Federal Housing Administration
Proposed Legislative Changes Would Affect Borrower Benefits and Risks to the Insurance Funds Gao ID: GAO-07-1109T July 18, 2007Fewer borrowers are using the Federal Housing Administration's (FHA) single-family and manufactured housing insurance programs. To help counter this trend, proposed changes to the single-family program would raise loan limits, allow risk-based pricing of premiums, and reduce down payments. Changes such as higher loan limits also were proposed for the manufactured housing program. To assist Congress in considering the impact of these changes, this testimony provides information from recently issued GAO reports and preliminary views from ongoing work. Specifically, GAO discusses (1) trends in FHA's share of the mortgage market, (2) likely impacts of proposed changes to the single-family program, (3) practices important to implementing the changes to the single-family program, if passed, and (4) preliminary observations from our work on the manufactured housing program. To conduct this work, GAO analyzed agency, Home Mortgage Disclosure Act, and Census data and interviewed agency and lending industry officials and other stakeholders.
FHA's share of the single-family mortgage market declined 13 percentage points from 1996 through 2005, with conventional lenders gaining notably increased percentages of lower-income and minority borrowers. This decline in market share was associated with a number of factors, including FHA's product restrictions and product innovations in the conventional market. The proposed changes to the single-family program could affect borrowers as well as program costs. For example, GAO estimated that in 2005 FHA could have insured 9 to 10 percent more loans if proposed mortgage limits were in effect. But, if the risk-based pricing proposal had been in effect in 2005, 20 percent of borrowers would not have qualified for FHA insurance. FHA determined that the expected claim rates of these borrowers were higher than it found tolerable for either the borrower or the Mutual Mortgage Insurance Fund. Absent any program changes, FHA estimates that the fund would require an appropriation of approximately $143 million in fiscal year 2008. If proposed changes were passed, FHA estimates that the fund would generate $342 million in negative subsidies (i.e., net cash inflows). Although FHA is taking steps to enhance tools important to implementing the proposed changes to its single-family program, it does not plan to use a common industry practice, piloting, to mitigate the risks of any zero-downpayment product. In response to prior GAO recommendations, FHA improved its loan performance models and is refining its mortgage scorecard (which evaluates the default risk of borrowers). However, the proposals would introduce new risks and challenges. The proposal to lower down payments is of particular concern given the greater default risk of these loans and the difficulty of setting prices for new products whose risks may not be well understood. One of the ways FHA plans to mitigate new or increased risks is through stricter underwriting standards, but it does not plan to pilot any zero-down-payment product. Other mortgage institutions use pilots to manage risks associated with changing or expanding product lines. Proposals for the manufactured home loan program would increase loan limits, insure each loan made, incorporate stricter underwriting requirements, and set premium rates. While the changes could benefit borrowers, according to FHA and the Congressional Budget Office, the potential costs could expand the government's liability. However, FHA has not articulated which borrowers would be targeted if the program were expanded, specified changes in its underwriting requirements, developed a risk-based pricing structure for the proposed legislation, or estimated costs to the General Insurance Fund. As a result, the potential effects of the changes on the program and the insurance fund are unclear.
GAO-07-1109T, Federal Housing Administration: Proposed Legislative Changes Would Affect Borrower Benefits and Risks to the Insurance Funds
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Testimony:
Before the Committee on Banking, Housing, and Urban Affairs, U.S.
Senate:
United States Government Accountability Office:
GAO:
For Release on Delivery Expected at 9:30 a.m. EDT:
Wednesday, July 18, 2007:
Federal Housing Administration:
Proposed Legislative Changes Would Affect Borrower Benefits and Risks
to the Insurance Funds:
Statement of William B. Shear, Director:
Financial Markets and Community Investment:
GAO-07-1109T:
GAO Highlights:
Highlights of GAO-07-1109T, a testimony before the Committee on
Banking, Housing, and Urban Affairs, U.S. Senate
Why GAO Did This Study:
Fewer borrowers are using the Federal Housing Administration‘s (FHA)
single-family and manufactured housing insurance programs. To help
counter this trend, proposed changes to the single-family program would
raise loan limits, allow risk-based pricing of premiums, and reduce
down payments. Changes such as higher loan limits also were proposed
for the manufactured housing program. To assist Congress in considering
the impact of these changes, this testimony provides information from
recently issued GAO reports and preliminary views from ongoing work.
Specifically, GAO discusses (1) trends in FHA‘s share of the mortgage
market, (2) likely impacts of proposed changes to the single-family
program, (3) practices important to implementing the changes to the
single-family program, if passed, and (4) preliminary observations from
our work on the manufactured housing program. To conduct this work, GAO
analyzed agency, Home Mortgage Disclosure Act, and Census data and
interviewed agency and lending industry officials and other
stakeholders.
What GAO Found:
FHA‘s share of the single-family mortgage market declined 13 percentage
points from 1996 through 2005, with conventional lenders gaining
notably increased percentages of lower-income and minority borrowers.
This decline in market share was associated with a number of factors,
including FHA‘s product restrictions and product innovations in the
conventional market.
The proposed changes to the single-family program could affect
borrowers as well as program costs. For example, GAO estimated that in
2005 FHA could have insured 9 to 10 percent more loans if proposed
mortgage limits were in effect. But, if the risk-based pricing proposal
had been in effect in 2005, 20 percent of borrowers would not have
qualified for FHA insurance. FHA determined that the expected claim
rates of these borrowers were higher than it found tolerable for either
the borrower or the Mutual Mortgage Insurance Fund. Absent any program
changes, FHA estimates that the fund would require an appropriation of
approximately $143 million in fiscal year 2008. If proposed changes
were passed, FHA estimates that the fund would generate $342 million in
negative subsidies (i.e., net cash inflows).
Although FHA is taking steps to enhance tools important to implementing
the proposed changes to its single-family program, it does not plan to
use a common industry practice, piloting, to mitigate the risks of any
zero-down-payment product. In response to prior GAO recommendations,
FHA improved its loan performance models and is refining its mortgage
scorecard (which evaluates the default risk of borrowers). However, the
proposals would introduce new risks and challenges. The proposal to
lower down payments is of particular concern given the greater default
risk of these loans and the difficulty of setting prices for new
products whose risks may not be well understood. One of the ways FHA
plans to mitigate new or increased risks is through stricter
underwriting standards, but it does not plan to pilot any zero-down-
payment product. Other mortgage institutions use pilots to manage risks
associated with changing or expanding product lines.
Proposals for the manufactured home loan program would increase loan
limits, insure each loan made, incorporate stricter underwriting
requirements, and set premium rates. While the changes could benefit
borrowers, according to FHA and the Congressional Budget Office, the
potential costs could expand the government‘s liability. However, FHA
has not articulated which borrowers would be targeted if the program
were expanded, specified changes in its underwriting requirements,
developed a risk-based pricing structure for the proposed legislation,
or estimated costs to the General Insurance Fund. As a result, the
potential effects of the changes on the program and the insurance fund
are unclear.
What GAO Recommends:
While making no new recommendations, GAO reemphasizes the need for
continued management attention to prior GAO recommendations that could
help address risks and challenges associated with the single-family
legislative proposals.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-07-1109T].
To view the full product, including the scope and methodology, click on
the link above. For more information, contact William B. Shear at (202)
512-8678 or shearw@gao.gov.
[End of section]
Mr. Chairman and Members of the Committee:
I am pleased to have the opportunity to share information and
perspectives with the committee as it considers modernization proposals
for the Department of Housing and Urban Development's (HUD) Federal
Housing Administration (FHA). FHA provides insurance for single-family
home mortgages made by private lenders. In fiscal year 2006, it insured
almost 426,000 mortgages representing $55 billion in mortgage
insurance. According to FHA's estimates, the single-family insurance
program currently operates with a negative subsidy, meaning that the
present value of estimated cash inflows (such as borrower premiums) to
FHA's Mutual Mortgage Insurance Fund exceeds the present value of
estimated cash outflows (such as insurance claims). However, absent any
program changes, FHA has estimated that the program would require a
positive subsidy--that is, an appropriation of budget authority--in
fiscal year 2008. In addition to single-family home mortgages, FHA
insures loans for manufactured housing--that is, factory-built housing
designed to meet HUD's national building code. Comparatively, this is a
much smaller program than the single-family insurance program, insuring
1,438 loans in 2006 representing $54 million in mortgage insurance. FHA
insures its manufactured home loans under the General Insurance Fund.
FHA has faced several challenges in recent years. Its single-family
insurance program has experienced rising delinquency rates and a sharp
decline in the number of participating borrowers, due partly to
increased competition from conventional mortgage providers.[Footnote 1]
The conventional market has prime and subprime segments. Prime
borrowers typically have strong credit scores and obtain the most
competitive interest rates and mortgage terms.[Footnote 2] In contrast,
subprime borrowers typically have blemished credit and lower credit
scores, may have difficulty providing income documentation, and
generally pay higher interest rates and fees than prime borrowers. As
conventional providers have improved their ability to evaluate risk,
FHA has experienced 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.
Additionally, the lending market associated with manufactured homes has
undergone significant changes over the last 15 years. Market growth in
the 1990s was followed by a large number of repossessions from 2000 to
2002 due to the deteriorating credit quality of borrowers, and many
lenders exited the manufactured home loan market. The FHA-insured
segment of the market experienced a dramatic decline over this period.
The number of manufactured home loans insured by FHA decreased from
23,897 loans in 1990 to 1,438 loans in 2006, a 94 percent decline.
To adapt to market changes, FHA has implemented new administrative
procedures in its single-family insurance program and proposed
legislation designed to modernize its insurance processes and products.
FHA's recent administrative changes include allowing higher-performing
single-family lenders to endorse, or approve, loans for FHA insurance
without prior review by FHA and adopting conventional market appraisal
requirements. The legislative proposals for the single-family insurance
program also would 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. In addition, legislative changes have been
proposed for FHA's Title I Manufactured Home Loan program that include
increasing the loan limits, incorporating stricter underwriting
requirements, and revising the premium structure.
My testimony today discusses two reports that we issued in June 2007 on
FHA's share of the single-family mortgage market and FHA's proposals to
modernize its single-family insurance program, as well as preliminary
views from ongoing work we are conducting on FHA's Title I Manufactured
Home Loan program.[Footnote 3] Specifically, I will discuss (1) trends
in FHA's share of the home purchase mortgage market and factors
underlying these trends; (2) likely program and budgetary impacts of
proposed changes to FHA's single-family insurance program; (3) tools,
resources, and risk-management practices important to FHA's
implementation of the legislative proposals for its single-family
insurance program, if passed; and (4) preliminary observations from our
ongoing work on the Manufactured Home Loan program.[Footnote 4]
In conducting this work, we analyzed loan data from 1996 through 2005
collected under the Home Mortgage Disclosure Act (HMDA) to assess
trends in the overall market for home purchase mortgages and used 2005
HMDA data (the most current available) to examine the effect of raising
loan limits on demand for FHA-insured single-family loans. We estimated
the effects of risk-based pricing on borrowers' eligibility for FHA
single-family insurance and the premiums they would pay by analyzing
Single Family Data Warehouse (SFDW) data on FHA's 2005 home purchase
borrowers. We also analyzed data from the Manufactured Home Loan
program, Census data from the Manufactured Housing and American Housing
Surveys, and other sources. We interviewed officials from FHA, Ginnie
Mae, Fannie Mae, and Freddie Mac; FHA lenders, private mortgage
insurers, and mortgage and real estate industry groups; and academic
researchers. We conducted this work from September 2006 to July 2007 in
accordance with generally accepted government auditing standards.
In summary, we found that:
* From 1996 through 2005, FHA's share of the market for home purchase
mortgages declined from 19 to 6 percent, while the prime and subprime
shares increased 3 and 13 percentage points, respectively. The agency
experienced a sharp decrease among minority and lower-income
populations where it traditionally has had a strong presence. This
decline in market share was associated with a number of factors--
including FHA's product restrictions and product innovations in the
conventional market, particularly in the subprime market--and has been
accompanied by higher ultimate costs for certain conventional subprime
borrowers.
* FHA's proposed changes to its single-family insurance program could
affect borrower demand and the cost and availability of its insurance
as well as the budgetary costs of the program. Based on our analysis of
2005 HMDA data, we estimated 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. In addition, our analysis of
data for FHA home purchase borrowers in 2005 showed that, under FHA's
risk-based pricing proposal, 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 20 percent were
borrowers with expected lifetime claim rates more than 2.5 times
greater than the average claim rate. Finally, 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 has planned steps to enhance the tools and resources
important to implementing the proposed changes to its single-family
insurance program--and help address risks and challenges associated
with the proposals. However, it 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 its loan performance models by
incorporating additional variables and is in the process of addressing
a number of limitations in its mortgage scorecard. Although FHA has
taken actions to enhance key tools and resources, 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 these loans and the difficulty of setting
prices for new products whose risks may not be well understood. FHA
plans to take steps, such as instituting stricter underwriting
standards, to mitigate these risks. 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.
* In response to the dramatic decline in FHA-insured manufactured home
loans, legislative proposals for the Manufactured Home Loan program
would increase loan limits, insure each loan made, incorporate stricter
underwriting requirements, and establish up-front and adjust annual
insurance premiums. According to FHA and some industry officials, the
potential benefits of proposed changes for borrowers include obtaining
larger loans and additional financing with lower interest rates as more
lenders likely would participate because a greater portion of their
portfolios could be insured. The Congressional Budget Office (CBO) and
FHA also noted potential costs, such as expanded liability for the
General Insurance Fund. Additionally, risk factors unique to
manufactured home lending affect loan performance. But, FHA has not yet
articulated which borrowers would be targeted or undertaken risk
assessments to estimate the effects of the proposed legislation on the
volume of lending and claims and the overall financial soundness of the
program.
While the two reports I have summarized make no new recommendations,
they include observations about how developments in the different
segments of the mortgage market could affect FHA's market share in the
future and the need for careful implementation of the legislative
proposals, if passed. We noted that, notwithstanding the actions of
conventional providers, FHA could be a vehicle to provide lower-priced
and more sustainable mortgage options for some borrowers who are
considering or struggling to maintain higher-priced subprime loans.
However, careful assessment and management of the risks associated with
serving these borrowers would be necessary to avoid exacerbating
problems in the financial performance of FHA's single-family insurance
program. We also acknowledged that FHA has performed considerable
analysis to support its legislative proposals for the single-family
insurance program and has made or planned enhancements to many of the
specific tools and resources that would be important to its
implementation of them, but stated that the proposals present risks and
challenges and should be viewed with caution. Continued management
attention to our prior recommendations, including piloting new products
and improving its mortgage scorecard, could help FHA address these
risks.
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's
single-family program insures 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. The Title I
Manufactured Home Loan program was created to reduce the risk to
lenders through insurance or a guarantee, and thereby expand access to
funding for buyers of manufactured homes. According to data from FHA,
the majority of its Title I borrowers from 2004 to 2007 were lower-
income and 34 years of age or younger.
FHA insures most of its single-family mortgages under its Mutual
Mortgage Insurance Fund, which is supported by borrowers' insurance
premiums. The single-family 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). In
addition to insuring mortgages on single-family homes, FHA has insured
loans for manufactured housing since 1969. FHA insures its manufactured
home loans under the General Insurance Fund, which is supported by
lenders' insurance premiums (currently an annual premium of 1 percent,
based on the initial loan amount).
Borrowers insured under FHA's single-family program are required to
make a cash investment of a minimum of 3 percent. FHA allows down-
payment assistance from third-party sources, including nonprofit
organizations that receive contributions from property sellers. When a
homebuyer receives down-payment assistance from one of these
organizations, the organization requires the property seller to make a
financial payment to their organization. These nonprofits are commonly
called "seller-funded" down-payment assistance providers.
Partly in response to changes in the mortgage market, HUD has proposed
legislation intended to modernize FHA. Provisions in the proposal
relating to its single-family insurance program would among other
things authorize FHA to change the way it sets insurance premiums,
reduce down-payment requirements, and insure larger loans. The proposed
legislation would enable FHA to depart from its current, essentially
flat, premium structure and charge a wider range of premiums based on
individual borrowers' risk of default. HUD's proposal also would
eliminate the minimum cash investment requirement and enable FHA to
offer some borrowers a no-down-payment product. FHA is subject to
limits in the size of the loans it can insure. For example, for a one-
family property in a high-cost area, the FHA limit is 87 percent of the
limit established by Freddie Mac. In a low-cost area, the limit is 48
percent of the Freddie Mac limit. The legislative proposal would raise
these limits to 100 percent and 65 percent of the Freddie Mac limit,
respectively. In addition, Congress has proposed changes to FHA's Title
I Manufactured Home Loan program that would increase loan limits and
index them annually; insure each loan made instead of capping insurance
at 10 percent of the value of a lender's portfolio; incorporate
stricter underwriting requirements; and establish up-front and annual
premiums.
Decline in FHA's Market Share Was Associated with Product and Process
Developments of Other Mortgage Market Participants:
In a report we issued in June 2007, we noted that a combination of
factors created conditions that favored conventional mortgages over FHA
products resulting in FHA losing a considerable market share to the
conventional market, especially to the subprime market.[Footnote 5]
Based on our analysis of HMDA data, FHA's share of the market for home
purchase mortgages (in terms of numbers of loans) declined 13
percentage points from 1996 through 2005, while the prime share
increased slightly, and the subprime share grew 13 percentage
points.[Footnote 6] In addition, the agency experienced a sharp
decrease among minority and lower-income populations where it
traditionally has had a strong presence.
Specifically, we found that:
* From 1996 through 2005, FHA's share of the home purchase mortgage
market declined while the conventional share increased. As shown in
figure 1, FHA's market share fell from almost 19 percent (about 583,000
loans) in 1996 to about 6 percent (about 295,000 loans) in 2005, with
almost all of the decline occurring after 2001. Over the 10-year
period, the market share for conventional mortgages rose from almost 75
percent (about 2.3 million loans in 1996) to about 91 percent (about
4.2 million loans in 2005), with much of the increase due to growth in
subprime lending. More specifically, prime market share increased from
73 percent to 76 percent overall, falling somewhat from 1996 through
2000 but then increasing about 5 percentage points after 2000. Subprime
market share increased substantially over the 10-year period, from 2
percent to 15 percent, with most of the increase occurring after 2001
(growing from 5 percent in 2001 to 15 percent in 2005).
Figure 1: Market Shares for Home Purchase Loans, 1996-2005:
[See PDF for image]
Source: GAO analysis of HMDA data.
[End of figure]
* FHA traditionally played a major role among minority borrowers.
However, over the 10-year period, FHA's share of this submarket fell
substantially. Specifically, FHA's market share dropped from 32 to 7
percent among minority borrowers. In contrast, prime market share
increased from 59 to 65 percent among minority borrowers and subprime
market share increased from 2 to 26 percent.
* Lower-income (that is, low-and moderate-income) borrowers
historically relied heavily on FHA products, but FHA's market share
dropped in this submarket as well.[Footnote 7] From 1996 through 2005,
FHA's market share decreased among borrowers of all income levels, but
particularly among lower-income borrowers, where it declined from 26 to
10 percent. Over the same period, prime market share increased from 65
to 72 percent and subprime market share increased from 1 to 15 percent.
The decline in FHA's market share was associated with a number of
factors and has been accompanied by higher ultimate costs for certain
conventional borrowers. FHA's lack of process improvements and product
restrictions relative to the conventional market provided conditions
that favored conventional over FHA-insured mortgages. According to
mortgage industry officials that we interviewed, processing FHA-insured
loans is more costly, time consuming, and labor intensive than
processing conventional mortgages. FHA and mortgage industry officials
with whom we spoke also cited FHA loan limits as a factor that
contributed to the decline in FHA market share. In some areas of the
country, particularly in parts of California and the Northeast, the
loan limits were significantly lower than the median home price. Some
mortgage industry officials also pointed to other product restrictions
as a reason why FHA loans have been less competitive than conventional
loans. For example, many borrowers do not or cannot make a down
payment, and unlike FHA, in recent years members of the conventional
mortgage market have been increasingly active in supporting low-and no-
down-payment mortgages.
During the 10-year period we examined, several developments occurred in
the conventional market that contributed to FHA's declining market
share. I will discuss four of these developments. First, the
conventional market offered products that increased consumer choices
for borrowers, including those who may have previously chosen an FHA-
insured loan. These products--interest-only loans, no-and low-
documentation mortgages, piggyback loans, and hybrid adjustable rate
mortgages (ARM)--became popular, especially during the subprime
market's rapid growth after 2001, because they featured flexible
payment and interest options that increased initial
affordability.[Footnote 8] In combination with historically low
interest rates, these products made it easier for homebuyers to
purchase homes in a period of strong house price appreciation.
Second, advances in underwriting technology, particularly mortgage
scoring and automated underwriting systems, allowed conventional
mortgage providers to process loan applications more quickly and
consistently than in the past and broaden their customer base. FHA
implemented its own mortgage scoring tool, called the Technology Open
to Approved Lenders (TOTAL) scorecard, in 2004. However, in prior work
we found that the way FHA developed TOTAL may limit the scorecard's
effectiveness.[Footnote 9] To the extent that conventional mortgage
providers were better able than FHA to use scoring tools to identify
lower-risk borrowers in FHA's traditional market segment, these
borrowers may have migrated toward conventional products, contributing
to the decline in FHA's market share.
Third, there was an increase in mortgage originations through third
parties such as loan correspondents and mortgage brokers, particularly
in the subprime market. This trend has been associated with the decline
in FHA's market share because the third-party originators primarily
market non-FHA products. Finally, the growth in private mortgage
securitization (the bundling of mortgage loans into bond-like
securities that can be bought and sold on the secondary market),
particularly for subprime loans, allowed lenders to sell loans from
their portfolios, transferring credit risk to investors, and use the
proceeds to make more loans.
As a result of these developments and lower interest rates, more
homebuyers--especially minority and lower-income families--were able to
obtain conventional loans, but many of these loans had high ultimate
costs. As previously discussed, much of the increase in mortgages to
minorities and lower-income borrowers was due to the growth in subprime
lending, and many of these loans offered lower initial costs through
their interest-only features and low introductory interest rates.
However, these mortgages became more costly as the interest rates on
many of these loans reset to higher rates, typically 2 to 3 percentage
points higher in a relatively short period.
Highly leveraged and weaker credit borrowers--the typical subprime
borrowers who have obtained nontraditional mortgage products such as
hybrid ARMs--are the most vulnerable to payment shocks. As a result,
borrowers who obtained subprime mortgages have experienced relatively
high rates of default (defined as payments more than 90 days past due)
and foreclosure (in any stage of the foreclosure process). According to
the Mortgage Bankers Association, as of December 31, 2006, the
cumulative default and foreclosure rates for all subprime mortgages
were 7.78 and 4.53 percent, respectively.[Footnote 10] Some mortgage
industry researchers predict that subprime default and foreclosure
rates likely will worsen as the loans age; a substantial portion of
these loans have yet to reach the age when loans tend to experience the
highest rates of default and foreclosure--between 4 and 7 years.
Furthermore, because most recent subprime loans have adjustable-rate
features, default and foreclosure rates for ARMs are in particular
danger of increasing as resetting interest rates cause monthly mortgage
payments on the loans to rise.
Single-Family Modernization Proposals Likely Would Affect Program
Participation and Costs:
In our June 2007 report on FHA's modernization efforts, we noted that
FHA's proposed legislative changes to its single-family insurance
program likely would affect program participation and costs.[Footnote
11] For example, we estimated 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.
Raising Loan Limits Likely Would Increase Demand for FHA Loans:
Our analysis indicated that raising the loan limits for FHA's single-
family insurance program likely would increase the number of loans
insured by FHA by making more loans eligible for FHA insurance. In some
areas of the country, 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; 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 indicated that the agency could have insured
from 9 to 10 percent more loans in 2005 had the higher mortgage limits
been in place.[Footnote 12] 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 additional loans that would have been insured by FHA were in areas
where the loan limits were set at the floor. Only 14 percent of the 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.
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 the same premium
rates. 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. FHA has proposed risk-
based pricing as a solution to the adverse selection problem.
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 13] 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 loan-to-value (LTV) ratio (loan amount divided
by sales price or appraised value) and credit score.[Footnote 14]
Borrowers in categories with higher expected lifetime claim rates would
have higher premiums than those in categories with lower claim rates.
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. However, FHA would use its TOTAL mortgage
scorecard to make the final determination of a borrower's placement in
a particular risk category. Because TOTAL takes into account more
borrower and loan characteristics than LTV ratio and credit score (such
as borrower reserves and payment-to-income ratio), 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.
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. Twenty percent would not have
qualified for FHA insurance had the risk-based pricing proposal been in
effect. As shown in figure 2, risk-based pricing would have had a
similar impact on first-time and low-income homebuyers FHA served in
2005.
Figure 2: 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 Single Family Data Warehouse 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]
Risk-based pricing also would 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 Mutual Mortgage
Insurance 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 15] FHA
officials stated that setting risk-based premiums for potential future
FHA borrowers with similar characteristics would require prices higher
than borrowers might be able to afford.
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 Mutual Mortgage Insurance 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 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.
FHA's subsidy estimates for fiscal year 2008 should be viewed with
caution given that FHA has generally underestimated the subsidy costs
for the Mutual Mortgage Insurance Fund. To meet federal requirements,
FHA annually reestimates subsidy costs for each loan cohort dating back
to fiscal year 1992.[Footnote 16] 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 below, FHA has taken some steps to
improve its subsidy estimates.
FHA Has Enhanced Tools and Resources Important to Implementing Single-
Family Proposals but Does Not Intend to Mitigate Risks by Piloting New
Products:
FHA has planned or taken steps to enhance the tools and resources that
would be important to implementing the legislative proposals for its
single-family insurance program. For example, we found that:
* FHA has improved the loan performance models it would use to
implement risk-based pricing by adding factors that have been found to
influence credit risk. In a September 2005 report, 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 17] In
response, HUD's 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 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,
whether the loan is an adjustable-rate mortgage, and property
type.[Footnote 18] An FHA contractor is helping the agency test
additional variables to include in the scorecard and is scheduled to
issue a final report on its work in August 2007.
* FHA 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, the
legislative proposals would introduce new risks. Our past work has
shown that FHA has not always utilized risk-management practices used
by other mortgage institutions. For example, we reported in November
2005 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 19] 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 20] Despite the detrimental impact
of these loans on the Mutual Mortgage Insurance 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 21]
While FHA plans to take some steps, such as instituting stricter
underwriting standards, to mitigate the risks associated with lowering
down-payment requirements, it does not plan to pilot any zero-down-
payment product the agency is authorized to offer. 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. 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 22] We 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.
FHA Has Not Assessed the Effects of Proposed Changes to Its
Manufactured Home Loan Program:
Now I will make some preliminary observations based on our ongoing work
for you and Senators Reed and Schumer on FHA's Manufactured Home Loan
program. Our objectives are to (1) describe selected characteristics of
manufactured housing and the demographics of the owners, (2) compare
federal and state consumer and tenant protections for owners of
manufactured homes, and (3) describe the proposed changes to the
Manufactured Home Loan program and assess potential benefits and costs
to borrowers and the federal government.
Currently, this is the only active federal loan program that includes
an option for a "home-only" product; that is, a personal property loan
for the purchase of a manufactured home without the land on which the
home will be located. Available data on selected characteristics of
manufactured homes and their owners in 2005 indicate that manufactured
homes can be an affordable housing option, with monthly housing costs
considerably lower than other housing types. In addition, we found most
manufactured homes were located in rural areas and more were located in
Southern states than in other regions. Further, owners of manufactured
homes have more consumer protections if homes are considered real
rather than personal property, but the laws in the eight states we
visited provide varying protections.[Footnote 23]
Legislative proposals for the Manufactured Home Loan program would
increase loan limits, insure each loan made, incorporate stricter
underwriting requirements, establish up-front insurance premiums, and
adjust the annual premium. For instance, limits for a home-only loan
would rise from $48,600 to $69,678, loan guarantees would apply to
individual loans rather than be capped at 10 percent of the value of a
lender's portfolio, and underwriting requirements would be revised with
the stated intent of strengthening the financial soundness of the
program. According to FHA and some industry officials, the potential
benefits of proposed changes for borrowers include obtaining loan
amounts sufficient to buy larger homes, additional financing with lower
interest rates as more lenders would likely participate in a program
where a greater portion of their portfolios could be insured, and an
expansion of the secondary market that could provide more liquidity for
lenders to make more loans.
According to FHA and CBO, the potential costs of the proposed changes
could involve an expansion of the government's liability under the
program because FHA would be insuring individual loans rather than a
limited portion of a lender's portfolio. Additionally, industry
officials identified risk factors unique to manufactured housing that
affect loan performance, which in turn could affect claims to FHA's
General Insurance Fund. For instance, the ability of the owner of a
manufactured home to build equity may be limited when the land is
leased, which also often increases the risks associated with the loan.
If a borrower with a home on leased land were to default, lenders could
face higher costs and lower recoveries (relative to site-built homes)
in trying to repossess, move, and resell the personal property.
To gain an understanding of the effects of the proposed changes, we
developed a model with various scenarios based on the experience of FHA
loans and loan performance data from manufactured home lenders.
Although risk factors unique to manufactured home lending (such as
placement on leased land) as well as commonly used predictors of loan
performance (such as credit scores) are associated with default risk,
these data were not available. Instead, we presented low, medium, and
high levels of borrower default risk and incorporated other factors
(such as premiums and lender recovery) to illustrate how variations in
these key factors affect potential gains and losses to FHA's General
Insurance Fund. The preliminary results of our analysis show that in
all cases when borrowers had medium or high default risk, the fund
experienced a loss.
While our scenario analysis offers a very general illustration of how
the proposed changes could affect the General Insurance Fund, the
effects of the proposed changes are unclear because FHA has not
articulated which borrowers would be targeted if the program were
expanded, specified changes in its underwriting requirements, developed
a risk-based pricing structure for the proposed legislation, or
estimated costs to the General Insurance Fund. Our internal control
standards for federal agencies require that an agency identify risks
that may be posed by new legislation.[Footnote 24] FHA has stated that
it has not yet made these risk assessments because the legislation has
not yet passed and that they chose to focus their resources on the much
larger single-family insurance program. As a result, FHA has yet to
determine the effects the proposed legislation may have on the volume
of lending and claims and the overall financial soundness of the
program.
Mr. Chairman, this concludes my prepared statement. I would be happy to
answer any questions at this time.
Contacts and Acknowledgments:
For further information on this testimony, please contact William B.
Shear at (202) 512-8678 or shearw@gao.gov. Individuals making key
contributions to this testimony included Triana Bash, Andy Finkel,
Nadine Garrick, Tina Paek, Barbara Roesmann, Paige Smith, and Steve
Westley.
FOOTNOTES
[1] The conventional market comprises mortgages that do not carry
government insurance or guarantees.
[2] Credit scores, which assign a numeric value to a borrower's credit
history, have become a common tool for assessing loan applications.
[3] 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) and GAO, Federal Housing Administration: Modernization
Proposals Would Have Program and Budget Implications and Require
Continued Improvements in Risk Management, GAO-07-708 (Washington,
D.C.: June 29, 2007).
[4] Home purchase mortgages do not include mortgages for refinancing
existing loans.
[5] GAO-07-645.
[6] HMDA data capture about 80 percent of the mortgage loans funded
each year according to estimates by the Board of Governors of the
Federal Reserve System and are one of the most comprehensive sources of
information on mortgage lending.
[7] We defined low income as less than 80 percent of the median income
for the census tract, moderate income as at least 80 percent but less
than 120 percent, and upper income as 120 percent and above.
[8] Interest-only loans allow borrowers to defer the principal payments
for some period and hybrid ARMs allow borrowers to pay a lower interest
rate for a specified time, usually between 2 and 5 years, before the
loan resets to the fully indexed interest rate. Piggyback loans are
simultaneous second mortgages that allow borrowers to make little or no
down payment. No-and low-documentation loans allow for less detailed
proof of income or assets than lenders traditionally require.
[9] GAO, Mortgage Financing: HUD Could Realize Additional Benefits from
Its Mortgage Scorecard, GAO-06-435 (Washington, D.C.: Apr. 13, 2006).
[10] For subprime ARMs, the corresponding figures were 9.16 and 5.62
percent. In comparison, as of the same date, the default and
foreclosure rates for FHA-insured loans were 5.78 and 2.19 percent,
respectively (6.62 and 2.54 percent for ARMs) and for prime loans, 0.86
and 0.50, respectively (1.45 and 0.92 for ARMs).
[11] GAO-07-708.
[12] 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 the local median home price, with a floor
in low-cost areas of $233,773 and a ceiling in high-cost areas of
$359,650. We made different assumptions about the share of newly
eligible loans that likely would be insured by FHA, all of which
yielded similar results.
[13] Different pricing would apply to refinances of existing FHA-
insured mortgages.
[14] The Omnibus Budget Reconciliation Act of 1990 requires an annual
independent actuarial review of the economic net worth and soundness of
the Mutual Mortgage Insurance Fund.
[15] Additionally, the vast majority of these borrowers (90 percent)
received down-payment assistance from nonprofits, most of which
received funding from property sellers.
[16] 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.
[17] 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 influence
subsidy estimates.
[18] GAO-06-435.
[19] 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).
[20] We reviewed a national sample of FHA-insured home purchase loans
from 2000, 2001, and 2002.
[21] 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.
[22] GAO, Mortgage Financing: Actions Needed to Help FHA Manage Risks
from New Mortgage Loan Products, GAO-05-194 (Washington, D.C.: Feb. 11,
2005).
[23] We selected the eight states (Arizona, Florida, Georgia, Missouri,
New Hampshire, North Carolina, Oregon, Texas) based on factors
including the volume of FHA Title I loans in the state from 1990 to
2007; the concentration of manufactured housing as a percentage of
housing units in the state; information from our interviews of industry
and consumer officials; and previous studies conducted on manufactured
housing.
[24] GAO, Standards for Internal Control in the Federal Government,
GAO/AIMD-00-21.3.1 (Washington, D.C.: Nov. 1, 1999).
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