United States General Accounting Office

GAO Report to the Chairman, Subcommittee

on Housing and Community Opportunity,

Committee on Banking and Financial

Services, House of Representatives

May 1997 HOMEOWNERSHIP

Potential Effects of

Reducing FHA’s

Insurance Coverage for

Home Mortgages

GAO/RCED-97-93

GAO United States

General Accounting Office

Washington, D.C. 20548

Resources, Community, and

Economic Development Division

B-276382 

May 1, 1997

The Honorable Rick A. Lazio

Chairman, Subcommittee on Housing

 and Community Opportunity

Committee on Banking

 and Financial Services

House of Representatives

Dear Mr. Chairman:

This report responds to your request that we analyze and present certain information on the

implications of limiting the portion of single-family home mortgages insured by the Department

of Housing and Urban Development’s (HUD) Federal Housing Administration (FHA). Specifically,

the report discusses the impact of a reduction in FHA’s insurance coverage on (1) home

mortgage lenders, the home mortgage market, and the types of borrowers served by FHA; (2) the

financial condition of FHA’s insurance fund; and (3) HUD’s Government National Mortgage

Association.

As agreed with your office, unless you publicly announce its contents earlier, we plan no further

distribution of this report until 30 days from the date of this letter. At that time we will send

copies of this report to the Secretaries of Housing and Urban Development and Veterans

Affairs. We will make copies available to others on request.

Please call me at (202) 512-7631 if you or your staff have any questions. Major contributors to

this report are listed in appendix V.

Sincerely yours,

Judy A. England-Joseph

Director, Housing and Community

 Development Issues
Executive Summary

Purpose Through its Federal Housing Administration (FHA), the Department of

Housing and Urban Development (HUD) insures private lenders against

nearly all losses resulting from foreclosures on single-family homes

insured under HUD’s Mutual Mortgage Insurance Fund (Fund). Although

FHA has always received enough in premiums from borrowers and other

revenues to more than cover these losses, losses totaled about

$12.8 billion in 1994 dollars, or about $24,400 for each foreclosed and

subsequently sold single-family home over the 19-year period ending in

1993. The Department of Veterans Affairs (VA) also operates a single-family

mortgage guaranty program. However, unlike FHA, VA covers only 25 to

50 percent of the original loan amount against losses incurred when

borrowers default on loans, leaving lenders responsible for any remaining

losses. Virtually all FHA and VA single-family mortgages are pooled into

securities that are then sold to investors with the help of HUD’s

Government National Mortgage Association (Ginnie Mae).

Concerned about the financial health of the Fund and its exposure to

losses when borrowers default on the loans it has insured, the Chairman of

the Subcommittee on Housing and Community Opportunity, House

Committee on Banking and Financial Services, asked GAO to address the

following three questions about the implications of limiting the insured

portion of future FHA-insured loans to that used by VA: (1) How are lenders

and the market expected to react to an increased risk of loss to lenders

and how will this affect FHA’s borrowers? (2) What potential financial

impact will reducing FHA’s coverage have on the Fund under different

economic conditions? (3) What are the potential impacts of reducing FHA’s

insurance coverage on Ginnie Mae?

Background FHA and VA are the principal providers of federally backed mortgage

insurance. Together, they insured 46 percent of all the insured mortgages

originated in 1995; FHA insured 32 percent and VA insured 14 percent.1

FHA-insured single-family mortgages in the Fund were valued at about

$337 billion as of September 30, 1996. Although eligibility for VA’s program

is limited to U.S. veterans and their families and to certain active duty

military personnel, FHA’s program may be used by any household that

meets financial underwriting and loan amount requirements. However, a

1

The remaining insured mortgages were insured by private companies, and a very small portion (less

than 1 percent) was insured by the Department of Agriculture’s Rural Housing Service. Although VA

actually guarantees rather than insures mortgages, this report uses the term “mortgage insurance” to

refer to the guaranty provided by VA as well as the insurance provided by FHA, the Rural Housing

Service, and private mortgage insurers.

Page 2 GAO/RCED-97-93 Homeownership
Executive Summary

primary goal of FHA is to assist households who may be underserved by the

private market.

Home mortgage lenders usually require mortgage insurance when a home

buyer has a down payment of less than 20 percent of the value of the home

because defaults are more likely on these loans than on loans with greater

down payments. If an FHA-insured mortgage goes to foreclosure, FHA pays

the lender for virtually all of the losses associated with the property and

then almost always takes possession of and subsequently sells the

property. VA, on the other hand, has the following two options if a

mortgage it has insured goes to foreclosure: (1) paying the lender the

insurance due and leaving the property with the lender or (2) purchasing

the property from the lender and reselling it. For example, if the cost of

paying the insurance claim is less than the estimated costs of taking

possession of the property and reselling it, VA will choose the former—this

is referred to as a VA no-bid. If VA chooses the “no-bid” option, the limit on

the amount that VA guarantees against loss is from 25 to 50 percent of the

mortgage’s balance, depending on the original loan amount. The partial VA

guaranty allows VA the option of leaving a foreclosed property with the

lender. Similarly, a reduction in FHA’s insurance coverage could result in

FHA leaving foreclosed properties with lenders and paying only the insured

portion of the mortgage’s balance.

FHA’s primary single-family mortgage program currently requires no federal

funds to operate. The Fund, which supports this program, is required by

law to contain sufficient reserves and funding to cover the estimated

future payment of claims on foreclosed mortgages and other costs. Cash

flows into the Fund from insurance premiums and from the sale of

foreclosed property. According to Price Waterhouse’s most recent study of

the Fund’s financial soundness issued in February 1997, at the end of fiscal

year 1996, the Fund had an estimated economic value/reserves of about

$9.4 billion and an estimated capital reserve ratio of 2.54 percent—a ratio

greater than the 2-percent capital reserve ratio target set by the Congress

for fiscal year 2000.2

 The reserves in the Fund have always been more than

enough to cover the expenses incurred. However, if the Fund were to

deplete its reserves, the U.S. Treasury would have to directly cover

lenders’ claims and other costs of the program, by law. On the other hand,

VA’s program is not required to be self-sustaining; VA’s program receives an

appropriation of federal funds each year.

2

The capital reserve ratio is the economic value/reserves of the Fund expressed as a percentage of the

outstanding principal balance of FHA-insured loans (insurance-in-force). The economic value/reserves

of the Fund are the current assets available to the Fund, plus the net present value of all future cash

inflows and outflows expected to result from mortgages insured under the Fund.

Page 3 GAO/RCED-97-93 Homeownership
Executive Summary

In 1995, virtually all FHA- and VA-insured mortgages were pooled into

securities that were then sold to investors with the help of Ginnie Mae,

which, like FHA, is a part of HUD. Under Ginnie Mae’s program, issuers of

securities backed by pooled mortgages sell the securities to investors.

Issuers can be mortgage bankers, savings institutions, or other financial

intermediaries. The investors that buy the securities are guaranteed by

Ginnie Mae to receive timely principal and interest payments, regardless of

the performance of the mortgages backing the securities or the issuer’s

performance. Ginnie Mae’s net revenues (after expenses) totaled

$515 million in fiscal year 1996. Ginnie Mae derived its revenues from

interest on U.S. securities and fees collected from lenders to cover its

costs and offset its future payments of claims under the guaranty

representing its major sources of revenues.

The actual impact of a reduction in insurance coverage on the financial

condition of the Fund will depend on future economic conditions. Since

uncertainty always exists when forecasting future economic conditions,

especially over a long period of time, GAO prepared estimates of the

financial impact on the Fund under three different economic scenarios (a

baseline, an optimistic, and a pessimistic scenario), assuming a different

rate of appreciation in the price of homes over the next 30 years for each

economic scenario.3

Results in Brief If FHA’s insurance coverage is reduced and lenders become responsible for

the risk associated with the uninsured portion of loans, lenders will likely

make fewer and more costly FHA loans. The general consensus of a

HUD-sponsored lender focus group was that the number of FHA-insured

loans would fall by about 28 percent and that interest rates would increase

by one-quarter to one-half of a percent.4

 Although some decrease in

volume and increase in interest rates would be likely, GAO’s analyses

indicate that the changes would likely not be as great as those that the

focus group predicted. This is because the higher revenues earned by

lenders from a one-quarter percent increase in interest rates would likely

3

Although future economic conditions are uncertain, GAO placed greater emphasis in this report on its

baseline economic scenario because it assumes slightly lower house price appreciation than the rates

forecasted by DRI/McGraw-Hill, a private economic forecasting company that GAO used in developing

its economic scenarios. GAO’s baseline scenario assumes house price appreciation rates to be

1 percentage point lower than DRI’s forecast. GAO’s optimistic and pessimistic economic scenarios

assume a house price appreciation of 2 percentage points higher or lower than the baseline,

respectively.

4

In October 1995, HUD held a lender focus group to identify lenders’ anticipated responses to a

reduction in FHA’s insurance coverage. The lenders represented in the focus group were responsible

for 35 to 40 percent of all FHA-insured loans in 1994.

Page 4 GAO/RCED-97-93 Homeownership
Executive Summary

produce more than enough revenue to lenders to cover any losses that

they would incur if FHA’s insurance coverage were reduced. Moreover,

according to VA officials, there was no discernible reduction in the volume

of VA loans after the Department’s current policy of limiting losses on each

property to the guarantee amount—referred to as the “no-bid”

policy—went into effect in 1985. Nevertheless, any reduction in the

volume of loans and increase in interest rates is likely to

disproportionately affect higher-risk borrowers—low-income, first-time,

and minority borrowers and those individuals purchasing older

homes—the types of borrowers frequently served by FHA.

Although uncertainty is associated with any forecast, the federal

government would likely improve the financial health of the Fund—by

lowering its exposure to financial losses—if FHA’s insurance coverage were

reduced, according to GAO’s analyses. Specifically, the ratio of the capital

reserves/economic value in the Fund to its outstanding insurance

liabilities—the capital reserve ratio—would likely increase over time if FHA

provided only the partial coverage currently used by VA. This would likely

occur in part because FHA would be liable for only a portion of the losses

on loans that go to foreclosure and therefore would suffer lower financial

losses than it would under full insurance coverage. The losses thus

avoided by partial insurance coverage would more than offset the

premium income lost from a reduction in the volume of FHA loans.

Decreasing FHA’s insurance coverage would have an even greater positive

impact on the Fund’s capital reserve ratio if future economic conditions

are worse than the conditions assumed in GAO’s baseline scenario. This

would likely occur because FHA would face a greater number of insurance

claims under adverse economic conditions and, in turn, the reduction in

claims payments with partial insurance coverage rather than with full

coverage would be greater.

Reducing FHA’s insurance coverage might shift some losses from FHA to

Ginnie Mae. When lenders who have issued securities backed by pools of

FHA- and VA-insured mortgages are unable to pay investors in these

securities, Ginnie Mae steps in and provides the investor with payments.

Reducing FHA’s insurance coverage might increase costs for Ginnie Mae if

more lenders were unable to make payments to investors because they

could not shoulder their portion of the losses on defaulted FHA-insured

loans. However, if lenders respond to a reduction in FHA’s insurance

coverage by taking steps to maintain their financial position, such as

targeting FHA-insured loans away from the riskiest borrowers and

Page 5 GAO/RCED-97-93 Homeownership
Executive Summary

increasing interest rates, the impact on Ginnie Mae’s losses would likely be

lessened.

GAO’s Analysis

Lenders Are Likely to

Make Fewer and More

Costly Loans to

Higher-Risk Borrowers If

FHA’s Coverage Is Reduced

Lenders are likely to reduce the number of FHA-insured loans made each

year by tightening underwriting standards and increasing interest rates if

FHA reduces the portion of losses it will cover on loans that go to

foreclosure. The lender focus group convened by HUD indicated that an

interest rate increase of one-quarter to one-half a percentage point for

FHA-insured loans would be necessary to compensate them for the

additional risk they would face.5

 According to GAO’s analysis, an interest

rate increase of one-quarter percentage point—the lowest figure in the

range estimated by the focus group—would produce more than enough

revenue to cover lenders’ estimated losses, even under the most adverse

economic conditions experienced by FHA in the last 20 years. The focus

group also projected that FHA’s volume of loans would fall by 28 percent if

its insurance coverage were reduced. However, VA officials told GAO that

there was no discernible reduction in the volume of VA loans after VA’s

current no-bid policy went into effect in 1985. If lenders do not increase

interest rates as much as the focus group predicted or if the rate increase

is targeted to higher-risk borrowers, as is likely, the volume of loans made

by FHA following a coverage reduction would likely fall by less than

28 percent.

Regardless of the size of the reduction in FHA’s loan volume, reducing FHA’s

insurance coverage would likely have a greater effect on low-income,

first-time, and minority borrowers, as well as on individuals purchasing

older homes, than on other borrowers with better access to private

mortgage credit. Lenders indicated that they would probably tighten

underwriting standards for FHA-insured loans to target them away from

borrowers in higher-risk categories. GAO’s analysis indicates that, all else

held equal, the loss rate and/or rate of foreclosure for minorities, buildings

with multiple living units, loans written at higher interest rates, older

properties, and smaller loans are higher, suggesting that those are the

5

An interest rate increase of one-quarter to one-half percent on a $100,000, 30-year loan, originated at

8 percent, would increase monthly mortgage payments by $17 to $35, respectively.

Page 6 GAO/RCED-97-93 Homeownership
Executive Summary

types of loans that lenders would likely refrain from making.6 Reducing

FHA’s insurance coverage would also lessen FHA’s ability to stabilize local

housing markets during regional economic downturns.

Reducing FHA’s Insurance

Coverage Would Likely

Increase the Fund’s Capital

Reserve Ratio

The capital reserve ratio of the Fund would likely increase if insurance

coverage levels were reduced. For each partial coverage scenario that GAO

examined, the estimated capital reserve ratio for loans made by FHA in

fiscal year 1995 is at least 25 percent higher than GAO’s estimate of that

ratio under full coverage. This higher ratio would occur because FHA

would cover a smaller percentage of the losses on each foreclosed loan

and because lenders would likely make fewer FHA-insured loans to

higher-risk borrowers, thus exposing FHA to less risk than with full

coverage. The capital reserve ratio is likely to increase regardless of

whether FHA implements a partial coverage schedule identical to VA’s or

uses one of the other partial coverage options that GAO examined.7

The impact of reducing FHA’s insurance coverage on the estimated

economic value/reserves of the loans that FHA will insure in the future is

less certain than the impact of reducing FHA’s insurance coverage on the

capital reserve ratio, assuming baseline economic conditions. The

economic value of FHA loans is important for various reasons. First, the

estimated economic value represents capital reserves that, when divided

by the outstanding principal amount of FHA loans, equal the estimated

capital reserve ratio. Second, the economic value provides an estimate of

how profitable these loans are for FHA, which is important because

estimated increases in economic value due to legislative changes allow

additional mandatory spending authorizations to be made, other revenues

to be reduced, or projected deficits in the federal budget to be reduced.

If FHA’s insurance coverage is reduced, the change in the economic value

of FHA loans will depend largely on the way that lenders respond. The

smaller the reduction in FHA-insured loans that lenders make and the

greater their ability to target FHA loans to less-risky borrowers, the greater

the positive effect on the economic value of the new loans insured. GAO’s

estimates under baseline economic conditions of the economic value of

6

Buildings with multiple living units are homes containing two to four living units, such as duplexes.

Provided that they contain no more than four units, these homes are eligible for mortgage insurance

through FHA’s primary program.

7

In addition to analyzing the impact of reducing FHA’s insurance coverage to VA’s current level of

coverage, GAO also examined two other alternatives—(1) the impact of retaining full FHA insurance

coverage for first-time home buyers and VA coverage for all repeat buyers and (2) reducing FHA’s

insurance coverage for all new FHA loans but to a level slightly higher than VA’s.

Page 7 GAO/RCED-97-93 Homeownership
Executive Summary

the loans made by FHA in fiscal year 1995, assuming partial insurance

coverage, range from about $29 million less than to $150 million greater

than GAO’s full coverage estimate of $536 million.

Under GAO’s pessimistic economic scenario, which assumes house price

rates of appreciation of 2 percentage points lower than GAO’s baseline

economic scenario, reducing FHA’s insurance coverage could have a much

greater positive effect on FHA’s economic value and the resulting capital

reserve ratio. GAO estimates that a reduction in FHA’s insurance coverage

could increase economic value by as much as $150 million under baseline

economic conditions, compared with an increase in economic value of as

much as $199 million under pessimistic economic conditions.

Reducing FHA’s Insurance

Coverage Might Shift Some

Losses to Ginnie Mae

Reducing FHA’s insurance coverage might shift some losses from FHA to

Ginnie Mae. Ginnie Mae is ultimately responsible for ensuring that

investors receive timely principal and interest payments on securities

backed by pools of FHA and VA mortgages. Ginnie Mae’s costs increased

after changes in VA’s “no-bid” procedures took effect in the 1980s, in part

because lenders were left to cover a portion of the losses on VA-guaranteed

loans more often than they had in the past, causing some lenders to

default.8

 When lenders default, Ginnie Mae takes over the lenders’ entire

portfolio of FHA and VA loans that have been pooled into securities and

becomes responsible for making timely payments to investors of any

shortfalls in principal and interest payments. In addition, Ginnie Mae

incurs costs for paying taxes and insurance, as well as costs associated

with acquiring, managing, and disposing of portfolio properties.

The extent to which Ginnie Mae’s losses might increase depends largely on

lenders’ responses to a reduction in FHA’s insurance coverage. If lenders

respond by very carefully targeting FHA-insured loans away from the

most-risky borrowers, fewer loans will default, and lenders will be in a

better position to cover their share of the losses for the FHA-insured loans

that default anyway. The increase in losses for Ginnie Mae will then be

lower than if lenders did not target loans as carefully. Similarly, if lenders

increase interest rates on FHA-insured loans, they will have more funds for

covering their share of the losses on the loans that default. Fewer losses

8

In 1984, the Congress enacted provisions of the Deficit Reduction Act to, among other things, reduce

the losses associated with foreclosures on VA home loans. The act required VA, in deciding whether to

pay the VA guaranty on defaulted loans or acquire the property, to limit its loss to the amount of the

guaranty. The act also required VA, in deciding whether to acquire a property, to consider

post-acquisition costs that were previously excluded from VA’s decision. After the implementation of

these provisions in 1985, the number of VA no-bids increased substantially—rising from 2 percent of

all VA foreclosures in 1982 to 24 percent in 1988.

Page 8 GAO/RCED-97-93 Homeownership
Executive Summary

will then be shifted to Ginnie Mae as a result of a reduction in FHA’s

insurance coverage.

Reducing FHA’s insurance coverage would not likely affect Ginnie Mae’s

ability to provide lenders of FHA and VA loans with liquidity (cash), since

Ginnie Mae’s securities would continue to maintain the U.S. Government’s

full faith and credit guarantee.

Agency Comments GAO provided HUD and VA with a draft of this report for their review and

comment. GAO received written comments on the draft report from HUD.

(See app. IV.) In addition, GAO received comments on the draft report from

Ginnie Mae’s Executive Assistant, which are discussed at the end of

chapter 4. VA’s Acting Under Secretary for Benefits provided GAO with a

memorandum that clarified changes to information contained in the report

and updated figures with more recent information. Where appropriate, GAO

incorporated VA’s clarifications into the report.

HUD disagreed with some of the conclusions reached by GAO. For example,

HUD stated that it believes, on the basis of its analysis, which assumed a

slightly higher rate of appreciation in house prices than that assumed in

GAO’s baseline and a 28-percent reduction in loan volume, that reducing

FHA’s insurance coverage will decrease the economic value of the Fund.

HUD also stated that GAO overstates the private sector’s ability to accept the

transfer of risk. HUD said that the increase in price and rationing that will

occur is understated by GAO and that eliminating the catastrophic coverage

feature (insurance against all losses) of FHA insurance could result in

losses that quickly overwhelm the resources of lenders. HUD also stated

that GAO gives inadequate attention to the potential that FHA’s lenders will

withdraw from the marketplace in times of economic downturns under a

partial insurance model.

GAO agrees with HUD that under certain combinations of assumptions about

the rate of appreciation in house prices and reductions in loan volume, the

estimated economic value of FHA loans would be less than under full

insurance coverage. In general, the smaller the reduction in loan volume,

the higher the economic value contributed by the remaining loans insured

by FHA, according to GAO’s analysis. Under its baseline scenario,9 GAO

estimates a small ($29 million) decline in economic value from changing to

9

As in previous reports, GAO continues to use a slightly lower rate of appreciation in house prices than

forecasted (1 percentage point) in its baseline estimate to be conservative in assessing the impact of

reducing FHA’s insurance coverage on the capital reserve ratio, which is a measure of how well the

Fund can withstand difficult economic conditions.

Page 9 GAO/RCED-97-93 Homeownership
Executive Summary

partial insurance if the loan volume drops by 28 percent and lenders only

loosely target their application denials toward high-risk categories of

borrowers. Furthermore, under its optimistic economic scenario, which

assumes higher-than-expected rates of house price appreciation, GAO

estimates that the economic value of FHA’s fiscal year 1995 loans will likely

decline by about $67 million to $94 million below the value achieved under

full insurance if the volume of loans is reduced by 28 percent. However,

GAO believes that a 28-percent reduction in the volume of loans may not be

likely and that such a fall in the volume of loans is even more unlikely if

house prices increase at a rate greater than forecasted. Moreover, while

both GAO’s and HUD’s analyses estimate that economic value would likely

be reduced under certain assumptions, both analyses estimate that under

these same assumptions, the capital ratio will be higher under partial

insurance than under full insurance.

HUD believes that GAO is understating the likely increase in price (interest

rates) resulting from partial insurance. GAO disagrees. GAO’s analysis of the

adequacy of the additional revenues that would be earned by lenders from

a one-quarter-percent increase in interest rates to cover additional losses

resulting from partial insurance is based on the most adverse economic

conditions experienced by FHA in the last 20 years. While it is difficult to

quantify the volatility of losses, GAO’s analysis suggests that lenders would

likely earn more than enough revenues to cover losses from a reduction in

FHA’s insurance coverage even under extremely adverse circumstances.

Under GAO’s baseline economic scenario, this increase in interest rates

would cover losses several times over. As a result, GAO believes that it is

unlikely that interest rates would increase by as much as one-quarter

percentage point in a competitive marketplace. While GAO agrees that

catastrophic losses may overwhelm the resources of some lenders, it does

not believe that such losses would jeopardize FHA. During the lender focus

group meeting, FHA lenders still concluded that making FHA loans under

partial insurance is profitable and that 72 percent of FHA’s loan volume

would be retained.

In response to HUD’s comment on the potential that FHA’s lenders would

withdraw from the marketplace in times of economic downturn under a

partial insurance model, GAO has added information describing the role of

FHA as a countercyclical force in the market during times of economic

hardship and the adverse impact that partial insurance could have on this

role. GAO’s detailed responses and HUD’s entire comments appear in

appendix IV and are summarized and discussed at the end of chapters 2

through 4.

Page 10 GAO/RCED-97-93 Homeownership
Page 11 GAO/RCED-97-93 Homeownership
Contents

Executive Summary 2

Chapter 1 

Introduction

16

FHA’s Insurance Coverage Is Higher Than That of Other Insurers 16

FHA Is the Biggest Federal Insurer, but Private Mortgage Insurers

Serve the Most Home Buyers

17

Customers Targeted by FHA and VA 18

FHA’s Program Is Financially Self-Sufficient, but VA’s Program Is

Not

19

Ginnie Mae Connects Federally Insured Mortgages With

Secondary Market Investors

20

Objectives, Scope, and Methodology 20

Chapter 2 

If FHA’s Insurance

Coverage Is Reduced,

Lenders May Make

Fewer and Higher

Interest Loans to

Some Types of

Borrowers

24

Mortgage-Lending Industry Officials Anticipate a Reduction in the

Volume of Loans and an Increase in Interest Rates

25

Lenders’ Estimates of the Reduction in FHA’s Volume of Loans

and Increase in FHA’s Interest Rates May Be Overstated

26

VA’s Views on Limited Insurance Coverage Differ From Lenders’

Views

28

Limiting FHA’s Insurance Coverage May Cause Changes in the

Lending Industry

28

Reducing FHA’s Insurance Coverage May Make It More Difficult

for Some Borrowers to Purchase a Home

29

Agency Comments and Our Evaluation 33

Chapter 3 

Reducing FHA’s

Insurance Coverage

Would Likely Improve

the Financial Health

of FHA’s Fund

36

Our Approach to Forecasting FHA’s Capital Reserve Ratio Under

Partial Insurance Coverage

37

Our Baseline Estimates of Increases in the Fund’s Capital Ratio

Attributable to Partial Insurance

39

Our Estimates Under Other Economic Scenarios 41

Conclusions 43

Agency Comments and Our Evaluation 44

Page 12 GAO/RCED-97-93 Homeownership
Contents

Chapter 4 

Reducing FHA’s

Insurance Coverage

May Transfer Some

Financial Losses to

the Government

National Mortgage

Association

45

Reducing FHA’s Insurance Coverage May Contribute to Some

Issuers’ Defaults and Resulting Losses for Ginnie Mae

46

Ginnie Mae’s Exposure to Losses Depends on How Lenders

Respond to a Reduction in FHA’s Insurance Coverage

49

Agency Comments and Our Evaluation 49

Appendixes Appendix I: Description of Interest Rate Change Analyses 52

Appendix II: Loss Rate Estimates and Volume-Reduction

Scenarios

55

Appendix III: Other Approaches Would Result in More Modest

Changes to the Fund’s Capital Ratio

60

Appendix IV: Comments From the Department of Housing and

Urban Development

62

Appendix V: Major Contributors to This Report 78

Related GAO Products 80

Tables Table 1.1: VA’s Partial Guarantee Schedule 16

 Table 3.1: GAO’s Estimates of the Impact of Reducing Insurance

Coverage to VA’s Levels on Loans Insured by FHA in Fiscal Year

1995, Under Base Case Economic Conditions

40

 Table 3.2: Estimates of the Impact of Reducing Insurance

Coverage to VA’s Levels on Loans Insured by FHA in Fiscal Year

1995, Under Pessimistic Economic Conditions

42

Table 3.3: Estimates of the Impact of Reducing Insurance

Coverage to VA’s Levels on Loans Insured by FHA in Fiscal Year

1995, Under Optimistic Economic Conditions

43

 Table I.1: Estimated Net Revenue to Lenders if They Had

Increased Interest Rates by One-Quarter of a Percent in Response

to an Insurance Coverage Reduction for FHA’s 1981 Loans

53

 Table II.1: Impact of Characteristics of Borrowers, Loans, and

Properties on Loss Rates

56

Table II.2: Impact of Selected Characteristics of Borrowers,

Loans, and Properties on Loss Rates

57

Page 13 GAO/RCED-97-93 Homeownership
Contents

 Table III.1: Estimates of the Impact of Alternative Insurance

Coverage Reduction Approaches on Loans Insured by FHA in

Fiscal Year 1995, Under Base Case Economic Conditions

61

Figures Figure 1.1: All Insured Mortgages, by Insurer, 1985-95 18

Figure 2.1: Proportion of Home Purchase Loans Insured in 1994

for Low-Income Borrowers and Minorities

30

Abbreviations

FHA Federal Housing Administration

GAO General Accounting Office

Ginnie Mae Government National Mortgage Association

HUD Department of Housing and Urban Affairs

LTV loan-to-value (ratio)

MBA Mortgage Bankers Association

SAMS Single-Family Accounting Management System

VA Department of Veterans Affairs

Page 14 GAO/RCED-97-93 Homeownership
Page 15 GAO/RCED-97-93 Homeownership
Chapter 1 

Introduction

Mortgage insurance helps home buyers with limited down payment funds

to obtain mortgages. It is generally used when a borrower makes a down

payment of less than 20 percent of the value of the home—when the

mortgage has a loan-to-value (LTV) ratio greater than 80 percent. Most

lenders require mortgage insurance for these loans because they are more

likely to default than loans with lower LTV ratios. If a loan with mortgage

insurance defaults, the lender may foreclose on the loan and collect all or

a portion of the losses from the insurer. Losses generally include the

unpaid principal balance and delinquent interest due on the loan, legal

expenses incurred during foreclosure, the expense of maintaining the

home, and any advances that the lender made to pay taxes or insurance.

The primary mortgage insurers are the Department of Housing and Urban

Development’s (HUD) Federal Housing Administration (FHA), the U.S.

Department of Veterans Affairs (VA), and private mortgage insurance

companies.10 Although FHA operates a number of single-family mortgage

insurance programs, its primary program is the Section 203(b)

Single-Family Mortgage Insurance program.

FHA’s Insurance

Coverage Is Higher

Than That of Other

Insurers

While FHA’s Section 203(b) program protects lenders against nearly

100 percent of the loss associated with a foreclosed mortgage, VA and

private mortgage insurers limit their coverage to a portion of the

mortgage’s balance. The amount that VA guarantees against loss is

established by legislation and has periodically increased. Furthermore,

VA’s guaranty depends on the loan’s original amount, as shown in table 1.1

below:

Table 1.1: VA’s Partial Guarantee

Schedule Loan’s original amount VA’s guaranty

Less than or equal to $45,000 50% of the loan

Greater than $45,000,

but not more than $56,250

$22,500

Greater than $56,250,

but not more than $144,000

40% of the loan or $36,000,

whichever is less

Greater than $144,000 25% of the loan or $50,750,

whichever is less

When a loan that it has guaranteed goes to foreclosure, VA chooses

between (1) paying the amount of insurance due on the property and

leaving it with the lender or (2) purchasing the property from the lender,

10For additional information on the insurance offered and borrowers served by FHA, VA, and private

mortgage insurers, see our August 1996 report entitled Homeownership: FHA’s Role in Helping People

Obtain Home Mortgages (GAO/RCED-96-123).

Page 16 GAO/RCED-97-93 Homeownership
Chapter 1 

Introduction

taking possession of it, and reselling it. VA selects the option that is likely

to be more financially advantageous. Specifically, if the guarantee amount,

as calculated according to the guidelines shown in table 1.1, is less than

the net expected costs of taking possession of the property and reselling it,

VA is required by law to choose the former option—this is generally

referred to as a VA “no-bid” because VA limits its losses by not acquiring the

property.11 Fewer than 12 percent of VA’s foreclosures during fiscal years

1990 through 1996 were “no-bids,” resulting in losses to lenders. The

“no-bid” policy allows VA the option of not bidding on a foreclosed

property, leaving the property with the lender, and limiting VA’s losses to

the guaranty amount.

For private mortgage insurers, the type and amount of coverage selected

by the lender determine how much the private mortgage insurer will pay if

the borrower defaults and the lender must foreclose. Typically, this

amount is limited to 20 percent to 30 percent of the losses but can go as

high as 35 percent.

FHA Is the Biggest

Federal Insurer, but

Private Mortgage

Insurers Serve the

Most Home Buyers

FHA serves more homeowners than VA, but private mortgage insurers

account for most of the mortgage insurance market, according to data on

loans insured in 1995.12 From 1985 through 1995, FHA’s share of all loans

insured each year has fluctuated from a low of 29 percent in 1992 to a high

of 51 percent in 1987. VA’s share during this period stayed at 13 to

20 percent. Private mortgage insurers’ share during the same period

fluctuated from a low of 29 percent in 1987 to a high of 57 percent in 1992.

The relative market shares of FHA, VA, and private mortgage insurers are

shown in figure 1.1.

11When determining whether to pay the guaranty amount or acquire the property, VA calculates the

costs of acquiring and reselling the property by considering the following two primary factors: (1) the

total indebtedness on the property (the outstanding mortgage balance, interest, and allowable charges)

and (2) the net value of the property (the appraised fair market value minus the administrative costs of

holding and reselling the property, currently estimated at 15.11 percent of the fair market value). If the

total indebtedness minus the guaranty amount (i.e., the unguaranteed portion) is greater than the net

value of the property, VA considers it as a “no-bid” case and will not acquire the property.

12The Department of Agriculture’s Rural Housing Service also insures a small number of mortgages

each year.

Page 17 GAO/RCED-97-93 Homeownership
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Introduction

Figure 1.1: All Insured Mortgages, by Insurer, 1985-95a

Percent of insured mortgages

0

10

20

30

40

50

60

70

80

90

100

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995

Year of origination

VA

Private mortgage insurers

FHA

aThis figure does not include data on the small number of loans insured through the Department

of Agriculture’s Rural Housing Service.

Source: GAO’s analysis of HUD’s data.

Customers Targeted

by FHA and VA

Although a primary goal of FHA is to assist borrowers who may be

underserved by the private market, any household who takes out a loan no

greater than FHA’s maximum loan amount and who meets other financial

qualifications is eligible to obtain FHA’s mortgage insurance.13 VA’s

insurance is available only to U.S. veterans, their families, and certain

active duty military personnel. Like FHA insurance, private mortgage

insurance is available to any household who meets the insurer’s loan

guidelines and financial qualifications.

13The maximum loan amount permitted under FHA’s program for single-family homes in the highest

cost areas in the continental United States is currently set at $160,950.

Page 18 GAO/RCED-97-93 Homeownership
Chapter 1 

Introduction

FHA’s Program Is

Financially

Self-Sufficient, but

VA’s Program Is Not

Unlike VA, FHA requires no federal funds to carry out its primary

single-family mortgage insurance program. Borrowers who obtain

FHA-insured mortgage loans pay insurance premiums, which are deposited

into HUD’s Mutual Mortgage Insurance Fund (Fund). According to studies

conducted by GAO and Price Waterhouse, the Fund’s reserves exceed those

needed to meet the legislatively prescribed capital reserve ratio.14 Price

Waterhouse reported that the Fund had an estimated capital reserve ratio

of 2.54 percent at the end of fiscal year 1996—a ratio greater than the

2-percent target set in 1990 by the Congress for fiscal year 2000. Capital

reserve ratio estimates are computed by presenting the net present value

of all future cash inflows and outflows expected to result from the

mortgages insured by FHA (the economic value of the Fund) as of the end

of a fiscal year, plus accumulated reserves, as a percentage of the total

insurance-in-force at that time. Price Waterhouse estimated that by 2000,

this ratio would be 3.57 percent. In addition to the capital reserve ratio,

Price Waterhouse estimated that the economic value of the loans insured

by FHA would increase from $9.4 billion at the end of fiscal year 1996 to

$14.8 billion by the end of fiscal year 2000. Economic value provides an

estimate of the profitability of FHA loans, which is important because

estimated increases in economic value due to legislative changes allow

additional mandatory spending authorizations to be made, other revenues

to be reduced, or projected deficits in the federal budget to be reduced.

Although the most recent estimate of the Fund’s capital reserve ratio

exceeds the 2-percent legislative target, the Fund experienced substantial

losses during the 1980s. This occurred primarily because foreclosure rates

on single-family homes supported by the Fund were high in economically

stressed regions. To help place the Fund on a financially sound basis,

legislative reforms such as requiring FHA borrowers to pay more in

insurance premiums were made in 1990.

VA’s program requires an annual federal appropriation because premiums

collected from borrowers of VA-insured mortgages do not cover the

estimated future losses for these mortgages. In 1996, VA received a credit

subsidy of $697 million for covering costs associated with its mortgage

insurance operations.

14Mortgage Financing: FHA Has Achieved Its Home Mortgage Capital Reserve Target

(GAO/RCED-96-50, Apr. 12, 1996) and An Actuarial Review for Fiscal Year 1996 of the Federal Housing

Administration’s Mutual Mortgage Insurance Fund: Final Report, Price Waterhouse LLP (Feb. 14,

1997).

Page 19 GAO/RCED-97-93 Homeownership
Chapter 1 

Introduction

Ginnie Mae Connects

Federally Insured

Mortgages With

Secondary Market

Investors

Almost all mortgages insured by FHA and VA are pooled into securities that

are then sold to investors with the help of HUD’s Government National

Mortgage Association (Ginnie Mae). Issuers of Ginnie Mae securities can

be mortgage bankers, savings institutions, or other financial

intermediaries. The investors that buy the securities are guaranteed by

Ginnie Mae to receive timely principal and interest payments, regardless of

the performance of the mortgages backing the securities or the issuer’s

performance. At the end of fiscal year 1996, Ginnie Mae had outstanding

guarantees of mortgage-backed securities totaling $533 billion.

Objectives, Scope,

and Methodology

To obtain information on the impact of reducing FHA’s insurance coverage,

the Chairman, Subcommittee on Housing and Community Opportunity,

House Committee on Banking and Financial Services, asked us to address

the following three questions: (1) How are lenders and the market

expected to react to an increased risk of loss to lenders and how will this

affect FHA’s borrowers? (2) What potential financial impact will reducing

FHA’s coverage have on the Fund under different economic conditions?

(3) What are the potential impacts of reducing FHA’s insurance coverage on

Ginnie Mae?

To identify lenders’ anticipated responses to a reduction in FHA’s insurance

coverage, we reviewed Price Waterhouse’s summary of the results of a

focus group held in October 1995 by HUD and interviewed officials from

four mortgage-lending institutions. The lenders represented in the focus

group were responsible for approximately 35 to 40 percent of all

FHA-insured loans in 1994. The four lenders that we interviewed were

among the largest FHA lenders in four regions. One of these lenders is the

largest FHA lender nationwide, and 1 was among the 14 lenders in HUD’s

focus group.

We analyzed the reasonableness of the interest rate increase and loan

volume decrease predicted by the lenders that participated in HUD’s focus

group. Specifically, we analyzed the group’s estimated interest rate

increase by comparing the increase in lenders’ revenues likely to result

from the rate increase with the increase in lenders’ losses likely to result

from a reduction in FHA’s insurance coverage. Appendix I presents a more

detailed discussion of this analysis. We analyzed the volume decrease

predicted by the focus group by considering the following factors: (1) the

potential effect of an interest rate increase on the number of FHA-insured

loans made, (2) the likelihood that lenders would target an interest rate

Page 20 GAO/RCED-97-93 Homeownership
Chapter 1 

Introduction

increase toward higher-risk borrowers, and (3) the impact of tighter

underwriting standards on FHA’s volume of loans in the long run.

To obtain information on the types of borrowers that would most likely be

affected by an insurance coverage reduction, we obtained information

from VA and FHA on their mortgage insurance programs and the types of

borrowers they currently serve. We also used HUD’s data on foreclosed

properties and on the demographic characteristics of FHA’s borrowers to

conduct a regression analysis. Specifically, we analyzed the effects of

several variables on total loss rates and losses to the lender.15 Appendix II

presents a more detailed discussion of this analysis.

To estimate the impact that reducing FHA’s insurance coverage to VA levels

would have on the estimated capital reserve ratio of the Fund, we used an

econometric model of FHA’s loan terminations and a model of the cash

flows associated with FHA mortgages, both of which had been developed

for a previous GAO report.16 Specifically, we used these models to estimate

the impact of reducing FHA’s insurance coverage on the estimated

economic value and the resulting capital reserve ratio for loans insured by

FHA in fiscal year 1995 under three different economic scenarios. Our

baseline economic scenario assumes that house price appreciation rates

are 1 percentage point lower than those in forecasts prepared by

DRI/McGraw-Hill, a private economic-forecasting company. Our

pessimistic economic scenario assumes that house price appreciation

rates are 2 percentage points lower than our baseline. Our optimistic

economic scenario assumes that house price appreciation rates are

2 percentage points higher than our baseline. Although future economic

conditions are uncertain, to be conservative in assessing the impact of

reducing FHA’s insurance coverage on the capital reserve ratio and to be

consistent with past analyses that we have made of the actuarial condition

of FHA’s Fund, we placed greater emphasis on the estimates prepared

under the baseline economic scenario. Our estimates of the impact of

reducing FHA’s insurance coverage on the Fund’s capital reserve ratio are

based on the assumption that FHA’s current premium structure would not

change following a reduction in FHA’s insurance coverage. Furthermore,

because lenders’ responses to a reduction in insurance coverage play an

important role in the impact of a reduction on FHA’s Fund, we also

15We defined loss rate as the loss (or profit) on a foreclosed property divided by the acquisition cost.

We defined acquisition cost as the claim paid by FHA plus any extra costs incurred for FHA’s

acquisition of the property. We defined loss to the lender as any loss in excess of the amount that

would be covered under VA’s guarantee limits.

16See our April 1996 report entitled Mortgage Financing: FHA Has Achieved Its Home Mortgage Capital

Reserve Target (GAO/RCED-96-50).

Page 21 GAO/RCED-97-93 Homeownership
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Introduction

prepared estimates assuming several different FHA loan volume reduction

scenarios.

Our econometric analysis estimated the historical relationships between

the probability of a loan’s foreclosure and prepayment and key

explanatory factors, such as the borrower’s equity and the interest rate.

Using our estimates of these relationships, we developed forecasts of

future loan performance to estimate the economic net worth and resulting

capital reserve ratio for FHA loans originated in fiscal year 1995 under the

three economic scenarios. We selected loans made in fiscal year 1995

because it was the most recent year for which complete data were

available and because any change in FHA’s insurance coverage would apply

only to new FHA-insured loans and not to FHA’s entire portfolio of existing

loans. The econometric model and equations used to forecast the impact

on the fiscal year 1995 loans were developed on the basis of historical data

on the performance of FHA loans originated from fiscal year 1975 through

fiscal year 1994.

We looked primarily at the impact of reducing FHA’s coverage to VA’s levels.

However, we also looked at the impact of two alternative scenarios for

reducing FHA’s coverage: (1) retaining full coverage for first-time home

buyers but reducing coverage to VA’s levels for repeat buyers and

(2) imposing a graduated coverage schedule that provides slightly higher

coverage levels than VA’s program for loans of low and moderate

size—60 percent coverage for the lowest loan amounts, declining to

30 percent for the highest loan amounts. These scenarios are discussed in

greater detail in appendix III.

We obtained data from FHA’s property disposition database—the

Single-Family Accounting Management System (SAMS)—so that we could

examine the division of foreclosed loan losses between FHA and mortgage

lenders if FHA were to change from full to partial insurance. We calculated

the loss rate and determined what fraction of the loss rate would be paid

by FHA, recognizing that the remainder would be paid by the lender, under

a partial insurance program like VA’s and assuming a no-bid type policy in

effect for FHA. Appendix II presents a detailed explanation of this analysis.

To obtain information on the potential impacts on Ginnie Mae, we met

with Ginnie Mae officials and reviewed an analysis conducted by Price

Waterhouse for them on the likely results of reducing FHA’s insurance

coverage.

Page 22 GAO/RCED-97-93 Homeownership
Chapter 1 

Introduction

Our analysis of the implications of limiting the insured portion of future

FHA-insured loans to that used by VA did not include assessing the

implications of such a change on FHA’s staffing levels.

We performed our work from May 1996 through March 1997 in accordance

with generally accepted government auditing standards. HUD’s comments

on a draft of this report and our responses to them are included in

chapters 2 through 4 and in appendix IV.

Page 23 GAO/RCED-97-93 Homeownership
Chapter 2 

If FHA’s Insurance Coverage Is Reduced,

Lenders May Make Fewer and Higher

Interest Loans to Some Types of Borrowers

Since its inception in 1934, FHA’s single-family mortgage insurance program

has protected private lenders against nearly all losses resulting from

foreclosures. Losses incurred by FHA have averaged about $24,400 for each

foreclosed and subsequently sold defaulted single-family property.17 These

losses were offset by insurance premiums paid by FHA’s borrowers, not by

funds from the U.S. Treasury. For home loans made by private lenders that

are guaranteed by other federal agencies such as VA or made in the

conventional market and insured by private mortgage insurers, lenders are

not fully protected against losses.

A reduction in FHA’s insurance coverage would increase lenders’

vulnerability to risks associated with the uninsured portion of loans. Some

FHA lenders and other mortgage-lending industry representatives believe

that a reduction in FHA’s insurance coverage will reduce the number of FHA

mortgage loans made and increase interest rates on them as lenders try to

compensate for losses on loans that go to foreclosure. While such market

responses by lenders are expected, we question whether the volume of

FHA-insured loans would decline as much and whether interest rates would

increase as much as anticipated by FHA’s lenders. VA officials told us that

there was no discernible reduction in the volume of VA loans after its

current partial insurance policy went into effect in 1985. While it is

difficult to predict precisely such market responses, any reduction in the

volume of loans and increase in interest rates would probably be borne

disproportionately by low-income, first-time, and minority homeowners

and those individuals purchasing older homes because these are the types

of borrowers that are frequently served by FHA and that many housing

advocates believe are not being completely served by the private market.

For such borrowers, FHA represents a significant source of mortgage

insurance. For this reason, reducing FHA’s insurance coverage may make it

more difficult and, in some cases, more costly for some potential home

buyers to purchase a home. While some potential home buyers may be

ruled out, others may have to delay their purchase of a home or reduce the

value of the home purchased. Any reduction in FHA’s insurance coverage

would shift risk to originators of FHA mortgages, causing possible changes

in the lending industry, such as mergers of small FHA lenders. Reducing

FHA’s insurance coverage could also lessen FHA’s ability to stabilize local

housing markets when regional economies decline.

17During the 19-year period ending September 30, 1993, FHA incurred losses totaling about $12.8 billion

in 1994 dollars following the foreclosure and subsequent sale of about 525,000 defaulted single-family

housing loans that FHA had insured.

Page 24 GAO/RCED-97-93 Homeownership
Chapter 2 

If FHA’s Insurance Coverage Is Reduced,

Lenders May Make Fewer and Higher

Interest Loans to Some Types of Borrowers

Mortgage-Lending

Industry Officials

Anticipate a

Reduction in the

Volume of Loans and

an Increase in Interest

Rates

To assess the impact that an FHA partial guarantee would have on the

mortgage markets and borrowers, FHA sponsored a meeting of 14 FHA

lenders in October 1995 to obtain their views. Price Waterhouse was

retained by FHA and Ginnie Mae to gather the lenders’ responses.

According to an FHA official, collectively, the 14 lenders accounted for 35

to 40 percent of all FHA loans made nationwide. The lenders indicated that

if FHA implements a partial insurance guarantee, they would (1) charge

FHA’s borrowers between one-quarter to one-half percent more in interest

and (2) establish stricter underwriting standards that would limit the

number of higher-risk borrowers who would qualify for an FHA-insured

loan. The lenders believe that these two market responses would be

necessary to offset losses they might incur if a borrower defaulted on a

loan and to compensate them for the additional risk.

The lenders estimated that these two market responses would cause the

number of FHA-insured loans they make to decline by 28 percent under

normal economic conditions and more in the event of an economic or

natural disaster in a particular geographical area.18 These lenders

concluded that 18 percent of the 28-percent volume reduction would be

due to higher-risk borrowers who, because of the higher costs and stricter

underwriting standards, would not be able to obtain an FHA-insured loan,

while the remaining 10-percent reduction would be due to low-risk

borrowers who would opt to obtain privately insured mortgages at a lower

cost.

The four FHA lenders we contacted agreed with the lenders convened by

FHA that some borrowers would not be able to obtain an FHA loan, but none

of the four offered estimates of specific percentage reductions in volume

of loans. Those four lenders, who are among the largest FHA lenders in

California, Colorado, Virginia, and Maryland, noted that they would also

pass on costs they may incur from a reduction in FHA’s insurance coverage

to the consumer in the form of higher interest rates and that they would

set higher underwriting standards that would exclude higher-risk

individuals from qualifying for an FHA loan. These lenders said they would

determine an appropriate interest rate to charge borrowers by considering

factors such as the risk of default, amount of the loan, value and location

of the property, and amount of funds they would no longer receive from

FHA if borrowers defaulted on loans. The lenders believe that because of

these changes, many high-risk people would not be able to acquire a home

18According to Price Waterhouse, the 28-percent decrease in FHA loans was a general consensus of the

14 FHA lenders.

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Chapter 2 

If FHA’s Insurance Coverage Is Reduced,

Lenders May Make Fewer and Higher

Interest Loans to Some Types of Borrowers

because they would be either unable to afford the loan or unable to qualify

for the loan under the more restrictive underwriting standards.

FHA lenders at the October 1995 meeting and other mortgage-lending

industry representatives also pointed out other adverse impacts that

reducing FHA’s insurance coverage could have on them and the mortgage

market. The lenders predicted that a partial FHA insurance guarantee

would make some lenders less willing to make FHA loans and that some

medium-sized lenders would stop making FHA loans because they would be

unable to afford the increased risk of losses. Only one of the four lenders

we spoke to indicated that he might stop making FHA loans because of a

limit on FHA’s insurance coverage.

An executive with the Mortgage Bankers Association (MBA) said that large

FHA lenders will not pull out of the FHA market if FHA’s coverage is reduced

but that smaller lenders would leave the program because they would not

be able to afford the additional risk associated with a partial guarantee. In

addition, the executive stated that the existing insurance program is

working well and is serving many borrowers who would not be served by

the conventional market. Reducing the program’s insurance coverage, the

executive believes, would make lenders less inclined to make loans to

some low- and moderate-income borrowers, first-time home buyers, and

households in inner cities.

Lenders’ Estimates of

the Reduction in

FHA’s Volume of

Loans and Increase in

FHA’s Interest Rates

May Be Overstated

While we cannot estimate the actual loan volume and interest rate that

may prevail if FHA’s insurance coverage is reduced, our analysis of FHA’s

loan volume and interest rates under normal economic conditions shows

that lenders may provide more loans at lower costs than predicted by

those FHA lenders in the focus group if FHA reduces its insurance

guarantee. As previously stated, FHA’s lenders estimated that they will lose

about 28 percent of their business if FHA loans were partially insured. This

estimate is based on the following three assumptions: (1) as a result of the

increased risk faced by lenders, interest rates charged to FHA’s borrowers

will rise by one-quarter to one-half percent; (2) the increase in interest

rates and a tightening of underwriting standards will result in a loss of

18 percent of FHA’s high-risk borrowers; and (3) the increase in interest

rates will result in a further loss of 10 percent of FHA’s least-risky

borrowers.

Our analysis shows that these assumptions may overstate the extent to

which FHA’s loan volume may decrease and interest rates may increase.

Page 26 GAO/RCED-97-93 Homeownership
Chapter 2 

If FHA’s Insurance Coverage Is Reduced,

Lenders May Make Fewer and Higher

Interest Loans to Some Types of Borrowers

This is because the higher revenues earned by lenders from a one-quarter

to one-half percent increase in interest rates may exceed the losses that

lenders would incur if FHA’s insurance coverage were limited to the VA

levels. This increase in lenders’ net revenues could prompt some lenders

to moderate any interest rate increases, resulting in a loan volume above

that projected by the lenders. Finally, if FHA were to respond to a reduction

in risk related to lower insurance coverage by lowering FHA’s insurance

premiums, this reduction in cost to FHA’s borrowers would partly offset

any interest rate increase by lenders. This reduction in borrowers’ costs

would also mitigate the effect of the lower-risk borrowers lost by FHA.

An increase in interest rates of one-quarter of a percent would produce

enough revenue to lenders to cover losses, even under the most adverse

economic conditions experienced by FHA in the last 20 years. We chose

two criteria to determine the most adverse economic conditions. We

examined Price Waterhouse’s 1995 actuarial study to determine which

fiscal year in the last 20 had the highest rate of lifetime foreclosures and

HUD’s A43 database to determine which fiscal year had the highest loss rate

per foreclosed loan. We found that the highest rate of lifetime foreclosures

was 22 percent for FHA loans written in fiscal year 1981 and the highest

loss rate per foreclosed loan was 45 percent, for FHA loans written in fiscal

year 1982. If 1981’s foreclosure rate were repeated and loss rates per

foreclosed loan were slightly higher than 1982’s experience, the

one-quarter percent increase in interest would still generate more income

than a lender would lose in increased claims.

Furthermore, if the increase in interest rates charged to borrowers were

less than the one-quarter to one-half percent assumed by the lender’s focus

group, fewer low-risk borrowers may opt to leave FHA’s applicant pool. In

addition, lenders would have the capacity and the incentive to target

interest rate increases to higher-risk borrowers, such as those making low

down payments. The exclusion of some higher-risk borrowers would

reduce the lenders’ expected losses and their incentive to increase rates.

While tighter underwriting criteria will lead to some reduction in FHA’s

business among higher-risk borrowers, some of that decrease may be

temporary. Persons attempting to buy homes with low down payments or

high payment-to-income ratios may be prevented from using the FHA

program if tighter standards are imposed. However, those people could

return to the home purchase market at a later time when their income

and/or savings have increased. At that point, the decline in volume would

Page 27 GAO/RCED-97-93 Homeownership
Chapter 2 

If FHA’s Insurance Coverage Is Reduced,

Lenders May Make Fewer and Higher

Interest Loans to Some Types of Borrowers

at least be partially replaced by an increase in more credit-worthy

applicants.

VA’s Views on Limited

Insurance Coverage

Differ From Lenders’

Views

VA operates a home loan insurance program that, depending on the original

amount of the loan, guarantees from 25 to 50 percent of the loan. VA

officials told us that there was no discernible reduction in the volume of VA

loans after the current no-bid policy went into effect in 1985.19 They also

told us that despite repeated predictions from lenders and others at the

time, they did not experience an exodus by VA’s lenders because of the

no-bid policy. VA officials noted that some of their lenders perceive that

rates for VA loans are higher than those for FHA loans because of VA’s no-bid

policy. However, VA officials said they do not know if this is true because

of the lack of supporting data.

VA officials also pointed out that on a typical foreclosure, the VA guarantee

is adequate to cover most losses and that VA and the lender share in a

substantial portion of the losses only for foreclosures that involve

catastrophic losses. VA had no estimates of the savings that it realized

because of its partial guarantee (no-bids) but told us they thought that the

savings were relatively small. VA’s data show that lenders sustained losses

in less than 16 percent of VA’s foreclosures during fiscal years 1992 to 1994.

Limiting FHA’s

Insurance Coverage

May Cause Changes in

the Lending Industry

Limiting FHA’s insurance coverage would change the distribution of risk

among market participants. Originators of VA’s guaranteed loans or loans

made without government guarantees are initially exposed to the risk of

catastrophic losses (losses that exceed the amount insured). In the market

for nongovernment-insured loans, the catastrophic risk is often sold to the

government-sponsored enterprises—the Federal National Mortgage

Association and the Federal Home Loan Mortgage Corporation. Because

FHA’s single family program provides 100-percent insurance coverage, FHA’s

lenders are not exposed to these risks. Any reduction in FHA’s coverage

would entail shifting this risk to the originators of FHA mortgages.

The lending industry could respond to this new distribution of risk in

several ways. Lenders could sell this risk to other financial firms as occurs

19VA’s no-bid policy is an option that limits losses to VA by allowing VA to take back a property or

leave it with the lender, depending on which action is more in VA’s financial interest. VA decides which

option to follow after estimating and comparing the cost of taking possession of and reselling a

foreclosed property with the cost of leaving the property with the lender and paying the lender the

guaranteed portion of the mortgaged loan. When a no-bid occurs, the lender is responsible for losses

incurred above those guaranteed by VA.

Page 28 GAO/RCED-97-93 Homeownership
Chapter 2 

If FHA’s Insurance Coverage Is Reduced,

Lenders May Make Fewer and Higher

Interest Loans to Some Types of Borrowers

in the conventional mortgage market. Small, geographically concentrated

lenders would be exposed to greater risk than would geographically

diversified lenders, as the smaller lenders may experience losses from

regional as well as national downturns. Small lenders may merge or be

absorbed by larger lenders so as to geographically diversify, or may leave

the FHA lending market. If lenders continued to hold this catastrophic risk,

their regulators or shareholders might require capital to be held against

this risk, decreasing the profitability of lending.

Reducing FHA’s

Insurance Coverage

May Make It More

Difficult for Some

Borrowers to

Purchase a Home

FHA plays a significant role in the single-family housing market by

providing higher-risk borrowers with insured loans and stabilizing housing

markets in areas that are affected by natural disasters or economic

distress. For example, FHA insured 35 percent of the insured home

purchase loans made in 1994. However, FHA fulfills an even larger role in

some specific market segments, particularly low-income home buyers,

minorities, central city residents, and borrowers qualifying for loans with

high loan-to-value (LTV), housing-expense-to-income, or debt-to-income

ratios.20 The recipients of these loans are typically higher-risk borrowers

that do not qualify for a conventional home loan with private mortgage

insurance. While about a third of the loans that FHA insured in 1995 might

have qualified for conventional mortgages, the other two-thirds probably

would not have qualified, on the basis of maximum LTV and qualifying

ratios of the loans that FHA insured.21 Without FHA’s 100-percent insurance

coverage on losses, private lenders anticipate that they would most likely

serve fewer FHA high-risk borrowers and would raise interest rates on FHA

loans. While we do anticipate that lenders would increase interest rates

and reduce lending to higher-risk borrowers, as discussed previously, our

analysis shows that the volume of loans may not decrease and interest

rates may not increase as much as anticipated by FHA’s lenders. For these

reasons, reducing FHA’s insurance coverage will make it more difficult and,

in some cases, more costly for some potential home buyers to obtain home

mortgages.

20The LTV ratio is the amount of the loan divided by the property’s appraised value. FHA’s way of

calculating LTV is different from the private sector’s or VA’s, which results in a slightly lower LTV

ratio. The total debt-to-income ratio compares all of the borrower’s long-term debt payments, including

his/her housing expenses, with his/her income.

21For a full discussion of the role that FHA plays in the housing market, see Homeownership: FHA’s

Role in Helping People Obtain Home Mortgages (GAO/RCED-96-123, Aug. 13, 1996).

Page 29 GAO/RCED-97-93 Homeownership
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FHA Is a Significant

Insurer for Low-Income,

Minority, and First-Time

Home Buyers

Borrowers with FHA-insured mortgages are more likely to have lower

incomes, be first-time home buyers, or be minorities than borrowers with

privately insured loans. While FHA insured about 35 percent of all insured

mortgages used to purchase homes in 1994, it insured 46 percent of the

insured home purchase mortgages made to low-income borrowers and

48 percent of those made to minorities. Furthermore, mortgages for

low-income and minority home buyers constituted a greater portion of

FHA’s 1994 business than they did for private mortgage insurance or VA, as

shown in figure 2.1. In addition, about 67 percent of all 1994 FHA home

purchase borrowers were first-time home buyers.

Figure 2.1: Proportion of Home

Purchase Loans Insured in 1994 for

Low-Income Borrowers and Minorities

Percentage of Insurer’s 1994 Originations

0

5

10

15

20

25

30

35

40

45

FHA VA PMI

42

28

34

22

24

16

Low-Income Home Buyers

Minority Home Buyers

Source: GAO’s analysis of data from the Home Mortgage Disclosure Act and the Mortgage

Insurance Companies of America.

FHA also plays a primary role in providing central cities with mortgage

loans. According to an October 1995 FHA study of 1993 data from the Home

Mortgage Disclosure Act, 46 percent of the FHA-insured loans were for

Page 30 GAO/RCED-97-93 Homeownership
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properties located in central cities compared with 38 percent for private

insurers.22 In terms of market share in central cities, FHA accounted for

35 percent of the FHA eligible market in 1993.23

FHA also plays an important role in insuring high LTV ratio loans. FHA

insured 43 percent of all the home purchase loans made in 1994 with an

LTV ratio of at least 90 percent. Private mortgage insurers insured

37 percent and VA guaranteed 19 percent. Furthermore, FHA and VA loans

account for almost all the loans made with LTV ratios greater than

95 percent. In 1994, 65 percent of FHA’s home purchase loans and

86 percent of VA’s loans had LTV ratios of at least 95 percent, compared

with only 8 percent of the private mortgage insurance loans with such LTV

ratios.

Most FHA-Insured Home

Loans Would Most Likely

Not Qualify for Private

Mortgage Insurance

On the basis of the LTV and qualifying ratios of their FHA-insured mortgages

and the maximum ratios generally permitted by private mortgage insurers,

about 66 percent of the loans insured by FHA in 1995 would probably not

have qualified for private mortgage insurance.24 These loans had LTV ratios

above the private mortgage maximum of 97 percent, had housing

expense-to-income ratios above the private mortgage insurance maximum

of 33 percent, or had total debt-to-income ratios above the private

mortgage insurance maximum of 38 percent.25

The number of first-time or low-income FHA borrowers who would not

qualify for private mortgage insurance is even higher. Looking exclusively

at first-time home buyers who took out FHA insurance in 1995, 77 percent

would not have met the private mortgage insurers’ LTV and qualifying ratio

standards. An even greater portion (85 percent) of the low-income

borrowers would not have met the private mortgage insurance companies’

standards.

22An Analysis of FHA’s Single-Family Insurance Program, Department of Housing and Urban

Development (Oct. 1995).

23“FHA eligible” loans are conventional loans below FHA’s maximum loan amount for each

metropolitan area.

24However, some of the borrowers obtaining those loans might have been able to obtain privately

insured loans by increasing their down payments or buying lower-priced homes.

25Not every borrower who meets the LTV and qualifying ratio guidelines used by private mortgage

insurers automatically qualifies for private mortgage insurance because lenders and insurers consider

additional factors, such as credit history, during the underwriting process. Similarly, borrowers who

fail to meet all three of the private mortgage insurance guidelines may occasionally qualify for private

mortgage insurance because of compensating factors considered during the underwriting process.

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In addition, FHA’s higher debt-to-income and LTV ratios means that FHA

serves higher- risk borrowers who would most likely not qualify for

conventional home loans. FHA is able to serve higher-risk borrowers

because it insures lenders against almost 100 percent of the losses

associated with a foreclosed loan. FHA, therefore, assumes 100 percent of

the risk of loss on a loan it insures. Private lenders reduce the risk of loss

on conventional loans by maintaining stricter underwriting standards and

by requiring private mortgage insurance that protects them against a

portion of the loss.

FHA Insures Housing

Market Stability

FHA has been instrumental in providing housing market stability in some

areas where private mortgage companies have decreased their

single-family insurance activities because of a change in the areas’

economy or problems from a natural disaster. Except for FHA’s loan limit,26

 the terms under which FHA and VA mortgage insurance is available such as

the maximum LTV ratio do not generally vary across different geographic

locations, according to the FHA program’s guidelines. However, private

mortgage insurance companies may change the conditions under which

they will provide new insurance in a particular geographic area to reflect

the increased risk of losses in an area experiencing economic hardship. By

tightening the terms of the insurance they would provide, private mortgage

insurance companies have, in the past, decreased their share of the market

in economically stressed regions of the country.

Private mortgage insurance companies accounted for about two-thirds of

the insured market in 1984. However, changing economic and market

conditions that occurred during the early and mid-1980s, including severe

regional recessions and attendant declines in property values in some

energy-producing states, resulted in decreasing loan activity by private

insurers in some single-family markets. For example, in the five

energy-producing states of Alaska, Colorado, Louisiana, Oklahoma, and

Texas, the private mortgage insurance companies’ market share declined

from 41 percent in 1984 to 9 percent in 1987. In contrast, FHA increased its

market share from 1984 through 1987, including in the aforementioned

states. FHA’s lenders and other mortgage industry officials indicated,

however, that partial insurance would compromise FHA’s mission to

stabilize distressed communities. This is because the lenders’ increased

exposure to risk would make them disinclined to provide riskier

borrowers with home loans in areas affected by economic distress or by

natural disaster.

26FHA’s loan limit may differ among geographic areas to reflect differentials in the cost of housing.

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Some FHA Loans Are More

Risky Than Others

To determine which FHA borrowers represent the greatest risk to lenders

and therefore are more likely to be denied a loan as a result of tighter

underwriting standards applied by lenders, we analyzed the actual loss

experience on foreclosed properties acquired and then sold from fiscal

year 1992 through fiscal year 1994.27 We found that five variables had

consistent and significant associations with the losses that lenders would

sustain if FHA’s insurance coverage were to be reduced to VA’s level. Those

variables were (1) minority borrowers, (2) buildings with multiple living

units (characterized as investor loans), (3) loans written at higher interest

rates, (4) older properties, and (5) smaller loans. Loans with these

characteristics have higher loss rates, all else held equal, and expose

lenders to a greater risk of loss.28 Therefore, lenders may

disproportionately reduce their lending in these risk categories. While our

analysis did not show that first-time home buyers have higher loss rates

and expose lenders to a greater risk of loss, FHA’s lenders convened at the

1995 focus group considered that many such borrowers would be priced

out of the market. Our analysis of factors contributing to higher loss rates

is explained in greater detail in appendix II.

Agency Comments

and Our Evaluation

HUD stated that our report does not adequately discuss the impact that

reducing FHA’s insurance coverage would have on FHA’s ability to stabilize

regional housing markets during periods of economic distress. We agree

that FHA has historically played a role in stabilizing local housing markets

affected by economic stress. Information has been added to the report

reflecting FHA’s role in market stabilization and the possible effect that a

reduction in FHA’s insurance coverage could have on diminishing FHA’s

ability to continue to stabilize distressed communities.

HUD also stated that our report does not adequately discuss the impact that

reducing FHA’s insurance coverage would have on the structure of the

lending industry. We agree that reducing FHA’s insurance coverage may

change the types and numbers of firms making FHA loans and the capital

structure of those lenders. While a full analysis of the structure of the

mortgage lending industry is beyond the scope of this report, we have

added to this chapter a discussion of possible changes in the structure of

the mortgage- lending industry.

27Data were gathered and linked from three FHA databases—SAMS database of foreclosed properties,

FHA’s A43 (financial characteristics), and the F42 (demographic characteristics) database.

28Previous work by GAO, Price Waterhouse, and others indicates that these variables influence the

probability of foreclosure in the same way that they influence loss rates.

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HUD disagreed with our finding that reducing FHA’s insurance coverage may

reduce the number of FHA loans by less than 28 percent. HUD pointed out

that because lenders consider the volatility of losses as well as the

expected level of losses, lenders may seek to reduce the volatility of losses

even if the revenue from higher interest rates covers the expected level of

losses. We agree that lenders consider volatility in their decision making,

and that lenders would have an incentive to tighten underwriting if FHA

insurance were limited. However, our expectation that lending will be

reduced by less than 28 percent is not based on an assumption that

underwriting will not be tightened. Rather, it is predicated on our analysis

that suggests that with a one-quarter percent rise in interest rates, lenders

would likely earn more than enough revenues to cover losses from a

reduction in FHA’s insurance coverage even under extremely adverse

circumstances. If interest rates increase by less than one-quarter of a

percent, fewer borrowers would be priced out of FHA’s insurance. Our

expectation is also predicated on the fact that borrowers excluded from

the FHA program may reapply and qualify at a later date.

We disagree with HUD’s comment that it is inappropriate to use VA’s

experience (including the VA no-bid procedure) as a basis for predicting

lenders’ response to a reduction in FHA’s insurance coverage. HUD pointed

out that VA has always operated a partial insurance program and that for

this reason, it is inappropriate to use the example of changes in VA’s no-bid

procedure as a predictor of the impact that a reduction in FHA’s insurance

coverage would have on lenders’ participation.

While it is true that VA has always provided only partial insurance

coverage, as discussed in this report, the 1984 changes to VA’s no-bid

process, required by the 1984 Deficit Reduction Act, had a substantial

impact on the number of foreclosed loans for which VA paid the total

guarantee and left the property with the lender—rising from less than

2 percent of all VA foreclosures during fiscal year 1982 to 24 percent in

fiscal year 1988. Therefore, lenders’ response to changes in the VA program

is likely to be indicative of their response to a change in the FHA program.

HUD also stated that the VA program is very limited and serves borrowers

who are very different from the type served by FHA (i.e., borrowers who

are concentrated geographically, with stable employment, higher incomes,

and subject to military discipline) and for this reason the two programs

are not comparable. While the VA program is available to some active

military personnel, veterans, and their families, currently about 80 percent

of VA’s borrowers are veterans and not subject to military discipline. Also,

Page 34 GAO/RCED-97-93 Homeownership
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as pointed out in chapter 2, FHA’s and VA’s programs are similar in that a

large proportion of the home buyers served by both programs are

low-income borrowers and minorities and both play an important role in

insuring high LTV loans. Finally, as discussed in our earlier report, VA’s and

FHA’s programs serve similar geographic markets.29

29For a full discussion of FHA’s and VA’s role in the housing market, see Homeownership: FHA’s Role

in Helping People Obtain Home Mortgages (GAO/RCED-96-123, Aug. 13, 1996).

Page 35 GAO/RCED-97-93 Homeownership
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Likely Improve the Financial Health of

FHA’s Fund

Reducing FHA’s insurance coverage to the level permitted for VA home

loans would likely reduce the Fund’s exposure to financial losses, thereby

improving its financial health. However, the actual impact of reducing

FHA’s insurance coverage on the economic value/reserves, the resulting

capital ratio of loans insured by FHA in fiscal year 1995, and the validity of

our estimates would depend on future economic conditions and on how

lenders would respond to a reduction in FHA’s insurance coverage. We

estimate that reducing FHA’s insurance coverage would likely result in

increasing the capital reserve ratio for the loans insured by FHA in fiscal

year 1995 above the ratio that results from the current policy of full

insurance coverage. A higher capital reserve ratio will result under

reduced insurance coverage even if FHA’s volume of loans declines by

28 percent as predicted by FHA’s lenders. This occurs because the positive

financial effect of the following factors more than offsets the loss of

premium income on loans that are not insured by the Fund when the

volume of loans is reduced. First, by reducing FHA’s insurance coverage to

VA’s level, FHA would be liable for only a portion of the losses on loans that

are foreclosed. Our analysis shows that FHA’s losses on loans that go to

foreclosure would be reduced by an estimated 16 percent if FHA were to go

to a partial insurance coverage like VA’s, thereby increasing the estimated

economic value/reserves of the loans it insures. Second, when FHA’s

volume of loans is reduced, which would likely occur if FHA’s mortgage

insurance coverage were reduced, the capital reserve ratio increases

because, on average, the loans that would be excluded from FHA’s

insurance would be higher-risk loans for which higher foreclosure and loss

rates would be expected.

Our estimates also show that at various house price appreciation rates—a

key factor influencing future economic value/reserves and resulting capital

reserve ratios—the capital reserve ratio increases when moving from full

mortgage insurance to partial insurance. In fact, if house price

appreciation rates are 2 percentage points lower than those used in our

estimate, reducing FHA’s insurance coverage may have a much greater

positive effect on the capital reserve ratio of the loans insured by FHA than

on the capital reserve ratio in our baseline estimate.

Although our analysis indicates that reducing FHA’s insurance coverage is

likely to increase the Fund’s capital reserve ratio, the impact on a key

component of the ratio—the estimated economic value/reserves of the

Fund—is less certain. This is because the effect of insurance coverage

reductions on the economic value of the Fund depends largely on the way

in which lenders respond in excluding loans from FHA insurance. This is

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important because our analysis indicates that the smaller the reduction in

the volume of FHA loans, the higher the economic value contributed by the

remaining loans insured by FHA in fiscal year 1995. Our estimates of the

impact of reducing FHA’s insurance coverage on the Fund’s capital reserves

are based on the assumption that FHA’s premium structure would not

change following a reduction in FHA’s insurance coverage.

Alternative approaches to reducing FHA’s insurance coverage that we

assessed—retaining full FHA insurance coverage for first-time home-buyers

but reducing FHA’s coverage for repeat buyers to VA’s current level and

reducing FHA insurance coverage to a level higher than VA’s—also

increased the capital reserve ratio above the full insurance ratio but not by

as much as the VA limitation on insurance coverage did. (See app. III for a

more detailed discussion of these analyses.)

Our Approach to

Forecasting FHA’s

Capital Reserve Ratio

Under Partial

Insurance Coverage

The actual impact of reducing FHA’s insurance coverage on the economic

value/reserves, the resulting capital ratio of loans insured by FHA in fiscal

year 1995, and the validity of our estimates would depend on future

economic conditions and on how lenders would respond to a reduction in

FHA’s insurance coverage. To estimate the financial impact on FHA from a

reduction in insurance coverage, we prepared estimates of economic value

and resulting capital ratios under three different economic

scenarios—baseline, optimistic, and pessimistic—assuming a different

rate of appreciation in house prices over the next 30 years for each

economic scenario.

Although future rates of appreciation in house prices are uncertain, to be

conservative in assessing the impact of reducing FHA’s insurance coverage

on the capital reserve ratio of FHA’s Fund and to be consistent with past

analyses that we have made of the actuarial condition of the Fund, we

placed greater emphasis on our mid-range baseline economic scenario,

which assumes slightly lower house price appreciation rates (1 percentage

point annually) than the rates forecasted by DRI/McGraw-Hill, a private

economic-forecasting company. Our optimistic and pessimistic economic

scenarios assume that price appreciation rates for houses will be

2 percentage points higher or lower than those in our baseline. Our

estimates of economic value and resulting capital ratios under reduced

insurance coverage were compared with our estimates for these measures

under full insurance coverage to determine if the Fund’s financial health

would be improved. Appendix II contains a detailed description of how we

Page 37 GAO/RCED-97-93 Homeownership
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estimated the decrease in the average loss rate per loan to be employed

under partial FHA insurance coverage.

While our estimates of the impact of reducing FHA’s insurance coverage on

the Fund’s capital reserves are based on the assumption that FHA’s

premium structure would not change, the financial improvement in the

Fund resulting from a reduction in insurance coverage may result in a

lowering of FHA’s premium charged to borrowers. If that occurs, the

reduced insurance premium may at least partially offset any increase in

the Fund’s capital reserves.

Because the financial outcome of the loans made by FHA in fiscal year 1995

is sensitive to the volume of loans made, our three economic scenarios

included estimates that we made under three loan volume

assumptions—no change in the volume of loans, a 28-percent reduction in

volume as predicted by FHA lenders, and a midpoint reduction of

14 percent. Furthermore, because FHA’s lender focus group did not discuss

how higher-risk and lower-risk borrowers would be identified for

exclusion from the program, we used two different assumptions regarding

lenders’ ability to screen-out borrowers under each loan volume reduction.

Under one assumption, which we call “loose-targeting,” lenders would

tighten underwriting standards to a limited extent so that there would be

some tendency for higher-risk borrowers to be denied loans. Under the

other assumption “tight-targeting” we assume a stronger tendency for

denials to be concentrated on higher-risk applicants. Appendix II

describes in detail how we implemented those assumptions.

Our estimates of the financial impact of reducing FHA’s insurance coverage

to VA’s levels under our baseline, optimistic, and pessimistic scenarios

follow. We present our estimates for the alternative coverage reduction

scenarios in appendix III.

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Our Baseline

Estimates of

Increases in the

Fund’s Capital Ratio

Attributable to Partial

Insurance

As shown in table 3.1, all of our baseline estimates of capital reserve ratios

for loans made by FHA in fiscal year 1995 under VA’s level of insurance

coverage are higher than our estimated ratio of 1.48 percent under full

insurance coverage remaining in effect.30 Increases in the capital reserve

ratio above those resulting from full insurance coverage range from 0.41 to

0.51 percentage points under the volume reduction scenarios.31

30The 2-percent capital reserve target, prescribed by legislation, applies to the entire portfolio of FHA

insured loans in the MMI Fund. HUD does not have to meet the 2-percent requirement on a sub-group

of loans insured in a single year. The initial capital reserve ratio for loans written in a single year can

be lower than 2-percent, and the loans can still contribute to an improvement in the Fund’s financial

health. This is due to the fact that, while the economic value of a group of loans written in 1 year, if

estimated accurately, will not change over time, the volume of loans outstanding (the denominator)

will decline. Thus, over time, the capital ratio for loans written in any given year will increase. In our

analysis, what determines whether loans written in a given year contribute more to the Fund’s

financial health is whether the estimated capital ratio is greater than it would be with FHA’s full

insurance coverage in place. This, in fact, is the case under all our scenarios and options.

31We used the full mortgage principal to calculate capital reserve ratios in this report to maintain

consistency with estimates in our previous reports. However, if FHA were to cover less than

100 percent of the mortgage’s balance, it would be possible to calculate a capital reserve ratio using

the smaller insured portion of mortgage principal rather than the full mortgage principal as the

denominator. If the capital reserve ratio were calculated using only the insured portion of the

mortgage balance under partial insurance, the ratios would increase above those we estimate, as the

denominator in the ratio calculation would be smaller.

Page 39 GAO/RCED-97-93 Homeownership
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Table 3.1: GAO’s Estimates of the Impact of Reducing Insurance Coverage to VA’s Levels on Loans Insured by FHA in

Fiscal Year 1995, Under Base Case Economic Conditions

Dollars in millions

Level of coverage

Volume

reduction

(percent)

Volume

reduction

technique

Dollar

volume

of loans

Estimated

economic

value

Initial capital

ratioa (percent)

Full insurance coverage 0 N/A $36,200 $536 1.48

VA insurance coverage levels 0 N/A 36,200 686 1.89

14

Loose targeting

Tight targeting

31,100

31,700

588

615

1.89

1.94

28

Loose targeting

Tight targeting

26,400

27,300

507

543

1.92

1.99

Legend

N/A = not applicable

a“Initial Capital Ratio” refers to the economic value of the loans insured by FHA in 1995 as a

percentage of the total original loan amounts for these loans.

Source: GAO’s analysis.

Although our analysis indicates that reducing FHA’s insurance coverage is

likely to increase the Fund’s capital reserve ratio, the impact on a key

component of the ratio—the estimated economic value of the Fund—is

less certain. This is because the effect of insurance coverage reductions on

the economic value of the Fund depends largely on the way in which

lenders would respond in excluding loans from FHA’s insurance.

The size and nature of the reduction in the volume of the loans that would

accompany a reduction in FHA’s insurance coverage to VA’s levels are

important factors in determining the reduction’s impact on the economic

value and resulting capital ratio of FHA’s 1995 loans. If insurance coverage

on FHA’s 1995 loans were reduced to VA’s levels with no change in the

volume of loans insured, the estimated economic value of the loans would

be $686 million—substantially greater than our estimate assuming no

coverage reduction ($536 million). This is because of the reduction in

claim payments that would be expected from lowered insurance coverage.

However, FHA’s lenders estimate that 28-percent fewer FHA-insured loans

would be made each year if a partial insurance program like VA’s were

established for FHA. With a 28-percent volume reduction, we estimate that

the economic value of FHA’s 1995 loans would be in the range of

$507 million to $543 million—not substantially different from the

Page 40 GAO/RCED-97-93 Homeownership
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FHA’s Fund

$536 million-estimated economic value of the 1995 loans if full insurance

coverage remained in effect.32 The reduction in lending volume under less

than full insurance coverage scenarios partially offsets the increase in

economic value stemming from reduced claim payments, as some of the

loans that would not be insured would have had positive expected cash

flows.

Although a reduction in FHA’s insurance coverage to VA’s levels would

cause some volume reduction, as noted earlier, we question whether the

reduction would be as high as the FHA lender estimate of 28 percent. This

is important because our analysis indicates that the smaller the reduction

in the volume of FHA’s loans, the higher the estimated economic value of

FHA’s loans. For example, assuming a 14-percent volume reduction, we

estimate that the economic value of the FHA-insured loans made in 1995

would be in the range of $588 million to $615 million if the insurance

coverage were reduced to VA’s levels, compared with the $507 million to

$543 million estimated economic value under a 28-percent reduction.

Our Estimates Under

Other Economic

Scenarios

If future price appreciation for houses is lower (pessimistic case scenario)

than predicted under our base case scenario, reducing FHA’s insurance

coverage to VA’s levels could have a much more positive effect on

economic value and the resulting capital reserve ratio than on the capital

reserve ratio in our baseline scenario. As shown in table 3.2, if a VA-like

partial guarantee had been in place for FHA in fiscal year 1995, the

estimated capital ratio and economic value of the loans made that year

under our pessimistic case scenario would be much higher under partial

insurance than they would be with full insurance coverage.33 The effect of

reduced coverage is larger under our pessimistic scenario because in that

scenario, our model projects higher claims in future years so that limited

coverage would save more claim payments.

32Our estimated change in economic value varies by about $30 million, depending on how precisely

lenders can target tighter underwriting standards to high-risk borrowers. Lenders may target their loan

rejections even more or less precisely than we have assumed in our analysis, which could lead to

values outside our estimated range.

33Under our optimistic scenario, the capital ratio increases from 1.98 percent to 2.31 percent, if

reduced insurance coverage results in no reduction in the volume of loans.

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Table 3.2: Estimates of the Impact of Reducing Insurance Coverage to VA’s Levels on Loans Insured by FHA in Fiscal Year

1995, Under Pessimistic Economic Conditions

Dollars in millions

Level of coverage

Volume

reduction

(percent)

Volume

reduction

technique

Dollar

volume of

loans

Estimated

economic

value

Initial capital

ratioa (percent)

Full insurance coverage 0 N/A $36,200 $245 0.68

VA insurance coverage levels 0 N/A 36,200 444 1.22

14

Loose targeting

Tight targeting

31,100

31,700

383

406

1.23

1.28

28

Loose targeting

Tight targeting

26,400

27,300

336

366

1.27

1.34

Legend

N/A = not applicable

a“Initial Capital Ratio” refers to the estimated economic value of the loans insured by FHA in 1995

as a percentage of the total original loan amounts for these loans.

Source: GAO’s analysis.

If the future price appreciation for houses is higher (optimistic case

scenario) than predicted under our base case scenario, reducing FHA’s

insurance coverage to VA’s levels could have a much smaller positive

impact on the capital reserve ratio than in our baseline scenario as shown

in table 3.3. The impact on economic value depends on the extent of the

volume reduction accompanying the limitation in insurance coverage. If

the reduction in lending volume is as large as 28 percent, the economic

value declines below that resulting in our baseline scenario, while a

14-percent reduction in lending leads to a small increase in economic

value. However, it is likely that higher house price appreciation rates

would be associated with smaller reductions in lending volume because

lenders’ expected losses would be lower.

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Table 3.3: Estimates of the Impact of Reducing Insurance Coverage to VA’s Levels on Loans Insured by FHA in Fiscal Year

1995, Under Optimistic Economic Conditions

Dollars in millions

Level of coverage

Volume

reduction

(percent)

Volume

reduction

technique

Dollar

volume of

loans

Estimated

economic

value

Initial capital

ratioa (percent)

Full insurance coverage 0 N/A $36,200 $717 1.98

VA insurance coverage levels 0 N/A 36,200 837 2.31

14

Loose targeting

Tight targeting

31,100

31,700

721

747

2.32

2.36

28

Loose targeting

Tight targeting

26,400

27,300

623

650

2.36

2.38

Legend

N/A = not applicable

a“Initial Capital Ratio” refers to the estimated economic value of the loans insured by FHA in 1995

as a percentage of the total original loan amounts for these loans.

Source: GAO analysis.

Conclusions If FHA’s insurance coverage were reduced to VA’s insurance coverage

levels, FHA would be insuring better-quality loans with less loss exposure.

As a result, FHA’s capital reserve ratio would increase. While the Fund’s

financial health has improved and is projected to continue to improve at

least in the near term, reducing FHA’s insurance coverage would enhance

the Fund’s ability to maintain financial self-sufficiency in an uncertain

future. Forecasting economic value and resulting capital ratios to

determine whether FHA will have the funds it needs to cover its losses over

the 30-year life of an FHA mortgage is uncertain. Loan performance and,

therefore, capital ratios, will depend on a number of economic and other

factors, particularly on the actual rate of appreciation in house prices over

that period. This uncertainty was demonstrated during the 1980s when the

Fund experienced substantial losses requiring legislative reforms to help

improve its financial health.

However, reducing FHA’s insurance coverage does pose trade-offs affecting

lenders, borrowers, and FHA’s role. Private lenders will likely react by

raising interest rates and making fewer higher-risk FHA loans although not

to the extent predicted by FHA’s lenders. Borrowers most likely affected by

such reactions by lenders would be low-income, first-time, and minority

home buyers and those individuals purchasing older homes—the type of

Page 43 GAO/RCED-97-93 Homeownership
Chapter 3 

Reducing FHA’s Insurance Coverage Would

Likely Improve the Financial Health of

FHA’s Fund

households for which FHA has historically been the primary lender. While

the denial of home loans for some of these borrowers may be temporary,

posing delays until their income and/or savings have increased, for other

borrowers it may mean losing their only opportunity to become home

owners. Finally, partial FHA insurance could result in changes in the

lending industry, particularly among smaller FHA lenders and diminish the

federal role in stabilizing markets.

Agency Comments

and Our Evaluation

HUD stated that our report used overly conservative assumptions

concerning house price appreciation rates and that using more optimistic

assumptions would show that limits on FHA insurance would reduce the

economic value to FHA of originated loans. As pointed out in our report,

estimates of economic value and changes in economic value are sensitive

to the underlying assumptions used in the forecast of future economic

conditions and are subject to uncertainty. We disagree with HUD’s

statement that our assumptions are overly conservative. Our choice of

baseline economic conditions is consistent with our approach in previous

reports and conservative in terms of assessing the impact of reducing FHA’s

insurance coverage on the capital reserve ratio of FHA’s Fund. We also

disagree with HUD’s conclusion that economic value would be reduced by a

limitation in insurance coverage under optimistic assumptions concerning

house price appreciation. The direction of the change in economic value

depends in large part on lenders’ behavior, which is difficult to predict.

This is true for both the baseline and optimistic scenarios that we

analyzed. Using a higher rate of house price appreciation than that

assumed in our baseline scenario, we find that economic value is reduced

by $67 million to $94 million if loan volumes are reduced by 28 percent.

However, we believe that optimistic economic conditions are likely to lead

to smaller reductions in volume than would pessimistic conditions. Thus,

the 28-percent volume reduction under optimistic conditions is even less

likely than under the baseline. If the volume of loans is reduced by 14

percent under optimistic economic conditions, the economic value

increases by $4 million to $30 million above that resulting under full

insurance.

Page 44 GAO/RCED-97-93 Homeownership
Chapter 4 

Reducing FHA’s Insurance Coverage May

Transfer Some Financial Losses to the

Government National Mortgage Association

Ginnie Mae’s full guaranty of the timely payment of principal and interest

to investors in its securities was established through legislation that,

unless changed, would remain in place no matter what level of insurance

coverage is provided by FHA for the single-family loans it insures.

Specifically, Ginnie Mae’s securities would continue to maintain the U.S.

government’s full-faith-and-credit guaranty, and Ginnie Mae’s ability to

provide lenders of FHA and VA loans with liquidity (cash or assets readily

convertible into cash) would not be impaired. However, because of this

full guaranty, Ginnie Mae officials believe that reducing FHA’s insurance

coverage would result in transferring some of the losses that would have

been incurred by FHA under full insurance to Ginnie Mae. The amount of

such additional losses that may be incurred by Ginnie Mae, however, is not

clear. The amount will depend on how successful lenders are in reducing

their risk of loss and the likelihood of default if lenders make fewer

higher-risk loans and charge higher interest rates.

Ginnie Mae’s net revenues (after expenses) totaled $515 million in fiscal

year 1996. The major source of Ginnie Mae’s revenues was interest from U.

S. securities and fees collected from lenders to cover its costs and offset

its future payments of claims under the guaranty. Ginnie Mae incurs losses

when its approved issuers (mortgage bankers, savings institutions, and

other financial intermediaries) default on their payments to investors in

Ginnie Mae securities. In the past, losses to Ginnie Mae’s issuers on

partially insured VA loans was one of several factors contributing to

issuers’ defaults. How lenders respond to a reduction in FHA’s insurance

coverage will largely determine the financial impact on Ginnie Mae. If

FHA’s lenders react to a reduction in coverage by making fewer higher-risk

loans and increasing mortgage interest rates, lenders’ risk of loss and

possible default may be reduced. Ginnie Mae’s costs could rise or fall

depending on how well lenders target the reduced volume of loans toward

the highest-risk borrowers and the extent to which revenues from

increased interest rates are adequate to cover these losses. On the other

hand, any reduction in the volume of loans resulting from a reduction in

FHA’s insurance coverage would also result in a proportionate reduction in

Ginnie Mae’s guaranty fees and net revenues. Since a reduction in FHA’s

insurance coverage could result in FHA’s not taking possession of a

foreclosed property, Ginnie Mae would also see an increase in its

mortgage and property holdings.

Page 45 GAO/RCED-97-93 Homeownership
Chapter 4 

Reducing FHA’s Insurance Coverage May

Transfer Some Financial Losses to the

Government National Mortgage Association

Reducing FHA’s

Insurance Coverage

May Contribute to

Some Issuers’

Defaults and

Resulting Losses for

Ginnie Mae

When a Ginnie Mae issuer defaults in making timely payments of principal

and interest to investors, Ginnie Mae makes the payments and takes over

the issuer’s entire portfolio of FHA and VA mortgage loans that stand behind

securities that Ginnie Mae has guaranteed. When Ginnie Mae takes over

such portfolios, it exposes itself to greater financial losses because it must

manage these portfolios by (1) collecting principal and interest payments

from borrowers, (2) making payments to owners of the securities, and

(3) awarding servicing contracts to firms that manage the portfolios.

Ginnie Mae officials pointed out that VA’s partial insurance coverage has

contributed to increasing the likelihood that issuers will default. VA

currently guarantees a portion of the loan for the mortgage against loss,

and issuers are responsible for losses incurred above those guaranteed by

VA. If the Congress directed FHA to move to a partial insurance program

similar to VA’s, the move would likely expose the entire Ginnie Mae

portfolio of newly securitized loans to losses from this new risk, according

to Ginnie Mae officials. Ginnie Mae officials believe that the likelihood of

losses to issuers from no-bids would increase substantially, especially

during periods of economic decline.

To estimate the financial impact from partial FHA insurance, Ginnie Mae

directed its consultant, Price Waterhouse, to explicitly simulate the

implementation of a partial insurance program for FHA similar to that

currently used in VA’s guaranty program.34 In doing so, Price Waterhouse

assumed, under economic conditions similar to those in our base case, a

decline in FHA’s annual loan volume of 28 percent on the basis of the

consensus reached by FHA’s lender focus group discussed earlier.

The results of the model showed that issuers’ increased exposure to losses

along with a decrease in guaranty fees resulting from a lower volume of

loans would have a negative financial impact on Ginnie Mae. However, the

model’s results also indicated that Ginnie Mae would remain sound and

that its ability to provide the U.S. housing market with liquidity would not

be impaired. The severity of the financial impact on Ginnie Mae would be

curtailed, however, as lenders’ redistributed insurance activity away from

the riskiest borrowers in order to minimize the impact of an FHA partial

guaranty on the lenders’ financial resources. Under normal economic

conditions, Price Waterhouse estimated that Ginnie Mae’s guaranty fee

revenues would decline by approximately 10 percent, on average,

primarily owing to the 28-percent reduction in the volume of loans

34This model, which combines a series of econometric models with a financial model, is designed to

enable Ginnie Mae’s management to simulate the impacts of changes in a wide variety of economic,

financial, policy, and programmatic variables on Ginnie Mae’s financial condition.

Page 46 GAO/RCED-97-93 Homeownership
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Reducing FHA’s Insurance Coverage May

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Government National Mortgage Association

projected by the industry focus group. As a result, Ginnie Mae’s net

revenues would decline by from 2 to 7 percent annually. In present-value

terms, the cumulative decline in net revenues over the period 1997 through

2007 is estimated at $287 million, or 6.5 percent. At the same time,

however, the results show that advances against defaulted

mortgage-backed security pools would show little change primarily

because of the offsetting effect of the issuers’ response.35 Specifically,

according to Price Waterhouse, Ginnie Mae’s losses on defaulted mortgage

pools are curtailed as lenders respond to the reduced insurance coverage

by redirecting lending away from risky borrowers. According to the

model’s results, the most dramatic effect on Ginnie Mae would be on its

holdings of mortgages and properties. Since a partial insurance program

could allow FHA the option of not taking possession of a foreclosed

property but instead leaving it with the lender, Ginnie Mae could see a

dramatic increase in the property it acquires from defaulted lenders. Price

Waterhouse estimated that Ginnie Mae would see a five-fold increase in

the dollar volume of mortgages and property holdings because of partial

FHA insurance coverage. The Price Waterhouse analysis also indicated,

however, that Ginnie Mae would remain financially sound, even under a

partial insurance coverage, as indicated by the fact that Ginnie Mae’s U.S.

Treasury holdings (reserves for future losses invested in U.S. Treasury

securities) would continue to follow a smooth path upward. The study’s

results show that the implementation of partial insurance coverage results

in only a small decline in Ginnie Mae’s U.S. Treasury holdings, compared

with such holdings under full FHA insurance coverage, primarily because of

the decreased volume of loans. Since Ginnie Mae’s reserves would

continue to grow in relation to securities outstanding, Ginnie Mae’s

financial soundness and ability to provide the U.S. housing market with

liquidity should not be impaired, according to the Price Waterhouse study.

While the estimated impacts reported above provide an indication of the

potential financial impact on Ginnie Mae, it should be noted that a number

of personal and financial variables can lead to defaults by issuers and

subsequent losses for Ginnie Mae. We did not have the opportunity during

this review to completely evaluate the reasonableness of Ginnie Mae’s

model or the assumptions behind the analysis. Although the results seem

reasonable, we question some of the assumptions used. As noted in

chapter 2, we question whether the lenders’ reduction in loan volume will

approach the 28-percent reduction assumed in the analysis. Similarly,

while the analysis assumes that lenders will increase interest rates in

35Advances against mortgage-backed security pools consist of principal and interest payments made by

Ginnie Mae to security investors to make up for those payments not made by defaulted Ginnie Mae

issuers.

Page 47 GAO/RCED-97-93 Homeownership
Chapter 4 

Reducing FHA’s Insurance Coverage May

Transfer Some Financial Losses to the

Government National Mortgage Association

response to a partial FHA insurance program, the fact that the increased

interest revenue would reduce the likelihood of lenders’ defaults was not

incorporated into the model. Both of these factors would tend to lessen

the financial impact on Ginnie Mae.

During the 1980s, VA’s

No-Bids Were One of

Several Factors Leading to

Issuers’ Defaults

During the 1980s, Ginnie Mae, while remaining profitable, began to

experience increased defaults by issuers that exposed it to greater

financial losses. As pointed out in our June 1993 report, four factors

contributed to weakening Ginnie Mae’s issuers’ financial health and

increasing defaults.36 Changes in VA’s home loan guaranty program, which

resulted in lenders’ becoming responsible for losses above the VA

guarantee, were among these factors. Other factors were economic

distress and a resulting decline in regional real estate markets, a flawed

FHA multifamily coinsurance program design, and issuers’ mismanagement

of funds. Of the four factors that contributed to increasing issuers’

defaults, Ginnie Mae officials considered declining regional real estate

markets to be the major factor.

When borrowers are unable to repay their mortgages, the issuers who

pooled these mortgages become responsible for making payments to

investors. If Ginnie Mae’s issuers sustain losses brought on by events such

as those discussed above, some issuers may be financially weakened,

causing them also to default. In honoring its guaranties to investors and

acquiring these issuers’ portfolios of defaulted mortgages, Ginnie Mae

replenishes funds in certain accounts and hires firms to temporarily

administer the portfolios.

In 1984, the Congress enacted provisions of the Deficit Reduction Act to,

among other things, reduce losses associated with foreclosures on VA’s

home loans. The act required VA, in deciding whether to pay the total VA

guaranty on defaulted loans or acquire the property, to limit its estimated

loss to the amount of the guaranty. In making its decision on whether to

acquire a property, the act required VA to consider post-acquisition costs

that were previously excluded from VA’s decision. This increased the

number of foreclosed properties for which expected losses exceeded the

guaranty amount. After these provisions were implemented in 1985, the

number of VA’s no-bids increased substantially—rising from 6 percent of

all VA foreclosures in 1984 to 21 percent in 1987. When VA leaves properties

with issuers, the issuers are responsible for losses incurred above those

36See Government National Mortgage Association: Greater Staffing Flexibility Needed to Improve

Management (GAO/RCED-93-100, June 30, 1993).

Page 48 GAO/RCED-97-93 Homeownership
Chapter 4 

Reducing FHA’s Insurance Coverage May

Transfer Some Financial Losses to the

Government National Mortgage Association

guaranteed by VA. As issuers’ resources are reduced by such losses, the

probability that they will default increases. When issuers default, Ginnie

Mae is responsible for the portion of the losses not guaranteed by VA.

The number of defaulted Ginnie Mae issuers rose from 5 in 1983 to a peak

of 19 in 1989, declined back to 6 in 1992, and has averaged 4 per year since

then. In total, Ginnie Mae acquired portfolios of defaulted mortgages

valued at about $20 billion from its issuers from fiscal year 1987 through

fiscal 1996; over half of this amount, $11.5 billion, occurred in 1989.

Ginnie Mae’s

Exposure to Losses

Depends on How

Lenders Respond to a

Reduction in FHA’s

Insurance Coverage

The extent to which a reduction in FHA’s insurance coverage will increase

Ginnie Mae’s exposure to financial losses depends on how lenders react.

Annually, about 72 percent of Ginnie Mae’s newly guaranteed securities

are made up of almost 100-percent FHA-insured mortgages, and the

remaining 35 percent is partially guaranteed against loss to the lender by

VA. At present, only VA loans, with their partial guaranty, are candidates for

a possible no-bid. Providing partial insurance coverage on FHA loans would

expose the entire pool of newly securitized FHA loans to the possibility of a

no-bid, thus increasing the lender’s and Ginnie Mae’s risk exposure.

However, as noted in chapter 2, FHA’s lenders will most likely respond to

this increase in risk by making fewer higher-risk loans and by increasing

interest rates for mortgages. Making fewer higher-risk loans would reduce

the likelihood of borrowers’ defaults, thus reducing lenders’ risk.

According to Price Waterhouse’s analysis, “the severity of the FHA partial

guaranty’s negative financial impact on Ginnie Mae would be curtailed by

lenders’ redistribution of insurance activity away from the riskiest

borrowers.” At the same time, increasing interest rates may produce the

additional revenue needed to cover any increased losses resulting from a

reduction in FHA’s insurance coverage—a factor not considered in the

Price Waterhouse analysis. Our analysis in appendix I shows that

increasing interest rates by an extra one-quarter percent would produce

enough revenue to lenders to cover losses even under adverse economic

conditions, thus reducing substantially the likelihood that issuers would

default.

Agency Comments

and Our Evaluation

In commenting on a draft of this report, Ginnie Mae officials stated that

the discussion of the impact on Ginnie Mae was not well supported by the

analytical results from the memorandum that Ginnie Mae’s contractor

provided us with. In addition, they stated that we should have included the

Page 49 GAO/RCED-97-93 Homeownership
Chapter 4 

Reducing FHA’s Insurance Coverage May

Transfer Some Financial Losses to the

Government National Mortgage Association

results of an “extreme economic stress” level test conducted by Price

Waterhouse for Ginnie Mae—rates of house price depreciation greater

than those experienced during the Great Depression of 1929-33.

While Ginnie Mae’s contractor provided us with considerable quantitative

material, we limited our discussion in this report to the material contained

in the contractor’s memorandum that best summarized the impact on

Ginnie Mae from a reduction in FHA’s insurance coverage. As such, we

believe that the information contained in this report accurately

summarizes and reflects the results contained in the memorandum from

Ginnie Mae’s contractor. We chose not to include Ginnie Mae’s extreme

economic stress scenario because (1) it is very unlikely that such a severe

event would occur and (2) if it were to occur, the impacts would be so

severe for FHA’s lenders (under either full or partial insurance coverage)

that we question the usefulness of the forecasts, especially since such an

economic event is far more severe than any recent historical conditions

encountered.

Ginnie Mae also provided suggested clarifications to the report that we

have incorporated where appropriate.

Page 50 GAO/RCED-97-93 Homeownership
Page 51 GAO/RCED-97-93 Homeownership
Appendix I 

Description of Interest Rate Change

Analyses

Chapter 2 described the potential lender responses and impacts on

potential borrowers of a reduction in the Federal Housing Administration’s

(FHA) insurance coverage. This appendix provides a detailed description of

the analyses we conducted of potential interest rate changes resulting

from a reduction in FHA’s insurance coverage. Appendix II describes our

analysis of impacts on potential borrowers.

Interest Rate Changes

Resulting From a

Reduction in FHA’s

Insurance Coverage

We determined that lenders would be unlikely to increase interest rates by

as much as the lender focus group convened by the Department of

Housing and Urban Development (HUD) estimated. The focus group

estimated that lenders would raise interest rates on FHA-insured loans by

one-quarter to one-half of a percent to cover the losses they would become

responsible for if FHA reduced its insurance coverage. As shown in table

I.1, an increase of one-quarter of a percent would produce enough revenue

to lenders to cover losses, even under adverse economic conditions. The

adverse conditions we examined are based on foreclosure rates and

balances of loans originated in fiscal year 1981, which had the highest rate

of foreclosure of any year in the last 20, and a rapid rate of prepayment.

The highest loss rate for any origination year was 45 percent for loans

originated in fiscal year 1982. Our analysis of loans originated in that year

indicates that lenders’ losses would have been 7.7 percent, if a partial

guarantee had been in place. The rate of losses to lenders used in the

following analysis is 9 percent, which is higher than the 7.7-percent losses

that we estimate lenders would have experienced for 1982 loans.

Page 52 GAO/RCED-97-93 Homeownership
Appendix I 

Description of Interest Rate Change

Analyses

Table I.1: Estimated Net Revenue to Lenders If They Had Increased Interest Rates by One-Quarter of a Percent in Response

to an Insurance Coverage Reduction for FHA’s 1981 Loans

As percentage of all 1981 originations Per $1 million in originations

Year

Loans

resulting in

claims

Loans that

prepay

Loans still

active

Remaining

principal

Extra losses

resulting from

claims

Extra interest rate

revenue

1981 0.10 0.17 100.00 100.00 $95 $ 2,493

1982 1.59 0.42 99.73 99.67 1,494 2,435

1983 3.50 6.93 97.73 99.31 3,283 2,167

1984 2.88 4.15 87.30 98.89 2,692 1,984

1985 2.72 4.83 80.27 98.42 2,531 1,789

1986 2.33 14.08 72.72 97.88 2,159 1,378

1987 2.18 12.13 56.30 97.28 2,008 1,021

1988 1.84 4.10 41.99 96.59 1,679 870

1989 1.17 2.61 36.05 95.81 1,057 773

1990 0.83 2.28 32.27 94.93 741 692

1991 0.60 2.13 29.16 93.94 533 621

1992 0.45 2.91 26.43 92.81 399 535

1993 0.34 2.94 23.07 91.53 297 453

1994 0.26 2.62 19.78 90.08 224 381

1995 0.21 1.03 16.91 88.44 174 347

Present value of

cash flows ($9,901) $10,105

Net revenue $204

Source: GAO’s analysis of data from Price Waterhouse’s MMI Fund analysis for fiscal year 1995.

The first column in table I.1 shows the policy year, ranging from the 1st to

the 15th year of a group of mortgages totaling $1 million in unpaid

principal at the time the loans were made. The second, third, and fourth

columns show the fraction of loans that terminate in claims and

prepayments and the fraction of remaining loans at the end of each year.

We calculated these columns from data in Price Waterhouse’s 1995

Actuarial Study and refer to FHA mortgages made in fiscal year 1981. The

next column shows the reduction in principal from amortization on the

standard 30-year fixed-rate mortgages calculated at an interest rate of

13.24 percent (the average rate on 30-year, fixed-rate FHA mortgages in

1981). The losses to lenders from a limitation on FHA’s insurance coverage,

per $1 million of loan originations, would equal the following: $1 million in

originations times the percent of the original balance remaining each year

after amortization; times the fraction of loans terminating in a claim in

Page 53 GAO/RCED-97-93 Homeownership
Appendix I 

Description of Interest Rate Change

Analyses

each year; times 1.05, the ratio of acquisition costs to the outstanding loan

balance; times the 9-percent loss rate assumed for this analysis. The last

column shows the extra revenue that would accrue to lenders from

charging an extra one-quarter of a percent per year, calculated as

one-quarter of a percent times the remaining mortgage balance. We show

the present value of the additional claim costs and additional interest

revenue at the bottom of the table (using 13.24 percent as the discount

rate). The difference in present values demonstrates that the additional

revenues generated by an interest rate increase of one-quarter would have

been more than sufficient to cover the additional claim costs resulting

from a limit in FHA insurance, even under the highly adverse circumstances

of fiscal year 1981 and a 9- percent loss rate to lenders.

Page 54 GAO/RCED-97-93 Homeownership
Appendix II 

Loss Rate Estimates and Volume-Reduction

Scenarios

This appendix provides a detailed description of our analysis of FHA’s loss

rates. We first describe the regression analysis that we conducted to

determine which financial and demographic variables are associated with

higher loss rates. We then describe our methodology for targeting loans

with high loss rates for volume-reduction scenarios.

Impact of

Characteristics of

Borrowers, Loans,

and Properties on

Loss Rates

To determine what types of households would be most affected by a

reduction in FHA’s insurance coverage, we analyzed FHA’s data on

foreclosed properties acquired and sold by FHA during fiscal years 1992-94.

We gathered and linked data from three FHA databases—the Single-Family

Accounting Management System (SAMS, for data on foreclosed properties),

A43 (for accounting data), and F42 (for demographics on borrowers).

Using these data, we analyzed the effects of several variables on losses.

We conducted regression analyses using two dependent variables—the

total loss rate and the loss to the lender. The total loss rate was defined as

the loss (or profit) on a foreclosed property divided by the acquisition cost

(the claim paid by FHA plus any extra legal or other costs incurred by FHA

for acquisition of the property). The loss to the lender was defined as any

loss in excess of the amount that would be covered at the Department of

Veterans Affairs’ (VA) guarantee limits.

We found that certain variables had consistent and significant associations

with losses that lenders would sustain, as shown in tables II.1 and II.2.

Other things equal, loans on buildings with multiple living units, loans to

minority borrowers, loans written at higher interest rates, loans for older

properties, and smaller loans had higher loss rates.37

The results in table II.1 are based on a merger of three HUD files, including

the F42 database, which represents a sample of loans. The results in table

II.2 use data from HUD’s A43 database only, which is a population of

mortgages originated.

37Income and loan size were adjusted to 1995 constant dollars.

Page 55 GAO/RCED-97-93 Homeownership
Appendix II 

Loss Rate Estimates and Volume-Reduction

Scenarios

Table II.1: Impact of Characteristics of

Borrowers, Loans, and Properties on

Loss Rates Total loss rate Lenders’ loss rate

Income and loan size in thousands

Variable Coefficient Significancea Coefficient Significancea

Intercept 0.1126 –0.1608

Black 0.0878 ** 0.0643 **

Hispanic 0.0332 ** 0.0257 **

Native American 0.0416 0.0252

Asian and Pacific

Island 0.0023 0.0082

Unknown race 0.0517 ** 0.0597 **

Female 0.0060 0.0055 *

Borrower age –0.0000 0.0002

Multiple living

units 0.1809

**

0.1743

**

Income –0.0000 –0.0000

First-time-buyer 0.0066 * 0.0036

Interest rate 0.0339 ** 0.0197 **

Loan size –0.0020 ** –0.0003 **

Loan-to-value 0.0078 0.0011

No appraisal –0.0040 –0.0088

Building age 0.0030 ** 0.0021 **

R-squared 0.244 0.216

Observations 19,974

aTwo asterisks indicate significance at the 99-percent confidence level, and one asterisk

indicates significance at the 90-percent level.

Source: GAO’s analysis of HUD’s data.

Page 56 GAO/RCED-97-93 Homeownership
Appendix II 

Loss Rate Estimates and Volume-Reduction

Scenarios

Table II.2: Impact of Selected

Characteristics of Borrowers, Loans,

and Properties on Loss Rates Total loss rate Lenders’ loss rate

Loan size in thousands

Variable Coefficient Significancea Coefficient Significancea

Intercept 0.6608 0.1927

Black 0.1049 ** 0.0812 **

Hispanic 0.0450 ** 0.0341 **

Native American 0.0436 ** 0.0407 **

Asian and Pacific

Island 0.0027 0.0085

Unknown race 0.0290 ** 0.0182 **

Multiple living

units 0.3067

**

0.2536

**

Loan size –0.0036 ** –0.0014 **

Loan-to-value 0.0097 ** 0.0048 **

No appraisal –0.0094 * 0.0021

R-squared 0.154 0.106

Observations 118,529

aTwo asterisks indicate significance at the 99-percent confidence level, and one asterisk

indicates significance at the 90-percent level.

Source: GAO’s analysis of HUD’s data.

Determination of Loss

Rates and

Volume-Reduction

Scenarios

To estimate the impact of a reduction in FHA’s insurance coverage to VA’s

levels on the economic value and resulting capital reserve ratio of

FHA-insured loans, we adjusted the econometric model of FHA’s home loans

developed previously.38 We made two adjustments to reflect the estimated

decrease in the average loss rate per loan and the reduction in the volume

of FHA loans that are likely from an insurance coverage reduction.

We applied VA’s guaranty limits to the losses experienced on FHA loans

during fiscal years 1992-94 and determined what portion of the losses

would have been paid by FHA and what portion would have been borne by

the lender if VA limits had been in effect for those loans. We estimated that

lowering FHA’s insurance coverage on these foreclosed loans would have

lowered FHA’s average loss rate by 17 percent (from 36 to 30 percent) and

losses by about $780 million over the 3-year period.

38See Mortgage Financing: FHA Has Achieved Its Home Mortgage Capital Reserve Target

(GAO/RCED-96-50, Apr. 12, 1996).

Page 57 GAO/RCED-97-93 Homeownership
Appendix II 

Loss Rate Estimates and Volume-Reduction

Scenarios

Regarding the adjustments that we made to our model to reflect

reductions in FHA’s loan volume, FHA’s lender focus group indicated that

FHA’s loan volume would be reduced by 28 percent—18 percent because of

higher costs and tighter underwriting standards targeted at higher-risk

borrowers plus 10 percent because higher FHA costs would cause lowerrisk borrowers to obtain lower-cost private mortgage insurance. However,

the lender focus groups did not discuss how these changes would be

implemented or how higher- and lower-risk borrowers would be identified.

Hence, we estimated our loan volume reduction scenarios using two

different assumptions regarding (1) lenders’ ability to screen out

higher-risk borrowers and (2) which lower-risk borrowers would seek

private insurance. Under what we call the “loose-targeting” scenario, we

assumed that lenders would tighten underwriting standards to a limited

extent so that there was some tendency for higher-risk borrowers to be

denied loans. Under our “tight-targeting” scenario, we assumed a stronger

tendency for denials to be concentrated among higher-risk applicants.

Under both scenarios, we assumed that lenders would screen out loans to

properties with two to four living units, as these loans have high

foreclosure and loss rates. These loans constituted 4 percent of the loans

insured by FHA in fiscal year 1995. For the remaining loans, our

loose-targeting scenario assumed that a further 14 percent of FHA’s fiscal

year 1995 insured loans would be screened out by tighter underwriting

standards. The loans excluded would be loans written at loan-to-value

(LTV) ratios of 95 percent or above and would be spread randomly through

the lower half of the loan size distribution, as small loans have higher

foreclosure and loss rates. Under tight targeting, we assumed that the

smallest 14 percent of the loans with 95 percent or higher LTV ratios would

not be insured.

We then eliminated 10 percent of fiscal year 1995’s insured loans to

account for lower-risk borrowers who may seek private insurance rather

than FHA insurance because of costs. These loans were taken from the

population of loans originated with LTV ratios of less than 95 percent,

selected randomly from the top half of the size distribution.

While we chose to focus on the LTV, loan’s size, and number of units in a

property as our determinants of risk, lenders could use a variety of

approaches to target FHA-insured loans away from borrowers associated

with greater risks of loss. Our analysis of FHA’s data on loan losses, as

discussed above, indicates that in addition to the loan’s size, its LTV ratio,

and the number of units in the property, the age of the property, race of

the borrower, and interest rate on the mortgage are associated with higher

Page 58 GAO/RCED-97-93 Homeownership
Appendix II 

Loss Rate Estimates and Volume-Reduction

Scenarios

foreclosure and/or loss rates on mortgages. However, while lenders may

know the age of the property before making a loan, FHA’s A43 database

does not record the age of the property, so we could not use this variable

to eliminate loans. We did not choose loans for volume reduction on the

basis of the borrower’s race.39 Lastly, interest rates are driven largely by

macroeconomic factors. For these reasons, we focused on the loan’s size,

the LTV ratio, and the number of units in the property to determine which

loans carried the most risk and should be excluded from reduced-volume

scenarios. Lenders could use additional variables to target risk even more

closely.

39Legislation prohibits discrimination based on race. Some analysts maintain that, though illegal, some

lending decisions are influenced by race. The extent to which this happens is a subject of controversy

and beyond the scope of this report.

Page 59 GAO/RCED-97-93 Homeownership
Appendix III 

Other Approaches Would Result in More

Modest Changes to the Fund’s Capital Ratio

While chapter 3 focused primarily on the financial impact on FHA’s capital

reserves of imposing insurance coverage limitations similar to those used

in VA’s loan guarantee program, we also estimated the impact of

implementing two alternative methods of reducing FHA’s insurance

coverage. The primary objectives of the proposals we reviewed are to

reduce FHA’s liability while attempting to provide a higher level of coverage

for those current FHA customers who may be underserved by the

conventional market, such as first-time home buyers and borrowers with

low and moderate incomes. Specifically, we estimated the impact of

reducing FHA’s insurance coverage to VA’s levels for all repeat buyers while

retaining FHA’s existing 100-percent coverage for first-time home buyers.

We also estimated the impact of imposing a graduated coverage schedule

like VA’s, adjusted to provide slightly higher coverage levels for loans of

low and moderate size—60-percent coverage for the lowest loan amounts,

declining to 30 percent for high loan amounts.

While, according to our analysis, these proposals had less of an impact

than using VA’s coverage levels on the estimated economic value of the

Fund compared with the current full insurance policy, they do increase

FHA’s capital reserve ratio. For the first-time home buyer alternative, we

estimated the economic value and the capital reserve ratio under the

assumptions that there would be no reduction in the volume of loans and

that the volume of loans for repeat home buyers would be reduced by 14

percent, while insurance coverage would remain unchanged for first-time

buyers.40 We estimate that this would increase economic value by

$96 million to $118 million over our baseline’s full- insurance estimate and

increase the capital reserve ratio by about 0.3 percent.

Since loans of lower dollar amount have higher losses, we also examined

the alternative of imposing insurance coverage limits that are similar to

VA’s but with slightly higher coverage levels for lower loan amounts.

Specifically, insurance coverage was set at 5 percentage points higher than

VA’s for loans from $90,000 to $144,000 and the same as VA’s for loans

above $144,000. For loans less than $90,000, the insurance coverage was

set 10 percentage points higher. We produced estimates assuming no

reduction in loan volume and a 14-percent reduction in the volume of

loans. Under these scenarios, we estimate an increase in economic value

above our baseline’s full insurance coverage scenario of $90 million if loan

volumes are not reduced but estimate an increase in economic value of

$9 million to $20 million if loan volumes are reduced 14 percent. Capital

40Because less risk is transferred to lenders under this and the following alternative, we reasoned that

any reduction in the volume of loans would be less than that indicated by FHA’s lender focus group.

Page 60 GAO/RCED-97-93 Homeownership
Appendix III 

Other Approaches Would Result in More

Modest Changes to the Fund’s Capital Ratio

reserve ratios increase by about one-quarter of a percent. Our estimates

under these two alternatives are shown in table III.1.

Table III.1: Estimates of the Impact of Alternative Insurance Coverage Reduction Approaches on Loans Insured by FHA in

Fiscal Year 1995, Under Base Case Economic Conditions

Dollars in millions

Insurance coverage

Volume

reduction

(percent)

Volume

reduction

technique

Dollar

volume

of loans

Estimated

economic

value

Initial capital

ratioa (percent)

Full insurance coverage 0 N/A $36,200 $536 1.48

Retain full insurance coverage

for first-time home buyers 0 N/A 36,200 654 1.80

14

Loose targeting

Tight targeting

35,200

35,000

632

639

1.81

1.82

Reduce insurance coverage to

levels higher than VA’s 0 N/A 36,200 626 1.73

14

Loose targeting

Tight targeting

31,100

31,700

545

556

1.75

1.76

Legend

N/A = not applicable

a“Initial Capital Ratio” refers to the economic value of the loans insured by FHA in 1995 as a

percentage of the total original loan amounts for these loans.

Source: GAO’s analysis.

Page 61 GAO/RCED-97-93 Homeownership
Appendix IV 

Comments From the Department of Housing

and Urban Development

Note: GAO comments

supplementing those in the

report text appear at the

end of this appendix.

Page 62 GAO/RCED-97-93 Homeownership
Appendix IV 

Comments From the Department of Housing

and Urban Development

See comment 1.

Page 63 GAO/RCED-97-93 Homeownership
Appendix IV 

Comments From the Department of Housing

and Urban Development

See comment 2.

Page 64 GAO/RCED-97-93 Homeownership
Appendix IV 

Comments From the Department of Housing

and Urban Development

See comment 3.

See comment 4.

Page 65 GAO/RCED-97-93 Homeownership
Appendix IV 

Comments From the Department of Housing

and Urban Development

See comment 5.

See comment 6.

Page 66 GAO/RCED-97-93 Homeownership
Appendix IV 

Comments From the Department of Housing

and Urban Development

See comment 7.

Page 67 GAO/RCED-97-93 Homeownership
Appendix IV 

Comments From the Department of Housing

and Urban Development

See comment 8.

Page 68 GAO/RCED-97-93 Homeownership
Appendix IV 

Comments From the Department of Housing

and Urban Development

See comment 9.

See comment 10.

Page 69 GAO/RCED-97-93 Homeownership
Appendix IV 

Comments From the Department of Housing

and Urban Development

Page 70 GAO/RCED-97-93 Homeownership
Appendix IV 

Comments From the Department of Housing

and Urban Development

Page 71 GAO/RCED-97-93 Homeownership
Appendix IV 

Comments From the Department of Housing

and Urban Development

Page 72 GAO/RCED-97-93 Homeownership
Appendix IV 

Comments From the Department of Housing

and Urban Development

Page 73 GAO/RCED-97-93 Homeownership
Appendix IV 

Comments From the Department of Housing

and Urban Development

The following are GAO’s comments on the Department of Housing and

Urban Development’s letter dated April 4, 1997.

GAO’s Comments 1. We believe that our report provides adequate information in chapters 1

and 2 on the relationship among FHA, VA, private lenders, and Ginnie Mae

and the role that each plays in the U.S. housing market, especially in terms

of the type of borrowers that each serves. Our report also provides

information on the impacts that partial insurance would have on FHA,

Ginnie Mae, private lenders, and potential home buyers. Also, we believe

that our report provides reasonable estimates, on the basis of our analysis,

of the impact on lenders and high-risk borrowers of a change to a partial

insurance program for FHA. We agree that FHA’s role in stabilizing housing

markets during periods of economic distress will be lessened by a

reduction in FHA’s insurance coverage; hence, information has been added

to reflect this in the report.

2. We believe that the report provides reasonable estimates of the range of

possible changes in economic value that may result from a limitation of

FHA’s insurance coverage. We agree with FHA that the estimated effect of

limiting coverage depends on assumptions about economic conditions,

and we clearly indicate circumstances in which economic value is

estimated to decrease as a result of a limitation on insurance coverage.

One of our scenarios in table 3.1 (baseline forecast with a 28-percent

reduction in the volume of loans) and two of our scenarios in table 3.3

(optimistic forecast with a 28-percent reduction in volume of loans) show

declining economic value. Several other scenarios show changes that are

positive but small in magnitude.

3. Our expectation that the volume of loans would likely decline by less

than 28 percent is not based on a belief that lenders who are able to cover

their expected risk will have no incentive to reduce their loan originations.

Our expectation rests on two premises. The first premise is that the

estimate made by FHA’s lender focus group of a one-quarter to one-half

percentage point increase in interest rates is overstated. We believe that

the estimate is overstated because such an increase would cover expected

losses 5 to 10 times over and would more than cover losses under the most

adverse conditions experienced by FHA over the last 20 years. If lenders

raise interest rates by a smaller amount than was predicted by the focus

group, fewer potential borrowers would be priced out of the FHA program.

The second premise is that borrowers who are excluded from the FHA

program because lenders require higher down payments or higher income

Page 74 GAO/RCED-97-93 Homeownership
Appendix IV 

Comments From the Department of Housing

and Urban Development

may return to the housing market at a later date. For at least some of these

borrowers, savings and/or income will have increased, allowing them to

qualify for mortgages under more stringent underwriting standards. While

we agree with FHA’s lender focus group that issues of risk and the volatility

of risk would cause FHA lenders to tighten underwriting standards, we

believe that some of the resulting decrease in FHA’s insured lending will be

temporary, not permanent.

4. Text has been added to chapter 2, which discusses the transfer of risk

for non-FHA loans. The added text discusses the possibility that limiting

FHA’s insurance coverage could change the distribution of risk among

market participants and the fact that any reduction in FHA’s coverage

would entail shifting this risk to the originators of FHA mortgages.

5. We believe that the 1984 changes that were made in VA’s procedures for

determining when to acquire a foreclosed property or leave it with the

lender provide valuable insight into the potential response of FHA’s lenders

to a change in their risk exposure. However, HUD believes that it is

inappropriate to use VA’s experience (including the VA no-bid procedures)

as a basis for predicting lenders’ response to a reduction in FHA’s insurance

coverage for two reasons. First, VA has always operated a partial insurance

program, and for this reason, the 1984 changes in VA’s no-bid procedure

would not have as major an impact on lenders’ participation as a reduction

in FHA’s insurance coverage. Second, HUD stated that VA’s program is very

limited and serves a very different type of borrower from the type served

by FHA. We disagree on both points. While VA has always provided only

partial insurance coverage, as discussed in this report, the 1984 changes to

VA’s no-bid process required by the 1984 Deficit Reduction Act had a

substantial impact on the level of risk assumed by VA’s lenders. The

number of foreclosed loans in which VA paid the total guarantee and left

the property with the lender increased substantially after the no-bid policy

went into effect in fiscal year 1985. While VA’s program is available to

members of the armed forces, veterans and their families currently make

up about 80 percent of VA’s borrowers. In addition, as pointed out in

chapter 2 of this report, FHA’s and VA’s programs are very similar in terms

of the types of borrowers, LTV ratios, and geographic markets served.

6. We agree that one cannot eliminate the risk of catastrophic loss, and our

report does not suggest that this may occur. Our report states that

reducing FHA’s insurance coverage will shift this risk to lenders, who will

then respond by increasing interest rates and making fewer higher-risk

loans. Lenders may sell this risk to other firms. Even after considering

Page 75 GAO/RCED-97-93 Homeownership
Appendix IV 

Comments From the Department of Housing

and Urban Development

catastrophic losses, HUD’s lender focus group concluded that making FHA

loans under partial insurance is profitable and that 72 percent of FHA

volume of loans would be retained. The report also states that this

increase in the risk of loss to lenders could lead to increased financial

losses for Ginnie Mae.

7. Text that discusses the issue of capital requirements has been added to

chapter 2.

8. We added information to the section of chapter 2 to explain that

because other factors, such as credit history, are considered during the

underwriting process, not every borrower who meets the private mortgage

insurers’ LTV and qualifying ratio guidelines may necessarily be eligible for

private mortgage insurance. Similarly, we note that private mortgage

insurance might still be provided to a borrower who fails to meet all of the

LTV and qualifying ratio guidelines if compensating factors are deemed

sufficient during the underwriting process. This information, although

useful for understanding the types of borrowers likely to be most affected

by an insurance coverage reduction, is not the basis for our critique of the

28-percent volume reduction estimate. As discussed in chapter 2, we

believe that the 28-percent estimate is overstated for two reasons. First,

the 28 percent estimate is predicated upon an interest rate increase of

one-quarter to one-half percentage point, which our analysis indicates is

more than is likely to occur. Also, potential borrowers who are excluded

by tightened underwriting criteria may qualify for a loan at a later date—a

possibility not considered by the lender focus group convened by FHA.

9. As noted in chapter 3, our analyses of the impact of a coverage

reduction on the capital reserve ratio and economic value of FHA’s fiscal

year 1995 loans assumes, as did HUD’s analysis, that FHA’s premium

structure would remain unchanged. Our analysis is largely based on the

results of the lender focus group sponsored by HUD, which assumed a

constant premium structure. Our report explains in chapters 2 and 3 that

reducing FHA’s insurance coverage might cause decisionmakers to lower

premiums. Our report also explains that if this occurs, the reduced

insurance premium may at least partially offset any increase in the Fund’s

capital reserve.

10. HUD stated that we did not adequately discuss the impact that reducing

FHA’s insurance coverage would have on FHA’s ability to stabilize regional

housing markets during periods of economic distress. We agree.

Information has been added to the report reflecting FHA’s role in market

Page 76 GAO/RCED-97-93 Homeownership
Appendix IV 

Comments From the Department of Housing

and Urban Development

stabilization and the possible diminishing effect that a reduction in FHA’s

insurance coverage could have on FHA’s ability to continue to stabilize

distressed communities.

Page 77 GAO/RCED-97-93 Homeownership
Appendix V 

Major Contributors to This Report

Resources,

Community, and

Economic

Development

Division, Washington,

D.C.

Leslie Black-Plumeau

Jay R. Cherlow

Austin Kelly

Robert S. Procaccini

Phillis Riley

Patrick L. Valentine

Page 78 GAO/RCED-97-93 Homeownership
Appendix V 

Major Contributors to This Report

Page 79 GAO/RCED-97-93 Homeownership
Related GAO Products

Homeownership: FHA’s Role in Helping People Obtain Home Mortgages

(GAO/RCED-96-123, Aug. 13, 1996).

Mortgage Financing: FHA Has Achieved Its Home Mortgage Capital Reserve

Target (GAO/RCED-96-50, Apr. 12, 1996).

Rural Housing: Opportunities Exist for Cost Savings and Management

Improvement (GAO/RCED-96-11, Nov. 16, 1995).

Homeownership: Mixed Results and High Costs Raise Concerns About

HUD’s Mortgage Assignment Program (GAO/RCED-96-2, Oct. 18, 1995).

Property Disposition: Information on HUD’s Acquisition and Disposition of

Single-Family Properties (GAO/RCED-95-144FS, July 24, 1995).

Rural Housing: Shift to Guaranteed Program Can Benefit Borrowers and

Reduce Government’s Exposure (GAO/RCED/AIMD-95-63, Dec. 21, 1994).

Mortgage Financing: Financial Health of FHA’s Home Mortgage Insurance

Program Has Improved (GAO/RCED-95-20, Oct. 18, 1994).

Rural Development: Patchwork of Federal Programs Needs to Be

Reappraised (GAO/RCED-94-165, July 28, 1994).

Homeownership: Appropriations Made to Finance VA’s Housing Program

May Be Overestimated (GAO/RCED-93-173, Sept. 8, 1993).

Homeownership: Actuarial Soundness of FHA’s Single-Family Mortgage

Insurance Program (GAO/T-RCED-93-64, July 27, 1993).

Government National Mortgage Association: Greater Staffing Flexibility

Needed to Improve Management (GAO/RCED-93-100, June 30, 1993).

Homeownership: Loan Policy Changes Made to Strengthen FHA’s Mortgage

Insurance Program (GAO/RCED-91-61, Mar. 1, 1991).

(365641) Page 80 GAO/RCED-97-93 Homeownership
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