Federal Housing Administration
Proposed Reforms Will Heighten the Need for Continued Improvements in Managing Risks and Estimating Program Costs Gao ID: GAO-06-868T June 20, 2006The Department of Housing and Urban Development's (HUD) Federal Housing Administration (FHA) has faced several challenges in recent years, including rising default rates, higher-than-expected program costs, and a sharp decline in program participation. To help FHA adapt to market changes, HUD has proposed a number of changes to the National Housing Act that would raise FHA's mortgage limits, allow greater flexibility in setting insurance premiums, and reduce down-payment requirements. Implementing the proposed reforms would require FHA to manage new risks and estimate the costs of program changes. To assist Congress in considering issues faced by FHA, this testimony provides information from recent reports GAO has issued that address FHA's risk management and cost estimates. Specifically, this testimony looks at (1) FHA's development and use of its mortgage scorecard, (2) FHA's consistent underestimation of program costs, (3) instructive practices for managing risks of new mortgage products, and (4) weaknesses in FHA's management of risks related to loans with down-payment assistance.
Recent trends in mortgage lending have significantly affected FHA, including increased use of automated tools (e.g., mortgage scoring) to underwrite loans, increased competition from lenders offering low-and no-down-payment products, and a growing proportion of FHA-insured loans with down-payment assistance. Although FHA has taken steps to improve its risk management, in a series of recent reports, GAO identified a number of weaknesses in FHA's ability to manage risk and estimate program costs during this period of change. The way that FHA developed and uses its mortgage scorecard, while generally reasonable, limits how effectively it assesses the default risk of borrowers. With one exception, FHA's reestimates of program costs have been less favorable than originally estimated, including a $7 billion reestimate for fiscal year 2003. FHA has not consistently implemented practices used by other mortgage institutions to help manage the risks associated with new mortgage products. FHA has not developed sufficient standards and controls to manage risks associated with insuring a growing proportion of loans with down-payment assistance. GAO made several recommendations in its recent reports, including that FHA (1) incorporate the risks posed by down-payment assistance into its mortgage scorecard, (2) study and report on the impact of variables not in its loan performance models that have been found to influence credit risk, and (3) consider piloting new mortgage products. FHA has taken actions in response to GAO's recommendations, but additional improvements in managing risk and estimating program costs will be important if FHA is to successfully implement its proposed program changes.
GAO-06-868T, Federal Housing Administration: Proposed Reforms Will Heighten the Need for Continued Improvements in Managing Risks and Estimating Program Costs
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Testimony:
Before the Subcommittee on Housing and Transportation, Committee on
Banking, Housing, and Urban Affairs, United States Senate:
United States Government Accountability Office:
GAO:
For Release on Delivery Expected at 2:30 p.m. EDT:
Tuesday, June 20, 2006:
Federal Housing Administration:
Proposed Reforms Will Heighten the Need for Continued Improvements in
Managing Risks and Estimating Program Costs:
Statement of William B. Shear, Director:
Financial Markets and Community Investment:
GAO-06-868T:
GAO Highlights:
Highlights of GAO-06-868T, a testimony before the Subcommittee on
Housing and Transportation, Committee on Banking, Housing, and Urban
Affairs, United States Senate.
Why GAO Did This Study:
The Department of Housing and Urban Development‘s (HUD) Federal Housing
Administration (FHA) has faced several challenges in recent years,
including rising default rates, higher-than-expected program costs, and
a sharp decline in program participation. To help FHA adapt to market
changes, HUD has proposed a number of changes to the National Housing
Act that would raise FHA‘s mortgage limits, allow greater flexibility
in setting insurance premiums, and reduce down-payment requirements.
Implementing the proposed reforms would require FHA to manage new risks
and estimate the costs of program changes. To assist Congress in
considering issues faced by FHA, this testimony provides information
from recent reports GAO has issued that address FHA‘s risk management
and cost estimates. Specifically, this testimony looks at (1) FHA‘s
development and use of its mortgage scorecard, (2) FHA‘s consistent
underestimation of program costs, (3) instructive practices for
managing risks of new mortgage products, and (4) weaknesses in FHA‘s
management of risks related to loans with down-payment assistance.
What GAO Found:
Recent trends in mortgage lending have significantly affected FHA,
including increased use of automated tools (e.g., mortgage scoring) to
underwrite loans, increased competition from lenders offering low-and
no-down-payment products, and a growing proportion of FHA-insured loans
with down-payment assistance. Although FHA has taken steps to improve
its risk management, in a series of recent reports, GAO identified a
number of weaknesses in FHA‘s ability to manage risk and estimate
program costs during this period of change. For example:
* The way that FHA developed and uses its mortgage scorecard, while
generally reasonable, limits how effectively it assesses the default
risk of borrowers.
* With one exception, FHA‘s reestimates of program costs have been less
favorable than originally estimated, including a $7 billion reestimate
for fiscal year 2003.
* FHA has not consistently implemented practices used by other mortgage
institutions to help manage the risks associated with new mortgage
products.
* FHA has not developed sufficient standards and controls to manage
risks associated with insuring a growing proportion of loans with down-
payment assistance.
GAO made several recommendations in its recent reports, including that
FHA (1) incorporate the risks posed by down-payment assistance into its
mortgage scorecard, (2) study and report on the impact of variables not
in its loan performance models that have been found to influence credit
risk, and (3) consider piloting new mortgage products. FHA has taken
actions in response to GAO‘s recommendations, but additional
improvements in managing risk and estimating program costs will be
important if FHA is to successfully implement its proposed program
changes.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-06-868T].
To view the full product, including the scope and methodology, click on
the link above. For more information, contact William B. Shear at (202)
512-8678 or shearw@gao.gov
[End of Section]
Mr. Chairman and Members of the Subcommittee:
I am pleased to have the opportunity to share information and
perspectives with the committee as it considers issues facing the
Department of Housing and Urban Development's (HUD) Federal Housing
Administration (FHA). FHA provides insurance for single-family home
mortgages made by private lenders and in fiscal year 2005 insured about
480,000 mortgages, representing $58 billion in mortgage insurance. The
insurance program is supported by the Mutual Mortgage Insurance Fund
(Fund), which is financed through insurance premiums that FHA charges
to borrowers. According to HUD's estimates, FHA's mortgage insurance
program is currently a negative subsidy program, meaning that the Fund
is self-financed and currently operates at a profit. However, the
program has faced several challenges in recent years, including rising
default rates, higher-than-expected program costs, and a sharp decline
in program participation due, in part, to increased competition from
conventional mortgage providers.
To help FHA adapt to market changes, HUD has proposed a number of
changes to the National Housing Act that would, among other things,
raise FHA's maximum mortgage limits, give the agency flexibility to set
insurance premiums based on the credit risk of borrowers, and reduce
down-payment requirements from the current 3 percent to potentially
zero. However, to implement this legislative proposal, FHA would have
to manage new risks and accurately estimate the costs of program
changes. For example, to set risk-based insurance premiums, FHA would
need to understand the relationships between borrower and loan
characteristics and the likelihood of default, as well as how the
premiums would affect the Fund's financial condition. Further, reducing
the down-payment requirements for certain borrowers (and thus
increasing the loan-to-value ratios) has important implications for the
risks of these loans. Loans with low or no down payments carry greater
risk, partly because the higher the loan-to-value ratio, the less cash
borrowers will have invested in their homes and the more likely that
they may default on mortgage obligations, especially during times of
economic hardship.[Footnote 1]
My testimony today discusses four reports that we issued since 2005
that examined different aspects of FHA's ability to manage risks and
estimate program costs. Specifically, I will discuss (1) FHA's
development and use of a mortgage scorecard to assess the default risk
of borrowers, (2) FHA's consistent underestimation of subsidy costs for
its single-family insurance program and particularly large subsidy
reestimate for fiscal year 2003, (3) practices that could be
instructive for FHA in managing the risks of new mortgage products, and
(4) weaknesses in how FHA has managed risks associated with growth in
the proportion of loans with down-payment assistance.
In preparing these reports, we reviewed and analyzed information
concerning FHA's approach to developing its mortgage scorecard and the
scorecard's benefits and limitations; FHA's estimates of subsidy costs
and the factors underlying the agency's subsidy reestimates; steps
mortgage industry participants take to design and implement low-and no-
down-payment mortgage products; and the standards and controls FHA uses
to manage the risks of loans with down-payment assistance. We
interviewed officials at FHA, the U.S. Department of Agriculture, and
U.S. Department of Veteran Affairs (VA); and staff at selected mortgage
providers, private mortgage insurers; Fannie Mae and Freddie Mac; the
Office of Federal Housing Enterprise Oversight; selected state housing
finance agencies; and nonprofit down-payment assistance providers. We
conducted this work in Boston, Massachusetts, and Washington, D.C.,
from January 2004 through February 2006 in accordance with generally
accepted government auditing standards.
In summary, our past work identified a number of weaknesses in FHA's
ability to manage risk and estimate program costs:
* While generally reasonable, the way that FHA developed and uses its
mortgage scorecard--an automated tool that evaluates the default risk
of borrowers--limits the scorecard's effectiveness. FHA and its
contractor used variables that reflected borrower and loan
characteristics to create the scorecard, as well as an accepted
modeling process to test the variables' accuracy in predicting default.
However, the data used to develop the scorecard were 12 years old by
the time that FHA began using the scorecard in 2004, and the mortgage
market has changed significantly since then. In addition, the scorecard
does not include certain key variables that could help explain expected
loan performance such as the source of the down payment.
* FHA's subsidy reestimates reflect a consistent underestimation of the
costs of its single-family insurance program. For example, as of the
end of fiscal year 2003, FHA submitted a $7 billion reestimate for the
Fund, reflecting a reduction in estimated profits. Increases in the
expected level of insurance claims--potentially stemming from changes
in underwriting guidelines, among other factors--were a major cause of
the $7 billion reestimate.
* Some of the practices of other mortgage institutions offer a
framework that could help FHA manage the risks associated with new
products such as no-down-payment mortgages. For example, mortgage
institutions may limit the volume of new products issued--that is,
pilot a product--and sometimes require stricter underwriting on these
products. While FHA has utilized pilots or demonstrations when making
changes to its single-family mortgage insurance, it generally has done
so in response to a legislative requirement and not on its own
initiative. Moreover, FHA officials have questioned the circumstances
under which pilot programs were needed and also said that they lacked
sufficient resources to appropriately manage a pilot.
* FHA has not developed sufficient standards and controls to manage
risks associated with the growing proportion of loans with down-payment
assistance. Unlike other mortgage industry participants, FHA does not
restrict homebuyers' use of down-payment assistance from nonprofit
organizations that receive part of their funding from home sellers.
However, our analysis of a national sample of FHA-insured loans found
that the probability that loans with seller-funded nonprofit down-
payment assistance would result in an insurance claim was 76 percent
higher than comparable loans without such assistance.
On the basis of our findings from the four reports I have summarized,
we made several recommendations designed to improve FHA's risk
management and cost estimates. For example, to improve its assessment
of borrowers' default risk, we recommended that FHA develop policies
for updating the scorecard, incorporate the risks posed by down-payment
assistance into the scorecard, and explore additional uses for this
tool.
To more reliably estimate subsidy costs, we recommended that FHA study
and report in the annual actuarial review of the Fund the impact of
variables not in the agency's loan performance models (used in
estimating subsidy costs) that have been found in other studies to
influence credit risk.[Footnote 2] In light of the risks that new
mortgage products present and in recognition of established risk
management practices, we also suggested that Congress consider (1)
limiting the initial availability of any new single-family insurance
product it might authorize and (2) directing FHA to consider using
various techniques for mitigating risks for a no-down-payment product,
or products about which the risks were not well understood.
FHA has taken actions in response to some of our recommendations. For
example, FHA agreed to consider incorporating a variable for down-
payment assistance in its mortgage scorecard. To more accurately assess
subsidy costs, an FHA contractor is considering the specific variables
that we recommended FHA include in its annual actuarial review and
incorporated the source of down payment in the 2005 actuarial review of
the Fund. FHA also has agreed to improve its oversight of down-payment
assistance lending, including modifying its information systems to
document assistance from seller-funded nonprofits.
While these actions represent improvements in FHA's risk management,
additional improvements will be important if FHA is to successfully
implement some of the program changes HUD has proposed. Accordingly,
consideration of this proposal should include serious deliberation of
the associated risks and the capacity of FHA to mitigate them.
Background:
Congress established FHA in 1934 under the National Housing Act (P.L.
73-479) to broaden homeownership, shore up and protect lending
institutions, and stimulate employment in the building industry. FHA's
single-family program insures private lenders against losses (up to
almost 100 percent of the loan amount) from borrower defaults on
mortgages that meet FHA criteria. In 2004, more than three-quarters of
the loans that FHA insured went to first-time homebuyers, and more than
one-third of these loans went to minorities. From 2001 through 2005,
FHA insured about 5 million mortgages with a total value of about $590
billion. However, FHA's loan volume fell sharply over that period, and
in 2005 FHA-insured loans accounted for less than 4 percent of the
single-family mortgage market, compared with about 13 percent a decade
ago. Additionally, default rates for FHA-insured mortgages have risen
steeply over the past several years, a period during which home prices
have appreciated rapidly and default rates for conventional and VA-
guaranteed mortgages have been relatively stable.
FHA determines the expected cost of its insurance program, known as the
credit subsidy cost, by estimating the program's future
performance.[Footnote 3] Similar to other agencies, FHA is required to
reestimate credit subsidy costs annually to reflect actual loan
performance and expected changes in estimates of future loan
performance. FHA's mortgage insurance program is currently a negative
subsidy program, meaning that the present value of estimated cash
inflows to the Fund exceed the present value of estimated cash
outflows. FHA has estimated that the loans it expects to insure in 2007
will have a subsidy rate of -0.37, a rate closer to zero (the point at
which estimated cash inflows equal estimated cash outflows) than any
previous estimate. The economic value, or net worth, of the Fund that
supports FHA's insurance depends on the relative size of cash outflows
and inflows over time. Cash flows out of the Fund for payments
associated with claims on defaulted loans and refunds of up-front
premiums on prepaid mortgages. To cover these outflows, FHA receives
cash inflows from borrowers' insurance premiums and net proceeds from
recoveries on defaulted loans. If the Fund were to be exhausted, the
U.S. Treasury would have to cover lenders' claims directly.
Two major trends in the conventional mortgage market have significantly
affected FHA.[Footnote 4] First, in recent years, members of the
conventional mortgage market (such as private mortgage insurers, Fannie
Mae, and Freddie Mac) increasingly have been active in supporting low-
and even no-down-payment mortgages, increasing consumer choices for
borrowers who may have previously chosen an FHA-insured loan. Second,
to help assess the default risk of borrowers, particularly those with
high loan-to-value ratios, the mortgage industry has increasingly used
mortgage scoring and automated underwriting systems.[Footnote 5]
Mortgage scoring is a technology-based tool that relies on the
statistical analysis of millions of previously originated mortgage
loans to determine how key attributes such as the borrower's credit
history, property characteristics, and terms of the mortgage affect
future loan performance. As a result of such tools, the mortgage
industry is able to process loan applications more quickly and
consistently than in the past. In 2004, FHA implemented a mortgage
scoring tool, called the FHA Technology Open to Approved Lenders
(TOTAL) Scorecard, to be used in conjunction with existing automated
underwriting systems.
HUD's legislative proposal is intended to modernize FHA, in part, to
respond to the changes in the mortgage market. The proposal, among
other things, would authorize FHA to change the way it sets insurance
premiums, insure larger loans, and reduce down-payment requirements.
The proposed legislation would enable FHA to depart from its current,
essentially flat, premium structure and charge a wider range of
premiums based on individual borrowers' risk of default. Currently, FHA
also requires homebuyers to make a 3 percent contribution toward the
purchase of a property. HUD's proposal would eliminate this
contribution requirement and enable FHA to offer some borrowers a no-
down-payment product. FHA is subject to limits in the size of the loans
it can insure. For example, for a one-family property in a high-cost
area, the FHA limit is 87 percent of the limit established by Freddie
Mac. The legislative proposal would raise this limit to 100 percent of
the Freddie Mac limit.
The Way FHA Developed and Uses TOTAL Limits the Scorecard's
Effectiveness in Assessing the Default Risk of Borrowers:
If Congress authorizes the reforms HUD has proposed, FHA's ability to
assess the default risk of borrowers will take on increased importance
because FHA would be adjusting insurance premiums based on its
assessments of the credit risk of borrowers and insure potentially
larger and riskier mortgages with low or no down payments. A primary
tool that FHA uses to assess the default risk of borrowers who apply
for FHA-insured mortgages is its TOTAL scorecard.
Age of Data, Lack of Key Variables, and Lack of Policy for Updating
TOTAL Could Limit Its Effectiveness:
In reports we issued in November 2005 and April 2006, we noted that
while FHA's process for developing TOTAL generally was reasonable, some
of the choices FHA made in the development process could limit the
scorecard's effectiveness.[Footnote 6] FHA and its contractor used
variables that reflected borrower and loan characteristics to create
TOTAL, as well as an accepted modeling process to test the variables'
accuracy in predicting default. However, we also found that:
* The data used to develop TOTAL were 12 years old by the time FHA
implemented the scorecard. Specifically, when FHA began developing
TOTAL in 1998, the agency chose to use 1992 loan data, which would be
old enough to provide a sufficient number of defaults that could be
attributed to a borrower's poor creditworthiness. However, FHA did not
implement TOTAL until 2004 and has not subsequently updated the data
used in the scorecard. Best practices of private-sector organizations
call for scorecards to be based on data that are representative of the
current mortgage market--specifically, relevant data that are no more
than several years old. In the past 12 years, significant changes--
growth in the use of down-payment assistance, for example--have
occurred in the mortgage market that have affected the characteristics
of those applying for FHA-insured loans. As a result, the relationships
between borrower and loan characteristics and the likelihood of default
also may have changed.
* TOTAL does not include certain key variables that could help explain
expected loan performance. For example, TOTAL does not include a
variable for the source of the down payment. However, FHA contractors,
HUD's Inspector General, and our work have all identified the source of
a down payment as an important indicator of risk, and the use of down-
payment assistance in the FHA program has grown rapidly over the last 5
years. Further, TOTAL does not include other important variables--such
as a variable for generally riskier adjustable rate loans--included in
other scorecards used by private-sector entities.
* Although FHA has a contract to update TOTAL by 2007, the agency did
not develop a formal plan for updating TOTAL on a regular basis. Best
practices in the private sector and reflected in bank regulator
guidance call for having formal policies to ensure that scorecards are
routinely updated. Without policies and procedures for routinely
updating TOTAL, the scorecard may become less reliable and, therefore,
less effective at predicting the likelihood of default.
To improve TOTAL's effectiveness, we recommended, among other things,
that HUD develop policies and procedures for regularly updating TOTAL
and more fully consider the risks posed by down-payment assistance when
underwriting loans by including the presence and source of down-payment
assistance as a loan variable in the scorecard. In response, FHA agreed
to consider incorporating a variable for down-payment assistance in
TOTAL.
HUD Could Realize Additional Benefits from an Expanded Use of TOTAL:
Despite potential limitations in the use of TOTAL, HUD still could
realize additional benefits from the scorecard, if, like private-sector
lenders and mortgage insurers, it put TOTAL to other uses. Based on its
current use of TOTAL, FHA lenders and borrowers have seen two added
benefits--less paperwork and more consistent underwriting decisions.
However, private lenders and mortgage insurers put their scorecards to
other uses, including to help price products based on risk and launch
new products. For example, to set risk-based prices, private-sector
organizations use scorecards to rank the relative risk of borrowers and
price products according to that ranking. By increasing their use of
scorecards, these organizations are able to broaden their customer base
and improve their financial performance. Adopting these best practices
from the private sector could generate similar kinds of benefits for
FHA, particularly if FHA were to implement risk-based pricing.
To the extent that conventional mortgage lenders and insurers are
better able than FHA to use mortgage scoring to identify and approve
relatively low-risk borrowers and charge fees based on default risk,
FHA may face adverse selection--that is, conventional providers may
approve lower-risk borrowers in FHA's traditional market segment,
leaving relatively high-risk borrowers for FHA. Accordingly, the
greater the effectiveness of TOTAL, the greater the likelihood that FHA
will be able to effectively manage the risks posed by borrowers seeking
FHA-insured loans.
To improve how FHA benefits from TOTAL, we recommended that the agency
explore additional uses for the scorecard, including using it to
implement risk-based pricing of mortgage insurance and to develop new
products. These actions could enhance FHA's ability to effectively
compete in the mortgage market. In response to our recommendations, FHA
indicated that it planned to explore these uses for TOTAL.
FHA's Reestimates Reflect Consistent Underestimation of Program Costs,
Primarily Because of Higher Claims than Initially Estimated:
If implemented, HUD's legislative proposal could affect the Fund's cash
inflows and outflows and, as a result, significantly affect the credit
subsidy costs of the insurance program. For example, changes in FHA's
insurance premiums could affect the revenues FHA receives, and changes
in the composition and riskiness of the loan portfolio (as a result of
larger loans or more loans with no down payments) could affect the size
and number of insurance claims FHA pays.
As previously noted, FHA, like other federal agencies, is required to
reestimate credit subsidy costs annually to reflect actual loan
performance and expected changes in estimates of future loan
performance. FHA has estimated negative credit subsidies for the Fund
since 1992, when federal credit reform became effective. However, as we
reported in September 2005, with the exception of the 1992 reestimate,
FHA's subsidy reestimates have been less favorable than the original
estimates.[Footnote 7] In particular, FHA's $7 billion reestimate for
fiscal year 2003 was more than twice the size of any other reestimate
from fiscal years 2000 through 2004.
The $7 billion reestimate for fiscal year 2003 had three main
components. The first component was the $3.9 billion difference between
FHA's fiscal year 2003 estimates of the net present value of future
cash flows and the estimates it made one year earlier. Most of this
difference stemmed from changes in FHA's estimates of claims and, to a
lesser extent, prepayments (the payment of a loan before its maturity
date). That is, FHA changed its estimate of future loan performance
based on its observation of actual loan performance during fiscal year
2003 and revised economic assumptions. The second component was the
$2.1 billion difference between estimated and actual cash flows
occurring during fiscal year 2003. Underestimation of claims (net of
recoveries on claims) and an overestimation of net fees (insurance
premium receipts less premium refunds) for loans made prior to fiscal
year 2003 largely account for the difference. The third component was
an interest adjustment on the reestimate required by Office of
Management and Budget guidance that increased the total reestimate by
$1.1 billion.
Several recent policy changes and trends may have contributed to
changes in the expected claims underlying the $7 billion reestimate.
For example:
* Revised underwriting guidelines made it easier for borrowers who are
more susceptible to changes in economic conditions--and therefore more
likely to default on their mortgages--to obtain an FHA-insured loan.
* Competition from conventional mortgage providers could have resulted
in FHA insuring more risky borrowers.
* FHA insured an increasing number of loans with down-payment
assistance, which generally have a greater risk of default.
* FHA's loan performance models did not include key variables that help
estimate loan performance, such as credit scores, and as of September
2005, the source of down payment.
The major factors underlying the surge in prepayment activity that also
contributed to the reestimate were declining interest rates and rapid
appreciation of housing prices. These trends created incentives and
opportunities for borrowers to refinance using conventional loans.
To more reliably estimate program costs, we recommended that FHA study
and report on how variables found to influence credit risk, such as
payment-to-income ratios, credit scores, and down-payment assistance
would affect the forecasting ability of its loan performance models. We
also recommended that when changing the definitions of key variables,
FHA report the impact of such changes on the models' forecasting
ability. In response, FHA indicated, among other things, that its
contractor was considering the specific variables that we had
recommended FHA include in its annual actuarial review and had
incorporated the source of down-payment assistance in the 2005
actuarial review of the Fund.
Practices Used by Other Mortgage Institutions Could Help FHA Manage
Risks from Low-or No-Down-Payment Products:
If Congress authorized FHA to insure mortgages with smaller or no down
payments, practices used by other mortgage institutions could help FHA
to design and implement these new products. In a February 2005 report,
we identified steps that mortgage institutions take when introducing
new products.[Footnote 8] Specifically, mortgage institutions often
utilize special requirements when introducing new products, such as
requiring additional credit enhancements (mechanisms for transferring
risk from one party to another) or implementing stricter underwriting
requirements, and limiting how widely they make available a new
product.
Mortgage Institutions Require Additional Credit Enhancements, Stricter
Underwriting, and Higher Premiums for Low-and No-Down-Payment Products:
Some mortgage institutions require additional credit enhancements on
low-and no-down-payment products, which generally are riskier because
they have higher loan-to-value ratios than loans with larger down
payments. For example, Fannie Mae and Freddie Mac mitigate the risk of
low-and no-down-payment products by requiring additional credit
enhancements such as higher mortgage insurance coverage. Although FHA
is required to provide up to 100 percent coverage of the loans it
insures, FHA may engage in co-insurance of its single-family loans.
Under co-insurance, FHA could require lenders to share in the risks of
insuring mortgages by assuming some percentage of the losses on the
loans that they originated (lenders would generally use private
mortgage insurance for risk sharing).
Mortgage institutions also can mitigate the risk of low-and no-down-
payment products through stricter underwriting. Institutions can do
this in a number of ways, including requiring a higher credit score
threshold for certain products, requiring greater borrower reserves, or
requiring more documentation of income or assets from the borrower.
Although the changes FHA could make are limited by statutory standards,
it could benefit from similar approaches. The HUD Secretary has
latitude within statutory limitations to change underwriting
requirements for new and existing products and has done so many times.
For example, FHA expanded its definition of what could be included as
borrower's effective income when calculating payment-to-income ratios.
However, FHA officials told us that they were unlikely to mandate a
credit score threshold or borrower reserve requirements for a no-down-
payment product because the product was intended to serve borrowers who
are underserved by the conventional market, including those who lack
credit scores and have little wealth or personal savings.
Finally, mortgage institutions can increase fees or charge higher
premiums to help offset the potential costs of products that are
believed to have greater risk. For example, Fannie Mae officials stated
that they would charge higher guarantee fees on low-and no-down-payment
loans if they were not able to require higher insurance
coverage.[Footnote 9] FHA, if authorized to implement risk-based
pricing, could set higher premiums on FHA-insured loans understood to
have greater risk.
We recommended that if FHA implemented a no-down-payment mortgage
product or other new products about which the risks were not well
understood, the agency should (1) consider incorporating stricter
underwriting criteria such as appropriate credit score thresholds or
borrower reserve requirements and (2) utilize other techniques for
mitigating risks, including the use of credit enhancements. In
response, FHA said it agreed that these techniques should be evaluated
when considering or proposing a new FHA product.
Before Fully Implementing New Products, Some Mortgage Institutions May
Limit Availability:
Some mortgage institutions initially may offer new products on a
limited basis. For example, Fannie Mae and Freddie Mac sometimes use
pilots, or limited offerings of new products, to build experience with
a new product type. Fannie Mae and Freddie Mac also sometimes set
volume limits for the percentage of their business that could be low-
and no-down-payment lending. FHA has utilized pilots or demonstrations
when making changes to its single-family mortgage insurance but
generally has done so in response to legislative requirement rather
than on its own initiative. For example, FHA's Home Equity Conversion
Mortgage insurance program started as a pilot that authorized FHA to
insure 2,500 reverse mortgages.[Footnote 10] Additionally, some
mortgage institutions may limit the origination and servicing of new
products to their better lenders and servicers. Fannie Mae and Freddie
Mac both reported that these were important steps in introducing a new
product.
We recommended that when FHA releases new products or makes significant
changes to existing products, it consider similar steps to limit the
initial availability of these products. FHA officials agreed that they
could, under certain circumstances, envision piloting or limiting the
ways in which a new product would be available, but pointed to the
practical limitations of doing so. For example, FHA officials told us
that administering the Home Equity Conversion Mortgage pilot program
was difficult because of the challenges of equitably selecting a
limited number of lenders and borrowers. FHA generally offers products
on a national basis and, if they did not, specific regions of the
county or lenders might question why they were not able to receive the
same benefit. FHA officials told us they have conducted pilot programs
when Congress has authorized them, but they questioned the
circumstances under which pilot programs were needed, and also said
that they lacked sufficient resources to appropriately manage a pilot.
However, if FHA does not limit the availability of new or changed
products, the agency runs the risk of facing higher claims from
products whose risks may not be well understood.
FHA Has Not Implemented Sufficient Standards and Controls to Manage
Risks Associated with the Growing Proportion of Loans with Down-Payment
Assistance:
HUD's legislative proposal would represent a significant change to the
agency's single-family mortgage insurance program and presents new risk
management challenges. In our November 2005 report examining FHA's
actions to manage the new risks associated with the growing proportion
of loans with down-payment assistance, we found that the agency did not
implement sufficient standards and controls to manage the risks posed
by these loans.[Footnote 11]
The Percentage of Loans with Down-Payment Assistance in FHA's Portfolio
Has Been Increasing and These Loans Do Not Perform as Well as Similar
Loans without Assistance:
Homebuyers who receive FHA-insured mortgages often have limited funds
and, to meet the 3 percent borrower investment FHA currently requires,
may obtain down-payment assistance from a third party, such as a
relative or a charitable organization (nonprofit) that is funded by
property sellers. The proportion of FHA-insured loans that are financed
in part by down-payment assistance from various sources has increased
substantially in the last few years, while the overall number of loans
that FHA insures has fallen dramatically. Money from nonprofits funded
by seller contributions has accounted for a growing percentage of that
assistance. From 2000 to 2004, the total proportion of FHA-insured
purchase loans that had a loan-to-value ratio greater than 95 percent
and that also involved down-payment assistance, from any source, grew
from 35 to nearly 50 percent. Approximately 6 percent of FHA-insured
purchase loans in 2000 received down-payment assistance from nonprofits
(the large majority of which were funded by property sellers), but by
2004 nonprofit assistance grew to about 30 percent.
We and others have found that loans with down-payment assistance do not
perform as well as loans without down-payment assistance. We analyzed
loan performance by source of down-payment assistance, using two
samples of FHA-insured purchase loans from 2000, 2001, and 2002--a
national sample and a sample from three Metropolitan Statistical Areas
(MSA) with high rates of down-payment assistance.[Footnote 12] Holding
other variables constant, our analysis indicated that FHA-insured loans
with down-payment assistance had higher delinquency and claim rates
than similar loans without such assistance. For example, we found that
the probability that loans with nonseller-funded sources of down-
payment assistance would result in insurance claims was 49 percent
higher in the national sample and 45 percent higher in the MSA sample
than it was for comparable loans without assistance. Similarly, the
probability that loans with nonprofit seller-funded, down-payment
assistance would result in insurance claims was 76 percent higher in
the national sample and 166 percent higher in the MSA sample than it
was for comparable loans without assistance. The poorer performance of
loans with nonprofit seller-funded, down-payment assistance may be
explained, in part, by the sales prices of the homes bought with such
assistance. More specifically, our analysis indicated that FHA-insured
homes bought with seller-funded nonprofit assistance were appraised and
sold for about 2 to 3 percent more than comparable homes bought without
such assistance. The difference in performance also may be partially
explained by the homebuyer having less equity in the transaction.
Stricter Standards and Additional Controls Could Help FHA Manage the
Risks Posed by Loans with Down-Payment Assistance:
FHA has implemented some standards and internal controls to manage the
risks associated with loans with down-payment assistance, but stricter
standards and additional controls could help FHA better manage risks
posed by these loans while meeting its mission of expanding
homeownership opportunities. Like other mortgage industry participants,
FHA generally applies the same underwriting standards to loans with
down-payment assistance that it applies to loans without such
assistance. One important exception is that FHA, unlike others, does
not limit the use of down-payment assistance from seller-funded
nonprofits. Some mortgage industry participants view assistance from
seller-funded nonprofits as a seller inducement to the sale and,
therefore, either restrict or prohibit its use. FHA has not viewed such
assistance as a seller inducement and, therefore, does not subject this
assistance to the limits it otherwise places on contributions from
sellers. However, due in part to concerns about loans with nonprofit
seller-funded, down-payment assistance, FHA has proposed legislation
that could help eliminate the need for such assistance by allowing some
FHA borrowers to make no down payments for an FHA-insured loan.
FHA has taken some steps to assess and manage the risks associated with
loans with down-payment assistance, but additional controls may be
warranted. For example, FHA has contracted for two studies to assess
the use of such assistance with FHA-insured loans and conducted ad hoc
performance analyses of loans with down-payment assistance but has not
routinely assessed the impact that the widespread use of down-payment
assistance has had on loan performance. Also, FHA has targeted its
monitoring of appraisers to those that do a high volume of loans with
down-payment assistance, but FHA has not targeted its monitoring of
lenders to those that do a high volume of loans with down-payment
assistance, even though FHA holds lenders, as well as appraisers,
accountable for ensuring a fair valuation of the property it insures.
Our report made several recommendations designed to better manage the
risks of loans with down-payment assistance generally, and more
specifically from seller-funded nonprofits. Overall, we recommended
that in considering the costs and benefits of its policy permitting
down-payment assistance, FHA also consider risk-mitigation techniques
such as including down-payment assistance as a factor when underwriting
loans or more closely monitoring loans with such assistance. For down-
payment assistance providers that receive funding from property
sellers, we recommended that FHA take additional steps to mitigate the
risks of these loans, such as treating such assistance as a seller
contribution and, therefore, subject to existing limits on seller
contributions. In response, FHA agreed to improve its oversight of down-
payment assistance lending by (1) modifying its information systems to
document assistance from seller-funded nonprofits and (2) requiring
lenders to inform appraisers when assistance is provided by seller-
funded nonprofits. In addition, HUD has proposed a zero down- payment
program as an alternative to seller-funded, down-payment assistance.
In May 2006, the Internal Revenue Service issued a ruling stating that
organizations that provide seller-funded, down-payment assistance to
home buyers do not qualify as tax-exempt charities. FHA permitted these
organizations to provide down-payment assistance because they qualified
as charities. Accordingly, the ruling could significantly reduce the
number of FHA-insured loans with seller-funded down payments.
Observations:
The risks FHA faces in today's mortgage market are growing. For
example, the agency has seen increased competition from conventional
mortgage and insurance providers, many of which offer low-and no-down-
payment products and that may be better able than FHA to identify and
approve relatively low-risk borrowers. Additionally, FHA is insuring a
greater proportion of loans with down-payment assistance. These loans
are more likely to result in insurance claims than loans without such
assistance.
To effectively manage the risks posed by FHA's existing products, we
have concluded from our prior work that the agency must significantly
improve its risk management and cost estimation practices. We are
encouraged by a variety of steps FHA has taken to enhance its
capabilities in these areas, such as developing and implementing a
mortgage scorecard and improving its loan performance models. However,
FHA needs to take additional steps, such as establishing policies and
procedures for updating TOTAL scorecard on a regular basis, more fully
considering the risks posed by down-payment assistance when
underwriting loans, developing a framework for introducing new products
in a way that mitigates risk, and studying and reporting on the impact
of variables found to influence credit risk that are not currently in
the agency's loan performance models.
HUD's legislative proposal could help FHA serve more low-income and
first-time homebuyers, but also would introduce additional risks to the
Fund. Consideration of this proposal should include serious
deliberation of the associated risks and the capacity of FHA to
mitigate them.
Mr. Chairman, this concludes my prepared statement. I would be happy to
answer any questions at this time.
Contacts and Acknowledgments:
For further information on this testimony, please contact William B.
Shear at (202) 512-8678. Individuals making key contributions to this
testimony included Triana Bash, Anne Cangi, Marcia Carlsen, John
Fisher, Austin Kelly, John McGrail, Andrew Pauline, Barbara Roesmann,
Mathew Scirč, Katherine Trimble, and Steve Westley.
FOOTNOTES
[1] Loan-to-value ratio is the loan amount divided by the sales price
or appraised value of the property.
[2] Since 1990, the National Housing Act has required an annual and
independent actuarial analysis of the economic net worth and soundness
of the Fund. 12 U.S.C. Section 1711 (g).
[3] Pursuant to the Federal Credit Reform Act of 1990, HUD must
annually estimate the credit subsidy cost for its loan insurance
programs. Credit subsidy costs are the net present value of estimated
payments it makes less the estimated amounts it receives, excluding
administrative costs.
[4] Conventional mortgages do not carry government insurance or
guarantees.
[5] Underwriting refers to a risk analysis that uses information
collected during the origination process to decide whether to approve a
loan.
[6] GAO, Mortgage Financing: HUD Could Realize Additional Benefits from
its Mortgage Scorecard, GAO-06-435 (Washington, D.C.: April 13, 2006).
GAO, Mortgage Financing: Additional Action Needed to Manage Risks of
FHA-Insured Loans with Down Payment Assistance, GAO-06-24 (Washington,
D.C.: November 9, 2005).
[7] GAO, Mortgage Financing: FHA's $7 Billion Reestimate Reflects
Higher Claims and Changing Loan Performance Estimates, GAO-05-875
(Washington, D.C.: Sep. 2, 2005).
[8] GAO, Mortgage Financing: Actions Needed to Help FHA Manage Risks
from New Mortgage Loan Products, GAO-05-194 (Washington, D.C.: Feb. 11,
2005).
[9] Fannie Mae and Freddie Mac charge fees for guaranteeing timely
payment on mortgage backed securities they issue. The fees are based,
in part, on the credit risk they face.
[10] Under this program, homeowners borrow against equity in their home
and receive payments from their lenders.
[11] GAO-06-24.
[12] The data (current as of June 30, 2005) consisted of purchase loans
insured by FHA's 203(b) program, its main single-family program, and
its 234(c), condominium program. The three MSAs were Atlanta,
Indianapolis, and Salt Lake City.
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