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77–638 PDF 2002

S. HRG. 107–276

HEALTH OF HUD’S FEDERAL HOUSING

ADMINISTRATION’S INSURANCE FUND

HEARING

BEFORE THE

SUBCOMMITTEE ON HOUSING AND TRANSPORTATION

OF THE

COMMITTEE ON

BANKING, HOUSING, AND URBAN AFFAIRS

UNITED STATES SENATE

ONE HUNDRED SEVENTH CONGRESS

FIRST SESSION

ON

THE FINANCIAL STATUS OF THE DEPARTMENT OF HOUSING AND

URBAN DEVELOPMENT’S FEDERAL HOUSING ADMINISTRATION’S MUTUAL MORTGAGE INSURANCE FUND

MARCH 19, 2001

Printed for the use of the Committee on Banking, Housing, and Urban Affairs

(

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

PHIL GRAMM, Texas, Chairman

RICHARD C. SHELBY, Alabama

ROBERT F. BENNETT, Utah

WAYNE ALLARD, Colorado

MICHAEL B. ENZI, Wyoming

CHUCK HAGEL, Nebraska

RICK SANTORUM, Pennsylvania

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

JOHN ENSIGN, Nevada

PAUL S. SARBANES, Maryland

CHRISTOPHER J. DODD, Connecticut

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

ZELL MILLER, Georgia

THOMAS R. CARPER, Delaware

DEBBIE STABENOW, Michigan

JON S. CORZINE, New Jersey

WAYNE A. ABERNATHY, Staff Director

STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel

SHERRY E. LITTLE, Legislative Assistant

MELODY H. FENNEL, Professional Staff Member

JONATHAN MILLER, Democratic Professional Staff Member

GEORGE E. WHITTLE, Editor

SUBCOMMITTEE ON HOUSING AND TRANSPORTATION

WAYNE ALLARD, Colorado, Chairman

JACK REED, Rhode Island, Ranking Member

RICK SANTORUM, Pennsylvania

JOHN ENSIGN, Nevada

RICHARD C. SHELBY, Alabama

MICHAEL B. ENZI, Wyoming

CHUCK HAGEL, Nebraska

THOMAS R. CARPER, Delaware

DEBBIE STABENOW, Michigan

JON S. CORZINE, New Jersey

CHRISTOPHER J. DODD, Connecticut

CHARLES E. SCHUMER, New York

JOHN CARSON, Staff Director

TEWANA WILKERSON, Deputy Legislative Assistant

(II)

CONTENTS

MONDAY, MARCH 19, 2001

Page

Opening statement of Senator Allard .................................................................... 1

Opening statements, comments, or prepared statements of:

Senator Reed ..................................................................................................... 2

Senator Corzine ................................................................................................ 3

Prepared statement ................................................................................... 21

WITNESSES

Thomas J. McCool, Managing Director, Financial Markets and Community

Investment, U.S. General Accounting Office; accompanied by: Mathew

Scire, Stanley Czerwinski, Jay Cherlow, and Christine Bonham .................... 21

Prepared statement .......................................................................................... 46

(III)

(1)

HEALTH OF HUD’S FEDERAL HOUSING

ADMINISTRATION’S INSURANCE FUND

MONDAY, MARCH 19, 2001

U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, SUBCOMMITTEE ON HOUSING AND TRANSPORTATION, Washington, DC.

The Subcommittee met at 1 p.m., in room SD–538 of the Dirksen

Senate Office Building, Senator Wayne Allard (Chairman of the

Subcommittee) presiding.

OPENING STATEMENT OF SENATOR WAYNE ALLARD

Senator ALLARD. I want to call the Subcommittee on Housing

and Transportation to order. I would like to welcome each of you

to this hearing of the Housing and Transportation Subcommittee.

Today’s hearing will focus on the health of the FHA’s Mutual Mortgage Insurance Fund.

Over the last 2 years, this Subcommittee has heard various proposals to spend down the so-called FHA reserve. However, before

any action is taken, Congress must establish, with the help of the

General Accounting Office and other accounting experts, the safe

and the adequate levels of the FHA’s reserves. Only then should

we address a potential surplus.

FHA provides an important program for first-time low and moderate income and minority homeowners. These families should not

be overcharged FHA premiums. Premiums in excess of an amount

necessary to maintain an actuarially sound reserve ratio in the

FHA’s Mutual Mortgage Insurance Fund can only be characterized

as a tax on homeownership.

On the other hand, Congress, in conjunction with the Department of Housing and Urban Development, must ensure that FHA

stays healthy, so that it can continue to function as an important

source of homeownership.

Congress has previously determined that a capital reserve ratio

of 2 percent of the MMI Fund’s amortized insurance-in-force is necessary to ensure the safety and the soundness of the MMI Fund.

However, it has never been clear how the Congress arrived at that

number.

Last year, the accounting firm of Deloitte & Touche found that

the capital adequacy ratio of the Fund was 3.66 percent, far in excess of the Congressionally mandated goal of 2 percent. So while

it is important for Congress to know the capital adequacy ratio, it

is just as important to understand the implications of the ratio and

whether a 2 percent reserve is sufficient.

2

In order to get a better handle on this issue, I requested that the

GAO look into the matter. Today, the GAO is releasing a report

that finds the current reserve is adequate to withstand all but the

most serious economic scenarios. However, GAO also sounds a note

of caution. Economic conditions can quickly change, thus changing

the value of the Fund and the level of the reserve.

I believe that the most prudent course of action is for the Congress to increase the reserve requirement to either 2.5 percent or

3 percent of the insurance-in-force and then direct the Department

to reinstate distributive shares whenever the reserve fund becomes

excessive.

Later this week, I will be introducing legislation that would require partial rebates of FHA’s mortgage insurance premiums to

certain mortgagors upon repayment of their FHA-insured mortgages. My legislation takes the cautious approach of providing

rebates only when the reserve ratio is in excess of 3 percent, or 150

percent of the reserve level mandated by Congress. If the reserve

ratio drops below 3 percent, distributive shares would be suspended. Of course, this rebate would be based on sound actuarial

and accounting practice, since the major reason for the strength in

the Fund is the fact that we are experienced a near-perfect economy in recent years.

The FHA’s single-family mortgage program was designed to operate as a mutual insurance program where the homeowners were

granted rebates on excess of premiums required to maintain actuarial soundness. This rebate program was suspended at the direction of Congress in 1990, when the MMI Fund was in the red, and

with the intent that the payment of distributive shares or rebates

would resume when the Fund was again financially sound.

With a sufficient capital reserve ratio, it is time to resume rebates and return the MMI program to its prior status as a mutual

insurance fund.

Our witnesses today will be Mr. Thomas McCool, Managing Director of the Financial Markets and Community Investment Team

at the U.S. General Accounting Office. Mr. McCool is accompanied

by Jay Cherlow, Christine Bonham, Mathew Scire, and Stanley

Czerwinski.

Welcome.

It is good to see you again, Stan. I look forward to hearing from

all of you.

We will go ahead and ask if there are any other statements from

Members of the Subcommittee.

Senator Reed.

OPENING COMMENTS OF SENATOR JACK REED

Senator REED. Thank you very much, Mr. Chairman. I am looking forward to working with you on this issue and a number of

other issues as we go forward with this Subcommittee.

Gentlemen, thank you also for being here today as witnesses.

The FHA’s Mutual Mortgage Insurance Fund has proven to be

very robust over the last several years. It is a source of support for

the housing sector of our economy. Indeed, the FHA’s insurance

loans go to first-time homebuyers, primarily, and also significantly

3

help minority communities, African-Americans and Hispanics, to be

homeowners. All of these are very laudatory.

One interesting aspect of the present economy is the fact that so

many communities are facing a shortage of affordable, decent housing, and we are all trying to find ways in which we can increase

the housing stock. The FHA’s reserve fund might provide such a

mechanism.

As you know, and as the Chairman explained, you have looked

closely at the reserve fund. It is required to maintain a 2-percent

capital ratio. It is doing quite a bit better than that at the moment.

It is somewhere between 3.2 percent, your estimate, and 3.66 percent, the Deloitte & Touche estimate. This is a good sign. Now the

question is, what can we do with this excess surplus, if you will.

As you know, many Senators, including Senator Kerry, Senator

Sarbanes, and myself have urged that we take a portion of this reserve and use it to capitalize an Affordable Housing Trust Fund for

building both rental and homeownership housing. And given what

I see in my State of the dire need for affordable, decent housing,

I think that is a very important priority which we should support.

My colleague, Senator Allard, has just explained his proposal to

rebate premiums.

I look forward to the testimony today, not only to examine the

soundness of the Fund, but also to be more fully informed about

the possible use of its proceeds.

I thank the Chairman for calling this hearing.

Senator ALLARD. Thank you.

Senator Corzine.

OPENING COMMENTS OF SENATOR JON S. CORZINE

Senator CORZINE. Thank you, Mr. Chairman.

Mr. McCool, I appreciate you and your staff joining us. This is

an issue I have a great interest in, mainly along the lines that Senator Reed talked about.

Affordable housing in New Jersey is one of the most important

topics on our agenda, and certainly, we would like to understand

the potential use of the Fund for that purpose.

But I would also make the other observation that we have come

through a decade of robust economic times and we are now facing

something that may be slightly more discouraging. One wonders

about the adequacy of a Fund under different circumstances. I certainly want to hear your views with regard to it.

I look forward to the discussions at this hearing and going forward, and I thank you for having this hearing, Mr. Chairman.

Senator REED. Mr. Chairman, may I make one amendment to my

statement?

Senator ALLARD. Yes, you may.

Senator REED. I greeted the gentlemen, which is testimony to my

poor peripheral vision.

[Laughter.]

Welcome, Ms. Bonham.

[Laughter.]

Senator ALLARD. We will go ahead and start the panel.

Mr. McCool, it is my understanding that you are going to give

the testimony this morning.

4

OPENING STATEMENT OF THOMAS J. McCOOL

MANAGING DIRECTOR

FINANCIAL MARKETS AND COMMUNITY INVESTMENT

U.S. GENERAL ACCOUNTING OFFICE

ACCOMPANIED BY: MATHEW SCIRE, STANLEY CZERWINSKI,

JAY CHERLOW, AND CHRISTINE BONHAM

Mr. MCCOOL. Mr. Chairman, Members of the Subcommittee, we

are here today to discuss the results of our analysis of the financial

health of the Mutual Mortgage Insurance Fund of the Department

of Housing and Urban Development’s Federal Housing Administration. Through the MMI Fund, the FHA operates a single-family

insurance program that helps millions of Americans buy homes,

particularly low-income families and those without cash for down

payments.

For most of its history, the Fund was relatively healthy; however,

in fiscal year 1990 the Fund was estimated to have a negative economic value, and its future was in doubt. To help place the Fund

on a financially sound basis, Congress enacted legislation that required the Secretary of HUD to, among other things, take steps to

achieve a capital ratio of 2 percent by November 2000, and to

maintain or exceed that ratio at all times thereafter. As a result

of the 1990 housing reforms, the Fund must not only meet capital

ratio requirements, it must also achieve actuarial soundness; that

is, the Fund must contain sufficient reserves and funding to cover

estimated future losses resulting from the payment of claims on

foreclosed mortgages and administrative costs. However, the legislation does not define actuarial soundness.

The 1990 FHA reforms required that an independent contractor

conduct an annual actuarial review of the Fund. These reviews

have shown that during the 1990’s, the estimated economic value

of the Fund, its capital resources plus the net present value of future cash flows, grew substantially. You can see by the chart in my

prepared statement that by the end of fiscal year 1995, the Fund

attained an estimated economic value that slightly exceeded the

amount required for the 2-percent capital ratio. The gray represents 2 percent of the unamortized insurance-in-force and the

white represents the value of the Fund.

Since that time, the estimated economic value of the Fund continued to grow and always exceeded the amount required for a 2-

percent capital ratio. In the most recent review, Deloitte & Touche

estimated the Fund’s economic value at about $17 billion at the

end of fiscal year 2000. This represents about 3.51 percent of the

Fund’s insurance-in-force.

Mr. Chairman, you asked us to estimate the value of the Fund

at the end of fiscal year 1999, given expected economic conditions,

and compare our estimate to the estimate of the value of the Fund

reported by HUD for that year. Also, to determine the extent to

which a 2-percent capital ratio would allow the Fund to withstand

worse-than-expected economic conditions and resulting loan performance. And also, to describe some options for adjusting the size

of the Fund if the estimated capital ratio is different from the

amount needed and required.

In summary: First, we estimate that the Fund had an economic value of approximately $15.8 billion at the end of fiscal year 1999.

5

*Attached to prepared statement.

And this estimate implies a capital ratio of 3.2 percent of the

unamortized insurance-in-force. Although we did not evaluate the

quality of Deloitte’s estimates, which were prepared using a different method of analysis, we believe that our results and theirs

are comparable because of the uncertainty inherent in forecasting

and the professional judgments made in this type of analysis.

Second, given the economic value of the Fund and the state of

the economy at the end of fiscal year 1999, a 2 percent capital ratio

appears sufficient to withstand moderately severe economic downturns that could lead to worse-than-expected loan performance.

Some more severe downturns that we analyzed also did not cause

the estimated capital ratio to decline by as much as 2 percentage

points. However, there were certain more severe scenarios in which

an economic value of 2 percent of insurance-in-force would not have

been adequate. Nonetheless, because of the nature of such analysis,

we urge caution in concluding that the estimated value of the Fund

today implies that the Fund would necessarily withstand any particular economic scenario under all circumstances.

The third point, Congress and the Secretary of HUD have taken

and could take a number of steps to influence the economic value

of the Fund. The impact that these actions have on the capital

ratio and FHA borrowers is not always certain. However, actions

that influence the Fund’s reserve levels will also affect the Federal

budget. In short, any proposal that seeks to use reserves, if not

accompanied by a reduction in other spending or an increase in receipts, will result in a decline in the Federal budget surplus.

I am going to go through the three parts of our report.

First, I am going to spend just a little bit of time talking about

our estimate of the value of the Fund and the comparison with the

Deloitte estimate.

The economic value of the Fund consists of current capital resources and the net present value of future cash flows. Investments

in nonmarketable Treasury securities represent the largest component of FHA’s current capital resources. Estimating the net present

value of future cash flows is a complex actuarial exercise that required extensive professional judgment. Cash flows into the Fund

from premiums and the sale of foreclosed properties; cash flows out

of the Fund to pay claims on foreclosed mortgages, premium refunds, and administrative expenses.

If you look at the chart,* you can see the inflows again from premiums and sale of properties and the flows out of the Fund from

paying claims on foreclosed mortgages and premium refunds and

administrative expenses.

At the end of the fiscal year 1999, the Fund had capital resources

of $14.3 billion. Using our models and forecasts of likely values of

economic variables, we estimated that the Fund had a net present

value of future cash flows of $1.5 billion at that time. This yielded

an estimated economic value of $15.8 billion and a capital ratio of

3.2 percent.

Now these are a little bit different than the numbers for 1999

that Deloitte came up with. And the primary source of the difference had to do with the timing of the estimates. Deloitte had to

6

do its estimate before the end of the fiscal year and we were able

to do ours after the fact, so we had a more accurate count of the

capital resources, whereas, Deloitte overestimated the capital resources by about a billion dollars. Again, part of that just reflects

the difference in the time when Deloitte had to do its estimate

versus when we did ours.

The Fund’s economic value principally reflects the large amount

of capital resources that the Fund has accrued. These result from

previous cash flows that reflect the robustness of the economy, the

low-interest rates and high levels of employment usually associated

with high levels of mortgage activity, along with higher premium

rates throughout the 1990’s.

The estimated value of future cash flows also contributed to the

strength of the Fund at the end of fiscal 1999, and in addition,

forecasts for the near future show rising housing prices and stable

interest rates. As a result, our models predict low levels of foreclosure and prepayment and a cash flow into the Fund from mortgages already in FHA’s portfolio at the end of the 1999 fiscal year

will be more than sufficient to cover the cash outflows associated

with these loans.

Now, again, that is a static estimate. It is just a comparison between Deloitte’s and our estimate.

I think the more substantive part of our analysis had to do with

trying to understand this issue of actuarial soundness.

To provide a framework within which actuarial soundness could

be assessed, we need to move beyond estimates of the capital ratio

under expected economic conditions. Instead, we believe that to determine actuarial soundness one should measure the Fund’s ability

to withstand worse-than-expected conditions, although how much

worse is a more difficult judgment.

We generated economic scenarios that were based on economic

events in the last 25 years. In addition, we generated other scenarios that lead to worse-than-expected levels of performance in

the future. Using the actual historical scenarios, we found that

the effect on the Fund’s estimated value was actually fairly minimal. The worst historical scenario we tested, which was based on

the 1981–1982 national recession, lowered the capital ratio by less

than four-tenths of a percentage point, from about 3.2 to about 2.8

percent. To see how the economic value of the Fund would change

as the extent of adversity increased, we extended regional scenarios

that were based on historical economic downturns to the Nation as

a whole.

We extended the west south central and pacific downturns which

reduced the capital ratio by about 1 percentage point and then we

extended the New England downturn to the country as a whole,

and that reduced the capital ratio by about 2.4 percentage points,

so from about 3.2 to about 0.8.

In another scenario, we specified falling interest rates that would

induce refinancing, followed by a recession. And again, in this particular scenario, we estimated that the capital ratio of the Fund

would be reduced from 3.2 to about 1.4 percent.

Again, these are all different sets of scenarios, some of them

more likely than others, obviously. But the idea here is to try to

see what kind of a stress it might take to actually reduce the Fund

7

*Attached to prepared statement.

by either 3 percent or 2 percent or 1 percent, whatever the particular level you are trying to test.

Now, because we are starting from a position where the economy

is doing very well and the recent historical experience has been

very good, we were not able to generate, using our economic models, foreclosure rates that were in keeping with those that were

experienced in the 1980’s. We wanted to see just how the Fund

would withstand such foreclosure rates.

So we tried some alternative scenarios, one in which we actually

imposed foreclosure rates that were experienced in the years 1986

through 1990, for the years 2000 through 2004. When we did this—

these again were historical foreclosure rates, they just did not flow

from our economic model, per se—we found that the ratio, the capital ratio, would fall from about 3.2 to about 0.9 percent. Again,

that is a fall of over 2 percentage points.

An alternative exercise which we did—again, it is not so much

a stress test as it is kind of a sensitivity analysis—was to see what

would be the effect of extending certain experience to a larger part

of the FHA’s portfolio. We used the southwestern experience, which

actually affected about 9 percent of FHA’s portfolio, and we extended it to larger and larger parts of their portfolio to see how

large an effect it would take to actually reduce the capital ratio by

2 percent or reduce it, in fact, to zero, in one extreme case.

As you can see from the graph,* if 36 percent of the FHA’s portfolio experienced foreclosure rates similar to those in the southwest

in the late 1980’s, that would bring the estimated capital ratio

down to about 1 percent. If 55 percent of the portfolio experienced

such foreclosure rates, that would actually bring the estimated capital ratio down to zero.

Again, that does not mean that these are likely events. Our analysis is just an attempt to show how large an effect you would need

in order to generate a certain result.

Now, while we believe that our models make good use of historical experience in identifying factors that influence foreclosures and

prepayments, we also know that there are certain limitations.

Nonetheless, several additional factors lead us to believe that

Congress and others should apply caution in concluding that the

estimated value of the Fund today implies that the Fund could

withstand the economic scenarios that we examined under all circumstances.

In particular, the performance of our model is very dependent on

the fact that a lot of the loans were originated in the fiscal years

1998 and 1999. And as a result, the performance of these loans will

have an important effect on the overall performance of the loan

portfolio, but we don’t have a lot of experience with these loans.

They are, obviously, 1 or 2 or 3 years old. As long as the influences

of key predictive factors on the probabilities of foreclosure and prepayment have not changed, then we can be reasonably confident

the estimates of the relationships will apply. However, in recent

years, FHA’s competitors in the conventional mortgage market are

offering to selected homebuyers products that compete with FHA

8

for those homebuyers who are borrowing more than 95 percent of

the value of their homes.

If these private-sector competitors have attracted some less risky

borrowers who might otherwise have insured their mortgages with

the FHA, then the average risk level of FHA’s loans may have

increased. Again, we don’t know that is true. That is just one possibility, which would imply that we might be under-predicting

foreclosures in our current model.

It is also true that there have been changes in FHA’s insurance

program. A number of changes that FHA has made or might make

in the future could affect the future cash flows associated with

loans in FHA’s portfolio. FHA’s loss mitigation program might affect cash outflows, depending on whether the program succeeds in

reducing foreclosures or whether the program may result in delayed foreclosures that lead to larger losses. We don’t know the answer. We just know that this is one thing that has changed and

therefore could change our model’s predictions in the future. Also,

steps taken by HUD to improve the oversight of lenders and the

disposition of properties could reduce the level of losses to FHA

below what we have estimated.

In addition, as we are talking about the existing portfolio at the

end of 1999, we don’t know what is going to happen with new

loans, either loans that are made in 2000 or loans that are made

in 2001, or those loans made going forward. Our analysis of the

ability of the Fund to withstand adverse economic conditions requires making the assumption that the adverse conditions would

not also cause loans insured by FHA after fiscal year 1999 to be

an economic drain on the Fund. And that is again just one of the

assumptions we had to make in doing our analysis.

Now, I would like to turn to the last issue which has to do with

discussing options for drawing on the Fund, which have uncertain

outcomes, obviously. If Congress or the Secretary of HUD believes

that the economic value of the Fund is higher than the amount

needed to ensure actuarial soundness, several changes to the

FHA’s single-family loan program could be adopted. The impact

that these actions might have on the capital ratio and FHA’s borrowers is difficult to assess without using tools designed to estimate the multiple impacts that policy changes often have.

Although it is difficult to predict the overall impact of a change

on the Fund’s capital ratio and thus on FHA borrowers as a whole,

different options would likely have different impacts on current and

prospective FHA-insured borrowers. Some proposals would more

likely benefit existing and future FHA-insured borrowers, while

others would benefit only future borrowers, and still others would

benefit neither of these groups.

Because of the difficulty in reliably measuring the effect of most

actions that could be taken either by Congress or by the Secretary

of HUD on the Fund’s capital ratio, we cannot precisely measure

the effect of these policies on the budget. However, any actions

taken by Congress or the Secretary that influence the Fund’s capital ratio will have a similar effect on the budget.

Last, I want to just talk a little bit about actuarial soundness

and what it means, and what it doesn’t mean.

9

Whether actions should be taken to change the value of the Fund

depends on whether the Fund’s capital resources and expected revenues exceed the amount needed to meet its expected cash outflows

under designated stressful conditions; that is, whether it is actuarially sound. Assessing whether this condition exists requires that

the degree of risk the Fund’s expected to be able to withstand must

be specified. If the Fund is expected to withstand what Price

Waterhouse calls reasonably adverse economic downturns, then our

results could be construed to mean that the Fund is taking in more

revenue than it needs. Alternatively, if the Fund is expected to

never exhaust its resources or to be able to withstand stresses such

as the Great Depression, the current Fund might not be adequate.

Because we believe that actuarial soundness depends on a variety of factors that could vary over time, we also believe that a minimum or target capital ratio won’t necessarily guarantee that the

Fund will be actuarially sound over time. We believe that to evaluate the actuarial soundness of the Fund, one or more scenarios that

the Fund is to withstand would need to be specified. Then it would

be appropriate to calculate the economic value of the Fund under

the scenarios. As long as the estimated economic value is positive

and the desired stress scenario is used to make that estimate, the

Fund could be said to be actuarially sound. However, it might be

appropriate to leave a cushion to account for the factors not captured by the model and the inherent uncertainty attached to any

forecast. In any event, we believe that a single, static capital ratio

does not necessarily measure actuarial soundness.

For these reasons, Mr. Chairman, Congress may wish to consider

taking action to specify criteria for determining when the Fund is

actuarially sound. Specifically, the Congress may want to consider

defining the types of economic conditions under which the Fund

would be expected to meet its commitments without borrowing

from the Treasury.

Mr. Chairman, this concludes my statement. We would be happy

to answer any questions that you or any other Members of the Subcommittee might have.

Senator ALLARD. Thank you very much. I thought that was a

very good statement you made and I want to thank you for your

efforts and diligence in putting together this report.

Just for Members of the Subcommittee, we have 5 minutes per

Member. We have a small clock down here. It is a little difficult

to read, but when the light starts turning orange, you have a

minute left. When it is green you are okay. And when it is red, we

ask that you stop.

I want to start out with just where we are today.

My memory recalls that back in 1979 or so, we had a reserve in

the Fund of about 5.3 percent. Frankly, it is quite a bit higher than

what we are having today. But then in 1990, about 11 years later,

we are running into some deficits in the Fund. Would you explain

briefly why this should or should not be a concern for us today?

Mr. MCCOOL. Well, I think that it both should and should not

be a concern. Again, part of it is that the Fund was run down over

a 10-year period and it had to do with the sequence of economic

factors. It had to do with very high interest rates in the early

1980’s and a recession in the early 1980’s, followed by a number

10

of regional downturns. You have high regional unemployment

rates, much higher average unemployment rates for the economy

as a whole than you currently have. So, again, you can find a high

ratio turn into a lower or negative ratio over time if you get the

right sequence or concurrence of events. But it is also true that the

1980’s in particular were different than the 1990’s have been, in

terms of things like interest rates and unemployment rates, and at

least so far in terms of housing price changes.

Senator ALLARD. Probably the increase in interest rates had as

much to do with anybody as to help assure the—— Mr. MCCOOL. The early 1980’s interest rates had a lot to do with

the later 1980’s performance, yes.

Senator ALLARD. Last week, the Mortgage Bankers of America

released data showing that the delinquency rates on FHA loans is

now 10.46 percent, about 101⁄2 percent, which is well over three

times the conventional rate of about 3 percent.

In my first hearing, I think, as Subcommittee Chairman, we

looked at those delinquency rates 2 years ago. At that time, we

were alarmed that the delinquency rate was 8.45 percent and that

our ARM’s, the delinquency rate was 10.46 percent. Two years

later, both of those figures have gone up, I think, rather substantially to 101⁄2 percent and 12 percent, respectively, where the

ARM’s are 12 percent and the regular loans are at 101⁄2 percent.

The trend is now upward and we are still in a relatively healthy

housing market, at least in Colorado.

What happens in a recession? At what point should we become

concerned that this could threaten the FHA Fund’s actuarial

soundness?

Mr. MCCOOL. In particular, in a recession that causes a substantial increase in unemployment rates and either a flat or potentially

a reduction in housing prices, you can get increases in foreclosures

and delinquencies. And that can have an effect on FHA. It depends

a lot on how severe the recession is, how long it lasts, as to how

much an effect it will have.

Senator ALLARD. Which is obviously what has been happening

even before we were in any kind of an economic downturn, with

these figures that we are looking at.

Mr. MCCOOL. It is hard to predict and it is hard to—that may

be true. But we also have to be a little careful about changes in

delinquency rates on average because part of it can also reflect just

sort of an aging of the portfolio.

Senator ALLARD. Yes.

Mr. MCCOOL. You did have a lot of new loans in the portfolio and

generally, new loans don’t default. It usually takes a few years before they reach the default stage. So it could also just be a question

of some of those loans moving into the peak years for defaults; you

need to look at the loans on a cohort-by-cohort basis to see if default rates are really necessarily increasing.

Senator ALLARD. When we talked about the high delinquency

rates on the ARM’s, Mr. Apgar testified in front of our Committee

at that time and he indicated that they can deal with the problem.

Have you seen any evidence that would indicate they have taken

any kind of action on this particular issue when you did your

audit?

11

Mr. MCCOOL. Stan handled that.

Senator ALLARD. Mr. Czerwinski, maybe you can answer that.

Mr. CZERWINSKI. I remember that hearing very well. We talked

about how ARM’s were very sensitive to interest rates. Interest

rates were probably one of the key problems in the 1980’s. ARM’s

combined with interest rates was one of the key problems with

FHA. And as Tom mentioned, it is an aging of the portfolio that

is an issue.

Mr. Apgar promised to reduce the number of ARM’s and put

stricter underwriting standards in place, which they have done. If

you look at the current portfolio and what is being written now,

there are much fewer ARM’s. That is the good news.

I think probably what you were picking up in the delinquency

rates now is that some of these ARM’s from the past are aging a

bit. Interest rates have been coming up. So, we still have to work

our way through some of the past policies. But I don’t think you

will be seeing that as much in the future.

There is one other issue lurking out there, and that is called

streamlined refinancing. That is rolling over mortgages. And the

way FHA has been doing it is to do it without that much underwriting requirements. That is the next issue that is waiting.

We talked about ARM’s in 1998. In 2001, we are now saying, gee,

what happened with ARM’s? My guess is we may be talking in

2003 about streamlined refinancing.

Senator ALLARD. Thank you.

I will now go to my Ranking Member, Senator Reed.

Senator REED. Thank you, Mr. Chairman.

Thank you very much, Mr. McCool, for your testimony.

Is it fair to say that the FHA Fund is performing very well when

tested against all of your scenarios, that essentially, it is in good

shape?

Mr. MCCOOL. In the sense that at least none of our economic scenarios brought it down to zero; the Fund still had a positive value,

even in our more stringent scenarios. So in that sense, yes.

Senator REED. And you used foreclosure rates from the 1980’s,

which were very severe foreclosure rates.

Mr. MCCOOL. In the one scenario, yes. We used foreclosure rates

from the 1986 through 1990 period, which were the steepest, the

worst we have seen in the post-war period, yes.

Senator REED. That is really the most extreme test you could

apply, in terms of foreclosure rates.

Mr. MCCOOL. Again, given what we have seen in the post-war

period, yes.

Senator REED. And still, the Fund was able to maintain a very

positive——

Mr. MCCOOL. It still had a 0.9-percent capital ratio.

Senator REED. In your scenarios generally, the assumption I

think, and this might just be the limitations of modeling, is that

the FHA managers really can’t respond to changes in the economy

with preventive action or new policies. Is that fair to say?

Mr. MCCOOL. It is fair to say. But it is also true that we are

looking at a portfolio that is under contract. There is only so many

things that the FHA can do with those.

Senator REED. Right.

12

Mr. MCCOOL. They can do more with new business than they can

with existing business.

Senator REED. But in terms of getting out of a precipitous decline, trying to get to at least a plateau with new business, you can

make some policy changes that would presumably help.

Mr. MCCOOL. You can mitigate it, sure.

Senator REED. That is something that I suspect, given the limitations of the modeling, that you can’t model particularly well.

Mr. MCCOOL. No, we were not modeling that at all in our particular scenario.

Senator REED. Let me ask again a question about both your

model and the FHA portfolio. Is there any regional bias in terms

of the number of, the concentration of loans, in one particular geographic region?

Mr. MCCOOL. I think it is the regional bias of the FHA portfolio.

Mr. CHERLOW. I don’t know if you could call it a bias. But certainly, in certain parts of the country, FHA has a larger market

share than in other parts of the country.

Senator REED. Right. A regional downturn in those areas would

have a more traumatic effect on the Fund than other areas. Is that

correct?

Mr. CHERLOW. That is right.

Senator REED. And your model compensated for the geographic

specificity?

Mr. CHERLOW. Our model weights the loans from each region

according to the share that they are in FHA’s portfolio.

Senator ALLARD. Where do you have those larger number? Where

do we have the larger number of FHA loans? Can you comment on

that?

Mr. CHERLOW. Yes, sir. California, Texas, Florida. Those are the

three largest States.

Senator REED. California, Texas, Florida. California is enduring

some unusual problems right now in terms of an energy crisis, etc.

So that that might be sort of a caution to the Fund managers.

You tested 2 percent as a capital ratio, Mr. McCool. There has

been discussions about legislation that would increase the statutory

level to 3 percent and then use funds above and beyond that for

other purposes. Putting aside the purposes, is that 3-percent capital ratio level significantly high enough, given the fact that the 2

percent level seems to have survived all these various tasks?

Mr. MCCOOL. Again, it depends on what you are trying to protect

the Fund against. From our analysis, 3 percent would be better to

protect it against, again, the more extreme scenarios, some of

which did lower the Fund by more than 2 percentage points.

Senator REED. If the Fund is reduced to 0.9 percent, which is

your worst-case scenario, would you deem the Fund to be in

extremis and something that is at risk? Or is that at a level sufficient to operate?

Mr. MCCOOL. It still obviously is solvent.

Senator REED. Right.

Mr. MCCOOL. The question is, what happens next? Do you have

an additional negative shock? And you could be in more trouble. If

you have positive shocks, then you might be back over 2 percent

again. So it depends on what happens next.

13

Senator REED. But I guess, for the record, 3 percent is better

than 2 percent, and 2 percent is okay.

Mr. MCCOOL. Three percent is safer than 2 percent.

Senator REED. Okay.

Mr. MCCOOL. I would definitely say that.

Senator REED. I am not going to get into your modeling because

I am exhausted my modeling knowledge. Is there a comparable private-sector institution that we can look to for guidance regarding

a loan loss reserve level? And what might that be?

Mr. MCCOOL. There are a number of alternative ways of thinking

about capital ratios. There are bank capital ratios where the regulators impose credit-based capital standards.

There is, again, not quite private sector, but almost fully private

sector capital regulations that OFHEO, imposes on Fannie Mae

and Freddie Mac. And there is the rating agencies also that impose

their own implicit capital standards on those they rate, asking

again for much higher capital ratio for a triple A rating than for

a double A rating and for a single A rating.

There are many different ways that people think about what

kind of capital reserves you need, depending on risk and how you

want to measure that risk.

Senator REED. In a nutshell, how would this 2 percent statutory

level rate with those?

Mr. MCCOOL. Well, it is certainly simpler. And it is not clear how

risk-based it is. I guess that would be the simple answer.

Senator REED. Thank you very much, Mr. McCool.

Thank you, Mr. Chairman.

Senator ALLARD. The Senator from New Jersey.

Senator CORZINE. Thank you, Mr. Chairman.

Pursuing that just a little bit more, Fannie Mae has a risk-based

system, I presume, that is much more complicated. But if my memory serves me correct, it is something like 4 percent, if I am not

mistaken.

Mr. MCCOOL. Again, there are two different issues. Fannie Mae

and Freddie Mac have their own modeling approaches and then

OFHEO, who is their regulator, is to impose a new statutory requirement once their role is cleared by OMB, which hasn’t actually

happened yet.

Senator CORZINE. Right.

Mr. MCCOOL. But I do not actually know what their rule will impose on Fannie Mae and Freddie Mac. They have statutory requirements that are minimum capital requirements that depend on

whether something is off balance sheet or on balance sheet. I think

it is 21⁄2 percent for on balance sheet and 0.45 percent for off balance sheet, if my memory serves me correctly. Those are not riskbased. Those are just leverage-based.

Senator CORZINE. Right. Has there been any attempt by either

yourselves or others to rate or a proxy rating, what the Fund would

be rated if it were going to outside private entities?

Mr. MCCOOL. We certainly have not, and I do not know that anyone else has.

Mr. CHERLOW. Not that I am aware of, sir.

Senator CORZINE. And one of the best tests, at least in the experience I have had, is looking at secondary market spreads on what

14

packages of FHA, which, I guess, is in Ginnie Mae format. Have

these spreads widened or tightened? Do you follow those through

time and seeing whether there is a risk premium that is growing

or shrinking?

Mr. MCCOOL. I have not really looked at any trends in those, no.

Senator CORZINE. Actually, it might be an interesting phenomenon. It tends to track at least how the marketplace in general is

looking at it.

I was going to ask some of these regional concentration questions. They tend to be the most important in some of the valuing

of the credit proportions.

Is there a statutory requirement to be at 2 percent? And what

are the timeframes that surround when you are out of it and you

have to get back into it?

Mr. MCCOOL. The statutory requirement is that the ratio be

above 2 percent.

Senator CORZINE. Okay.

Mr. MCCOOL. I am not sure it goes much beyond that in terms

of specifying what happens if you do not meet that, other than,

again, things like restricting the Secretary from instituting distributive shares or things like that. But there is no real enforcement tools, I don’t think.

Mr. SCIRE. The statutory requirement is a minimum capital

ratio. And that was put in in the 1990 reforms. The deadline was

to reach the 2 percent level by 2000.

Actually, they met the capital ratio well before 2000. But it is a

minimum capital requirement. The law does not specify or define

actuarial soundness, which is a trigger for certain things that the

Secretary can do, such as paying distributive shares, which the

1990 reforms discontinued.

Senator CORZINE. A larger risk of default with higher loans than

smaller loan portfolio?

Mr. CHERLOW. Do you mean larger loans or larger loan-to-value

ratios?

Senator CORZINE. Larger loans. Just the larger end of the spectrum of your mortgages.

Mr. CHERLOW. Not generally. In fact, at times it appeared that

the smallest of the FHA loans were the ones that had the largest

risk of default, the very small ones.

But loan-to-value ratio is very important, those loans where the

borrower is borrowing a larger share of the purchase price and

therefore, has lower equity. Those tend to be more risky.

Senator CORZINE. Do you all have statistics built into your model

with regard to those kinds of matters?

Mr. CHERLOW. That is right. The model takes into account loan

size and loan-to-value ratio, as well as other variables.

Senator ALLARD. I think a key question for me as we look at legislation is whether the 2 percent reserve should be increased to 2.5

or 3 percent. Frankly, I feel like we need to be conservative. I don’t

think we need to be ridiculous about it. But I do think that we

need to err on the conservative side.

There are two scenarios that you had that indicated that there

would be an increased risk to the Fund. And I might just talk

about those two briefly.

15

The first one, you described a situation where mortgage interest

rates are falling, which is happening right now. And I know that

there is an awful lot of refinancing going on in my State. I assume

that is happening nationwide because of the drop in interest rates.

I think it is a big inducement for borrowers to continue to go into

kind of a refinancing mode.

In your scenario, you describe that then a recession sets in. And

there is kind of a familiar ring to that. Our economy is heading

down right now. And under that scenario, you say that we totally

eliminate the 2 percent reserve, or near total elimination. Is it not

possible that we may be entering into that situation right now?

Mr. MCCOOL. I think it would depend very much on how large

and how long a recession we had.

Senator ALLARD. Yes.

Mr. MCCOOL. I am not actually sure about how big the recession

was that we stressed this system with.

Mr. CHERLOW. The recession we modeled has a fairly substantial

decline in house prices. Really the most critical factor is whether

or not people find themselves in a negative equity position.

Senator ALLARD. Which is not happening right now, at least not

in my State.

Mr. CHERLOW. Yes.

Senator ALLARD. I do not know about other States. Did you get

any feel for that?

Mr. CHERLOW. No, sir, not yet.

Senator ALLARD. Second, you had a scenario which was discussed

a little bit by my colleague about the foreclosure rates from the

1980’s being duplicated. That was that 5-year period. Now, you described that more than wiped out the 2 percent reserve. That is a

scenario that has happened within the past 25 years. It seems to

me that we want a reserve that will at least sustain us through

a period, one that we have experienced in recent history. Would

you comment on that further?

Mr. MCCOOL. Again, as we have been saying, to a large extent,

it is up to Congress to decide what stress they want the Fund to

be able to undergo. It could be a mild stress or a stress like the

Great Depression. And each one gives you a different potential capital ratio or relationship between risk and capital, depending on

how you want to specify it.

Senator ALLARD. You also mentioned the private sector out there.

They will go and rate soundness, AAA, AA, and A. If you were to

rate this, where would you rate it?

Mr. MCCOOL. Well, we are not in the rating business.

[Laughter.]

It is a little hard for us to do that.

Senator ALLARD. Is there anything we can learn from the safety

and soundness requirements imposed on banks with the FDIC?

Mr. MCCOOL. As I said, part of it depends on what you are trying

to achieve. The banks’ capital ratios basically are effectively 8 percent. But they depend a lot on the extent of credit risk that is associated with a particular type of asset. And we know that the bank

supervisors are undertaking to change those standards because

they think the current standards are too simple and they generate

16

certain types of perverse behavior. So, they are trying to move to

a system that, again, matches capital more with risk.

Now, again, the other financial institution supervisory model

that has similarities to the stress test we have been talking about

is the OFHEO stress test for Fannie Mae and Freddie Mac. That

involves a very substantial credit stress, as well as a very, very

large interest rate stress. So, in some ways, it is similar to some

of the stresses we did, but it also has alternative or additional

stress factors.

Senator ALLARD. And their standard was not just to be conservative, but it was almost to the point where it was a catastrophic

situation. Am I correct?

Mr. MCCOOL. That is certainly how Fannie Mae and Freddie Mac

characterize it.

Senator ALLARD. Yes. Actually, private mortgage insurers also.

Mr. MCCOOL. Right.

Senator ALLARD. They are required by law to hold reserves that

are in the catastrophic. All we are asking here is just that we be

very conservative. At least that is kind of been my position.

I guess the fundamental question is why should FHA be different? Why should the standard for actuarial soundness be lower

for a public fund than for a private fund, for example?

Mr. MCCOOL. Part of it does depend on FHA’s role compared

with the private sector. FHA does have a role to be in the market

when others pull out. That is what the private sector can do. If

things get tough, the private sector can decide not to play. FHA is

supposed to be there to play. Plus the fact is that FHA is backed

by the Federal Government. So it does have that backstop, which

the private sector does not have. There are similarities, but there

are also, I think, some differences.

Senator ALLARD. Thank you.

I am going to call on my colleague from Rhode Island now.

Senator REED. Thank you, Mr. Chairman.

Let’s go back to the 1980’s. Nostalgia calls. As I recall, it wasn’t

just poor economic conditions, but some negligence, if not worse, in

appraising of properties and lending, et cetera, that helped with

that precipitous decline. And I note that KPMG has just finished

an audit contracted by HUD’s Inspector General that cites improvements in FHA’s oversight of lenders and appraisers.

Have you built that into the model going forward, the improvement in these oversight measures? One would hope that the Fund

could now withstand more, and not be in the position that it was

in the 1980’s?

Mr. CHERLOW. One factor that is definitely built in, Senator, has

to do with what is called the loss rate or the amount that FHA

loses on each property, what percentage of the claim value does it

not get back when it sells the property.

When GAO first began doing this type of work around 1990, it

was common for the loss rate to be higher—I think we were using

in those days 42 percent. Nowadays, I think it is more like 35 percent. So, in fact, one of the differences between the 1980’s and now

is that FHA has succeeded in reducing its loss rate a fair amount.

Senator REED. Thank you. In your report, you suggest that the

Secretary of HUD should develop better tools for assessing the imVerDate 11-MAY-2000 14:41 Apr 09, 2002 Jkt 000000 PO 00000 Frm 00020 Fmt 6633 Sfmt 6633 77638.TXT SBANK4 PsN: SBANK4
17

pacts that policy changes will have on the volume and riskiness of

the loans that it insures. And since we are all contemplating policy

changes here, what are those tools? Might you be more specific?

Mr. MCCOOL. Well, I think there are a number of possible tools.

One of the things that we were suggesting was to try to come up

with a better sense of how changes, in particular, in premia and

other financial attributes of FHA, affect the demand for FHA loans.

For example, there is this issue about what would happen if you

were to raise or lower premiums. And again, right now, there is a

simple presumption that the level of FHA lending either stays the

same or increases or decreases in the same proportion as the rest

of the market does, which is the current demand model that

Deloitte & Touche uses.

What we think would be better would be to get a sense of, if you

change premiums, since you are competing with alternatives such

as the conventional market, what would be the effect on the relative size of FHA compared with the rest of the market? In particular, what might be the effect on the risk characteristics of that

piece that the FHA gets, to be able to truly understand the effect

of a change in policy.

Senator REED. Thank you.

Deloitte & Touche has done their actuarial study. You have done

your study. You cited that their study is comparable. What does

that mean?

Mr. MCCOOL. What we mean is the results are comparable. We

did not really do an analysis of Deloitte & Touche methodology.

That was not what we were attempting to do. Also, our model was

built to some extent for a different purpose than theirs. We were

trying not to get into comparing our model to theirs in the sense

of the mechanics of it. We were just saying that the results we

came out with in measuring the Fund and the capital ratio were,

we thought, similar to what Deloitte & Touche came out with.

Senator REED. What confidence is there in the actuarial review

that they did?

Mr. MCCOOL. Well, if they continue to come out with estimates

that are close to ours, it gives us more and more confidence.

[Laughter.]

Senator REED. Thank you.

Senator ALLARD. I have a few more questions.

You have noted that in your report, 40 percent of FHA’s loans

are on new mortgages from 1998 to 1999, and that we have no good

data on their performance. Should this concern us? And is it possible that these loans are riskier than other loans in the portfolio?

Mr. MCCOOL. I think, from our perspective, it simply makes us

want to be cautious because the portfolio is so loaded toward new

loans which we have little experience with.

The question of the relative riskiness again is difficult to know.

We have heard a lot about the private sector using technological

tools to do a better job of trying to figure out who are the less risky

part of the lower end of the mortgage distribution. There may be

an attempt by the private sector not so much to harm FHA, but

to make money by offering better terms to the less risky part of the

low down payment end of the mortgage spectrum. As a result, it

could be that FHA is left with a slightly riskier portfolio. We don’t

18

know that. That is again something we will need to keep an eye

on as these loans mature.

Senator ALLARD. Is there any information you can give us on the

potential for this adverse selection?

Mr. MCCOOL. Whether we have any sense of the magnitude?

Mr. CHERLOW. Right. I would agree with what Mr. McCool said.

We probably don’t have a good sense now of how large an effect

that might be. Unfortunately, we would have a better idea in 2005

what the picture of the Fund at the end of 1999 is, because then

you will have data, but that is rather too late to be of a lot of use.

Senator ALLARD. Does your report take into account the January

reduction in premiums that was instituted on the Fund by HUD?

Mr. CHERLOW. Not in our estimates because we are just looking

at the books of business through 1999 and the premium change applies to new business. But it is certainly one of the factors that we

would cite as far as going forward and evaluating the actuarial

soundness of the Fund. In our model and Deloitte’s, and Price

Waterhouse’s in the years before, these estimates are not based on

new business. They are based on existing business.

Senator ALLARD. Sure.

Mr. CHERLOW. So what happens to new business, of course, is

important as well. And with the lower premiums, there is less revenue coming in, obviously, to meet the claims.

Senator ALLARD. How significant a factor do you think the new

premiums might be? Can you speculate on that? Minimal? Moderate?

Mr. SCIRE. HUD estimated that over a 6 year period, it would cost $6 billion.

Senator ALLARD. Yes.

Mr. SCIRE. You might say that estimate is actually conservative

because it doesn’t take into account any change in risk and volume

or demand for FHA’s product. And you would expect with a lower

insurance premium that they might be able to compete better and

therefore, attract less risky business. But their estimate is based

upon what the demand for mortgage insurance generally would be

in the future.

Senator ALLARD. They were looking at a $6 billion cost.

Mr. SCIRE. That is right.

Senator ALLARD. Do you know how much of that cost was allocated just this year, for example?

Mr. SCIRE. No, I don’t know how much of that would be for this

year. I know it was over a 6 year period.

Senator ALLARD. I think that would be interesting. I would be

interested if you could make that available, as to how that was

allocated out over that time period per year.

Now, your report, then, or the KPMG or the Deloitte & Touche

audits factor in the anticipated impact of loss mitigations by FHA.

You haven’t done that.

Mr. SCIRE. No. HUD estimated that the projected value of the MMI Fund in 2006 would be almost $6 billion lower given lower

premiums that became effective this January. Because this is an

estimate for a projected value as of a future date, it cannot be allocated among the intervening years, without establishing projected

estimates for those years. Nonetheless, assuming—as FHA does—

19

that there is no change in the volume and riskiness of loans FHA

insures, the difference between the value of the Fund under the

previous premium structure and the value under the new premium

structure will increase each year in proportion to the volume of

business predicted each year because the up-front premium being

collected for new loans will be smaller. However, it is possible that

the lower cost of FHA mortgage insurance would allow FHA to attract more borrowers and less risky borrowers, which would have

a favorable effect on the economic value of the Fund and thereby

partially offset the effect of lower up-front premiums. In addition,

fewer refunds of up-front premiums are likely given that FHA

shortened the period in which the borrowers are eligible for such

refunds.

Senator ALLARD. Okay. And there is evidence from most recent

KPMG and Deloitte & Touche audits that the FHA Fund is experiencing higher claims and faster prepayments than projected in

1999. In fact, the KPMG audit appears to show that a reestimate

of claims and prepayments hurt FHA’s bottom line by nearly $4

billion in fiscal year 2000. Have you taken a look at these numbers

and should they concern us?

Mr. SCIRE. Well, I think that that underscores the need for looking at the capital ratio again and again over time, and the caution

that we urge in interpreting that having a 2 percent ratio today

means that a 2 percent ratio would be sufficient to cover moderately severe conditions regardless of what happens in the future.

So, yes, I think that it is something that would give you cause

for concern.

Senator ALLARD. My time has expired.

Senator REED. Go ahead.

Senator ALLARD. I have just a couple more issue areas that I

want to cover and then I will be finished.

Senator REED. Fine.

Senator ALLARD. In your report, you state that one could conclude that borrowers during the 1990’s overpaid for their insurance. Explain why one might interpret a surplus in FHA’s Fund

this way.

Mr. MCCOOL. I think it is based on the idea of the MMI Fund

being a mutual insurance fund and the extent to which, if you have

more than sufficient resources generated to insure, the risks

against which you are trying to insure, and there is something left

over, then the idea would be, in a mutual insurance fund, you

would give some rebates to those people who paid.

Senator ALLARD. Doesn’t this argue in favor of a return to distributive shares?

Mr. MCCOOL. Well, again, that is a policy decision. That depends

on the total view you have about what the MMI Fund is about and

what the FHA is about.

Senator ALLARD. Under the current regulations, when is the Secretary required to reinstitute distributive shares?

Mr. SCIRE. Under current regulations, it establishes two different

accounts—a general surplus account and a participating reserve

account. The Secretary semiannually is supposed to allocate any

profits from the Fund to these two accounts and to do that taking

into account the actuarial status of the Fund. And it is from this

20

participating reserve account that the Secretary makes distributive

shares.

I believe the short answer to that question is that the Secretary

is supposed to take into account the actuarial status of the Fund

before making distributive shares.

Senator ALLARD. Would it be reasonable to conclude that if the

Fund is more than 150 percent above the statutorily mandated reserve, that it could be considered actuarially sound, particularly in

light of the fact of your previous arguments, the standards for a

public fund might be lower than those for a private fund?

Mr. MCCOOL. As I think I said before, the actuarial soundness

depends on what you want the Fund to be able to withstand. And

that is for you in Congress to decide just how much risk you want

to be able to withstand.

Senator ALLARD. Are there any other members of the panel that

want to make any closing comments?

Senator REED. I have one question, Mr. Chairman.

Senator ALLARD. Let me call on the Ranking Member.

Senator REED. Just one final question. Your analogy to a mutual

insurance fund as the measure of whether there is overpayment by

premium payers, does that consciously take into consideration the

fact that this is a mutual fund that is supported by, essentially, the

Federal Government? Does that make a difference in your analogy?

Mr. MCCOOL. As I said, it is simply that, when you talk about

premiums being overpaid, that is the sense in which they are overpaid. The members of the mutual organization are paying more

than is necessary to provide the insurance for themselves. This

would mean that they necessarily have to get any amount repaid

or a particular amount repaid.

Senator REED. But, conceivably, or hypothetically, this is a mutual organization that would never take place unless it was supported by the Federal Government. So that there is a very large

public purpose and public direction here. It is not simply a mutual

organization.

Mr. MCCOOL. Right.

Senator REED. Thank you.

Senator ALLARD. I want to thank the panel, and I want to thank

the Members of the Subcommittee for their questions. I thought

this was a very informative hearing.

I am going to adjourn the hearing.

[Whereupon, at 2:03 p.m., the hearing was adjourned.]

[Prepared statements submitted for the record follow:]

21

1The Act defined the capital ratio as the ratio of the Fund’s capital, or economic net worth,

to its unamortized insurance-in-force. However, the Act defined unamortized insurance-in-force

as the remaining obligation on outstanding mortgages—a definition generally understood to

apply to amortized insurance-in-force. FHA has calculated the 2-percent capital ratio using

unamortized insurance-in-force as it is generally understood—which is the initial amount of

mortgages. All capital ratios reported here are measured using unamortized insurance-in-force

as it is generally understood.

PREPARED STATEMENT OF SENATOR JON S. CORZINE

Thank you, Mr. Chairman, for holding this hearing and thanks to Mr. McCool for

appearing here today to help us understand the General Accounting Office’s report

on the FHA’s Mutual Mortgage Insurance Fund.

I am looking forward to hearing about the GAO’s findings with regard to the

Fund’s 2 percent capital reserve requirement and the Fund’s ability to withstand

times of economic stress. Given the continuing downturn in economic indicators, I

hope we will hear some encouraging news on that front.

Additionally, I am looking forward to discussing, in this or other hearings, the potential for using any excess FHA MMI receipts to promote affordable housing. There

is a serious shortage of such housing in many parts of the country, and we need

to explore all possible ways to address the problem.

Again, Mr. Chairman, I thank you for holding this hearing and I look forward to

hearing from our witness today.

—————

PREPARED STATEMENT OF THOMAS J. McCOOL

MANAGING DIRECTOR, FINANCIAL MARKETS AND COMMUNITY INVESTMENT

U.S. GENERAL ACCOUNTING OFFICE

MARCH 19, 2001

Mr. Chairman and Members of the Subcommittee: We are here today to discuss

the results of our analysis of the financial health of the Mutual Mortgage Insurance

Fund (Fund) of the Department of Housing and Urban Development’s (HUD) Federal Housing Administration (FHA). Through the Fund, FHA operates a single-family insurance program that helps millions of Americans buy homes. The Fund, which

is financed through insurance premiums, has operated without cost to the American

taxpayer. Last year, the Fund’s economic value appeared to have reached its highest

level in at least 20 years—prompting proposals to spend some of the Fund’s current

resources or reduce net cash flows into the Fund. Concerned about how the soundness of the Fund is measured and proposals to spend what some were calling ‘‘excess reserves,’’ you requested that we analyze the financial health of the Fund.

Since 1990 the economic health of the Fund has been assessed by measuring the

economic value of the Fund—its capital resources plus the net present value of

future cash flows—and the related capital ratio—the economic value as a percent

of the Fund’s insurance-in-force. For most of its history, the Fund was relatively

healthy; however, in fiscal year 1990 the Fund was estimated to have a negative

economic value, and its future was in doubt. To help place the Fund on a financially

sound basis, Congress enacted legislation in November 1990 that required the

Secretary of HUD to, among other things, take steps to achieve a capital ratio of

2 percent by November 2000 1 and to maintain or exceed that ratio at all times

thereafter. The legislation also required the Secretary to raise insurance premiums

and suspend the rebates, called distributive shares, that FHA borrowers had been

eligible to receive under certain circumstances. As a result of the 1990 housing reforms, the Fund must not only meet capital ratio requirements, it must also achieve

actuarial soundness; that is, the Fund must contain sufficient reserves and funding

to cover estimated future losses resulting from the payment of claims on foreclosed

mortgages and administrative costs. However, neither the legislation nor the actuarial profession defines actuarial soundness.

The 1990 FHA reforms required that an independent contractor conduct an annual actuarial review of the Fund. These reviews have shown that during the

1990’s, the estimated economic value of the Fund grew substantially. As figure 1

shows, by the end of fiscal year 1995, the Fund attained an estimated economic

value that slightly exceeded the amount required for a 2-percent capital ratio. Since

that time, the estimated economic value of the Fund continued to grow and always

exceeded the amount required for a 2-percent capital ratio. In the most recent review, Deloitte & Touche (Deloitte) estimated the Fund’s economic value at about

22

$17.0 billion at the end of fiscal year 2000. This represents about 3.51 percent of

the Fund’s insurance-in-force—well above the required minimum of 2 percent.

Concerned about the adequacy of the minimum 2 percent requirement and about

proposals to spend what some were calling excess reserves, you asked us to determine the conditions under which an estimated capital ratio of 2 percent would be

adequate to maintain the actuarial soundness of the Fund. Specifically, you asked

us to: (1) estimate the value of the Fund at the end of fiscal year 1999, given expected economic conditions, and compare our estimate to the estimate of the value

of the Fund reported by HUD for that year; (2) determine the extent to which a

2-percent capital ratio would allow the Fund to withstand worse-than-expected loan

performance due to economic and other factors; and (3) describe some options for

adjusting the size of the Fund if the estimated capital ratio is different from the

amount needed and describe the impact that these options might have on the Fund,

FHA mortgagors, and the Federal budget.

In summary:

• We estimate that the Fund had an economic value of about $15.8 billion at the

end of fiscal year 1999. This estimate implies a capital ratio of 3.20 percent of

the unamortized insurance-in-force. Although we did not evaluate the quality of

the 1999 estimates prepared by Deloitte, using a different method of analysis, we

believe that Deloitte’s estimates and ours are comparable because of the uncertainty inherent in forecasting and the professional judgments made in this type

of analysis. Both of these estimates easily exceed the minimum required capital

ratio of 2 percent that Congress set in 1990.

• Given the economic value of the Fund and the state of the economy at the end

of fiscal year 1999, a 2-percent capital ratio appears sufficient to withstand moderately severe economic downturns that could lead to worse-than-expected loan

performance. That is, under economic scenarios that we developed to represent

regional and national economic downturns that the Nation experienced between

1975 and 1999, the estimated capital ratio fell by only slightly less than 0.4 percentage points. Some more severe downturns that we analyzed also did not cause

the estimated capital ratio to decline by as much as 2 percentage points. However,

in three more severe scenarios, an economic value of 2 percent of insurance-inforce would not have been adequate. Nonetheless, because of the nature of such

analysis, we urge caution in concluding that the estimated value of the Fund

today implies that the Fund would necessarily withstand any particular economic

scenario under all circumstances.

• Congress and the Secretary of HUD have taken and could take a number of actions to influence the economic value of the Fund. The impact that these actions

have on the capital ratio and FHA borrowers is not always certain. However, actions that influence the Fund’s reserve levels will also affect the Federal budget.

In short, any proposal that seeks to use reserves, if not accompanied by a reducVerDate 11-MAY-2000 14:41 Apr 09, 2002 Jkt 000000 PO 00000 Frm 00026 Fmt 6621 Sfmt 6621 77638.TXT SBANK4 PsN: SBANK4
23

tion in other spending or an increase in receipts, will result in a decline in the

Federal budget surplus.

Let me start by describing our estimates of the Fund’s economic value and capital

ratio and how our estimates compare with estimates prepared by Deloitte & Touche.

The Fund’s Capital Ratio Exceeds 3 Percent

The economic value of the Fund consists of current capital resources and the net

present value of future cash flows. Investments in nonmarketable Treasury securities represent the largest component of FHA’s current capital resources. Estimating

the net present value of future cash flows is a complex actuarial exercise that requires extensive professional judgment. Cash flows into the Fund from premiums

and the sale of foreclosed properties; cash flows out of the Fund to pay claims on

foreclosed mortgages, premium refunds, and administrative expenses. (See figure 2.)

At the end of fiscal year 1999, the Fund had capital resources of $14.3 billion.

Using our models and forecasts of likely values of key economic variables, we estimated that the Fund had a net present value of future cash flows of $1.5 billion

at that time. This yielded an estimated economic value of $15.8 billion and a capital

ratio of 3.20 percent. Given the inherent uncertainty of these estimates and the professional judgments involved, these numbers are comparable to those of Deloitte at

the end of 1999, when Deloitte estimated that under expected economic conditions

the capital value was $16.6 billion and the capital ratio was 3.66 percent. Much of

the difference seems to be the result of performing the analyses at different times.

Because Deloitte performed its analysis before the end of fiscal year 1999, it had

to estimate the Fund’s capital resources and insurance-in-force, while we were able

to use the year-end values. In its recent estimates for 2000, Deloitte noted that in

the actuarial review for the fiscal year 1999, it had overestimated the Fund’s capital

24

2Most borrowers with FHA-insured loans who received them prior to September 1983 were

required to pay an annual insurance premium for the life of the loan. In addition, most borrowers who received FHA-insured loans after June 1991 are required to pay an annual insurance premium for up to the life of the loan, depending on loan type and the initial loan-to-value

ratio of the loan. Borrowers who received FHA-insured loans between September 1983 and June

1991 were not required to pay annual mortgage insurance premiums.

resources by about $1 billion. However, Deloitte did not restate the economic value

and capital ratio for 1999; instead it adjusted the starting point for the 2000 estimate of economic value. If Deloitte had restated the economic value and capital ratio

for fiscal year 1999, the 1999 values would likely have been smaller. Because

Deloitte & Touche uses estimates for the Fund’s capital resources and insurancein-force, it is difficult to compare its estimates of the Fund’s economic value and

capital ratio over time.

The Fund’s economic value principally reflects the large amount of capital resources that the Fund has accrued. Because current capital resources are the result

of previous cash flows, the robustness of the economy and the higher premium rates

throughout most of the 1990’s accounted for the accumulation of these substantial

capital resources. Good economic times that are accompanied by relatively low interest rates and relatively high levels of employment are usually associated with high

levels of mortgage activity and relatively low levels of foreclosure; therefore, cash

inflows have been high relative to outflows during this period.

The estimated value of future cash flows also contributed to the strength of the

Fund at the end of fiscal 1999. As a result of relatively low interest rates and the

robust economy, FHA insured a relatively large number of mortgages in fiscal years

1998 and 1999, and these loans make up a large portion of FHA’s insurance-in-force.

Because of their low interest rates and because forecasts of economic variables for

the near future show house prices rising while unemployment and interest rates

remain fairly stable, our models predict that these new loans will have low levels

of foreclosure and of prepayment. At the same time, we assume that many FHAinsured homebuyers will continue to pay FHA annual insurance premiums.2 Thus,

our models predict that cash flowing into the Fund from mortgages already in

FHA’s portfolio at the end of fiscal year 1999 will be more than sufficient to cover

the cash outflows associated with these loans.

The future cash flows are estimates based on a number of assumptions about the

future, including predictions of mortgage foreclosures and the likelihood that those

holding FHA-insured mortgages will prepay their loans. These predictions are based

on elaborate models that estimate past relationships between foreclosures and prepayments and certain economic variables, such as changes in house prices. To the

extent that these relationships are different in the future, the actual foreclosures

and prepayments will differ from the estimates. The estimating procedures make

many other assumptions, and I will describe some of these limitations in greater

detail later in my testimony.

The Actuarial Soundness of the Fund Depends on the Risks That

Congress Wants the Fund to Withstand

Although our estimates and the Deloitte’s estimates of the Fund’s capital ratio

under expected economic conditions are comparable, we cannot conclude on the

basis of these estimates alone that the Fund is actuarially sound. Instead, we beVerDate 11-MAY-2000 14:41 Apr 09, 2002 Jkt 000000 PO 00000 Frm 00028 Fmt 6621 Sfmt 6621 77638.TXT SBANK4 PsN: SBANK4
25

lieve that to determine actuarial soundness one should measure the Fund’s ability

to withstand certain worse-than-expected conditions. According to our estimates,

worse-than-expected loan performance that could be brought on by moderately severe economic conditions would not cause the estimated value of the fund at the end

of fiscal year 1999 to decline by more than 2 percent of insurance-in-force. Some

more severe downturns that we analyzed also did not cause the estimated capital

ratio to decline by as much as 2 percentage points. However, a few more severe economic scenarios could result in such poor loan performance that the estimated value

of the fund at the end of fiscal year 1999 could decline by more than 2 percent of

insurance-in-force.

To help determine the Fund’s ability to withstand certain worse-than-expected

conditions, we generated economic scenarios that were based on economic events in

the last 25 years and other scenarios that could lead to worse-than-expected loan

performance in the future. Under each of these scenarios, we used our models to

estimate the economic value of the Fund and the related capital ratio. (See table

2.) Most of the scenarios we looked at had only a small impact on the capital ratio.

For example, the worst historical scenario we tested, one based on the 1981–1982

national recession, lowered the capital ratio by less than 0.4 percentage points—

about 20 percent of the required 2 percent minimum capital ratio. To see how the

economic value of the Fund would change as the extent of adversity increased, we

extended regional scenarios that were based on historical economic downturns experienced in three States—the west south central downturn based on Louisiana in the

late 1980’s, the New England downturn based on Massachusetts in the late 1980’s

and early 1990’s, and the Pacific downturn based on California in the 1990’s—to the

Nation as a whole. In extending the west south central and Pacific downturns, the

estimated capital ratio was about 1 percentage point lower than in the base case.

However, our models estimate that extending the New England downturn to the

country as a whole would reduce the capital ratio by almost 2.4 percentage points.

In another scenario, in which we specify that interest rates fall substantially, inducing refinancing, and then a recession sets in, leading to increased foreclosures, the

estimated capital ratio fell substantially, by over 1.8 percentage points.

In one other scenario, the capital ratio fell by over 2 percentage points. In that

scenario we assumed that foreclosure rates in 2000 through 2004 equal foreclosure

rates from 1986 through 1990 for mortgages originated in the 10-year periods prior

to 2000 and 1986, respectively.

26

27

Because none of our economic scenarios generated foreclosure rates as high as

those experienced in the west south central states in the late 1980’s, we applied

these rates directly to our models, assuming that for the next 5 years foreclosure

rates in most cases would be equivalent to those experienced by the west south central states in 1986 through 1990. Then we varied the proportion of FHA’s portfolio

experiencing these west south central foreclosure rates. As figure 3 shows, if about

36 percent of the portfolio experiences these rates, the estimated capital ratio would

be 2 percentage points lower than the expected case; and if 55 percent of the portfolio experienced these rates, the economic value of the Fund would fall to zero.

As we have stated in the past, there is considerable uncertainty associated with

any estimate of the economic value of the Fund because of uncertainty about the

performance of FHA’s loan portfolio over the life of the existing loans, which, in

some cases, can be for 30 years. We believe that our models make good use of historical experience in identifying the key factors that influence loan foreclosures and

prepayments and estimating the relationships between those factors and loan performance. In addition, we have relied on reasonable, and in some cases conservative,

forecasts of economic variables, such as the rate of house price appreciation and the

unemployment rate, in finding that the Fund’s economic value in fiscal year 1999

appeared higher than necessary to withstand many adverse economic scenarios.

Nonetheless, several additional factors lead us to believe that Congress and others

should apply caution in concluding that the estimated value of the Fund today implies that the Fund could withstand the economic scenarios that we examined under

all circumstances. Our estimates and those of others are valid only under a certain

set of conditions, including that loans FHA insured in recent years and loans it insured in the more distant past have a similar response to economic conditions, and

that cash inflows associated with future loans at least offset cash outflows associated with those loans. Some specific factors beyond those incorporated in our models

that could determine the extent to which the Fund will be able to withstand adverse

economic conditions are as follows:

• The performance of recent loans—Over 40 percent of FHA’s loan portfolio at

the end of fiscal year 1999 consisted of loans originated in fiscal years 1998 and

1999. As a result, the performance of these loans will have an important effect

on the overall performance of FHA’s loan portfolio. However, because these loans

are so new, we do not have a lot of data yet showing how well they will perform

28

3 Between 1943 and 1990, FHA rebated these so-called excess funds to borrowers as distributive shares. In 1990, however, Congress suspended the payment of these shares until the Secretary of HUD determines that the Fund is actuarially sound. HUD has announced that it will

resume paying distributive shares. HUD officials said that they are developing systems to facilitate the payment of these shares and expect to be ready to resume paying them in mid-2001.

over their lifetimes, which is often 30 years. Our model is based on data on loan

performance for loans originating from 1975 through 1999. As long as the influences of key predictive factors on the probabilities of foreclosure and prepayment

have not changed much over time, then we can be reasonably confident that the

estimates of these relationships generated by our models will apply to these recent loans. However, in recent years, FHA’s competitors in the conventional mortgage market—private mortgage insurers and conventional mortgage lenders—are

increasingly offering to selected homebuyers products that compete with FHA’s for

those homebuyers who are borrowing more than 95 percent of the value of their

homes. By lowering the required down payment, conventional mortgage lenders

and private mortgage insurers may have attracted some less risky borrowers who

might otherwise have insured their mortgages with FHA. And this may have

increased the average risk of FHA-insured loans in the late 1990’s. However, because these loans are relatively new, the increased risk would not yet be observable in the data on foreclosures and prepayments. If this effect, known as adverse

selection, has been substantial, the economic value of the Fund may be lower than

we estimate, and it may be more difficult for the Fund to withstand worse-thanexpected loan performance than our estimates suggest.

• Changes in FHA’s insurance program—A number of changes that FHA has

made or might make in the future could affect the future cash flows associated

with loans in FHA’s portfolio as of the end of fiscal year 1999 and, therefore, the

Fund’s economic value, in ways that are not accounted for in our models. For example, if HUD reinstitutes paying distributive shares to borrowers when they pay

their mortgages in full or voluntarily terminate their insurance, cash outflows

might be higher than our estimates.3 FHA’s loss mitigation program might either

reduce or increase cash outflows, depending on whether the program succeeds in

reducing foreclosures or whether the program mainly results in delayed foreclosures that lead to larger losses for FHA in the long run. On the other hand,

if FHA’s financial counseling program reduces foreclosures for those homebuyers

who received such counseling, then losses to the Fund will be less than we have

estimated. Steps taken by HUD to improve the oversight of lenders and the disposition of properties could also reduce the level of losses to FHA below what we

have estimated.

• The impact of new loans—Our models do not look at cash flows associated with

loans that FHA would insure after fiscal year 1999. Our analysis of the ability

of the Fund to withstand adverse economic conditions requires making the assumption that the adverse conditions would not also cause loans insured by FHA

after fiscal year 1999 to be an economic drain on the Fund. Since the 1990 FHA

reforms, the cash flows associated with each year’s loans have been estimated to

have a positive economic value, thereby adding to the economic value of the entire

Fund. However, during adverse economic times, new loans might perform worse

than loans that were insured by FHA during the 1990’s. Furthermore, recent and

future changes in FHA’s insurance program may cause these loans to perform differently from how past experience suggests that they will. If, for example, FHA

loosens underwriting standards, future loans may perform worse than past experience suggests. In addition, the recent reduction in up-front premiums could reduce

cash inflows into the Fund, although it could also lower the riskiness of the loans

that FHA insures. If the newly insured loans perform so poorly that they have

a negative economic value, then the loss to the Fund in any of the adverse economic scenarios that we have considered would be greater than what we have

estimated. Alternatively, if the newly issued loans have positive economic values,

then they would contribute to further growth of the Fund.

Caution also needs to be applied in making changes to FHA’s insurance program

because of the current uncertainty about their impact on the Fund. In analyzing the

impact of changes in FHA’s programs and policies on the Fund, it is important to

recognize that such changes can affect the volume and riskiness of loans that FHA

insures. Although the models currently used in the annual actuarial reviews of the

Fund can be used to estimate the direct impact that some policy changes may have

on the Fund’s economic value, these models cannot isolate indirect effects on the volume and riskiness of FHA’s loans. Accordingly, in our report, we recommended that

29

4Mortgage Financing: FHA’s Fund Has Grown, but Options for Drawing on the Fund Have

Uncertain Outcomes (GAO–01–460, February 28, 2001). 5During the 106th Congress, legislation was introduced that proposed using the Fund’s resources to fund affordable rental housing. (See S. 2997.) 6The subsidy cost is the estimated net cost to the Government, in present value terms, of

FHA-insured loans over the entire period the loans are outstanding.

the Secretary of HUD develop better tools for assessing the impacts that these

changes may have on the volume and riskiness of loans that it insures.4

Options for Drawing on the Fund Have Uncertain Outcomes,

But Any Use of the Fund’s Reserves Will Affect the Federal Budget

Given the recent growth in the economic value of the Fund, several proposals

have been made to use what some are calling excess reserves or take other actions

that could result in a change in the value of the Fund. If Congress or the Secretary

of HUD believes that the economic value of the Fund is higher than the amount

needed to ensure actuarial soundness, several changes to the FHA single-family

loan program could be adopted. The impact that these actions might have on the

capital ratio and FHA borrowers is difficult to assess without using tools designed

to estimate the multiple impacts that policy changes often have. However, any

actions that influence the Fund’s reserve levels will also affect the Federal budget.

In short, any proposal that seeks to use reserves, if not accompanied by a reduction

in other spending or an increase in receipts, would result in either a reduction in

the surplus or an increase in any existing deficit.

Several changes to the FHA’s single-family loan program could be adopted if the

Congress or the Secretary of HUD believes that the economic value of the Fund is

higher than the amount needed to meet its definition of actuarial soundness. For

example, actions that the Secretary could take that could reduce the value of the

Fund include lowering insurance premiums, adjusting underwriting standards, and

reinstituting distributive shares. However, Congressional action in the form of new

legislation would be required to make other program changes that are not now authorized by the statute. These would include such actions as changing the maximum

amount FHA-insured homebuyers may borrow relative to the price of the house they

are purchasing and using the Fund’s reserves for other Federal programs.5

Reliably estimating the potential effect of various options on the Fund’s capital

ratio and FHA borrowers is difficult because the impacts of these policy changes are

complex, and tools available for handling these complexities may not be adequate.

Policy changes have not only immediate, straightforward impacts on the Fund and

FHA’s borrowers, they also have more indirect impacts that may intensify or offset

the original effect. Implementing these options could affect both the volume and the

average riskiness of loans made, which, in turn, could affect any future estimate of

the Fund’s economic value. As a result of this complexity, obtaining a reliable estimate would likely require that economic models be used to estimate the indirect

effects of policy changes. At this time, however, neither the models used by HUD

to assess the financial health of the Fund, nor those used by others, explicitly recognize the indirect effects of policy changes on the volume and the riskiness of FHA’s

loans. As a result, HUD cannot reliably estimate the impact of policy changes on

the Fund.

Although it is difficult to predict the overall impact of a change on the Fund’s

capital ratio and thus on FHA borrowers as a whole, different options would likely

have different impacts on current and prospective FHA-insured borrowers. Some

proposals would more likely benefit existing and future FHA-insured borrowers,

while others would benefit only future borrowers, and still others would benefit neither of these groups. One interpretation of the higher premiums that borrowers paid

during the period in which the economic value of the Fund has been rising is that

borrowers during the 1990’s ‘‘overpaid’’ for their insurance. Some options for reducing the capital ratio, such as reinstituting distributive shares, would be more likely

to compensate these borrowers. The payment of distributive shares would benefit

certain existing borrowers who voluntarily terminate their mortgages. If these policies continued into the future, they would also benefit future policyholders. Alternatively, reducing up-front premiums, reducing the number of years over which annual insurance premiums must be paid, or relaxing underwriting standards would

tend to benefit only future borrowers.

Under 1990 credit reform legislation, the FHA’s budget is required to reflect the

subsidy cost to the Government of FHA’s loan insurance activities for that year.6

Credit reform was intended to ensure that the full cost of credit activities for the

current budget year would be reflected in the Federal budget so that Congress and

the Executive Branch could consider these costs when making annual budget deciVerDate 11-MAY-2000 14:41 Apr 09, 2002 Jkt 000000 PO 00000 Frm 00033 Fmt 6621 Sfmt 6621 77638.TXT SBANK4 PsN: SBANK4
30

7 If Congress were to use the Fund’s reserves to fund other programs, the reserves would be

lower, but there would be no effect on the negative subsidy amount reported in FHA’s budget

submissions. 8 Assuming that the volume and the riskiness of FHA-insured loans will not change, HUD

estimates that the recent reductions in up-front premiums combined with the introduction of

mortgage insurance cancellation policies will lower the estimated value of the Fund by almost

$6 billion over the next 6 years. 9 As part of the effort to control Federal budget results, the Budget Enforcement Act of 1990,

as amended, created controls over laws changing or creating mandatory spending (basically entitlements) and receipts.

sions. For FHA’s Mutual Mortgage Insurance Fund, the subsidy cost is negative;

that is, the program is operating at a profit. Under credit reform, the negative subsidy receipts would be available for appropriation for other uses, and a balance

would not be permitted to accumulate in the liquidating account. However, to accommodate the differing statutory requirements of budgeting for the subsidy cost of

insuring the loans and maintaining a 2-percent reserve, the Office of Management

and Budget (OMB) and FHA have allowed reserves to accumulate in the Fund in

the form of interest-bearing Treasury securities. At the end of fiscal year 1999, the

FHA held nearly $15 billion in Treasury securities. These securities represent a

claim on the U.S. Treasury to cover future losses to the Fund. From the perspective

of the U.S. Treasury, these securities represent a liability. From the standpoint of

the Government as a whole, the securities represent a debt owed by one part of the

Federal Government to another. By investing in nonmarketable Treasury securities,

FHA makes funds available to other Federal programs. Each year that the Fund

runs a surplus, the budget surplus for the Federal Government, as a whole, is higher than it would otherwise have been if FHA had not been insuring profitable loans.

When the total Federal budget was in a deficit (as it was for most of the 1990’s),

that deficit was lower than it would have been if the Fund had not been realizing

a surplus at the same time.

Because of the difficulty in reliably measuring the effect of most actions that could

be taken either by Congress or the Secretary of HUD on the Fund’s capital ratio,

we cannot precisely measure the effect of these policies on the budget. However, any

actions taken by Congress or the Secretary that influence the Fund’s capital ratio

will have a similar effect on the Federal budget. If Congress or the Secretary of

HUD adopts policies, such as lowering premiums, paying distributive shares, or

loosening underwriting standards, that reduce the profitability of the Fund, the negative subsidy amount reported in FHA’s budget submission and the Fund’s reserve will both be lower.7 Some of these policies—lowering premiums and paying distributive shares—would affect FHA’s cash flows immediately.8 Thus, the amount of

money available for FHA to invest in Treasury securities would be lower. Treasury

in turn would have less money available for other purposes, and the overall surplus

would decline. If the amounts of cash flowing out of the Fund exceeded current receipts, FHA would be required to redeem its investments in Treasury securities to

make the required payments. Assuming no changes in other spending and taxes,

Treasury then would be required to either increase borrowing from the public or use

general tax revenues to meet its financial obligations to FHA. In either case, the

annual budget surplus would be lower.

Budgetary scoring for budget control purposes under the 1990 Budget Enforcement Act 9 is required only when a law is enacted; actions taken by the Secretary

under existing authorities are not scored for budget control purposes, even though

they may affect the budget surplus or deficit. Whether and how the proposals under

discussion would be scored depend on the exact wording of the new law and is determined by OMB for Budget Enforcement Act purposes. However, any action taken

by Congress or the Administration to reduce FHA’s reserves, if not accompanied by

a similar reduction in other Government spending or by an increase in receipts, will

result in either a reduction in the surplus or an increase in any existing deficit.

Actuarial Soundness Should be Defined

Whether actions should be taken to change the value of the Fund depends on

whether the Fund’s capital resources and expected revenues exceed the amount

needed to meet its expected cash outflows under designated stressful conditions;

that is, whether it is actuarially sound. Assessing whether this condition exists requires that the degree of risk that the Fund is expected to be able to withstand

must be specified. If the Fund is expected to withstand what Price Waterhouse

called reasonably adverse economic downturns, then our results could be construed

to mean that the Fund is taking in more revenue than it needs. Alternatively, if

the Fund is expected to never exhaust its reserves, the current Fund might not be

adequate.

31

The 1990 reforms did not specify the amount of risk that the Fund needed to

withstand. Instead, the reforms specified a minimum capital ratio and required that

the Fund achieve actuarial soundness before the Secretary of HUD could take certain actions that might reduce the value of the Fund. Because we believe that actuarial soundness depends on a variety of factors that could vary over time, setting

a minimum or target capital ratio will not guarantee that the Fund will be actuarially sound over time. For example, if the Fund comprised primarily seasoned loans

with known characteristics, a capital ratio below the current 2-percent minimum

might be adequate. But under conditions such as those that prevail today, when the

Fund is composed of many new loans, a 2-percent ratio might be inadequate if recent and future loans perform considerably worse than expected.

We believe that to evaluate the actuarial soundness of the Fund, one or more scenarios that the Fund is to withstand would need to be specified. Then it would be

appropriate to calculate the economic value of the Fund or the capital ratio under

the scenario(s). As long as the estimated economic value of the Fund is positive

when the desired stress scenario(s) is used to make that estimate, the Fund could

be said to be actuarially sound. However, it might be appropriate to leave a cushion

to account for the factors not captured by the model and the inherent uncertainty

attached to any forecast. In any event, we believe that a single, static capital ratio

does not measure actuarial soundness.

Matters for Congressional Consideration

For these reasons, Mr. Chairman, Congress may wish to consider taking action

to specify criteria for determining when the Fund is actuarially sound. More specifically, Congress may want to consider defining the types of economic conditions

under which the Fund would be expected to meet its commitments without borrowing from the Treasury.

Mr. Chairman, this concludes my statement. We would be pleased to respond to

any questions that you or Members of the Subcommittee may have.