Federal Housing Administration
Managing Risks from a New Zero Down Payment Product Gao ID: GAO-05-857T June 30, 2005To assist Congress in considering legislation to authorize the Secretary of the Department of Housing and Urban Development (HUD) to carry out a pilot program to insure zero down payment mortgages, this testimony provides information about practices mortgage institutions use in designing and implementing low and no down payment products. It also contains information about how these practices could be instructive for FHA in managing risks associated with a zero down payment product--a product for which the risks are not well understood. This testimony is primarily based on GAO's February 2005 report, Mortgage Financing: Actions Needed to Help FHA Manage Risks from New Mortgage Loan Products, (GAO-05-194).
In recent years, many mortgage institutions have become increasingly active in supporting low and even no down payment mortgage products. In considering the risks of these new products, a substantial amount of research GAO reviewed indicates that loan-to-value (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 sometimes require additional credit enhancements, such as higher insurance coverage, and 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, but does not currently use this authority. FHA has used stricter underwriting criteria, but told us it is unlikely they would use a credit score threshold for a new zero down payment product. Mortgage institutions may also 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, but 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.
GAO-05-857T, Federal Housing Administration: Managing Risks from a New Zero Down Payment Product
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Testimony:
Before the Subcommittee on Housing and Community Opportunity, Committee
on Financial Services,:
House of Representatives:
United States Government Accountability Office:
GAO:
For Release on Delivery Expected at 10:00 a.m. EDT:
Thursday, June 30, 2005:
Federal Housing Administration:
Managing Risks from a New Zero Down Payment Product:
Statement of William B. Shear, Director, Financial Markets and
Community Investment:
GAO-05-857T:
GAO Highlights:
Highlights of GAO-05-857T, a testimony to the Subcommittee on Housing
and Community Opportunity, Committee on Financial Services, House of
Representatives:
Why GAO Did This Study:
To assist Congress in considering legislation to authorize the
Secretary of the Department of Housing and Urban Development (HUD) to
carry out a pilot program to insure zero down payment mortgages, this
testimony provides information about practices mortgage institutions
use in designing and implementing low and no down payment products. It
also contains information about how these practices could be
instructive for FHA in managing risks associated with a zero down
payment product -- a product for which the risks are not well
understood. This testimony is primarily based on GAO‘s February 2005
report, Mortgage Financing: Actions Needed to Help FHA Manage Risks
from New Mortgage Loan Products, (GAO-05-194).
What GAO Found:
In recent years, many mortgage institutions have become increasingly
active in supporting low and even no down payment mortgage products. In
considering the risks of these new products, a substantial amount of
research GAO reviewed indicates that loan-to-value (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 sometimes require additional credit enhancements, such as
higher insurance coverage, and 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,
but does not currently use this authority. FHA has used stricter
underwriting criteria, but told us it is unlikely they would use a
credit score threshold for a new zero down payment product. Mortgage
institutions may also 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, but 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.
Average Four-Year Default Rates for FHA Insured Loans Originated in
1998, 1999, and 2000 (by LTV):
[See Figure 1]
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 a no down payment product and that HUD establish a
framework for when and how to pilot this and other new or changed
products. HUD told us that they face challenges in administering a
pilot program. We believe that HUD needs to further consider piloting
or limiting volume of new or changed products, including a zero down
payment product.
www.gao.gov/cgi-bin/getrpt?GAO-05-857T.
To view the full product, including the scope and methodology, click on
the link above. For more information, contact William Shear at (202)
512-8678 or shearw@gao.gov.
[End of figure]
Mr. Chairman and Members of the Subcommittee:
I am pleased to be here today to provide the committee with information
and perspectives as it considers legislation that would authorize the
Secretary of Housing and Urban Development (HUD) to carry out a pilot
program to insure zero down payment mortgages. The Federal Housing
Administration (FHA) at HUD currently insures low down payment
mortgages to homebuyers across the nation. FHA requires homebuyers to
make a 3 percent contribution toward the purchase of the home, though
some of this may come in the form of a gift from others. FHA also
permits some closing costs to be financed. My testimony today is
primarily based on a report we completed for this Subcommittee on
managing risks associated with low and no down payment loans, which was
issued in February, 2005.[Footnote 1] I will focus my discussion on the
practices mortgage institutions use in designing and implementing low
and no down payment products and how these practices could be
instructive for the FHA in managing risks associated with a zero down
payment product. A substantial body of research indicates that loans
with lower down payments are generally riskier than those with higher
down payments.
To obtain information for our report, we interviewed officials from
FHA; staff at selected conventional mortgage providers;[Footnote 2]
private mortgage insurers; and two government-sponsored enterprises
(GSE), Fannie Mae and Freddie Mac. We obtained information about the
standards of low and no down payment mortgage products they support and
the steps they take to design, implement, and monitor these products.
However, we did not verify that these institutions, in fact, used these
practices. We conducted this work from January through December 2004 in
accordance with generally accepted government auditing standards.
In summary, there are several risk-management practices mortgage
institutions use in designing, implementing, and monitoring low and no
down payment products, and we believe these practices could be
instructive for FHA in managing risks associated with a zero down
payment product.
* Mortgage institutions can mitigate the risk of low and no down
payment products by requiring additional credit enhancements such as
higher mortgage insurance coverage. For example, Fannie Mae and Freddie
Mac require higher mortgage insurance for loans with a loan-to-value
ratio (LTV) of great than 95 percent.[Footnote 3] While FHA already
will pay up to 100 percent of the losses from a foreclosure on a house,
it does have the authority to share risk but does not currently use
this authority.
* Mortgage institutions sometimes implement stricter underwriting to
manage the additional risks associated with a new mortgage product. For
example, institutions can require a higher credit score or higher
reserves from the borrower. FHA has made adjustments to its
underwriting criteria on its existing products but FHA officials told
us that FHA is unlikely to mandate a credit score threshold for a zero
down payment product.
* Mortgage institutions increase fees and charge higher premiums to
compensate for the additional risks associated with a new mortgage
product. For example, Fannie Mae officials 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. FHA is
authorized to make, and has made, adjustments to its up-front and
annual premiums on its existing products. The administration proposed
higher premiums as part of its 2006 budget proposal for a zero-down
payment product.
* Mortgage institutions sometimes use pilots or limit the initial
availability of new products to build experience or better understand
the factors that contribute to risk for these products. For example,
Freddie Mac limited the initial availability of its 100 LTV product.
Some mortgage institutions also may limit the origination and servicing
of the product to their better lenders and servicers. However, FHA
officials told us they face challenges in piloting and limiting
mortgage products to certain approved lenders or servicers.
* According to officials of mortgage institutions, including FHA, they
also often put in place more substantial monitoring and oversight
mechanisms for their new products and then make changes based on what
they learn. 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. FHA officials
told us they also more closely monitor loans underwritten under revised
guidelines. In light of the risks that new lending products present and
in recognition of established risk management practices, in our report,
we suggested that Congress consider limiting the initial availability
of any new single-family insurance product it may authorize, including
a zero down payment product. We also suggested that Congress consider
directing HUD to consider using various techniques for mitigating risks
for a no down payment product, or products about which the risks are
not well understood. We recommended that FHA consider using pilots for
new products and for making significant changes to its existing
products, regardless of any new products Congress may authorize.
Additionally, we recommended that FHA explore various techniques for
mitigating risks when implementing new products that have greater risk
or for which risk is not well understood, such as a zero down payment
product.
However, during the course of our work, HUD officials told us that they
face challenges in administering a pilot program and they question the
circumstances in which they can limit the availability of a new
product. We believe that HUD needs to further consider piloting or
limiting volume of new or changed products, including a zero down
payment product. There are several available techniques for limiting an
initial product that could help to address HUD's concerns, 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 when the risks of that product are not well
understood could exceed the cost of initially implementing such a
product on a limited basis. To the extent HUD believes it does not have
the authority for exercising the options we describe, we recommend it
seek the authority from Congress.
Background:
Mortgage insurance, a commonly used credit enhancement, protects
lenders against losses in the event of default, and FHA is a government
mortgage insurer in a market that also includes private insurers.
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 plays a
particularly large role in certain market segments, including low-
income and first-time homebuyers. In 2000, almost 90 percent of FHA-
insured home purchase mortgages had an LTV higher than 95 percent. FHA
insures most of its mortgages for single-family housing under its
Mutual Mortgage Insurance (MMI) Fund. To cover lender's losses, FHA
collects 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.
In recent years, other members of the conventional mortgage market
(such as private mortgage insurers, government-sponsored enterprises
such as Fannie Mae and Freddie Mac, and large private lenders) have
been increasingly active in supporting low and even no down payment
mortgage products. For example, Fannie Mae and Freddie Mac's no down
payment mortgage products were introduced in 2000; and many private
mortgage insurers will now insure a mortgage up to 100 percent LTV.
However, the characteristics and standards for low and no down payment
products vary among mortgage institutions. Currently, 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. In recent
years, a growing proportion of borrowers have received down payment
assistance, which further helps them meet the hurdle of accumulating
sufficient funds to purchase a home. Based on our preliminary analysis
of FHA-insured loans that had LTVs above 95 percent, use of down
payment assistance has grown to over half of such loans insured during
the first seven months of 2005.
When considering the risk of mortgages, a substantial amount of
research GAO reviewed indicates that the LTV ratio and the borrower's
credit score are among the most important factors when estimating the
risk level associated with individual mortgages.[Footnote 4] We also
analyzed the performance, expressed by the percent of borrowers
defaulting within four years of mortgage origination, of low and no
down payment mortgages supported by FHA and others.[Footnote 5] Our
analysis supports the findings we found in the research 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. As can be seen in Figure 1, when focusing
only on LTV for FHA loans, default rates increase as the LTV ranges
increase. 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 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).
Figure 1: Average Four-Year Default Rates for FHA Insured Loans
Originated in 1998, 1999, and 2000 (by LTV):
[See PDF for image] --graphic text:
Bar graph with three items.
LTV: High (>96%);
Average default rate: 3.37%.
LTV: Medium (87%-96%);
Average default rate: 2.26%.
LTV: Low (
