**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 2006 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 changes called for in the Act were specifically designed to remedy
the financial difficulties encountered by the Fund in the 1980s. Each
change was intended either to reduce the risks inherent in new 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 measure as the 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

1

legislation. No distributive shares have been paid since the passage of
NAHA. In all our estimates of Fund performance, we followed the current
HUD policy and assumed that no distributive shares will be paid even
though the capital ratio has met the NAHA mandate.

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

During the past fifteen years, FHA has implemented several policy
changes that affected the financial strength of the MMI Fund. Some of
the major changes include revised underwriting guidelines and other
policy issues, underwriting adjustable rate mortgages and homeownership
counseling, usage of automated underwriting systems, reduction of
upfront mortgage insurance premium and related changes, and increases in
the maximum mortgage limits. Each of these developments is summarized
below.

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

In 1995, FHA introduced several changes in the underwriting guidelines.
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 previous five-year period to determine the
    borrower's income stability, the revised policy required that the
    income can 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 for less than two years
    became acceptable, where the lender determines there are reasonable
    prospects of its continuance.

-   • Part-time income was recognized, where part-time income refers to
    income generated by 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.

-   • Only debts extending ten or more months are required to be
    included in the calculations of 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.

2

-   • Borrowers who have saved cash at home and are able to adequately
    demonstrate the ability to continue 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 additional households to become
homeowners, the relaxation 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. ARM borrowers now must qualify using
the mortgage payment based on the maximum second-year interest rate.
This applies to all ARMs with loan-to-value (LTV) equal to or greater
than 95 percent. Also, any form of temporary interest rate buydowns for
ARMs is no longer acceptable.

Another focus of the 1998 revisions was on homeownership counseling. In
the past, first-time buyers receiving counseling were eligible for a
reduced upfront FHA insurance premium. While FHA permits funding for
approved homeownership counseling programs, 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 required 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. When upfront
premium was reduced in 2001 for all FHA borrowers, there was no longer
special benefit for borrowers who went through homeownership counseling
programs. **3. Automated Underwriting Systems **

In 1998, FHA announced that it approved Freddie Mac's Loan Prospector
(LP) for underwriting FHA insured mortgages. At the same time, FHA made
a substantial number of revisions to its credit policies and reduced the
documentation requirements for LP-assessed loans, as described in the LP
User's Guide. This was the first time that FHA incorporated automatic
underwriting systems (AUSs) in its insurance endorsement process. One
year later, in 1999, Fannie Mae's *** ***

3

Desktop Underwriter (DU) and PMI Mortgage Services' pmiAURA, and later
on, Countrywide Funding Corporation's AUSs were also approved to
underwrite FHA mortgages.

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

In 2000, in recognition of the continued financial strength and increase
in the size of 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 for all borrowers. The eligibility
period for UFMIP refunds was shortened to five years for loans endorsed
prior to December 8, 2004, and eliminated for loans endorsed after that
date except for borrowers who refinance with a new FHA insured mortgage.
In the latter case, when the refund can be applied toward the UFMIP of
the new FHA-insured loan, 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 specified
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 balance
    reaches 78 percent of the original house price. The mortgagor has to
    pay the annual mortgage insurance premiums for at least five years.

-   • For mortgages with terms equal to or less than 15 years and having
    a loan-to-value ratio of 90 percent or greater, the annual mortgage
    insurance premiums will be canceled when the loan balance reaches 78
    percent of the original house price, 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 or less, no annual mortgage
    insurance premium will be charged.

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

In late December 2005, HUD announced the increase of FHA's single-family
loan limits for 2006, in accordance with National Housing Act provisions
that allow the national floor and ceiling to adjust with the conforming
loan limit.^1^ The new maximum insurable single-family loan size in
low-cost areas (the "Floor") is \$200,160 and the new maximum insurable
amount in

^1^ See Mortgagee Letter 2005-49, December 21, 2005.

4

high cost areas (the "Ceiling") is \$362,790.^2^ The nationwide mortgage
floors for low-cost areas are \$256,248, \$309,744, and \$384,936 for
two-, three-, and four-unit mortgage loans, respectively, and the
respective statutory ceilings for high cost areas are \$464,449,
\$561,411, and \$697,696. These changes became effective starting
January 1, 2006.

**C. Current and Future Market Environment**

**1. Interest Rates **

According to the Federal Reserve Board statistics, the one-year
constant-maturity Treasury yield rose from 3.64 percent on July 1, 2005
to 5.16 percent on July 1, 2006. Similarly, the ten-year Treasury yield
rose from 4.18 percent on July 1, 2005 to 5.09 percent on July 1, 2006.
These changes produced a flat yield curve. Mortgage interest rates also
increased. The average conventional 30-year fixed-rate mortgage
commitment rate posted by Freddie Mac increased from 5.70 percent to
6.76 percent between July 2005 and July 2006.

Based on this market-wide trend, Global Insight, Inc. forecasted
Treasury yields to remain stable during FY 2007. On the other hand, the
mortgage rates are projected to continue to rise rapidly in 2007, and
gradually stabilize at the level of 7.21 percent after FY 2010.

**2. House Price Growth Rate **

Projections of future national average home price growth rates are
obtained from the Global Insight June 2006 long-range forecast.
According to that forecast, the realized annual growth rate in the
national average house price between the first quarter of 2005 and the
second quarter of 2006 is about 11 percent, about twice the 5.5 percent
projected by Global Insight back in May 2005. The
stronger-than-anticipated growth rates in 2005 and into 2006 strengthen
the quality of all existing books of business. On the other hand, the
projected future growth rate between the third quarter of 2006 and the
first quarter of 2008 is only about 2.4 percent, which is less than half
of the growth rate projected by Global Insight last year for the same
period. This is consistent with the OFHEO's report that national house
price growth has started to slow down. The projected long-term
stabilized growth rate is also lowered from last year's projection of
4.2 percent to 3.7 percent. The slower growth rate in housing prices
will negatively affect the strength of new books of business over the
coming years, especially for FYs 2006 through 2008.

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.

*** ***5

**3. Mortgage Demand **

FHA's market share remained low during FY 2006. The MMI Fund origination
volume during FY 2006 estimated by FHA is 5.4 percent lower than that
was forecasted in the FY 2005 Review. This 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 12.22
percent in FY 2002 to an estimated 3.81 percent in FY 2006.

In response to the decreasing market share, the President's FY 2007
budget proposal included a plan for revitalizing the FHA program. At the
time this Review was prepared, the proposal had been passed by the House
of Representatives but is still subject to the Senate review. With the
uncertainty of the passage of the proposal and the specific provisions
of final bill, this Review is prepared with no adjustment for the
potential impact of the FHA reform proposal.

With the rising interest rate trend expected to continue over the next
few years, future refinance origination share is likely to remain low
relative to its peak in FY 2003. The smaller origination volume for new
books of business 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. If the borrower's income does not
increase as rapidly as the mortgage payments, more ability-to-pay
related defaults could occur. However, as long as the house price
appreciation rates remain non-negative, most of the income-driven
defaults may not lead to claim losses.

Section II presents the impacts of these forecasts on the MMI Fund in
greater detail. Section V provides analyses of the fund's sensitivity to
changes in specific economic variables.

**D. High Concentration of Loans with Gift Letters in Newer Books **

The trend of an increasing share of MMIF insured loans receiving
downpayment gift assistance from non-profit organizations continued
during this past year. Non-profit organization assisted mortgages now
represent about one-quarter of the FY 2005 and FY 2006 books of
business. FHA allows a borrower to use outright gifts of cash as
downpayment assistance. Eligible gift sources include: relatives,
employers or labor unions, tax-exempt charitable organizations,
governmental agencies, public entities that have programs to provide
homeownership assistance to low- and moderate-income families or
first-time homebuyers, or close friends with a clearly defined and
documented interest in the borrower. A recent Government Accountability
Office

6

(GAO) report^3\ ^documented that many downpayment gifts provided by
non-profit organizations were contributed by the home sellers involved
in the specific transactions and possibly with inflated house values.
The FY 2005 Review documented that these loans with gift assistances,
especially from the non-profit organizations, experienced
higher-than-average claim rates. In May 26, 2006, the Internal Revenue
Service (IRS) issued a ruling^4\ ^that non-profit organizations that
fund downpayment assistance programs with contributions from the
property sellers do not meet legal requirements for tax-exempt status.
The IRS has started a large number of investigations of organizations
involved in such activities. The IRS expects that the non-profit status
of all organizations that engage in such activities will be taken away
within the next two years. These actions will eliminate this type of
high risk loans from future books of business. To take a conservative
stand, we assume that the share of these high-risk loans in FHA's new
books of business will steadily diminish over the next three years. **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.

We based our analysis on FHA historical origination, prepayment, and
claim data through February 28, 2006. 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 2006 through FY 2013. This section
also provides a reconciliation and explanation of the major differences
between the FY 2005 and the FY 2006 Reviews.

^3^ "Mortgage Finance Additional Action Needed to Manage Risks of
FHA-Insured Loans with Down Payment\
Assistance," by Government Accountability Office, November 2005.\
^4^ Internal Revenue Bulletin: 2006-21, by Internal Revenue Service.

7

**Section III. Current Status of the Fund** -- presents the estimated
economic value and capital ratio for the Fund at the end of FY 2006 and
provides an analysis of the performance of the books of business from FY
1977 through FY 2006.

**Section IV. Characteristics of the FY 2006 Book of Business** --
describes the FY 2006 book of business and compares the risk
characteristics of the current book to those of 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 in 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 we draw 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 to transform the raw data into the data used to simulate
future mortgage and Fund performance.

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

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

8