriting for
approximately 6 to 7 percent of loans it insures. FHA officials told us
that, as part of the review, it may place greater emphasis on reviewing
those aspects of the insurance product that are the subject of a recent
change. Some mortgage institutions, such as Fannie Mae, told us that
they may conduct rigorous quality control sampling of new acquisitions,
early payment defaults, and nonperforming loans. Depending on the scale
of a new initiative, and its perceived risk, these quality control
reviews could include a review of up to 100 percent of the loans that
are part of the new product.
Fannie Mae and Freddie Mac also reported that they conduct more regular
reviews at seller/servicer sites for new products. In some cases,
Fannie Mae and Freddie Mac have staff who conduct on-site audits at the
sellers and servicers to provide this extra layer of oversight. FHA
officials also reported that they have staff that conduct reviews of
lenders that they have identified as representing higher risk to FHA
programs. However, we recently reported that HUD's oversight of lenders
could be improved and identified a number of recommendations for
improving this oversight.[Footnote 44] Mortgage institutions may issue
a lender bulletin, announcement, or seller/servicer guidelines to
clarify instructions for new products or changes to existing products.
FHA does this through the mortgagee letters it issues to all of its
approved lenders. Mortgage institutions may also issue a lender
bulletin, announcement, or seller/servicer guidelines to communicate
required additional controls, practices, procedures, reporting, and
remitting. Importantly, changes can be made to the structure of a
product, including the automated underwriting systems used to approve
individual loans, based on information learned from monitoring of new
products or from other sources.
FHA officials told us that they routinely analyze the changing
performance of loans they insure as part of the annual process for
estimating and re-estimating subsidy costs. The Federal Credit Reform
Act of 1990 requires that federal government programs that make direct
loans or loan guarantees (including insuring loans) account for the
full cost of their programs on an annual budgetary basis. Specifically,
federal agencies must develop subsidy estimates of the net cost of
their programs that include estimates of the net costs and revenues
over the projected lives of the loans made in each fiscal year. FHA's
Mutual Mortgage Insurance Fund has historically been self-sufficient
(not requiring subsidy). When preparing cost estimates for loan
guarantee programs, agencies are expected to develop a plan to
establish the appropriate information, models, and documentation to
better understand the new product and to be able to make changes based
on what they learn.[Footnote 45] FHA officials state that they have a
process in which changes to their model are made to reflect the
incorporation of new programs and policies and that they review the
performance of a new program in the context of their annual development
of subsidy estimates, as well as their annual actuarial study.[Footnote
46]
Conclusions:
While credit score is an effective predictor of default, LTV remains an
effective predictor of default. Loans with lower or no down payments
carry greater risk. Without any compensating measures such as
offsetting credit enhancements and increased risk monitoring and
oversight of lenders, introducing a new FHA no down payment product
would expose FHA to greater credit risk. The administration's proposal
for a zero down product included increased premiums to help compensate
for an increase in the cost of the FHA program, and the Federal Housing
Commissioner stated that borrowers would be required to go through
prepurchase counseling. The extent to which increased cost for one
program could effect the overall performance of FHA's Mutual Mortgage
Insurance (MMI) fund depends, in part, on the scale of any new product,
its relative cost, and how the new product affects demand for FHA's
existing products.
Although FHA appears to follow many key practices used by mortgage
institutions in designing and implementing new products, several
practices not currently or consistently followed by FHA stand out as
appropriate means to manage the risks associated with introducing new
products or significantly changing existing products. Moreover, these
practices can be viewed as part of a framework used by some mortgage
institutions for managing the risks associated with new or changed
products. The framework includes techniques such as limiting the
availability of a new product until it is better understood and
establishing stricter underwriting standards--all of which would help
FHA to manage risk associated with any new product it may introduce.
For example, FHA could set volume limits or limit the initial number of
lenders participating in the product. Further, changes in FHA's
premiums, an important practice used by FHA, within statutory limits,
permits FHA to potentially offset additional costs stemming from a new
product that entails greater risk or not well understood risk.
FHA officials believe that the agency does not have sufficient
resources to implement products with limited volumes, such as through a
pilot program. However, when FHA introduces new products or makes
significant changes to existing products with risks that are not well
understood, such actions could introduce significant risks when
implemented broadly. Products that would introduce significant risks
can impose significant costs. We believe that FHA could mitigate these
costs by using techniques such as piloting.
Matters for Congressional Consideration:
If Congress authorizes FHA to insure no down payment products or any
other new single-family insurance products, Congress may want to
consider a number of means to mitigate the additional risks that these
loans may pose. Such means may include limiting the initial
availability of such a new product, requiring higher premiums,
requiring stricter underwriting standards, or requiring enhanced
monitoring. Such risk mitigation techniques would serve to help protect
the Mutual Mortgage Insurance Fund while allowing FHA the time to learn
more about the performance of loans using this new product. Limits on
the initial availability of the new product would be consistent with
the approach Congress took in implementing the HECM program. The limits
could also come in the form of an FHA requirement to limit the new
product to better performing lenders and servicers as part of a
demonstration program or to limit the time period during which the
product is first offered.
Recommendations for Executive Action:
If Congress provides the authority for FHA to implement a no down
payment mortgage product or other products about which the risks are
not well understood, we recommend that the Secretary of HUD direct the
Assistant Secretary for HUD-Federal Housing Commissioner to consider
the following three actions:
* incorporating stricter underwriting criteria such as appropriate
credit score thresholds or borrower reserve requirements,
* piloting the initial product or limiting its initial availability and
asking Congress for the authority if HUD officials determine they
currently do not have this authority, and:
* utilizing other techniques for mitigating risks including use of
credit enhancements and prepurchase counseling.
Regardless of any new products Congress may authorize, when making
significant changes to its existing products or establishing new
products, we recommend that the Secretary of HUD direct the Assistant
Secretary for HUD-Federal Housing Commissioner to consider the
following two actions:
* limiting the initial availability of the product and when doing so,
the Commissioner should establish the conditions under which piloting
should be used, the techniques for limiting the initial availability of
a product, and the methods of enhanced monitoring that would be
connected to predetermined measures of success or failure for the
product; and:
* asking Congress for the authority to offer its new products or
significant changes to existing products on a limited basis, such as
through pilots, if HUD officials determine they currently lack
sufficient authority.
Agency Comments and Our Evaluation:
We provided a draft of this report to HUD, Fannie Mae, Freddie Mac,
USDA, and VA. We received written comments from HUD, which are
reprinted in appendix III. We also received technical comments from
HUD, Fannie Mae, Freddie Mac, and USDA, which have been incorporated
where appropriate. VA did not have comments on the draft.
HUD stated that it is in basic agreement with GAO that all policy
options, implications, and implementation methods should be evaluated
when considering or proposing a new FHA product. HUD also stated that
in designing its zero down payment program it considered the items that
we recommended it consider, including piloting. HUD stated that it
adopted the prepurchase counseling requirement as a component of a
proposed zero down program and that it determined that structuring the
mortgage insurance premium in such a way as to minimize risk represents
the most appropriate tool for managing the risk of this proposed
program.
However, it is not clear under what circumstances HUD believes that
piloting or limiting the availability of a changed or new product would
be appropriate or possible. As we noted in our draft report, HUD
officials told us that they face challenges in administering a pilot
program because of the difficulty of selecting only a limited number of
lenders and borrowers. HUD officials also held that they may not have
the authority to limit products and that they lacked sufficient
resources to adequately manage products as part of a pilot or with
limited volumes.
We believe that HUD needs to further consider piloting or limiting
volume of new or changed products because, as we state in the report,
it is a practice followed by others in the mortgage industry and could
assist HUD in mitigating the risks and costs associated with new or
changed products, while still allowing HUD to meet its goal of
providing homeownership opportunities. Difficulties in selecting a
limited number of lenders and questions about a lack of authority could
both be addressed by seeking clear authority from Congress on these
matters, if HUD officials determine they currently lack sufficient
authority. As we note in our report, when considering the resources
necessary to implement products with limited volumes, if FHA does not
use pilots or limit the availability of certain new or changed
products, FHA may face costs due to the significant risks that can be
associated with products that are implemented broadly and about which
the risks are not well understood. We do not believe that implementing
products with initial limits is appropriate or necessary in all cases.
To ensure that piloting or limiting the initial availability is given
sufficient consideration, we continue to recommend that HUD consider
establishing the conditions under which piloting should be used and the
techniques for limiting the initial availability of a product, as well
as the methods of enhanced monitoring that would be connected to
predetermined measures of success or failure for the product.
As agreed with your office, unless you publicly announce the contents
of this report earlier, we plan no further distribution until 30 days
from the report date. At that time, we will send copies of this report
to the appropriate Congressional Committees and the Secretaries of
Housing and Urban Development, Agriculture, and Veterans Affairs. We
also will make copies available to others upon request. In addition,
the report will be available at no charge on the GAO Web site at
[Hyperlink, http://www.gao.gov]v.
If you or your staff have any questions concerning this report, please
contact me at (202) 512-8678 or [Hyperlink, shearw@gao.gov] or Mathew
Scirè, Assistant Director, at (202) 512-6794 or [Hyperlink,
sciremj@gao.gov]. Key contributors to this report are listed in
appendix IV.
Sincerely yours,
Signed by:
William B. Shear:
Director, Financial Markets and Community Investment:
[End of section]
Appendixes:
Appendix I: Scope and Methodology:
To describe key characteristics and standards of mortgage products, we
interviewed officials at the Federal Housing Administration (FHA), U.S.
Department of Agriculture (USDA), and U.S. Department of Veterans
Affairs (VA); as well as staff at a conventional mortgage providers
(Bank of America); private mortgage insurers (for example, The PMI
Group, Inc; Mortgage Guarantee Insurance Corporation); government-
sponsored enterprises (GSE) (such as Fannie Mae and Freddie Mac);
Office of Federal Housing Enterprise Oversight (OFHEO); various state
housing finance agencies; and nonprofit down payment assistance
providers (for example, Nehemiah Corporation of America and Ameridream,
Inc.). We reviewed descriptions of various mortgage products and
compared the standards used across entities including FHA, USDA, and VA
regulations and program guidance and the GSEs seller/servicer guides.
We reviewed Web sites of state housing finance agencies and if we
identified zero down payment programs, we corroborated some of the Web
site information through interviews of agency officials. To report on
the volume of mortgage products, we reviewed relevant reports including
reports from the U.S. Department of Housing and Urban Development
(HUD).
To determine what economic research indicates about the variables that
are most important when estimating the risk level associated with
individual mortgages, we conducted a literature search. To identify
recent and relevant papers, we used various Internet search engines
(such as Online Computer Library Center, FirstSearch: EconLit; HUD
USER) and inquired with various mortgage industry participants (for
instance, FHA, Fannie Mae, Freddie Mac, and Nehemiah). Research we
reviewed includes articles, reports, and papers that were made
available to us from economic journals, the Internet, libraries, or
were provided to us by various entities (e.g., HUD, Fannie Mae, Freddie
Mac). For the purposes of this report, we refer to these documents as
"papers."
To facilitate the search we developed several criteria. For example, we
used the following search terms: mortgage, performance, default, LTV
ratio, credit score, and down payment assistance. We excluded the
following terms from our search: multifamily and commercial. We limited
our search to papers published or issued from 1999 to 2004; however, we
did include some papers relevant to our inquiry that were published or
issued prior to 1999 that we determined were significant to our
research objectives. We identified 151 papers. There may be some
relevant research that our search did not identify.
For the papers we identified, we conducted a multistep review.
Initially, we determined which papers to include in our analysis.
Papers included in the analysis were those that (1) were relevant to
our inquiry, (2) included empirical analysis, and (3) utilized
satisfactory methodologies. Papers that were not relevant were excluded
from our analysis (for example, subject of paper was off-point--car
loans; or analysis of loans in foreign country). Additionally, we
determined if the paper included empirical analysis. If the paper did
not include empirical analysis, we did not include it. However, we did
review the paper to determine if it talked about papers that we had not
yet identified that appeared to have empirical analysis. If the paper
did identify an additional paper that appeared to be relevant to our
inquiry, we attempted to obtain it. Finally, we excluded papers with
weak methodologies. GAO economists conducted the evaluations of
economic models. During this review, we excluded 106 papers leaving 45
for the second-stage review. Many of the papers we excluded were
excluded for lack of relevance or because they did not include
empirical analysis. The second review consisted of documenting the
findings of the papers that were relevant, had empirical analysis, and
used satisfactory methodologies. To facilitate this analysis, we
developed and maintained an Access database to document our analysis--
cataloging the specific factors these papers identified as being
important to estimating the risk level associated with individual
mortgages. Finally, for these papers, we synthesized the literature by
determining how many papers found each variable to be important. For a
bibliography of the 45 papers included in our analysis, see appendix
II.
To examine the relationship between mortgage performance and two key
underwriting variables, loan-to-value (LTV) ratio and credit score, we
calculated 4-year default rates for several categories of mortgages
with various LTV ratios and credit scores. We selected 4-year default
rates because it best balanced the competing goals of having recent
loans and the greatest number of years of default experience. To
perform this analysis, we first obtained mortgage volume and
performance data from three mortgage institutions: FHA (government
mortgages) and Fannie Mae and Freddie Mac (conventional
mortgages).[Footnote 47] The FHA mortgage data consist of a stratified
random sample of over 400,000 FHA-insured mortgages originated in
calendar years 1992, 1994, and 1996.[Footnote 48] We used these data
because they are the only significant data set of FHA loans that
includes credit scores and that had at least 4 years of loan
performance activity. The data come from a sample built by FHA for
research purposes. The Fannie Mae and Freddie Mac data consist of all
purchase-money mortgages originated in calendar years 1997, 1998, and
1999 and purchased by Fannie Mae or Freddie Mac. The data provided by
Fannie Mae and Freddie Mac exclude government-insured mortgages. We
selected these loan years because they include loans that aged at least
4 years and because, during these years, the GSEs began to purchase an
increasing number of loans with higher LTVs. The GSEs provided us data
that they considered to be proprietary. Although we limited the
reporting of our analysis to that which was considered nonproprietary,
this did not limit our overall findings for this objective. A
comparison of results from the FHA and the conventional mortgage
performance analysis should be done with care, for a number of reasons
because the data are from different years, FHA and the GSEs calculated
LTVs differently, and FHA's average 4-year default rate is higher than
for the GSEs.
For this analysis, we used the LTV ratio contained in the data system
for each mortgage institution. FHA defines the LTV ratio as the
original mortgage balance, excluding the financed mortgage insurance
premium, divided by the appraised value of the house. For the GSEs, LTV
ratio is defined as the original mortgage balance divided by the lesser
of the sale price of the house or the appraised value of the house.
For this analysis, the credit score is the Fair Isaac score contained
in each institution's data system. The mortgage institutions obtain
credit scores in various ways. FHA has only recently begun to collect
credit scores in its single-family data warehouse. However, for
research purposes, FHA purchased historic credit score information for
the sample of mortgages originated in 1992, 1994, and 1996. On the
other hand, Fannie Mae obtains credit score information in two ways.
For some mortgages, the lender obtained the borrower's credit score
information when it originated the mortgage, and upon Fannie Mae's
purchase of the mortgage, the lender provides this credit score
information to Fannie Mae. In some cases, however, lenders do not
obtain borrower's credit scores; when Fannie Mae purchases the
mortgage, it obtains a credit score for the borrower. For some
mortgages, the institutions indicated that a credit score for a
particular mortgage was unknown. Within the FHA data, about 8 percent
of the mortgages had unknown scores; within the GSE data, about 3
percent of the mortgages had unknown scores. We included mortgages with
unknown credit scores in our analysis and presented the loan
performance results.
We carried out several actions to ensure that data provided by FHA,
Fannie Mae, and Freddie Mac were sufficiently reliable for use in our
analysis. For the FHA sample data, we met with FHA staff involved in
generating the sample data set. We also discussed data quality
procedures with appropriate FHA staff. Based on these discussions in
which FHA officials described their policies and procedures and the
results of external audits of their data systems, we determined that
the FHA data were sufficiently reliable to use in our analysis. FHA
officials indicated that their data systems contain data entry edit
checks and that data submitted by lenders was reviewed by FHA. FHA's
data system was audited by external auditors, and no major issues
concerning data quality were raised. We also discussed data quality
procedures with appropriate Fannie Mae and Freddie Mac staff. These
procedures included data entry edit checks, exception reports, and
checks for reasonableness. Additionally, we reviewed reports from
audits of Fannie Mae and Freddie Mac. These audits included an
assessment of the Fannie Mae information systems that generated the
data used in this report. The audits also assessed Freddie Mac
information systems that generated the data used in this report. We
also compared the data with similar publicly available data. Based on
these discussions and reviews of audit reports, we determined that the
data Fannie Mae and Freddie Mac provided were sufficiently reliable to
use in our analysis.
With these data, we generated FHA and conventional 4-year default rates
for several combinations of LTV ratios and credit scores. To do this,
we:
* defined default as a credit event that includes foreclosed mortgages,
as well as mortgages that did not experience foreclosure, but that
would typically lead to a credit loss, such as a "short sale" or a
"deed-in-lieu of foreclosure" termination of the mortgage;
* selected six LTV ratio categories;
* selected six credit score categories;
* combined Fannie Mae and Freddie Mac mortgage volume and performance
data;
* combined mortgage volume and performance data for the sample (of
mortgages insured by FHA in 1992, 1994, and 1996; and conventional
mortgages originated in 1997, 1998, and 1999 and purchased by Fannie
Mae or Freddie Mac);
* calculated the average 4-year default rate for FHA (weighted average)
and for all conventional loans separately by dividing the total dollar
amount of mortgages experiencing a credit event by the total dollar
amount of mortgages originated (for FHA) or purchased (for
conventional);
* calculated the average 4-year default rates for sampled FHA loans and
for conventional loans that fell within each LTV ratio and credit score
category; and:
* calculated the relative 4-year default rates for each LTV ratio and
credit score categories for FHA loans and for conventional loans by
dividing the average 4-year default rate for each specific LTV and
credit score category by the average 4-year default rate for sampled
FHA loans and all conventional loans, respectively.
For example, if the merged average 4-year default rate for FHA loans
within a particular LTV ratio and credit score category was 3 percent,
and the average 4-year default rate for all FHA loans was 2 percent,
the relative 4-year default rate for FHA loans within this particular
category would be 3 divided by 2, or 1.5 times the average FHA default
rate.
We do not present relative default rates for categories with small
numbers of mortgages because the performance information may not be
reliable when there are too few observations. In the figures, these
instances are noted as "N/A." For the FHA analysis, we used a cutoff of
about 1,000 mortgages to determine whether there were sufficient
observations to reliably measure the relative default rate. For the
conventional analysis, we used a cutoff of about 3,000 mortgages to
determine whether the relative default rate was reliable. We chose a
higher cutoff for the GSE analysis because the GSEs have a lower
default rate, and analysis of less frequent events requires a larger
sample size.
To determine what lessons FHA might learn from others that support low
and no down payment lending we obtained testimonial information from
the mortgage industry (for example, FHA, GSEs, private mortgage
insurers, and a private lender) about the steps they take to design and
implement low and no down payment lending. We selected these entities
based on the parallels to FHA, as well as their significance in the
mortgage industry. Where available, we reviewed industry and academic
information relevant to these steps in carrying out low and no down
payment lending.
We performed our audit work from January 2004 to December 2004 in
accordance with generally accepted government auditing standards.
[End of section]
Appendix II: Papers Identified in Literature Search and Included in
Analysis:
Paper: Brent W. Ambrose and Charles A. Capone. "The Hazard Rates of
First and Second Defaults," Journal of Real Estate Finance and
Economics, vol. 20 no. 3 (May 2000);
LTV: Yes;
Credit score: [Empty];
Other factor(s): Yes.
Paper: Brent W. Ambrose and Charles A. Capone. "Modeling the
Conditional Probability of Foreclosure in the Context of Single-Family
Mortgage Default Resolutions," Real Estate Economics, vol. 26 no. 3
(1998);
LTV: Yes;
Credit score: No;
Other factor(s): Yes.
Paper: Richard Anderson and James VanderHoff. "Mortgage Default Rates
and Borrower Race," The Journal of Real Estate Research, vol. 18 no. 2
(Sep/Oct 1999);
LTV: No;
Credit score: No;
Other factor(s): Yes.
Paper: Robert B. Avery, Raphael W. Bostic, Paul S. Calem, and Glenn B.
Canner. "Credit Risk, Credit Scoring, and the Performance of Home
Mortgages," Federal Reserve Bulletin (July 1996);
LTV: Yes;
Credit score: Yes;
Other factor(s): Yes.
Paper: James A. Berkovec, Glenn B. Canner, Stuart A. Gabriel and
Timothy H. Hannan. "Race, Redlining, and Residential Mortgage Loan
Performance," Journal of Real Estate Finance and Economics, vol. 9 no.
1 (July 1994);
LTV: Yes;
Credit score: No;
Other factor(s): Yes.
Paper: Paul S. Calem and Susan M. Wachter. "Community Reinvestment and
Credit Risk: Evidence from an Affordable-Home-Loan Program," Real
Estate Economics, vol. 27 no. 1 (1999);
LTV: No;
Credit score: Yes;
Other factor(s): No.
Paper: Paul S. Calem and James Follain. The Asset-Correlation Parameter
in Basel II for Mortgages on Single-Family Residences, a report
prepared as background for public comment on the Advance Notice of
Proposed Rulemaking on the Proposed New Basel Capital Accord, November
6, 2003;
LTV: Yes;
Credit score: Yes;
Other factor(s): Yes.
Paper: Paul S. Calem and Michael LaCour-Little. Risk-based Capital
Requirements for Mortgage Loans, November 2001;
LTV: Yes;
Credit score: Yes;
Other factor(s): No.
Paper: Charles A. Calhoun and Yongheng Deng. "A Dynamic Analysis of
Fixed-and Adjustable-Rate Mortgage Terminations," Journal of Real
Estate Finance and Economics, vol. 24 no. 1/2 (Jan 2002);
LTV: Yes;
Credit score: No;
Other factor(s): Yes.
Paper: Dennis R. Capozza, Dick Kazarian, and Thomas A. Thomson.
"Mortgage Default in Local Markets," Real Estate Economics, vol. 25 no.
4 (Winter 1997);
LTV: Yes;
Credit score: No;
Other factor(s): Yes.
Paper: Richard L. Cooperstein, F. Stevens Redburn, and Harry G. Meyers.
"Modelling Mortgage Terminations in Turbulent Times," AREUEA Journal,
vol. 19 no. 4 (1991);
LTV: Yes;
Credit score: No;
Other factor(s): Yes.
Paper: Robert F. Cotterman. Analysis of FHA Single-Family Default and
Loss Rates, a report prepared for the Office of Policy Development and
Research, U.S. Department of Housing and Urban Development, March 25,
2004;
LTV: Yes;
Credit score: Yes;
Other factor(s): Yes.
Paper: Robert F. Cotterman. New Evidence on the Relationship Between
Race and Mortgage Default: The Importance of Credit History Data, a
report prepared for the Office of Policy Development and Research, U.S.
Department of Housing and Urban Development, May 23, 2002;
LTV: Yes;
Credit score: Yes;
Other factor(s): Yes.
Paper: Robert F. Cotterman. Neighborhood Effects in Mortgage Default
Risk, a report prepared for the Office of Policy Development and
Research, U.S. Department of Housing and Urban Development, March 2001;
LTV: Yes;
Credit score: Yes;
Other factor(s): Yes.
Paper: Robert F. Cotterman. Assessing Problems of Default in Local
Mortgage Markets, a report prepared for the Office of Policy
Development and Research, U.S. Department of Housing and Urban
Development, March 2001;
LTV: Yes;
Credit score: No;
Other factor(s): Yes.
Paper: Amy Crews Cutts and Robert Van Order. "On the Economics of
Subprime Lending." Freddie Mac Working Paper Series # 04-01(January
2004) (http://freddiemac.com/corporate/reports/);
LTV: Yes;
Credit score: Yes;
Other factor(s): Yes.
Paper: Ralph DeFranco. "Modeling Residential Mortgage Termination and
Severity Using Loan Level Data." (Ph.D diss., University of California,
Berkeley, 2002);
LTV: Yes;
Credit score: Yes;
Other factor(s): Yes.
Paper: Yongheng Deng, John M. Quigley. Woodhead Behavior and the
Pricing of Residential Mortgages, (December 2002);
LTV: Yes;
Credit score: No;
Other factor(s): Yes.
Paper: Yongheng Deng and Stuart Gabriel. Enhancing Mortgage Credit
Availability Among Underserved and Higher Credit-Risk Populations: An
Assessment of Default and Prepayment Option Exercise Among FHA-Insured
Borrowers, a report prepared for the U.S. Department of Housing and
Urban Development, August 2002;
LTV: Yes;
Credit score: Yes;
Other factor(s): Yes.
Paper: Yongheng Deng and Stuart Gabriel. Modeling the Performance of
FHA-Insured Loans: Borrowers Heterogeneity and the Exercise of Mortgage
Default and Prepayment Options, a report submitted to the Office of
Policy Development and Research, U.S. Department of Housing and Urban
Development, May 2002;
LTV: Yes;
Credit score: Yes;
Other factor(s): Yes.
Paper: Yongheng Deng, John M. Quigley, and Robert Van Order. "Mortgage
Terminations, Heterogeneity and the Exercise of Mortgage Options,"
Econometrica, vol. 68 no. 2 (March 2000);
LTV: Yes;
Credit score: No;
Other factor(s): Yes.
Paper: Yongheng Deng, John M. Quigley, and Robert Van Order, Mortgage
Default and Low Downpayment Loans: The Costs of Public Subsidy,
National Bureau of Economic Research: Working Paper No. 5184
(Cambridge, Mass.: July 1995);
LTV: Yes;
Credit score: No;
Other factor(s): Yes.
Paper: Peter J. Elmer and Steven A Seelig. "Insolvency, Trigger Events,
and Consumer Risk Posture in the Theory of Single-Family Mortgage
Default," Journal of Housing Research, vol. 10 no. 1 (1999);
LTV: Yes;
Credit score: No;
Other factor(s): Yes.
Paper: Robert M. Feinberg and David Nickerson. "Crime and Residential
Mortgage Default: An Empirical Analysis." Applied Economics Letters,
vol. 9 (2002);
LTV: No;
Credit score: No;
Other factor(s): Yes.
Paper: Dan Feshbach and Michael Simpson. "Tools for Boosting Portfolio
Performance," Mortgage Banking, October 1999;
LTV: Yes;
Credit score: Yes;
Other factor(s): Yes.
Paper: Dan Feshbach and Pat Schwinn. "A Tactical Approach to Credit
Scores," Mortgage Banking, February 1999;
LTV: Yes;
Credit score: Yes;
Other factor(s): Yes.
Paper: Gerson M. Goldberg and John P. Harding. "Investment
Characteristics of Low-and Moderate-Income Mortgage Loans," Journal of
Housing Economics, vol. 12 (2003);
LTV: Yes;
Credit score: No;
Other factor(s): Yes.
Paper: Government Accountability Office. Mortgage Financing: Changes in
the Performance of FHA-Insured Loans, GAO-02-773. Washington, D.C. July
10, 2002;
LTV: Yes;
Credit score: No;
Other factor(s): Yes.
Paper: Government Accountability Office. Mortgage Financing: FHA's Fund
Has Grown, but Options for Drawing on the Fund Have Uncertain Outcomes,
GAO-01-460. Washington, D.C. February 28, 2001;
LTV: Yes;
Credit score: No;
Other factor(s): Yes.
Paper: Valentina Hartarska, Claudio Gonzalez-Vega, and David Dobos.
Credit Counseling and the Incidence of Default on Housing Loans by Low-
Income Households, a paper prepared as part of a collaborative research
program between Ohio State University and Paul Taylor and Associates,
of Columbus, Ohio. (February 2002);
LTV: No;
Credit score: No;
Other factor(s): Yes.
Paper: Abdighani Hirad and Peter M. Zorn (corresponding author). A
Little Knowledge Is a Good Thing: Empirical Evidence of the
Effectiveness of Pre-Purchase Homeownership Counseling, May 22, 2001;
LTV: No;
Credit score: No;
Other factor(s): Yes.
Paper: The Department of Housing and Urban Development, Office of
Inspector General. Follow-up of Down Payment Assistance Programs
Operated by Private Nonprofit Entities. 2002-SE-0001, Seattle,
Washington, September 25, 2002;
LTV: No;
Credit score: No;
Other factor(s): Yes.
Paper: The Department of Housing and Urban Development, Office of
Inspector General. Final Report of Nationwide Audit: Down Payment
Assistance Programs (Office of Insured Single Family Housing), 2000-SE-
121-0001, Seattle, Washington, March 31, 2000;
LTV: No;
Credit score: No;
Other factor(s): Yes.
Paper: Michael Lacour-Little and Stephen Malpezzi. "Appraisal Quality
and Residential Mortgage Default: Evidence From Alaska," Journal of
Real Estate Finance and Economics, vol. 27 no. 2 (2003);
LTV: Yes;
Credit score: No;
Other factor(s): Yes.
Paper: Andrey D. Pavlov. "Competing Risks of Mortgage Termination: Who
Refinances, Who Moves, and Who Defaults," Journal of Real Estate
Finance and Economics, vol. 23 no. 2 (September 2001);
LTV: Yes;
Credit score: No;
Other factor(s): Yes.
Paper: Anthony Pennington-Cross. "Credit History and the Performance of
Prime and Nonprime Mortgages," Journal of Real Estate Finance and
Economics, vol. 27 no. 3 (2003);
LTV: No;
Credit score: Yes;
Other factor(s): Yes.
Paper: Anthony Pennington-Cross. "Subprime and Prime Mortgages: Loss
Distributions." Office of Federal Housing Enterprise Oversight Working
Paper Series 03-01 (May 27, 2003);
LTV: Yes;
Credit score: Yes;
Other factor(s): Yes.
Paper: Anthony Pennington-Cross. "Patterns of Default and Prepayment
for Prime and Nonprime Mortgages." Office of Federal Housing Enterprise
Oversight Working Paper 02-1 (March 2002);
LTV: Yes;
Credit score: Yes;
Other factor(s): Yes.
Paper: Roberto G. Quercia, Michael A. Stegman, Walter R. Davis, and
Eric Stein. Community Reinvestment Lending: A Description and Contrast
of Loan Products and Their Performance, a report prepared for the Joint
Center for Housing Studies' Symposium on Low-Income Homeownership as an
Asset-Building Strategy, September 2000;
LTV: Yes;
Credit score: Yes;
Other factor(s): Yes.
Paper: Roberto G. Quercia, George W. McCarthy, and Michael A. Stegman.
"Mortgage Default Among Rural, Low-Income Borrowers," Journal of
Housing Research vol. 6 no. 2 (1995);
LTV: Yes;
Credit score: No;
Other factor(s): Yes.
Paper: Stephen L. Ross. "Mortgage Lending, Sample Selection and
Default," Real Estate Economics, vol. 28 no. 4 (Winter 2000);
LTV: Yes;
Credit score: No;
Other factor(s): Yes.
Paper: Robert A. Van Order and Peter M. Zorn. The Performance of Low
Income and Minority Mortgages: A Tale of Two Options, August 2001;
LTV: Yes;
Credit score: Yes;
Other factor(s): Yes.
Paper: Robert Van Order and Peter Zorn. Performance of Low-Income and
Minority Mortgages, a report prepared for the Joint Center for Housing
Studies' Symposium on Low-Income Homeownership as an Asset-Building
Strategy, September 2001;
LTV: Yes;
Credit score: Yes;
Other factor(s): Yes.
Paper: Robert Van Order and Peter Zorn. "Income, Location, and Default:
Some Implications for Community Lending," Real Estate Economics, vol.
28 no. 3 (2000);
LTV: Yes;
Credit score: No;
Other factor(s): Yes.
Paper: Economic Systems Inc., ORC Macro, and The Hay Group. Evaluation
of VA's Home Loan Guaranty Program: Final Report. A report prepared for
the Department of Veterans Affairs. (July 2004);
LTV: Yes;
Credit score: No;
Other factor(s): Yes.
Source: GAO.
[End of table]
[End of section]
Appendix III: Comments from the Department of Housing and Urban
Development:
U.S. DEPARTMENT OF HOUSING AND URBAN DEVELOPMENT:
WASHINGTON, DC 20410-8000:
ASSISTANT SECRETARY FOR HOUSING-
FEDERAL HOUSING COMMISSIONER:
JAN 14 2005:
Mr. William B. Shear:
Director:
Financial Markets and Community Investments:
United States Government Accountability Office:
Washington, DC 20548:
Dear Mr. Shear:
Thank you for the opportunity to comment on the GAO Draft Report
entitled Actions Needed to Help FHA Manage Risks From New Mortgage Loan
Products.
The Department is in basic agreement with the GAO in that all policy
options, implications, and implementation methods should be evaluated
when considering or proposing a new FHA product. In fact, the
Department conducts such evaluations routinely. New products are
proposed only after a thorough and complete analysis of all aspects of
implementation and risk management. Appropriate measures that balance
financial risk with the intended social purpose of a program, most
often to provide homeownership opportunities, are always proposed and
evaluated as part of the process in developing new mortgage insurance
products.
The Report identifies three specific actions which GAO recommends be
considered for inclusion in the Department's proposed zero down payment
program: imposing stricter underwriting criteria (higher credit scores
or reserve requirements), artificially limiting program participation
through the use of a pilot program, and credit enhancements and pre-
purchase counseling. As we discussed with the GAO, these actions, along
with others, were each considered during the Department's development
of the zero down program and while most were not adopted, alternative
solutions to achieve the objectives were incorporated into the program
design.
The items the GAO recommended for consideration are all designed to
mitigate risk and limit financial exposure to the FHA Insurance Fund
consistent with the FHA's mission of providing homeownership
opportunities to populations unserved or underserved by the private
market. While FHA considered the recommended solutions proposed by GAO
and adopted the pre-purchase counseling requirement as a component of
the proposed zero down program, FHA determined, through the use of the
same tools explored by GAO such as risk modeling, market comparison,
portfolio performance, and consultation, that the most appropriate tool
for balancing the expected performance of these loans against the goal
of providing homeownership opportunities to this population was to
structure the mortgage insurance premium in such a way as to minimize
the financial risk.
Again, we appreciate the opportunity to comment on the Draft Report and
will continue, as recommended by the GAO, to consider all possible
elements of program design when developing new program proposals and
adopt the combination that best fits the objectives of the proposed
program.
Sincerely,
Signed by:
Margaret A. Young:
Deputy Assistant Secretary For Finance and Budget:
[End of section]
Appendix IV: GAO Contacts and Staff Acknowledgments:
GAO Contacts:
William B. Shear, (202) 512-8678;
Matthew Scirè, (202) 512-6794:
Staff Acknowledgments:
In addition to those individuals named above, Anne Cangi, Rudy
Chatloss, Bert Japikse, Austin Kelly, Marc Molino, Andy Pauline,
Roberto Piñero, and Mitch Rachlis made key contributions to this
report.
(250169):
FOOTNOTES
[1] For purposes of this report, we define loans with LTV ratios of
greater than 97 percent as having a high LTV ratio.
[2] Credit scores are a single numerical score, based on an
individual's credit history, that measures that individual's
creditworthiness.
[3] Conventional lenders provide mortgages that do not carry government
insurance or guarantees.
[4] While this analysis is useful in determining the extent to which
LTV ratios and credit scores are helpful in predicting the risk level
associated with individual mortgages, the FHA and conventional relative
default rates are not strictly comparable because they are for
different time periods and because FHA has a higher overall default
rate.
[5] For this analysis, we define default as a credit event that
includes foreclosed mortgages, as well as mortgages that did not
experience a foreclosure, but that would typically lead to a credit
loss, such as a "short sale" or a "third party sale" termination of the
mortgage. Delinquency was not considered to be default.
[6] Structured transaction is a broad term that covers any of several
methods of dividing cash flows among several investors in a pool of
mortgages.
[7] A credit enhancement is provided when a party agrees to assume
risks associated with a loan. For example, mortgage insurance is a type
of credit enhancement.
[8] FHA also has the authority to obtain credit enhancements through
the use of co-insurance. Co-insurance requires lenders to share in the
risks of insuring mortgages by assuming some percentage of the losses
on the loans that they originated.
[9] For example, Congress established volume limits with the
introduction of FHA's Home Equity Conversion Mortgage program.
[10] Claim amount includes outstanding loan amount plus other costs
including legal fees.
[11] Single-family loans insured by FHA may be used to finance the
purchase of new or existing one-to-four-family properties. 12 U.S.C.
§1709(b).
[12] Referred to as the conforming loan limit because the mortgages
conform to underwriting standards established by Fannie Mae and Freddie
Mac. The limit is higher for single-family mortgages secured by two-,
three-, and four-unit dwellings.
[13] Susan Wharton Gates, Vanessa Gail Perry, and Peter Zorn,
"Automated Underwriting in Mortgage Lending: Good News for the
Underserved," Housing Policy Debate, 13, no. 2, 2002.
[14] Fair, Isaac and Company, "Understanding your Credit Score," July
2002.
[15] The conforming loan limit is 50 percent higher for Alaska, Hawaii,
Guam, and the U.S. Virgin Islands.
[16] Often state housing finance agencies define first-time homebuyers
as individuals who, during the past three consecutive years have not
had ownership in a primary residence.
[17] State housing finance agencies have also been actively involved in
low and no down payment mortgage lending. Using primarily mortgage
revenue bonds that are sold to investors, they are able to originate,
fund, or self-insure below-market interest rate mortgages.
[18] Closing costs could include a loan origination fee, a mortgage
recordation fee, a title transfer tax, appraisal fees, attorney fees,
and title insurance.
[19] According to USDA officials, a borrower may finance closing costs
and the Guarantee Fee as long as they do not exceed the property's
appraised value.
[20] Out-of-pocket expenses can include expenses such as funds required
to establish an escrow account.
[21] Michael Collins, "Pursuing the American Dream: Homeownership and
the Role of Federal Housing Policy," January 2002.
[22] Fannie Mae officials noted that Fannie Mae's automated
underwriting system allows for a higher total-debt-to-income ratio and
factors the ratio in its evaluation of the loan.
[23] FHA covers 100 percent of the mortgage balance but does not cover
all of the costs of the foreclosure.
[24] Research we reviewed includes articles, reports, and papers that
were made available to us from economic journals, the internet,
libraries, or were provided to us by various entities (e.g., HUD,
Fannie Mae, Freddie Mac). For the purposes of this report, we refer to
these documents as "papers."
[25] Many papers employ multiple models to analyze the importance of
variables; as a result, summing the number of papers that found a
variable important and the number of papers that found a variable not
important will not equal the total number of papers that analyzed the
importance of a specific variable. For example, two of the papers that
assessed the importance of LTV found it important in some circumstances
but not in others.
[26] Of the 45 papers identified, 13 identified both LTV ratio and
credit score as important and useful when estimating the risk level
associated with individual mortgages.
[27] Of the papers we reviewed, researchers used several measures of
loan performance (e.g., default, delinquency, severity). Please see
each paper for the particular loan performance measure it used.
[28] Robert B. Avery, Raphael W. Bostic, Paul S. Calem, and Glenn B.
Canner. "Credit Risk, Credit Scoring, and the Performance of Home
Mortgages," Federal Reserve Bulletin (July 1996).
[29] Yongheng Deng, John M. Quigley, and Robert Van Order, Mortgage
Default and Low Downpayment Loans: The Costs of Public Subsidy,
National Bureau of Economic Research: Working Paper No. 5184
(Cambridge, Mass.: July 1995).
[30] Yongheng Deng and Stuart Gabriel, Modeling the Performance of FHA-
Insured Loans: Borrower Heterogeneity and the Exercise of Mortgage
Default and Prepayment Options, a report submitted to the Office of
Policy Development and Research, U.S. Department of Housing and Urban
Development, May 2002.
[31] Generally, the studies that found the LTV ratio to be important
had sample sizes greater than 6,000 (and in some cases in the
millions). In comparison, three of the four studies that did not find
LTV to be important had smaller sample sizes and the fourth study found
LTV to be important for the prime market, but not for the subprime
market. Additionally, one study used national aggregate data rather
than loan level data. This study found LTV important in some
specifications, but not in others.
[32] Amy Crews Cutts and Robert Van Order, "On the Economics of
Subprime Lending." Freddie Mac Working Paper Series #04-01(January
2004) (http://freddiemac.com/corporate/reports/).
[33] Generally, the mortgage industry began widely using credit score
information in the late 1990s; therefore, considering credit score in
empirical loan performance analysis is very recent. Further, there was
a particularly strong housing market during this period.
[34] Robert F. Cotterman. Analysis of FHA Single-family Default and
Loss Rates, a report submitted to the Office of Policy Development and
Research, U.S. Department of Housing and Urban Development, March 25,
2004.
[35] Cotterman. Analysis of FHA Single-family Default and Loss Rates.
[36] Qualifying ratios evaluated in the studies we identified include
ratios such as payment-to-income, debt-to income, personal savings as
percentage of disposable income, and household liabilities divided by
household assets.
[37] Avery, Bostic, Calem, and Canner. "Credit Risk, Credit Scoring,
and the Performance of Home Mortgages."
[38] Robert Van Order and Peter Zorn. "Performance of Low-Income and
Minority Mortgages," A paper prepared for the Joint Center for Housing
Studies' Symposium on Low-Income Homeownership as an Asset-Building
Strategy, Working Paper: LIHO-01.10 (September 2001).
[39] Deng, Quigley, and Van Order, Mortgage Default and Low Downpayment
Loans: The Costs of Public Subsidy.
[40] The data used in the analysis include a sample of FHA-insured
mortgages originated in calendar years 1992, 1994, and 1996 and
conventional mortgages originated in calendar years 1997, 1998, and
1999. These data represent the most recently available data for each
entity that includes variables necessary to conduct the analysis (such
as LTV ratio and credit score). We did not include mortgages guaranteed
by the USDA and VA in our analysis because credit score information for
these mortgages was not readily available. Fannie Mae and Freddie Mac
provided the conventional data.
In our analysis, we specified six LTV ratio categories and six credit
score categories. We defined default as a credit event that includes
foreclosed mortgages, as well as mortgages that did not experience
foreclosure, but that would typically lead to a credit loss, such as a
"short sale" or a "third party sale" termination of the mortgage.
We calculated average 4-year default rates (by dollar amount) for FHA-
insured and conventional mortgages within specified LTV ratio and
credit score categories. The average 4-year default rates for each LTV
ratio and credit score categories were calculated as follows: the total
dollar amount of mortgages originated (in all three cohorts) and
defaulted within 4 years of origination, divided by the total dollar
amount of mortgages originated (in all three cohorts). We then
classified the default rates for each LTV ratio and credit score
category relative to the average default rate for the FHA-insured and
conventional mortgages, respectively. The relative default rates for
each LTV ratio and credit score category were calculated as follows:
the average default rate for each category, divided by the average
default rate for all FHA-insured or conventional mortgages as
appropriate. For a more detailed description of our analysis, see
appendix I: Scope and Methodology.
[41] Structured transaction is a broad term that covers any of several
methods of dividing cash flows among several investors in a pool of
mortgages. Alt A is a broad term that describes mortgages that fall
just outside of the underwriting guidelines that govern the regular
mortgage purchase business of the GSEs. Alt A mortgages are loans to
borrowers with relatively minor credit problems.
[42] According to FHA, FHA discontinued the multifamily co-insurance
program after experiencing significant losses. Since then, Congress
provided FHA authority to enter into risk sharing agreements with GSEs
and housing finance agencies on certain multifamily loans.
[43] The GSE officials did not tell us the numeric extent to which they
limited products' issuance during its pilot phase.
[44] GAO, Single-Family Housing: Progress Made, but Opportunities Exist
to Improve HUD's Oversight of FHA Lenders, GAO-05-13 (Washington, D.C.:
Nov. 12, 2004).
[45] The Federal Accounting Standards Advisory Board (FASAB) is
responsible for promulgating accounting standards for the U.S.
Government, and these standards are recognized as generally accepted
accounting principles for the federal government. FASAB developed
standards for agencies that describe the types of analysis that would
be expected for a change to an existing program, including relevant
historical data and modeling capabilities.
[46] The Cranston Gonzales National Affordable Housing Act requires an
independent actuarial analysis of the economic net worth and soundness
of FHA's MMI Fund.
[47] We did not include mortgages guaranteed by USDA and the VA in our
analysis because credit score information for these mortgages was not
readily available.
[48] Foreclosed mortgages were over-sampled in 1992 and 1994. The
figures presented in the text are weighted according to the sample
weights provided by HUD.
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