Number range CHAPTER**Section I: Introduction**

The Cranston-Gonzalez National Affordable Housing Act (NAHA), enacted in
1990, mandated that the Federal Housing Administration\'s (FHA\'s)
Mutual Mortgage Insurance (MMI) Fund maintain a capital ratio of 2.00
percent starting from October 1, 2000. As defined by NAHA, the
definition of the capital ratio is the ratio of the Fund's capital or
economic net worth to its unamortized insurance-in-force (IIF). NAHA
also established the requirement for the MMI fund to undergo an annual
independent actuarial review.

The purpose of the annual actuarial review is to assess the actuarial
soundness of the Fund, and the review for FY 2005 is reported in this
document. The analysis estimated the economic value of the MMI Fund as
well as the capital ratio to see if the Fund has met the capital
standards set forth in NAHA. The analysis was based on the information
provided by HUD, such as historical performance of the existing MMI Fund
loans, projected future economic conditions, loss-given-claim rates, and
projected mortgage originations.

**A. Implementation of NAHA**

Following the issuance of the fiscal year (FY) 1989 Actuarial Review and
the ensuing debate, Congress mandated various changes to the MMI Fund as
part of the 1990 Cranston-Gonzalez Act. The required revisions to the
MMI Fund focused on four major issues: 1) the development of an
actuarial standard of financial soundness, 2) modification of minimum
equity requirements, 3) changes in the pricing of insurance premiums,
and 4) revisions to policies regarding distributive shares.

The provisions of NAHA regarding the MMI Fund have had a significant
impact on the performance of the current and future books of business.
The changes called for in the Act were specifically designed to remedy
the past financial difficulties encountered by the Fund. Each change was
intended to either reduce the risks inherent in the additional books of
business or to adjust premiums to more adequately compensate for these
risks.

The NAHA legislation required that the Fund be operated on an
actuarially sound basis by providing specific capital standards for the
Fund and timeframes in which these standards should be met. It also
defined the actuarial standard as a ratio of the Fund\'s capital or
economic net worth to its unamortized insurance-in-force.

To further strengthen the capital position of the Fund, the NAHA
legislation linked FHA\'s ability to pay distributive shares to the
actuarial soundness of the entire MMI Fund (as defined in the
legislation) rather than solely considering the performance of the loans
endorsed during a particular year as was done in the past. This
amendment sought to ensure that distributive share payments would not be
made if the Fund did not achieve the capital standards established by
the legislation. In all our estimates of Fund performance, we have
assumed that no distributive shares will be paid. We made this
assumption because it is the current FHA policy.

**B. FHA Policy Developments and Underwriting Changes**

During the past ten years, FHA implemented several policy changes. Some
of the major changes include revised underwriting guidelines and other
policy issues, underwriting adjustable rate mortgages and homeownership
counseling, usage of an automated underwriting system, reduction of
upfront mortgage insurance premium and related changes, and increases in
FHA single-family maximum mortgage limits. Each of these developments is
summarized below.

**1. Revised Underwriting Guidelines and Other Policy Issues**

In 1995, FHA undertook several changes in the underwriting guidelines
and policy issues. The purpose of the revisions was to eliminate
unnecessary barriers to homeownership, provide the flexibility to
underwrite creditworthy non-traditional and underserved borrowers, and
clarify certain underwriting requirements so that they are not applied
in a discriminatory manner. Some of the changes were as follows:

-   Instead of using the last five years to determine the borrower's
    income stability, the revised policy required that income be
    expected to continue for the first three years of the mortgage for
    it to be used in qualifying the borrower.

-   Overtime and/or bonus income received less than two years is
    acceptable where the lender determines that there are reasonable
    prospects of its continuance.

-   The recognition of part-time income, where part-time income refers
    to jobs taken in addition to the normal, regular employment to
    supplement the borrower's income. The lender must determine that the
    continuance of this income is reliable and provide a strong
    explanation for including such income as effective income in
    qualifying the borrower.

-   FHA requires only debts extending ten or more months to be included
    in the debt-to-income ratios. Childcare costs are no longer to be
    considered in the computation of the debt-to-income ratio, except
    for court-ordered or voluntary child support payments.

-   Borrowers who have saved cash at home and are able to adequately
    demonstrate the ability to do so are permitted to have this money
    included as an acceptable source of funds to close the mortgages.

-   HUD permits, under most circumstances, a "three repository merged
    credit report" (TRMCR) rather than a Residential Mortgage Credit
    Report (RMCR).

While these modifications enabled many households to become homeowners,
this loosening of the underwriting rules also lead to an increase in FHA
claim rates.

**2. Underwriting Adjustable Rate Mortgages and Homeownership
Counseling**

Several changes were made in 1998 in the underwriting of adjustable rate
mortgages (ARMs) and homeownership counseling. The policy revisions
addressed the high losses that FHA was experiencing. Based on FHA's
study of ARM claim rates, it was necessary to change the credit policy
to maintain actuarial soundness. Borrowers must now qualify using the
mortgage payment based on the maximum second year interest rate. This
applies to all mortgages with loan-to-value (LTV) equal to or greater
than 95 percent. Also, any form of temporary interest rate buydown for
adjustable rate mortgages is no longer acceptable.

Another focus of the revisions was on homeownership counseling. In the
past, FHA had provided funding for approved homeownership counseling for
the benefit of borrowers. However, unacceptable practices such as
borrowers simply being asked to complete homeownership workbooks without
any additional interaction with the counseling program were observed.
The new rule requires that the type of homeownership counseling obtained
by the first-time homebuyer must be examined by FHA's quality assurance
staff as part of its regular reviews of the lenders. FHA required that
counseling be delivered in a classroom setting, face-to-face, or via
electronic media and involve 15 to 20 hours of instruction. Other
counseling programs accepted by either Freddie Mac or Fannie Mae also
meet this requirement.

**3. Automated Underwriting Systems**

In 1998, FHA announced that it approved Freddie Mac's Loan Prospector
(LP) for the use in underwriting FHA insured mortgages. At the same
time, FHA made a substantial number of revisions to its credit policies
and reduced documentation requirements for LP-assessed loans, as
described in the LP User's Guide. This is the first time that FHA
incorporated automatic underwriting systems (AUSs) in its loan approval
process. A year later, in 1999, Fannie Mae's Desktop Underwriter (DU)
and PMI Mortgage Services' pmiAURA automated underwriting systems were
also approved to underwrite FHA mortgages.

**4. Further Reduction in Upfront Mortgage Insurance Premiums**

In 2000, in recognition of the continued strength and increase in the
MMI Fund, FHA revised its Upfront Mortgage Insurance Premiums (UFMIP)
policy for all loans closed on or after January 1, 2001. The new UFMIP
is 1.50 percent and the borrower does not have to be a first-time
homebuyer or to have received homeownership counseling. The eligibility
for UFMIP refunds has been shortened to five years for loans endorsed
prior to December 8, 2004, and eliminated for loans endorsed after this
date except for borrowers who refinance with a new FHA insured mortgage.
In the latter case, the refund eligibility expires after 3 years.

In the past, some FHA borrowers needed to pay annual mortgage insurance
premiums throughout the life of the mortgage. The new rule specifies
that annual mortgage insurance premiums will be automatically canceled
for all loans closed on or after January 1, 2001 under the following
conditions:

-   For mortgages with terms of more than 15 years, the annual mortgage
    insurance premiums will be canceled when the loan-to-value ratio
    reaches 78 percent. The mortgagor has to pay the annual mortgage
    insurance premiums for at least five years.

-   For mortgages with terms equal or less than 15 years and a
    loan-to-value ratio of 90 percent or greater, the annual mortgage
    insurance premiums will be canceled when the loan-to-value ratio
    reaches 78 percent, regardless of the length of time the mortgagor
    has paid the annual mortgage premiums.

-   For mortgages with terms equal to or less than 15 years and a
    loan-to-value ratio of 89.9 percent and less will not be charged
    annual mortgage insurance premiums.

**5. Increase in FHA's Single-Family Loan Limits**

In late December 2004, HUD announced that it would raise FHA's
single-family loan limit. The new mortgage limits ("the floor") will be
\$172,632 and the new ceilings for high cost areas are \$312,895.[^1]
The nationwide mortgage limits are \$220,992, \$267,120, and \$331,968
for two, three, and four-units mortgage loans. The statutory ceilings of
two, three, and four-unit mortgage loans for high cost areas are
\$400,548, \$484,155, and \$601,692, respectively. The increase in loan
limit is the result of increases in Fannie Mae and Freddie Mac
conforming mortgage loan limits. This change was effective starting
January 1, 2005.

**C. Current and Future Market Environment**

**1. Interest Rates**

According to the Federal Reserve Bank statistics, three-month interest
rates on short-term Treasury securities increased through FY 2005. The
one-year Treasury rate rose from 2.09 percent on June 30, 2004 to 3.36
percent on June 30, 2005. The ten-year treasury rate, however, declined
from 4.62 percent on June 30, 2004 to 4.36 percent on June 30, 2005.
Mortgage interest rates also dropped slightly. The average conventional
30-year fixed-rate mortgage commitment rate posted by Freddie Mac
decreased from 6.13 percent to 6.02 percent between the second quarter
of 2004 and the second quarter of 2005.

Consistent with this rising trend, Global Insight, Inc. also forecasted
interest rates to rise rapidly 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. Due to the
observed rate increases during the last year, the MMI Fund origination
volume during FY 2005 is now estimated to be 40 percent lower than was
forecasted in the FY 2004 review. This substantial reduction in the
forecasted future books of business is consistent with the current trend
of FHA's market share. FHA's market share continued to decrease from
12.18 percent in FY 2002 to an estimated 3.77 percent in FY 2005.

With the rising interest rate trend expected to continue over the next
few years, future refinance origination volume will remain low. The
smaller origination volume for new books will lead to slower growth in
the insurance in force of the MMI Fund. On the other hand, the
associated slower prepayment rates in FRMs make the insurance in force
of the existing portfolio decrease more slowly, leaving more loans
subject to claim risk for a longer time period. As for ARMs, rising
interest rates mean higher payment levels in the next few years. Should
the borrower's income not increase as rapidly as the mortgage payments,
more ability-to-pay-related claims could be observed.

**2. House Price Growth Rate**

Projections of future home price growth rate are obtained from the
Global Insight May 2005 long-range forecast. Generally, annual growth
rates in house prices are projected to stay high for the second and
third quarter of FY 2005, but start to drop quickly to 3 percent by the
end of FY 2005, and remain below 4 percent throughout FY 2008 before
rising back to a stable 4.2 percent growth rate by FY 2015. The slower
growth rate in housing prices implies a deceleration of economic growth
for the fiscal years 2005 through 2008. This represents a temporary
slowdown in the housing market and affects the strength of the MMI Fund
in the projected future.

Section II presents the impacts of these forecasts in greater detail and
Section V provides an analysis of the fund's sensitivity to changes in
specific economic variables.

# D. Higher Concentration of Loans with Gift Letters 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's data warehouse started tracking loans with gift letters
in FY 1998. FHA allows a borrower to use outright gifts of cash as
downpayment assistance. Eligible sources of cash gift include the
borrower's relative, employer or labor union, a charitable organization,
a governmental 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. Our current analysis indicates that
these gift loans perform worse than their counterparts across all
origination years and all exposure years. For the first time, we
incorporated this gift effect into the Annual Review, and it weakens the
projected performance of the MMIF over the foreseeable future.

# E. Data Sources and Future Projections

The estimates presented in this Review require projections of events
more than 30 years into the future. These projections are dependent upon
a number of assumptions, including economic forecasts by Global Insight,
Inc. and the assumption that FHA does not change its refund and premium
policies. Since the assumptions may not be accurate, the actual results
will vary, perhaps significantly, from our current projections.

Furthermore, we based our analysis on FHA historical data through March
31, 2005. While we have reviewed the integrity and consistency of these
data and believe them to be reliable, we have not audited them for
accuracy. The information contained in this Review may not correspond
exactly with other published analyses that rely on FHA data compiled at
a different time or obtained from other data sources.

**F. Structure of this Report**

The remainder of this report is divided into the following sections:

**Section II. Summary of Findings and Comparison with FY 2005 Actuarial
Review** -- presents the Fund\'s estimated economic value, capital
ratio, and insurance-in-force for FY 2005 through FY 2012. This section
also provides a reconciliation and explanation of the major differences
between the FY 2004 Review and the FY 2005 Review.

**Section III. Current Status of the Fund** -- presents the estimated
economic value and capital ratio for the Fund for the end of FY 2005 and
provides an analysis of the performance of the books of business from FY
1976 through FY 2005.

**Section IV. Characteristics of the FY 2005 Book of Business** --
describes the FY 2005 book of business and compares the risk
characteristics of the current book to previous books.

**Section V. MMI Fund Sensitivities** -- presents sensitivity analyses
of the MMI Fund using alternative economic assumptions and loan
characteristics.

**Section VI. Summary of Methodology** -- presents an overview of the
econometric and cash flow models used for the review.

# Section VII. Considerations and Limitations -- describes the main assumptions and the limitations of the data and models relevant to the results presented in this review.

**Section VIII. Conclusions** -- provides a summary of the report\'s
results and the conclusions that can be drawn from those results.

**Appendix A. Econometric Analysis of Mortgages** -- provides a
technical description of our econometric model for individual mortgage
product types.

**Appendix B. Cash Flow Analysis** -- provides a technical description
of our cash flow model.

**Appendix C. Data for Loan Performance Simulation** -- explains the
algorithms used in transforming the raw data into the data used to
simulate future mortgage performance.

**Appendix D. Economic Forecasts** -- describes the forecast of future
economic factors that affect the performance of the Fund and the
alternative economic scenarios associated with various sensitivity
analyses.

**Appendix E. Econometric Results** -- presents claim and prepayment
rates estimated from the econometric model.

[^1]: The new loan limit is still subject to the 95 percent of area
    median house price rule, thus continuing to cause the FHA population
    to consist of below-median-priced homes.