**Section II: Summary of Findings** **and Comparison with FY 2004
Actuarial Review**

This section presents the economic value and capital ratios of the Fund
for FY 2005 and provides an explanation of how the results of this
year\'s Review compare with those of last year.

**A. The FY 2005 Actuarial Review**

The FY 2005 Actuarial Review assesses the actuarial soundness of the MMI
Fund as of the end of FY 2005 (September 30, 2005) in terms of whether
the Fund has maintained at least the two percent capital ratio required
by NAHA, and projects the status of the Fund through FY 2012. The
objectives of our analysis include:

-   evaluating the historical experience of the fund, including loan
    termination experience due to claims and prepayments, and losses
    associated with those terminations;

-   estimating future loan termination rates and their corresponding
    losses and projecting future cash flows of the existing Fund
    portfolio and future books of business;

-   determining the adequacy of current and future capital resources to
    meet estimated cash requirements.

We conducted this review by estimating the economic relationships of
historical loan performance using historical data provided by FHA,
applying the appropriate policy parameters, and using forecasts of
future macroeconomic conditions.

The econometric and cash flow models developed are similar in most
respect to those of last year with some modifications for this FY 2005
Review. The analysis reflects loan level data on the Fund\'s experience
reported through March 2005. These models also incorporate a set of
economic assumptions and forecasts for future years. The model applies
the historical average claim loss severity rates that were claimed over
FY 2000 and FY 2004 for each of the six FHA mortgage product types to
estimate future claim loss rates. (For descriptions of the individual
models and assumptions, see Appendices A through D.) Our major findings
are as follows:

-   as of the end of FY 2005, the MMI Fund had an estimated economic
    value of **\$21.621 billion** and an unamortized insurance-in-force
    of **\$358.871 billion**;

-   the FY 2005 book of business has added an estimated **\$0.570
    billion** in present value to the economic value of the MMI Fund;

-   we estimated that the capital ratio was **6.02 percent** as of
    September 30, 2005, and projected that it will be **6.62**
    **percent** as of September 30, 2012. Based on these estimates, we
    conclude that the Fund would continue to exceed the NAHA-mandated
    2.00 percent capital ratio in the foreseeable future.

Our current projections indicate that the Fund\'s economic value will
continue to increase in the future, rising by an average of 6.54 percent
in each successive fiscal year through FY 2012. Due to the expected
interest rate increases and the associated reduction in the prepayment
rate of the existing books of business, the insurance in force of the
fund would increase by an even slower average rate of 5.14 percent per
annum through FY 2012. The higher growth rate of the economic value than
that of the IIF implies that the Fund's reported capital ratio will
gradually increase to 6.62 percent at the end of FY 2012. Exhibit II-1
provides estimates of the Fund\'s economic value, insurance in force,
and capital ratio through the end of FY 2012.

**Exhibit II-1**

+---------+---------+---------+---------+---------+---------+---------+
| **Pr    |         |         |         |         |         |         |
| ojected |         |         |         |         |         |         |
| MMI     |         |         |         |         |         |         |
| Fund    |         |         |         |         |         |         |
| Perf    |         |         |         |         |         |         |
| ormance |         |         |         |         |         |         |
| for FYs |         |         |         |         |         |         |
| 2005 to |         |         |         |         |         |         |
| 2012**  |         |         |         |         |         |         |
|         |         |         |         |         |         |         |
| **(\$   |         |         |         |         |         |         |
| Mill    |         |         |         |         |         |         |
| ions)** |         |         |         |         |         |         |
+---------+---------+---------+---------+---------+---------+---------+
| *       | **E     | **      | *       | **In    | **E     | **Inv   |
| *Fiscal | conomic | Capital | *Volume | surance | conomic | estment |
| Year**  | Value   | Ratio   | of New  | in      | Value   | Return  |
|         | of the  | (%)**   | Endo    | For     | of New  | on Fund |
|         | Fu      |         | rse-men | ce^c^** | Book of | Bal     |
|         | nd^a^** |         | ts^b^** |         | Bus     | ances** |
|         |         |         |         |         | iness** |         |
+---------+---------+---------+---------+---------+---------+---------+
| 2005    | 21,621  | 6.02    | 58,264  | 358,871 | 570     |         |
+---------+---------+---------+---------+---------+---------+---------+
| 2006    | 22,702  | 6.16    | 54,664  | 368,763 | 318     | 764     |
+---------+---------+---------+---------+---------+---------+---------+
| 2007    | 24,130  | 6.40    | 54,965  | 377,235 | 499     | 929     |
+---------+---------+---------+---------+---------+---------+---------+
| 2008    | 25,729  | 6.58    | 57,065  | 390,895 | 534     | 1,065   |
+---------+---------+---------+---------+---------+---------+---------+
| 2009    | 27,434  | 6.70    | 60,973  | 409,701 | 486     | 1,219   |
+---------+---------+---------+---------+---------+---------+---------+
| 2010    | 29,286  | 6.70    | 69,231  | 436,918 | 476     | 1,377   |
+---------+---------+---------+---------+---------+---------+---------+
| 2011    | 31,361  | 6.66    | 79,308  | 470,685 | 523     | 1,552   |
+---------+---------+---------+---------+---------+---------+---------+
| 2012    | 33,680  | 6.62    | 88,898  | 508,753 | 578     | 1,741   |
+---------+---------+---------+---------+---------+---------+---------+

^a^ All values are as of the end of each fiscal year. The economic value
for future years (FYs 2006 through 2012) is equal to the economic value
of the Fund at the end of the previous year, plus the current year\'s
interest earned on previous business, plus the economic value of the new
book of business.

^b^ Based on Federal Housing Administration's projection as of June
2005.

^c^ Estimated based on the data extract on March 31, 2005.

### B. Change in the Estimated Strength of the Fund 

Exhibit II-2 displays the components of the Fund\'s current economic
value and capital ratio for the FY 2004 Review and the FY 2005 Review.
The FY 2004 Review estimated that the Fund had \$21.977 billion in
economic value at the end of FY 2004 to cover future claim losses.

Exhibit II-2

  ------------------------------------------- --------------- --------------
  **Estimates of MMI Fund Economic Value as                   
  End of FY 2005**                                            

  **(\$ Millions)**                                           

  **Item**                                    **End of FY     **End of FY
                                              2004^a^**       2005**

                                                               

  Cash                                        \$ 4,874        

  Investments                                 23,424          

  Properties and Mortgages                    1,462           

  Other Assets and Receivables                460             

  Total Assets                                30,220          

  Liabilities                                 7,397           

  Total Capital Resources                     22,823          

  Net Gain from Investments                                   509^b^

  Net Insurance Income in FY 2005                             \(167\)

  **Total Capital Resources**                                 **23,165**

                                                              

  PV of Future Cash Flows                                     (1,544)

  **Economic Value**                          **21,977^c^**   **21,621**

  Unamortized Insurance-In-Force              397,285^c^      358,871

  **Current Capital Ratio**                   5.53%^c^        **6.02%**

                                                              

  Amortized Insurance-In-Force                                332,393

  **Current Capital Ratio with Amortized                      **6.50%**
  Insurance-In-Force**                                        
  ------------------------------------------- --------------- --------------

^a^ Source: Audited Financial Statements for FY 2004.

^b^ Estimated by assuming the total capital resources as of the end of
FY 2004 earns a total investment return equal to 1-year Treasury
Constant Maturity Rate, which averaged 2.23 percent during FY 2005.
(Source: Board of Governors of the Federal Reserve System).

^c^ From the FY 2004 Actuarial Review.

The FY 2005 Review estimates that the fund had total capital resources
of \$23.165 billion at the end of FY 2005 and that the present value of
future cash flows was -\$1.544 billion. Thus, the Fund had \$21.621
billion in economic value, which can be used to cover unanticipated
future claim losses of the existing portfolio.

As seen in Exhibit II-2, the current economic value of MMIF Fund
decreased by a factor of 0.98 from that of last year's Review and the
current Fund\'s capital ratio actually increased by a factor of 1.09
over that of last year's Review. That is, the capital ratio increased
from 5.53 percent to 6.02 percent. This is because the insurance in
force decreased even more than that of the economic value due to the
high level of refinancing activity continuing from FY 2004 and the
significantly lower origination volume of the FY 2005 book of business.
Exhibit II-3 compares the two Reviews by annual books of business. It
shows that the present value of future cash flows deteriorates from the
FY 2004 projection. The deterioration is mainly from the FYs 2003-2004
books of business because these two books have a high concentration in
loans with down payment gift assistance from entities other than
relatives. The current Review shows that the total present value of
future cash flows from prior books of business is negative \$1.544
billion.

**Exhibit II-3**

+-----------------+----------------+-----------------+-----------------+
| **Present Value |                |                 |                 |
| of Future Cash  |                |                 |                 |
| Flows**         |                |                 |                 |
|                 |                |                 |                 |
| **by Book of    |                |                 |                 |
| Business, FY    |                |                 |                 |
| 2004 Review, FY |                |                 |                 |
| 2005 Review,    |                |                 |                 |
| and Difference  |                |                 |                 |
| (\$ Millions)** |                |                 |                 |
+=================+================+=================+=================+
| **Book of       | **2004         | **2005          | **              |
| Business**      | Review^a^**    | Review^b^**     | Difference^c^** |
+-----------------+----------------+-----------------+-----------------+
| 1976            | 0              | 0               | 0               |
+-----------------+----------------+-----------------+-----------------+
| 1977            | 1              | 0               | -1              |
+-----------------+----------------+-----------------+-----------------+
| 1978            | 2              | 1               | -1              |
+-----------------+----------------+-----------------+-----------------+
| 1979            | 3              | 2               | -2              |
+-----------------+----------------+-----------------+-----------------+
| 1980            | 2              | 1               | -1              |
+-----------------+----------------+-----------------+-----------------+
| 1981            | 1              | 1               | 0               |
+-----------------+----------------+-----------------+-----------------+
| 1982            | 0              | 0               | 0               |
+-----------------+----------------+-----------------+-----------------+
| 1983            | 2              | 2               | 0               |
+-----------------+----------------+-----------------+-----------------+
| 1984            | -1             | -1              | 0               |
+-----------------+----------------+-----------------+-----------------+
| 1985            | -2             | -2              | 0               |
+-----------------+----------------+-----------------+-----------------+
| 1986            | -7             | -5              | 2               |
+-----------------+----------------+-----------------+-----------------+
| 1987            | -10            | -7              | 3               |
+-----------------+----------------+-----------------+-----------------+
| 1988            | -7             | -5              | 2               |
+-----------------+----------------+-----------------+-----------------+
| 1989            | -9             | -6              | 3               |
+-----------------+----------------+-----------------+-----------------+
| 1990            | -13            | -8              | 5               |
+-----------------+----------------+-----------------+-----------------+
| 1991            | -15            | -9              | 6               |
+-----------------+----------------+-----------------+-----------------+
| 1992            | -21            | -13             | 8               |
+-----------------+----------------+-----------------+-----------------+
| 1993            | -34            | -20             | 14              |
+-----------------+----------------+-----------------+-----------------+
| 1994            | -43            | -26             | 17              |
+-----------------+----------------+-----------------+-----------------+
| 1995            | -30            | -17             | 12              |
+-----------------+----------------+-----------------+-----------------+
| 1996            | -80            | -43             | 37              |
+-----------------+----------------+-----------------+-----------------+
| 1997            | -103           | -55             | 48              |
+-----------------+----------------+-----------------+-----------------+
| 1998            | -158           | -97             | 61              |
+-----------------+----------------+-----------------+-----------------+
| 1999            | -292           | -175            | 117             |
+-----------------+----------------+-----------------+-----------------+
| 2000            | -330           | -198            | 132             |
+-----------------+----------------+-----------------+-----------------+
| 2001            | -261           | -116            | 145             |
+-----------------+----------------+-----------------+-----------------+
| 2002            | -237           | -120            | 117             |
+-----------------+----------------+-----------------+-----------------+
| 2003            | 434            | 221             | -213            |
+-----------------+----------------+-----------------+-----------------+
| 2004            | 391            | -406            | -796            |
+-----------------+----------------+-----------------+-----------------+
| **Total**       | -817           | -1,100          | -283            |
+-----------------+----------------+-----------------+-----------------+

^a^Values as of the end of FY 2004

^b^Values as of the end of FY 2005

^c^Numbers do not add due to rounding for this and some subsequent
Exhibits.

### C. Decomposition of Changes from the FY 2004 Review to the FY 2005 Review 

This section describes the sources of change in estimates between the FY
2004 Review and the FY 2005 Review for the FY 2005 economic value and
the FY 2011 capital ratio. Separating out the effects of interrelated
approaches and assumptions can be done only up to a certain degree of
accuracy. The interrelationships among the approaches and assumptions
prevent us from identifying and analyzing these as purely independent
effects as these are sometimes jointly determined. However, this section
still presents a reasonable allocation of all changes from last year, by
source of change. The purpose of the decomposition is twofold. First, it
describes the change in the economic value from FY 2004 to FY 2005.
Second, it explains changes between the current estimate of the capital
ratio in FY 2005 and the estimate for FY 2005 that was presented in the
FY 2004 Review.

**1. Change in Economic Value from FY 2004 to FY 2005**

The FY 2004 Review estimated the economic value of the Fund as of the
end of FY 2005 at \$24.430 billion, and the projected FY 2005 and FY
2011 capital ratios to be 5.82 percent and 6.71 percent, respectively.
We now estimate the end of FY 2005 economic value of the MMI Fund to be
\$21.621 billion, which represents a decrease of \$2.809 billion from
the estimate reported in the FY 2004 Review. This 11.5 percent decrease
in the estimated economic value of the MMI Fund is accompanied by an
even larger decrease in the unamortized IIF of 15 percent and resulted
in the estimated capital ratio increasing by 0.2 percentage points, from
5.82 percent in the FY 2004 Review to 6.02 percent in the FY 2005
Review.

**2. Current Estimate of FY 2005 Economic Value Compared with the
Estimate Presented in the FY 2004 Actuarial Review**

The FY 2004 Review projected that the FY 2005 book of business and
investment return on the Fund\'s balances would add \$1.722 billion and
\$0.731 billion, respectively, to the economic value of the Fund,
resulting in a projected FY 2005 economic value of \$24.430 billion.
This year's estimate of the FY 2005 economic value is \$2.809 billion
lower than the economic value projected for FY 2005 in last year's
Review.

Exhibit II-4 provides a summary of the decomposition of changes in the
current economic value of the Fund and in the FY 2011 capital ratio from
the FY 2004 Review to the FY 2005 Review. The most significant driver of
this decrease is due to the impact of the rising share of loans with
gift letters in the newer books of business. Because the loans with gift
letters experienced considerable higher claim rates than otherwise
seemingly identical loans with no downpayment gifts, the newer books of
business turn out to be much riskier and yield lower economic values and
initial capital ratios. The second major factor causing the decrease in
economic value is the lower-than-estimated origination volume for FY
2004 book of business and the lower estimate of origination volume of
the FY 2005 and future business volumes. Other modifications in the
econometric models and loss severity assumptions reduced the economic
value even further. Finally, the high overall claim rates experienced
during FY 2004, partially contributed by the new accelerated claims
operation, also lead to higher projected short-term claim rates across
all books of business and resulted in a reduction in the FY 2005
economic value.

# Exhibit II-4

+--------------------------------+--------+--------+--------+--------+
| **Summary of Changes in MMI    |        |        |        |        |
| Fund Estimated Economic Value  |        |        |        |        |
| Between FY 2004 and FY 2005**  |        |        |        |        |
|                                |        |        |        |        |
| **(\$ Millions)**              |        |        |        |        |
+--------------------------------+--------+--------+--------+--------+
|                                | Change | FY     | Change | C      |
|                                | in FY  | 2005   | in     | orresp |
|                                | 2005   | Ec     |        | onding |
|                                | Ec     | onomic | FY     |        |
|                                | onomic | Value  | 2011   | FY     |
|                                | Value  |        | C      | 2011   |
|                                |        |        | apital | C      |
|                                |        |        | Ratio  | apital |
|                                |        |        | (%)    | Ratio  |
|                                |        |        |        | (%)    |
+--------------------------------+--------+--------+--------+--------+
| FY 2004 Economic Value         |        | \$21,  |        |        |
| Presented in the FY 2004       |        | 977^a^ |        |        |
| Review                         |        |        |        |        |
+--------------------------------+--------+--------+--------+--------+
| FY 2005 Economic Value         | \$731  | \$     |        |        |
| Presented in the FY 2004       |        | 22,708 |        |        |
| Review, Excluding the FY 2005  |        |        |        |        |
| Book of Business:              |        |        |        |        |
+--------------------------------+--------+--------+--------+--------+
| Plus: Forecasted Value of 2005 | \      |        |        |        |
| Book of Business Presented in  | $1,722 |        |        |        |
| the FY 2004 Review             |        |        |        |        |
+--------------------------------+--------+--------+--------+--------+
| Equals: FY 2005 Economic Value |        | **\$24 |        | **6    |
| Presented in the FY 2004       |        | ,430** |        | .71%** |
| Actuarial Review               |        |        |        |        |
+--------------------------------+--------+--------+--------+--------+
| Plus: a. Update Origination    | -\$403 | \$     | 0.01%  | 6.72%  |
| Volume in the FY 2004          |        | 24,027 |        |        |
+--------------------------------+--------+--------+--------+--------+
| Plus: b. Update Actual         | -\$155 | \$     | -0.03% | 6.69%  |
| Conditional Claim Rates and    |        | 23,872 |        |        |
|                                |        |        |        |        |
| Conditional Prepayment Rates   |        |        |        |        |
| in the FY 2004                 |        |        |        |        |
+--------------------------------+--------+--------+--------+--------+
| Plus: c. Change by switching   | -\$247 | \$     | 1.67%  | 8.36%  |
| to FY 2005 loan level          |        | 23,625 |        |        |
|                                |        |        |        |        |
| multinomial logit econometric  |        |        |        |        |
| model                          |        |        |        |        |
+--------------------------------+--------+--------+--------+--------+
| Plus: d. Change due to updated | -\$137 | \$     | -0.46% | 7.90%  |
| economic forecast              |        | 23,488 |        |        |
+--------------------------------+--------+--------+--------+--------+
| Plus: e. Change by Loss        | -\$184 | \$     | -0.10% | 7.80%  |
| Severity Assumptions for Six   |        | 23,304 |        |        |
|                                |        |        |        |        |
| Products to FY 2005            |        |        |        |        |
+--------------------------------+--------+--------+--------+--------+
| Plus: f. Change by             | -\     | \$     | -1.35% | 6.45%  |
| incorporating performance      | $1,763 | 21,541 |        |        |
|                                |        |        |        |        |
| difference of loans with       |        |        |        |        |
| different gift sources         |        |        |        |        |
+--------------------------------+--------+--------+--------+--------+
| Plus: g Change by new refund   | \$80   | \$     | 0.21%  | 6.66%  |
| policy                         |        | 21,621 |        |        |
+--------------------------------+--------+--------+--------+--------+
| **Equals: Estimate of FY 2005  | **-\$2 | **\$21 | **-0   | **6    |
| Economic Value**               | ,809** | ,621** | .05%** | .66%** |
+--------------------------------+--------+--------+--------+--------+

^a^ Economic value as the end of FY 2004.

**3. Decomposition of the Differences of Economic Value and Capital
Ratio of the Current Review and Those of the FY 2004 Review**

We decomposed the change in the estimated status of the Fund to adjust
for the actual FY 2004 origination volume and for the FY 2004 actual
conditional prepayment and conditional claim rates. Then we showed the
change due to the reduced size and composition of future books of
business. Furthermore, we decomposed the change in the estimated status
of the fund that resulted from model modifications made in the current
FY2005 Review and from new economic forecasts. Exhibit II-4 summarizes
the individual effects of the changes on the Fund's economic value and
capital ratio in FYs 2005 and 2011.

**a. Updated Origination Volume of FY2004**

The first component of change depicted in Exhibit II-4 is with respect
to the Fund's economic value and capital ratio due to the updated
origination volume for FY 2004. The actual realized origination volume
of the FY 2004 book is 18.42 percent less than the forecasted volume
reported in the FY 2004 Review. The loan distribution among key
characteristics also varies slightly from last year's forecast, with a
higher portion of streamline-refinanced loans than last year's
projection. Since the realized origination volume of FY 2004 is
significantly lower than the one forecasted in last year's Review, it
contributes less economic value to the Fund, causing the FY2005 economic
value to decrease by \$0.403 billion.

**b. Updated Actual Mortgage Termination Experiences**

The second element of change delineated in Exhibit II-4 contributing to
the Fund's economic value and capital ratio is the updated conditional
prepayment and conditional claim rates that were observed during FY
2004. The record high prepayment rate experienced during FYs 2003 and
2004 caused the UPB of most recent books of business to reduce
dramatically. However, due to the long lag time between default and
claim, many loans that defaulted back in 2002 and 2003 have just gone
through the foreclosure and claim cycle and became realized as claims in
FY 2004. As the number of claim cases remained stable but the total loan
count in the portfolio decreased, a substantially higher conditional
claim rate was realized in FY 2004. Meanwhile, the accelerated claim
disposition (Section 601) Demonstration, which accelerates the
processing speed of claim cases, further increased the number of claims
realized during 2004. The high overall prepayment and claim rates
experienced during FY 2004 lead to higher short-term claim rates across
all books of business, thereby resulting in the reduction in the
economic value for FY 2005 by \$0.155 billion and the reduction in the
projected capital ratio for FY 2011 by 0.03 percent.

**c. Change in Projection Model Specifications and Updated Origination
Volume of FY 2005 and Projected Future Books of Business**

To conduct this year's Review, we followed last year's econometric and
the discounted cash flow models, with some changes on model
specifications. (For descriptions of model specification assumption
changes, see Appendices A and B). The loan-level multinomial logit
econometric models allow good fits to the age functions of the claim
rates during the early years of the mortgage life, and effectively
capture the nature of the competing risk between prepayments and claims.
The future cash flows are simulated and discounted quarterly. In
addition, we also updated the origination volume and composition of the
projected 2005 and future books of business. Compared to the FY 2004
Review, FHA's 2005 forecast of origination volume for FY 2005 and FY
2011 books of business decreased 40 percent and 30 percent respectively.
This substantial reduction in the forecasted future books of business is
in line with the current status of the FHA market share. The FHA market
share continued to decrease from 12.18 percent in FY 2002 to 3.77
percent in FY 2005. However, there is little research regarding the
causes and the consequences of this decreasing share phenomenon. While
the original LTV concentration moved toward the higher-risk categories,
this risk attribute has been reflected in the econometric models we
developed for this Actuarial Review.

**d. Changes in Economic Environment**

The one-year Treasury rate rose from 2.09 percent on June 30, 2004 to
3.36 percent on June 30, 2005. On the other hand, the ten-year rate
declined from 4.62 percent on June 30, 2004 to 4.36 percent on June 30,
2005. Although this suggests an overall flatter yield curve, the slope
of the yield curve in the very short run actually became steeper than in
last year's economic forecast by the Global Insight. Similar to the
long-term Treasury rate, mortgage interest rates also dropped slightly.
The average conventional 30-year fixed-rate mortgage commitment rates
posted by Freddie Mac decreased from 6.13 percent in the second quarter
of 2004 to 6.02% in the second quarter of 2005. This lower mortgage rate
caused the prepayment rate to remain high throughout FY 2005.

In spite of the slightly decreasing trend on the ten-year Treasury rate
and the 30-year mortgage commitment rate during the second quarter of
2004 and the second quarter of 2005, Global Insight, Inc. forecasted all
their interest rates to rise sharply during the next few years. By the
end of the projection period of this Review, FY 2012, the one-year
Treasury rate is expected to rise to a stable level of 5.35 percent.
Moreover, Global Insight projects that the rate increase would happen
immediately after the end of FY 2005. Within one year, the market
mortgage rate is projected to rise from 6.02 percent as of second
quarter of 2005 to 6.77 percent at second quarter of 2006. This rapidly
rising interest rate means there will be less incentive for existing
mortgage borrowers to refinance. The rising interest rate environment,
therefore, indicates that the prepayment rate of the mortgages in the
MMI Fund would slow down, making the insurance in force of the existing
portfolio drop more slowly. The extended duration of the existing MMI
Fund portfolio implies that more loans would remain in the portfolio. On
the other hand, the smaller origination volume forecasted by FHA for new
books of business will lead to slower growth in the overall insurance in
force of the MMI Fund.

According to Global Insight, the house price growth rate between the
second quarter of 2004 and the second quarter of 2005 was 6.25 percent.
However, this growth rate is forecasted to decrease from the current
level to 3.18 percent by the fourth quarter of 2005 and to decrease
further to below 2 percent in 2006. Due to this immediate housing market
slowdown projection, the performances of the FYs 2005 and 2006 books of
business are expected to be weaker than the older books. That is, the
lower projected house price growth rate would lead to an increase in the
future probability of negative equity, which in turn leads to an
increase in the projected number of claims. As a result, the economic
value of FY 2005 decreased by \$0.137 billion from last year's
projection. Due to the change in the economic forecast, the capital
ratio of FY 2011 decreases by 0.46 percentage points to 7.90 percent.

**e. Change Due to Loss Severity Assumption for Six FHA Mortgage
Products**

In the FY 2004 Review, we applied the average claim loss rate of 35
percent, which was the average experienced in FY 2002 and FY 2003, to
estimate future claim losses for all FHA-insured mortgage loans. Also,
we assumed the average claim loss rates observed would remain in the
future. For this year's Review we estimated loss severity rates by using
the historical average loss severity rates of loans being claimed during
the FYs 2000 -- 2004 for the same loan type. Furthermore,
differentiation stratified by LTV categories was also explored but shows
an insignificant pattern. These new loss severity assumptions are 36.96
percent for 30-year non-streamline refinance fixed rate mortgages, 48.76
percent for 15-year non-streamline refinance fixed rate mortgages, 34.11
percent for non-streamline refinance adjustable rate mortgages, 30.88
percent for 30-year streamline refinance fixed rate mortgages, 46.17
percent for 15-year streamline refinance mortgages, and 30.59 percent
for streamline refinance adjustable rate mortgages. Given the overall
higher loss rates than that of last year's assumption, the economic
value of the MMIF Fund for FY 2005 decreased by \$0.184 billion and the
corresponding capital ratio for FY 2011 was reduced by 0.10 percentage
points.

**f. Change Due to Higher Concentration of Gift Loans in Newer Books**

One noticeable trend revealed in this year's data extract is the rapidly
rising concentration of loans with gift letters in the newer books of
business. FHA allows a borrower to use outright gifts of cash toward the
down payment requirement. The cash gift could be from the borrower's
relative, employer or labor union, a charitable organization, a
government agency, a public entity that has a program to provide
homeownership assistance to low- and moderate-income families or
first-time home buyers, or a close friend with a clearly defined and
documented interest in the borrower. However, the gift donor may not be
a person or entity with an interest in the sale of the property, such as
the seller, real estate agent or broker, builder, or any entity
associated with them.

A recent HUD sponsored publication[^1] documented potential application
problems associated with loans with down payment assistance from
non-profit, religious, or community sources. HUD's internal analysis
also showed that these loans experienced relatively higher claim rates
than loans with downpayment assistance from other sources or no gift.
Our independent study indicates that higher claim rates were observed on
all gift sources except that from the borrower's relatives. The higher
concentration of recent books in higher claim rate gift sourced loans is
incorporated into our econometric model.

As shown in Section IV, the higher concentration of loans with
downpayment assistance of gifts from non-relative sources now represent
substantial share of FHA's newer books of business. The claim rates of
these loans appear to be much higher than other non-gift loans and loans
with gift from relatives. When we refined econometric model to
incorporate this change in business concentration, the estimated
economic value for FY 2005 decreased to \$21.541 billion, an incremental
decrease of \$1.763 billion. Assuming all future books of business to
have the similar high concentration of gift letter loans, we projected
the capital ratio of the MMI Fund to be 6.45% by the end of FY 2011,
indicating a slower growth comparing with the capital ratio of 7.80%
before this adjustment. The high claim rate of the gift-letter loans
translated into a reduction of 1.35 percentage points in FY 2011's
capital ratio.

This is a fairly new phenomenon which has had a major economic impact on
the fund and we suggest the situation be closely monitored.

**g. Change Due to the Elimination of Upfront Mortgage Insurance Premium
Refund Policy**

In January 2005, FHA eliminated the upfront mortgage insurance premium
refund except for borrowers who refinance to another mortgage insured by
FHA. This elimination of refund is effective for loans endorsed on or
after December 8^th^, 2004. In addition, the refund schedule for
borrowers who refinance with a new FHA-insured mortgage on or after this
same date is modified to a three year time period.  This policy change
reduces the future premium refund cash out flows of the MMI Fund.
Holding everything else constant, it will lead to an increase of the
economic value and capital ratio. We estimate that this policy change
will bring the FY 2005 economic value from \$21,541 billion to \$21,621
billion, an incremental increase of \$0.08 billion. The FY 2011 capital
ratio is expected to rise by 0.21 percentage to 6.66 percent.

### D. The Impact of Hurricane Katrina occurred August 2005 

Hurricane Katrina, the deadliest hurricane in the United States since
1900, landed near Buras, Louisana in the early morning of August 29
after crossing the Gulf of Mexico, where it intensified rapidly to a
Category 5 hurricane. Katrina brought intensive damages around the area
of the states of Alabama, Mississippi, and especially Louisiana.

The areas determined eligible for individual assistance by the Federal
Emergency Management Agency (FEMA) are:

-   Alabama: Baldwin, Mobile, and Washington Counties.

-   Mississippi: Amite, Forrest, George, Greene, Hancock, Harrison,
    Jackson, Lamar, Marion, Pearl River, Perry, Pike, Stone, Walthall,
    and Wilkinson Counties.

-   Louisiana: The parishes of Acadia, Ascension, Assumption, Calcasieu,
    Cameron, East Baton Rouge, East Feliciana, Iberia, Iberville,
    Jefferson, Jefferson Davis, Lafayette, Lafourche, Livingston,
    Orleans, Pointe Coupee, Plaquemines, St. Bernard, St. Charles, St.
    Helena, St. James, St. John, St. Mary, St. Martin, St. Tammany,
    Tangipahoa, Terrebonne, Vermilion, Washington, West Baton Rouge, and
    West Feliciana.

As of March 31, 2005, 1.56% of the still-active loans insured by FHA
were originated from the above counties. This is roughly \$5.17 billion
out of the still active unamortized IIF of \$358.87 billion as of the
end of 2005, were originated from these adversely affected areas.

Exhibit II-6 below shows that there were 11 counties remaining seriously
flooded as of September 7, 2005, ten days after the landfall of the
Hurricane. About \$3.08 billion unamortized IIF of the MMI Fund are
associated with these underwater counties. Since the estimate of the
total damage is not yet available and the recovery plan is still unclear
at this time, we can only estimate the potential impact to the MMI Fund
by making some assumptions. We assume that one quarter of the housing
underlying these mortgage loans would receive compensation neither from
natural hazard insurance policies nor from FEMA recovery subsidy and
would never be rebuilt. Assuming a 100% of loss severity rate on these
loans, we estimate that Hurricane Katrina could cause FHA a total loss
of \$0.77 billion over FYs 2006 and 2007. Under these rather severe
assumptions, the FY 2005 Economic Value of the MMI Fund could be further
lowered to about \$20.842 billion and the FY 2005 Capital Ratio lowered
to 5.83%. However, since the national recovery plan is still very
preliminary at the time of this Review, it is unclear that such losses
would actually occur. Rather, this analysis suggests a possible severe
downside result of the hurricane. As a result of the uncertainty, the
impact of the Hurricane Katrina is excluded from the Base Case analysis
of the FY 2005 Actuarial Review.

Exhibit II-6

![](media/image1.wmf)

Source: http://www.gismaps.fema.gov/2005pages/katrina.shtm

[^1]: "An Examination of Downpayment Gift Programs Administered by
    Non-Profit Organizations," March 1, 2005, Concentrance Consulting
    Group.