Federal Housing Administration
Ability to Manage Risks and Program Changes Will Affect Financial Performance Gao ID: GAO-07-615T March 15, 2007The Federal Housing Administration (FHA) has seen increased competition from conventional mortgage and insurance providers. Additionally, because of the worsening performance of the mortgages it insures, FHA has estimated that its single-family insurance program would require a subsidy--that is, appropriations--in fiscal year 2008 in the absence of program changes. To help FHA adapt to the evolving market, proposed changes to the National Housing Act would allow greater flexibility in setting insurance premiums and reduce down-payment requirements. To assist Congress in considering the financial challenges facing FHA, this testimony provides information from recent reports GAO has issued and ongoing work concerning the proposed legislation that address different aspects of FHA's risk management. Specifically, this testimony looks at (1) FHA's management of risk related to loans with down-payment assistance, (2) instructive practices for managing risks of new products, (3) FHA's development and use of its mortgage scorecard, and (4) FHA's estimation of program costs.
Recent trends in mortgage lending have significantly affected FHA, including growth in the proportion of FHA-insured loans with down-payment assistance, wider availability of low- and no-down-payment products, and increased use of automated tools (e.g., mortgage scoring) to underwrite loans. 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 estimate and manage risk that may affect its financial performance. For example, FHA has not developed sufficient standards and controls to manage risks associated with the substantial proportion of loans with down-payment assistance, including assistance from nonprofit organizations funded by home sellers. According to FHA, high claim and loss rates for loans with such assistance were major reasons for the estimated positive subsidy cost (meaning that the present value of estimated cash inflows would be less than the present value of estimated cash outflows) for fiscal year 2008, absent any program changes. FHA has not consistently implemented practices--such as stricter underwriting or piloting--used by other mortgage institutions to help manage the risks associated with new product offerings. Although FHA has indicated that it would impose stricter underwriting standards for a no-down-payment mortgage if the legislative changes were enacted, it does not plan to pilot the product. The way that FHA developed its mortgage scorecard, while generally reasonable, limits how effectively it assesses the default risk of borrowers. With increased competition from conventional mortgage providers, limitations in its scorecard could cause FHA to insure mortgages that are relatively more risky. FHA's reestimates of the costs of its single-family mortgage program have generally been less favorable than originally estimated. Increases in the expected level of claims were a major cause of a particularly large reestimate that FHA submitted as of the end of fiscal year 2003. GAO made several recommendations in its recent reports, including that FHA (1) incorporate the risks posed by down-payment assistance into its 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 products. FHA has taken actions in response to GAO's recommendations, but continued focus on risk management will be necessary for FHA to operate in a financially sound manner in the face of market and program changes.
GAO-07-615T, Federal Housing Administration: Ability to Manage Risks and Program Changes Will Affect Financial Performance
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Testimony Before the Subcommittee on Transportation, Housing, and Urban
Development, and Related Agencies, Committee on Appropriations, United
States Senate:
United States Government Accountability Office:
GAO:
For Release on Delivery Expected at 9:30 a.m. EDT Thursday, March 15,
2007:
Federal Housing Administration:
Ability to Manage Risks and Program Changes Will Affect Financial
Performance:
Statement of William B. Shear, Director:
Financial Markets and Community Investment:
GAO-07-615T:
GAO Highlights:
Highlights of GAO-07-615T, a testimony before the Subcommittee on
Transportation, Housing and Urban Development, and Related Agencies,
Committee on Appropriations, U.S. Senate
Why GAO Did This Study:
The Federal Housing Administration (FHA) has seen increased competition
from conventional mortgage and insurance providers. Additionally,
because of the worsening performance of the mortgages it insures, FHA
has estimated that its single-family insurance program would require a
subsidy”that is, appropriations”in fiscal year 2008 in the absence of
program changes. To help FHA adapt to the evolving market, proposed
changes to the National Housing Act would allow greater flexibility in
setting insurance premiums and reduce down-payment requirements. To
assist Congress in considering the financial challenges facing FHA,
this testimony provides information from recent reports GAO has issued
and ongoing work concerning the proposed legislation that address
different aspects of FHA‘s risk management. Specifically, this
testimony looks at (1) FHA‘s management of risk related to loans with
down-payment assistance, (2) instructive practices for managing risks
of new products, (3) FHA‘s development and use of its mortgage
scorecard, and (4) FHA‘s estimation of program costs.
What GAO Found:
Recent trends in mortgage lending have significantly affected FHA,
including growth in the proportion of FHA-insured loans with down-
payment assistance, wider availability of low- and no-down-payment
products, and increased use of automated tools (e.g., mortgage scoring)
to underwrite loans. 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 estimate and manage risk that may affect
its financial performance. For example:
* FHA has not developed sufficient standards and controls to manage
risks associated with the substantial proportion of loans with down-
payment assistance, including assistance from nonprofit organizations
funded by home sellers. According to FHA, high claim and loss rates for
loans with such assistance were major reasons for the estimated
positive subsidy cost (meaning that the present value of estimated cash
inflows would be less than the present value of estimated cash
outflows) for fiscal year 2008, absent any program changes.
* FHA has not consistently implemented practices”such as stricter
underwriting or piloting”used by other mortgage institutions to help
manage the risks associated with new product offerings. Although FHA
has indicated that it would impose stricter underwriting standards for
a no-down-payment mortgage if the legislative changes were enacted, it
does not plan to pilot the product.
* The way that FHA developed its mortgage scorecard, while generally
reasonable, limits how effectively it assesses the default risk of
borrowers. With increased competition from conventional mortgage
providers, limitations in its scorecard could cause FHA to insure
mortgages that are relatively more risky.
* FHA‘s reestimates of the costs of its single-family mortgage program
have generally been less favorable than originally estimated. Increases
in the expected level of claims were a major cause of a particularly
large reestimate that FHA submitted as of the end of fiscal year 2003.
GAO made several recommendations in its recent reports, including that
FHA (1) incorporate the risks posed by down-payment assistance into its
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 products. FHA has taken actions in
response to GAO‘s recommendations, but continued focus on risk
management will be necessary for FHA to operate in a financially sound
manner in the face of market and program changes.
What GAO Recommends:
In the reports discussed in this testimony, GAO made recommendations
designed to improve FHA‘s risk management and estimates of program
costs.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-07-615T].
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]
Madam Chairman and Members of the Subcommittee:
I am pleased to have the opportunity to share information and
perspectives with the committee as it examines issues concerning the
financial performance of 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. In
fiscal year 2006, it insured about 426,000 mortgages, representing $55
billion in mortgage insurance. According to FHA's estimates, the
insurance program currently operates with a negative subsidy, meaning
that the present value of estimated cash inflows (such as borrower
premiums) to FHA's Mutual Mortgage Insurance Fund (Fund) exceeds the
present value of estimated cash outflows (such as claims).
But, 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, because of the
worsening performance of the mortgages it insures, FHA has estimated
that the program would require a positive subsidy--that is, an
appropriation of budget authority--in fiscal year 2008 if no program
changes were made.
To help FHA adapt to market changes, HUD has proposed a number of
changes to the National Housing Act that, among other things, would
give FHA 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. Whether under its existing authority or
using any additional flexibility that Congress may grant, FHA's ability
to manage risks and program changes will affect the financial
performance of the insurance program.
My testimony today discusses four reports that we have issued since
2005 on different aspects of FHA's risk management, as well as ongoing
work we are conducting on FHA's proposed legislative changes and the
tools and resources it would use to implement them, if passed. This
body of work addresses a number of issues relevant to FHA's financial
performance. Specifically, I will discuss (1) weaknesses in how FHA has
managed the risks of loans with down-payment assistance, (2) practices
that could be instructive for FHA in managing the risks of new mortgage
products, (3) FHA's development and use of a mortgage scorecard, and
(4) FHA's estimation of subsidy costs for its single-family insurance
program.
In conducting this work, we reviewed and analyzed information
concerning the standards and controls FHA uses to manage the risks of
loans with down-payment assistance; steps mortgage industry
participants take to design and implement low-and no-down-payment
mortgage products; FHA's approach to developing its mortgage scorecard
and the scorecard's benefits and limitations; FHA's estimates of
program costs and the factors underlying the agency's cost reestimates;
and FHA's plans and resources for implementing its proposed legislative
changes. We interviewed officials from FHA, the U.S. Department of
Agriculture, and U.S. Department of Veterans Affairs; and staff at
selected private mortgage providers and insurers, Fannie Mae, Freddie
Mac, the Office of Federal Housing Enterprise Oversight, selected state
housing finance agencies, and nonprofit down-payment assistance
providers. We conducted this work from January 2004 to March 2007 in
accordance with generally accepted government auditing standards.
In summary, our work identified a number of weaknesses in FHA's ability
to estimate and manage risk that may affect the financial performance
of the insurance program:
* FHA has not developed sufficient standards and controls to manage
risks associated with the substantial 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 of loans with this type of down-
payment assistance resulting in an insurance claim was 76 percent
higher than comparable loans without such assistance. Additionally, the
financial risks of these loans recently have been realized in effects
on the credit subsidy estimates. According to FHA, high claim and loss
rates for loans with this type of down-payment assistance were major
reasons why the estimated credit subsidy rate--the expected cost--for
the single-family insurance program would be positive, or less
favorable, in fiscal year 2008 (absent any program changes).
* 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. However, FHA
officials have indicated that they would institute stricter
underwriting standards for any no-down-payment mortgage authorized by
their legislative proposal.
* While generally reasonable, the way that FHA developed its mortgage
scorecard--an automated tool that evaluates the default risk of
borrowers--limits the scorecard's effectiveness. More specifically, FHA
and its contractor used variables that reflected borrower and loan
characteristics to create the scorecard and an accepted modeling
process to test the variables' accuracy in predicting default. But, the
data used to develop the scorecard were 12 years old by the time that
FHA began using the scorecard in 2004, and the market has changed
significantly since then. In addition, the scorecard does not include
all the important variables that could help explain expected loan
performance such as the source of the down payment. With competition
from conventional providers, limitations in the scorecard could cause
FHA to insure mortgages that are relatively more risky. Our ongoing
work indicates that FHA plans to use the scorecard to help set
insurance premiums if legislative changes are enacted. Accordingly, any
limitations in the scorecard's ability to predict defaults could result
in FHA mispricing its products.
* Although FHA has improved its ability to estimate the subsidy costs
for its single-family insurance program, it generally has
underestimated these costs. To meet federal requirements, FHA annually
reestimates subsidy costs for each loan cohort.[Footnote 1] The current
reestimated subsidy costs for all except the fiscal year 1992 and 1993
cohorts are less favorable--that is, higher--than originally estimated.
Increases in the expected level of insurance claims--potentially
stemming from changes in underwriting guidelines, among other factors-
-were a major cause of a particularly large reestimate that FHA
submitted as of the end of fiscal year 2003.
On the basis of our findings from the reports I have summarized, we
made several recommendations designed to improve FHA's risk management.
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 program 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 (the results of which are used in
estimating and reestimating program costs) that have been found in
other studies to influence credit risk.[Footnote 2]
FHA has taken actions in response to some of our findings and
recommendations. For example, FHA has developed and begun putting in
place policies for annually updating the scorecard and testing
additional predictive variables. To more reliably assess program costs,
an FHA contractor incorporated the source of down-payment assistance
and borrower credit scores in recent actuarial reviews of the Fund.
While these actions represent improvements in FHA's risk management,
sustained management attention to the issues that we have identified
and continued Congressional oversight of FHA will play an important
role in ensuring that FHA is able to expand homeownership opportunities
for low-and middle-income families while operating in a manner that is
financially sound.
Background:
Congress established FHA in 1934 under the National Housing Act (P.L.
73-479) to broaden homeownership, protect lending institutions, and
stimulate employment in the building industry. FHA's single-family
programs insure private lenders against losses (up to almost 100
percent of the loan amount) from borrower defaults on mortgages that
meet FHA criteria. In 2005, more than three-quarters of the loans that
FHA insured went to first-time homebuyers, and about 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 about 5 percent of single-family home
purchase mortgages, compared with about 19 percent in 2001.[Footnote 3]
Additionally, default rates for FHA-insured mortgages have risen
steeply over the past several years, a period during which home prices
have generally appreciated rapidly.
FHA determines the expected cost of its insurance program, known as the
credit subsidy cost, by estimating the program's future
performance.[Footnote 4] 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 has estimated negative credit subsidies for the Fund
from 1992, when federal credit reform became effective, through 2007.
However, FHA has estimated that, assuming no program changes, the loans
it expects to insure in fiscal year 2008 would require a positive
subsidy, meaning that the present value of estimated cash inflows would
be less than the present value of estimated cash outflows. 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. An independent
contractor's actuarial review of the Fund for fiscal year 2006
estimated that the Fund's capital ratio--the economic value divided by
the insurance-in-force--is 6.82 percent, well above the mandated 2
percent minimum.[Footnote 5] 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 6] 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 (loan amount divided by sales price or
appraised value), the mortgage industry has increasingly used mortgage
scoring and automated underwriting systems.[Footnote 7] 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.
Partly in response to changes in the mortgage market, HUD has proposed
legislation intended to modernize FHA. Provisions in the proposal would
authorize FHA to change the way it sets insurance premiums 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 the property. HUD's proposal would
eliminate this contribution requirement and enable FHA to offer some
borrowers a no-down-payment product.
FHA Has Not Implemented Sufficient Standards and Controls to Manage
Financial Risks of Loans with Down-Payment Assistance:
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 8] 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. According to FHA, high claim and loss rates for loans with
this type of down-payment assistance were major reasons for changing
the estimated credit subsidy rate from negative to positive for fiscal
year 2008 (in the absence of any program changes). Furthermore,
incorporating the impact of such loans into the actuarial study of the
Fund for fiscal year 2005 resulted in almost a $2 billion (7 percent)
decrease in the Fund's estimated economic value.
Loans with Down-Payment Assistance Are a Substantial Portion of FHA's
Portfolio and Pose Greater Financial Risks Than 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 the
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 percent 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.
The corresponding percentages for 2005 and 2006 were about the same.
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 9] 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 (e.g., gifts from relatives) 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. This difference in performance may be explained, in
part, by the higher sales prices of comparable homes bought with seller-
funded down-payment assistance. 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 the
financial 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 treated
such assistance as a seller inducement and, therefore, does not subject
this assistance to the limits it otherwise places on contributions from
sellers.
Concerns about loans with nonprofit seller-funded down-payment
assistance have prompted FHA and IRS to initiate steps that could curb
their use. For example, FHA has begun drafting a proposed rule that, as
described by FHA, would appear to prohibit down-payment assistance from
seller-funded nonprofits. FHA's legislative proposal could also
eliminate the need for such assistance by allowing some FHA borrowers
to make no down payments for an FHA-insured loan. Finally, in May 2006,
IRS 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. However, FHA officials told us that
as of March 2007, they were not aware of IRS rescinding the charitable
status of any of these organizations.
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) more
routinely monitoring the performance of loans with down-payment
assistance. Also, as previously noted, HUD has initiated steps to curb
and provide alternatives to seller-funded down-payment assistance.
Practices That Other Mortgage Institutions Use 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 that other mortgage institutions use could help FHA
to design and manage the financial risks of these new products. In a
February 2005 report, we identified steps that mortgage institutions
take when introducing new products.[Footnote 10] 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. By adopting such practices, FHA could reduce
the potential for higher claims on products whose risks may not be well
understood.
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.
In commenting on our February 2005 report, 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 were underserved by the
conventional market, including those who lacked credit scores and had
little wealth or personal savings. However, in the course of our
ongoing work on FHA's legislative proposal, FHA officials indicated
that they would likely set a credit score threshold for any no-down-
payment product.
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 11] Our ongoing work indicates that FHA, if
authorized to implement risk-based pricing, would charge higher
premiums for loans with higher loan-to-value ratios, all other things
being equal.
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 12] 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.
Consistent with these views, FHA officials told us more recently that
they would not limit the initial availability of any products
authorized by its legislative proposal. 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.
The Way FHA Developed TOTAL Limits the Scorecard's Effectiveness in
Assessing the Default Risk of Borrowers:
A primary tool that FHA uses to assess the default risk of borrowers
who apply for FHA-insured mortgages is its TOTAL scorecard. TOTAL's
capabilities are important, because 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 and operate in a financially sound manner.
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 13] 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 had a contract to update TOTAL, the agency did not
develop a formal plan for updating TOTAL on a regular basis. Best
practices in the private sector, also 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, such as including the presence and source of down-
payment assistance as a loan variable in the scorecard. In response,
FHA has developed and begun putting in place policies and procedures
that call for annual (1) monitoring of the scorecard's ability to
predict loan default, (2) testing of additional predictive variables to
include in the scorecard, and (3) updating the scorecard with recent
loan performance data.
We also recommended that HUD explore additional uses for TOTAL,
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 and avoid
adverse selection. Our ongoing work indicates that FHA plans to use
borrowers' TOTAL scores to help set insurance premiums. Accordingly,
any limitations in TOTAL's ability to predict defaults could result in
FHA mispricing its products.
FHA's Current Reestimated Subsidy Costs Are Generally Less Favorable
than its Original Estimates:
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. In doing so, FHA reestimates subsidy costs for each loan
cohort.
As we reported in September 2005, FHA's subsidy reestimates generally
have been less favorable (i.e., higher) than the original estimates
since federal credit reform became effective in 1992.[Footnote 14] The
current reestimated subsidy costs for all except the fiscal year 1992
and 1993 cohorts are higher than the original estimates. For example,
the current reestimated cost for the fiscal year 2006 cohort is about
$800 million less favorable than originally estimated.
With respect to reestimates across cohorts, our report examined factors
contributing to an unusually large $7 billion reestimate (more than
twice the size of other recent reestimates) that FHA submitted as of
the end of fiscal year 2003 for the fiscal year 1992 through 2003
cohorts. These factors included increases in estimated claims and
prepayments (the payment of a loan before its maturity date). Several
policy changes and trends may have contributed to changes in the
expected claims. For example:
* Revised underwriting guidelines made it easier for borrowers who were
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 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, HUD indicated that its contractor was considering
the specific variables that we had recommended FHA include in its
annual actuarial review of the Fund. The contractor subsequently
incorporated the source of down-payment assistance in the fiscal year
2005 actuarial review and borrower credit scores in the fiscal year
2006 review.
Madam 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 or shearw@gao.gov. Individuals making key
contributions to this testimony included Barbara Roesmann, Paige Smith,
Laurie Latuda, and Steve Westley.
FOOTNOTES
[1] Essentially, a cohort includes the loans insured in a given year.
[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] These figures represent mortgages for owner-occupied homes only.
[4] Pursuant to the Federal Credit Reform Act of 1990, HUD must
annually estimate the credit subsidy cost for its mortgage insurance
programs. Credit subsidy costs are the net present value of estimated
payments HUD makes less the estimated amounts it receives, excluding
administrative costs.
[5] In fiscal year 2006, the Fund's estimated economic value was $22
billion and the unamortized insurance-in-force was $323 billion.
[6] Conventional mortgages do not carry government insurance or
guarantees.
[7] Underwriting refers to a risk analysis that uses information
collected during the origination process to decide whether to approve a
loan.
[8] GAO, Mortgage Financing: Additional Action Needed to Manage Risks
of FHA-Insured Loans with Down Payment Assistance, GAO-06-24
(Washington, D.C.: Nov. 9, 2005).
[9] 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.
[10] GAO, Mortgage Financing: Actions Needed to Help FHA Manage Risks
from New Mortgage Loan Products, GAO-05-194 (Washington, D.C.: Feb. 11,
2005).
[11] 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.
[12] Under this program, homeowners borrow against equity in their home
and receive payments from their lenders.
[13] GAO, Mortgage Financing: HUD Could Realize Additional Benefits
from its Mortgage Scorecard, GAO-06-435 (Washington, D.C.: Apr. 13,
2006) and GAO-06-24.
[14] 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).
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