Residential Care Facilities Mortgage Insurance Program
Opportunities to Improve Program and Risk Management Gao ID: GAO-06-515 May 24, 2006Through its Section 232 program, the Department of Housing and Urban Development's (HUD) Federal Housing Administration (FHA) insures approximately $12.5 billion in mortgages for residential care facilities. In response to a requirement in the 2005 Consolidated Appropriations Conference Report and a congressional request, GAO examined (1) HUD's management of the program, including loan underwriting and monitoring; (2) the extent to which HUD's oversight of insured facilities is coordinated with the states' oversight of quality of care; (3) the financial risks the program poses to HUD's General Insurance/Special Risk Insurance (GI/SRI) Fund; and (4) how HUD estimates the annual credit subsidy cost for the program.
While HUD's decentralized program management allows its 51 field offices flexibility in their specific practices, GAO found differences in the extent to which staff in the five field offices it visited were aware of current program requirements. For example, four offices were unaware of required addendums to the programs' standard regulatory agreement. Further, while individual offices had developed useful practices for loan underwriting and monitoring, they lacked a mechanism for systematically sharing such practices with other offices. Also, field office officials were concerned about adequate current or future levels of staff expertise--a critical factor in managing program risk in that health care facility loans are complicated and require specialized knowledge and expertise. FHA requires a review of the most recent annual state-administered inspection report for state-licensed facilities applying for program insurance, and recommends, but does not require, continued monitoring of such reports for facilities once it has insured them. Four of the five HUD field offices GAO visited do not routinely collect annual inspection reports for their insured facilities. While the reports are but one of several monitoring tools, they provide potential indicators of future financial risk. HUD has proposed revising its standard regulatory agreements to require insured facility owners or operators to submit annual inspection reports and to report notices of violations. However, the proposed revisions have been awaiting approval since August 2004, and the implementation date is uncertain. The Section 232 program accounts for only about 16 percent of the GI/SRI Fund's total unpaid principal balance, but program and industry trends pose potential risks to the Section 232 program and to the GI/SRI Fund. For example, in recent years the program has insured increasing numbers of assisted living facility loans and refinancing loans, for which there are limited data available to assess long-term performance. Other potential risk factors include increasing prepayments (full repayment before loan maturity) and loan concentration in several large markets and among relatively few lenders. Projected shifts in demand for residential care facilities could affect currently insured facilities and the overall market for the types of facilities that HUD insures under the program. To estimate the program subsidy cost, HUD uses a model to project cash flows for each loan cohort (the loans originated in a given fiscal year) over its entire life. HUD's model does not explicitly or fully consider certain factors, such as loan prepayment penalties, interest rate changes, or differences in loans to different types of facilities, and uses some proxy data that is not comparable to Section 232 loans. The model's exclusion of potentially relevant factors and it use of this proxy data could affect the reliability of HUD's credit subsidy estimates.
RecommendationsOur recommendations from this work are listed below with a Contact for more information. Status will change from "In process" to "Open," "Closed - implemented," or "Closed - not implemented" based on our follow up work.
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Report to Congressional Addressees:
May 2006:
Residential Care Facilities Mortgage Insurance Program:
Opportunities to Improve Program and Risk Management:
GAO-06-515:
GAO Highlights:
Highlights of GAO-06-515, a report to congressional addressees.
Why GAO Did This Study:
Through its Section 232 program, the Department of Housing and Urban
Development‘s (HUD) Federal Housing Administration (FHA) insures
approximately $12.5 billion in mortgages for residential care
facilities. In response to a requirement in the 2005 Consolidated
Appropriations Conference Report and a congressional request, GAO
examined (1) HUD‘s management of the program, including loan
underwriting and monitoring; (2) the extent to which HUD‘s oversight of
insured facilities is coordinated with the states‘ oversight of quality
of care; (3) the financial risks the program poses to HUD‘s General
Insurance/Special Risk Insurance (GI/SRI) Fund; and (4) how HUD
estimates the annual credit subsidy cost for the program.
What GAO Found:
While HUD‘s decentralized program management allows its 51 field
offices flexibility in their specific practices, GAO found differences
in the extent to which staff in the five field offices it visited were
aware of current program requirements. For example, four offices were
unaware of required addendums to the programs‘ standard regulatory
agreement. Further, while individual offices had developed useful
practices for loan underwriting and monitoring, they lacked a mechanism
for systematically sharing such practices with other offices. Also,
field office officials were concerned about adequate current or future
levels of staff expertise”a critical factor in managing program risk in
that health care facility loans are complicated and require specialized
knowledge and expertise.
FHA requires a review of the most recent annual state-administered
inspection report for state-licensed facilities applying for program
insurance, and recommends, but does not require, continued monitoring
of such reports for facilities once it has insured them. Four of the
five HUD field offices GAO visited do not routinely collect annual
inspection reports for their insured facilities. While the reports are
but one of several monitoring tools, they provide potential indicators
of future financial risk. HUD has proposed revising its standard
regulatory agreements to require insured facility owners or operators
to submit annual inspection reports and to report notices of
violations. However, the proposed revisions have been awaiting approval
since August 2004, and the implementation date is uncertain.
The Section 232 program accounts for only about 16 percent of the
GI/SRI Fund‘s total unpaid principal balance, but program and industry
trends pose potential risks to the Section 232 program and to the
GI/SRI Fund. For example, in recent years the program has insured
increasing numbers of assisted living facility loans and refinancing
loans, for which there are limited data available to assess long-term
performance. Other potential risk factors include increasing
prepayments (full repayment before loan maturity) and loan
concentration in several large markets and among relatively few
lenders. Projected shifts in demand for residential care facilities
could affect currently insured facilities and the overall market for
the types of facilities that HUD insures under the program.
To estimate the program subsidy cost, HUD uses a model to project cash
flows for each loan cohort (the loans originated in a given fiscal
year) over its entire life. HUD‘s model does not explicitly or fully
consider certain factors, such as loan prepayment penalties, interest
rate changes, or differences in loans to different types of facilities,
and uses some proxy data that is not comparable to Section 232 loans.
The model‘s exclusion of potentially relevant factors and it use of
this proxy data could affect the reliability of HUD‘s credit subsidy
estimates.
What GAO Recommends:
GAO recommends, among other things, that the HUD Secretary establish a
process for sharing practices among field offices, assure appropriate
levels of staff with appropriate expertise, and incorporate reviews of
federal or state inspection reports into loan monitoring. GAO also
recommends that HUD explore factoring additional information into its
credit subsidy model. In written comments, HUD agreed with all of GAO‘s
recommendations except exploring the value of adding certain factors to
its credit subsidy model.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-06-515].
To view the full product, including the scope and methodology, click on
the link above. For more information, contact David G. Wood at (202)
512-6878 or WoodD@gao.gov.
[End of Section]
Contents:
Letter:
Results in Brief:
Background:
HUD's Decentralized Management Provides Field Offices Flexibility, but
Varying Awareness of Underwriting and Monitoring Practices and Concerns
Over Insufficient Staff Expertise Increase Program's Potential Risks:
FHA's Coordination with States' Oversight of Quality of Care for
Section 232 Residential Care Facilities Is Limited:
Program and Industry Trends Show Sources of Potential Risks to the GI/
SRI Fund:
HUD's Model for Estimating Credit Subsidy Costs Excludes Some
Potentially Relevant Factors:
Conclusions:
Recommendations for Executive Action:
Agency Comments and Our Evaluation:
Appendixes:
Appendix I: Objectives, Scope, and Methodology:
Appendix II: Information on the Application Processing, Underwriting,
and Oversight of Section 232 Loans:
Appendix III: HUD Officials Addressed Some Issues Raised by the
Agency's Inspector General in 2002, but Several Key Items Remain
Unresolved:
Appendix IV: HUD's Use of Proxy Data for Refinance Loans:
Appendix V: Comments from the Department of Housing and Urban
Development:
Appendix VI: GAO Contact and Staff Acknowledgments:
Figures Figures:
Figure 1: The Section 232 Program Comprises a Relatively Small Part of
the GI/SRI Fund:
Figure 2: Overall 5-and 10-Year Claim Rates for the Most Recent Cohorts
of the Section 232 Program Are Among the Highest Historical Claim
Rates:
Figure 3: The 5-Year Claim Rate for New Construction Loans Has
Increased in the Most Recent Cohort for Which Claim Rate Data Are
Available:
Figure 4: The 5-Year Claim Rates for Assisted Living and Board and Care
Facilities Have Increased in the Most Recent Cohorts for Which Claim
Rate Data Are Available:
Figure 5: Section 232 Properties Are Concentrated in Several States:
Figure 6: Initial Credit Subsidy Estimates for Section 232 Program New
Construction and Substantial Rehabilitation Loans and for Section 232
Program Refinance and Purchase Loans Have Not Indicated a Need for
Subsidies:
Figure 7: Conditional Claim Rates Are Different for Section 232 and
Section 207 Refinance Loans:
Figure 8: Conditional Prepayment Rates are Different for Section 232
and Section 207 Refinance Loans:
Abbreviations:
CON: Certificate of Need:
DAP: Development Application Processing:
FASAB: Federal Accounting Standards Advisory Board:
FASS: Financial Assessment Subsystem:
FHA: Federal Housing Administration:
GI/SRI: General Insurance/Special Risk Insurance:
HUD: U.S. Department of Housing and Urban Development:
LQMD: Lender Quality Management Division:
MAP: Multifamily Accelerated Processing:
OMB: Office of Management and Budget:
TAP: Traditional Application Processing:
OPIIS: Online Property Integrated Information Suite:
Letter:
May 24, 2006:
Congressional Addressees:
Through its Section 232 Mortgage Insurance for Residential Care
Facilities program (Section 232 program), the Department of Housing and
Urban Development's (HUD) Federal Housing Administration (FHA) insures
mortgages for nursing homes, assisted living facilities, board and care
homes, and intermediate care facilities. As of December 31, 2005, the
program insured mortgages with an unpaid principal balance of
approximately $12.5 billion.[Footnote 1] The program insures HUD-
approved private lenders against financial losses from loan defaults;
insured loans can be used to finance the purchase, construction, or
rehabilitation of a facility, enable borrowers to refinance projects
that do not need substantial rehabilitation, or to install fire safety
equipment.
For budget and accounting purposes, the Section 232 program is part of
HUD's General Insurance/Special Risk Insurance (GI/SRI) Fund; other
programs in the GI/SRI Fund provide mortgage insurance for various
types of multifamily housing projects and for hospitals. HUD is
required to annually estimate the subsidy cost, or the cost to the
federal government of guaranteeing credit to residential care
facilities over the life of the loans.[Footnote 2] This estimate
requires FHA to forecast future cash flows associated with the loans,
which can be influenced by factors that are associated with the
potential risks facing the program's loan portfolio.
While private lenders may finance the purchase or construction of
nursing homes, public funding, including Medicare and Medicaid, has
accounted for an increasing percentage of spending on nursing home
care.[Footnote 3] For example, in 2000 Medicare and Medicaid financed
39 percent of the nation's spending on nursing home care, up 28 percent
from 1990.[Footnote 4] In 2004, Medicare accounted for 14 percent and
Medicaid accounted for 44 percent of the nation's spending on nursing
home care, and the total of all public funds, including Medicare and
Medicaid, accounted for approximately 61 percent.[Footnote 5] Federal
and state governments share responsibility for oversight of nursing
homes that participate in the Medicare and Medicaid programs. The U.S.
Department of Health and Human Services defines standards that nursing
homes must meet to participate in the Medicare and Medicaid programs
and contracts with states to conduct annual inspections.[Footnote 6]
Generally, states license nursing homes (and in some cases related
facilities) and oversee their operations through inspections.
The 2005 Consolidated Appropriations Conference Report mandated that we
review the design and management of two FHA mortgage insurance programs
--those for the Section 232 program and the Section 242 Hospital
Mortgage Insurance program.[Footnote 7] In addition, the Ranking Member
of the Subcommittee on Housing and Transportation, Senate Committee on
Banking, and others requested that we review several aspects of the
Section 232 program. Accordingly, this report provides both the results
of the mandated review and our response to the request. Specifically,
we examined: (1) HUD's management of the program, including loan
underwriting and monitoring; (2) the extent to which HUD's oversight of
insured residential care facilities is coordinated with the states'
oversight of the quality of care provided by those facilities that are
subject to state licensing or inspection; (3) the financial
implications of the program to the GI/SRI Fund, including risk posed by
program and market trends; and (4) how HUD estimates the annual credit
subsidy for the program, including the factors and assumptions used. In
addition, we examined HUD's action in response to a HUD Inspector
General report that concluded that HUD's Office of Housing did not have
adequate controls to effectively manage the Section 232 program; this
information is summarized in appendix III.
To address these objectives, we reviewed program manuals and
documentation of loan processing procedures and underwriting
requirements and analyzed program financial data that we tested and
found reliable for our purposes.[Footnote 8] In examining HUD's
management of the program, we focused on how underwriting and loan
monitoring activities were carried out through visits to five of HUD's
field offices (Atlanta, Georgia; Buffalo, New York; Chicago, Illinois;
Los Angeles, California; and San Francisco, California), where we
interviewed program officials and obtained relevant documents in each
office.[Footnote 9] We also reviewed documentation of the model HUD
uses to estimate program subsidy costs, applicable program laws,
regulations, and policy statements. We obtained relevant program
documentation and interviewed headquarters officials in HUD's Office of
Multifamily Development and Office of Asset Management and HUD's Office
of Evaluation and Office of Inspector General. We also interviewed
representatives of residential care associations; lenders with loans
insured by the program, as well as other private lenders that offer non-
FHA-insured residential care loans; and representatives of nursing
homes and assisted living facilities. Our review did not include an
evaluation of the need for the Section 232 program. See appendix I for
more detailed information on our objectives, scope, and methodology.
We conducted our work in Washington, D.C., and the HUD field office
locations noted above between February 2005 and April 2006 in
accordance with generally accepted government auditing standards.
Results in Brief:
While HUD's decentralized management of the Section 232 program allows
field offices some flexibility in their specific practices, in our
visits to five field offices we found a lack of awareness of some
current program requirements, potentially useful loan underwriting and
monitoring practices developed in individual offices that were not
systematically shared with other offices, and concerns by field office
managers about current or future levels of staff expertise. For
example, four of the field offices were not aware of a notice that
disqualifies potential Section 232 borrowers if they have had a
bankruptcy in their past, and four offices were unaware of required
addendums to the programs' standard regulatory agreement regarding
certain state licensing requirements for nursing homes. While
individual offices had developed useful practices for implementing the
program's loan underwriting and monitoring requirements, they lacked a
mechanism for systematically sharing practices with other offices. For
example, two field offices included asset management staff--persons
that monitor and oversee a loan after it has been insured--in the
underwriting stages of loans to better assess their risks, while the
other field offices did not. We also found that field office officials
were concerned about adequate current or future levels of staff
expertise--a critical factor in avoiding unwarranted risk in the
Section 232 program, in that health care facility loans are generally
more complicated and require more specialized knowledge and expertise
compared with loans insured under HUD's other multifamily programs.
Lack of awareness of current requirements and insufficient staff
expertise can contribute to the program insuring loans with increased
risks.
FHA's coordination with states' oversight of residential care
facilities' quality of care provided to residents is limited. FHA
requires field office officials to review the most recent annual state
administered inspection report for existing state-licensed facilities
as part of the application. HUD recommends, but does not require, that
officials continue monitoring annual inspection reports for a
residential care facility once it is insured, particularly if the
officials do not perform an on-site management review (an examination
of operations, occupancy, financial management, and possible quality of
care issues) of the facility. Four of the five HUD field offices we
visited do not routinely review annual inspection reports for the
insured facilities they oversee; further, HUD field offices conduct a
limited number of management reviews of Section 232 facilities. While
annual inspection reports are but one of several means of monitoring
insured properties, FHA's limited use of them may lead the agency to
miss potential indicators of risk for some of its insured loans.
Because serious quality of care deficiencies can have a variety of
implications that affect cash flow streams, ranging from a related
reduction in occupancy to the more direct financial implications such
as civil money penalties and loss of licensing and reimbursements, they
may ultimately affect a facility's ability to repay the loan. Some
private lenders told us they use the annual state inspection reports in
coordination with other financial indicators to assess the financial
risk of loans to facilities subject to state inspections. HUD is in the
process of revising its residential care facility regulatory
agreements--which establish loan conditions applicable to an owner and
potential operator--to require owners or operators to (1) submit to HUD
annual inspection reports and (2) report to HUD any notices of
inspection violations. However, the proposed revisions have been
awaiting approval since August 2004, and it is not clear when the
revised agreements will be approved.
Although the Section 232 program is a small component of the GI/ SRI
Fund--representing approximately 16 percent of the total unpaid
principal balance--program and industry trends may pose financial risks
to the fund. For example:
* In recent years, HUD has insured increasing numbers of mortgages that
are refinances of existing loans, as well as loans for assisted living
facilities. Because these types of loans are relatively new to the
portfolio, there are limited data to observe long-term claim trends,
making their risk difficult to assess. However, the 5-year claim rate
(the portion of loans leading to a claim within 5 years of origination)
was significantly higher for more recent assisted living facility
loans.
* The proportion of loans that terminate due to prepayment within 10
years of origination is increasing. Prepayment occurs when a borrower
pays a loan in full before the loan reaches maturity. As more borrowers
prepay their loans, HUD loses future cash flows of premiums. Such
losses could be offset to some extent, in that prepayments may
ultimately result in fewer claims.
* Program loans are concentrated in several states and among relatively
few lenders. As of 2005, five states (California, Illinois,
Massachusetts, New York, and Ohio) accounted for 51 percent of active
loan amounts, with one state--New York--representing 24 percent.
Further, while a total of 109 lenders held active loans, just 6 held
over half of the active loan portfolio. Geographic concentration makes
the program vulnerable to swings in regional economic conditions, while
concentration among lenders potentially makes the program more
vulnerable if one or a few large lenders encounters financial
difficulty.
In addition, industry developments and uncertainty in the funding of
the Medicaid and Medicare programs pose potential risks. Projected
shifts in demand for residential care facilities could affect not only
the facilities currently insured by HUD but also the overall market for
the particular types of facilities that HUD insures under the program.
To estimate the subsidy cost of the Section 232 program, HUD uses a
cash flow model to project the expected cash flows for all of these
loans over their entire life. The cash flow model uses assumptions
based on historical and projected data to estimate the amount and
timing of claims, subsequent recoveries from these claims, prepayments,
and premiums and fees paid by the borrower. We found that HUD's model
does not explicitly consider certain factors such as loan prepayment
penalties or lockouts (the period of time during which prepayment is
prohibited), which can affect whether and when a loan is prepaid and
may also show changes in the risk of claim and expected collections of
premiums. HUD's cash flow model also does not fully capture the effects
on existing loans when market interest rates change, nor explicitly
consider differences in loan performance between different types of
facilities. Furthermore, the model includes some proxy data with
borrower characteristics and performance that is not comparable to
Section 232 loans. The model's exclusion of potentially relevant
factors and its use of this proxy data could affect the reliability of
HUD's credit subsidy estimates.
This report contains recommendations to HUD designed to ensure that
field offices understand and implement current program requirements,
including sharing practices among field offices. We also recommend that
HUD incorporate reviews of annual inspection reports for nursing homes
and other residential care facilities into its loan monitoring process,
complete its proposed revision to the residential care facility
regulatory agreement in a timely manner, and consider including
additional variables and methods in its credit subsidy modeling. We
provided a draft of this report to HUD and received written comments
from the Assistant Secretary for Housing, which are discussed later in
this report and in appendix V. In its response, HUD generally concurred
with our recommendations intended to ensure that field offices are
aware of and implement current program requirements and policies, but
disagreed with most parts of our recommendation related to HUD's credit
subsidy model. Specifically, HUD did not agree to consider factoring
additional information into its credit subsidy model including
prepayment penalties and restrictions, initial loan-to-value and debt
service coverage ratios, and the ratio of contract rates and market
rates. Because we believe that factoring such information into the
credit subsidy model could be useful, we did not modify our
recommendation.
Background:
Section 232 of the National Housing Act, as amended, authorizes FHA to
insure mortgages made by private lenders to finance the construction or
renovation of nursing homes, intermediate care facilities, board and
care homes, and assisted living facilities.[Footnote 10] Congress
established the Section 232 program in 1959 to provide mortgage
insurance for the construction and rehabilitation of nursing homes. The
Housing and Community Development Act of 1987 expanded the program to
allow for the insuring of refinancing or purchase of FHA-insured
facilities and, in 1994, HUD issued regulations implementing
legislation to expand the program to allow for the insuring of assisted
living facilities and the refinancing of loans for facilities not
previously insured by FHA. Since 1960, FHA has insured 4,372 loans
through the Section 232 program in all 50 states, the District of
Columbia, the U.S. Virgin Islands, and Puerto Rico. As of the end of
fiscal year 2005, there were 2,054 currently insured loans.
FHA does not insure all residential care facilities, as there are
approximately 16,500 nursing home facilities and over 36,000 assisted
living facilities in operation.[Footnote 11] We did not identify any
private mortgage insurance that is currently available for loans made
to nursing homes or other similar facilities. According to HUD
officials, in recent times, the Section 232 program exists, in part, to
support the market for residential care facilities when the private
market is reluctant to finance such projects due to market conditions.
The loans are advantageous to borrowers because they are nonrecourse
loans whereby the lender (in this case the lender and the insurer, FHA)
has no claim against the borrower in the event of default and can only
recover the property. The loans are also generally long term (in some
cases up to 40 years) and, according to HUD and lender officials, offer
an interest rate that is, in many cases, lower than what private
lenders offer for non-FHA insured loans made to nursing homes and other
similar facilities. Additionally, FHA insures 99 percent of the unpaid
principal balance plus accrued interest.
HUD administers the Section 232 program through its field offices, with
HUD headquarters oversight. HUD's field structure consists of 18 Hub
offices and 33 program centers. Generally, each Hub office has a number
of program centers that report to it. Program centers administer
multifamily programs within the states in which they are located or
portions thereof. Hub offices also administer multifamily programs, as
well as augment the operations of and coordinate workload between their
program centers.
Under Medicaid, states set their own nursing home payment rates
(reimbursement rates), and the federal government provides funds to
match states' share of spending as determined by a federal formula.
Within broad federal guidelines, states have considerable flexibility
to set reimbursement rates for nursing homes that participate in
Medicaid but are required to ensure that payments are consistent with
efficiency, economy, and quality of care.[Footnote 12] Under Medicare,
skilled nursing facilities receive a federal per diem payment that
reflects the resident's care needs and is adjusted for geographic
differences in costs.
HUD's Decentralized Management Provides Field Offices Flexibility, but
Varying Awareness of Underwriting and Monitoring Practices and Concerns
Over Insufficient Staff Expertise Increase Program's Potential Risks:
While the decentralization of the program allows field offices some
flexibility in their specific practices, the results of our visits to
five field offices revealed differences in the extent to which field
office staff were aware of current program requirements. Further, while
individual offices had developed useful practices for implementing the
program's loan underwriting and monitoring requirements, they lack a
mechanism for systematically sharing practices with other offices. We
also found that field office officials were concerned about adequate
current or future levels of staff expertise--a critical factor in
avoiding unwarranted risk in the Section 232 program, in that health
care facility loans are generally more complicated and require
specialized expertise compared with loans insured under HUD's other
multifamily programs. Lack of awareness of current requirements and
insufficient staff expertise can contribute to insuring loans with
increased risks. Both factors are related to recommendations made in
the HUD Office of Inspector General's 2002 report that HUD has not
fully addressed (see app. III for further information on weaknesses
identified by HUD's Inspector General).
Some Field Offices Were Not Aware of All Current Program Requirements:
FHA has numerous underwriting requirements for loans insured under the
Section 232 program; for example, facilities must provide evidence of
market need; a (real estate) appraisal; and be in compliance with
limits on loan-to-value and debt service coverage ratios.[Footnote 13]
FHA also requires a variety of reviews for monitoring Section 232
loans. (Loan underwriting and monitoring requirements, which can
involve fairly complex reviews and analyses, are described in more
detail in app. II.)
According to HUD headquarters officials, the field offices that
administer the Section 232 program are required to follow all program
statutes and regulations, but the decentralization of the program
allows field offices some flexibility in their specific practices. For
example, individual field offices can designate how to staff the
underwriting and monitoring of Section 232 loans, depending on such
factors as loan volume relative to other multifamily programs, to fully
utilize resources. HUD headquarters provides guidance on program
policies and requirements; when necessary, reviews applications for
certain types of loans, such as those submitted by nonprofit entities;
and provides technical assistance or additional guidance and support if
contacted by field offices. HUD headquarters staff also conduct Quality
Management Reviews, which are management reviews of field offices
administering HUD programs and services. For these reviews, evaluators
visit offices and coordinate subsequent reports. The process also
involves reporting the status of follow-up corrective actions. While
not focused on the Section 232 program, this process helps to oversee
the program by reviewing the management of the field offices that
administer it.
We found that the five field offices that we visited varied in their
understanding and awareness of policies related to the Section 232
program. For example, staff in two field offices said that their
standard regulatory agreement (that serves as the basic insurance
contract and spells out the respective obligations of FHA, the lender,
and the borrower) did not include language that would require operators
of insured facilities to submit financial statements on new
loans.[Footnote 14] According to officials at HUD headquarters, field
offices should be using language requiring these financial statements.
HUD and most lender officials we interviewed told us that operator
financial statements provide information on the legal entity operating
the facility in cases where the borrower and the operator of the
residential care facility are different entities. These officials also
stated that, in such situations, borrower financial statements may not
disclose expenses, income, and other financial information, and may
only show the transactions between the borrower and operator, thus
making operator financial statements a necessity. Also, HUD's Inspector
General identified HUD's lack of a requirement for operators to submit
financial statements electronically to be part of an internal control
weakness for the Section 232 program.
Additionally, we found that the field offices that we visited were not
always aware of specific notices that established new requirements or
processes for the Section 232 program. For example:
* Four of the five field offices that we visited were not aware of a
notice that disqualifies potential Section 232 borrowers if they have
had a bankruptcy in their past. According to a HUD headquarters
officials, this policy is intended to protect HUD from insuring a
potentially risky loan based on a borrower's financial history.
* Officials at four of the five field offices we visited did not know
about required addendums to the regulatory agreement regarding state
licensing requirements for nursing homes. HUD developed these addendums
to place a lien on a property's operational documents, such as a
Certificate of Need and state licenses, to prevent operators from
taking these documents with them upon termination of a property's
lease.[Footnote 15] Without these documents, a facility may not be able
to operate and, consequently, the property's value would be greatly
diminished.
According to HUD headquarters officials, HUD headquarters communicates
changes in the Section 232 program's policies and procedures to field
offices in a variety of ways besides sending formal notices. For
example, HUD headquarters also posts some notices on a "frequently-
asked questions" section of a Web site available to field offices,
lenders, attorneys, and others.[Footnote 16] HUD headquarters officials
also conduct nationwide conference calls with the field offices in
which various HUD multifamily programs, including the Section 232
program, are discussed. The conference calls are conducted separately
for loan development staff and asset management staff that work,
respectively, on the underwriting and monitoring of loans. HUD
headquarters officials stated that these conference calls provide a
forum to disseminate information to the field offices and for
individual field offices to discuss any issues, questions, or concerns
regarding any multifamily programs, including the Section 232 program.
HUD headquarters officials stated that they plan to address the lack of
awareness we observed by updating the "Multifamily Asset Management and
Project Servicing Handbook" to clarify current policies and
requirements for the Section 232 program. HUD is also planning to
update the handbook to address the 2002 HUD Inspector General report
that identified that HUD's current handbook was not specific to Section
232 nursing home operations. However, HUD officials told us the updates
to the handbook would not be completed until the proposed revisions to
the applicable regulatory agreements have been approved. The proposed
revisions have been awaiting approval since August 2004, and it is not
clear when the revised agreements will be approved.
Field Offices Do Not Systematically Share Information on Practices:
As discussed earlier, field offices have some flexibility in practices
that they use in administering the Section 232 program. In our visits
to five field offices, we found a variety of practices that could be
useful in the underwriting and monitoring of Section 232 loans if
shared with other field offices. However, currently, HUD does not have
systematic means by which to share this information among field
offices.
Officials in two of the five field offices we visited identified
specific practices they had developed to carry out loan underwriting
requirements. For example:
* Asset management staff, whose focus is monitoring the performance of
loans that are already insured, are asked to review a variety of
documents submitted in the underwriting process, such as financial
statements and information on the occupancy of the facility.
* In one of the offices, staff members may contact relevant state
officials, just before the closing of a loan, to verify that the state
has not identified any quality of care deficiencies since the facility
submitted the application for mortgage insurance.
* Officials in one office stated that they conduct an additional review
before approving a loan application for mortgage insurance to ensure
that all required steps, such as mortgage credit analysis and
valuation, have been properly performed.
According to the officials in these two offices, it is necessary to
take these additional steps in order to adequately underwrite a loan
under this program. They stated that the additional steps result in the
better screening of loan risk and could result in the rejection of a
risky loan they might otherwise approve.
We found a similar variety of practices in the monitoring of Section
232 loans. In some cases, field offices we visited had taken additional
steps beyond those required by HUD. For example:
* While HUD requires a review of the annual financial statements of
insured facilities, two field offices that we visited require monthly
financial accounting reports from facilities either for the first year
of the loan or until the facility has reached stable occupancy.
* Two field offices had developed their own specialized checklists for
monitoring Section 232 loans. These checklists were specifically
designed for the oversight of residential care facility loans and
included items such as the facility's replacement reserve accounts and
professional liability insurance, among other items.
* One of the offices had established a Section 232 working group, where
underwriting and asset management staff met periodically to discuss
loans in the portfolio and issues related to the overall management of
the program in the field office. Additionally, three of the five field
offices we visited had specialized staff with expertise in overseeing
residential care facility loans. These were asset management staff
whose primary or sole responsibility was oversight of the Section 232
portfolio.
* While HUD headquarters officials stated that they do not require
management reviews of Section 232 facilities, three of the five field
offices we visited conducted management reviews on some part of their
Section 232 portfolios.
* One field office obtained the state annual inspection reports on its
Section 232 facilities on a regular basis.
According to officials in these offices, the unique characteristics
associated with residential care facilities make the additional
measures necessary.
Officials in field offices we visited that had developed these specific
practices stated that the practices result in better underwriting and
monitoring of loans and could potentially help to prevent claims.
However, HUD field offices do not have a systematic means by which to
share information with other field offices about practices they have
developed. While field office officials can raise concerns and issues
through conference calls with HUD headquarters officials, most
explained that these conference calls are not particularly designed for
field offices to share practices with other field offices. Officials in
the five field offices that we visited told us that they occasionally
contact their counterparts in other field offices regarding loan
processing or asset management questions or issues. Additionally,
officials in some field offices said that they occasionally see their
counterparts at regional lender conferences. However, aside from these
forms of contact, there was no systematic method by which to learn
about other field office practices. Consequently, officials in one
field office are likely to be unaware of additional steps or practices
taken by another field office that are intended to help officials
improve underwriting or monitoring of Section 232 loans. Officials at
all field offices that we visited told us that they could benefit from
the sharing of such practices regarding underwriting and monitoring
procedures established by different offices.
Officials Cited Concerns about Adequate Levels of Staff Expertise:
Officials in two of the five field offices stated that a lack of
expertise on residential care facility loans, either in underwriting or
loan oversight, is a current concern in their office. They specifically
noted a lack of expertise in residential care facilities and their
overall management. Officials in all of the field offices that we
visited stated that additional training on Section 232 loans would be
beneficial to provide more knowledge and expertise, as there has been
very little Section 232-specific training. In its 2002 report, HUD's
Office of Inspector General also identified that field office project
managers did not have sufficient training on reviewing Section 232
loans and dealing with the issues unique to Section 232 properties.
All of the private lenders we interviewed--those that offer non-FHA
insured loans to residential care facilities and face similar risks to
FHA--had a specialized group that conducted the underwriting of these
loans. All of the individuals that conducted the underwriting of these
loans were part of a health care lending unit that focused exclusively
on loans made to health care facilities. According to the lenders, they
believed it was necessary to have specialized staff underwriting such
loans due to the unique nature of lending money to a facility that was
designed for a residential health care business. Additionally, almost
all of the private lenders we interviewed had specialized staff that
monitored their residential care facility loans. According to lender
staff we interviewed, nursing home and assisted living facility loans
require an understanding of the market, trends, expenses, income, and
other such unique characteristics associated with these types of
facilities.
While officials in only two of the five offices expressed concern about
the expertise of current staff, officials in all field offices we
visited stated that they are concerned about the ability to adequately
staff the Section 232 program in the next 5 years. They stated that as
older staff retire in the next 5 years or so, any expertise that such
staff currently have will take time to replace. All of the field
offices that we visited staffed the underwriting process for Section
232 loans similar to that of other multifamily programs, based on
workload and staff resources. However, while two field offices assigned
their Section 232 properties, along with other multifamily properties,
to general asset management staff for oversight, three field offices
designated specific staff to oversee Section 232 properties. This was
due to the latter field office officials' belief, similar to that of
the private lenders we interviewed, that the properties require a
certain level of knowledge and expertise associated with residential
care facilities. Expertise in Section 232 loans allows for a better
understanding of the distinct issues associated with oversight of
residential care facilities. In one of the offices that had general
asset management staff overseeing the portfolio, eight project managers
shared responsibility for monitoring Section 232 properties in
conjunction with other multifamily program properties. In contrast, in
one of the offices with staff designated specifically for the Section
232 program, one member of the asset management staff was responsible
for the entire Section 232 portfolio. Officials from the two field
offices that have experienced staff specialized in monitoring Section
232 loans stated that they are concerned about losing their specialized
staff over time and acknowledged that they will need to find
replacements in order to continue to adequately monitor Section 232
loans. Their concern stems in part from the fact that Section 232
facilities, unlike other multifamily properties, require specialized
knowledge and an understanding of the marketing, trends, and revenue
streams associated with residential care facilities.
According to officials in all of the field offices that we visited,
monitoring of Section 232 loans, when compared with other FHA-insured
multifamily programs, requires additional measures. Section 232 loans
contain a complex business component--the actual assisted living
service or the nursing service operating in a facility--making them
different from other multifamily programs that are solely realty loans.
Consequently, for Section 232 loans, field office officials monitor the
financial health of the business, including expenses, income, and other
such items. Some field office officials also stated that it is
important to monitor the operator to ensure that the facility is
adequately managed. Additionally, some field office officials stated
that to ensure the facility is generating enough income, they have to
monitor Medicare and Medicaid reimbursement rates, as well as occupancy
rates.
According to HUD headquarters officials, as part of its overall
strategic human capital efforts, HUD is currently assessing the loss of
human capital in field offices over time. However, this effort is not
focused on the Section 232 program specifically but is intended to
examine general human capital issues and needs.
FHA's Coordination with States' Oversight of Quality of Care for
Section 232 Residential Care Facilities Is Limited:
FHA requires field office officials, when processing applications for
Section 232 mortgage insurance from existing state-licensed facilities
to review the most recent annual state-administered inspection report
for the facilities, but does not require the continued monitoring of
annual inspection reports for state-licensed facilities once it has
insured them. Four of the five HUD field offices we visited do not
routinely collect annual inspection reports for the insured facilities
they oversee. While such reports are but one of several means of
monitoring insured properties, FHA's limited use of them may lead the
agency to overlook potential indicators of risk for some of its insured
loans.
FHA Requires Some Coordination with States' Oversight of Quality of
Care for Section 232 Residential Care Facilities:
State inspections or surveys of residential care facilities may stem
from state licensing requirements or the facilities' participation in
Medicare or Medicaid. Nursing homes are state licensed, while states
vary in their licensing requirements for assisted living facilities.
The Department of Health and Human Services' Centers for Medicare &
Medicaid Services requires that nursing homes receiving Medicare and
Medicaid funding be federally certified, and all certified facilities
are subject to annual federal inspections administered by the states.
State survey agencies, under agreements between the states and the
Secretary of Health and Human Services, conduct the annual federally
required inspections. To complete the annual inspections, teams of
state surveyors visit Medicare and Medicaid participating facilities
and assess compliance with federal facility requirements, particularly
whether care and services provided meet the assessed needs of the
residents. These teams also assess the quality of care provided to
residents of the facilities, looking at indicators such as preventing
avoidable pressure sores, weight loss, or accidents. Overall, annual
inspections provide a regular review of quality of care by officials
with relevant backgrounds, such as, registered nurses, social workers,
dieticians, and other specialists. For facilities that are applying for
mortgage insurance under the Section 232 program, FHA requires a copy
of the state license needed to operate the facility and a copy of the
latest state annual inspection report on the facilities' operation.
HUD's "Multifamily Asset Management and Servicing Handbook" recommends
that, once nursing home loans are insured under the program, HUD
officials responsible for loan monitoring continue to review state
annual inspection reports if they do not undertake management reviews
of the facility. Management reviews focus on an insured facility's
financial indicators and general management practices, but,
particularly if conducted on-site, could provide some information on
issues related to the quality of care at a facility. Because of their
wider scope, however, management reviews would not likely go into the
same depth on quality of care issues as annual inspections. HUD
headquarters officials told us that the handbook's recommendation
applies to all Section 232 facilities; further, HUD headquarters
officials stated that management reviews for Section 232 properties
should be conducted based on need and available resources. We found
that two of five field offices we visited did not regularly conduct any
regular management reviews and did not review annual inspection reports
during loan monitoring. Of the three field offices that did conduct
management reviews on some Section 232 properties, one also reviewed
annual inspection reports during loan monitoring. Additionally, the
offices that did not review annual inspection reports had little direct
interaction with the state agencies. Private lenders overseeing non-FHA
insured residential care facilities told us that they regularly conduct
various levels of management reviews and review annual inspection
reports on a consistent basis.
FHA has emphasized the importance of ongoing coordination with state
oversight agencies in its proposed revisions to its regulatory
agreements, which require owners or operators of insured facilities to
report any state or federal violations to FHA. HUD's proposed revisions
to the regulatory agreements also include a requirement that the owner
or operator provide HUD with copies of annual inspection reports that
can be used as part of loan monitoring. However, the proposed revisions
to the regulatory agreements have yet to be approved.
FHA's Limited Coordination with States on Oversight Issues May Lead to
Missed Identification of Risk Indicators:
Serious quality of care deficiencies can have a variety of implications
that affect cash flow streams, ranging from a related reduction in
occupancy to the potential for civil money penalties and loss of
licensing and reimbursements. Consequently, quality of care concerns
can ultimately affect a facility's financial condition. For many
Section 232 properties, in particular nursing homes, state oversight of
quality of care helps to determine whether a facility is licensed and
eligible to receive Medicaid and Medicare reimbursements. This is
particularly important to the Section 232 program because, as noted
earlier in this report, Medicaid and Medicare reimbursements typically
account for a significant portion of nursing home income.
Federal or state annual inspection reports, to the extent that they are
available for facilities, provide regular evaluations of nursing homes
and other residential care facilities. As discussed earlier, annual
inspections provide a review of quality of care by officials with
relevant backgrounds. In a 2005 report, we found inconsistencies across
states in conducting surveys and state surveyors understating serious
deficiencies in quality of care.[Footnote 17] Nonetheless, annual
inspection reports serve as an important indicator of a property's risk
related to problems with the quality of care to residents.
Annual inspection reports, coupled with other information such as
facility staffing profiles, resident turnover, and data from financial
statements, could assist HUD's field offices in overseeing loan
performance. Additionally, reviewing facilities' quality of care
records over time, as well as any corrective action plans needed to
come into compliance with state and federal quality of care
requirements could further the field offices' ability to identify loan
performance risks. The reports may also prompt HUD field office
officials to communicate with federal or state nursing home regulatory
agencies for further information on facilities that appear to be high
risk. These agencies may have available information on civil money
penalties and sanctions, which serve as additional indicators of
quality of care risk. Private lenders we spoke with acknowledged that
annual inspection reports provided insight into the management of a
facility and coupled with other information could help to assess
financial risk.
Program and Industry Trends Show Sources of Potential Risks to the GI/
SRI Fund:
The Section 232 program represents a relatively small share of the
broader GI/ SRI Fund. However, program and industry trends show sources
of potential risks that could affect the future performance of the
Section 232 portfolio and the GI/SRI Fund. FHA uses a number of tools
to mitigate risk to the program and to the fund.
The Section 232 Program Represents a Small Percentage of the GI/SRI
Fund:
The Section 232 program is a relatively small share of the total GI/SRI
Fund. HUD estimated that the program would represent only about 5.3
percent of the fund's fiscal year 2006 commitment authority.[Footnote
18] Similarly, the Section 232 program represents a little less than 16
percent or a little more than $12.5 billion of the nearly $80 billion
in unpaid principle balance in the GI/SRI Fund (see fig. 1). Despite
its small size, a significant worsening in the performance of the
Section 232 program could negatively affect the performance of the GI/
SRI Fund. The extent, though, of the impact on the overall performance
of the GI/SRI Fund would depend upon numerous factors including changes
in the size and performance of the other programs in the fund.
Figure 1: The Section 232 Program Comprises a Relatively Small Part of
the GI/SRI Fund:
[See PDF for image]
Note: Numbers have been rounded to closest whole number.
[End of figure]
Program Trends Show Sources of Potential Risk:
As discussed below, several trends exist within the Section 232 program
that pose potential risks to the Section 232 portfolio and, therefore,
to the GI/SRI Fund.
Higher Claim Rates for Recent Loan Cohorts:
To identify potential trends in loan performance, we analyzed 5-and 10-
year claim rates for Section 232 loans based on data that spanned from
fiscal year 1960 through the end of fiscal year 2005, for the entire
portfolio, as well as by type of loan purpose and type of insured
facility. The analysis of the entire portfolio showed that the 10-year
claim rates for more recent loan cohorts (loans originated between 1987
and 1991 and loans originated between 1992 and 1996) ranked among the
highest historical cohort claim rates (see fig. 2).[Footnote 19] The 5-
year claim rate for loans originated between 1997 and 2001 also ranked
among the highest historical cohort claim rates. A continued increase
in claim rates could have a negative effect on the performance of the
GI/SRI Fund.
Figure 2: Overall 5-and 10-Year Claim Rates for the Most Recent Cohorts
of the Section 232 Program Are Among the Highest Historical Claim
Rates:
[See PDF for image]
[End of figure]
Changes in Claim Rates by Loan Purpose:
Section 232 loans can have a loan purpose in one of two categories--new
construction/substantial rehabilitation loans or refinance/purchase
loans. New construction loans are for loans that involve the
construction of a new residential care facility. Substantial
rehabilitation loans are for loans that meet HUD criteria for
substantial rehabilitation of a residential care facility, such as two
or more building components being substantially replaced. Purchase
loans are for loans in which the borrower is acquiring an existing
residential care facility, while refinance loans are the refinancing of
an existing HUD insured loan or a loan not previously insured by HUD.
As described earlier in the report, HUD began to allow for the
refinancing of FHA-insured facilities and non-FHA insured facilities in
1987 and 1994, respectively. When analyzing Section 232 loan data by
loan purpose, we found that new construction/substantial rehabilitation
loans have a higher 5-year claim rate than refinance/purchase loans for
the most recent cohort:
for which data are available (see fig. 3).[Footnote 20] New
construction/substantial rehabilitation loans originated between 1997
and 2001 also have the highest historical 5-year cohort claim rate for
these type of loans. Because of the higher claim rates in recent years,
continued monitoring will be important. In contrast, the number of
refinance and purchase loans endorsed in the last 5 years is more than
double those endorsed in the previous 5 years. The future impact of the
refinance and purchase loans on the overall performance of the Section
232 program is uncertain since they have existed for a shorter period
of time and thus there is currently limited data available to assess
the relative risk of claims.
Figure 3: The 5-Year Claim Rate for New Construction Loans Has
Increased in the Most Recent Cohort for Which Claim Rate Data Are
Available:
[See PDF for image]
[End of figure]
Changes in Claim Rates by Facility Type:
As discussed earlier in the report, HUD insures different types of
residential care facilities that include nursing homes, intermediate
care facilities, assisted living facilities, and board and care
facilities. Assisted living facilities are relatively new to the
portfolio, and the number of these loans have been increasing. Our
analysis of Section 232 loan data by facility type found that board and
care facilities had a slightly higher 10-year claim rate than nursing
home facilities in the most recent cohorts; however, these loans remain
a very small percentage of the active portfolio and are being made in
decreasing numbers. There are limited data to observe claim trends on
assisted living facilities, making their risk difficult to assess, but
the 5-year claim rates for assisted living facilities have increased
significantly in the most recent cohort years for which claim rate data
are available (see fig. 4). A continued high claim rate in assisted
living facilities could negatively affect the performance of the
Section 232 program and the GI/SRI Fund. However, lenders and HUD
officials told us that, although assisted living facilities had high
claim rates in the past, they believe the market has stabilized and
lessons have been learned.
Figure 4: The 5-Year Claim Rates for Assisted Living and Board and Care
Facilities Have Increased in the Most Recent Cohorts for Which Claim
Rate Data Are Available:
[See PDF for image]
[End of figure]
Increase in Loan Prepayments:
Another observable trend is the increase in the portion of loans in
each cohort that is prepaid. (Prepayment occurs when a borrower pays a
loan in full before the loan reaches maturity.) There have been 1,688
prepayments in the Section 232 program from 1960 through the end of
fiscal year 2005 and loans that terminate do so overwhelmingly because
of prepayment. Moreover, the proportion of loans that terminate due to
prepayment within 10 years of origination is increasing. Specifically,
the 10-year prepayment rates for the three most recent cohorts for
which 10-year claim rates are available are more than double that of
some earlier cohorts. As more borrowers prepay their loans, HUD loses
future cash flows from premiums; thus, higher prepayment rates will
likely make the net present value of cash flows decrease. However, the
decrease could be offset to the extent that higher prepayment rates
result in fewer claims (a prepaid loan cannot result in a claim).
Concentration of Loans:
Market concentration also poses some risks to the GI/SRI Fund. The
Section 232 program is concentrated in several large markets and in
loans made by relatively few lenders. As of 2005, five states
(California, Illinois, Massachusetts, New York, and Ohio) held 51
percent of active Section 232 loan dollars and 38 percent of active
loan properties (see fig. 5). New York holds close to 24 percent of the
active loan dollars in the portfolio. This is an improvement since 1995
when we found that eight states accounted for 70 percent of the
portfolio, and New York accounted for 32 percent of the portfolio.
However, the current market concentration could still pose risk to the
portfolio if a sudden market change took place in one or more of the
states with a larger percentage of the insured Section 232 loans. We
also found significant loan concentration among a small group of
lenders. While a total of 109 lenders held active loans, 6 hold over
half of the active loan portfolio. GMAC Commercial Mortgage Corporation
holds more than 17 percent of all active mortgages in the Section 232
program, the single largest share of any lender. This concentration
among lenders potentially makes the program more vulnerable if one or a
few large lenders encounter financial difficulty.
Figure 5: Section 232 Properties Are Concentrated in Several States:
[See PDF for image]
Note: Active loan dollars are from F47 as of the end of calendar year
2005, and number of loans are from F47 as of the end of fiscal year
2005. This also does not include one loan for which property state
information was not available in F47. Numbers have been rounded to
closest whole number.
[End of figure]
Industry Faces Uncertainties:
The Section 232 program may also face risks from trends in the
residential care industry at large that include uncertainty about
sources of revenue and occupancy. Nursing home revenue is generated in
large part from the Medicare and Medicaid programs, which make up 58
percent of national nursing home spending. Private lenders we
interviewed that offer non-FHA-insured residential care facility loans
explained that one of the primary reasons their loans are shorter-term
loans than those of HUD is due to their perception of the potential,
long-term uncertainty in the funding of the Medicaid and Medicare
programs, which generally account for a large share of patient payments
in nursing homes. We and others have reported that Medicare and
Medicaid spending may not be sustainable at current levels.[Footnote
21] In our 2003 report on the impact of fiscal pressures on state
reimbursement rates, however, we found that even in states that
recently faced fiscal pressures, reimbursement rates remained largely
unaffected.[Footnote 22] At that time, we concluded that any future
changes to state reimbursement rates remain uncertain. If program cuts
occur in federal spending on Medicaid that result in shifting costs
from the federal government to state governments, states could contain
costs by taking a number of steps, including freezing or reducing
reimbursement rates to providers. An ongoing tension exists, however,
between what federal and state governments and the nursing home
industry believe to be reasonable Medicare and Medicaid reimbursement
rates to operate efficient and economic facilities that provide quality
care to public beneficiaries. As the federal and state governments face
growing long-term financial pressure on their budgets, these budgetary
pressures may have some spillover effects on Medicare and Medicaid
revenue streams for the nursing home industry.
Uncertainty also exists about the future demand for residential care
facilities and the corresponding effects on occupancy. As the number of
Americans aged 65 and older increases at a rapid pace, lenders we
interviewed projected an increased need for residential care
facilities.[Footnote 23] Industry officials also noted a rise in
alternatives to nursing home care, such as assisted living facilities
and home and community-based care options. As patients choose
alternative care options, traditional nursing homes may face occupancy
challenges. Overall, these changes to the nursing home facilities
patient base may lower occupancy and income levels for nursing homes,
including those in the Section 232 portfolio. However, these changes
may positively affect the occupancy and income levels of other types of
residential care facilities, including those in the Section 232
portfolio.
FHA Uses a Number of Tools to Mitigate Risks:
As described elsewhere in this report, FHA uses a number of tools to
mitigate risks to the program and to the GI/SRI Fund. These tools
include imposing requirements prior to insuring loans to help prevent
riskier loans from entering the Section 232 portfolio. FHA also uses
various tools--such as reports on physical inspections of facilities,
and financial and other information captured in data systems--to
monitor the status of insured facilities and the performance of their
loans. Additionally, FHA officials use quality control reviews to
mitigate the risk for the program as a whole using two processes:
Quality Management Reviews and Lender Qualifications and Monitoring
Division reviews (the latter reviews are described in app. II).
HUD's Model for Estimating Credit Subsidy Costs Excludes Some
Potentially Relevant Factors:
HUD's model for estimating annual credit subsidies--which incorporates
assessments of various risks that loan cohorts will face and includes
assumptions consistent with the Office of Management and Budget (OMB)
guidance--does not explicitly consider the impacts of some potentially
important factors. These factors include: variables to capture the
impact of prepayment penalties or restrictions on prepayments, the loan-
to-value ratio and debt service coverage ratios of Section 232
properties at the time of loan origination and differences between
types of residential care facilities. Further, the model does not fully
capture the effects on existing loans to changes in market interest
rates, and it uses proxy data that are not comparable to the loans in
the Section 232 program. As a result, HUD's model for estimating the
program's credit subsidy may result in over-or underestimation of
costs.
HUD Uses a Model to Estimate Credit Subsidy Costs:
Federal law requires HUD to estimate a credit subsidy for its loan
guarantees. The credit subsidy cost is the estimated long-term cost to
the government of a loan guarantee calculated on a net present value
basis and excluding administrative costs. HUD estimates a credit
subsidy for each loan cohort. This estimate reflects HUD's assessment
of various risks, based in part on the performance of loans already
insured. Since 2000, HUD has annually estimated two credit subsidy
rates for the Section 232 program, reflecting its two largest risk
categories: loans for new construction and substantial rehabilitation,
and loans for refinance and purchase loans.[Footnote 24] HUD uses an
identical methodology for each estimate.
To estimate the initial subsidy cost of the Section 232 program, HUD
uses a cash flow model to project the cash flows for all identified
loans over their expected life. The cash flow model incorporates
regression models and uses assumptions based on historical and
projected data to estimate the amount and timing of claims, subsequent
recoveries from these claims, prepayments, and premiums and fees paid
by the borrower. The regression models incorporate various economic
variables such as changes in GDP, unemployment rate, and 10-year bond
rates. The model also has broken out claim and prepayment data into new
construction and refinance loans since these loans are expected to
perform differently.
HUD inputs its estimated cash flows into OMB's credit subsidy
calculator, which calculates the present value of the cash flows and
produces the official credit subsidy rate. A positive credit subsidy
rate means that the present value of cash outflows is greater than
inflows, and a negative credit subsidy rate means that the present
value of cash inflows is greater than cash outflows. For the Section
232 program, cash inflows include premiums and fees, servicing and
repayment income from notes held in inventory, rental income from
properties held in inventory, and sale income from notes and properties
sold from inventory. Cash outflows include claim payments and expenses
related to properties held in inventory.
Since HUD began estimating the initial subsidy cost of the Section 232
program, it has estimated that the present value of cash inflows would
exceed the outflows. As a result, the initial credit subsidy rates for
the Section 232 program were negative. However, estimates from more
recent years showed that the negative subsidy rates on new construction
and substantial rehabilitation loans have generally been shrinking,
meaning that the projected difference between the program's cash
inflows and cash outflows was decreasing. In HUD's most recent estimate
(for the fiscal year 2007 cohort), the estimated cash inflows exceed
the estimated cash outflows by a considerably greater margin than in
any previous year's estimate. This may reflect increased premiums for
Section 232 loans; the President's proposed budget for fiscal year 2007
specifies increases in mortgage insurance premiums for almost all FHA
programs, including increasing the rate for Section 232 refinance and
new construction loans to 80 basis points from 57 basis points. Figure
6 shows changes in the initial estimated credit subsidy rate over time
for both loan categories.
Figure 6: Initial Credit Subsidy Estimates for Section 232 Program New
Construction and Substantial Rehabilitation Loans and for Section 232
Program Refinance and Purchase Loans Have Not Indicated a Need for
Subsidies:
[See PDF for image]
Note: Initial credit subsidy estimates were not available for 1997 for
new construction and substantial rehabilitation loans and for 1996-1999
for refinance and purchase loans.
[End of figure]
Features of the Credit Subsidy Model May Lead to Unreliable Credit
Subsidy Estimates:
HUD's model for estimating credit subsidy rates incorporates numerous
variables, but the model's exclusion of potentially relevant factors
and its use of proxy data from another FHA loan program may negatively
affect the quality of the estimates. Including additional information
in the model could enhance the predictive value of the model.
Prepayment Penalties or Restrictions:
According to some economic studies, prepayment penalties, or penalties
associated with the payment of a loan before its maturity date, can
significantly affect borrowers' prepayment patterns.[Footnote 25] This
is also important for claims, since if a loan is prepaid it can no
longer go to claim. HUD's model does not explicitly consider the
potential impact of prepayment penalties or restrictions, even though
they can influence the timing of prepayments and claims and collections
of premiums. According to FHA officials, FHA does not place prepayment
penalties on FHA-insured nursing home loans. However, according to the
Section 232 program's regulations, a lender can impose a prepayment
penalty charge and place a prepayment restriction on the mortgage's
term, amount, and conditions.[Footnote 26] We reviewed a sample of
Section 232 loans and found that prepayment penalties and restrictions
were consistently applied to these loans.[Footnote 27]
According to FHA officials and mortgage bankers, prepayment
restrictions on Section 232 loans typically range from 2 to 10 years of
prepayment restrictions and 2 to 8 years of prepayment penalties. While
FHA does not specifically maintain data on insured residential care
facility financing terms, prepayment restrictions are specified on the
mortgage note, which is available to FHA. Incorporation of such data
into the Section 232 program's credit subsidy rate model could refine
HUD's credit subsidy estimate by enhancing the model's ability to
account for estimated changes in cash flows as a result of prepayment
restrictions.
According to HUD officials responsible for HUD's cash flow model,
prepayment penalties and restrictions are not incorporated into the
model because HUD does not collect such data. HUD officials added that
even though the cash flow model does not explicitly account for
prepayment penalties and restrictions, its use of historic data
implicitly captures trends that may occur as a result of prepayment
penalties and restrictions. The model's projections are influenced by
the average level of prepayment protection in the historical data but
not by the trend. If prepayment penalties and other restrictions have
changed over time in the past, or change in the future, then not
incorporating this information could lead to less reliable estimates.
Debt Service Coverage Ratio at Point of Loan Origination:
Initial debt service coverage ratios are another important factor that
may affect cash flows, as loans with lower initial debt service
coverage ratios may be more likely to default and result in a claim
payment. HUD's cash flow model does not consider the initial debt
service coverage ratio of Section 232 loans at the point of loan
origination. By initial debt service coverage ratio, we are referring
to the projected debt service coverage ratio that is considered during
loan underwriting. According to the HUD official responsible for HUD's
cash flow model, the initial debt service coverage ratio of a
residential care facility is not included as a part of the cash flow
model because it (1) is not a cash flow, (2) does not vary, and (3) has
no predictive value. We agree that a debt service coverage ratio is not
a cash flow. However, initial debt service coverage ratios potentially
affect relevant cash flows, as do other factors that are included in
HUD's model but are also not cash flows to HUD, such as prepayments.
For example, the model considers estimated prepayments because they
potentially affect future cash inflows from fees and future cash
outflows from claim payments.
Our analysis of available projected debt service coverage ratios, which
include the amount of new debt being insured, shows that these ratios
varied from 1.1 to 3.6.[Footnote 28] All other factors being equal,
loans with debt service coverage ratios of 3.6 are generally considered
to have less risk than a loan with only a 1.1 debt service coverage
ratio.
Economic theory suggests that the debt service coverage ratio is an
important factor in commercial mortgage defaults. However, empirical
studies show mixed results regarding the significance of the impact of
debt service coverage ratios upon commercial mortgage defaults. Some
studies indicate that debt service coverage ratios are meaningful
factors in modeling default risk and are helpful in predicting
commercial mortgage terminations.[Footnote 29] Other studies find
initial debt service coverage ratios to be statistically insignificant
in modeling commercial mortgage defaults.[Footnote 30] These mixed
results may be the consequence of relatively small sample sizes and
model specification issues.
Loan-to-Value Ratio at Point of Loan Origination:
Initial loan-to-value ratios are another important factor that may
affect cash flows, as loans with higher initial loan-to-value ratios
may be more likely to default and result in a claim payment. By initial
loan-to-value ratio, we are referring to the projected loan-to-value
ratio that is considered during loan underwriting. HUD's cash flow
model also does not consider the initial loan-to-value ratio of Section
232 loans at the point of loan origination.
According to the HUD official responsible for HUD's cash flow model,
the initial loan-to-value ratio of a Section 232 property is not
included as a part of the cash flow model because it does not vary and
has no predictive value. However, our analysis of available projected
loan-to-value ratios, which include the amount of new debt being
insured, shows that these ratios varied from 66 percent to 95
percent.[Footnote 31] All other factors being equal, loans with loan-
to-value ratios of 66 percent are generally considered to have less
risk than a loan with only a 95 percent loan-to-value ratio. While
economic theory suggests that the loan-to-value ratio is an important
factor in commercial mortgage defaults, empirical studies show mixed
results regarding its significance. Some studies indicate that loan-to-
value ratios are meaningful factors in modeling default risk and are
helpful in predicting commercial mortgage terminations.[Footnote 32]
Other studies find initial loan-to-value ratios to be statistically
insignificant in modeling commercial mortgage defaults.[Footnote 33]
These mixed results may be the consequence of relatively small sample
sizes and model specification issues.
Types of Facilities Insured and Changes in Interest Rates:
The model's ability to reliably forecast claim rates may be enhanced by
incorporating a variable indicating facility type into the regression
analysis. HUD's cash flow model does not explicitly consider
differences in loan performance between types of facilities, such as
nursing homes, assisted living facilities, and board and care
facilities. However, when looking at the most recent cohorts for which
5-year claim rates are available, our analysis found the 5-year claim
rates for assisted living facilities to be significantly higher than
the 5-year claim rates for nursing homes (6.7 percent 5-year claim rate
for nursing homes versus 13.6 percent for assisted living facilities).
In addition, we found that HUD's cash flow model generally incorporates
the interest rate on the individual loans (the contract rate) and the
prevailing market interest rate (captured by the 10-year bond rate) as
separate variables. Economic theory suggests, when modeling mortgage
terminations, that considering these two variables jointly as a single
variable in the form of a ratio is the best way to capture the effects
on existing loans when market interest rates change.[Footnote 34] For
example, if market rates fall below the contract rate on existing
Section 232 loans, then it may become more attractive for borrowers to
prepay. However, if market rates fall but remain above the contract
rates, then it may not become more attractive for borrowers to prepay.
Using a ratio captures the distinction between these two examples
because it considers the relative cost to the borrower of the mortgage
given the contract rate, as compared to the mortgage with the market
interest rate. By generally considering the contract rate and market
interest rate separately, HUD potentially loses the ability to capture
this distinction and predict large responses when market rates fall and
small responses when market rates rise.[Footnote 35]
Use of Proxy Data:
HUD's use of Section 207 loans as a proxy for Section 232 refinance
loans could lead to less reliable credit subsidy estimates for the
Section 232 program. HUD uses certain Section 207 loans--refinance
loans for existing multifamily housing properties--as proxy data for
the claim regression for Section 232 refinance loans. The Section 207
loans are not residential health care facility loans. According to HUD
officials, HUD uses the Section 207 loans because there are
insufficient data on Section 232 refinance loans. A HUD official told
us that Section 207 loans were selected as proxy data because they are
refinance loans and because they have similar performance to the
Section 232 refinance loans, as indicated by the cumulative claim rates
they calculated.
Consideration of the basis for using proxy data is important. When
using the experience of another agency or a private lender as a proxy,
the Federal Accounting Standards Advisory Board (FASAB) suggests that
an agency explain why this experience is applicable to the agency's
credit program and examine possible biases for which an adjustment is
needed, such as different borrower characteristics.[Footnote 36] HUD
could reasonably be expected to follow the FASAB guidance when using
data from a different program at HUD. HUD told us that they did not
compare borrower characteristics for Section 207 loans and Section 232
loans. A HUD official told us that HUD agreed that they would not
expect borrowers of Section 207 loans to have similar characteristics
to borrowers of Section 232 loans.
HUD analyzed the comparability of Section 207 and Section 232 refinance
loans using cumulative claim rate analysis, but we question the
methodology the agency used to make this comparison. Additionally, we
compared the refinance loans for each of the programs by calculating
conditional claim and prepayment rates as well as 5-year cumulative
claim and prepayment rates, and we found significant differences
between the programs (see app. IV for a further description of HUD's
methodology and our comparison of the two programs).
We question HUD's use of Section 207 loans as a proxy for Section 232
loans, given the differences we observed. We cannot fully estimate the
overall impact on the credit subsidy estimate, and the effects of the
claim and prepayment rates could partially offset each other. The
higher prepayment rates for Section 207 loans could lead to HUD
underestimating future revenues for Section 232 loans (HUD would
project that many of these loans would terminate, although they would
actually remain active and pay premium revenue to HUD.) The lower claim
rates on Section 207 loans could result in HUD estimating that fewer of
its Section 232 loans would result in a claim and thus lead it to
underestimate future costs.
In the future, more data will be available on the actual performance of
Section 232 refinance loans that can be used in estimating credit
subsidy needs. To avoid using questionable proxy data in the interim,
one possible approach, among others, would be to use a simpler
estimation method, such as using average claim and prepayment rates
over time as is done in estimating credit subsidy rates for the Section
242 Hospital Mortgage Insurance program.
Conclusions:
The Section 232 program is the only source of mortgage insurance for
residential care facilities. Accordingly, it is important to ensure
good program and risk management practices. While some field offices we
visited had adopted practices to better manage risks of their Section
232 loans, varying awareness of program requirements and insufficient
levels of staff expertise contribute to increased financial risk in the
Section 232 program loan portfolio and thus the GI/SRI Fund. HUD has
numerous underwriting and monitoring guidelines and policies to manage
the risks of Section 232 loans. However, to the extent that field
office staff do not accurately implement current underwriting and
monitoring guidelines and policies, they potentially allow loans with
unwarranted risks to enter the portfolio and may miss opportunities to
identify problems with already-insured loans early enough to help
prevent claims. Revising the "Multifamily Asset Management and Project
Servicing Handbook" to include monitoring requirements specific to the
Section 232 program, as the Office of Inspector General noted in its
2002 report, would help in this regard. So too would the sharing of
additional practices, such as involving asset management staff in the
underwriting process, undertaken by some field offices to better manage
risks in their program loans. Moreover, adequately training staff to
develop expertise on residential care loans and industry could help
assure proper underwriting and oversight of Section 232 loans, which
tend to be more complex than those in other HUD multifamily programs.
Field office officials' concerns about their existing levels of staff
expertise heighten the need for appropriate guidance and additional
training specific to the Section 232 program, while the potential loss
of specialized staff within the next 5 years underscores the need for
HUD, in the context of its strategic human capital efforts, to assure
adequate program expertise in the future.
Although HUD recommends that field offices obtain and review annual
inspection reports for licensed facilities insured by the program, four
of five offices we visited did not do so. By not routinely using, in
combination with other performance indicators, the results of annual
inspection reports on insured facilities subject to such inspections,
HUD may be missing important indicators of problems that could result
in claims that might otherwise have been prevented. Reviewing
inspection reports is also a means of obtaining relevant information
about insured facilities that have not been the subject of FHA
management reviews. HUD's long-proposed revisions to its residential
care facility regulatory agreement recognize the potential usefulness
of information on state-administered inspections by requiring that
owners or operators report inspection violations and supply HUD with
copies of annual inspection reports. The proposed revisions would also
address a number of the internal control weaknesses identified by the
HUD Inspector General's 2002 report, but it remains unclear when the
proposed revisions will be approved, leaving the program exposed to
identified weaknesses in the interim.
While the Section 232 program represents a relatively small portion of
the GI/SRI Fund, it faces risks that could affect the performance of
the loan portfolio and the fund. HUD uses a number of tools to mitigate
risks, and it will be important to continue monitoring program trends
and industry developments. Recent increases in the numbers of assisted
living facility loans and refinance loans are a source of uncertainty,
in that there is as yet little data with which to assess their long-
term performance. Similarly, industry trends and the availability of
future Medicaid and Medicare funds are sources of uncertainty, and
heighten the need for HUD to have sufficient staff expertise with which
to monitor future developments that could affect the program and
ultimately the GI/SRI Fund.
HUD's model for estimating the program's credit subsidy incorporates
assessments of various risks that loan cohorts face, but it does not
explicitly consider certain factors that could result in over-or
underestimation of costs. These factors include prepayment penalties,
lockout provisions, facility type, loan-to-value ratio, the debt
service coverage ratio of loans at commitment, and the ratio of
contract rates to markets rates, which some economic studies suggest
are potentially useful in modeling risks. Including such factors could
enhance the credit subsidy estimates and provide HUD and the Congress
with better cost data with which to assess the program. Additionally,
HUD's use of Section 207 refinance loans, which we do not find to be a
good proxy for Section 232 refinance loans, could specifically
contribute to over-or underestimation of the credit subsidy for the
refinance loans in the program.
Recommendations for Executive Action:
To ensure that field offices are aware of and implement current
requirements and policies for the Section 232 Mortgage Insurance for
Residential Care Facilities program, and reduce risk to the GI/SRI
Fund, we recommend that the Secretary of Housing and Urban Development
direct the FHA Commissioner to take the following actions:
* Revise the "Multifamily Asset Management and Project Servicing
Handbook" in a timely manner to include monitoring requirements
specific to Section 232 properties;
* Establish a process for systematically sharing loan underwriting and
monitoring practices among field offices involved with the Section 232
program;
* Assure, as part of the department's strategic human capital
management efforts, sufficient levels of staff with appropriate
training and expertise for Section 232 loans;
* Incorporate a review of annual inspection reports for insured Section
232 facilities that are subject to federal or state inspections, even
in the absence of a revised regulatory agreement; and:
* Complete and implement the revised regulatory agreements in a timely
manner.
To potentially improve HUD's estimates of the program's annual credit
subsidy, we recommend that the Secretary of Housing and Urban
Development explore the value of explicitly factoring additional
information into its credit subsidy model, such as prepayment penalties
and restrictions, debt service coverage and loan-to-value ratios of
facilities as they enter the program, facility type, and the ratio of
contract rates to market rates. We also recommend that the Secretary of
Housing and Urban Development specifically explore other means of
modeling the performance of Section 232 refinance loans.
Agency Comments and Our Evaluation:
We provided a draft of this report to HUD for their review and comment.
In written comments from HUD's Assistant Secretary for Housing-Federal
Housing Commissioner, HUD generally concurred with our recommendations
intended to ensure that field offices are aware of and implement
current program requirements and policies. However, the agency
disagreed with most parts of our recommendation related to HUD's credit
subsidy model. The Assistant Secretary's letter appears in appendix V.
HUD stated that it has initiated a full review of the Section 232
program and that GAO's recommendations related to ensuring that field
offices are aware of and implement current requirements are being
incorporated into plans for revising the program. More specifically,
HUD stated that it:
* will draft and implement changes to the program handbook;
* will initiate staff training and assure that staff is adequately
trained in underwriting and servicing policies; and:
* plans to prepare a report addressing state and federal inspections,
among other things, to enhance FHA participation in and oversight of
insured health care mortgages.
HUD also provided a timeline by which to complete and implement the
revised regulatory agreements.
Concerning our recommendation that HUD explore the value of explicitly
factoring in additional information into its credit subsidy model, HUD
stated that it agreed to take into account differences among types of
residential care facilities in its modeling, when it has sufficient
historical data and if the data indicate that loan performance varies
sufficiently by type of facility. However, HUD disagreed with
considering other factors we suggested, as follows:
* Initial loan-to-value and debt service coverage ratios. HUD stated
that (1) studies we cited in our draft report found these ratios to be
statistically insignificant in predicting commercial mortgage defaults
and (2) that data are unavailable for this analysis. We agree, as our
draft report stated, that economic studies have shown mixed results
regarding the significance of the impact of loan-to-value and debt
service coverage ratios on commercial mortgage defaults, with some
studies finding them to be significant predictors and others finding
them to be insignificant predictors. We further stated that these mixed
results may be the result of small sample sizes and model specification
issues. Nevertheless, we continue to believe that HUD should explore
the value of factoring initial loan-to-value ratio and debt service
coverage ratio into its credit subsidy model, and we did not change our
recommendation. Regarding the second point, HUD has the data for
analyzing loan-to-value and debt service coverage ratios in individual
loan files and could include these data in its credit subsidy modeling
by creating an electronic record of this information either for its
entire portfolio or for a sample of the portfolio. Consequently, we did
not change the recommendation.
* Factors potentially affecting prepayments. HUD disagreed with our
suggestion that its credit subsidy model does not fully capture the
effects of prepayment penalties, stating that its use of historical
data captures the effect of prepayment penalties on project owners'
behavior. However, as we stated in the draft report, HUD's use of
historic data would not fully capture trends related to changes in
prepayments. HUD also stated that it has tested using the difference
between mortgage interest rates and the 10-year Treasury bond rates in
its modeling of prepayments. However, our recommendation was to
consider a ratio of these two interest rates, not the difference. As we
noted in our report, economic theory suggests that the use of a ratio
is the best way to capture the effects on existing loans when market
interest rates change. Consequently, we did not change the
recommendation.
* Use of Section 207 loans as proxy data for refinance loans. HUD
stated that it did not believe that the differences between Section 207
and Section 232 loans that our report noted justify concerns that
residential care refinance loans are being improperly modeled and noted
a lack of available data. We agree that sufficient relevant data on
Section 232 refinance loan performance do not yet exist, but we
continue to question the use of Section 207 loan data as a proxy. While
we did not change the recommendation, we added language to our report
suggesting that, until enough Section 232 refinance loan data are
available, one possible approach, among others, would be to use a
simpler estimation method, such as using average claim and prepayment
rates over time as is done in estimating credit subsidy rates for the
Section 242 Hospital Mortgage Insurance program.
We are sending copies of this report to the Secretary of the Department
of Housing and Urban Development (HUD). 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].
If you or your staff have any questions about this report or need
additional information, please contact me at 202-512-8678 or w
[Hyperlink, woodd@gao.gov] oodd@gao.gov. Contact points for our offices
of Congressional Relations or Public Affairs may be found on the last
page of this report. GAO staff who made major contributions to this
report are listed in appendix V.
Signed by:
David G. Wood, Director:
Financial Markets and Community Investment:
List of Congressional Addressees:
The Honorable Christopher Bond:
Chairman:
The Honorable Patty Murray:
Ranking Member:
Subcommittee on Transportation, Treasury, the Judiciary, Housing and
Urban Development, and Related Agencies:
Committee on Appropriations:
United States Senate:
The Honorable Jack Reed:
Ranking Minority Member:
Subcommittee on Housing and Transportation:
Committee on Banking, Housing, and Urban Affairs:
United States Senate:
The Honorable Joe Knollenberg:
Chairman:
The Honorable John W. Olver:
Ranking Member:
Subcommittee on Transportation, Treasury, and Housing and Urban
Development, The Judiciary, District of Columbia, and Independent
Agencies:
Committee on Appropriations:
House of Representatives:
The Honorable Lincoln Chafee:
United States Senate:
The Honorable Patrick Kennedy:
House of Representatives:
The Honorable James Langevin:
House of Representatives:
[End of section]
Appendix I: Objectives, Scope, and Methodology:
Our objectives were to examine (1) the Department of Housing and Urban
Development's (HUD) overall management of the program, including loan
underwriting and monitoring; (2) the extent to which HUD's oversight of
insured health care facilities is coordinated with the states'
oversight of the quality of care provided by facilities; and (3) the
financial implications of the program to the General Insurance/Special
Risk Insurance (GI/SRI) Fund, including risk posed by program and
market trends; and (4) how HUD estimates the annual credit subsidy for
the program, including the factors and assumptions used. In addition,
we examined HUD's action in response to a HUD Inspector General report
that concluded that HUD's Office of Housing did not have adequate
controls to effectively manage the Section 232 program; this
information is summarized in appendix III.
To examine HUD's overall management of the Section 232 program, we
obtained and reviewed program manuals, guidance, and documentation,
including the "MAP Guide," HUD's Section 232 "Mortgage Insurance for
Residential Care Facilities Handbook," and HUD's "Multifamily Asset
Management and Project Servicing Handbook," for loan processing
procedures, underwriting policies and requirements, and oversight
policies and requirements. We also interviewed HUD officials at HUD
headquarters who are responsible for providing guidance and policies on
loan underwriting and oversight and three private lenders that offered
FHA-insured Section 232 loans. In addition, we conducted site visits to
five HUD field offices (Atlanta, Georgia; Buffalo, New York; Chicago,
Illinois; Los Angeles, California; and San Francisco, California) and
conducted interviews with HUD officials, including the Hub or acting
Hub director, appraisers, mortgage credit analysts, and project
managers that are responsible for Section 232 loan applications,
underwriting, and oversight, as well as other Federal Housing
Administration (FHA) programs. We gathered relevant program
documentation from each site visit. We also interviewed an official
from one of HUD's Multifamily Property Disposition Centers during our
site visit to Atlanta. To capture a variety of Section 232 loan
activity, we selected five HUD field offices on the basis of (1) the
volume of Section 232 loans the field office had processed during
fiscal year 2004 up to September 2005; (2) the dollar amount of Section
232 loans processed in the field office during fiscal year 2004 up to
September 2005; (3) the timeliness of processing Section 232 loans
during the last 2 years; (4) historical claim-rate data for the field
office--that is, the rate at which Section 232 loans processed by the
field office have gone to claim; (5) HUD's suggestions for field office
site visits; and (6) geographical dispersion.
To better understand how private lenders that do not participate in the
Section 232 program manage risks, we interviewed five private lenders
that offered non-FHA insured loans to residential health care
facilities. We also interviewed representatives of three residential
care facilities with FHA-insured Section 232 loans to better understand
the borrowers perspective of the Section 232 program.
To examine the extent to which HUD coordinated with states' oversight
of quality of care provided by facilities, we reviewed FHA requirements
for conducting management reviews and reviewing annual inspection
reports. We also interviewed officials in FHA's Office of Multifamily
Development and Office of Asset Management and field office officials
about policies for coordination between FHA and state residential care
oversight and rate setting agencies, as well as policies for review of
annual inspection reports. In addition, we interviewed private lenders
of FHA-insured and non-FHA insured residential care facilities to
better understand common industry practices for coordination between
lenders and state residential care oversight and rate setting agencies.
To examine the financial risks that the program poses to the GI/SRI
Fund, we interviewed and obtained documentation from HUD's Office of
Evaluation and analyzed HUD data on program portfolio characteristics,
including number of loans by cohort, current insurance in force,
geographic and lender concentration of loans, and claims. We also
analyzed HUD data used for their refinance credit subsidy regression
model. Specifically:
* To obtain the number of active and terminated loans and claim rate
history, we analyzed data from extracts of HUD's F47 database, a
multifamily database. We obtained extracts from HUD in May 2005,
September 2005, and February 2006. Unless otherwise indicated, all
analyses from the F47 data in the report utilized the May 2005 extract
with subsequent updates from the other extracts and was current as of
the end of fiscal year 2005. To assess the reliability of the F47
database extract, we reviewed relevant documentation, interviewed
agency officials who worked with the database, and conducted manual
data testing, including comparison to published data. Because of the
small number of loans endorsed in individual fiscal years, we conducted
analyses of cohorts that were created by combining data from 5 to 6
fiscal years. For claim rate analyses, we analyzed 5-and 10-year claim
rates for the data based on the date of loan termination.
* Our analyses found 13 loans for which facility type information was
not able to be determined from the extract. FHA administrators were
able to determine the facility type for all but one of these loans
using the Development Application Processing (DAP) system. This one
terminated loan was excluded from facility type endorsement and claim
rate analysis and, therefore, had little impact on this report. We also
determined final endorsement date information to be missing from 799
records. Our analyses only used initial endorsement date information
for which data was available for every record; therefore, there was no
impact on this report. We also determined there were nine loans for
which the facility type information was incorrect based on the
endorsement date.[Footnote 37] FHA administrators checked in the DAP
system and confirmed the correct facility type for these loans;
therefore, there was no impact on the report. We determined the data to
be sufficiently reliable for analysis of number of active and
terminated loans, as well as claim rates.
* To determine the proportion of the Section 232 Mortgage Insurance
program's commitment authority to the larger GI/SRI Fund's commitment
authority, we reviewed HUD's fiscal year 2006 budget.
* To determine the proportion of the Section 232 Mortgage Insurance
program's unpaid principal balance to the larger GI/SRI Fund unpaid
principal balance, we obtained the GI/SRI Fund's unpaid principal
balance as of December 31, 2005 from HUD's Office of Evaluation. We
also analyzed data from HUD's Multifamily Data Web site, which is
extracted from HUD's F47 database, to determine the unpaid principal
balance of Nursing Home Mortgage Insurance program loans as of December
31, 2005.[Footnote 38]
* To determine the geographic concentration of loan properties in the
program, we analyzed data current as of the end of fiscal year 2005
from our extract of HUD's F47 database. Our analysis determined
property state data was missing for 270 project numbers. FHA
administrators informed us that loans endorsed more than 20 years ago,
before electronic records were maintained, may have missing data that
is unavailable. Our analyses of geographic concentration of loan
properties utilized only one record with missing property state data;
therefore, there was little impact on our findings. We determined the
data to be sufficiently reliable for analysis of geographic loan
concentration.
* To determine the geographic concentration of loan dollars in the
program we analyzed data current as of December 31, 2005, from HUD's
Multifamily Housing Data Web site.
* To determine prepayment history in the program, we analyzed data from
our F47 extract, current as of the end of fiscal year 2005. We also
analyzed 5-and 10-year prepayment rates for the data based on the date
of loan termination.
* To determine the appropriateness of using Section 207 refinance loans
as proxy data in the Section 232 refinance loan credit subsidy estimate
regression model, we analyzed data from several extracts from HUD's
Office of Evaluation. The extracts contained the loan data used by HUD
to calculate cumulative claim rates for Section 232 and 207 refinance
loans for loans endorsed from fiscal year 1992 through fiscal year
2005. The extracts did not include termination codes for all terminated
loans. We determined termination code data for these loans from HUD
data current as of December 31, 2005, from HUD's Multifamily Housing
Data Web site. We also combined the extracts to include all loans in
one larger extract. In addition, we performed manual data reliability
assessments of these extracts and determined that three loans should
not have been included in the extracts because they had section of the
act codes that were not within the parameters of our analysis as
defined by the notes included in HUD's extracts. These loans were not
included in our analysis and, therefore, had no impact on our findings.
We determined the data to be sufficiently reliable for analysis of the
comparability of Section 207 refinance loans to Section 232 refinance
loans.
We conducted a literature review and interviewed numerous officials of
lenders, residential care associations, and HUD to obtain information
on risks due to health care market trends. We also searched for
Inspectors General and agency reports through HUD Web sites. Finally,
we conducted a search on our internal Web site to identify previous
work on the Section 232 program.
To determine how HUD estimates the annual credit subsidy rate for the
program, we reviewed documentation of HUD's credit subsidy estimation
procedures, reviewed the cash flow model for the program, and we
interviewed program officials from HUD's Office of Evaluation and
program auditors from the Office of Management and Budget (OMB). We
also compared the assumptions used in HUD's cash flow model with
relevant OMB guidance and reviewed economic literature on modeling
defaults to identify factors that are important for estimation.
Additionally, we analyzed data provided by HUD field offices on initial
loan-to-value ratios and debt service coverage ratios (at the time of
loan application). We obtained the credit subsidy rates from the
Federal Credit Supplement of the United States Budget.
To review the actions HUD has taken in response to the HUD Inspector
General's 2002 report on the Section 232 program, we interviewed
officials in HUD's Office of Inspector General. In addition, we
reviewed the HUD Inspector General's 2002 report, as well as HUD's
Management Plan Status Reports for Implementation of Recommendation 1A
of audit 2002-KC-0002. We also interviewed HUD headquarters officials,
as well as field office officials during our site visits.
Our review did not include an evaluation of underwriting criteria or
the need for the program. We conducted our work in Atlanta, Georgia;
Buffalo, New York; Chicago, Illinois; Los Angeles, California; San
Francisco, California, and Washington, D.C., between February 2005 and
April 2006, in accordance with generally accepted government auditing
standards.
[End of section]
Appendix II: Information on the Application Processing, Underwriting,
and Oversight of Section 232 Loans:
Application Processing and Underwriting for Section 232 Loans:
The Department of Housing and Urban Development (HUD) currently
processes a majority of the Section 232 loans using the Multifamily
Accelerated Processing (MAP) program and processes some loans under
Traditional Application Processing (TAP). Under MAP, the lender
conducts the underwriting of the loan and submits a package directly to
the Hub or program center for mortgage insurance. The Hub or program
center reviews the lender's underwriting and makes a decision whether
or not to provide mortgage insurance for the loan. New construction and
substantial rehabilitation loans require a preapplication meeting where
HUD reviews required documentation up front. Under TAP, HUD, not the
lender, is primarily responsible for the underwriting of the loan and
determines whether or not to accept the loan.
FHA has numerous underwriting requirements for loans made under the
Section 232 program. Some examples include:
* Requiring documentation of a state-issued Certificate of Need (CON)
for skilled nursing facilities and intermediate care facilities, and in
states without a certificate of needs procedure, an alternative study
of market needs and feasibility.
* Requiring an appraisal of the facility (prepared by the lender under
the MAP program) and a market study with comparable properties.
* Reviewing current or prospective operators of the residential care
facility and ensuring that they meet certain standards. For example,
FHA has a requirement that operators of an assisted living facility
have a proven track record of at least 3 years in developing,
marketing, and operating either an assisted living facility or a board
and care home.[Footnote 39]
* For new construction facilities specifically, FHA requires a business
plan along with an estimate of occupancy rates and prospective
reimbursement rates with the percentage of population for patients
whose costs are reimbursed through Medicare and Medicaid.
* For existing facilities applying for a refinance loan, FHA requires
the submission of vacancy and turnover rates and current provider
agreements for Medicare and Medicaid, 3 years of balance sheet and
operating statements, as well as the latest inspection report on the
project's operation.[Footnote 40]
* Requiring limits on loan-to-value and debt service coverage ratios,
ratios identified by field office officials we interviewed as two of
the more important financial ratios in the underwriting process. For
example, for Section 232 loans, the loan-to-value ratio cannot exceed
90 percent for new construction loans, and 85 percent loan-to-value for
refinance loans.[Footnote 41]
For loans processed under MAP, HUD field office officials are required
to use MAP Guide checklists to ensure that lenders follow FHA's
underwriting requirements. These checklists contained guidelines for
reviewing lender submissions and overall parameters that an application
must meet. For example, field office officials use an appraisal review
checklist in the MAP Guide to ensure that the submitted market study
complies with MAP requirements. For applications processed under TAP,
field office officials stated that they use similar checklists to the
ones included in the MAP Guide as the MAP Guide incorporates many of
the Section 232 underwriting requirements.
For MAP loans, HUD headquarters has a Lender Qualifications and
Monitoring Division (LQMD) that conducts reviews of loans. LQMD is
responsible for evaluating lender qualifications and lender
performance. It reviews and ultimately approves lenders requesting MAP
lender approval for loan underwriting. The division reviews a sample of
lenders when a loan has defaulted or there is a need for additional
lender oversight. While LQMD reviews are not specific to the Section
232 program, they help to monitor lenders participating in the program
and ultimately help to reduce the number of risky loans that enter the
portfolio.
Oversight and Monitoring of Section 232 Loans:
FHA requires field office staff to conduct a number of reviews for
oversight of Section 232 loans. For example, staff address
noncompliance items that are identified by HUD's Financial Assessment
Sub-System (FASS) for each facility. Noncompliance items can include
items such as unauthorized distribution of project funds or
unauthorized loans from project funds. Using information from the
annual financial statement, FASS's computer model statistically
calculates financial ratios, or indicators, for each facility, and
applies acceptable ranges of performance, weights, and thresholds for
each indicator. FASS then generates a score for each facility based on
these indicators, and this financial score represents a single
aggregate financial measure of the facility. However, a HUD draft
contractor study found that FASS did not adequately account for the
unique nature of nursing homes in the Section 232 portfolio and,
therefore, was a poor predictor of a nursing home going to claim. Field
office officials we interviewed also review physical inspections
conducted by HUD's Real Estate Assessment Center (REAC), which is
responsible for conducting physical assessments of all HUD-insured
properties. Officials also ensure that the professional liability
requirement for facilities is met and conduct file reviews to identify
any activities that warrant additional oversight.[Footnote 42]
Additionally, officials in each field office we visited stated that
they are required to monitor projects in HUD's Real Estate Management
System, the official source of data on HUD's multifamily housing
portfolio that maintains data on properties and to conduct risk
assessments on their properties at least once a year to identify those
facilities that are designated as troubled or potentially troubled
based on their physical inspection, financial condition, and other
factors.
Field offices also varied in the utilization of HUD's Online Property
Integrated Information Suite (OPIIS), a centralized resource for HUD
multifamily data and property analysis. According to officials at HUD
headquarters, field office officials can use OPIIS to conduct a variety
of portfolio analysis and view risk assessments on their properties to
better assist them in overseeing their portfolios. For example, OPIIS
contains an Integrated Risk Assessment score that combines financial,
physical, loan payment status history, and other data into a score that
can be used to identify at-risk properties and prioritize workloads.
However, four of the five field offices that we visited did not
frequently use OPIIS. Some of these offices used the system to develop
risk rankings for their properties or in trying to obtain data about a
property, but none of them regularly used the system for the monitoring
of Section 232 loans. The one field office that utilized OPIIS more
frequently did so because the system partly incorporates a loan risk
and rankings system that the field office had previously developed for
its own use. Officials in this field office stated that an issue with
OPIIS is that it is not designed to capture important, specific
financial information that is unique to some Section 232 loans, such as
expenses on food or medication.
[End of section]
Appendix III: HUD Officials Addressed Some Issues Raised by the
Agency's Inspector General in 2002, but Several Key Items Remain
Unresolved:
In a 2002 report, the Department of Housing and Urban Development's
(HUD) Inspector General found that HUD's Office of Housing did not have
adequate controls to effectively manage the Section 232
program.[Footnote 43] Because of these weaknesses, the Inspector
General found that HUD lacked assurance of the effective operation of
Section 232 properties. The Inspector General noted that the Office of
Housing had already taken steps to develop an action plan to address
the weaknesses identified by a task force, but that time frames had not
yet been established. The Inspector General recommended that the Office
of Housing establish specific time frames for implementing the
corrective actions for the 10 weaknesses identified by the task force
and that it monitor the actions to ensure timely and effective
completion.
HUD officials developed a plan to correct the 10 control weaknesses
identified by the Office of Housing, which included the current status
of each action and specific target dates to complete the corrective
actions. According to the Inspector General, HUD has taken action to
address 2 of the 10 control weakness findings identified by the Office
of Housing Task force and for which the Inspector General recommended
that timelines for corrective actions be established.
The eight unresolved control weaknesses identified by the Office of
Housing task force are all contingent upon approval of the proposed
revisions to the regulatory agreements. However, the proposed revisions
have been awaiting approval since August 2, 2004. According to HUD
officials, the delay is a result of numerous administrative issues,
which include changes in FHA management and extended public comment
periods.
The addressed control weaknesses and respective corrective actions
involved loan underwriting. The Inspector General agreed with the
Office of Housing task force, which found that HUD's underwriting
process for Section 232 properties needed to be strengthened and that
HUD needed to complete market studies and background checks of
applicants as part of the process. The Inspector General also agreed
with the Office of Housing task force's finding of potential problems
associated with the nonrecourse nature of HUD Section 232 loans. In
particular, it found that HUD needed to strengthen the regulatory
agreements and underwriting process for Section 232 loans if these
mortgages were to remain nonrecourse and to avoid potential increase in
the portfolio claim rate. HUD addressed these findings by adding
requirements for operators, reviews of operators' financial statements,
and professional liability insurance. Furthermore, applications for
projects that are considered marginal are rejected.
The eight remaining control weaknesses for which HUD has not fully
completed its corrective actions are as follows:
HUD lacks a handbook detailing monitoring requirements for nursing
homes and assisted living facilities. The Inspector General found that
HUD did not have a handbook specific to the Section 232 program
monitoring requirements ensuring that all facilities follow the
applicable regulatory agreements and state and federal requirements. In
our site visits to five field offices, we found inconsistencies in the
extent to which oversight procedures were followed, such as requiring
operators to submit financial statements. HUD plans to include Section
232 project monitoring requirements in the "Multifamily Asset
Management and Project Servicing Handbook" once the proposed revisions
to the applicable regulatory agreements have been approved. In
addition, HUD headquarters officials told us that they plan to issue
updated guidance on loan oversight for Section 232 properties while
awaiting approval of the proposed revisions to the regulatory
agreements.
HUD's regulatory agreement does not include specific requirements for
Section 232 properties. The Inspector General found that the regulatory
agreement for owners lacked requirements for Section 232 properties,
such as compliance with Medicare and Medicaid guidelines. The Inspector
General also found inconsistencies between the requirements for
facilities operated by the owners and those operated by a separate
entity. The Inspector General recognized that these omissions created
an inability for HUD to control the activities of operators and
ultimately created risk to the General Insurance/Special Risk Insurance
Fund. HUD's proposed revisions to the regulatory agreements have
provisions that address these concerns; however, they are still
awaiting approval.
The Financial Assessment Subsystem (FASS) does not allow the owner and
operator to submit annual financial statements electronically, denying
HUD the ability to use the financial check and compliance feature in
the system. The Inspector General found that the Real Estate Assessment
Center's (REAC) FASS did not include all Section 232 properties.
Furthermore, operators were not required to submit annual financial
statements electronically through the system. HUD headquarters
officials agreed that, while operators are unable to submit annual
financial statements electronically, FASS has allowed electronic
submissions from owners since the system's inception. However, the
Inspector General found that because operator financial statements are
not required to be submitted electronically, HUD is unable to utilize
the financial and compliance checks performed within the system to
identify and follow up on deficiencies. HUD plans to modify FASS to
allow electronic submission of operator financial statements; however,
implementation has been delayed by funding problems and approval of the
proposed revision to the operator regulatory agreement.
The Office of Housing needs to improve monitoring and legal tools to
provide early indication of possible default. The Office of Housing
task force identified a need for improved monitoring and legal tools to
provide early indication of potential default. To better understand
issues related to monitoring loans, HUD's Office of Evaluation
completed several studies on Section 232 program performance.[Footnote
44] As of April 2006, all of these studies remain in draft form. Also,
to aid in monitoring, HUD has proposed revisions to the applicable
regulatory agreements to require that owners and operators submit
annual inspection reports and inform HUD of state or federal
violations. These reports can be an early indicator of quality of care
concerns and possible claim. However, the proposed revisions to the
regulatory agreements have not been made final.
The Office of Housing staff needs additional training on servicing
nursing homes and assisted living facilities. The Inspector General
identified that project managers did not have sufficient training on
reviewing Section 232 properties and dealing with the issues unique to
Section 232 properties. HUD's management plan states that, as of
September 2004, REAC has conducted financial statement analysis for HUD
hubs for the last 2 fiscal years. HUD has also proposed training
specific to Section 232 program financial analysis upon approval of
revisions to the applicable regulatory agreements and subject to the
availability of funds. However, HUD headquarters officials stated that
there were very limited funds available for training.
Certain conditions lead to loss of Certificate of Need (CON) or
license. The HUD Inspector General identified that, in some states, the
CON and operating licenses may not transfer with the property.
Consequently, an operator may hold these operational documents and take
them with them upon termination of the lease. Without these documents,
a facility is not viable as a residential care facility and its value
is significantly diminished. This presents a large risk to HUD should
the loan go to claim or should HUD have to acquire the property. HUD's
proposed revisions to the applicable regulatory agreements address this
concern by categorizing these operational documents as part of the
mortgaged properties.
Receivables need to be included in the relevant legal documents to
strengthen HUD's control over assets of the property in case of
regulatory agreement violations.[Footnote 45] The Inspector General
established that the Section 232 security agreement language was too
broad to ensure that all property assets are covered by the mortgage.
To address this concern, HUD proposed revisions to the applicable
regulatory agreements to include receivables in the personalty pledged
as security for the mortgage. Additionally, HUD proposed added language
in the owner regulatory agreement requiring the owner to execute a
security agreement and financial statement upon all items of equipment
and receivables.
Field offices do not have consistent procedures for using different
addendums for mortgages, regulatory agreements, and security
agreements. The Office of Housing's task force found inconsistencies in
the field offices' use of legal agreements between HUD and owners and
operators, such as differing addendums to mortgages, regulatory
agreements, and security agreements. We also found similar
discrepancies during our five site visits. For example, only one office
used addendums to HUD's legal agreements to prevent operators from
keeping these operational documents once the lease terminates. HUD has
proposed revisions to the regulatory agreements, and once they are
approved and implemented all offices will use the same legal
documentation. In the interim, HUD headquarters officials told us they
plan to provide field offices with updated guidance on Section 232 loan
oversight.
[End of section]
Appendix IV: HUD's Use of Proxy Data for Refinance Loans:
As discussed earlier in this report, we question the Department of
Housing and Urban Development's (HUD) use of Section 207 loans as a
proxy for Section 232 loans in the claim regression that is part of
HUD's credit subsidy estimates. This appendix provides greater detail
on our analysis.
HUD's Comparison Did Not Allow for Differences in the Age of Loans:
Cumulative claim rates are generally compared for a set period of time
and for loans from the same years of origination. However, HUD
calculated the cumulative claim rates without making these adjustments,
which confounds claim differences between programs with differences due
solely to timing. HUD calculated the cumulative claim rates for each
program by taking the total number of loans that went to claim during a
14-year time period and dividing this by the total number of loans in
that same time period. In this case, HUD was comparing a program that
has been expanding over time, the Section 232 program, with a program
that has had less loan volume in recent years, the Section 207 program.
From 1992 to 1998, HUD insured 1,434 Section 207 loans. From 1999 to
2005, HUD insured 870 Section 207 loans. As a result, HUD has been
comparing the claim rate of loans that have had very little time in
which to default (Section 232 loans had an average age of 4 years) with
the claim rate of loans that have had substantial time in which to
default (Section 207 loans had an average age of 7.5 years). A
comparison between two programs' claim rates should allow for
differences in the age of the loans. HUD officials also told us that
they have not analyzed the comparability of these two loan types in
terms of their prepayment rates.
Substantial Differences Exist between Section 207 and Section 232
Loans:
To examine the comparability of the Section 207 and Section 232 loans,
we compared the conditional claim and prepayment rates of the two types
of loans. An analysis of conditional claim and prepayment rates
compares claim and prepayment probabilities for loans of the same age,
so that comparisons based on loans of widely varying ages are avoided.
We found that the Section 207 loans generally had lower and, in some
cases, significantly lower conditional claim rates than the Section 232
loans. The differences were greater in the later years when loans more
often go to claim. (see fig. 7). For example, the conditional claim
rate for Section 207 loans in fiscal year 8 was .14 percent as compared
with a conditional claim rate of 3.88 percent for Section 232 loans in
fiscal year 8.
Figure 7: Conditional Claim Rates Are Different for Section 232 and
Section 207 Refinance Loans:
[See PDF for image]
Note: Through year 8, there are at least 200 loans in each category of
loan for each conditional claim rate year. Beyond year 8, the loan
numbers are small (particularly for Section 232 loans), and conclusions
are less reliable.
[End of figure]
We found that Section 207 loans had generally higher, and sometimes
significantly higher, conditional prepayment rates compared to Section
232 loans. The differences were greater in the later years when loans
more often are prepaid. (see fig. 8). For example, the conditional
prepayment rate for Section 207 loans in fiscal year 8 was 21.72
percent as compared to a conditional prepayment 11.25 percent for
Section 232 loans in fiscal year 8 (making the conditional prepayment
rate for the Section 207 loans 93 percent higher than the conditional
prepayment rate for Section 232 loans).
Figure 8: Conditional Prepayment Rates are Different for Section 232
and Section 207 Refinance Loans:
[See PDF for image]
Note: Through year 8, there are at least 200 loans in each category of
loan for each conditional prepayment rate year. Beyond year 8, the loan
numbers are small (particularly for Section 232 loans), and conclusions
are less reliable.
[End of figure]
Additionally, we examined and compared cumulative 5-year claim and
prepayment rates. Section 207 loans had a 5-year cumulative claim rate
of 3 percent, while for the Section 232 loans it was approximately 6.7
percent. The 5-year cumulative prepayment rate for Section 207 loans
was about 27 percent, while for Section 232 loans it was about 11
percent.
[End of section]
Appendix V: 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:
May 12 2006:
Mr. David Wood:
Director, Financial Markets and Community Investment:
United States Government Accountability Office:
Washington, DC 20548:
Dear Mr. Wood:
Thank you for the opportunity to respond to the draft report entitled
Residential Care Facilities Mortgage Insurance Program: Opportunities
to Improve Program and Risk Management (GAO-06-515). The Department
plans to implement the GAO recommendations as follows:
The Department has already separated the revision of the healthcare
regulatory agreements and other closing documents from the rental
housing revisions, so that specific focus can be placed on assuring the
unique nature of health care operating structures and oversight will be
adequately addressed in those revisions.
June 30, 2006 - Conclude industry and stakeholder fact gathering that
began in March 2006 to better define the role of the FHA 232 program in
providing mortgage insurance for the critical healthcare market
segment.
September 30, 2006 - Prepare report addressing key ownership and
operator structure and agreements including conventional mortgage
practices for project oversight, available third party sources for
project operations review, state and federal inspections, receivables
financing, insurance practices and policies, and risk management
approaches to enhance FHA participation in and oversight of insured
healthcare mortgages.
March 31, 2007 - Complete plan to implement findings and draft
appropriate policy and handbook changes. Recommend organizational
changes to assure adequate skills and staffing are dedicated to the
healthcare programs. Complete the revisions of the regulatory
agreements and closing documents. Prepare regulatory changes for
clearance and publication in the Federal Register. Initiate staff
training based upon proposed changes and implement program changes that
do not require regulatory clearance.
February 28, 2008 - Fully implement the revised healthcare program
assuring that staff is adequately trained in the underwriting and
servicing policies and adherence to those policies is consistent across
all responsible areas.
The Department believes that these actions will fully accomplish the
recommendations made by Report GAO-06-515 related to program redesign,
enhanced staff and organizational structure, and asset and risk
management. However, for reasons already explained to the GAO, the
Department does not agree with the GAO's recommendations for changes to
the annual credit subsidy estimations. This disagreement is based upon
the following:
The GAO recommends that a property's loan-to-value and debt service
coverage ratios at origination should be included in the econometric
models used to estimate conditional claim rates for Section 232 loans.
The data is unavailable for analysis and is unlikely to be
statistically significant if they were available. GAO acknowledges that
recent statistical studies have found no statistical relationship
between ratios at origination and subsequent performance.
The GAO contends that FHA's models suffer from a failure to capture
prepayment penalties. Because FHA uses all of its historical experience
to model conditional prepayment rates, it is capturing the effect of
prepayment penalties on project owners' behavior. The GAO report goes
on to state that FHA does not capture the effect of changes in market
interest rates in its prepayment models. In fact, FHA does include both
the mortgage interest rate and the 10-year Treasury bond rate in its
models and has tested using the difference between the two as an
explanatory variable. FHA uses the model specification with the
greatest explanatory power. Each year FHA tests alternative
specifications and will continue to test whether inclusion of the rate
difference will improve its models.
The report questioned the use of multifamily refinance loans as proxy
data for residential care refinance loans, but did not recommend
another source of historical data that could be used to generate
performance estimates. Given the sparsity of available data, FHA does
not believe that the differences noted in Appendix IV are great enough
to justify concern that residential care facility loans are being
improperly modeled.
The GAO recommends taking into account the differences among types of
residential care facilities in its modeling. FHA agrees to do so when
sufficient historical data are available and if the data indicate that
loan performance varies sufficiently by type of facility to warrant the
creation of new risk categories.
The Department acknowledges the unique nature of these healthcare loans
and the resulting need for specialized underwriting and oversight. To
that end, the Department has initiated a full review of the program and
has found the added insight and recommendations provided by the GAO
report to be very useful. These recommendations, along with those
previously made by the Inspector General are being incorporated into
the findings that will be the basis for program revisions.
If you have any questions concerning this response, please contact
Charles H. (Hank) Williams, Deputy Assistant Secretary for Multifamily
Housing Programs at (202) 708-2495.
Sincerely:
Signed by:
Brian Montgomery:
Assistant Secretary for Housing-Federal Housing Commissioner:
[End of section]
Appendix VI: GAO Contact and Staff Acknowledgments:
GAO Contact:
David G. Wood (202) 512-8678:
Staff Acknowledgments:
In addition to the individual named above, Paul Schmidt, Assistant
Director; Austin Kelly; Tarek Mahmassani; John McGrail; Andy Pauline;
Carl Ramirez; Richard Vagnoni; Wendy Wierzbicki; and Amber Yancey-
Carroll made key contributions to this report.
(250238):
FOOTNOTES
[1] Based on data from the HUD's F47 multifamily database.
[2] Pursuant to the Federal Credit Reform Act of 1990, HUD must
annually estimate the credit subsidy cost for all of its loan guarantee
programs.
[3] Medicare is the federal health care program for the elderly and
people with disabilities. In addition to other health services,
Medicare covers up to 100 days of nursing home care following a
hospital stay. Medicaid is the joint federal-state health care
financing program for certain categories of low-income individuals,
including elderly and disabled individuals. Medicaid also pays for long-
term care services, including nursing home care.
[4] GAO, Nursing Homes: Quality of Care More Related to Staffing than
Spending, GAO-02-431R (Washington, D.C.: June 13, 2002), 1.
[5] GAO analysis of data from the U.S. Department of Health and Human
Services, Centers for Medicare & Medicaid Services.
[6] While we refer to these inspections as annual, every nursing home
receiving Medicare or Medicaid payments must undergo a standard
inspection survey not less than once every 15 months, and the statewide
average interval for these surveys must not exceed 12 months.
[7] We provided the results of the mandated study of the Hospital
Mortgage Insurance program in GAO, Hospital Mortgage Insurance Program:
Program and Risk Management Could be Enhanced, GAO-06-316 (Washington,
D.C.: Feb. 28, 2006).
[8] Underwriting refers to the process of determining the risk of
particular loan applications.
[9] We selected these locations on the basis of several factors for
each office, including (1) the historical claim rates experienced among
loans processed, (2) the volume and dollar amounts of loans, (3)
insurance application processing times, and (4) discussions with HUD
officials. Because we did not select the offices randomly, we do not
know the extent to which they are representative of all HUD's field
offices that process Section 232 program loans.
[10] According to HUD's "Section 232 Mortgage Insurance for Residential
Care Facilities Handbook," nursing homes are those facilities that
provide accommodation for persons who are not acutely ill and not in
need of hospital care but require skilled nursing care and related
medical services. Intermediate care facilities provide for the
accommodation of persons who require minimum, but continuous care, and
do not require skilled nursing services. In this report, we use the
term "nursing home" to include facilities providing skilled and/or
intermediate care services. Assisted living facilities are facilities
for residents who need assistance with activities of daily living.
Board and care facilities provide room, board, and continuous
protective oversight.
[11] Based on 2003-2005 data in GAO, Nursing Homes: Despite Increased
Oversight, Challenges Remain in Ensuring High-Quality Care and Resident
Safety, GAO-06-117 (Washington, D.C.: Dec. 28, 2005), 60, and 2004 data
in Robert Mollica and Heather Johnson-Lamarche, State Residential Care
and Assisted Living Policy: 2004 (National Academy for State Health
Policy, March 2005), 1-2.
[12] 42 U.S.C. §1396a(a).
[13] Loan-to-value is a ratio of the amount of the loan as a percentage
of the property's value or sales price. Debt service coverage ratio is
the ratio of the property's annual net operating income to the annual
debt service.
[14] Officials in one field office explained that they had previously
required operators to submit financial statements and were planning to
resume following this requirement.
[15] A Certificate of Need is a state regulatory process that requires
residential health care facilities to receive state approval before
offering certain new or expanded health care services.
[16] According to headquarters officials, the Web site includes notices
related to loan insurance applications processed under the Multifamily
Accelerated Processing (MAP) system, which includes the majority of
Section 232 loan applications.
[17] See GAO-06-117, 4.
[18] The GI/SRI Fund's commitment authority represents the maximum
aggregate amount of loans that can be guaranteed under the programs in
the fund.
[19] In our analysis of Section 232 loan data, we grouped loans into
cohorts (loans originated in a given fiscal year) of approximately 5
fiscal years of loans. This was done to allow for a more meaningful
analysis given the small number of Section 232 loans endorsed per
fiscal year. We analyzed 5-and 10-year claim and prepayment rates
because more claims and prepayments take place within 10 years of loan
endorsement.
[20] We are reporting 5-year claim rates rather than 10-year claim
rates when comparing refinance loans because HUD insured its first
refinance loans in 1992. As a result, there are limited data available
for 10-year claim rates.
[21] GAO, 21ST Century: Reexaming the Base of the Federal Government,
GAO-05-325SP (Washington, D.C; Feb. 1, 2005), 33-35; GAO, Long-Term
Care Financing: Growing Demand and Cost of Services Are Straining
Federal and State Budgets, GAO-05-564T (Washington, D.C; Apr. 27,
2005), 7; Fitch Ratings, 2005 Non-Profit Hospitals and Health Care
Systems Forecast (New York, NY: Jan. 20, 2005), 8.
[22] GAO-04-143, 3.
[23] GAO, Aging Issues: Related GAO Products in Calendar Years 2001 and
2002, GAO-04-275R (Washington, D.C.: Nov. 21, 2003), 1.
[24] For purposes of tracking Section 232 loans in its databases, HUD
groups together refinance and purchase loans. Similarly, it also groups
together new construction and substantial rehabilitation loans.
[25] Jesse M. Abraham and H. Scott Theobald, "A Simple Prepayment Model
of Commercial Mortgages," Journal of Housing Economics, vol. 6 no. 1,
(1997); Austin Kelly; V. Carlos Slawson, Jr., "Time-Varying Mortgage
Prepayment Penalties," Journal of Real Estate Finance and Economics,
vol. 23, no. 2, (2001); Qiang Fu, Michael LaCour-Little, and Kerry D.
Vandell, "Commercial Mortgage Prepayments Under Heterogeneous
Prepayment Penalty Structures," vol. 25, no. 3 (2003).
[26] The regulations also state that prepayment restrictions and
penalty charges must be acceptable to the FHA Commissioner.
[27] We analyzed prepayment restrictions from the mortgage notes of 32
projects with loan payments beginning in 2001 to 2005.
[28] We analyzed debt service coverage ratios from the underwriting
reports of 42 projects that applied for mortgage insurance between
fiscal years 2000 and 2006.
[29] Athanasios Episcopos, Andreas Pericli, and Jianxun Hu, "Commercial
Mortgage Default: A Comparison of Logit with Radial Basis Function
Networks," Journal of Real Estate Finance and Economics, vol. 17, no.
2, (1998); and Wayne R. Archer, Peter J. Elmer, David M. Harrison, and
David C. Ling, "Determinants of Multifamily Mortgage Default," Real
Estate Economics, vol. 30, no. 3 (2002).
[30] Brian A. Cochetti, Honeying Deng, Bin Gao, and Rui Yao, "The
Termination of Commercial Mortgage Contracts Through Prepayment and
Default: A Proportional Hazard Approach with Competing Risks," Real
Estate Economics; vol. 30, no. 4 (2002); Kerry D. Vandell, Walter
Barnes, David Hartzell, Dennis Kraft, and William Wendt, "Commercial
Mortgage Defaults: Proportional Hazards Estimation Using Individual
Loan Histories," Journal of the American Real Estate and Urban
Economics Association, vol. 21, no. 4 (1993).
[31] We analyzed loan-to-value ratios from the underwriting reports of
42 projects that applied for mortgage insurance between fiscal years
2000 and 2006.
[32] Y. Deng, J. Quigley, and A. Sanders, "Commercial Mortgage
Terminations: Evidence from CMBS," University of Southern California
(2004); Athanasios Episcopos, Andreas Pericli, and Jianxun Hu,
"Commercial Mortgage Default: A Comparison of Logit with Radial Basis
Function Networks," Journal of Real Estate Finance and Economics vol.
17, no. 2, (1998); and Office of Federal Housing Enterprise Oversight,
"Risk-Based Capital Regulation: Second Notice of Proposed Rulemaking,"
Federal Register 64 (1999).
[33] Wayne R. Archer, Peter J. Elmer, David M. Harrison, and David C.
Ling, "Determinants of Multifamily Mortgage Default," Real Estate
Economics, vol. 30, no. 3 (2002); B. Ambrose and A. Sanders,
"Commercial Mortgage-Backed Securities: Prepayment and Default,"
Journal of Real Estate Finance and Economics, vol. 26, no. 2 and 3.
[34] Scott Richard and Richard Roll, "Prepayments on Fixed-rate
Mortgage-backed Securities," Journal of Portfolio Management, Spring
1989. Additionally, we found other studies which include market rate
and contract rate as a ratio in the modeling of mortgage terminations.
These studies include B. Ambrose and A. Sanders, "Commercial Mortgage-
Backed Securities: Prepayment and Default," Journal of Real Estate
Finance and Economics, vol. 26, no. 2 and 3; and Qiang Fu, Michael
LaCour-Little, and Kerry D. Vandell, "Commercial Mortgage Prepayments
Under Heterogeneous Prepayment Penalty Structures," 25, 3 (2003).
[35] One of HUD's regressions calculates the difference between
contract rates and market rates. Considering the difference between the
contract rate and the market rate is better than considering the rates
separately, but is still not as strong an approximation as using a
ratio. See Richard and Roll.
[36] 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 regarding the basis for supporting
cash flow assumptions for loan guarantee programs.
[37] These nine loans were coded as assisted living facility loans in
F47. However, these loans were endorsed prior to HUD insuring assisted
living facilities in 1994.
[38] Department of Housing and Urban Development, "Insured Multifamily
Mortgages Database," Multifamily Data,
http://www.hud.gov/offices/hsg/comp/rpts/mfh/mf_f47.cfm (downloaded
Feb. 24, 2006).
[39] U.S. Department of Housing and Urban Development, Notice H 97-01,
4.
[40] According to the MAP Guide, the latest state residential care
facility agency's report on the project's operation is required. The
MAP Guide provides mortgage insurance program descriptions, mortgagor
and lender eligibility requirements, application requirements, HUD
underwriting standards for all technical disciplines, construction
administration requirements, and closing instructions.
[41] When determining the maximum insurable mortgage, HUD also has
requirements regarding the acquisition costs and net earnings. For
nonprofit mortgagors, the loan-to-value cannot exceed 95 percent for
new construction loans and 90 percent for refinance loans.
[42] In April 2001, HUD issued Notice H01-03, titled "Review of Health
Care Facility Portfolios and Changes to the Section 232 Programs."
Section X of the notice established the requirement that HUD-insured
health care facilities maintain professional liability insurance.
Housing Notice 04-15 lists the requirements for professional liability
insurance for owners and operators of health care facilities.
[43] Department of Housing and Urban Development, Office of Inspector
General, Nationwide Survey of HUD's Office of Housing Section 232
Nursing Home Program, 2002-KC-0002 (Kansas City, Missouri, 2002).
[44] These studies include: FHA, Review of HUD Disposition and Asset
Management Practices (Draft), May 12, 2004; Proposed Benchmark Report
Containing Per Unit Multifamily Expense and Revenue Data for 75 MSAs,
(Draft), Aug. 2, 2004; Effect of Rising Insurance Costs on FHA-Insured
Multifamily Mortgages (Draft), Mar. 16, 2004; and Analysis of FHA
Endorsed Mortgages Presented for Claim in FY 2003 (Draft), May 14,
2004.
[45] Receivables are the value of services billed to third-party payors
that have yet to be received. An example of receivables is the value of
Medicare services billed to the federal government that have not yet
been reimbursed.
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