Testimony 

Before the Subcommittee on Housing and 

Community Opportunity, Committee on 

Financial Services, House of 

Representatives

United States Government Accountability Office

GAO

For Release on Delivery 

Expected at 10:00 a.m. EDT 

Thursday, June 30, 2005 FEDERAL HOUSING 

ADMINISTRATION 

Managing Risks from a New 

Zero Down Payment 

Product 

Statement of William B. Shear, Director 

Financial Markets and Community Investment 

GAO-05-857T 
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

www.gao.gov/cgi-bin/getrpt?GAO-05-857T.

To view the full product, including the scope 

and methodology, click on the link above. 

For more information, contact William Shear 

at (202) 512-8678 or shearw@gao.gov. 

Highlights of GAO-05-857T, a testimony to 

the Subcommittee on Housing and 

Community Opportunity, Committee on 

Financial Services, House of 

Representatives 

June 30, 2005

FEDERAL HOUSING ADMINISTRATION

Managing Risks from a New Zero Down 

Payment Product 

In recent years, many mortgage institutions have become increasingly active 

in supporting low and even no down payment mortgage products. In 

considering the risks of these new products, a substantial amount of 

research GAO reviewed indicates that loan-to-value (LTV) ratio and credit 

score are among the most important factors when estimating the risk level 

associated with individual mortgages. GAO’s analysis of the performance of 

low and no down payment mortgages supported by FHA and others 

corroborates key findings in the literature. Generally, mortgages with higher 

LTV ratios (smaller down payments) and lower credit scores are riskier than 

mortgages with lower LTV ratios and higher credit scores.

Some practices of other mortgage institutions offer a framework that could 

help FHA manage the risks associated with introducing new products or 

making significant changes to existing products. Mortgage institutions 

sometimes require additional credit enhancements, such as higher insurance 

coverage, and stricter underwriting, such as credit score thresholds, when 

introducing a new low or no down payment product. FHA is authorized to 

require an additional credit enhancement, but does not currently use this 

authority. FHA has used stricter underwriting criteria, but told us it is 

unlikely they would use a credit score threshold for a new zero down 

payment product. Mortgage institutions may also impose limits on the 

volume of the new products they will permit and on who can sell and service 

these products. FHA officials question the circumstances in which they can 

limit volumes for their products and believe they do not have sufficient 

resources to manage a product with limited volumes, but the potential costs 

of making widely available a product with risk that is not well understood 

could exceed the cost of initially implementing such a product on a limited 

basis. 

Average Four-Year Default Rates for FHA Insured Loans Originated in 1998, 1999, and 2000 

(by LTV) 

LTV Average default rate

3.37

.90

2.26

% High

(>96%)

Medium

(87%-96%)

Low

(<83%)

Source: FY 2003 Actuarial Review of the Mutual Mortgage Insurance Fund.

To assist Congress in considering 

legislation to authorize the 

Secretary of the Department of 

Housing and Urban Development 

(HUD) to carry out a pilot program 

to insure zero down payment 

mortgages, this testimony provides 

information about practices 

mortgage institutions use in 

designing and implementing low 

and no down payment products. It 

also contains information about 

how these practices could be 

instructive for FHA in managing 

risks associated with a zero down 

payment product -- a product for 

which the risks are not well 

understood. This testimony is 

primarily based on GAO’s February 

2005 report, Mortgage Financing: 

Actions Needed to Help FHA 

Manage Risks from New Mortgage 

Loan Products, (GAO-05-194). 

What GAO Recommends

GAO suggests that Congress 

consider limiting any new no down 

payment product it may authorize. 

GAO recommends that HUD, 

among other things, consider 

piloting a no down payment 

product and that HUD establish a 

framework for when and how to 

pilot this and other new or changed 

products. HUD told us that they 

face challenges in administering a 

pilot program. We believe that 

HUD needs to further consider 

piloting or limiting volume of new 

or changed products, including a 

zero down payment product. 
Page 1 GAO-05-857T 

Mr. Chairman and Members of the Subcommittee: 

I am pleased to be here today to provide the committee with information 

and perspectives as it considers legislation that would authorize the 

Secretary of Housing and Urban Development (HUD) to carry out a pilot 

program to insure zero down payment mortgages. The Federal Housing 

Administration (FHA) at HUD currently insures low down payment 

mortgages to homebuyers across the nation. FHA requires homebuyers to 

make a 3 percent contribution toward the purchase of the home, though 

some of this may come in the form of a gift from others. FHA also permits 

some closing costs to be financed. My testimony today is primarily based 

on a report we completed for this Subcommittee on managing risks 

associated with low and no down payment loans, which was issued in 

February, 2005.1

 I will focus my discussion on the practices mortgage 

institutions use in designing and implementing low and no down payment 

products and how these practices could be instructive for the FHA in 

managing risks associated with a zero down payment product. A 

substantial body of research indicates that loans with lower down 

payments are generally riskier than those with higher down payments. 

To obtain information for our report, we interviewed officials from FHA; 

staff at selected conventional mortgage providers;2

 private mortgage 

insurers; and two government-sponsored enterprises (GSE), Fannie Mae 

and Freddie Mac. We obtained information about the standards of low and 

no down payment mortgage products they support and the steps they take 

to design, implement, and monitor these products. However, we did not 

verify that these institutions, in fact, used these practices. We conducted 

this work from January through December 2004 in accordance with 

generally accepted government auditing standards. 

In summary, there are several risk-management practices mortgage 

institutions use in designing, implementing, and monitoring low and no 

down payment products, and we believe these practices could be 

instructive for FHA in managing risks associated with a zero down 

payment product. 

 1

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

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

2

Conventional mortgages do not carry government insurance or guarantees. 
Page 2 GAO-05-857T 

• Mortgage institutions can mitigate the risk of low and no down payment 

products by requiring additional credit enhancements such as higher 

mortgage insurance coverage. For example, Fannie Mae and Freddie Mac 

require higher mortgage insurance for loans with a loan-to-value ratio 

(LTV) of great than 95 percent.3

 While FHA already will pay up to 100 

percent of the losses from a foreclosure on a house, it does have the 

authority to share risk but does not currently use this authority. 

• Mortgage institutions sometimes implement stricter underwriting to 

manage the additional risks associated with a new mortgage product. For 

example, institutions can require a higher credit score or higher reserves 

from the borrower. FHA has made adjustments to its underwriting criteria 

on its existing products but FHA officials told us that FHA is unlikely to 

mandate a credit score threshold for a zero down payment product. 

• Mortgage institutions increase fees and charge higher premiums to 

compensate for the additional risks associated with a new mortgage 

product. 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 the higher insurance coverage. FHA is authorized to make, 

and has made, adjustments to its up-front and annual premiums on its 

existing products. The administration proposed higher premiums as part 

of its 2006 budget proposal for a zero-down payment product. 

• Mortgage institutions sometimes use pilots or limit the initial availability of 

new products to build experience or better understand the factors that 

contribute to risk for these products. For example, Freddie Mac limited 

the initial availability of its 100 LTV product. Some mortgage institutions 

also may limit the origination and servicing of the product to their better 

lenders and servicers. However, FHA officials told us they face challenges 

in piloting and limiting mortgage products to certain approved lenders or 

servicers. 

• According to officials of mortgage institutions, including FHA, they also 

often put in place more substantial monitoring and oversight mechanisms 

for their new products and then make changes based on what they learn. 

Some mortgage institutions, such as Fannie Mae, told us that they may 

conduct rigorous quality control sampling of new acquisitions, early 

payment defaults, and nonperforming loans. Depending on the scale of a 

new initiative, and its perceived risk, these quality control reviews could 

 3

LTV is a ratio of the loan amount divided by the property sales price or appraised value of 

the house. 
Page 3 GAO-05-857T 

include a review of up to 100 percent of the loans that are part of the new 

product. FHA officials told us they also more closely monitor loans 

underwritten under revised guidelines. 

In light of the risks that new lending products present and in recognition 

of established risk management practices, in our report, we suggested that 

Congress consider limiting the initial availability of any new single-family 

insurance product it may authorize, including a zero down payment 

product. We also suggested that Congress consider directing HUD to 

consider using various techniques for mitigating risks for a no down 

payment product, or products about which the risks are not well 

understood. We recommended that FHA consider using pilots for new 

products and for making significant changes to its existing products, 

regardless of any new products Congress may authorize. Additionally, we 

recommended that FHA explore various techniques for mitigating risks 

when implementing new products that have greater risk or for which risk 

is not well understood, such as a zero down payment product. 

However, during the course of our work, HUD officials told us that they 

face challenges in administering a pilot program and they question the 

circumstances in which they can limit the availability of a new product. 

We believe that HUD needs to further consider piloting or limiting volume 

of new or changed products, including a zero down payment product. 

There are several available techniques for limiting an initial product that 

could help to address HUD’s concerns, including limiting the time period 

in which it is available. Further we believe that in some circumstances the 

potential costs of making widely available a product when the risks of that 

product are not well understood could exceed the cost of initially 

implementing such a product on a limited basis. To the extent HUD 

believes it does not have the authority for exercising the options we 

describe, we recommend it seek the authority from Congress. 

Mortgage insurance, a commonly used credit enhancement, protects 

lenders against losses in the event of default, and FHA is a government 

mortgage insurer in a market that also includes private insurers. During 

fiscal years 2001 to 2003, FHA insured a total of about 3.7 million 

mortgages with a total value of about $425 billion. FHA plays a 

Background 
Page 4 GAO-05-857T 

particularly large role in certain market segments, including low-income 

and first-time homebuyers. In 2000, almost 90 percent of FHA-insured 

home purchase mortgages had an LTV higher than 95 percent. FHA insures 

most of its mortgages for single-family housing under its Mutual Mortgage 

Insurance (MMI) Fund. To cover lender’s losses, FHA collects premiums 

from borrowers. These premiums, along with proceeds from the sale of 

foreclosed properties, pay for claims that FHA pays lenders as a result of 

foreclosures. 

In recent years, other members of the conventional mortgage market 

(such as private mortgage insurers, government-sponsored enterprises 

such as Fannie Mae and Freddie Mac, and large private lenders) have been 

increasingly active in supporting low and even no down payment mortgage 

products. For example, Fannie Mae and Freddie Mac’s no down payment 

mortgage products were introduced in 2000; and many private mortgage 

insurers will now insure a mortgage up to 100 percent LTV. However, the 

characteristics and standards for low and no down payment products vary 

among mortgage institutions. Currently, homebuyers with FHA-insured 

loans need to make a 3 percent contribution toward the purchase of the 

property and may finance some of the closing costs associated with the 

loan. As a result, an FHA-insured loan could equal nearly 100 percent of 

the property’s value or sales price. In recent years, a growing proportion of 

borrowers have received down payment assistance, which further helps 

them meet the hurdle of accumulating sufficient funds to purchase a 

home. Based on our preliminary analysis of FHA-insured loans that had 

LTVs above 95 percent, use of down payment assistance has grown to over 

half of such loans insured during the first seven months of 2005. 

When considering the risk of mortgages, a substantial amount of research 

GAO reviewed indicates that the LTV ratio and the borrower’s credit score 

are among the most important factors when estimating the risk level 

associated with individual mortgages.4

 We also analyzed the performance, 

expressed by the percent of borrowers defaulting within four years of 

mortgage origination, of low and no down payment mortgages supported 

by FHA and others.5

 Our analysis supports the findings we found in the 

research literature. Generally, mortgages with higher LTV ratios (smaller 

 4

Credit scores are a single numerical score, based on an individual’s credit history, which 

measures that individual’s creditworthiness. 

5

Mortgage defaults and foreclosures typically occur at the highest rates 4 to 7 years after 

the mortgages are issued. 
Page 5 GAO-05-857T 

down payments) and lower credit scores are riskier than mortgages with 

lower LTV ratios and higher credit scores. As can be seen in Figure 1, 

when focusing only on LTV for FHA loans, default rates increase as the 

LTV ranges increase. In theory, LTV ratios are important because of the 

direct relationship that exists between the amount of equity borrowers 

have in their homes and the risk of default. The higher the LTV ratio, the 

less cash borrowers will have invested in their homes and the more likely 

it is that they may default on mortgage obligations, especially during times 

of economic hardship (e.g., unemployment, divorce, home price 

depreciation). 

Figure 1: Average Four-Year Default Rates for FHA Insured Loans Originated in 

1998, 1999, and 2000 (by LTV) 

Risk assessment is a very important component of issuing and insuring 

mortgages, particularly when introducing a mortgage product that has the 

risk associated with a higher LTV. To help assess the risks associated with 

mortgages, the mortgage industry has moved toward greater use of 

mortgage scoring and automated underwriting systems.6

 Mortgage scoring 

is a technology-based tool that relies on the statistical analysis of millions 

of previously originated mortgage loans to determine how key attributes 

 6

The mortgage industry also uses credit scoring models for estimating the credit risk of 

individuals— these methodologies are based on information such as payment patterns. 

Statistical analyses identifying the characteristics of borrowers who were most likely to 

make loan payments have been used to create a weight or score associated with each of 

the characteristics. According to Fair, Isaac and Company sources, credit scores are often 

called “FICO scores” because most credit scores are produced from software developed by 

Fair, Isaac and Company. FICO scores generally range from 300 to 850 with higher scores 

indicating better credit history. The lower the credit score, the more compensating factors 

lenders might require to approve a loan. These factors can include a higher down payment 

and greater borrower reserves. 
Page 6 GAO-05-857T 

such as the borrower’s credit history, the property characteristics, and the 

terms of the mortgage note affect future loan performance. 

During the 1990s, private mortgage insurers, the GSEs, and larger financial 

institutions developed automated underwriting systems. Automated 

underwriting systems refer to the process of collecting and processing the 

data used in the underwriting process. These systems rely, in part, on 

individuals’ credit scores or credit history, and they have played an 

integral role in the provision of low and no down payment mortgage 

products. These systems allow lenders to quickly assess the riskiness of 

mortgages by simultaneously considering multiple factors including the 

credit score and credit history of borrowers. FHA has developed and 

recently implemented a mortgage scoring tool, called the FHA TOTAL 

Scorecard, to be used in conjunction with existing automated 

underwriting systems. More than 60 percent of all mortgages—

conventional and government-insured—were underwritten by an 

automated underwriting system, as of 2002, and this percentage continues 

to rise.7

According to representatives of mortgage institutions we interviewed, they 

use a number of similar practices in designing and implementing new 

products. These practices can be especially important when designing and 

implementing new products with higher or less well understood risk, such 

as low and no down payment products. Some of these practices could be 

helpful to FHA in its design and implementation of a zero down payment 

product, as well as other new products. More specifically, mortgage 

institutions often establish additional requirements for new products such 

as additional credit enhancements or underwriting requirements. Although 

FHA has less flexibility in imposing additional credit enhancements it does 

have the authority to seek co-insurance, which it is not currently using. 

FHA makes adjustments to underwriting criteria and to its premiums, but 

told us that it is unlikely to use a credit score threshold for a new zero 

down payment product. Further, mortgage institutions also use different 

means to limit how widely they make available a new product, particularly 

during its early years. FHA does sometimes use practices for limiting a 

 7

Susan Wharton Gates, Vanessa Gail Perry, and Peter Zorn, “Automated Underwriting in 

Mortgage Lending: Good News for the Underserved,” Housing Policy Debate, 13, no. 2, 

2002. 

Several Practices 

Mortgage Institutions 

Use in Designing and 

Implementing Low 

and No Down 

Payment Products 

Could Be Instructive 

for FHA in Managing 

Risk of a No Down 

Payment Product 
Page 7 GAO-05-857T 

new product but usually does not pilot products on its own initiative. FHA 

officials with whom we spoke question the circumstances in which they 

can limit the availability of a program and told us they do not have the 

resources to manage programs with limited availability. Finally, according 

to officials of mortgage institutions, including FHA, they also often put in 

place more substantial monitoring and oversight mechanisms for their 

new products including lender oversight. In an earlier report, we made 

recommendations designed to improve HUD’s oversight of FHA lenders.8

Some mortgage institutions require additional credit enhancements—

mechanisms for transferring risk from one party to another such as 

mortgage insurance—on low and no down payment products. Mortgage 

institutions such as 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. Fannie Mae 

and Freddie Mac believe that the higher-LTV loans represent a greater risk 

to them and they seek to partially mitigate this risk by requiring higher 

mortgage insurance coverage on these loans. For example, Fannie Mae 

and Freddie Mac require insurance coverage of 35 percent of the claim 

amount (on individual loans that foreclose) for loans that have an LTV of 

greater than 95 percent and require lower insurance coverage for loans 

with LTVs below 95 percent. 

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 co-insurance, 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). FHA has used co-insurance before, primarily in 

its multifamily programs, but does not currently use co-insurance at all.9

FHA officials told us they tried to put together a co-insurance agreement 

with Fannie Mae and Freddie Mac and, while they were able to come to 

 8

GAO, Single-Family Housing: Progress Made, but Opportunities Exist to Improve 

HUD’s Oversight of FHA Lenders, GAO-05-13 (Washington, D.C.: Nov. 12, 2004). 

9

According to FHA officials, FHA discontinued the multifamily co-insurance program after 

experiencing significant losses. Since then, Congress provided FHA authority to enter into 

risk-sharing agreements with GSEs and housing finance agencies on certain multifamily 

insurance. 

Mortgage Institutions 

Require Additional Credit 

Enhancements 
Page 8 GAO-05-857T 

agreement on the sharing of premiums, they could not reach agreement on 

the sharing of losses and it was never implemented. 

Mortgage institutions also can mitigate risk through stricter underwriting. 

For example, mortgage institutions such as Fannie Mae and Freddie Mac 

sometimes introduce stricter underwriting standards as part of the 

development of new low and no down payment products (or products 

about which they do not fully understand the risks). Institutions can do 

this in a number of ways, including requiring a higher credit score 

threshold for certain products, or requiring greater borrower reserves or 

more documentation of income or assets from the borrower. Once the 

mortgage institution has learned enough about the risks that were 

previously not understood, it can change the underwriting requirements 

for these new products. FHA could also benefit from mitigating risk such 

as through stricter underwriting. Although FHA has to meet some 

statutory standards, it retains some flexibility in how it implements a 

newly authorized product or changes an existing product. The HUD 

Secretary has latitude within statutory limitations in changing 

underwriting requirements for new and existing products and has done 

this many times. 

The requirements in H.R. 3043 that prospective zero down payment loans 

go through FHA’s TOTAL Scorecard and that borrowers receive 

prepurchase counseling are consistent with stricter underwriting. 

However, in addressing the final recommendations in our February report, 

FHA wrote that is unlikely to mandate a credit score threshold for a new 

zero down payment product because the new product is intended to serve 

borrowers who are underserved by the conventional market including 

those who lack credit scores. Also, FHA wrote that it is unlikely to 

mandate borrower reserve requirements since the purpose of a zero down 

payment product is to serve borrowers with little wealth or personal 

savings. 

Mortgage institutions can increase fees or charge higher premiums to help 

offset the potential costs of a program that is 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 

Mortgage Institutions May 

Require Stricter 

Underwriting for New Low 

and No Down Payment 

Products 

Mortgage Institutions May 

Increase Fees or Charge 

Higher Premiums 
Page 9 GAO-05-857T 

require higher insurance coverage.10 FHA could set higher premiums in 

anticipation of higher claims from no down payment loans. Within 

statutory limits, the HUD Secretary has the authority to set up-front and 

annual premiums that are charged to borrowers who have FHA-insured 

loans. In fact, in the administration’s 2006 budget proposal for a zero down 

payment product, it included higher up front and annual premiums for 

these loans. 

Some mortgage institutions may limit in some way a new product before 

fully implementing the new product. For example, Fannie Mae and 

Freddie Mac sometimes use pilots, or limited offerings of new products, to 

build experience with a new product type or to learn about particular 

variables that can help them better understand the factors that contribute 

to risk for these products. Freddie Mac and Fannie Mae also sometimes 

set volume limits for the percentage of their business that could be low 

and no down payment lending. Fannie Mae and Freddie Mac officials 

provided numerous examples of products that they now offer as standard 

products but which began as part of underwriting experiments. These 

include the Fannie Mae Flexible 97® product, as well as the Freddie Mac 

100 product. 

FHA has utilized pilots or demonstrations as well when making changes to 

its single-family mortgage insurance. Generally, HUD has done this in 

response to legislation that requires a pilot and not on its own initiative. 

For example, FHA’s Home Equity Conversion Mortgage (HECM) insurance 

program started as a pilot. Congress initiated HECM in 1987; the program 

is designed to provide elderly homeowners a financial vehicle to tap the 

equity in their homes without selling or moving from their homes 

(sometimes called a “reverse mortgage”). Through statute, HECM started 

as a demonstration program that authorized FHA to insure 2,500 reverse 

mortgages. Through subsequent legislation, FHA was authorized to insure 

an increasing number of these mortgages until Congress made the 

program permanent in 1998. Under the National Housing Act, the HECM 

program was required to undergo a series of evaluations and it has been 

evaluated four times since its inception. FHA officials told us that 

administering this demonstration for 2,500 loans was difficult because of 

 10Fannie Mae and Freddie Mac charge fees for guaranteeing timely payment on mortgage 

backed securities they issue. The fees are based, in part, on the credit risk they face. 

Before Fully Implementing 

New Products, Some 

Mortgage Institutions May 

Limit Their Availability 
Page 10 GAO-05-857T 

the challenges of selecting a limited number of lenders and borrowers. 

FHA ultimately had to use a lottery to limit loans to lenders. 

H.R. 3043 also would mandate that FHA pilot the zero down payment 

program: it limits the annual number of zero down mortgages to 10 

percent of the aggregate number of loans insured during the previous 

fiscal year, and sets an aggregate limit of 50,000 loans. The appropriate 

size for a pilot program depends on several factors. For example, the 

precise number of loans needed to detect a difference in performance 

between standard loans and loans of a new product type depends in part 

on how great the differences are in loan performance. If delinquencies 

early in the life of a mortgage were about 10 percent for FHA’s standard 

high LTV loans, and FHA wished to determine whether loans in the pilot 

had delinquency rates no more than 20 percent greater that the standard 

loans (delinquency no more than 12 percent), a sample size of about 1,000 

loans would be sufficient to detect this difference with 95 percent 

confidence. If delinquency rates or FHA’s desired degree of precision were 

different, a different sample size would be appropriate. 

FHA officials told us they have conducted pilot programs when Congress 

has authorized them, but they questioned the circumstances under which 

pilot programs are needed. FHA officials also said that they lacked 

sufficient resources to appropriately manage a pilot. 

Additionally, some mortgage institutions may also limit the initial 

implementation of a new product by limiting the origination and servicing 

of the product to their better lenders and servicers. Mortgage institutions 

may also limit servicing on the loans to servicers with particular product 

expertise, regardless of who originates the loans. Fannie Mae and Freddie 

Mac both reported that these were important steps in introducing a new 

product and noted that lenders tend to take a more conservative approach 

when first implementing a new product. FHA officials agreed that they 

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

in which a new or changed product would be available but pointed to the 

practical limitations in doing so. FHA approves the sellers and services 

that are authorized to support FHA’s single-family product, but FHA 

officials told us they face challenges in offering any of their programs only 

in certain regions of the country or in limiting programs to certain 

approved lenders or servicers. FHA generally offers products on a national 

basis and, when they do not, specific regions of the county or lenders 

might question why they are not able to receive the same benefit (even on 

a demonstration or pilot basis). However, these officials did provide 

examples in which their products had been initially limited to particular 
Page 11 GAO-05-857T 

regions of the country or to particular lenders, including the rollout of the 

HECMs and their TOTAL Scorecard. 

Mortgage institutions, including FHA, may take several steps related to 

increased monitoring of new products and subsequently make changes 

based on what they learned. Fannie Mae and Freddie Mac officials 

described processes in which they monitor actual versus expected loan 

performance for new products, sometimes including enhanced monitoring 

of early loan performance. Some mortgage institutions, such as Fannie 

Mae, told us that they may conduct rigorous quality control sampling of 

new acquisitions, early payment defaults, and nonperforming loans. 

Depending on the scale of a new initiative, and its perceived risk, these 

quality control reviews could include a review of up to 100 percent of the 

loans that are part of the new product. FHA officials told us they also 

monitor more closely loans underwritten under revised guidelines. 

Specifically, FHA officials told us that FHA routinely conducts a review of 

underwriting for approximately 6 to 7 percent of loans it insures. 

According to FHA officials, as part of the review, it may place greater 

emphasis on reviewing those aspects of the insurance product that are the 

subject of a recent change. 

Fannie Mae and Freddie Mac also reported that they conduct more regular 

reviews at mortgage servicer sites for new products. In some cases, Fannie 

Mae and Freddie Mac have staff who conduct on-site audits at the sellers 

and servicers to provide an extra layer of oversight. According to FHA 

officials, they have staff that conduct reviews of lenders that they have 

identified as representing higher risk to FHA programs. However, we 

recently reported that HUD’s oversight of lenders could be improved and 

identified a number of recommendations for improving this oversight.11

Loans with low or no down payments carry greater risk. Without any 

compensating measures such as offsetting credit enhancements and 

increased risk monitoring and oversight of lenders, introducing a new FHA 

no down payment product would expose FHA to greater credit risk. The 

administration’s proposal for a zero down product included increased 

premiums to help compensate for an increase in the cost of the FHA 

program which would permit FHA to potentially offset additional costs 

 11GAO-05-13. 

Mortgage Institutions 

Establish Enhanced 

Monitoring and Oversight 

for New Low and No Down 

Payment Products and 

Make Changes Based on 

What They Learn 

Conclusions 
Page 12 GAO-05-857T 

stemming from a new product that entails greater risk or not well 

understood risk. The proposed bill also requires that borrowers receive 

prepurchase counseling. 

Although FHA appears to follow many key practices used by mortgage 

institutions in designing and implementing new products, several practices 

not currently or consistently followed by FHA stand out as appropriate 

means to manage the risks associated with introducing new products or 

significantly changing existing products. Moreover, these practices can be 

viewed as part of a formal framework used by some mortgage institutions 

for managing the risks associated with new or changed products. The 

framework includes techniques such as limiting the availability of a new 

product until it is better understood and establishing stricter underwriting 

standards—all of which would help FHA to manage risk associated with 

any new product it may introduce. For example, FHA could set volume 

limits or limit the initial number of participating lenders in the product. 

Further, changes in FHA’s premiums, an important element of the 

administration’s 2006 budget proposal for a zero down payment product 

would permit FHA to potentially offset additional costs stemming from a 

new product that entails greater risk or not well understood risk. 

However, FHA officials believe that the agency does not have sufficient 

resources to implement products with limited volumes, such as through a 

pilot program. Yet, when FHA makes new products widely available or 

makes significant changes to existing products with less-understood risks, 

these products or actions also can introduce significant risks. Products 

that would introduce significant risks can impose significant costs. We 

believe that FHA could mitigate these risks and potential costs by using 

techniques such as piloting. Moreover, FHA told us that it believes that 

pilot programs are not needed because the risks of every new year of loans 

are assessed annually as part of credit subsidy budgetary transactions and 

in its annual actuarial study, and it could terminate the program early in its 

life if it identified problems.12 However, because it may take a few years to 

determine the risks of a new loan product, early termination could still 

 12The Federal Credit Reform Act of 1990 requires that federal government programs that 

make direct loans or loan guarantees (including insuring loans) account for the full cost of 

their programs on an annual budgetary basis. Specifically, federal agencies must develop 

subsidy estimates of the net cost of their programs that include estimates of the net costs 

and revenues over the projected lives of the loans made in each fiscal year. The Cranston 

Gonzales National Affordable Housing Act requires an independent actuarial analysis of the 

economic net worth and soundness of FHA’s MMI Fund. 
Page 13 GAO-05-857T 

expose the government to significant financial risk without some type of 

limits on the number of loans insured. If FHA is unsure about its authority 

to conduct pilots or concerned about expectations of equitable 

distribution of its products, Congress can make clear that FHA has this 

authority by requiring a product to be implemented as part of a pilot, or by 

explicitly giving the HUD Secretary the authority to establish and 

implement pilots for new products. 

If Congress authorizes FHA to insure a no down payment product or any 

other new single-family insurance products, Congress may want to provide 

guidance and clear authority to FHA on this new product. Congress may 

want to consider a number of means to mitigate the additional risks that 

these loans may pose. Such means may include limiting the initial 

availability of such a new product, requiring higher premiums, requiring 

stricter underwriting standards, or requiring enhanced monitoring. Such 

risk mitigation techniques would serve to help protect the Mutual 

Mortgage Insurance Fund while allowing FHA the time to learn more 

about the performance of loans using this new product. Limits on the 

initial availability of the new product would be consistent with the 

approach Congress took in implementing the HECM program. The limits 

could also come in the form of an FHA requirement to limit the new 

product to better performing lenders and servicers as part of a 

demonstration program or to limit the time period during which the 

product is first offered. 

Mr. Chairman, this completes my prepared statement. I would be pleased 

to respond to any questions you or other members of the Committee may 

have at this time. 

For more information regarding this testimony, please contact William B. 

Shear at (202) 512-8678 or shearw@gao.gov or Mathew Scirè at (202) 512-

6794 or sciremj@gao.gov. Contact points for our Offices of Congressional 

Relations and Public Affairs may be found on this last page of this 

testimony. Individuals making key contributions to this testimony also 

included Anne Cangi, Bert Japikse, Austin Kelly, Andy Pauline, Susan 

Etzel, and Barbara Roesmann. 

GAO Contacts and 

Staff 

Acknowledgments 

(250254) 
This is a work of the U.S. government and is not subject to copyright protection in the 

United States. It may be reproduced and distributed in its entirety without further 

permission from GAO. However, because this work may contain copyrighted images or 

other material, permission from the copyright holder may be necessary if you wish to 

reproduce this material separately. 
The Government Accountability Office, the audit, evaluation and 

investigative arm of Congress, exists to support Congress in meeting its 

constitutional responsibilities and to help improve the performance and 

accountability of the federal government for the American people. GAO 

examines the use of public funds; evaluates federal programs and policies; 

and provides analyses, recommendations, and other assistance to help 

Congress make informed oversight, policy, and funding decisions. GAO’s 

commitment to good government is reflected in its core values of 

accountability, integrity, and reliability. 

The fastest and easiest way to obtain copies of GAO documents at no cost 

is through GAO’s Web site (www.gao.gov). Each weekday, GAO posts 

newly released reports, testimony, and correspondence on its Web site. To 

have GAO e-mail you a list of newly posted products every afternoon, go 

to www.gao.gov and select “Subscribe to Updates.” 

The first copy of each printed report is free. Additional copies are $2 each. 

A check or money order should be made out to the Superintendent of 

Documents. GAO also accepts VISA and Mastercard. Orders for 100 or 

more copies mailed to a single address are discounted 25 percent. Orders 

should be sent to: 

U.S. Government Accountability Office 

441 G Street NW, Room LM 

Washington, D.C. 20548 

To order by Phone: Voice: (202) 512-6000 

TDD: (202) 512-2537 

Fax: (202) 512-6061 

Contact: 

Web site: www.gao.gov/fraudnet/fraudnet.htm 

E-mail: fraudnet@gao.gov

Automated answering system: (800) 424-5454 or (202) 512-7470 

Gloria Jarmon, Managing Director, JarmonG@gao.gov (202) 512-4400 

U.S. Government Accountability Office, 441 G Street NW, Room 7125 

Washington, D.C. 20548 

Paul Anderson, Managing Director, AndersonP1@gao.gov (202) 512-4800 

U.S. Government Accountability Office, 441 G Street NW, Room 7149 

Washington, D.C. 20548 

GAO’s Mission 

Obtaining Copies of 

GAO Reports and 

Testimony 

Order by Mail or Phone 

To Report Fraud, 

Waste, and Abuse in 

Federal Programs 

Congressional 

Relations 

Public Affairs 

PRINTED ON RECYCLED PAPER