Federal Housing Administration
Modernization Proposals Would Have Program and Budget Implications and Require Continued Improvements in Risk Management Gao ID: GAO-07-708 June 29, 2007In recent years, the Federal Housing Administration (FHA) has experienced a sharp decline in market share. Also, the agency has estimated that, absent program changes, its Mutual Mortgage Insurance Fund (Fund) would require appropriations in 2008. To adapt to market changes, FHA has implemented new procedures and proposed the following major legislative changes: raising FHA's loan limits, allowing risk-based pricing, and lowering down-payment requirements. GAO was asked to report on (1) the likely program and budget impacts of FHA's modernization efforts; (2) the tools, resources, and risk management practices important to FHA's implementation of the legislative proposals, if passed; and (3) other options that FHA and Congress could consider to help FHA adapt to market changes. To address these objectives, GAO analyzed FHA and Home Mortgage Disclosure Act (HMDA) data and interviewed officials from FHA and other mortgage institutions.
FHA's recent changes to insurance approval and appraisal requirements have streamlined its insurance process, and FHA's major legislative proposals could affect the demand for FHA's loans, the cost and availability of insurance to borrowers, and the insurance program's budgetary costs. Based on GAO's analysis of HMDA data, the number of FHA-insured loans could have been from 9 to 10 percent greater in 2005 had the higher, proposed mortgage limits been in effect. GAO's analysis of data on 2005 FHA home purchase borrowers shows that 43 percent would have paid the same or less under the risk-based pricing proposal than they actually paid, 37 percent would have paid more, and 20 percent (those with the highest expected claim rates) would not have qualified for FHA insurance. While to be viewed with caution, FHA has made estimates indicating that the loans it expects to insure in 2008 would result in negative subsidies (i.e., net cash inflows) of $342 million if the major legislative changes were enacted, rather than requiring an appropriation of $143 million absent any program changes. FHA has taken or planned steps to enhance tools and resources and adopt risk-management practices important to implementing the legislative proposals, but does not intend to use a common industry practice, piloting, to mitigate the risks of any zero-down-payment product it is authorized to offer. In response to prior GAO recommendations, FHA has taken steps to improve the loan performance and scoring models it would use in risk-based pricing. It also has identified minor changes to its information systems and staff increases needed to implement the proposals but faces long-term challenges in these areas. Additionally, the legislative proposals would introduce new risks. The proposal to lower down-payment requirements is of particular concern given the higher default rates on these loans and the difficulty of setting prices for new products whose risks may not be well known. GAO has previously indicated that Congress may want to consider requiring FHA to limit the initial availability of any new products and also recommended that FHA itself consider piloting. However, FHA has indicated that it does not plan to pilot any no-down-payment product it might offer. Mortgage industry participants and researchers have suggested more options that Congress and FHA could consider to help FHA adapt to changes in the mortgage market, but some changes could have budget impacts and complicate oversight efforts. Some administrative changes--such as implementing a more limited form of risk-based pricing--are within FHA's existing authority. Congress also could grant FHA additional authority that would allow it to invest the Fund's current resources in information technology and human capital, but this would increase the federal government's budget deficit. Finally, Congress could contemplate other approaches to the provision of federal mortgage insurance, such as creating a government corporation. However, any fundamental changes to how the federal government provides mortgage insurance could require new oversight mechanisms and would require careful deliberation.
GAO-07-708, Federal Housing Administration: Modernization Proposals Would Have Program and Budget Implications and Require Continued Improvements in Risk Management
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Report to Congressional Requesters:
United States Government Accountability Office:
GAO:
June 2007:
Federal Housing Administration:
Modernization Proposals Would Have Program and Budget Implications and
Require Continued Improvements in Risk Management:
GAO-07-708:
GAO Highlights:
Highlights of GAO-07-708, a report to congressional requesters
Why GAO Did This Study:
In recent years, the Federal Housing Administration (FHA) has
experienced a sharp decline in market share. Also, the agency has
estimated that, absent program changes, its Mutual Mortgage Insurance
Fund (Fund) would require appropriations in 2008. To adapt to market
changes, FHA has implemented new procedures and proposed the following
major legislative changes: raising FHA‘s loan limits, allowing risk-
based pricing, and lowering down-payment requirements. GAO was asked to
report on (1) the likely program and budget impacts of FHA‘s
modernization efforts; (2) the tools, resources, and risk-management
practices important to FHA‘s implementation of the legislative
proposals, if passed; and (3) other options that FHA and Congress could
consider to help FHA adapt to market changes. To address these
objectives, GAO analyzed FHA and Home Mortgage Disclosure Act (HMDA)
data and interviewed officials from FHA and other mortgage institutions.
What GAO Found:
FHA‘s recent changes to insurance approval and appraisal requirements
have streamlined its insurance process, and FHA‘s major legislative
proposals could affect the demand for FHA‘s loans, the cost and
availability of insurance to borrowers, and the insurance program‘s
budgetary costs. Based on GAO‘s analysis of HMDA data, the number of
FHA-insured loans could have been from 9 to 10 percent greater in 2005
had the higher, proposed mortgage limits been in effect. GAO‘s analysis
of data on 2005 FHA home purchase borrowers shows that 43 percent would
have paid the same or less under the risk-based pricing proposal than
they actually paid, 37 percent would have paid more, and 20 percent
(those with the highest expected claim rates) would not have qualified
for FHA insurance. While to be viewed with caution, FHA has made
estimates indicating that the loans it expects to insure in 2008 would
result in negative subsidies (i.e., net cash inflows) of $342 million
if the major legislative changes were enacted, rather than requiring an
appropriation of $143 million absent any program changes.
FHA has taken or planned steps to enhance tools and resources and adopt
risk-management practices important to implementing the legislative
proposals, but does not intend to use a common industry practice,
piloting, to mitigate the risks of any zero-down-payment product it is
authorized to offer. In response to prior GAO recommendations, FHA has
taken steps to improve the loan performance and scoring models it would
use in risk-based pricing. It also has identified minor changes to its
information systems and staff increases needed to implement the
proposals but faces long-term challenges in these areas. Additionally,
the legislative proposals would introduce new risks. The proposal to
lower down-payment requirements is of particular concern given the
higher default rates on these loans and the difficulty of setting
prices for new products whose risks may not be well known. GAO has
previously indicated that Congress may want to consider requiring FHA
to limit the initial availability of any new products and also
recommended that FHA itself consider piloting. However, FHA has
indicated that it does not plan to pilot any no-down-payment product it
might offer.
Mortgage industry participants and researchers have suggested more
options that Congress and FHA could consider to help FHA adapt to
changes in the mortgage market, but some changes could have budget
impacts and complicate oversight efforts. Some administrative
changes”such as implementing a more limited form of risk-based
pricing”are within FHA‘s existing authority. Congress also could grant
FHA additional authority that would allow it to invest the Fund‘s
current resources in information technology and human capital, but this
would increase the federal government‘s budget deficit. Finally,
Congress could contemplate other approaches to the provision of federal
mortgage insurance, such as creating a government corporation. However,
any fundamental changes to how the federal government provides mortgage
insurance could require new oversight mechanisms and would require
careful deliberation.
What GAO Recommends:
While making no new recommendations, GAO re-emphasizes the need for
continued management attention to prior GAO recommendations that could
help address risks and challenges associated with the legislative
proposals. HUD commented that the report‘s concerns about FHA‘s risk
management and emphasis on the need for piloting new products were
unwarranted.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-07-708].
To view the full product, including the scope and methodology, click on
the link above. For more information, contact William B. Shear at (202)
512-8678 or shearw@gao.gov
[End of section]
Contents:
Letter:
Results in Brief:
Background:
Modernization Efforts Have Streamlined FHA Processes and Likely Would
Affect Program Participation and Costs:
FHA Has Enhanced Tools and Resources Important to Implementing
Proposals but Does Not Intend to Mitigate Risks by Piloting New
Products:
Congress and FHA Could Consider Other Administrative and Legislative
Changes to Help FHA Adapt to Changes in the Mortgage Market:
Observations:
Agency Comments and Our Evaluation:
Appendix I: Objectives, Scope, and Methodology:
Appendix II: Comments from the Department of Housing and Urban
Development:
Appendix III: GAO Contact and Staff Acknowledgments:
Figures:
Figure 1: Proposed Changes to FHA's Loan Limits:
Figure 2: Impact of Borrower Credit Scores and LTV Ratios on Insurance
Premiums under FHA's Risk-Based Pricing Proposal:
Figure 3: Impact of FHA's Risk-Based Pricing Proposal on Borrowers'
Premiums, Including First-Time and Low-Income Homebuyers:
Figure 4: Impact of FHA's Risk-Based Pricing Proposal on Premiums Paid
by Different Racial Groups:
Figure 5: Impact of FHA's Risk-Based Pricing Proposal on Racial
Distribution of FHA Borrowers:
Abbreviations:
CBSA: core based statistical area:
FHA: Federal Housing Administration:
FTE: full-time equivalent:
HECM: Home Equity Conversion Mortgage:
HUD: Department of Housing and Urban Development:
HMDA: Home Mortgage Disclosure Act:
IRS: Internal Revenue Service:
LTV: loan-to-value:
MHC: Millennial Housing Commission:
United States Government Accountability Office:
Washington, DC 20548:
June 29, 2007:
The Honorable Richard C. Shelby:
Ranking Member:
Committee on Banking, Housing, and Urban Affairs:
United States Senate:
The Honorable Wayne Allard:
United States Senate:
The Department of Housing and Urban Development (HUD), through its
Federal Housing Administration (FHA), has helped millions of families
purchase homes by providing insurance for single-family home mortgages
made by private lenders. However, FHA's single-family insurance program
has faced several challenges in recent years, including rising
delinquency rates and a sharp decline in the number of participating
borrowers, due partly to increased competition from conventional
mortgage providers.[Footnote 1] As conventional providers have improved
their ability to evaluate risk, FHA has begun to experience adverse
selection--that is, conventional providers have identified and approved
relatively lower-risk borrowers in FHA's traditional market segment,
leaving relatively higher-risk borrowers for FHA. Furthermore, the
agency has estimated that, absent any program changes, the program
would for the first time operate with a positive subsidy in fiscal year
2008--meaning that the present value of estimated cash outflows (such
as insurance claims) to FHA's Mutual Mortgage Insurance Fund (Fund)
would exceed the present value of estimated cash inflows (such as
borrower premiums). To avoid a positive subsidy in fiscal year 2008,
FHA estimates that it would have to increase slightly the insurance
premiums charged to borrowers.
To adapt to market changes, FHA has implemented new administrative
procedures and proposed legislation designed to modernize its insurance
processes and products. FHA's recent administrative changes include
allowing higher-performing lenders to endorse, or approve, loans for
FHA insurance without prior review by FHA and adopting conventional
market appraisal requirements. The legislative proposals would, among
other things, raise FHA's 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, as we testified in June 2006, weaknesses in
FHA's risk management raise questions about the agency's ability to
successfully implement the proposed legislation.[Footnote 2] Given
these concerns, you asked us to evaluate FHA's modernization efforts.
Specifically, this report discusses (1) the likely program and
budgetary impacts of FHA's modernization efforts; (2) the tools,
resources, and risk-management practices important to FHA's
implementation of the legislative proposals, if passed; and (3) other
options that FHA and Congress could consider to help FHA adapt to
changes in the mortgage market and the pros and cons of these options.
To determine the likely program and budgetary impacts of FHA's
modernization efforts, we analyzed data collected under the Home
Mortgage Disclosure Act (HMDA) and from FHA's Single Family Data
Warehouse (SFDW).[Footnote 3] Specifically, we used 2005 HMDA data (the
most current available) to examine the effect of raising loan limits on
demand for FHA-insured loans. We determined the number of additional
loans in different geographic areas that would have been eligible for
FHA insurance under the revised loan limits and, based on FHA's current
market share, estimated the percentage of those loans that FHA might
have insured. We estimated the effects of risk-based pricing on
borrowers' eligibility for FHA insurance and the premiums they would
pay by analyzing SFDW data on FHA's 2005 home purchase borrowers to
determine the characteristics of borrowers that could fall into FHA's
proposed pricing categories. We reviewed recent administrative changes
made by FHA and interviewed FHA officials, several FHA lenders, and
mortgage and real estate industry groups about their effects on loan
and insurance processing times and costs. We also examined the
potential budgetary impacts of the legislative proposals by reviewing
the President's fiscal year 2008 budget and FHA's cost estimates. To
evaluate the tools, resources, and risk-management practices important
to FHA's implementation of the proposals, we relied on our prior work,
reviewed information provided by FHA, and interviewed officials from
FHA, private mortgage insurers, and the government-sponsored
enterprises (GSE) Fannie Mae and Freddie Mac.[Footnote 4] To determine
other options that FHA and Congress could consider, we reviewed
relevant literature and interviewed FHA officials, academic experts,
FHA lenders, and private mortgage insurers. Appendix I contains
additional information on our scope and methodology. We conducted this
work in Washington, D.C., from September 2006 to June 2007 in
accordance with generally accepted government auditing standards.
Results in Brief:
FHA's modernization efforts, which include completed administrative and
proposed legislative changes, have streamlined the agency's insurance
process and could affect the demand for FHA-insured loans, the cost and
availability of insurance to borrowers, and the budgetary costs of the
insurance program. In 2006, FHA made several administrative changes,
such as allowing higher-performing lenders to approve FHA insurance
without prior review by FHA and simplifying its appraisal process. FHA
and mortgage industry officials with whom we spoke said that these
changes have increased the efficiency of loan and insurance processing,
making FHA products more attractive and, therefore, more likely to be
used. For example, one FHA lender reported a 35 percent decrease in
loan processing times and a 25 percent reduction in operating costs for
its FHA business. In addition to these administrative changes, FHA has
proposed legislation that would grant the agency new flexibilities
intended to help address challenges, such as adverse selection,
resulting from innovations and increased competition in the mortgage
market. If passed, the legislative changes likely would affect borrower
participation in the program and the program's budgetary costs. Based
on our analysis of 2005 HMDA data, we estimate that the number of FHA-
insured loans in 2005 could have been from 9 to 10 percent greater had
the higher, proposed mortgage limits been in effect. Although the
effect of introducing risk-based premiums on the demand for FHA-insured
loans is especially difficult to estimate, risk-based pricing would
affect the cost and availability of FHA insurance. Specifically, risk-
based pricing would decrease premiums for lower-risk borrowers and
increase them for higher-risk borrowers. Our analysis of data for FHA
home purchase borrowers in 2005 shows that about 43 percent of those
borrowers would have paid the same or less than they actually paid, 37
percent would have paid more, and 20 percent would not have qualified
for FHA insurance based on FHA's plans as of May 2007. (The same
percentages hold true when risk-based pricing is compared with the
higher across-the-board premiums that FHA estimates it would have to
charge to avoid a positive subsidy in fiscal year 2008 absent any
program changes.) The 20 percent who would not have qualified were
borrowers with expected lifetime claim rates more than 2.5 times
greater than the average claim rate. The legislative proposals also
would have a budgetary impact, mostly reflected in subsidy costs. While
to be viewed with caution, FHA has made estimates indicating that the
loans it expects to insure in 2008 would result in negative subsidies
of $342 million if the major legislative changes were enacted, rather
than requiring an appropriation of $143 million absent any program
changes.
FHA has taken or planned steps to enhance the tools and resources
important to implementing the legislative proposals--and help address
risks and challenges associated with the proposals--but does not intend
to use a common industry practice, piloting, to mitigate the risks of
any zero-down-payment product it is authorized to offer. To implement
its risk-based pricing proposal, FHA would rely on statistical models
that estimate the performance of loans and its mortgage scorecard, an
automated tool that evaluates the default risk of borrowers. In
response to our prior recommendations, FHA has improved the forecasting
ability of its loan performance models by incorporating additional
variables found to influence credit risk and is in the process of
addressing a number of limitations in its mortgage scorecard that could
reduce its effectiveness for risk-based pricing. For instance, as we
reported in April 2006, the scorecard does not include a number of
important variables included in other mortgage institutions'
scorecards, such as the source of the down payment.[Footnote 5] FHA
also has identified changes in information systems needed to implement
the legislative proposals and has obligated or requested a total of $11
million for this purpose. To address human capital needs, the
President's fiscal year 2008 budget requests 21 additional staff for
FHA to help analyze industry trends, align the agency's business
processes with current mortgage industry practices, and promote new FHA
products. Although FHA has taken actions to enhance key tools and
resources, it operates in a highly competitive environment in which
other market participants have greater flexibility to hire and
compensate staff and invest in information technology, which enhances
their ability to adapt to market changes. Additionally, the legislative
proposals would introduce new risks and challenges. The proposal to
lower down-payment requirements is of particular concern given the
greater default risk of low-down-payment loans, housing market
conditions that could put borrowers with such loans in a negative
equity position, and the difficulty of setting prices for new products
whose risks may not be well understood. FHA plans to take some steps,
such as instituting stricter underwriting standards, to mitigate these
risks and challenges. However, while other mortgage institutions use
pilot programs to manage the risks associated with changing or
expanding their product lines, FHA has indicated that it does not plan
to pilot any zero-down-payment product it is authorized to offer and
lacks the resources to do so. We have previously reported that Congress
may want to consider requiring FHA to limit the initial availability of
any new products and also recommended that FHA itself consider piloting.
Mortgage industry participants and researchers have suggested a number
of additional administrative and legislative options that Congress and
FHA could consider to help FHA adapt to changes in the mortgage market,
but some changes could have budget impacts and complicate oversight
efforts. Some administrative changes--such as adjusting premiums or
even implementing a more limited form of risk-based pricing--are within
FHA's existing authority. Congress also could consider granting FHA
additional authorities that would increase the agency's operational
flexibility. For example, Congress could allow FHA to invest the Fund's
current resources--that is, negative subsidies that accrue in the
Fund's reserves--in information technology and human capital. However,
using the Fund's current resources would diminish its ability to
withstand severe economic conditions and would also increase the
federal government's budget deficit, all other things being equal.
Additionally, Congress could expressly authorize FHA to offer and pilot
new insurance products without prior congressional approval. Finally,
Congress could consider various alternative approaches to the provision
of federal mortgage insurance. For example, the federal government
could continue to provide mortgage insurance but through a more
independent government corporation, implement risk-sharing arrangements
with private partners, or let market forces determine the future need
for federal mortgage insurance by making no program changes and
allowing FHA's role in the mortgage market to increase or decrease
according to market conditions. However, any fundamental changes to how
the federal government provides mortgage insurance also could require
new oversight mechanisms and would require careful deliberation.
While our report does not make any new recommendations, we make
observations about the need for careful implementation of the
legislative proposals, if passed. While FHA has performed considerable
analysis to support its legislative proposals and has made or planned
enhancements to many of the specific tools and resources that would be
important to its implementation, the proposals present risks and
challenges and should be viewed with caution. Continued management
attention to our prior recommendations, including piloting new products
and steps to improve its mortgage scorecard, could help FHA address
these risks.
We provided HUD with a draft of this report. HUD commented that the
draft report provided a balanced assessment but also that the report's
concerns about FHA's risk management and emphasis on the need for
piloting zero-or lower-down-payment products were unwarranted. HUD
indicated that it had a firm basis for anticipating the performance of
these products as a result of its experience with loans with down-
payment assistance from nonprofit organizations funded by home sellers.
While we acknowledge that this experience could inform assessment of
how a zero-down-payment product would perform, the product could be
utilized by a different population of borrowers than seller-funded down-
payment assistance loans and may not perform similarly to these loans.
Also, if authorized to offer a zero-down-payment product in the near
future, FHA would be introducing it at a time when stagnating or
declining home prices in some parts of the country could increase the
risk of default. Because of these risks and uncertainties, we continue
to believe that a prudent way to introduce a zero-down-payment product
would be to limit its initial availability such as through a pilot
program. We discuss HUD's comments in the agency comments section, and
the agency's written comments are reproduced in appendix II.
Background:
Congress established FHA in 1934 under the National Housing Act (P.L.
73-479) to broaden homeownership, protect and sustain lending
institutions, and stimulate employment in the building industry. FHA
insures a variety of mortgages for initial home purchases, construction
and rehabilitation, and refinancing. In fiscal year 2006, FHA insured
almost 426,000 mortgages representing $55 billion in mortgage
insurance. FHA's single-family programs insure private lenders against
losses from borrower defaults on mortgages that meet FHA criteria for
properties with one to four housing units. FHA has played a
particularly large role among minority, lower-income, and first-time
homebuyers and generally is thought to promote stability in the market
by ensuring the availability of mortgage credit in areas that may be
underserved by the private sector or are experiencing economic
downturns. In fiscal year 2006, 79 percent of FHA-insured home purchase
loans went to first-time homebuyers, 31 percent of whom were minorities.
FHA is a government mortgage insurer in a market that also includes
private insurers. Generally, borrowers are required to purchase
mortgage insurance when the loan-to-value (LTV) ratio--the ratio of the
amount of the mortgage loan to the value of the home--exceeds 80
percent. Private mortgage insurance policies provide lenders coverage
on a portion (generally 20 to 30 percent) of the mortgage balance.
However, borrowers who have difficulty meeting down-payment and credit
requirements for conventional loans may find it easier to qualify for a
loan with FHA insurance, which covers 100 percent of the value of the
loan. Because the credit risk is mitigated by the federal guaranty, FHA
borrowers are allowed to make very low down payments and generally pay
interest rates that are competitive with prime mortgages.
FHA Insurance Requirements:
Legislation sets certain standards for FHA-insured loans. FHA-insured
borrowers are required to make a cash investment of a minimum of 3
percent. This investment may come from the borrowers' own funds or from
certain third-party sources. However, borrowers are permitted to
finance their mortgage insurance premiums and some closing costs, which
can create an effective LTV ratio of close to 100 percent for some FHA-
insured loans. Congress also has set limits on the size of the loans
that may be insured by FHA. These limits vary by county. The limit for
an FHA-insured mortgage is 95 percent of the local median home price,
not to exceed 87 percent or fall below 48 percent of the Freddie Mac
conforming loan limit, which was $417,000 in 2006. Therefore, in 2006,
FHA loan limits fell between a floor in low-cost areas of $200,160 and
a ceiling in high-cost areas of $362,790. Eighty-two percent of
counties nationwide had loan limits set at the low-cost floor, while 3
percent had limits set at the high-cost ceiling. The remaining 15
percent of counties had limits set between the floor and ceiling, at 95
percent of their local median home prices.
FHA's Mutual Mortgage Insurance Fund:
FHA insures most of its single-family mortgages under its Mutual
Mortgage Insurance Fund, which is supported by borrowers' insurance
premiums. FHA has the authority to establish and collect a single up-
front premium in an amount not to exceed 2.25 percent of the amount of
the original insured principal obligation of the mortgage, and annual
premiums of up to 0.5 percent of the remaining insured principal
balance, or 0.55 percent for borrowers with down payments of less than
5 percent. Currently, FHA uses a flat premium structure whereby all
borrowers pay the same 1.5 percent up-front fee and a 0.5 percent
annual fee.
The Omnibus Budget Reconciliation Act of 1990 requires an annual
independent actuarial review of the economic net worth and soundness of
the Fund. The actuarial review estimates the economic value of the Fund
as well as the capital ratio to see if the Fund has met the capital
standards in the act.[Footnote 6] The analysis considers the historical
performance of the existing loans in the Fund, projected future
economic conditions, loss given claim rates, and projected mortgage
originations. The Fund has met the capital ratio requirements since
1995, and the single-family mortgage insurance program has maintained a
negative overall credit subsidy rate, meaning that the present value of
estimated cash inflows from premiums and recoveries exceeds estimated
cash outflows for claim payments (excluding administrative costs).
However, in recent years, the subsidy rate has approached zero.
A few single-family mortgage insurance programs are insured as
obligations under either the General Insurance or Special Risk
Insurance Funds. These programs are Section 203(k) rehabilitation
mortgages, which enable borrowers to finance both the purchase (or
refinancing) of a house and the cost of its rehabilitation through a
single mortgage; Section 234(c) insurance for the purchase of a unit in
a condominium building; and reverse mortgages under the Home Equity
Conversion Mortgage (HECM) program, which can be used by homeowners age
62 and older to convert the equity in their home into a lump sum
payment, monthly streams of income, or a line of credit to be repaid
when they no longer occupy the home.
Trends in the Mortgage Market and Their Impact on FHA:
Two major trends in the conventional mortgage market have significantly
affected FHA. First, in recent years, members of the conventional
mortgage market increasingly have been active in supporting low-and no-
down-payment mortgages, increasing consumer choices for borrowers who
may have previously chosen an FHA-insured loan. Subprime lenders, in
particular, have offered mortgage products featuring flexible payment
and interest options that allowed borrowers to qualify for mortgages
despite a rise in home prices.[Footnote 7] Second, to help assess the
default risk of borrowers, particularly those with high LTV ratios, the
mortgage industry increasingly has used mortgage scoring and automated
underwriting systems. Underwriting refers to a risk analysis that uses
information collected during the origination process to decide whether
to approve a loan, and automated underwriting refers to the process by
which lenders enter information on potential borrowers into electronic
systems that contain an evaluative formula, or algorithm, called a
scorecard. The scorecard algorithm attempts to measure the borrower's
risk of default quickly and objectively by examining data such as
application information and credit scores. (Credit scores assign a
numeric value generally ranging from 300 to 850 to a borrower's credit
history, with higher values signifying better credit.) The scorecard
compares these data with specific underwriting criteria (e.g., cash
reserves and credit requirements) to predict the likelihood of default.
Since 2004, FHA has used its own scorecard called Technology Open to
Approved Lenders (TOTAL). FHA lenders now use TOTAL in conjunction with
automated underwriting systems to determine the likelihood of default.
Although TOTAL can determine the credit risk of a borrower, it does not
reject a loan. FHA requires lenders to manually underwrite loans that
are not accepted by TOTAL to determine if the loan should be accepted
or rejected.
Further, as we noted in a recent report, the share of home purchase
mortgage loans insured by FHA has fallen dramatically, from 19 percent
in 1996 to 6 percent in 2005, with almost all the decline occurring
since 2001.[Footnote 8] The combination of (1) FHA product restrictions
and a lack of process improvements relative to the conventional market
and (2) product innovations and expanded loan origination and funding
channels in the conventional market--coupled with interest rate and
house price changes--provided conditions that favored conventional
mortgages over FHA products. Conventional subprime loans, in
particular, emerged as an alternative to FHA-insured mortgages but
often at a higher ultimate cost to certain borrowers.
At the same time, FHA's financial performance has worsened. As we noted
in a recent testimony, one reason for deteriorating loan performance
has been the increase in FHA-insured loans with down-payment assistance
from nonprofit organizations funded by home sellers.[Footnote 9] Down-
payment assistance programs provide cash assistance to homebuyers who
cannot afford to make the minimum down payment or pay the closing costs
involved in obtaining a mortgage. From 2000 to 2006, the total
proportion of FHA-insured home purchase loans with down-payment
assistance from nonprofits (the large majority of which received
funding from property sellers) increased from about 2 percent to
approximately 33 percent.
Legislative Proposals for FHA Modernization:
To help FHA adapt to recent trends in the mortgage market, in 2006 HUD
submitted a legislative proposal to Congress that included changes that
would adjust loan limits for the single-family mortgage insurance
program, eliminate the requirement for a minimum down payment, and
provide greater flexibility to FHA to set insurance premiums based on
risk factors. HUD's proposal, as it currently stands, reflects
revisions made by the Expanding American Homeownership Act of 2006,
which was passed by the House of Representatives in July 2006.
Specifically, as shown in figure 1, the proposal would increase the
loan limit for FHA-insured mortgages from 95 to 100 percent of the
local median home price. It would also raise the loan limit floor in
low-cost areas from 48 to 65 percent of the conforming loan limit, and
the ceiling in high-cost areas from 87 to 100 percent of the conforming
limit.[Footnote 10] The proposal would also repeal the 3 percent
minimum cash investment requirement and allow FHA to set premiums
commensurate with the risk of the loan[Footnote 11]. FHA would
establish a premium structure allowing either a combination of upfront
and annual premiums or annual premiums alone, subject to specified
maximum amounts.
Figure 1: Proposed Changes to FHA's Loan Limits:
[See PDF for image]
Source: GAO, HUD.
[End of figure]
In addition to these three major changes, the modernization proposal
also contained other provisions, including:
* Permanently eliminating the limit on the number of HECM (reverse)
mortgages that can be insured, setting a single nationwide loan limit
for HECMs, and authorizing a HECM program for home purchases.[Footnote
12]
* Extending the permissible term of FHA-insured mortgages from 35 to 40
years.
* Moving HECMs, Section 203(k) rehabilitation mortgages, and Section
234(c) condominium unit mortgages from the General Insurance and
Special Risk Insurance Funds to the Mutual Mortgage Insurance Fund.
Moving the condominium program to the Fund would simplify the
origination and underwriting process for these loans because they would
no longer be subject to more complex requirements for multifamily
housing loans.
While FHA's planning has reflected revisions made to its original
proposal by the House of Representatives in the 109th Congress, new
bills introduced in the 110th Congress could further affect FHA's
planning.[Footnote 13]
Modernization Efforts Have Streamlined FHA Processes and Likely Would
Affect Program Participation and Costs:
FHA's modernization efforts, which include completed administrative and
proposed legislative changes, have streamlined the agency's insurance
processes and likely would affect program participation and costs.
According to FHA and mortgage industry officials with whom we spoke,
FHA's recent administrative changes have resulted in efficiency
improvements, making FHA products more attractive to use. FHA's
proposed legislation would grant the agency new leeway to help address
challenges, such as adverse selection, resulting from innovations and
increased competition in the mortgage market. If passed, the
legislative changes likely would have a number of program and budgetary
impacts. For example, we estimate that raising the FHA loan limits
could increase demand for FHA-insured loans, all other things being
equal. The risk-based pricing proposal would decrease premiums for
lower-risk borrowers, increase them for higher-risk borrowers, and
disqualify other potential borrowers. In addition, FHA estimates that
the legislative proposals would have a favorable budgetary impact.
Mortgage Industry Officials Report That FHA's Recent Administrative
Changes Have Increased the Efficiency of Loan and Insurance Processing:
FHA has taken a number of steps to make the loans it insures easier to
process and bring the agency more in line with the conventional market.
For example, in January 2006, FHA introduced the Lender Insurance
Program, which enables higher-performing lenders to endorse all FHA
loans except HECMs without a prior review by FHA.[Footnote 14] Prior to
that time, all lenders were required to mail loan case files to FHA for
review by contract staff before the loan could be endorsed for
insurance. If the contractor found a problem with the case file, FHA
would mail the file back to the lender for correction. Under the new
program, approved lenders are allowed to perform their own pre-
endorsement reviews and submit loan data electronically to
FHA.[Footnote 15] If the loan data pass checks for accuracy and
completeness, the lender is able to endorse the loan automatically. As
of December 31, 2006, 405 (31 percent) of the 1,314 FHA lenders
eligible for the program had been approved to participate. Between
January 1, 2006, and December 31, 2006, 46 percent of FHA-insured loans
were endorsed through the program.
In addition to implementing the Lender Insurance Program, FHA revised
its appraisal protocols and closing cost guidelines to align them more
closely with conventional standards. Specifically, the agency
simplified the appraisal process by adopting appraisal forms used in
the conventional market and eliminating the requirement that minor
property deficiencies be corrected prior to the sale of the property.
Under the revised procedures, FHA limits required repairs to those
necessary to protect the health and safety of the occupants, protect
the security of the property, or correct physical deficiencies or
conditions affecting structural integrity. Examples of property
conditions that must be repaired include inadequate access to the
exterior of the home from bedrooms, leaking roofs, and foundation
damage. The agency requires the appraiser to identify minor property
deficiencies (such as missing handrails, cracked window glass, and
minor plumbing leaks) on the appraisal form, but no longer stipulates
that they be repaired. These changes went into effect for all
appraisals performed on or after January 1, 2006. In January 2006, FHA
also eliminated its list of "allowable" and "non-allowable" closing
costs and other fees that may be collected from the borrower. The
agency made this change because FHA lenders had advised the agency that
home sellers sometimes balked at accepting a sales contract from a
homebuyer wishing to use FHA-insured financing because its guidelines
differed from standard practice and did not consider regional
variations. Lenders may now charge and collect from borrowers those
customary and reasonable costs necessary to close the mortgage.
According to FHA lenders and industry groups, these changes have
increased the efficiency of loan processing, making FHA products more
attractive to use. Representatives of a mortgage industry group told us
that feedback from the group's members on the Lender Insurance Program
had been positive.[Footnote 16] Similarly, the FHA lenders we
interviewed stated that the program had resulted in efficiency
improvements, such as reduced processing times or costs. For example,
one large FHA lender estimated that participating in the program had
reduced the time it took to process an FHA-insured loan by about 35
percent (or 15 to 20 days). The same FHA lender also estimated that
participation in the program had reduced the operating costs (mostly
printing and shipping costs) for its FHA business by about 25 percent.
Additionally, the FHA lenders we interviewed and representatives of a
real estate industry group noted that FHA's revised appraisal protocols
and closing costs had made it easier to originate FHA loans.
Representatives of the industry group noted that the revisions had
shortened the time it took to close an FHA loan, which was important in
a competitive market. Finally, the lenders we interviewed estimated
that the administrative changes had contributed, at least in part, to
recent modest increases in the number of FHA-insured loans they had
made.
According to FHA officials, the Lender Insurance Program also has
reduced the time it takes FHA to process insurance endorsements and led
to cost savings. They estimated that it takes FHA from 2 to 3 days to
endorse applications for insurance on loans that are not part of the
program. For loans endorsed through the program, they noted that
approval is virtually instantaneous if the loan passes quality checks.
In addition to reducing insurance processing times, the program has
resulted in cost savings for FHA. During the first year of the program,
FHA realized a reduction in contracting costs of more than $2 million,
as its contractors were required to perform fewer pre-endorsement
reviews. FHA also saved more than $70,000 in mailing costs during the
first 9 months of the program. FHA estimates that contract costs will
continue to decline as the program is expanded to include the HECM
program.
Raising Loan Limits Likely Would Increase Demand for FHA Loans, but the
Effect of Other Major Proposals on FHA Loan Volume Is Uncertain:
Our analysis indicates that raising FHA's loan limits likely would
increase the number of loans insured by FHA by making more loans
eligible for FHA insurance. In some areas of the country, particularly
in parts of California and the Northeast, median home prices have been
well above FHA's maximum loan limits, reducing the agency's ability to
serve borrowers in those markets. For example, the 2005 loan limit in
high-cost areas was $312,895 for one-unit properties, while the median
home price was about $399,000 in Boston, Massachusetts; about $432,000
in Newark, New Jersey; $500,000 in Salinas, California; and about
$646,000 in San Francisco, California. If the limits were increased,
FHA insurance would be available to a greater number of potential
borrowers. Our analysis of HMDA data indicates that the agency could
have insured from 9 to 10 percent more loans in 2005 had the higher
mortgage limits been in place.[Footnote 17] The greatest portion of
this increase resulted from raising the loan limit floor in low-cost
areas from 48 to 65 percent of the conforming loan limit. In
particular, 82 percent of the new loans that would have been insured by
FHA and 74 percent of the dollar amount of those loans in our analysis
occurred in areas where the loan limits were set at the floor. Only 14
percent of the new loans (22 percent of the dollar amount of new loans)
would have resulted from increasing the loan limit ceiling. Our
analysis also found that the average size of an FHA-insured loan in
2005 would have increased from approximately $123,000 to about $132,000
had the higher loan limits been in place.
The effect of the other major legislative proposals on the demand for
FHA-insured loans is difficult to estimate. Although FHA has not
estimated the effect on demand, FHA officials expect that risk-based
pricing would enable them to serve more borrowers. By reducing premiums
for relatively lower-risk borrowers, FHA expects to attract more of
these borrowers. However, increased premiums for higher-risk borrowers
could reduce these borrowers' demand for FHA products. Additionally,
some high-risk borrowers who previously would have qualified for FHA
insurance would not qualify under risk-based pricing. The effect of
lowering down-payment requirements on demand for FHA-insured loans is
also difficult to estimate. FHA expects a new zero-down-payment product
to attract borrowers who otherwise would have used down-payment
assistance from nonprofit organizations funded by home sellers.
However, underwriting restrictions could limit the number of borrowers
who would qualify for the product.
Developments in the subprime market also may affect the demand for FHA
loans. Since 2001, FHA's share of the mortgage market has declined as
the subprime market has grown. However, relatively high default and
foreclosure rates for subprime loans and a contraction of this market
segment could shift market share to FHA. For example, one major lender
we interviewed said that FHA's continued modernization efforts combined
with a weakening subprime market likely would result in renewed demand
for FHA products as simplified processes make it easier for lenders to
originate FHA-insured loans.
Risk-Based Pricing Could Help Address Adverse Selection but Would
Affect the Cost and Availability of FHA Insurance for Some Borrowers:
To help address the problem of adverse selection, FHA has sought
authority to price insurance premiums based on borrower risk, which
would affect the cost and availability of FHA insurance for some
borrowers. Currently, all FHA-insured borrowers pay an up-front premium
of 1.5 percent of the original insured loan amount, and annual premiums
of 0.5 percent of the remaining insured principal balance. Under this
flat pricing structure, lower-risk borrowers subsidize higher-risk
borrowers. In recent years, innovations in the mortgage market have
allowed conventional mortgage lenders and insurers to identify and
approve relatively low-risk borrowers and charge fees based on default
risk. As relatively lower-risk borrowers in FHA's traditional market
segment have selected conventional financing, FHA has been left with
more high-risk borrowers who require a subsidy and fewer low-risk
borrowers to provide that subsidy.
Partly due to this trend, the President's fiscal year 2008 budget
stated that, in the absence of risk-based pricing, FHA would need to
raise premiums to avoid the need for a positive subsidy. FHA officials
told us that they would have to raise premiums for all borrowers to
1.66 percent up front and 0.55 percent annually. Raising premiums for
all borrowers could exacerbate FHA's adverse selection problem by
causing even more lower-risk borrowers to opt for more competitive
conventional products rather than FHA-insured loans, leaving FHA with
even fewer lower-risk borrowers to subsidize higher-risk borrowers.
Rather than raise premiums for all borrowers, FHA has proposed risk-
based pricing as a solution to the adverse selection problem. Under
risk-based pricing, some future FHA borrowers would pay more than the
current premiums while others would pay about the same or less. As
previously noted, discounting premiums could make FHA a more attractive
option for relatively lower-risk borrowers.
As of May 2007, FHA's risk-based pricing proposal established six
different risk categories, each with a different premium rate, for
purchase and refinance loans.[Footnote 18] FHA used data from its most
recent actuarial review to establish the six risk categories and
corresponding premiums based on the relative performance of loans with
various combinations of LTV ratio and credit score. Borrowers in
categories with higher expected lifetime claim rates would have higher
premiums than those in categories with lower claim rates. Premiums
would range from 0.75 percent up front and 0.50 percent annually for
the lowest-risk borrowers, to 3.00 percent up front and 0.75 percent
annually for the highest-risk borrowers. Although the premiums that FHA
would charge borrowers in the six risk categories would be more
commensurate with the risks of the loans, lower-risk borrowers would
continue to subsidize higher-risk borrowers to some extent.
If FHA were granted the authority to implement its risk-based pricing
proposal, the agency would publish a pricing matrix that would allow
borrowers to identify their likely premiums based on their credit
scores and LTV ratios. As shown in figure 2, lower borrower credit
scores and higher LTV ratios would result in higher insurance premiums.
However, FHA would use its TOTAL mortgage scorecard to make the final
determination of a borrower's placement in a particular risk category.
While TOTAL takes into account more borrower and loan characteristics
than LTV ratio and credit score (such as borrower reserves and payment-
to-income ratio), it was designed to predict the probability of claims
or defaults that would later result in claims within 4 years of loan
origination rather than lifetime claim rates. Therefore, FHA rescaled
the TOTAL scores to reflect lifetime claim rates. Because of the
additional risk characteristics considered by TOTAL, a borrower's TOTAL
score could indicate that a borrower belongs in a higher risk category
than would be suggested by LTV ratio and credit score alone. FHA has
not produced a formal estimate of how often this would occur, but plans
to include this caveat in its pricing matrix.
Figure 2: Impact of Borrower Credit Scores and LTV Ratios on Insurance
Premiums under FHA's Risk-Based Pricing Proposal:
[See PDF for image]
Source: GAO, FHA.
[End of figure]
Our analysis of how the proposed pricing structure would affect home
purchase borrowers similar to those insured by FHA in 2005 found that
approximately 43 percent of borrowers would have paid the same or less
while 37 percent would have paid more. As discussed more fully later,
20 percent would not have qualified for FHA insurance had the risk-
based pricing proposal been in effect. These percentages hold true
whether comparing the proposed risk-based premiums to the current
premiums of 1.5 percent up front and 0.5 percent annually or the higher
premiums of 1.66 percent up front and 0.55 percent annually that,
according to FHA, would be needed to maintain a negative subsidy rate
in fiscal year 2008. As shown in figure 3, risk-based pricing would
have had a similar impact on first-time and low-income homebuyers FHA
served in 2005.
Figure 3: Impact of FHA's Risk-Based Pricing Proposal on Borrowers'
Premiums, Including First-Time and Low-Income Homebuyers:
[See PDF for image]
Source: GAO, SFDW.
Note: We analyzed SFDW data on 2005 home purchase borrowers. The figure
shows how these borrowers would have fared under FHA's risk-based
pricing proposal. Low-income homebuyers are those whose incomes are
less than or equal to 80 percent of the area median income. The figure
excludes the approximately 2 percent of borrowers for whom SFDW did not
contain either an LTV ratio or credit score (the two variables FHA
would use to determine risk-based premiums).
[End of figure]
Among FHA's 2005 borrowers, 47 percent of white borrowers and 40
percent of Hispanic borrowers would have paid the same or less under
the new proposed risk-based pricing structure than they did under the
present pricing structure, while 28 percent of black borrowers would
have paid the same or less. A little more than one-third of borrowers
in each racial category would have paid more (see fig. 4). FHA
officials concluded, in their analysis of an earlier version of the
risk-based pricing proposal, that any disparate impacts of risk-based
pricing using consumer credit scores would be based on valid business
reasons. Specifically, they noted that, although some racial
differences do exist in the distribution of credit scores and LTV
ratios, these variables are strongly associated with claim rates and
have become the primary risk factors used for pricing credit risk in
the conventional market.
Figure 4: Impact of FHA's Risk-Based Pricing Proposal on Premiums Paid
by Different Racial Groups:
[See PDF for image]
Source: GAO, SFDW.
Note: We analyzed SFDW data on 2005 home purchase borrowers. The figure
shows how these borrowers would have fared under FHA's risk-based
pricing proposal. It excludes the 2 percent of borrowers for whom SFDW
did not contain either an LTV ratio or credit score (the two variables
FHA would use to determine risk-based premiums) and the 2.9 percent of
borrowers for whom race was not disclosed. Percentages do not add to
100 due to rounding.
[End of figure]
Risk-based pricing would also affect the availability of FHA insurance
for some borrowers. Approximately 20 percent of FHA's 2005 borrowers
would not have qualified for FHA mortgage insurance under the
parameters of the risk-based pricing proposal we evaluated. FHA
determined that the expected claim rates of these borrowers were higher
than it found tolerable for either the borrower or the Fund. Those
borrowers who would not have qualified had high LTV ratios and low
credit scores. Their average credit score was 584, and their expected
lifetime claim rates are more than 2.5 times higher than the average
claim rate of all FHA loans.[Footnote 19] FHA officials stated that
setting risk-based premiums for potential future FHA borrowers with
similar characteristics would require prices higher than borrowers may
be able to afford.
The overall distribution of 2005 FHA borrowers (by income, first-time
borrower status, or race) would not have changed substantially had the
policy not to serve borrowers with these higher expected lifetime claim
rates been in place that year (all other things being equal). If the 20
percent of borrowers with the higher expected claim rates were removed
from FHA's 2005 borrower pool, our analysis found that low-income
homebuyers would have remained about 51 percent of the pool. First-time
homebuyers would have constituted about 78 percent of the pool,
compared with 79 percent when all borrowers are included. Similarly,
the overall racial distribution of borrowers would have changed
modestly (see fig. 5). The percentage of Hispanic borrowers would have
remained about 14 percent, black borrowers would have decreased from 13
to 11 percent, and white borrowers would have increased from 69 to 70
percent.
Figure 5: Impact of FHA's Risk-Based Pricing Proposal on Racial
Distribution of FHA Borrowers:
[See PDF for image]
Source: GAO, SFDW.
Note: We analyzed SFDW data on 2005 home purchase borrowers. The figure
shows how these borrowers would have fared under FHA's risk-based
pricing proposal. Percentages do not add to 100 due to rounding.
[End of figure]
All other things being equal, implementing the legislative proposals
likely would have had a slightly negative impact on FHA's ability to
meet certain performance measures related to the types of borrowers it
serves. HUD's strategic plan for fiscal years 2006 to 2011 calls for
the share of first-time minority homebuyers among FHA home purchase
mortgages to remain above 35 percent. Our analysis shows that 34
percent of fiscal year 2005 home purchase mortgages were for first-time
minority home buyers. Under risk-based pricing, a slightly lower
percentage, 32 percent, would have been first-time minority home
buyers. The strategic plan also calls for the share of FHA-insured home
purchase mortgages for first-time homebuyers to remain above 71
percent. Our analysis shows that 79 percent of fiscal year 2005 FHA
home purchase borrowers were first-time home buyers. Under risk-based
pricing, 77 percent would have been first-time home buyers.
Legislative Proposals Likely Would Have a Beneficial Budgetary Impact:
According to FHA's estimates, the three major legislative proposals
would have a beneficial impact on HUD's budget due to higher estimated
negative subsidies. According to the President's fiscal year 2008
budget, the credit subsidy rate for the Fund would be more favorable if
the legislative proposals were enacted. Absent any program changes, FHA
estimates that the Fund would require an appropriation of credit
subsidy budget authority of approximately $143 million. If the
legislative proposals were not enacted, FHA would consider raising
premiums to avoid the need for appropriations. If the major legislative
proposals were passed, FHA estimates that the Fund would generate $342
million in negative subsidies.[Footnote 20]
FHA's subsidy estimates for fiscal year 2008 should be viewed with
caution given that FHA has generally underestimated the subsidy costs
for the Fund. To meet federal requirements, FHA annually reestimates
subsidy costs for each loan cohort dating back to fiscal year
1992.[Footnote 21] 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 higher than originally
estimated. As discussed more fully later in this report, FHA has taken
some steps to improve its subsidy estimates.
FHA Has Enhanced Tools and Resources Important to Implementing
Proposals but Does Not Intend to Mitigate Risks by Piloting New
Products:
FHA has enhanced the tools and resources it uses that would be
important to implementing the legislative proposals, but has not always
used industry practices that could help the agency manage the risks
associated with program changes. To implement risk-based pricing, FHA
would rely on historical loan-level data, models that estimate loan
performance, and its TOTAL mortgage scorecard. Although FHA has
improved the forecasting ability of its models by adding variables
found to influence credit risk, the agency is still addressing
limitations in TOTAL that could reduce its effectiveness as a pricing
tool. FHA also has identified changes in information systems needed to
implement the legislative proposals and requested additional staff to
help promote new FHA products but faces long-term challenges in these
areas. However, the legislative proposals would introduce new risks and
challenges such as the difficulty of pricing loans with very low or no
down payments whose risks may not be well understood. While other
mortgage institutions use pilot programs to manage the risks associated
with changing or expanding their product lines, FHA has indicated that
it does not plan to pilot any no-down-payment product it is authorized
to offer.
Credit Score Information Has Enhanced the Data FHA Would Use to
Implement Proposals:
Mortgage institutions use detailed information on the characteristics
and performance of past loans to help predict the performance of future
loans and price them correctly. Like other mortgage institutions we
contacted, FHA has extensive loan-level data. These data are contained
in the agency's SFDW, which FHA implemented in 1996 to assemble
critical data from 12 single-family systems.[Footnote 22] SFDW is
updated monthly and currently contains data on approximately 33 million
FHA-insured loans dating back to fiscal year 1975. These data include
information on the borrower (such as age, gender, race, income, and
first-time home buyer status) and the loan (including whether it is an
adjustable-or fixed-rate mortgage, the source and amount of any down-
payment assistance, interest rate, premium rate, original mortgage
amount, and LTV ratio).
FHA has added information on borrower credit scores to the loan-level
data that it plans to use to assess risk and set insurance premiums if
the legislative proposals were enacted. Research has shown that credit
scores are a strong predictor of loan performance--that is, borrowers
with higher scores experience lower levels of default. FHA started
collecting credit score data in the late 1990s when it began allowing
its lenders to use automated underwriting systems and mortgage
scorecards. Upon approving the use of Fannie Mae and Freddie Mac's
mortgage scorecards in fiscal year 1998, FHA began receiving credit
score data for loans underwritten using these scoring tools. To develop
its own mortgage scorecard, FHA purchased archived credit scoring data
for loan origination samples dating back to 1992. Since implementing
its TOTAL mortgage scorecard in May 2004, FHA has collected credit
scores on almost all FHA borrowers.
FHA Has Made Some Improvements to Key Statistical Models, but
Additional Challenges Remain:
FHA would rely on both its loan performance models and TOTAL mortgage
scorecard to set insurance premiums if authorized to implement risk-
based pricing. Although FHA has improved the forecasting ability of its
loan performance models by incorporating additional variables found to
influence credit risk, FHA is still in the process of addressing a
number of limitations in TOTAL that could reduce its effectiveness for
risk-based pricing. The agency's actuarial review contractor developed
the loan performance models to estimate the economic value of the Fund
for the annual actuarial review. The models estimate lifetime claim and
prepayment (the payment of a loan before its maturity date) rates based
on factors such as origination year, age, interest rate, mortgage
product type, initial LTV ratio, and loan amount. FHA used the
projected lifetime claim and prepayment rates from the most recent
actuarial review as the basis for its proposed risk-based insurance
premiums.[Footnote 23]
FHA has improved its loan performance models by adding factors that
have been found to influence credit risk. In September 2005, we
reported that FHA's subsidy reestimates, which use data from FHA's loan
performance models, reflect a consistent underestimation of the costs
of its single-family insurance program. We recommended that FHA study
and report the impact (on the forecasting ability of its loan
performance models) of variables that have been found in other studies
to influence credit risk, such as payment-to-income ratios, credit
scores, and the presence of down-payment assistance.[Footnote 24] 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.
FHA also intends to use TOTAL to determine risk-based premiums, but we
have identified weaknesses in the scorecard that could limit its
effectiveness as a pricing tool. As previously noted, FHA plans to use
TOTAL to make the final determination regarding premium rates if
authorized to implement risk-based pricing. However, we reported in
April 2006 that TOTAL excludes a number of important variables included
in other mortgage scoring systems.[Footnote 25] For example, TOTAL does
not distinguish between adjustable-and fixed-rate mortgages. However,
adjustable-rate mortgages generally are considered to be higher risk
than otherwise comparable fixed-rate mortgages because borrowers are
subject to higher payments if interest rates rise. Unlike the mortgage
scorecards of other institutions, TOTAL also does not include an
indicator for property type (single-family detached homes or
condominiums, for example).[Footnote 26] While currently a small
component of FHA's business, FHA expects that it would insure more
condominium loans if the condominium program were moved to the Fund, as
set forth in its legislative proposal. Additionally, TOTAL does not
indicate the source of the down payment. We have reported that the
source of a down payment is an important indicator of risk, and the use
of down-payment assistance in the FHA program has grown substantially
since 2000. Finally, our April 2006 report noted that the data used to
develop TOTAL were not current and FHA had no plans to update the
scorecard on a regular basis.
Consistent with our recommendations concerning TOTAL, FHA developed
policies and procedures that call for (1) an annual evaluation of the
scorecard's predictive ability, (2) testing of additional predictive
variables to include in the scorecard, and (3) populating the scorecard
with more recent loan performance data. An FHA contractor is helping
the agency to implement these procedures and is scheduled to issue a
final report on its work in August 2007. After receiving the
contractor's report, FHA will decide what changes to TOTAL are
necessary. Because the magnitude of these changes has not yet been
determined, FHA does not have a completion date for this effort. FHA
officials indicated that they would initially implement risk-based
pricing using the current version of TOTAL but would use the updated
version when it became available.
FHA Has Identified Needed Changes in Information Technology but Faces
Funding and Implementation Challenges:
FHA has identified changes needed in its information technology to
implement the legislative proposals. FHA has divided these changes into
two phases. The first phase consists of simpler changes that it can
make in the short term, such as revising the system used to originate
FHA-insured loans to allow for down payments of less than 3 percent.
FHA also would need to make other changes to the system to support the
new loan limits, such as allowing the loan amount to equal 100 percent
of the conforming loan limit in applicable areas. The second phase
includes modifications to the computer programs that calculate the up-
front and annual insurance premiums to reflect risk-based pricing and
revisions related to the proposed changes to the HECM and condominium
programs.
FHA has not yet obtained some of the funding needed to make the
technology changes and does not have estimates for how long it would
take to complete all of the changes. In fiscal year 2006, the agency
obligated $2.8 million of the $10.9 million it estimated was needed to
make all anticipated changes. Specifically, FHA plans to use funds
reprogrammed from HUD's salaries and expense account and other
available funds to complete the first phase of changes. FHA estimates
that most of this work could be completed in a few months. The
President's fiscal year 2008 budget requests an additional $8.1 million
to fund the second phase of changes needed to implement the legislative
proposals. However, FHA officials told us that they did not have an
implementation schedule for this phase and were waiting until the
legislative proposals were approved and they had secured the funding to
develop one.
Although FHA officials indicated that they could implement the
legislative proposals after making these minor information technology
changes, they also told us that major systems changes and integration
would be needed to bring FHA's systems up to levels comparable with
other mortgage institutions. Currently, over 40 systems support FHA's
single-family business activity. While a thorough evaluation of large-
scale systems changes was outside the scope of our review, FHA has
indicated that its systems are poorly integrated, expensive to
maintain, and do not fully support the agency's operations and business
requirements.[Footnote 27] For example, the systems cannot easily share
or provide critical information because they use different database
platforms with varying capabilities; some of the older systems use an
outdated programming language; and the creation of ad hoc systems that
do not interface with other systems has resulted in duplicate data
entry. However, FHA has limited resources to devote to the development
of new systems for two main reasons. First, it has to compete with
other divisions within HUD for information technology resources. Of the
approximately $300 million that HUD has requested for information
technology development and maintenance in fiscal year 2008, about 5
percent would be for FHA's single-family operations. Second, FHA spends
what resources it has primarily on systems maintenance. Of the $19
million that FHA has budgeted for single-family information technology
in fiscal year 2007, FHA officials estimate that $15 million would be
devoted to systems maintenance.
In contrast with FHA, officials from other mortgage institutions with
whom we spoke indicated that they devote substantial resources to
developing new systems and enhancing existing systems that help them
price products and manage risk. To illustrate, officials from one
mortgage institution stated that they had a $15 million annual budget
for capital improvements in information technology. Officials from
another mortgage institution told us that 17 percent of the company's
total expenses were related to information technology and that they
recently spent about $15 million to develop a new system to price a
mortgage product for the foreign market. These and other mortgage
industry officials stressed that investments in state-of-the-art
information systems were critical to operating successfully in the
highly competitive mortgage market.
FHA Has Sought Limited Staff Increases to Help Implement Proposals, but
Other Workforce Challenges Remain:
According to FHA officials, the legislative proposals would not
fundamentally alter how the agency administers its single-family
mortgage insurance program and, therefore, would not require major
increases in staff above the approximately 950 single-family housing
employees it had as of March 2007. Although implementing the
legislative proposals would require considerable program analysis and
monitoring, much of the analysis required to develop the proposals was
performed primarily by staff from FHA's Offices of Finance and Budget
and Single Family Housing with assistance from several contractors, who
will continue to support the implementation. FHA officials told us that
marketing any new products authorized and explaining program changes to
lenders would be their next major challenge if the legislative
proposals were passed. They also noted that successful implementation
would require them to stay abreast of developments in the mortgage
market. Therefore, the President's fiscal year 2008 budget requests an
additional 21 full-time equivalent (FTE) positions to help promote new
FHA products, analyze industry trends, and align the agency's single-
family business processes with current mortgage industry practices.
Although a detailed assessment of FHA's staffing needs was outside the
scope of our review, a HUD contractor's 2004 workforce analysis
suggests that FHA faces broader challenges that could affect the
agency's operations going forward.[Footnote 28] The analysis projected
that FHA would have 78 fewer FTEs than needed to handle anticipated
work demands by fiscal year 2008, assuming hires and transfers equal to
the average numbers for 2001 through 2003. In addition to anticipated
FTE shortfalls, the report also identified existing and projected
deficits of FHA staff with certain important competencies such as
technical credibility and knowledge of single-family programs,
policies, and regulations.[Footnote 29] For example, the consultant
projected a difference of 28 percentage points between the percentage
of staff requiring technical credibility and the percentage that would
meet this requirement in fiscal year 2008. FHA officials have
acknowledged the agency's staffing challenges and have developed plans
to address the projected gaps. In fiscal years 2005 and 2006, FHA
gained 228 staff through hiring or transfers. However, the contractor
had assumed gains of 362 staff during those years, which means that the
projected fiscal year 2008 shortfall will be worse than originally
estimated without substantial staff accessions in fiscal years 2007 and
2008.
FHA also faces hiring and salary constraints that other mortgage
institutions do not. FHA's hiring authority is limited by statute and
congressional appropriations. Federal statute (Title 5 of the U.S.
Code) restricts the amounts that FHA can pay staff, and each year's
appropriation determines how many staff it can hire. Further, FHA must
compete with other divisions within HUD for staffing resources and may
not always receive its full request. Other mortgage institutions have
greater flexibility in their ability to hire and compensate staff. For
example, Fannie Mae and Freddie Mac are not subject to federal pay and
hiring restrictions. These restrictions create challenges for FHA as it
competes for qualified staff in the competitive mortgage labor market.
FHA's Prior Risk Management Did Not Always Utilize Common Industry
Practices Such as Piloting, but Some Planned Actions Could Help Address
New Risks and Challenges:
Although FHA has not always utilized risk-management practices that
other mortgage institutions use, it plans to take some steps to help
address the new risks and challenges associated with the legislative
proposals. In November 2005, we reported that HUD needed to take
additional actions to manage risks related to the approximately one-
third of its loans with down-payment assistance from seller-funded
nonprofits.[Footnote 30] Unlike other mortgage industry participants,
FHA does not restrict homebuyers' use of such assistance. Our 2005
analysis found that the probability that these loans would result in an
insurance claim was 76 percent higher than for comparable loans without
such assistance, and we recommended that FHA revise its underwriting
standards to consider such assistance as a seller contribution (which
cannot be used to meet the borrower contribution requirement).[Footnote
31] Despite the detrimental impact of these loans on the Fund, FHA did
not act promptly to mitigate the problem by adjusting underwriting
standards or using its existing authority to raise premiums. However,
in May 2007, FHA published a proposed rule that would prohibit seller-
funded down-payment assistance.[Footnote 32]
In addition, as we reported in February 2005, other mortgage
institutions limit the availability of or pilot new products to manage
risks associated with changing or expanding product lines.[Footnote 33]
We have previously indicated that, if Congress authorizes FHA to insure
new products, it should consider a number of means, including limiting
their initial availability, to mitigate the additional risks these
loans may pose. We also recommended that FHA consider similar steps for
any new or revised products. However, in response, FHA officials told
us that they lacked the resources to effectively manage a program with
limited volumes. We noted that if FHA did not limit the availability of
new or changed products, the potential costs of making widely available
a product with risks that may not be well understood could exceed the
cost of a pilot program. With respect to its legislative proposal, FHA
officials told us that they do not plan to pilot or limit the initial
availability of any zero-down-payment product the agency was authorized
to offer. They also indicated that they expected that a zero-down-
payment product would perform similarly to loans with seller-funded
down-payment assistance. While the experience of loans with this type
of assistance is informative, a zero-down-payment product could be
utilized by a different population of borrowers and may not perform the
same as these loans.
Nevertheless, if the legislative proposals were to be enacted, FHA
plans to take some steps to help address risks and challenges
associated with (1) managing the risks of no-down-payment loans, (2)
setting premiums to achieve a modestly negative subsidy rate, and (3)
modifying oversight of lenders. First, loans with low or no down
payments carry greater risk because of the direct relationship that
exists between the amount of equity borrowers have in their homes and
the risk of default. The higher the LTV ratio, the less cash borrowers
will have invested in their homes and the more likely it is that they
may default on mortgage obligations, especially during times of
economic hardship or price depreciation in the housing market. No-down-
payment loans became common in the conventional market when rapid
appreciation in home prices helped mitigate the risk of these loans.
However, if authorized to offer a zero-down-payment mortgage in the
near future, FHA would be introducing this product at a time when home
prices have stagnated or are declining in some parts of the country.
And because FHA would continue to allow borrowers to finance some
portion of closing costs and up-front insurance premiums, the effective
LTV ratio for loans with very low or no down payments could be greater
than 100 percent, further increasing FHA's insurance risk. To mitigate
the risks associated with loans with no down payments, FHA plans to
impose stricter underwriting criteria for such loans:
* FHA would limit the amount of up-front premium and closing costs that
could be financed; therefore, all borrowers would be making some
minimum cash contribution.
* FHA plans to require a minimum credit score of 640 to obtain FHA
insurance on loans with no down payments.[Footnote 34]
* FHA would limit its zero-down-payment product to loans for owner-
occupied, one-unit properties.
Second, FHA's legislative proposal would fundamentally change the way
the agency manages the Fund in that FHA would set premiums to achieve a
modestly negative overall subsidy rate, representing the weighted
average of the subsidy rates for the different risk-based pricing
categories. The President's budget for fiscal year 2008 estimates that
the weighted average subsidy rate would be -0.6 percent (meaning that
the Fund would generate negative subsidies amounting to 0.6 percent of
the total dollars insured for loans originated that year).[Footnote 35]
Achieving a modestly negative credit subsidy rate would depend on FHA's
ability to price new products whose risks may not be well understood,
although risk-based pricing could help FHA be more precise in setting
and adjusting premiums for different segments of its portfolio. FHA
officials told us that they would monitor the proportion of loans in
its two highest-risk categories and consider raising premiums or
tightening underwriting standards if unexpectedly high demand exposed
FHA to excessive financial risk. Fannie Mae, Freddie Mac, and the four
private mortgage insurers we interviewed noted that they carefully
monitor their portfolios to make sure that they do not have too many
loans in any given risk category and take similar steps when they
determine that this is the case.
Third, FHA may need to modify the way that it oversees lenders if the
legislative proposals were enacted. FHA has indicated that its
legislative proposals would help the agency to expand service to higher-
risk borrowers in a financially sound manner. However, FHA may need to
revise its Credit Watch program if it is to achieve this end. Under
Credit Watch, FHA terminates the loan origination authority of any
lender branch office that has a default and claim rate on mortgages
insured by FHA in the prior 24 months that exceeded both the national
average and 200 percent of the average rate for lenders in its
geographic area. Because termination currently is based on how a
lender's loans perform relative to other lenders in its geographic
area, lenders that chose to make loans to higher-risk borrowers could
suffer in comparison with lenders that served only lower-risk
borrowers. To encourage lenders to serve borrowers in the higher-risk
categories, FHA officials told us that they would consider taking into
account the mix of borrowers in the various risk categories when
evaluating a lender's performance. Because higher-risk loans can be
expected to incur higher default and claim rates, they stated that FHA
would not want to penalize lenders with larger shares of these loans as
long as the loans were performing within expected risk parameters. FHA
also has improved the accuracy and timeliness of the loan performance
data it uses to evaluate lenders by requiring lenders to update the
delinquency status of their loans more frequently.
Congress and FHA Could Consider Other Administrative and Legislative
Changes to Help FHA Adapt to Changes in the Mortgage Market:
Mortgage industry participants and researchers have suggested
additional options that Congress and FHA could consider to help FHA
adapt to changes in the mortgage market, but some changes could have
budget and oversight implications. FHA already has authority to
undertake some of these options. Other options would require additional
authorities from Congress to increase the agency's operational
flexibility. Congress also could consider alternative approaches to the
provision of federal mortgage insurance such as converting FHA to a
government corporation or implementing risk-sharing arrangements with
private partners.
FHA Has Existing Authority to Make More Administrative Changes:
Although FHA already has made several administrative changes to
streamline the agency's insurance processes, additional administrative
changes within FHA's existing authority could alleviate, to some
extent, the need for a positive subsidy in fiscal year 2008. More
specifically, FHA could exercise its existing authority to raise up-
front premiums up to 2.25 percent and, for borrowers with down payments
of less than 5 percent, annual premiums to 0.55 percent.
To moderate the need for a positive subsidy in fiscal year 2008, FHA
could use its existing authority to increase premiums in one of three
ways: (1) FHA could raise premiums for all borrowers, as the
President's fiscal year 2008 budget suggests will be necessary; (2) FHA
could charge the higher 0.55 percent annual premium to borrowers with
lower down payments; or (3) FHA could implement a more limited form of
risk-based pricing than it has proposed by adjusting premiums within
the current statutory limits. HUD's Office of General Counsel
determined in March 2006 that FHA has the authority to structure
premiums for programs under the Fund on the basis of risk. FHA could
implement premium adjustments, either for all or some borrowers,
through the regulation process. However, according to FHA officials,
the current statutory limits on premiums are too low to allow FHA to
implement a risk-based pricing plan that would allow the agency to set
prices high enough to compensate for the expected losses from the
highest-risk borrowers or a new zero-down-payment product. And while
raising premiums for some higher-risk borrowers could improve the
Fund's credit subsidy rate, raising premiums for all borrowers might
exacerbate FHA's adverse selection problem. That is, FHA could lose
higher credit quality borrowers, resulting in fewer borrowers to
subsidize lower credit quality borrowers. This, in turn, could require
FHA to raise premiums again.
Additional Authorities for Investment in Technology, Pay and Hiring,
and Introduction of Products Could Increase FHA's Operational
Flexibility:
According to mortgage industry participants and researchers, Congress
also could consider granting FHA additional authorities to increase the
agency's ability to invest in technology and staff or offer new
insurance products. First, Congress could grant FHA specific authority
to invest a portion of the Fund's current resources--that is, negative
subsidies that accrue in the Fund's reserves--in technology
enhancement. The congressionally-appointed Millennial Housing
Commission (MHC) found that FHA's dependence on the appropriations
process for budgetary resources and competition for funds within HUD
had led to under-investment in technology, increasing the agency's
operational risk and making it difficult for FHA to work efficiently
with lenders and other industry partners.[Footnote 36] Because FHA's
single-family insurance program historically has generated estimated
negative subsidies, FHA and some mortgage industry officials have
suggested that the agency be given the authority to use a portion of
the Fund's current resources to upgrade and maintain its technology.
One benefit of this option is that the technology enhancements could
improve FHA's operations. As previously noted, FHA has more than 40
single-family information systems that are poorly integrated, expensive
to maintain, and do not fully support the agency's business
requirements. However, according to FHA, the option would require a
statutory change to allow FHA to use the Fund's current resources to
pay for technology improvements. Also, the Fund is required by law to
operate on an actuarially sound basis. Because the soundness of the
Fund is measured by an estimate of its economic value--an estimate that
is subject to inherent uncertainty and professional judgment--the
Fund's current resources should be used with caution. Spending the
Fund's current resources would lower the Fund's reserves, which in turn
would lower the economic value of the Fund. As a result, the Fund's
ability to withstand severe economic conditions could be diminished.
Also, using the Fund's current resources would increase the federal
budget deficit unless accompanied by corresponding reductions in other
government spending or an increase in receipts.
Second, Congress could consider allowing FHA to manage its employees
outside of federal pay scales. Some federal agencies, such as the
Securities and Exchange Commission, the Office of Thrift Supervision,
and the Federal Deposit Insurance Corporation, are permitted to pay
salaries above normal federal pay scales in recognition of the special
skills demanded by sophisticated financial market operations.[Footnote
37] The MHC and mortgage industry officials have suggested that FHA be
given similar authority. This option could help FHA to recruit
experienced staff to help the agency adapt to market changes. Like the
authority to invest in technological enhancement, this option could be
funded with the Fund's current resources but would have similar
implications for the financial health of the Fund and the federal
budget deficit.
Third, Congress could authorize FHA to offer and pilot new insurance
products without prior congressional approval. A variety of new
mortgage products have appeared in the mortgage market in recent years,
but FHA's ability to keep pace with market innovations is limited. For
example, the MHC found that the statutes and regulations to which FHA
is subject dramatically increase the time necessary to develop and
implement new products. The MHC and mortgage industry officials have
recommended that Congress expressly authorize FHA to introduce new
products without requiring a new statute for each. Such authority would
offer FHA greater flexibility to keep pace with a rapidly changing
mortgage market. However, Congress would have less control over FHA's
product offerings and, in some cases, it might take years before a new
product's risks were well understood.
To manage the risks of new products, mortgage institutions may impose
limits on the volume of the new products they will permit and on who
can sell and service those products. Limits on the availability of new
or revised FHA mortgage insurance products are sometimes set through
legislation and focus on the volume of loans that FHA may insure. In a
prior report, we recommended that FHA consider using pilots for new
products and making significant changes to its existing
products.[Footnote 38] Since FHA officials questioned the circumstances
in which they could use pilots or limit volumes when not required by
Congress, we also recommended that FHA seek the authority to offer new
products on a limited basis, such as through pilots, if the agency
determines it currently lacks sufficient authority. However, FHA has
not sought this authority. Furthermore, while piloting could help FHA
manage the risks associated with implementing new products, FHA
officials told us that they lack the resources to manage a program with
limited volumes effectively.[Footnote 39]
Finally, Congress could authorize FHA to insure less than 100 percent
of the value of the loans it guarantees. Unlike private mortgage
insurers, which offer several levels of insurance coverage up to a
maximum of 40 or 42 percent (depending on the company) of the value of
the loan, FHA insures 100 percent of the value of the loan. But since
most FHA insurance claims are offset by some degree of loss recovery,
some mortgage industry observers have suggested that covering 100
percent of the value of the loan may not be necessary. In prior work,
we examined the potential effects of reducing FHA's insurance coverage
and found that while lower coverage would cause a reduction in the
volume of FHA-insured loans and a corresponding decline in income from
premiums, it would also result in reduced losses and ultimately have a
beneficial effect on the Fund.[Footnote 40] However, we also noted that
partial FHA coverage could lessen FHA's ability to stabilize local
housing markets when regional economies decline and may increase the
cost of FHA-insured loans as lenders set higher prices to cover their
risk.
Alternative Approaches for Providing Federal Mortgage Insurance Include
Converting FHA to a Government Corporation:
The MHC, HUD officials, and other mortgage industry participants have
suggested alternative approaches to provide federal mortgage insurance
in a changing mortgage market. First, since the mid-1990s, several
groups including HUD and the MHC have proposed converting FHA into
either an independent or a HUD-owned government corporation--that is,
an agency of government, established by Congress to perform a public
purpose, which provides a market-oriented service and produces revenue
that meets or approximates its expenditures. Government corporations
operate more independently than other agencies of government and can be
exempted from executive branch budgetary regulations and personnel and
compensation ceilings. Therefore, converting FHA to a corporation could
provide the corporation's managers with the flexibility to determine
the best ways to meet policy goals set by Congress or HUD.
This option could have budgetary and oversight implications that would
need to be considered when setting up the new corporation. For example,
Congress would have to determine the extent to which (1) the
corporation's earnings in excess of those needed for operations and
reserves would be available for other government activities and (2) the
corporation would be subject to federal budget requirements. Also, if
the corporation were created outside of HUD, Congress would have to
consider whether oversight of the corporation would require a new
oversight institution or could be performed by an existing organization.
Alternatively, rather than maintaining all the functions of a mortgage
insurer within a government entity, the MHC and private mortgage
insurers have suggested that the federal government could provide
mortgage insurance through risk-sharing agreements with private
partners.[Footnote 41] FHA already works with partners to conduct
various activities related to its operations. For example, FHA has
delegated underwriting authority to approved lenders, and contractors
perform many day-to-day activities (such as marketing foreclosed
properties) that once were performed by FHA employees. A public-private
risk-sharing arrangement would recognize that government has a better
ability to spread risk, while private mortgage industry participants
generally are more flexible and responsive to market pressures and
better able to innovate and adopt new technologies quickly. There are
many different possible ways to structure a risk-sharing approach, with
variables such as the amount of insurance coverage provided, the number
and type of risk-sharing partners, the degree of risk accepted by each
partner, and the roles and responsibilities of the partners.
Whatever the structure, a risk-sharing approach could result in greater
efficiency and allow FHA to reach new borrowers through new partner
channels. However, risk sharing also could diminish the federal
government's ability to stabilize markets if private partners lacked
incentive to serve markets where economic conditions were
deteriorating. Additionally, implementing risk-sharing arrangements
might require more specialized expertise than FHA currently has among
its staff. For example, careful analysis in both program design and
monitoring would be needed to ensure that FHA's financial interests
were adequately protected.
Finally, Congress and FHA could elect to make no changes at this time
and allow the private market to play the definitive role in determining
the future need for federal mortgage insurance. The recent decline in
FHA's market share occurred at a time when interest rates were low,
house price appreciation was high, and mortgage credit was widely
available. However, changes in the mortgage market, such as higher
interest rates and stricter underwriting standards for subprime loans,
may lead to an increasing role for FHA in the future or at least a
continued role for the federal government in guaranteeing mortgage
credit for some borrowers. Therefore, even if Congress and FHA were to
make no changes at this time, FHA's market share might increase due to
the recent change in market conditions. Or it might eventually become
so small as to indicate that there is no longer a need for a federal
role in providing mortgage insurance. If FHA's market share continues
to decline to such a level, FHA might be eliminated or critical
functions reassigned to maintain a minimal federal role in guaranteeing
mortgage credit.
Making no changes to FHA at this time would acknowledge the substantial
role the private market now plays in meeting the mortgage credit needs
of borrowers. However, some home buyers might find it more difficult
and more costly to obtain mortgages if FHA were eliminated or its
functions reduced and reassigned to another federal agency.[Footnote
42] And allowing FHA to become too small could impact the federal
government's ability to play a role in stabilizing mortgage markets
during an economic downturn. Also, any option that might lead to the
eventual elimination of FHA's single-family mortgage insurance program
would have broader implications for FHA and its other programs, such as
the multifamily mortgage insurance and regulatory programs, which this
report does not address. Such implications would, therefore, require
further study.
Observations:
Recent trends in the mortgage market, including the prevalence of low-
and no-down-payment mortgages and increased competition from
conventional mortgage and insurance providers, have posed challenges
for FHA. FHA's market share has declined substantially over the years,
and what was a negative subsidy rate for the single-family insurance
program has crept toward zero. To adapt to market changes, FHA has
implemented new administrative procedures and proposed legislation
designed to modernize its mortgage insurance processes, introduce
product changes, and provide additional risk-management tools. To its
credit, FHA has performed considerable analysis to support its
legislative proposal and has made or planned enhancements to many of
the specific tools and resources that would be important to its
implementation.
However, the proposals present risks and challenges and should be
viewed with caution for several reasons. First, FHA has not always
effectively managed risks associated with product changes, most notably
the growth in the proportion of FHA-insured loans with seller-funded
down-payment assistance. In that case, FHA did not use the risk-
management tools already at its disposal to mitigate adverse loan
performance that has had a detrimental impact on the Fund. Second, the
proposal to lower down-payment requirements potentially to zero raises
concerns given the greater default risk of loans with high LTVs,
policies that could result in effective LTV ratios of over 100 percent,
and housing market conditions that could put borrowers with such loans
in a negative equity position. Sound management of very low or no-down-
payment products would be necessary to help ensure that FHA and
borrowers do not experience financial losses. Piloting or otherwise
limiting the availability of new products would allow FHA the time to
learn more about the performance of these loans and could help avoid
unanticipated insurance claims. Despite the potential benefits of this
practice, FHA generally has not implemented pilots, unless directed to
do so by Congress. We have previously indicated that, if Congress
authorizes FHA to insure new products, Congress and FHA should consider
a number of means, including limiting their initial availability, to
mitigate the additional risks these loans may pose. We continue to
believe that piloting would be a prudent approach to introducing the
products authorized by FHA's legislative proposal. Finally, FHA would
face the challenge of setting risk-based premiums--potentially for
products whose risks may not be well understood--to achieve a specific
financial outcome, a relatively small negative subsidy. Because the
estimated subsidy rate is close to zero and FHA has consistently
underestimated its subsidy costs, FHA runs some risk of missing its
target and requiring a positive subsidy. Additionally, limitations we
have identified in FHA's TOTAL scorecard, which would be a key tool
used in risk-based pricing, could reduce the agency's ability to set
prices commensurate with the risk of the loans. Accordingly, it will be
important for FHA to continue making progress in addressing these
limitations.
Our recent report on trends in FHA's market share underscores the
challenges that FHA has faced in adapting to the changing mortgage
market. For example, we noted that FHA's share of the market for home
purchase mortgages has declined precipitously since 2001 due in part to
FHA product restrictions and a lack of process improvements relative to
the conventional market. While FHA has taken some steps to improve its
processes and enhance the tools and resources that it would use to
implement the modernization proposals, additional changes may be
necessary for FHA to operate successfully in the long run in a
competitive and dynamic mortgage market. Other mortgage industry
participants have greater flexibility to hire and compensate staff,
invest in information technology, and introduce new products, enhancing
their ability to adapt to market changes and manage risk. A number of
policy options that go beyond FHA's modernization proposals would give
FHA similar flexibility but would have other implications that would
require careful deliberation.
Agency Comments and Our Evaluation:
We provided HUD with a draft of this report for review and comment. HUD
provided comments in a letter from the Assistant Secretary for Housing-
Federal Housing Commissioner (see app. II). HUD said that the draft
report provided a balanced assessment but also that the report's
concerns about FHA's risk management and emphasis on the need for
piloting lower-down-payment products were unwarranted.
HUD said that it welcomed the draft report's acknowledgment of FHA's
improvements in program administration and risk management but
questioned the report's concerns about FHA's ability to understand and
manage risk. HUD indicated that its proposal to diversify FHA's product
offerings and pricing structure grew out of recognition that FHA was
subject to adverse selection, as evidenced by the loss of borrowers
with better credit profiles and growth in seller-funded down-payment
assistance loans. In addition, HUD listed steps it had taken to curtail
seller-funded down-payment assistance, including publishing a proposed
rule in May 2007 that would effectively eliminate seller-funded down-
payment assistance in conjunction with FHA-insured loans. Our draft
report cited a number of improvements in FHA's risk management, such as
enhancements to its loan performance models. However, we continue to
believe that our concerns about FHA's ability to manage risk are
warranted. As our draft report noted, FHA did not take prompt action to
mitigate the adverse financial impact of loans with seller-funded down-
payment assistance. Furthermore, our draft report identified additional
steps, such as improvements to TOTAL scorecard, that would help address
the risks and challenges associated with the legislative proposals.
With regard to piloting, HUD said that pilot programs are appropriate
where a concept is untested but that the concept of zero-or lower-down-
payments was well understood. HUD indicated that it had a firm basis
for anticipating the performance of zero-and lower-down-payment loans
as a result of its experience with mortgages with seller-funded down-
payment assistance. HUD said it used this experience to establish risk-
based insurance premiums and minimum credit scores for zero-and lower-
down-payment borrowers. Additionally, HUD said that it had recently
started to collect 30-day and 60-day delinquency data, giving the
agency the capability to track performance trends for different
segments of its loan portfolio on a monthly basis. HUD stated that, for
these reasons, the risks of zero-or lower-down-payment loans were
sufficiently well known or knowable to not warrant a pilot program.
As our draft report noted, we previously have reported that other
mortgage institutions limit the availability of, or pilot, new products
to manage the risks associated with changing or expanding their product
lines and have recommended that FHA consider adopting this practice.
Our draft report also acknowledged that FHA's experience with seller-
funded down-payment assistance could inform assessment of how a zero-
down-payment product would perform. However, we continue to believe
that FHA should consider limiting the availability of a loan product
with no down payment. In particular, our draft report discussed two
factors that indicate the need for caution in introducing such a
product. First, a zero-down-payment product could be utilized by a
different population of borrowers than seller-funded down-payment
assistance loans and may not perform similarly to these loans. Second,
zero-down-payment loans became common in the conventional mortgage
market when rapid appreciation in home prices helped mitigate the risks
of these loans. If authorized to offer a zero-down-payment product in
the near future, FHA would be introducing it at a time when home prices
have stagnated or are declining in some parts of the country. Because
of these risks and uncertainties, we continue to believe that a prudent
way to introduce a zero-down-payment product would be to limit its
initial availability such as through a pilot program.
We are sending copies of this report to the Chairman, Senate Committee
on Banking, Housing, and Urban Affairs; Chairman and Ranking Member,
Subcommittee on Housing and Transportation, Senate Committee on
Banking, Housing, and Urban Affairs; Chairman and Ranking Member, House
Committee on Financial Services; and Chairman and Ranking Member,
Subcommittee on Housing and Community Opportunity, House Committee on
Financial Services. We will also send copies to the Secretary of
Housing and Urban Development and to other interested parties and make
copies available to others upon request. In addition, the report will
be made available at no charge on the GAO Web site at http://
www.gao.gov.
Please contact me at (202) 512-8678 or shearw@gao.gov if you or your
staff have any questions about this report. Contact points for our
Offices of Congressional Relations and Public Affairs may be found on
the last page of this report. Key contributors to this report are
listed in appendix III.
Signed by:
William B. Shear:
Director, Financial Markets and Community Investment:
[End of section]
Appendix I: Objectives, Scope, and Methodology:
The Ranking Member of the Senate Committee on Banking, Housing, and
Urban Affairs and Senator Wayne Allard requested that we evaluate FHA's
modernization efforts, which include administrative and proposed
legislative changes. Specifically, we examined (1) the likely program
and budgetary impacts of FHA's modernization efforts, (2) the tools,
resources, and risk-management practices important to FHA's
implementation of the legislative proposals, if passed, and (3) other
options that FHA and Congress could consider to help FHA adapt to
changes in the mortgage market and the pros and cons of these options.
To determine the likely program and budgetary impacts of FHA's
modernization efforts, we reviewed FHA guidance on three administrative
changes implemented in 2006: the Lender Insurance Program and revisions
to the agency's appraisal protocols and closing cost guidelines. To
determine the extent to which these administrative changes have
affected the processing of FHA-insured loans, we interviewed
representatives of Countrywide Financial, Wells Fargo, Bank of America,
and Lenders One (a mortgage co-operative representing about 90
independent mortgage bankers). We selected Countrywide Financial and
Wells Fargo because they are large FHA lenders, Bank of America because
it had recently decided to grow its FHA business, and Lenders One
because some of its members make FHA loans. We also interviewed
representatives of three mortgage and real estate industry groups--
Mortgage Bankers Association, National Association of Realtors, and
National Association of Home Builders. To determine how the Lender
Insurance Program has affected the processing of FHA insurance, we
interviewed FHA officials and obtained documentation from them on the
extent of lender participation in the program and its effect on
insurance processing time and costs.
In evaluating the likely program impacts of FHA's proposed legislative
changes, we focused on the proposals to raise FHA loan limits,
institute risk-based pricing of mortgage insurance premiums, and lower
down-payment requirements. To examine the effect of raising loan limits
on demand for FHA-insured loans, we analyzed 2005 HMDA data (the most
current available). Specifically, we analyzed the home purchase loans
recorded in 2005 to determine the number of loans in each of 380 core
based statistical areas (CBSA) and used that data to calculate FHA's
market share in each CBSA.[Footnote 43] (These 380 CBSAs were those for
which we had data and included one aggregate "nonmetro" category.) We
then determined the number of additional loans that, based on their
loan amounts, would have been eligible for FHA insurance in 2005 had
the higher proposed loan limits been in effect. Finally, we estimated
the percentage of the newly-eligible loans in each CBSA that FHA would
have insured using the following range of assumptions: (1) that FHA's
market share would have been approximately the same as it was among all
loans in that CBSA under the actual 2005 loans limits, (2) that FHA's
market share would have been approximately the same as its share of
loans with loan amounts ranging from 70 to 100 percent of the actual
2005 loan limits in that CBSA, (3) that FHA's market share would have
been approximately the same as its share of loans with loan amounts
ranging from 75 to 100 percent of the actual 2005 loan limits in that
CBSA, and (4) that FHA's market share would be approximately the same
as its share of loans with loan amounts ranging from 80 to 100 percent
of the actual 2005 loan limits in that CBSA.[Footnote 44]
For each of these four scenarios, we calculated the total number and
dollar amount of new loans across all 380 CBSAs that could have been
insured by FHA had the higher loan limits been in effect. All four
assumptions yielded similar results. After arriving at an estimate of
an overall increase in the number of FHA-insured loans, we then
determined the proportions of the increase that would have resulted
from raising the loan limit floor in low-cost areas, raising the loan
limit ceiling in high-cost areas, or raising the limits in areas that
fell between the floor and the ceiling. Finally, we calculated the
average FHA-insured loan amount in 2005, as well as the average loan
amount that FHA might have insured had the loan limits been increased.
We assessed the reliability of the HMDA data we used by reviewing
information about the data, performing electronic data testing to
detect errors in completeness and reasonableness, and interviewing a
knowledgeable official regarding the quality of the data. We determined
that the data were sufficiently reliable for the purposes of this
report.
To estimate the effects of risk-based pricing on borrowers' eligibility
for FHA insurance and the premiums they would pay, we reviewed FHA's
risk-based pricing proposal and interviewed FHA officials regarding
their plans to implement risk-based pricing, if authorized. We then
analyzed SFDW data on FHA's 2005 home purchase borrowers to determine
how they would have been affected by FHA's risk-based pricing proposal.
(We focused on 2005 borrowers because that was the most recent year for
which we had complete data, and we restricted our analysis to purchase
loans because they comprise the bulk of FHA's business.) First, we
assigned borrowers to one of seven categories (FHA's six proposed risk-
based pricing categories and one category for those who would not have
been eligible for FHA insurance) based upon their LTV ratio and credit
score. Since FHA does not currently insure loans without a down
payment, we identified borrowers with down-payment assistance and
determined the source and amount of assistance to approximate borrowers
with LTV ratios of 100 percent. We recalculated the LTV ratio of their
loans by adding the amount of their assistance to the principal balance
of their loan. We then examined the demographic characteristics (race,
income, and first-time home buyer status) of borrowers in each of the
six pricing categories, as well as those borrowers who would no longer
qualify for FHA insurance. We assessed the reliability of the SFDW data
we used by reviewing information about the system and performing
electronic data testing to detect errors in completeness and
reasonableness. We determined that the data were sufficiently reliable
for the purposes of this report.
We also interviewed representatives of the following consumer advocacy
groups to obtain their views on FHA's proposed legislative changes:
Center for Responsible Lending, Consumer Action, Consumer Federation of
America, National Association of Consumer Advocates, National Community
Reinvestment Coalition, National Consumer Law Center, and National
Council of La Raza. We examined the potential budgetary impacts of the
legislative proposals by reviewing the President's fiscal year 2008
budget and FHA cost estimates as shown in the 2008 Federal Credit
Supplement. (The Federal Credit Supplement provides summary information
about federal direct loan and loan guarantee programs, including
current subsidy rates and reestimated subsidy rates.) To determine the
tools, resources, and risk-management practices important to FHA's
implementation of the legislative proposals, we interviewed and
reviewed documentation from FHA officials regarding the agency's plans
for implementing the legislative proposals, if passed. We focused on
completed and planned enhancements to FHA's SFDW data, loan performance
models, TOTAL mortgage scorecard, information technology, human
capital, and risk-management practices. To help us evaluate the need
for enhancements to FHA's tools, resources, and practices, we followed
up on our past work on (1) FHA's development and use of TOTAL, (2)
FHA's estimation of subsidy costs for its single- family insurance
program, (3) practices that could be instructive for FHA in managing
the risks of new mortgage products, and (4) FHA's management of loans
with down-payment assistance.[Footnote 45] To obtain information on the
tools and resources that other mortgage institutions use to set prices
and manage risk, we interviewed Fannie Mae, Freddie Mac, the Mortgage
Insurance Companies of America (the industry group that represents the
private mortgage insurance industry), and four private mortgage
insurance companies--AIG United Guaranty, Genworth Mortgage Insurance
Company, Mortgage Guaranty Insurance Corporation, and PMI Mortgage
Insurance Company.
To determine other options that FHA and Congress could consider and the
pros and cons of these options, we reviewed relevant literature,
including the report of the Millennial Housing Commission,[Footnote 46]
articles discussing past FHA restructuring proposals,[Footnote 47] and
our past work on various options for FHA.[Footnote 48] We also
interviewed FHA officials, academic experts, FHA lenders, and private
mortgage insurance companies.
We conducted this work in Washington, D.C., from September 2006 to June
2007 in accordance with generally accepted government auditing
standards.
[End of section]
Appendix II: Comments from the Department of Housing and Urban
Development:
[See PDF for image].
[End of figure].
U.S. Department Of Housing And Urban Development:
Washington, DC 20410-8000:
Assistant Secretary For Housing-
Federal Housing Commissioner:
JUN - 8 2007:
Mr. William B. Shear:
Director:
Financial Markets and Community Investments:
United States Government Accountability Office:
441 G Street, NW:
Washington, DC 20548:
Dear Mr. Shear:
Thank you for the opportunity to comment on the Government
Accountability Office (GAO) report, "Federal Housing Administration:
Modernization Proposals Would Have Program and Budget Implications and
Require Continued Improvements in Risk Management," (GAO-07 708). I
welcome GAO's acknowledgement that FHA has made substantial
improvements in both program administration and risk management, but
feel that GAO's remaining reservations about FHA's ability to manage
risk are unwarranted, and I believe that its recommendation that FHA
implement lower downpayment programs by pilot is not appropriate
considering the large volume of data now available for this type of
program. Let me elaborate.
FHA's modernization proposals grow out of internal analyses showing
that FHA was being adversely selected. As a result of profound changes
in primary and secondary mortgage markets, borrowers traditionally
served by FHA-lower-income and minority first-time homebuyers
increasingly had access to mortgage financing, but frequently at
excessive cost. As a government agency closely bound by statutes and
regulations, FHA was unable to respond to these changes in a flexible
manner. Under its one-size fits all pricing structure, FHA witnessed
the loss of borrowers with better credit profiles and the rapid growth
of seller-funded downpayment assistance loans.
FHA recognized the need to diversify its product offerings and its
pricing structure. It further recognized that borrowers using seller-
funded downpayment assistance loans would be served at lower risk to
themselves and to FHA's insurance fund by zero-or lower-downpayment
loans that would remove the incentive of parties to the purchase
transaction to inflate house prices and, consequently, mortgage
amounts, monthly payments, and borrower risk. FHA has taken steps to
curtail seller-funded downpayment assistance. It supported the Internal
Revenue Service when it issued a ruling withdrawing nonprofit status
from entities funneling seller-funded downpayment assistance to
borrowers, and, on May 11, 2007, it published a proposed rule that
would effectively eliminate seller-funded downpayment assistance from
use with FHA-insured loans. FHA believes that other alternatives,
including risk-based pricing and a variable downpayment program, would
better serve the same types of borrowers who currently need such
assistance.
In FY 2005, FHA included Zero Downpayment and Payment Incentives
products in its budget proposal, but these initiatives were not enacted
into law. In FY 2006, FHA submitted a comprehensive reform proposal to
Congress that passed the House of Representatives with a 415-to-7 vote,
but the legislation stalled in the Senate. In FY 2007, FHA is again
promoting a reform proposal that would increase its flexibility in
offering mortgage insurance products and would permit a wider range of
mortgage insurance premiums based on objective indicators of risk. With
this new authority, FHA seeks to increase the options available to its
traditional borrowers-lower-income and minority first-time homebuyers-
so that they can attain their goal of homeownership at reasonable cost.
Pricing risk in a mortgage insurance premium instead of the mortgage
interest rate gives borrowers access to prime interest rates, lowers
their current and overall borrowing costs, and facilitates more
transparent mortgage transactions.
While the GAO report shows commendable understanding of FHA, it
continues to express concern about FHA's ability to understand and
manage risk, and recommends that FHA pursue reform through the use of
pilot programs. FHA recognizes that pilot programs are appropriate
where a concept is untested. For example, in 1989, FHA piloted Home
Equity Conversion Mortgages that today have become FHA's fastest
growing program. But the concept of zero-or lower-downpayments is well
understood. In fact, the National Association of Realtors polled 7,548
consumers who bought homes between mid-2005 and mid-2006 and found that
45 percent of first-time buyers financed 100 percent of the
transaction; they made no downpayments whatsoever.
FHA already has a firm basis for anticipating the performance of zero-
and lower-downpayment loans by virtue of its experience with seller-
funded downpayment assistance. In its FY 2008 budget proposal, FHA used
this experience to posit minimum FICO scores for zero-and lower-
downpayment borrowers and premiums graded by potential risk based on
historical experience. As GAO is aware, FHA uses conditional claim and
prepayments rates produced by an independent annual actuarial review in
state-of-the-art cash flow models to re-examine loan performance and
reset premiums on an annual basis. Having recently started to collect
30-and 60-day as well as 90-day delinquency data, FHA now has the
capability of tracking trends by book of business or other segment of
the portfolio on a monthly basis. For these reasons, FHA believes that
the risks of zero-or lower-downpayment loans are sufficiently known or
knowable to that a a pilot program is unwarranted.
In conclusion, FHA is grateful for GAO's balanced assessment, but
respectfully suggests that FHA is ready now to manage the risks of zero-
and lower-downpayment loans and so, to offer an alternative to
borrowers who would otherwise be turned away or turn to higher cost
alternatives.
Sincerely,
Signed by:
Brian D. Montgomery:
Assistant Secretary for Housing-
Federal Housing Commissioner:
[End of section]
Appendix III: GAO Contact and Staff Acknowledgments:
GAO Contact:
William Shear (202) 512-8678 or shearw@gao.gov:
Staff Acknowledgments:
In addition, Steve Westley (Assistant Director), Steve Brown, Laurie
Latuda, John McGrail, Barbara Roesmann, Paige Smith, and Richard
Vagnoni made key contributions to this report.
FOOTNOTES
[1] The conventional market comprises mortgages that do not carry
government insurance or guarantees. For more information on the decline
in FHA's share of the mortgage market and the factors underlying this
trend, see GAO, Federal Housing Administration: Decline in the Agency's
Market Share Was Associated with Product and Process Developments of
Other Mortgage Market Participants, GAO-07-645 (Washington, D.C.: June
29, 2007).
[2] GAO, Federal Housing Administration: Proposed Reforms Will Heighten
the Need for Continued Improvements in Managing Risks and Estimating
Program Costs, GAO-06-868T (Washington, D.C.: June 20, 2006).
[3] HMDA requires lending institutions to collect and publicly disclose
information about housing loans and applications for such loans,
including the loan type and amount, property type, and borrower
characteristics (such as ethnicity, race, gender, and income). These
data are one of the most comprehensive sources of information on
mortgage lending. Among other things, FHA's SFDW contains information
on the borrower and loan characteristics of the mortgages FHA insures.
[4] Fannie Mae and Freddie Mac are government-sponsored private
corporations chartered by Congress to provide a continuous flow of
funds to mortgage lenders and borrowers by purchasing mortgages from
lenders and re-selling them to investors. They purchase single-family
mortgages up to the conforming loan limit, which for 2006 was set at
$417,000.
[5] GAO, Mortgage Financing: HUD Could Realize Additional Benefits from
Its Mortgage Scorecard, GAO-06-435 (Washington, D.C.: Apr. 13, 2006).
[6] The economic value of the Fund is the value of the Fund's assets
minus its liabilities, plus the net present value of future cash flows
of the outstanding portfolio. The capital ratio is the economic value
divided by the amount of unamortized insurance-in-force (the total
initial loan amounts of outstanding insured loans). The Omnibus Budget
Reconciliation Act of 1990 mandated that the Fund achieve a capital
ratio of at least 2 percent by fiscal year 2000 and maintain that level
in all future years. See P.L. 101-508, Section 2105.
[7] Subprime borrowers typically have blemished credit, may have
difficulty providing income documentation, and generally pay higher
interest rates and fees than prime borrowers.
[8] GAO-07-645.
[9] GAO, Federal Housing Administration: Ability to Manage Risks and
Program Changes Will Affect Financial Performance, GAO-07-615T
(Washington, D.C.: Mar. 15, 2007).
[10] According to FHA, the existing loan limits are lower than the cost
of new construction in many areas of the country and therefore do not
allow buyers of new homes to use FHA products.
[11] The proposal to repeal the 3 percent minimum cash investment
requirement would eliminate the complicated statutory formula used to
calculate down payments. This formula considers multiple variables such
as the average closing costs in the state.
[12] Under the program, seniors who wished to move from their current
home could get a home purchase loan for a new dwelling and convert that
loan into an HECM in a single transaction.
[13] See H.R. 1752, 110th Cong. (2007); H.R. 1852, 110th Cong. (2007);
S. 947, 110th Cong. (2007).
[14] FHA defines higher-performing lenders as those with 2 years of
acceptable default and claim rates (at or below 150 percent of the
national average). Because FHA is phasing in the Lender Insurance
Program, HECMs are not yet eligible for endorsement through the program.
[15] As was the agency's practice prior to the Lender Insurance
Program, FHA will select a sample of each lender's mortgages for post-
endorsement quality checks.
[16] Although the Lender Insurance Program has streamlined the
processing of FHA-insured loans, the HUD Inspector General has
expressed concerns that the program could increase the risk of fraud
because the lenders, rather than FHA, maintain the records on loans
insured through the program.
[17] Our analysis considered the number of additional loans that would
have been eligible for FHA insurance if the loan limits in 2005 had
been raised to 100 percent of area median income, with a floor in low-
cost areas of $233,773 and a ceiling in high-cost areas of $359,650.
For our assumptions about the share of newly eligible loans that would
likely be insured by FHA, see appendix I.
[18] Different pricing would apply to refinances of existing FHA-
insured mortgages.
[19] Additionally, the vast majority of these borrowers (90 percent)
received down-payment assistance from nonprofits, most of which
received funding from property sellers.
[20] These figures do not reflect FHA's proposals to eliminate the
limit on the number of mortgages insured under the HECM program and
move the program from the General Insurance Fund to the Mutual Mortgage
Insurance Fund. According to FHA's estimates, the HECM program would
generate about $338 million in negative subsidies in fiscal year 2008.
Therefore, moving the HECM program would result in negative subsidies
totaling about $680 million for the Fund.
[21] Agencies are required to reestimate subsidy costs annually to
reflect actual loan performance and expected changes in estimates of
future loan performance. Essentially, a cohort includes the loans
insured in a given year.
[22] These systems contain a wide variety of data that support FHA's
administration of its single-family mortgage insurance program,
including information on mortgage lenders and borrowers and the
financial details and performance of the loans.
[23] More specifically, FHA developed index values--the ratio of the
claim and prepayment rates for borrowers in different credit score and
LTV ratio groupings to the claim and prepayment rate for FHA's average
borrower. (FHA used loans with down-payment assistance from seller-
funded nonprofit organizations as a proxy for loans with LTV ratios of
100 percent.) FHA then applied these index values to the estimated
lifetime claim and prepayment rates for the fiscal year 2008 book of
business.
[24] See GAO, Mortgage Financing: FHA's $7 Billion Reestimate Reflects
Higher Claims and Changing Loan Performance Estimates, GAO-05-875
(Washington, D.C.: Sept. 2, 2005). While loan performance models are
critical to subsidy cost estimation, other factors such as assumptions
about the losses per insurance claim and economic conditions also
influence subsidy estimates.
[25] GAO-06-435.
[26] FHA indicated that variables for adjustable-rate mortgages and
property type were not included in TOTAL because the risk associated
with them did not differ significantly in the data sample used to
develop the model. However, the modeling effort may have failed to find
significant effects for these variables because of the small numbers of
loans with these characteristics in the development sample.
[27] These views are consistent with our October 2001 report on FHA's
single-family information systems. See GAO, Single-Family Housing:
Current Information Systems Do Not Fully Support the Business Processes
at HUD's Homeownership Centers, GAO-02-44 (Washington, D.C.: Oct. 24,
2001).
[28] LMI Government Consulting for the U.S. Department of Housing and
Urban Development, Strategic Workforce Plan (McLean, Va.: November
2004).
[29] The analysis defined technical credibility as demonstrating
programmatic, financial, and technical knowledge and expertise that is
commensurate with the demands of the position and understanding
requirements for the administration of federal grants and loan
guarantees.
[30] 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).
[31] We reviewed a national sample of FHA-insured home purchase loans
from 2000, 2001, and 2002.
[32] See 72 Fed. Reg. 27048 (May 11, 2007). FHA also has been
anticipating a reduction in the number of loans with down-payment
assistance from seller-funded nonprofit organizations as a result of
actions taken by the Internal Revenue Service (IRS). IRS issued a
ruling in May 2006 stating that these organizations do not qualify as
tax-exempt charities, effectively making loans with such assistance
ineligible for FHA insurance. According to FHA, as of June 2007, IRS
had rescinded the charitable status of three of the 185 organizations
that IRS is examining.
[33] GAO, Mortgage Financing: Actions Needed to Help FHA Manage Risks
from New Mortgage Loan Products, GAO-05-194 (Washington, D.C.: Feb. 11,
2005).
[34] Private mortgage insurers also set credit score thresholds for
zero-down-payment loans.
[35] If the HECM program were moved to the Fund, as FHA has proposed,
the weighted average subsidy rate would be -0.82 percent.
[36] The MHC, established by Congress in 2000, studied the federal role
in meeting the nation's housing challenges and issued a report in 2002,
which included recommendations for a variety of reforms to federal
housing programs. See Meeting Our Nation's Housing Challenges: Report
of the Bipartisan Millennial Housing Commission (Washington, D.C.: May
30, 2002).
[37] In 1989, the Financial Institutions Reform, Recovery and
Enforcement Act (P. L. 101-73) authorized certain financial regulators
to determine their own compensation and benefits so that they could
more effectively compete in the marketplace for qualified applicants.
In 2002, the Investor and Capital Markets Fee Relief Act (P. L. 107-
123) gave SEC similar authority as those federal banking regulatory
agencies. These agencies are permitted by statute to pay salaries in
excess of the Title 5 ceilings.
[38] GAO-05-194.
[39] FHA officials reported difficulties administering the HECM program
initially as a demonstration for only 2,500 loans because of the
challenges of selecting a limited number of lenders and borrowers.
[40] GAO, Homeownership: Potential Effects of Reducing FHA's Insurance
Coverage for Home Mortgages, GAO/RCED-97-93 (Washington, D.C.: May 1,
1997).
[41] FHA has implemented risk-sharing arrangements in its multifamily
insurance program.
[42] In 1995, legislation was introduced in the House and Senate (but
never enacted) that proposed to abolish FHA and replace FHA's single-
family mortgage insurance program with a program in which risk would be
shared between qualified mortgage insurers and a Federal Home Mortgage
Insurance Fund within the Department of the Treasury. The federal
government would have provided partial mortgage insurance on some
single-family homes (and would no longer have insured multifamily
mortgages).
[43] We excluded second liens and non-owner-occupied properties from
our analysis because they are not a substantial part of FHA's business.
As defined by the Office of Management and Budget, CBSAs are
statistical geographic entities consisting of the county or counties
associated with at least one core (urbanized area or urban cluster) of
at least 10,000 population, plus adjacent counties having a high degree
of social and economic integration with the core.
[44] Our analysis was based on an earlier FHA analysis. This analysis
assumed that FHA would achieve a market share for newly eligible loans
of (1) at least 50 percent of FHA's national market share for loans in
areas with median home prices exceeding the 87 percent conforming limit
and (2) 75 percent of FHA's current market share in an area that was
not constrained by the 87 percent conforming loan limit.
[45] See GAO-06-435, GAO-05-875, GAO-05-194, and GAO-06-24.
[46] Meeting Our Nation's Housing Challenges: Report of the Bipartisan
Millennial Housing Commission (Washington, D.C.: May 30, 2002).
[47] See, for example, Kerry D. Vandell, "FHA Restructuring Proposals:
Alternatives and Implications," Housing Policy Debate, volume 6, issue
2 (1995).
[48] See, for example, GAO/RCED-97-93.
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