United States Government Accountability Office

GAO Testimony 

Before the Subcommittee on Transportation, 

Housing, and Urban Development, and Related 

Agencies, Committee on Appropriations, 

United States Senate 

FEDERAL HOUSING 

ADMINISTRATION 

Ability to Manage Risks 

and Program Changes Will 

Affect Financial 

Performance 

Statement of William B. Shear, Director 

Financial Markets and Community Investment 

For Release on Delivery

Expected at 9:30 a.m. EDT

Thursday, March 15, 2007 

 

GAO-07-615T 
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

March 15, 2007

FEDERAL HOUSING ADMINISTRATION

Ability to Manage Risks and Program 

Changes Will Affect Financial 

Performance 

Highlights of GAO-07-615T, a testimony 

before the Subcommittee on 

Transportation, Housing and Urban 

Development, and Related Agencies, 

Committee on Appropriations, U.S. Senate 

The Federal Housing 

Administration (FHA) has seen 

increased competition from

conventional mortgage and

insurance providers. Additionally, 

because of the worsening 

performance of the mortgages it 

insures, FHA has estimated that its 

single-family insurance program 

would require a subsidy—that is, 

appropriations—in fiscal year 2008 

in the absence of program changes. 

To help FHA adapt to the evolving

market, proposed changes to the 

National Housing Act would allow

greater flexibility in setting 

insurance premiums and reduce 

down-payment requirements. To 

assist Congress in considering the

financial challenges facing FHA, 

this testimony provides

information from recent reports 

GAO has issued and ongoing work 

concerning the proposed

legislation that address different

aspects of FHA’s risk management. 

Specifically, this testimony looks at 

(1) FHA’s management of risk 

related to loans with downpayment assistance, (2) instructive 

practices for managing risks of new 

products, (3) FHA’s development 

and use of its mortgage scorecard,

and (4) FHA’s estimation of 

program costs. 

What GAO Recommends

In the reports discussed in this 

testimony, GAO made

recommendations designed to

improve FHA’s risk management 

and estimates of program costs. 

Recent trends in mortgage lending have significantly affected FHA, including

growth in the proportion of FHA-insured loans with down-payment 

assistance, wider availability of low- and no-down-payment products, and 

increased use of automated tools (e.g., mortgage scoring) to underwrite 

loans. Although FHA has taken steps to improve its risk management, in a 

series of recent reports, GAO identified a number of weaknesses in FHA’s 

ability to estimate and manage risk that may affect its financial performance. 

For example: 

• FHA has not developed sufficient standards and controls to manage risks 

associated with the substantial proportion of loans with down-payment 

assistance, including assistance from nonprofit organizations funded by 

home sellers. According to FHA, high claim and loss rates for loans with 

such assistance were major reasons for the estimated positive subsidy 

cost (meaning that the present value of estimated cash inflows would be 

less than the present value of estimated cash outflows) for fiscal year 

2008, absent any program changes. 

• FHA has not consistently implemented practices—such as stricter

underwriting or piloting—used by other mortgage institutions to help 

manage the risks associated with new product offerings. Although FHA 

has indicated that it would impose stricter underwriting standards for a 

no-down-payment mortgage if the legislative changes were enacted, it 

does not plan to pilot the product. 

• The way that FHA developed its mortgage scorecard, while generally

reasonable, limits how effectively it assesses the default risk of 

borrowers. With increased competition from conventional mortgage 

providers, limitations in its scorecard could cause FHA to insure 

mortgages that are relatively more risky. 

• FHA’s reestimates of the costs of its single-family mortgage program 

have generally been less favorable than originally estimated. Increases 

in the expected level of claims were a major cause of a particularly large 

reestimate that FHA submitted as of the end of fiscal year 2003. 

GAO made several recommendations in its recent reports, including that 

FHA (1) incorporate the risks posed by down-payment assistance into its 

scorecard, (2) study and report on the impact of variables not in its loan 

performance models that have been found to influence credit risk, and (3) 

consider piloting new products. FHA has taken actions in response to GAO’s 

recommendations, but continued focus on risk management will be 

necessary for FHA to operate in a financially sound manner in the face of 

market and program changes. 

www.gao.gov/cgi-bin/getrpt?GAO-07-615T.

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. 
Madam Chairman and Members of the Subcommittee: 

I am pleased to have the opportunity to share information and 

perspectives with the committee as it examines issues concerning the 

financial performance of 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 about 426,000 mortgages, 

representing $55 billion in mortgage insurance. According to FHA’s 

estimates, the 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 (Fund) 

exceeds the present value of estimated cash outflows (such as claims). 

But, the risks FHA faces in today’s mortgage market are growing. For 

example, the agency has seen increased competition from conventional 

mortgage and insurance providers, many of which offer low- and no-downpayment products, and that may be better able than FHA to identify and

approve relatively low-risk borrowers. Additionally, because of the 

worsening performance of the mortgages it insures, FHA has estimated 

that the program would require a positive subsidy—that is, an

appropriation of budget authority—in fiscal year 2008 if no program 

changes were made. 

To help FHA adapt to market changes, HUD has proposed a number of 

changes to the National Housing Act that, among other things, would give 

FHA 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. Whether under its existing authority or using 

any additional flexibility that Congress may grant, FHA’s ability to manage 

risks and program changes will affect the financial performance of the 

insurance program. 

My testimony today discusses four reports that we have issued since 2005

on different aspects of FHA’s risk management, as well as ongoing work 

we are conducting on FHA’s proposed legislative changes and the tools 

and resources it would use to implement them, if passed. This body of 

work addresses a number of issues relevant to FHA’s financial

performance. Specifically, I will discuss (1) weaknesses in how FHA has 

managed the risks of loans with down-payment assistance, (2) practices

that could be instructive for FHA in managing the risks of new mortgage 

products, (3) FHA’s development and use of a mortgage scorecard, and (4) 

FHA’s estimation of subsidy costs for its single-family insurance program. 

Page 1 GAO-07-615T
In conducting this work, we reviewed and analyzed information 

concerning the standards and controls FHA uses to manage the risks of 

loans with down-payment assistance; steps mortgage industry participants 

take to design and implement low- and no-down-payment mortgage 

products; FHA’s approach to developing its mortgage scorecard and the 

scorecard’s benefits and limitations; FHA’s estimates of program costs and 

the factors underlying the agency’s cost reestimates; and FHA’s plans and 

resources for implementing its proposed legislative changes. We 

interviewed officials from FHA, the U.S. Department of Agriculture, and 

U.S. Department of Veterans Affairs; and staff at selected private mortgage 

providers and insurers, Fannie Mae, Freddie Mac, the Office of Federal 

Housing Enterprise Oversight, selected state housing finance agencies, and 

nonprofit down-payment assistance providers. We conducted this work 

from January 2004 to March 2007 in accordance with generally accepted 

government auditing standards. 

In summary, our work identified a number of weaknesses in FHA’s ability 

to estimate and manage risk that may affect the financial performance of 

the insurance program: 

• FHA has not developed sufficient standards and controls to manage risks 

associated with the substantial proportion of loans with down-payment 

assistance. Unlike other mortgage industry participants, FHA does not 

restrict homebuyers’ use of down-payment assistance from nonprofit 

organizations that receive part of their funding from home sellers. 

However, our analysis of a national sample of FHA-insured loans found 

that the probability of loans with this type of down-payment assistance 

resulting in an insurance claim was 76 percent higher than comparable 

loans without such assistance. Additionally, the financial risks of these 

loans recently have been realized in effects on the credit subsidy 

estimates. According to FHA, high claim and loss rates for loans with this 

type of down-payment assistance were major reasons why the estimated 

credit subsidy rate—the expected cost—for the single-family insurance 

program would be positive, or less favorable, in fiscal year 2008 (absent 

any program changes). 

• Some of the practices of other mortgage institutions offer a framework 

that could help FHA manage the risks associated with new products such 

as no-down-payment mortgages. For example, mortgage institutions may 

limit the volume of new products issued—that is, pilot a product—and 

sometimes require stricter underwriting on these products. While FHA has 

utilized pilots or demonstrations when making changes to its single-family 

mortgage insurance, it generally has done so in response to a legislative 

requirement and not on its own initiative. Moreover, FHA officials have 

Page 2 GAO-07-615T
questioned the circumstances under which pilot programs were needed 

and also said that they lacked sufficient resources to appropriately manage 

a pilot. However, FHA officials have indicated that they would institute 

stricter underwriting standards for any no-down-payment mortgage 

authorized by their legislative proposal. 

• While generally reasonable, the way that FHA developed its mortgage 

scorecard—an automated tool that evaluates the default risk of 

borrowers—limits the scorecard’s effectiveness. More specifically, FHA 

and its contractor used variables that reflected borrower and loan 

characteristics to create the scorecard and an accepted modeling process 

to test the variables’ accuracy in predicting default. But, the data used to

develop the scorecard were 12 years old by the time that FHA began using

the scorecard in 2004, and the market has changed significantly since then. 

In addition, the scorecard does not include all the important variables that 

could help explain expected loan performance such as the source of the 

down payment. With competition from conventional providers, limitations

in the scorecard could cause FHA to insure mortgages that are relatively 

more risky. Our ongoing work indicates that FHA plans to use the 

scorecard to help set insurance premiums if legislative changes are 

enacted. Accordingly, any limitations in the scorecard’s ability to predict

defaults could result in FHA mispricing its products. 

• Although FHA has improved its ability to estimate the subsidy costs for its 

single-family insurance program, it generally has underestimated these 

costs. To meet federal requirements, FHA annually reestimates subsidy 

costs for each loan cohort.1 The current reestimated subsidy costs for all 

except the fiscal year 1992 and 1993 cohorts are less favorable—that is, 

higher—than originally estimated. Increases in the expected level of 

insurance claims—potentially stemming from changes in underwriting 

guidelines, among other factors—were a major cause of a particularly 

large reestimate that FHA submitted as of the end of fiscal year 2003. 

On the basis of our findings from the reports I have summarized, we made

several recommendations designed to improve FHA’s risk management. 

For example, to improve its assessment of borrowers’ default risk, we 

recommended that FHA develop policies for updating the scorecard, 

incorporate the risks posed by down-payment assistance into the 

scorecard, and explore additional uses for this tool. To more reliably 

estimate program costs, we recommended that FHA study and report in 

 1

Essentially, a cohort includes the loans insured in a given year. 

Page 3 GAO-07-615T
the annual actuarial review of the Fund the impact of variables not in the 

agency’s loan performance models (the results of which are used in 

estimating and reestimating program costs) that have been found in other 

studies to influence credit risk.2

FHA has taken actions in response to some of our findings and 

recommendations. For example, FHA has developed and begun putting in

place policies for annually updating the scorecard and testing additional 

predictive variables. To more reliably assess program costs, an FHA 

contractor incorporated the source of down-payment assistance and

borrower credit scores in recent actuarial reviews of the Fund. 

While these actions represent improvements in FHA’s risk management, 

sustained management attention to the issues that we have identified and 

continued Congressional oversight of FHA will play an important role in 

ensuring that FHA is able to expand homeownership opportunities for 

low- and middle-income families while operating in a manner that is 

financially sound. 

Congress established FHA in 1934 under the National Housing Act (P.L. 73-

479) to broaden homeownership, protect lending institutions, and 

stimulate employment in the building industry. FHA’s single-family 

programs insure private lenders against losses (up to almost 100 percent 

of the loan amount) from borrower defaults on mortgages that meet FHA 

criteria. In 2005, more than three-quarters of the loans that FHA insured 

went to first-time homebuyers, and about one-third of these loans went to 

minorities. From 2001 through 2005, FHA insured about 5 million 

mortgages with a total value of about $590 billion. However, FHA’s loan 

volume fell sharply over that period, and in 2005 FHA-insured loans 

accounted for about 5 percent of single-family home purchase mortgages, 

compared with about 19 percent in 2001.3

 Additionally, default rates for 

FHA-insured mortgages have risen steeply over the past several years, a 

period during which home prices have generally appreciated rapidly. 

Background 

 2

Since 1990, the National Housing Act has required an annual and independent actuarial 

analysis of the economic net worth and soundness of the Fund. 12 U.S.C. Section 1711 (g). 

3

These figures represent mortgages for owner-occupied homes only. 

Page 4 GAO-07-615T
FHA determines the expected cost of its insurance program, known as the 

credit subsidy cost, by estimating the program’s future performance.4

Similar to other agencies, FHA is required to reestimate credit subsidy 

costs annually to reflect actual loan performance and expected changes in

estimates of future loan performance. FHA has estimated negative credit 

subsidies for the Fund from 1992, when federal credit reform became 

effective, through 2007. However, FHA has estimated that, assuming no 

program changes, the loans it expects to insure in fiscal year 2008 would 

require a positive subsidy, meaning that the present value of estimated 

cash inflows would be less than the present value of estimated cash 

outflows. The economic value, or net worth, of the Fund that supports 

FHA’s insurance depends on the relative size of cash outflows and inflows 

over time. Cash flows out of the Fund for payments associated with claims 

on defaulted loans and refunds of up-front premiums on prepaid 

mortgages. To cover these outflows, FHA receives cash inflows from 

borrowers’ insurance premiums and net proceeds from recoveries on 

defaulted loans. An independent contractor’s actuarial review of the Fund 

for fiscal year 2006 estimated that the Fund’s capital ratio—the economic

value divided by the insurance-in-force—is 6.82 percent, well above the 

mandated 2 percent minimum.5

 If the Fund were to be exhausted, the U.S. 

Treasury would have to cover lenders’ claims directly. 

Two major trends in the conventional mortgage market have significantly 

affected FHA.6

 First, in recent years, members of the conventional 

mortgage market (such as private mortgage insurers, Fannie Mae, and 

Freddie Mac) increasingly have been active in supporting low- and even 

no-down-payment mortgages, increasing consumer choices for borrowers 

who may have previously chosen an FHA-insured loan. Second, to help 

assess the default risk of borrowers, particularly those with high loan-tovalue ratios (loan amount divided by sales price or appraised value), the 

mortgage industry has increasingly used mortgage scoring and automated 

underwriting systems.7

 Mortgage scoring is a technology-based tool that 

 4

Pursuant to the Federal Credit Reform Act of 1990, HUD must annually estimate the credit

subsidy cost for its mortgage insurance programs. Credit subsidy costs are the net present

value of estimated payments HUD makes less the estimated amounts it receives, excluding 

administrative costs. 

5

In fiscal year 2006, the Fund’s estimated economic value was $22 billion and the 

unamortized insurance-in-force was $323 billion.

6

Conventional mortgages do not carry government insurance or guarantees. 

7

Underwriting refers to a risk analysis that uses information collected during the 

origination process to decide whether to approve a loan. 

Page 5 GAO-07-615T
relies on the statistical analysis of millions of previously originated 

mortgage loans to determine how key attributes such as the borrower’s 

credit history, property characteristics, and terms of the mortgage affect 

future loan performance. As a result of such tools, the mortgage industry is 

able to process loan applications more quickly and consistently than in the 

past. In 2004, FHA implemented a mortgage scoring tool, called the FHA 

Technology Open to Approved Lenders (TOTAL) Scorecard, to be used in 

conjunction with existing automated underwriting systems. 

Partly in response to changes in the mortgage market, HUD has proposed 

legislation intended to modernize FHA. Provisions in the proposal would 

authorize FHA to change the way it sets insurance premiums and reduce 

down-payment requirements. 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. 

Currently, FHA also requires homebuyers to make a 3 percent contribution 

toward the purchase of the property. HUD’s proposal would eliminate this 

contribution requirement and enable FHA to offer some borrowers a nodown-payment product. 

In our November 2005 report examining FHA’s actions to manage the new 

risks associated with the growing proportion of loans with down-payment 

assistance, we found that the agency did not implement sufficient 

standards and controls to manage the risks posed by these loans.8

 Unlike 

other mortgage industry participants, FHA does not restrict homebuyers’ 

use of down-payment assistance from nonprofit organizations that receive 

part of their funding from home sellers. According to FHA, high claim and 

loss rates for loans with this type of down-payment assistance were major 

reasons for changing the estimated credit subsidy rate from negative to 

positive for fiscal year 2008 (in the absence of any program changes). 

Furthermore, incorporating the impact of such loans into the actuarial 

study of the Fund for fiscal year 2005 resulted in almost a $2 billion (7 

percent) decrease in the Fund’s estimated economic value. 

FHA Has Not 

Implemented 

Sufficient Standards 

and Controls to 

Manage Financial 

Risks of Loans with 

Down-Payment 

Assistance 

 8

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). 

Page 6 GAO-07-615T
Homebuyers who receive FHA-insured mortgages often have limited funds 

and, to meet the 3 percent borrower investment FHA currently requires, 

may obtain down-payment assistance from a third party, such as a relative

or a charitable organization (nonprofit) that is funded by the property 

sellers. The proportion of FHA-insured loans that are financed in part by 

down-payment assistance from various sources has increased 

substantially in the last few years, while the overall number of loans that 

FHA insures has fallen dramatically. Money from nonprofits funded by 

seller contributions has accounted for a growing percentage of that 

assistance. From 2000 to 2004, the total proportion of FHA-insured 

purchase loans that had a loan-to-value ratio greater than 95 percent and

that also involved down-payment assistance, from any source, grew from 

35 percent to nearly 50 percent. Approximately 6 percent of FHA-insured 

purchase loans in 2000 received down-payment assistance from nonprofits 

(the large majority of which were funded by property sellers), but by 2004 

nonprofit assistance grew to about 30 percent. The corresponding 

percentages for 2005 and 2006 were about the same. 

We and others have found that loans with down-payment assistance do not

perform as well as loans without down-payment assistance. We analyzed

loan performance by source of down-payment assistance, using two 

samples of FHA-insured purchase loans from 2000, 2001, and 2002—a 

national sample and a sample from three metropolitan statistical areas 

(MSA) with high rates of down-payment assistance.9

 Holding other 

variables constant, our analysis indicated that FHA-insured loans with 

down-payment assistance had higher delinquency and claim rates than 

similar loans without such assistance. For example, we found that the 

probability that loans with nonseller-funded sources of down-payment 

assistance (e.g., gifts from relatives) would result in insurance claims was 

49 percent higher in the national sample and 45 percent higher in the MSA 

sample than it was for comparable loans without assistance. Similarly, the 

probability that loans with nonprofit seller-funded down-payment 

assistance would result in insurance claims was 76 percent higher in the 

national sample and 166 percent higher in the MSA sample than it was for 

comparable loans without assistance. This difference in performance may 

be explained, in part, by the higher sales prices of comparable homes 

bought with seller-funded down-payment assistance. Our analysis 

Loans with Down-Payment 

Assistance Are a 

Substantial Portion of 

FHA’s Portfolio and Pose 

Greater Financial Risks 

Than Similar Loans 

without Assistance 

 9

The data (current as of June 30, 2005) consisted of purchase loans insured by FHA’s 203(b) 

program, its main single-family program, and its 234(c), condominium program. The three 

MSAs were Atlanta, Indianapolis, and Salt Lake City. 

Page 7 GAO-07-615T
indicated that FHA-insured homes bought with seller-funded nonprofit 

assistance were appraised and sold for about 2 to 3 percent more than 

comparable homes bought without such assistance. The difference in 

performance also may be partially explained by the homebuyer having less 

equity in the transaction.

FHA has implemented some standards and internal controls to manage the 

risks associated with loans with down-payment assistance, but stricter 

standards and additional controls could help FHA better manage the 

financial risks posed by these loans while meeting its mission of 

expanding homeownership opportunities. Like other mortgage industry 

participants, FHA generally applies the same underwriting standards to 

loans with down-payment assistance that it applies to loans without such 

assistance. One important exception is that FHA, unlike others, does not 

limit the use of down-payment assistance from seller-funded nonprofits. 

Some mortgage industry participants view assistance from seller-funded 

nonprofits as a seller inducement to the sale and, therefore, either restrict 

or prohibit its use. FHA has not treated such assistance as a seller 

inducement and, therefore, does not subject this assistance to the limits it 

otherwise places on contributions from sellers. 

Concerns about loans with nonprofit seller-funded down-payment 

assistance have prompted FHA and IRS to initiate steps that could curb 

their use. For example, FHA has begun drafting a proposed rule that, as 

described by FHA, would appear to prohibit down-payment assistance 

from seller-funded nonprofits. FHA’s legislative proposal could also 

eliminate the need for such assistance by allowing some FHA borrowers to 

make no down payments for an FHA-insured loan. Finally, in May 2006, 

IRS issued a ruling stating that organizations that provide seller-funded 

down-payment assistance to home buyers do not qualify as tax-exempt 

charities. FHA permitted these organizations to provide down-payment 

assistance because they qualified as charities. Accordingly, the ruling 

could significantly reduce the number of FHA-insured loans with sellerfunded down payments. However, FHA officials told us that as of March 

2007, they were not aware of IRS rescinding the charitable status of any of

these organizations. 

Our report made several recommendations designed to better manage the 

risks of loans with down-payment assistance generally, and more 

specifically from seller-funded nonprofits. Overall, we recommended that

in considering the costs and benefits of its policy permitting downpayment assistance, FHA also consider risk-mitigation techniques such as

Stricter Standards and 

Additional Controls Could 

Help FHA Manage the 

Risks Posed by Loans with 

Down-Payment Assistance 

Page 8 GAO-07-615T
including down-payment assistance as a factor when underwriting loans or 

more closely monitoring loans with such assistance. For down-payment 

assistance providers that receive funding from property sellers, we 

recommended that FHA take additional steps to mitigate the risks of these 

loans, such as treating such assistance as a seller contribution and, 

therefore, subject to existing limits on seller contributions. In response, 

FHA agreed to improve its oversight of down-payment assistance lending 

by (1) modifying its information systems to document assistance from 

seller-funded nonprofits and (2) more routinely monitoring the 

performance of loans with down-payment assistance. Also, as previously 

noted, HUD has initiated steps to curb and provide alternatives to sellerfunded down-payment assistance. 

If Congress authorized FHA to insure mortgages with smaller or no down 

payments, practices that other mortgage institutions use could help FHA 

to design and manage the financial risks of these new products. In a 

February 2005 report, we identified steps that mortgage institutions take 

when introducing new products.10 Specifically, mortgage institutions often 

utilize special requirements when introducing new products, such as 

requiring additional credit enhancements (mechanisms for transferring 

risk from one party to another) or implementing stricter underwriting 

requirements, and limiting how widely they make available a new product. 

By adopting such practices, FHA could reduce the potential for higher 

claims on products whose risks may not be well understood. 

Some mortgage institutions require additional credit enhancements on 

low- and no-down payment products, which generally are riskier because 

they have higher loan-to-value ratios than loans with larger down 

payments. For example, Fannie Mae and Freddie Mac mitigate the risk of 

low- and no-down payment products by requiring additional credit 

enhancements such as higher mortgage insurance coverage. Although FHA 

is required to provide up to 100 percent coverage of the loans it insures, 

FHA may engage in co-insurance of its single-family loans. Under coinsurance, FHA could require lenders to share in the risks of insuring 

mortgages by assuming some percentage of the losses on the loans that 

they originated (lenders would generally use private mortgage insurance 

for risk sharing). 

Practices That Other 

Mortgage Institutions 

Use Could Help FHA 

Manage Risks from 

Low- or No-DownPayment Products 

Mortgage Institutions 

Require Additional Credit 

Enhancements, Stricter 

Underwriting, and Higher 

Premiums for Low- and 

No-Down-Payment 

Products

 10GAO, Mortgage Financing: Actions Needed to Help FHA Manage Risks from New 

Mortgage Loan Products, GAO-05-194 (Washington, D.C.: Feb. 11, 2005). 

Page 9 GAO-07-615T
Mortgage institutions also can mitigate the risk of low- and no-downpayment products through stricter underwriting. Institutions can do this in

a number of ways, including requiring a higher credit score threshold for 

certain products, requiring greater borrower reserves, or requiring more 

documentation of income or assets from the borrower. Although the 

changes FHA could make are limited by statutory standards, it could 

benefit from similar approaches. The HUD Secretary has latitude within 

statutory limitations to change underwriting requirements for new and 

existing products and has done so many times. For example, FHA 

expanded its definition of what could be included as borrower’s effective 

income when calculating payment-to-income ratios. In commenting on our 

February 2005 report, FHA officials told us that they were unlikely to 

mandate a credit score threshold or borrower reserve requirements for a 

no-down-payment product because the product was intended to serve 

borrowers who were underserved by the conventional market, including

those who lacked credit scores and had little wealth or personal savings. 

However, in the course of our ongoing work on FHA’s legislative proposal, 

FHA officials indicated that they would likely set a credit score threshold 

for any no-down-payment product. 

Finally, mortgage institutions can increase fees or charge higher premiums 

to help offset the potential costs of products that are believed to have 

greater risk. For example, Fannie Mae officials stated that they would 

charge higher guarantee fees on low- and no-down payment loans if they 

were not able to require higher insurance coverage.11 Our ongoing work 

indicates that FHA, if authorized to implement risk-based pricing, would 

charge higher premiums for loans with higher loan-to-value ratios, all 

other things being equal.

We recommended that if FHA implemented a no-down-payment mortgage 

product or other new products about which the risks were not well 

understood, the agency should (1) consider incorporating stricter 

underwriting criteria such as appropriate credit score thresholds or 

borrower reserve requirements and (2) utilize other techniques for 

mitigating risks, including the use of credit enhancements. In response, 

FHA said it agreed that these techniques should be evaluated when 

considering or proposing a new FHA product. 

 11Fannie Mae and Freddie Mac charge fees for guaranteeing timely payment on mortgagebacked securities they issue. The fees are based, in part, on the credit risk they face. 

Page 10 GAO-07-615T
Some mortgage institutions initially may offer new products on a limited 

basis. For example, Fannie Mae and Freddie Mac sometimes use pilots, or 

limited offerings of new products, to build experience with a new product 

type. Fannie Mae and Freddie Mac also sometimes set volume limits for 

the percentage of their business that could be low- and no-down-payment 

lending. FHA has utilized pilots or demonstrations when making changes 

to its single-family mortgage insurance but generally has done so in 

response to legislative requirement rather than on its own initiative. For 

example, FHA’s Home Equity Conversion Mortgage insurance program 

started as a pilot that authorized FHA to insure 2,500 reverse mortgages.12

Additionally, some mortgage institutions may limit the origination and 

servicing of new products to their better lenders and servicers. Fannie Mae 

and Freddie Mac both reported that these were important steps in 

introducing a new product. 

We recommended that when FHA releases new products or makes 

significant changes to existing products, it consider similar steps to limit 

the initial availability of these products. FHA officials agreed that they 

could, under certain circumstances, envision piloting or limiting the ways 

in which a new product would be available, but pointed to the practical 

limitations of doing so. For example, FHA officials told us that 

administering the Home Equity Conversion Mortgage pilot program was 

difficult because of the challenges of equitably selecting a limited number 

of lenders and borrowers. FHA generally offers products on a national 

basis and, if they did not, specific regions of the county or lenders might 

question why they were not able to receive the same benefit. FHA officials 

told us they have conducted pilot programs when Congress has authorized 

them, but they questioned the circumstances under which pilot programs 

were needed, and also said that they lacked sufficient resources to 

appropriately manage a pilot. Consistent with these views, FHA officials 

told us more recently that they would not limit the initial availability of any 

products authorized by its legislative proposal. However, if FHA does not 

limit the availability of new or changed products, the agency runs the risk 

of facing higher claims from products whose risks may not be well 

understood. 

Before Fully Implementing 

New Products, Some 

Mortgage Institutions May 

Limit Availability 

 12Under this program, homeowners borrow against equity in their home and receive 

payments from their lenders. 

Page 11 GAO-07-615T
A primary tool that FHA uses to assess the default risk of borrowers who 

apply for FHA-insured mortgages is its TOTAL scorecard. TOTAL’s 

capabilities are important, because to the extent that conventional 

mortgage lenders and insurers are better able than FHA to use mortgage 

scoring to identify and approve relatively low-risk borrowers and charge 

fees based on default risk, FHA may face adverse selection. That is, 

conventional providers may approve lower-risk borrowers in FHA’s 

traditional market segment, leaving relatively high-risk borrowers for FHA. 

Accordingly, the greater the effectiveness of TOTAL, the greater the 

likelihood that FHA will be able to effectively manage the risks posed by 

borrowers and operate in a financially sound manner. 

In reports we issued in November 2005 and April 2006, we noted that while 

FHA’s process for developing TOTAL generally was reasonable, some of 

the choices FHA made in the development process could limit the 

scorecard’s effectiveness.13 FHA and its contractor used variables that 

reflected borrower and loan characteristics to create TOTAL, as well as an

accepted modeling process to test the variables’ accuracy in predicting 

default. However, we also found that 

The Way FHA 

Developed TOTAL 

Limits the Scorecard’s 

Effectiveness in 

Assessing the Default 

Risk of Borrowers 

• The data used to develop TOTAL were 12 years old by the time FHA 

implemented the scorecard. Specifically, when FHA began developing 

TOTAL in 1998, the agency chose to use 1992 loan data, which would be 

old enough to provide a sufficient number of defaults that could be 

attributed to a borrower’s poor creditworthiness. However, FHA did not 

implement TOTAL until 2004 and has not subsequently updated the data 

used in the scorecard. Best practices of private-sector organizations call 

for scorecards to be based on data that are representative of the current 

mortgage market—specifically, relevant data that are no more than several

years old. In the past 12 years, significant changes—growth in the use of 

down-payment assistance, for example—have occurred in the mortgage

market that have affected the characteristics of those applying for FHAinsured loans. As a result, the relationships between borrower and loan

characteristics and the likelihood of default also may have changed. 

• TOTAL does not include certain key variables that could help explain 

expected loan performance. For example, TOTAL does not include a 

variable for the source of the down payment. However, FHA contractors, 

HUD’s Inspector General, and our work have all identified the source of a 

 13GAO, Mortgage Financing: HUD Could Realize Additional Benefits from its Mortgage 

Scorecard, GAO-06-435 (Washington, D.C.: Apr. 13, 2006) and GAO-06-24. 

Page 12 GAO-07-615T
down payment as an important indicator of risk, and the use of downpayment assistance in the FHA program has grown rapidly over the last 5 

years. Further, TOTAL does not include other important variables—such 

as a variable for generally riskier adjustable rate loans—included in other 

scorecards used by private-sector entities. 

• Although FHA had a contract to update TOTAL, the agency did not 

develop a formal plan for updating TOTAL on a regular basis. Best 

practices in the private sector, also reflected in bank regulator guidance, 

call for having formal policies to ensure that scorecards are routinely 

updated. Without policies and procedures for routinely updating TOTAL, 

the scorecard may become less reliable and, therefore, less effective at 

predicting the likelihood of default.

To improve TOTAL’s effectiveness, we recommended, among other things, 

that HUD develop policies and procedures for regularly updating TOTAL 

and more fully consider the risks posed by down-payment assistance when

underwriting loans, such as including the presence and source of downpayment assistance as a loan variable in the scorecard. In response, FHA 

has developed and begun putting in place policies and procedures that call 

for annual (1) monitoring of the scorecard’s ability to predict loan default,

(2) testing of additional predictive variables to include in the scorecard,

and (3) updating the scorecard with recent loan performance data. 

We also recommended that HUD explore additional uses for TOTAL, 

including using it to implement risk-based pricing of mortgage insurance 

and to develop new products. These actions could enhance FHA’s ability 

to effectively compete in the mortgage market and avoid adverse 

selection. Our ongoing work indicates that FHA plans to use borrowers’ 

TOTAL scores to help set insurance premiums. Accordingly, any 

limitations in TOTAL’s ability to predict defaults could result in FHA 

mispricing its products. 

Page 13 GAO-07-615T
As previously noted, FHA, like other federal agencies, is required to 

reestimate credit subsidy costs annually to reflect actual loan performance 

and expected changes in estimates of future loan performance. In doing 

so, FHA reestimates subsidy costs for each loan cohort. 

As we reported in September 2005, FHA’s subsidy reestimates generally

have been less favorable (i.e., higher) than the original estimates since 

federal credit reform became effective in 1992.14 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 less favorable 

than originally estimated. 

With respect to reestimates across cohorts, our report examined factors 

contributing to an unusually large $7 billion reestimate (more than twice 

the size of other recent reestimates) that FHA submitted as of the end of 

fiscal year 2003 for the fiscal year 1992 through 2003 cohorts. These 

factors included increases in estimated claims and prepayments (the 

payment of a loan before its maturity date). Several policy changes and

trends may have contributed to changes in the expected claims. For 

example: 

FHA’s Current 

Reestimated Subsidy 

Costs Are Generally 

Less Favorable than 

its Original Estimates 

• Revised underwriting guidelines made it easier for borrowers who were 

more susceptible to changes in economic conditions—and therefore more 

likely to default on their mortgages—to obtain an FHA-insured loan. 

• Competition from conventional mortgage providers could have resulted in

FHA insuring more risky borrowers.

• FHA insured an increasing number of loans with down-payment 

assistance, which generally have a greater risk of default. 

• FHA’s loan performance models did not include key variables that help 

estimate loan performance, such as credit scores, and as of September 

2005, the source of down payment.

The major factors underlying the surge in prepayment activity were 

declining interest rates and rapid appreciation of housing prices. These 

 14GAO, Mortgage Financing: FHA’s $7 Billion Reestimate Reflects Higher Claims and

Changing Loan Performance Estimates, GAO-05-875 (Washington, D.C.: Sep. 2, 2005). 

Page 14 GAO-07-615T
trends created incentives and opportunities for borrowers to refinance 

using conventional loans. 

To more reliably estimate program costs, we recommended that FHA 

study and report on how variables found to influence credit risk, such as 

payment-to-income ratios, credit scores, and down-payment assistance 

would affect the forecasting ability of its loan performance models. We 

also recommended that when changing the definitions of key variables, 

FHA report the impact of such changes on the models’ forecasting ability. 

In response, HUD indicated that its contractor was considering the 

specific variables that we had recommended FHA include in its annual 

actuarial review of the Fund. The contractor subsequently incorporated 

the source of down-payment assistance in the fiscal year 2005 actuarial 

review and borrower credit scores in the fiscal year 2006 review. 

Madam Chairman, this concludes my prepared statement. I would be 

happy to answer any questions at this time. 

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 Barbara Roesmann, Paige Smith,

Laurie Latuda, and Steve Westley. 

Page 15 GAO-07-615T

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