Report to Congressional Requesters

United States Government Accountability Office

GAO 

June 2007 FEDERAL HOUSING 

ADMINISTRATION 

Modernization 

Proposals Would Have 

Program and Budget 

Implications and 

Require Continued 

Improvements in Risk 

Management 

GAO-07-708 
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

June 2007

FEDERAL HOUSING ADMINISTRATION

Modernization Proposals Would Have 

Program and Budget Implications and 

Require Continued Improvements in Risk 

Management 

Highlights of GAO-07-708, a report to 

congressional requesters 

In recent years, the Federal

Housing Administration (FHA) has 

experienced a sharp decline in

market share. Also, the agency has 

estimated that, absent program 

changes, its Mutual Mortgage

Insurance Fund (Fund) would 

require appropriations in 2008. To 

adapt to market changes, FHA has 

implemented new procedures and

proposed the following major 

legislative changes: raising FHA’s 

loan limits, allowing risk-based

pricing, and lowering downpayment requirements. GAO was 

asked to report on (1) the likely 

program and budget impacts of

FHA’s modernization efforts; 

(2) the tools, resources, and riskmanagement practices important to

FHA’s implementation of the 

legislative proposals, if passed; and 

(3) other options that FHA and

Congress could consider to help

FHA adapt to market changes. To 

address these objectives, GAO 

analyzed FHA and Home Mortgage

Disclosure Act (HMDA) data and 

interviewed officials from FHA and

other mortgage institutions. 

What GAO Recommends

While making no new 

recommendations, GAO reemphasizes the need for continued 

management attention to prior 

GAO recommendations that could

help address risks and challenges 

associated with the legislative 

proposals. HUD commented that 

the report’s concerns about FHA’s 

risk management and emphasis on

the need for piloting new products

were unwarranted. 

FHA’s recent changes to insurance approval and appraisal requirements 

have streamlined its insurance process, and FHA’s major legislative 

proposals could affect the demand for FHA’s loans, the cost and availability 

of insurance to borrowers, and the insurance program’s budgetary costs.

Based on GAO’s analysis of HMDA data, the number of FHA-insured loans 

could have been from 9 to 10 percent greater in 2005 had the higher, 

proposed mortgage limits been in effect. GAO’s analysis of data on 2005 FHA 

home purchase borrowers shows that 43 percent would have paid the same

or less under the risk-based pricing proposal than they actually paid, 37 

percent would have paid more, and 20 percent (those with the highest 

expected claim rates) would not have qualified for FHA insurance. While to 

be viewed with caution, FHA has made estimates indicating that the loans it 

expects to insure in 2008 would result in negative subsidies (i.e., net cash 

inflows) of $342 million if the major legislative changes were enacted, rather 

than requiring an appropriation of $143 million absent any program changes. 

FHA has taken or planned steps to enhance tools and resources and adopt 

risk-management practices important to implementing the legislative 

proposals, but does not intend to use a common industry practice, piloting, 

to mitigate the risks of any zero-down-payment product it is authorized to 

offer. In response to prior GAO recommendations, FHA has taken steps to 

improve the loan performance and scoring models it would use in risk-based 

pricing. It also has identified minor changes to its information systems and 

staff increases needed to implement the proposals but faces long-term 

challenges in these areas. Additionally, the legislative proposals would 

introduce new risks. The proposal to lower down-payment requirements is 

of particular concern given the higher default rates on these loans and the 

difficulty of setting prices for new products whose risks may not be well 

known. GAO has previously indicated that Congress may want to consider 

requiring FHA to limit the initial availability of any new products and also 

recommended that FHA itself consider piloting. However, FHA has indicated

that it does not plan to pilot any no-down-payment product it might offer. 

Mortgage industry participants and researchers have suggested more options 

that Congress and FHA could consider to help FHA adapt to changes in the 

mortgage market, but some changes could have budget impacts and 

complicate oversight efforts. Some administrative changes—such as

implementing a more limited form of risk-based pricing—are within FHA’s 

existing authority. Congress also could grant FHA additional authority that 

would allow it to invest the Fund’s current resources in information 

technology and human capital, but this would increase the federal 

government’s budget deficit. Finally, Congress could contemplate other 

approaches to the provision of federal mortgage insurance, such as creating 

a government corporation. However, any fundamental changes to how the 

federal government provides mortgage insurance could require new 

oversight mechanisms and would require careful deliberation. 

www.gao.gov/cgi-bin/getrpt?GAO-07-708.

To view the full product, including the scope 

and methodology, click on the link above. 

For more information, contact William B. 

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

Letter 1

Results in Brief 3

Background 6

Modernization Efforts Have Streamlined FHA Processes and Likely 

Would Affect Program Participation and Costs 12 

FHA Has Enhanced Tools and Resources Important to 

Implementing Proposals but Does Not Intend to Mitigate Risks 

by Piloting New Products 24 

Congress and FHA Could Consider Other Administrative and 

Legislative Changes to Help FHA Adapt to Changes in the 

Mortgage Market 33 

Observations 39

Agency Comments and Our Evaluation 41 

Appendix I Objectives, Scope, and Methodology 44 

Appendix II Comments from the Department of Housing and 

Urban Development 48 

Appendix III GAO Contact and Staff Acknowledgments 51

Figures 

Figure 1: Proposed Changes to FHA’s Loan Limits 11 

Figure 2: Impact of Borrower Credit Scores and LTV Ratios on 

Insurance Premiums under FHA’s Risk-Based Pricing 

Proposal 18

Figure 3: Impact of FHA’s Risk-Based Pricing Proposal on 

Borrowers’ Premiums, Including First-Time and LowIncome Homebuyers 19 

Figure 4: Impact of FHA’s Risk-Based Pricing Proposal on 

Premiums Paid by Different Racial Groups 20 

Figure 5: Impact of FHA’s Risk-Based Pricing Proposal on Racial 

Distribution of FHA Borrowers 22 

Page i GAO-07-708 FHA Modernization Efforts 
Abbreviations 

CBSA core based statistical area

FHA Federal Housing Administration 

FTE full-time equivalent 

HECM Home Equity Conversion Mortgage 

HUD Department of Housing and Urban Development 

HMDA Home Mortgage Disclosure Act 

IRS Internal Revenue Service 

LTV loan-to-value

MHC Millennial Housing Commission 

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Page ii GAO-07-708 FHA Modernization Efforts 
United States Government Accountability Office

Washington, DC 20548 

June 29, 2007 

The Honorable Richard C. Shelby 

Ranking Member 

Committee on Banking, Housing, 

 and Urban Affairs 

United States Senate 

The Honorable Wayne Allard 

United States Senate 

The Department of Housing and Urban Development (HUD), through its 

Federal Housing Administration (FHA), has helped millions of families 

purchase homes by providing insurance for single-family home mortgages 

made by private lenders. However, FHA’s single-family insurance program 

has faced several challenges in recent years, including rising delinquency

rates and a sharp decline in the number of participating borrowers, due 

partly to increased competition from conventional mortgage providers.1

 As 

conventional providers have improved their ability to evaluate risk, FHA 

has begun to experience adverse selection—that is, conventional 

providers have identified and approved relatively lower-risk borrowers in 

FHA’s traditional market segment, leaving relatively higher-risk borrowers 

for FHA. Furthermore, the agency has estimated that, absent any program 

changes, the program would for the first time operate with a positive 

subsidy in fiscal year 2008—meaning that the present value of estimated 

cash outflows (such as insurance claims) to FHA’s Mutual Mortgage 

Insurance Fund (Fund) would exceed the present value of estimated cash 

inflows (such as borrower premiums). To avoid a positive subsidy in fiscal

year 2008, FHA estimates that it would have to increase slightly the 

insurance premiums charged to borrowers. 

To adapt to market changes, FHA has implemented new administrative 

procedures and proposed legislation designed to modernize its insurance 

processes and products. FHA’s recent administrative changes include 

 1

The conventional market comprises mortgages that do not carry government insurance or

guarantees. For more information on the decline in FHA’s share of the mortgage market

and the factors underlying this trend, see GAO, Federal Housing Administration: Decline 

in the Agency’s Market Share Was Associated with Product and Process Developments of

Other Mortgage Market Participants, GAO-07-645 (Washington, D.C.: June 29, 2007). 

Page 1 GAO-07-708 FHA Modernization Efforts 
allowing higher-performing lenders to endorse, or approve, loans for FHA 

insurance without prior review by FHA and adopting conventional market 

appraisal requirements. The legislative proposals would, among other 

things, raise FHA’s mortgage limits, give the agency flexibility to set 

insurance premiums based on the credit risk of borrowers, and reduce 

down-payment requirements from the current 3 percent to potentially 

zero. However, as we testified in June 2006, weaknesses in FHA’s risk 

management raise questions about the agency’s ability to successfully 

implement the proposed legislation.2

 Given these concerns, you asked us 

to evaluate FHA’s modernization efforts. Specifically, this report discusses 

(1) the likely program and budgetary impacts of FHA’s modernization 

efforts; (2) the tools, resources, and risk-management practices important 

to FHA’s implementation of the legislative proposals, if passed; and 

(3) other options that FHA and Congress could consider to help FHA 

adapt to changes in the mortgage market and the pros and cons of these 

options. 

To determine the likely program and budgetary impacts of FHA’s 

modernization efforts, we analyzed data collected under the Home 

Mortgage Disclosure Act (HMDA) and from FHA’s Single Family Data 

Warehouse (SFDW).3

 Specifically, we used 2005 HMDA data (the most 

current available) to examine the effect of raising loan limits on demand 

for FHA-insured loans. We determined the number of additional loans in

different geographic areas that would have been eligible for FHA 

insurance under the revised loan limits and, based on FHA’s current 

market share, estimated the percentage of those loans that FHA might 

have insured. We estimated the effects of risk-based pricing on borrowers’ 

eligibility for FHA insurance and the premiums they would pay by 

analyzing SFDW data on FHA’s 2005 home purchase borrowers to 

determine the characteristics of borrowers that could fall into FHA’s 

proposed pricing categories. We reviewed recent administrative changes 

made by FHA and interviewed FHA officials, several FHA lenders, and 

 2

GAO, Federal Housing Administration: Proposed Reforms Will Heighten the Need for

Continued Improvements in Managing Risks and Estimating Program Costs, 

GAO-06-868T (Washington, D.C.: June 20, 2006). 

3

HMDA requires lending institutions to collect and publicly disclose information about

housing loans and applications for such loans, including the loan type and amount, 

property type, and borrower characteristics (such as ethnicity, race, gender, and income).

These data are one of the most comprehensive sources of information on mortgage 

lending. Among other things, FHA’s SFDW contains information on the borrower and loan

characteristics of the mortgages FHA insures.

Page 2 GAO-07-708 FHA Modernization Efforts 
mortgage and real estate industry groups about their effects on loan and

insurance processing times and costs. We also examined the potential 

budgetary impacts of the legislative proposals by reviewing the President’s 

fiscal year 2008 budget and FHA’s cost estimates. To evaluate the tools, 

resources, and risk-management practices important to FHA’s 

implementation of the proposals, we relied on our prior work, reviewed 

information provided by FHA, and interviewed officials from FHA, private 

mortgage insurers, and the government-sponsored enterprises (GSE) 

Fannie Mae and Freddie Mac.4

 To determine other options that FHA and 

Congress could consider, we reviewed relevant literature and interviewed 

FHA officials, academic experts, FHA lenders, and private mortgage 

insurers. Appendix I contains additional information on our scope and

methodology. We conducted this work in Washington, D.C., from 

September 2006 to June 2007 in accordance with generally accepted 

government auditing standards. 

FHA’s modernization efforts, which include completed administrative and 

proposed legislative changes, have streamlined the agency’s insurance 

process and could affect the demand for FHA-insured loans, the cost and 

availability of insurance to borrowers, and the budgetary costs of the 

insurance program. In 2006, FHA made several administrative changes, 

such as allowing higher-performing lenders to approve FHA insurance 

without prior review by FHA and simplifying its appraisal process. FHA 

and mortgage industry officials with whom we spoke said that these 

changes have increased the efficiency of loan and insurance processing, 

making FHA products more attractive and, therefore, more likely to be

used. For example, one FHA lender reported a 35 percent decrease in loan

processing times and a 25 percent reduction in operating costs for its FHA 

business. In addition to these administrative changes, FHA has proposed 

legislation that would grant the agency new flexibilities intended to help 

address challenges, such as adverse selection, resulting from innovations 

and increased competition in the mortgage market. If passed, the 

legislative changes likely would affect borrower participation in the 

program and the program’s budgetary costs. Based on our analysis of 2005 

HMDA data, we estimate that the number of FHA-insured loans in 2005

could have been from 9 to 10 percent greater had the higher, proposed 

Results in Brief 

 4

Fannie Mae and Freddie Mac are government-sponsored private corporations chartered by

Congress to provide a continuous flow of funds to mortgage lenders and borrowers by 

purchasing mortgages from lenders and re-selling them to investors. They purchase singlefamily mortgages up to the conforming loan limit, which for 2006 was set at $417,000. 

Page 3 GAO-07-708 FHA Modernization Efforts 
mortgage limits been in effect. Although the effect of introducing riskbased premiums on the demand for FHA-insured loans is especially 

difficult to estimate, risk-based pricing would affect the cost and 

availability of FHA insurance. Specifically, risk-based pricing would 

decrease premiums for lower-risk borrowers and increase them for higherrisk borrowers. Our analysis of data for FHA home purchase borrowers in 

2005 shows that about 43 percent of those borrowers would have paid the 

same or less than they actually paid, 37 percent would have paid more, and 

20 percent would not have qualified for FHA insurance based on FHA’s 

plans as of May 2007. (The same percentages hold true when risk-based 

pricing is compared with the higher across-the-board premiums that FHA 

estimates it would have to charge to avoid a positive subsidy in fiscal year 

2008 absent any program changes.) The 20 percent who would not have

qualified were borrowers with expected lifetime claim rates more than 2.5 

times greater than the average claim rate. The legislative proposals also 

would have a budgetary impact, mostly reflected in subsidy costs. While to 

be viewed with caution, FHA has made estimates indicating that the loans 

it expects to insure in 2008 would result in negative subsidies of $342 

million if the major legislative changes were enacted, rather than requiring 

an appropriation of $143 million absent any program changes. 

FHA has taken or planned steps to enhance the tools and resources 

important to implementing the legislative proposals—and help address 

risks and challenges associated with the proposals—but does not intend to

use a common industry practice, piloting, to mitigate the risks of any zerodown-payment product it is authorized to offer. To implement its riskbased pricing proposal, FHA would rely on statistical models that estimate 

the performance of loans and its mortgage scorecard, an automated tool 

that evaluates the default risk of borrowers. In response to our prior 

recommendations, FHA has improved the forecasting ability of its loan 

performance models by incorporating additional variables found to 

influence credit risk and is in the process of addressing a number of 

limitations in its mortgage scorecard that could reduce its effectiveness for 

risk-based pricing. For instance, as we reported in April 2006, the 

scorecard does not include a number of important variables included in

other mortgage institutions’ scorecards, such as the source of the down 

payment.5

 FHA also has identified changes in information systems needed 

to implement the legislative proposals and has obligated or requested a 

 5

GAO, Mortgage Financing: HUD Could Realize Additional Benefits from Its Mortgage 

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

Page 4 GAO-07-708 FHA Modernization Efforts 
total of $11 million for this purpose. To address human capital needs, the 

President’s fiscal year 2008 budget requests 21 additional staff for FHA to 

help analyze industry trends, align the agency’s business processes with 

current mortgage industry practices, and promote new FHA products. 

Although FHA has taken actions to enhance key tools and resources, it 

operates in a highly competitive environment in which other market 

participants have greater flexibility to hire and compensate staff and invest 

in information technology, which enhances their ability to adapt to market 

changes. Additionally, the legislative proposals would introduce new risks 

and challenges. The proposal to lower down-payment requirements is of 

particular concern given the greater default risk of low-down-payment 

loans, housing market conditions that could put borrowers with such 

loans in a negative equity position, and the difficulty of setting prices for 

new products whose risks may not be well understood. FHA plans to take 

some steps, such as instituting stricter underwriting standards, to mitigate 

these risks and challenges. However, while other mortgage institutions use 

pilot programs to manage the risks associated with changing or expanding

their product lines, FHA has indicated that it does not plan to pilot any 

zero-down-payment product it is authorized to offer and lacks the 

resources to do so. We have previously reported that Congress may want 

to consider requiring FHA to limit the initial availability of any new 

products and also recommended that FHA itself consider piloting. 

Mortgage industry participants and researchers have suggested a number

of additional administrative and legislative options that Congress and FHA 

could consider to help FHA adapt to changes in the mortgage market, but 

some changes could have budget impacts and complicate oversight efforts. 

Some administrative changes—such as adjusting premiums or even 

implementing a more limited form of risk-based pricing—are within FHA’s 

existing authority. Congress also could consider granting FHA additional 

authorities that would increase the agency’s operational flexibility. For 

example, Congress could allow FHA to invest the Fund’s current 

resources—that is, negative subsidies that accrue in the Fund’s reserves—

in information technology and human capital. However, using the Fund’s 

current resources would diminish its ability to withstand severe economic 

conditions and would also increase the federal government’s budget 

deficit, all other things being equal. Additionally, Congress could expressly 

authorize FHA to offer and pilot new insurance products without prior 

congressional approval. Finally, Congress could consider various 

alternative approaches to the provision of federal mortgage insurance. For

example, the federal government could continue to provide mortgage 

insurance but through a more independent government corporation, 

implement risk-sharing arrangements with private partners, or let market 

Page 5 GAO-07-708 FHA Modernization Efforts 
forces determine the future need for federal mortgage insurance by 

making no program changes and allowing FHA’s role in the mortgage 

market to increase or decrease according to market conditions. However, 

any fundamental changes to how the federal government provides 

mortgage insurance also could require new oversight mechanisms and 

would require careful deliberation. 

While our report does not make any new recommendations, we make 

observations about the need for careful implementation of the legislative 

proposals, if passed. While FHA has performed considerable analysis to 

support its legislative proposals and has made or planned enhancements 

to many of the specific tools and resources that would be important to its 

implementation, the proposals present risks and challenges and should be 

viewed with caution. Continued management attention to our prior 

recommendations, including piloting new products and steps to improve 

its mortgage scorecard, could help FHA address these risks. 

We provided HUD with a draft of this report. HUD commented that the 

draft report provided a balanced assessment but also that the report’s 

concerns about FHA’s risk management and emphasis on the need for 

piloting zero- or lower-down-payment products were unwarranted. HUD 

indicated that it had a firm basis for anticipating the performance of these 

products as a result of its experience with loans with down-payment 

assistance from nonprofit organizations funded by home sellers. While we 

acknowledge that this experience could inform assessment of how a zerodown-payment product would perform, the product could be utilized by a 

different population of borrowers than seller-funded down-payment 

assistance loans and may not perform similarly to these loans. Also, if 

authorized to offer a zero-down-payment product in the near future, FHA 

would be introducing it at a time when stagnating or declining home prices 

in some parts of the country could increase the risk of default. Because of 

these risks and uncertainties, we continue to believe that a prudent way to 

introduce a zero-down-payment product would be to limit its initial 

availability such as through a pilot program. We discuss HUD’s comments 

in the agency comments section, and the agency’s written comments are 

reproduced in appendix II. 

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

479) to broaden homeownership, protect and sustain lending institutions, 

and stimulate employment in the building industry. FHA insures a variety

of mortgages for initial home purchases, construction and rehabilitation, 

and refinancing. In fiscal year 2006, FHA insured almost 426,000 mortgages 

Background 

Page 6 GAO-07-708 FHA Modernization Efforts 
representing $55 billion in mortgage insurance. FHA’s single-family 

programs insure private lenders against losses from borrower defaults on

mortgages that meet FHA criteria for properties with one to four housing 

units. FHA has played a particularly large role among minority, lowerincome, and first-time homebuyers and generally is thought to promote 

stability in the market by ensuring the availability of mortgage credit in

areas that may be underserved by the private sector or are experiencing 

economic downturns. In fiscal year 2006, 79 percent of FHA-insured home 

purchase loans went to first-time homebuyers, 31 percent of whom were 

minorities. 

FHA is a government mortgage insurer in a market that also includes 

private insurers. Generally, borrowers are required to purchase mortgage 

insurance when the loan-to-value (LTV) ratio—the ratio of the amount of

the mortgage loan to the value of the home—exceeds 80 percent. Private

mortgage insurance policies provide lenders coverage on a portion 

(generally 20 to 30 percent) of the mortgage balance. However, borrowers 

who have difficulty meeting down-payment and credit requirements for 

conventional loans may find it easier to qualify for a loan with FHA 

insurance, which covers 100 percent of the value of the loan. Because the 

credit risk is mitigated by the federal guaranty, FHA borrowers are 

allowed to make very low down payments and generally pay interest rates 

that are competitive with prime mortgages. 

FHA Insurance 

Requirements 

Legislation sets certain standards for FHA-insured loans. FHA-insured 

borrowers are required to make a cash investment of a minimum of 3 

percent. This investment may come from the borrowers’ own funds or 

from certain third-party sources. However, borrowers are permitted to 

finance their mortgage insurance premiums and some closing costs, which 

can create an effective LTV ratio of close to 100 percent for some FHAinsured loans. Congress also has set limits on the size of the loans that 

may be insured by FHA. These limits vary by county. The limit for an FHAinsured mortgage is 95 percent of the local median home price, not to 

exceed 87 percent or fall below 48 percent of the Freddie Mac conforming 

loan limit, which was $417,000 in 2006. Therefore, in 2006, FHA loan limits 

fell between a floor in low-cost areas of $200,160 and a ceiling in high-cost

areas of $362,790. Eighty-two percent of counties nationwide had loan 

limits set at the low-cost floor, while 3 percent had limits set at the highcost ceiling. The remaining 15 percent of counties had limits set between 

the floor and ceiling, at 95 percent of their local median home prices. 

Page 7 GAO-07-708 FHA Modernization Efforts 
FHA insures most of its single-family mortgages under its Mutual Mortgage 

Insurance Fund, which is supported by borrowers’ insurance premiums. 

FHA has the authority to establish and collect a single up-front premium in 

an amount not to exceed 2.25 percent of the amount of the original insured 

principal obligation of the mortgage, and annual premiums of up to 0.5 

percent of the remaining insured principal balance, or 0.55 percent for 

borrowers with down payments of less than 5 percent. Currently, FHA 

uses a flat premium structure whereby all borrowers pay the same 1.5 

percent up-front fee and a 0.5 percent annual fee.

FHA’s Mutual Mortgage 

Insurance Fund 

The Omnibus Budget Reconciliation Act of 1990 requires an annual 

independent actuarial review of the economic net worth and soundness of 

the Fund. The actuarial review estimates the economic value of the Fund 

as well as the capital ratio to see if the Fund has met the capital standards 

in the act.

6

 The analysis considers the historical performance of the 

existing loans in the Fund, projected future economic conditions, loss 

given claim rates, and projected mortgage originations. The Fund has met 

the capital ratio requirements since 1995, and the single-family mortgage 

insurance program has maintained a negative overall credit subsidy rate, 

meaning that the present value of estimated cash inflows from premiums 

and recoveries exceeds estimated cash outflows for claim payments 

(excluding administrative costs). However, in recent years, the subsidy 

rate has approached zero. 

A few single-family mortgage insurance programs are insured as 

obligations under either the General Insurance or Special Risk Insurance 

Funds. These programs are Section 203(k) rehabilitation mortgages, which 

enable borrowers to finance both the purchase (or refinancing) of a house 

and the cost of its rehabilitation through a single mortgage; Section 234(c)

insurance for the purchase of a unit in a condominium building; and 

reverse mortgages under the Home Equity Conversion Mortgage (HECM) 

program, which can be used by homeowners age 62 and older to convert 

the equity in their home into a lump sum payment, monthly streams of 

income, or a line of credit to be repaid when they no longer occupy the 

home. 

 6

The economic value of the Fund is the value of the Fund’s assets minus its liabilities, plus 

the net present value of future cash flows of the outstanding portfolio. The capital ratio is 

the economic value divided by the amount of unamortized insurance-in-force (the total 

initial loan amounts of outstanding insured loans). The Omnibus Budget Reconciliation Act 

of 1990 mandated that the Fund achieve a capital ratio of at least 2 percent by fiscal year 

2000 and maintain that level in all future years. See P.L. 101-508, Section 2105. 

Page 8 GAO-07-708 FHA Modernization Efforts 
Two major trends in the conventional mortgage market have significantly 

affected FHA. First, in recent years, members of the conventional 

mortgage market increasingly have been active in supporting low- and nodown-payment mortgages, increasing consumer choices for borrowers 

who may have previously chosen an FHA-insured loan. Subprime lenders, 

in particular, have offered mortgage products featuring flexible payment 

and interest options that allowed borrowers to qualify for mortgages 

despite a rise in home prices.7

 Second, to help assess the default risk of 

borrowers, particularly those with high LTV ratios, the mortgage industry 

increasingly has used mortgage scoring and automated underwriting 

systems. Underwriting refers to a risk analysis that uses information 

collected during the origination process to decide whether to approve a 

loan, and automated underwriting refers to the process by which lenders 

enter information on potential borrowers into electronic systems that 

contain an evaluative formula, or algorithm, called a scorecard. The 

scorecard algorithm attempts to measure the borrower’s risk of default 

quickly and objectively by examining data such as application information 

and credit scores. (Credit scores assign a numeric value generally ranging

from 300 to 850 to a borrower’s credit history, with higher values 

signifying better credit.) The scorecard compares these data with specific 

underwriting criteria (e.g., cash reserves and credit requirements) to 

predict the likelihood of default. Since 2004, FHA has used its own 

scorecard called Technology Open to Approved Lenders (TOTAL). FHA 

lenders now use TOTAL in conjunction with automated underwriting 

systems to determine the likelihood of default. Although TOTAL can 

determine the credit risk of a borrower, it does not reject a loan. FHA 

requires lenders to manually underwrite loans that are not accepted by 

TOTAL to determine if the loan should be accepted or rejected. 

Trends in the Mortgage 

Market and Their Impact 

on FHA 

Further, as we noted in a recent report, the share of home purchase 

mortgage loans insured by FHA has fallen dramatically, from 19 percent in

1996 to 6 percent in 2005, with almost all the decline occurring since 2001.

8

The combination of (1) FHA product restrictions and a lack of process 

improvements relative to the conventional market and (2) product 

innovations and expanded loan origination and funding channels in the 

conventional market—coupled with interest rate and house price 

changes—provided conditions that favored conventional mortgages over 

 7

Subprime borrowers typically have blemished credit, may have difficulty providing income

documentation, and generally pay higher interest rates and fees than prime borrowers. 

8

GAO-07-645. 

Page 9 GAO-07-708 FHA Modernization Efforts 
FHA products. Conventional subprime loans, in particular, emerged as an 

alternative to FHA-insured mortgages but often at a higher ultimate cost to 

certain borrowers. 

At the same time, FHA’s financial performance has worsened. As we noted 

in a recent testimony, one reason for deteriorating loan performance has 

been the increase in FHA-insured loans with down-payment assistance 

from nonprofit organizations funded by home sellers.9

 Down-payment 

assistance programs provide cash assistance to homebuyers who cannot 

afford to make the minimum down payment or pay the closing costs 

involved in obtaining a mortgage. From 2000 to 2006, the total proportion 

of FHA-insured home purchase loans with down-payment assistance from 

nonprofits (the large majority of which received funding from property 

sellers) increased from about 2 percent to approximately 33 percent. 

Legislative Proposals for 

FHA Modernization 

To help FHA adapt to recent trends in the mortgage market, in 2006 HUD 

submitted a legislative proposal to Congress that included changes that 

would adjust loan limits for the single-family mortgage insurance program, 

eliminate the requirement for a minimum down payment, and provide 

greater flexibility to FHA to set insurance premiums based on risk factors. 

HUD’s proposal, as it currently stands, reflects revisions made by the 

Expanding American Homeownership Act of 2006, which was passed by 

the House of Representatives in July 2006. Specifically, as shown in figure 

1, the proposal would increase the loan limit for FHA-insured mortgages 

from 95 to 100 percent of the local median home price. It would also raise 

the loan limit floor in low-cost areas from 48 to 65 percent of the 

conforming loan limit, and the ceiling in high-cost areas from 87 to 100 

percent of the conforming limit.10 The proposal would also repeal the 3 

percent minimum cash investment requirement and allow FHA to set 

premiums commensurate with the risk of the loan.

11 FHA would establish a 

premium structure allowing either a combination of upfront and annual 

 9

GAO, Federal Housing Administration: Ability to Manage Risks and Program Changes 

Will Affect Financial Performance, GAO-07-615T (Washington, D.C.: Mar. 15, 2007).

10According to FHA, the existing loan limits are lower than the cost of new construction in

many areas of the country and therefore do not allow buyers of new homes to use FHA

products. 

11The proposal to repeal the 3 percent minimum cash investment requirement would

eliminate the complicated statutory formula used to calculate down payments. This 

formula considers multiple variables such as the average closing costs in the state. 

Page 10 GAO-07-708 FHA Modernization Efforts 
premiums or annual premiums alone, subject to specified maximum 

amounts. 

Figure 1: Proposed Changes to FHA’s Loan Limits 

95

90

85

80

75

70

65

60

55

50

45

Floor and ceiling 100

(percentage of the

conforming loan

limit)

FHA-insured

mortgage

loan limit

(percentage of

local median

home price)

Current

48

87

95

90

85

80

75

70

65

60

55

50

45

100

65

100

Proposed 

95%

100%

Sources: GAO, HUD.

In addition to these three major changes, the modernization proposal also 

contained other provisions, including: 

• Permanently eliminating the limit on the number of HECM (reverse) 

mortgages that can be insured, setting a single nationwide loan limit for 

HECMs, and authorizing a HECM program for home purchases.12

 12Under the program, seniors who wished to move from their current home could get a 

home purchase loan for a new dwelling and convert that loan into an HECM in a single 

transaction. 

Page 11 GAO-07-708 FHA Modernization Efforts 
• Extending the permissible term of FHA-insured mortgages from 35 to 

40 years. 

• Moving HECMs, Section 203(k) rehabilitation mortgages, and Section 

234(c) condominium unit mortgages from the General Insurance and

Special Risk Insurance Funds to the Mutual Mortgage Insurance Fund. 

Moving the condominium program to the Fund would simplify the 

origination and underwriting process for these loans because they 

would no longer be subject to more complex requirements for 

multifamily housing loans. 

While FHA’s planning has reflected revisions made to its original proposal 

by the House of Representatives in the 109th Congress, new bills 

introduced in the 110th Congress could further affect FHA’s planning.13

FHA’s modernization efforts, which include completed administrative and 

proposed legislative changes, have streamlined the agency’s insurance 

processes and likely would affect program participation and costs. 

According to FHA and mortgage industry officials with whom we spoke, 

FHA’s recent administrative changes have resulted in efficiency 

improvements, making FHA products more attractive to use. FHA’s 

proposed legislation would grant the agency new leeway to help address 

challenges, such as adverse selection, resulting from innovations and 

increased competition in the mortgage market. If passed, the legislative

changes likely would have a number of program and budgetary impacts. 

For example, we estimate that raising the FHA loan limits could increase 

demand for FHA-insured loans, all other things being equal. The risk-based 

pricing proposal would decrease premiums for lower-risk borrowers, 

increase them for higher-risk borrowers, and disqualify other potential 

borrowers. In addition, FHA estimates that the legislative proposals would 

have a favorable budgetary impact. 

Modernization Efforts 

Have Streamlined 

FHA Processes and 

Likely Would Affect 

Program Participation 

and Costs 

 13See H.R. 1752, 110th Cong. (2007); H.R. 1852, 110th Cong. (2007); S. 947, 110th Cong. 

(2007). 

Page 12 GAO-07-708 FHA Modernization Efforts 
FHA has taken a number of steps to make the loans it insures easier to 

process and bring the agency more in line with the conventional market.

For example, in January 2006, FHA introduced the Lender Insurance 

Program, which enables higher-performing lenders to endorse all FHA 

loans except HECMs without a prior review by FHA.14 Prior to that time, 

all lenders were required to mail loan case files to FHA for review by 

contract staff before the loan could be endorsed for insurance. If the 

contractor found a problem with the case file, FHA would mail the file 

back to the lender for correction. Under the new program, approved 

lenders are allowed to perform their own pre-endorsement reviews and 

submit loan data electronically to FHA.15 If the loan data pass checks for 

accuracy and completeness, the lender is able to endorse the loan 

automatically. As of December 31, 2006, 405 (31 percent) of the 1,314 FHA 

lenders eligible for the program had been approved to participate. 

Between January 1, 2006, and December 31, 2006, 46 percent of FHAinsured loans were endorsed through the program. 

Mortgage Industry 

Officials Report That FHA’s 

Recent Administrative 

Changes Have Increased 

the Efficiency of Loan and 

Insurance Processing 

In addition to implementing the Lender Insurance Program, FHA revised 

its appraisal protocols and closing cost guidelines to align them more 

closely with conventional standards. Specifically, the agency simplified the 

appraisal process by adopting appraisal forms used in the conventional 

market and eliminating the requirement that minor property deficiencies 

be corrected prior to the sale of the property. Under the revised 

procedures, FHA limits required repairs to those necessary to protect the 

health and safety of the occupants, protect the security of the property, or 

correct physical deficiencies or conditions affecting structural integrity. 

Examples of property conditions that must be repaired include inadequate

access to the exterior of the home from bedrooms, leaking roofs, and 

foundation damage. The agency requires the appraiser to identify minor 

property deficiencies (such as missing handrails, cracked window glass, 

and minor plumbing leaks) on the appraisal form, but no longer stipulates 

that they be repaired. These changes went into effect for all appraisals 

performed on or after January 1, 2006. In January 2006, FHA also 

eliminated its list of “allowable” and “non-allowable” closing costs and 

 14FHA defines higher-performing lenders as those with 2 years of acceptable default and 

claim rates (at or below 150 percent of the national average). Because FHA is phasing in 

the Lender Insurance Program, HECMs are not yet eligible for endorsement through the 

program.

15As was the agency’s practice prior to the Lender Insurance Program, FHA will select a 

sample of each lender’s mortgages for post-endorsement quality checks. 

Page 13 GAO-07-708 FHA Modernization Efforts 
other fees that may be collected from the borrower. The agency made this 

change because FHA lenders had advised the agency that home sellers 

sometimes balked at accepting a sales contract from a homebuyer wishing 

to use FHA-insured financing because its guidelines differed from standard 

practice and did not consider regional variations. Lenders may now charge 

and collect from borrowers those customary and reasonable costs 

necessary to close the mortgage. 

According to FHA lenders and industry groups, these changes have 

increased the efficiency of loan processing, making FHA products more 

attractive to use. Representatives of a mortgage industry group told us that 

feedback from the group’s members on the Lender Insurance Program had 

been positive.16 Similarly, the FHA lenders we interviewed stated that the

program had resulted in efficiency improvements, such as reduced 

processing times or costs. For example, one large FHA lender estimated 

that participating in the program had reduced the time it took to process 

an FHA-insured loan by about 35 percent (or 15 to 20 days). The same FHA 

lender also estimated that participation in the program had reduced the 

operating costs (mostly printing and shipping costs) for its FHA business 

by about 25 percent. Additionally, the FHA lenders we interviewed and 

representatives of a real estate industry group noted that FHA’s revised 

appraisal protocols and closing costs had made it easier to originate FHA 

loans. Representatives of the industry group noted that the revisions had 

shortened the time it took to close an FHA loan, which was important in a 

competitive market. Finally, the lenders we interviewed estimated that the 

administrative changes had contributed, at least in part, to recent modest

increases in the number of FHA-insured loans they had made. 

According to FHA officials, the Lender Insurance Program also has 

reduced the time it takes FHA to process insurance endorsements and led 

to cost savings. They estimated that it takes FHA from 2 to 3 days to 

endorse applications for insurance on loans that are not part of the 

program. For loans endorsed through the program, they noted that 

approval is virtually instantaneous if the loan passes quality checks. In 

addition to reducing insurance processing times, the program has resulted 

in cost savings for FHA. During the first year of the program, FHA realized 

a reduction in contracting costs of more than $2 million, as its contractors 

 16Although the Lender Insurance Program has streamlined the processing of FHA-insured 

loans, the HUD Inspector General has expressed concerns that the program could increase

the risk of fraud because the lenders, rather than FHA, maintain the records on loans 

insured through the program.

Page 14 GAO-07-708 FHA Modernization Efforts 
were required to perform fewer pre-endorsement reviews. FHA also saved

more than $70,000 in mailing costs during the first 9 months of the 

program. FHA estimates that contract costs will continue to decline as the 

program is expanded to include the HECM program. 

Raising Loan Limits Likely 

Would Increase Demand 

for FHA Loans, but the 

Effect of Other Major 

Proposals on FHA Loan 

Volume Is Uncertain

Our analysis indicates that raising FHA’s loan limits likely would increase 

the number of loans insured by FHA by making more loans eligible for 

FHA insurance. In some areas of the country, particularly in parts of 

California and the Northeast, median home prices have been well above 

FHA’s maximum loan limits, reducing the agency’s ability to serve 

borrowers in those markets. For example, the 2005 loan limit in high-cost 

areas was $312,895 for one-unit properties, while the median home price 

was about $399,000 in Boston, Massachusetts; about $432,000 in Newark, 

New Jersey; $500,000 in Salinas, California; and about $646,000 in San 

Francisco, California. If the limits were increased, FHA insurance would 

be available to a greater number of potential borrowers. Our analysis of 

HMDA data indicates that the agency could have insured from 9 to 10 

percent more loans in 2005 had the higher mortgage limits been in place.17

The greatest portion of this increase resulted from raising the loan limit 

floor in low-cost areas from 48 to 65 percent of the conforming loan limit. 

In particular, 82 percent of the new loans that would have been insured by

FHA and 74 percent of the dollar amount of those loans in our analysis 

occurred in areas where the loan limits were set at the floor. Only 14 

percent of the new loans (22 percent of the dollar amount of new loans) 

would have resulted from increasing the loan limit ceiling. Our analysis 

also found that the average size of an FHA-insured loan in 2005 would 

have increased from approximately $123,000 to about $132,000 had the 

higher loan limits been in place. 

The effect of the other major legislative proposals on the demand for FHAinsured loans is difficult to estimate. Although FHA has not estimated the 

effect on demand, FHA officials expect that risk-based pricing would 

enable them to serve more borrowers. By reducing premiums for relatively 

lower-risk borrowers, FHA expects to attract more of these borrowers. 

However, increased premiums for higher-risk borrowers could reduce 

 17Our analysis considered the number of additional loans that would have been eligible for 

FHA insurance if the loan limits in 2005 had been raised to 100 percent of area median 

income, with a floor in low-cost areas of $233,773 and a ceiling in high-cost areas of 

$359,650. For our assumptions about the share of newly eligible loans that would likely be

insured by FHA, see appendix I. 

Page 15 GAO-07-708 FHA Modernization Efforts 
these borrowers’ demand for FHA products. Additionally, some high-risk 

borrowers who previously would have qualified for FHA insurance would 

not qualify under risk-based pricing. The effect of lowering down-payment 

requirements on demand for FHA-insured loans is also difficult to 

estimate. FHA expects a new zero-down-payment product to attract 

borrowers who otherwise would have used down-payment assistance 

from nonprofit organizations funded by home sellers. However, 

underwriting restrictions could limit the number of borrowers who would

qualify for the product.

Developments in the subprime market also may affect the demand for 

FHA loans. Since 2001, FHA’s share of the mortgage market has declined

as the subprime market has grown. However, relatively high default and

foreclosure rates for subprime loans and a contraction of this market 

segment could shift market share to FHA. For example, one major lender 

we interviewed said that FHA’s continued modernization efforts combined 

with a weakening subprime market likely would result in renewed demand 

for FHA products as simplified processes make it easier for lenders to 

originate FHA-insured loans. 

Risk-Based Pricing Could 

Help Address Adverse 

Selection but Would Affect 

the Cost and Availability of 

FHA Insurance for Some 

Borrowers 

To help address the problem of adverse selection, FHA has sought 

authority to price insurance premiums based on borrower risk, which 

would affect the cost and availability of FHA insurance for some 

borrowers. Currently, all FHA-insured borrowers pay an up-front premium 

of 1.5 percent of the original insured loan amount, and annual premiums of 

0.5 percent of the remaining insured principal balance. Under this flat 

pricing structure, lower-risk borrowers subsidize higher-risk borrowers. In

recent years, innovations in the mortgage market have allowed 

conventional mortgage lenders and insurers to identify and approve 

relatively low-risk borrowers and charge fees based on default risk. As 

relatively lower-risk borrowers in FHA’s traditional market segment have

selected conventional financing, FHA has been left with more high-risk 

borrowers who require a subsidy and fewer low-risk borrowers to provide 

that subsidy. 

Partly due to this trend, the President’s fiscal year 2008 budget stated that,

in the absence of risk-based pricing, FHA would need to raise premiums to 

avoid the need for a positive subsidy. FHA officials told us that they would

have to raise premiums for all borrowers to 1.66 percent up front and 0.55

percent annually. Raising premiums for all borrowers could exacerbate

FHA’s adverse selection problem by causing even more lower-risk 

borrowers to opt for more competitive conventional products rather than 

Page 16 GAO-07-708 FHA Modernization Efforts 
FHA-insured loans, leaving FHA with even fewer lower-risk borrowers to 

subsidize higher-risk borrowers. Rather than raise premiums for all 

borrowers, FHA has proposed risk-based pricing as a solution to the 

adverse selection problem. Under risk-based pricing, some future FHA 

borrowers would pay more than the current premiums while others would 

pay about the same or less. As previously noted, discounting premiums 

could make FHA a more attractive option for relatively lower-risk 

borrowers. 

As of May 2007, FHA’s risk-based pricing proposal established six different 

risk categories, each with a different premium rate, for purchase and 

refinance loans.18 FHA used data from its most recent actuarial review to 

establish the six risk categories and corresponding premiums based on the 

relative performance of loans with various combinations of LTV ratio and

credit score. Borrowers in categories with higher expected lifetime claim 

rates would have higher premiums than those in categories with lower 

claim rates. Premiums would range from 0.75 percent up front and 0.50 

percent annually for the lowest-risk borrowers, to 3.00 percent up front 

and 0.75 percent annually for the highest-risk borrowers. Although the 

premiums that FHA would charge borrowers in the six risk categories 

would be more commensurate with the risks of the loans, lower-risk 

borrowers would continue to subsidize higher-risk borrowers to some 

extent. 

If FHA were granted the authority to implement its risk-based pricing 

proposal, the agency would publish a pricing matrix that would allow 

borrowers to identify their likely premiums based on their credit scores 

and LTV ratios. As shown in figure 2, lower borrower credit scores and 

higher LTV ratios would result in higher insurance premiums. However, 

FHA would use its TOTAL mortgage scorecard to make the final 

determination of a borrower’s placement in a particular risk category. 

While TOTAL takes into account more borrower and loan characteristics 

than LTV ratio and credit score (such as borrower reserves and paymentto-income ratio), it was designed to predict the probability of claims or 

defaults that would later result in claims within 4 years of loan origination 

rather than lifetime claim rates. Therefore, FHA rescaled the TOTAL 

scores to reflect lifetime claim rates. Because of the additional risk 

characteristics considered by TOTAL, a borrower’s TOTAL score could 

indicate that a borrower belongs in a higher risk category than would be 

 18Different pricing would apply to refinances of existing FHA-insured mortgages. 

Page 17 GAO-07-708 FHA Modernization Efforts 
suggested by LTV ratio and credit score alone. FHA has not produced a 

formal estimate of how often this would occur, but plans to include this 

caveat in its pricing matrix. 

Figure 2: Impact of Borrower Credit Scores and LTV Ratios on Insurance Premiums 

under FHA’s Risk-Based Pricing Proposal 

Low

High

High

Low

Sources: GAO, FHA.

Loan-tovalue ratio Credit score

Premiums

Low High

Our analysis of how the proposed pricing structure would affect home 

purchase borrowers similar to those insured by FHA in 2005 found that 

approximately 43 percent of borrowers would have paid the same or less 

while 37 percent would have paid more. As discussed more fully later, 20

percent would not have qualified for FHA insurance had the risk-based 

pricing proposal been in effect. These percentages hold true whether 

comparing the proposed risk-based premiums to the current premiums of 

Page 18 GAO-07-708 FHA Modernization Efforts 
1.5 percent up front and 0.5 percent annually or the higher premiums of 

1.66 percent up front and 0.55 percent annually that, according to FHA, 

would be needed to maintain a negative subsidy rate in fiscal year 2008. As 

shown in figure 3, risk-based pricing would have had a similar impact on 

first-time and low-income homebuyers FHA served in 2005. 

Figure 3: Impact of FHA’s Risk-Based Pricing Proposal on Borrowers’ Premiums, 

Including First-Time and Low-Income Homebuyers 

Percentage

Borrowers

No longer served

Pay more

Pay the same

Pay less

Sources: GAO, SFDW.

0

20

40

60

80

100

LowincomeFirsttimeAll

20 21

37 37

25 24

18 18

20

35

25

20

Note: We analyzed SFDW data on 2005 home purchase borrowers. The figure shows how these 

borrowers would have fared under FHA’s risk-based pricing proposal. Low-income homebuyers are 

those whose incomes are less than or equal to 80 percent of the area median income. The figure

excludes the approximately 2 percent of borrowers for whom SFDW did not contain either an LTV 

ratio or credit score (the two variables FHA would use to determine risk-based premiums). 

Among FHA’s 2005 borrowers, 47 percent of white borrowers and 40 

percent of Hispanic borrowers would have paid the same or less under the 

new proposed risk-based pricing structure than they did under the present 

pricing structure, while 28 percent of black borrowers would have paid the 

same or less. A little more than one-third of borrowers in each racial 

Page 19 GAO-07-708 FHA Modernization Efforts 
category would have paid more (see fig. 4). FHA officials concluded, in

their analysis of an earlier version of the risk-based pricing proposal, that 

any disparate impacts of risk-based pricing using consumer credit scores 

would be based on valid business reasons. Specifically, they noted that, 

although some racial differences do exist in the distribution of credit 

scores and LTV ratios, these variables are strongly associated with claim 

rates and have become the primary risk factors used for pricing credit risk

in the conventional market. 

Figure 4: Impact of FHA’s Risk-Based Pricing Proposal on Premiums Paid by

Different Racial Groups 

Percentage

Race

No longer served

Pay more

Pay the same

Pay less

Sources: GAO, SFDW.

0

20

40

60

80

100

All groups Black Hispanic White Other

20 32 20 18 16

37 40 39 36 37

25 19 24 26 27

19 9 16 21 20

Note: We analyzed SFDW data on 2005 home purchase borrowers. The figure shows how these 

borrowers would have fared under FHA’s risk-based pricing proposal. It excludes the 2 percent of 

borrowers for whom SFDW did not contain either an LTV ratio or credit score (the two variables FHA 

would use to determine risk-based premiums) and the 2.9 percent of borrowers for whom race was 

not disclosed. Percentages do not add to 100 due to rounding. 

Risk-based pricing would also affect the availability of FHA insurance for 

some borrowers. Approximately 20 percent of FHA’s 2005 borrowers 

Page 20 GAO-07-708 FHA Modernization Efforts 
would not have qualified for FHA mortgage insurance under the 

parameters of the risk-based pricing proposal we evaluated. FHA 

determined that the expected claim rates of these borrowers were higher 

than it found tolerable for either the borrower or the Fund. Those 

borrowers who would not have qualified had high LTV ratios and low 

credit scores. Their average credit score was 584, and their expected 

lifetime claim rates are more than 2.5 times higher than the average claim

rate of all FHA loans.19 FHA officials stated that setting risk-based 

premiums for potential future FHA borrowers with similar characteristics 

would require prices higher than borrowers may be able to afford. 

The overall distribution of 2005 FHA borrowers (by income, first-time 

borrower status, or race) would not have changed substantially had the 

policy not to serve borrowers with these higher expected lifetime claim 

rates been in place that year (all other things being equal). If the 20 

percent of borrowers with the higher expected claim rates were removed 

from FHA’s 2005 borrower pool, our analysis found that low-income 

homebuyers would have remained about 51 percent of the pool. First-time 

homebuyers would have constituted about 78 percent of the pool, 

compared with 79 percent when all borrowers are included. Similarly, the 

overall racial distribution of borrowers would have changed modestly (see 

fig. 5). The percentage of Hispanic borrowers would have remained about 

14 percent, black borrowers would have decreased from 13 to 11 percent, 

and white borrowers would have increased from 69 to 70 percent. 

 19Additionally, the vast majority of these borrowers (90 percent) received down-payment 

assistance from nonprofits, most of which received funding from property sellers. 

Page 21 GAO-07-708 FHA Modernization Efforts 
Figure 5: Impact of FHA’s Risk-Based Pricing Proposal on Racial Distribution of

FHA Borrowers

Percentage

Borrowers

Other

White

Hispanic

Black

Sources: GAO, SFDW.

0

20

40

60

80

100

2005

(under

risk-based

pricing)

2005 

5 5

69 70

14 14

13 11

Note: We analyzed SFDW data on 2005 home purchase borrowers. The figure shows how these 

borrowers would have fared under FHA’s risk-based pricing proposal. Percentages do not add to 100 

due to rounding.

All other things being equal, implementing the legislative proposals likely

would have had a slightly negative impact on FHA’s ability to meet certain 

performance measures related to the types of borrowers it serves. HUD’s 

strategic plan for fiscal years 2006 to 2011 calls for the share of first-time 

minority homebuyers among FHA home purchase mortgages to remain 

above 35 percent. Our analysis shows that 34 percent of fiscal year 2005 

home purchase mortgages were for first-time minority home buyers. 

Under risk-based pricing, a slightly lower percentage, 32 percent, would 

have been first-time minority home buyers. The strategic plan also calls for 

the share of FHA-insured home purchase mortgages for first-time 

homebuyers to remain above 71 percent. Our analysis shows that 

Page 22 GAO-07-708 FHA Modernization Efforts 
79 percent of fiscal year 2005 FHA home purchase borrowers were firsttime home buyers. Under risk-based pricing, 77 percent would have been 

first-time home buyers. 

Legislative Proposals 

Likely Would Have a 

Beneficial Budgetary 

Impact 

According to FHA’s estimates, the three major legislative proposals would 

have a beneficial impact on HUD’s budget due to higher estimated 

negative subsidies. According to the President’s fiscal year 2008 budget, 

the credit subsidy rate for the Fund would be more favorable if the 

legislative proposals were enacted. Absent any program changes, FHA 

estimates that the Fund would require an appropriation of credit subsidy 

budget authority of approximately $143 million. If the legislative proposals 

were not enacted, FHA would consider raising premiums to avoid the need 

for appropriations. If the major legislative proposals were passed, FHA 

estimates that the Fund would generate $342 million in negative 

subsidies.20

FHA’s subsidy estimates for fiscal year 2008 should be viewed with 

caution given that FHA has generally underestimated the subsidy costs for 

the Fund. To meet federal requirements, FHA annually reestimates subsidy 

costs for each loan cohort dating back to fiscal year 1992.21 The current 

reestimated subsidy costs for all except the fiscal year 1992 and 1993 

cohorts are higher than the original estimates. For example, the current 

reestimated cost for the fiscal year 2006 cohort is about $800 million 

higher than originally estimated. As discussed more fully later in this 

report, FHA has taken some steps to improve its subsidy estimates. 

 20These figures do not reflect FHA’s proposals to eliminate the limit on the number of 

mortgages insured under the HECM program and move the program from the General 

Insurance Fund to the Mutual Mortgage Insurance Fund. According to FHA’s estimates, the 

HECM program would generate about $338 million in negative subsidies in fiscal year 2008.

Therefore, moving the HECM program would result in negative subsidies totaling about

$680 million for the Fund. 

21Agencies are required to reestimate subsidy costs annually to reflect actual loan 

performance and expected changes in estimates of future loan performance. Essentially, a

cohort includes the loans insured in a given year. 

Page 23 GAO-07-708 FHA Modernization Efforts 
FHA has enhanced the tools and resources it uses that would be important 

to implementing the legislative proposals, but has not always used 

industry practices that could help the agency manage the risks associated 

with program changes. To implement risk-based pricing, FHA would rely 

on historical loan-level data, models that estimate loan performance, and 

its TOTAL mortgage scorecard. Although FHA has improved the 

forecasting ability of its models by adding variables found to influence 

credit risk, the agency is still addressing limitations in TOTAL that could 

reduce its effectiveness as a pricing tool. FHA also has identified changes

in information systems needed to implement the legislative proposals and 

requested additional staff to help promote new FHA products but faces 

long-term challenges in these areas. However, the legislative proposals 

would introduce new risks and challenges such as the difficulty of pricing 

loans with very low or no down payments whose risks may not be well 

understood. While other mortgage institutions use pilot programs to 

manage the risks associated with changing or expanding their product 

lines, FHA has indicated that it does not plan to pilot any no-downpayment product it is authorized to offer. 

Mortgage institutions use detailed information on the characteristics and 

performance of past loans to help predict the performance of future loans 

and price them correctly. Like other mortgage institutions we contacted,

FHA has extensive loan-level data. These data are contained in the 

agency’s SFDW, which FHA implemented in 1996 to assemble critical data

from 12 single-family systems.22 SFDW is updated monthly and currently 

contains data on approximately 33 million FHA-insured loans dating back 

to fiscal year 1975. These data include information on the borrower (such 

as age, gender, race, income, and first-time home buyer status) and the 

loan (including whether it is an adjustable- or fixed-rate mortgage, the 

source and amount of any down-payment assistance, interest rate, 

premium rate, original mortgage amount, and LTV ratio). 

FHA Has Enhanced 

Tools and Resources 

Important to 

Implementing 

Proposals but Does 

Not Intend to Mitigate 

Risks by Piloting New 

Products 

Credit Score Information 

Has Enhanced the Data 

FHA Would Use to 

Implement Proposals 

FHA has added information on borrower credit scores to the loan-level 

data that it plans to use to assess risk and set insurance premiums if the 

legislative proposals were enacted. Research has shown that credit scores 

are a strong predictor of loan performance—that is, borrowers with higher 

 22These systems contain a wide variety of data that support FHA’s administration of its

single-family mortgage insurance program, including information on mortgage lenders and

borrowers and the financial details and performance of the loans.

Page 24 GAO-07-708 FHA Modernization Efforts 
scores experience lower levels of default. FHA started collecting credit 

score data in the late 1990s when it began allowing its lenders to use 

automated underwriting systems and mortgage scorecards. Upon 

approving the use of Fannie Mae and Freddie Mac’s mortgage scorecards 

in fiscal year 1998, FHA began receiving credit score data for loans 

underwritten using these scoring tools. To develop its own mortgage 

scorecard, FHA purchased archived credit scoring data for loan 

origination samples dating back to 1992. Since implementing its TOTAL 

mortgage scorecard in May 2004, FHA has collected credit scores on 

almost all FHA borrowers. 

FHA Has Made Some 

Improvements to Key 

Statistical Models, but 

Additional Challenges 

Remain 

FHA would rely on both its loan performance models and TOTAL 

mortgage scorecard to set insurance premiums if authorized to implement 

risk-based pricing. Although FHA has improved the forecasting ability of 

its loan performance models by incorporating additional variables found 

to influence credit risk, FHA is still in the process of addressing a number

of limitations in TOTAL that could reduce its effectiveness for risk-based 

pricing. The agency’s actuarial review contractor developed the loan 

performance models to estimate the economic value of the Fund for the 

annual actuarial review. The models estimate lifetime claim and 

prepayment (the payment of a loan before its maturity date) rates based 

on factors such as origination year, age, interest rate, mortgage product 

type, initial LTV ratio, and loan amount. FHA used the projected lifetime 

claim and prepayment rates from the most recent actuarial review as the 

basis for its proposed risk-based insurance premiums.23

FHA has improved its loan performance models by adding factors that 

have been found to influence credit risk. In September 2005, we reported 

that FHA’s subsidy reestimates, which use data from FHA’s loan 

performance models, reflect a consistent underestimation of the costs of 

its single-family insurance program. We recommended that FHA study and 

report the impact (on the forecasting ability of its loan performance 

models) of variables that have been found in other studies to influence 

credit risk, such as payment-to-income ratios, credit scores, and the 

 23More specifically, FHA developed index values—the ratio of the claim and prepayment

rates for borrowers in different credit score and LTV ratio groupings to the claim and 

prepayment rate for FHA’s average borrower. (FHA used loans with down-payment

assistance from seller-funded nonprofit organizations as a proxy for loans with LTV ratios

of 100 percent.) FHA then applied these index values to the estimated lifetime claim and 

prepayment rates for the fiscal year 2008 book of business. 

Page 25 GAO-07-708 FHA Modernization Efforts 
presence of down-payment assistance.24 In response, HUD indicated that 

its contractor was considering the specific variables that we had 

recommended FHA include in its annual actuarial review of the Fund. The 

contractor subsequently incorporated the source of down-payment 

assistance in the fiscal year 2005 actuarial review and borrower credit 

scores in the fiscal year 2006 review. 

FHA also intends to use TOTAL to determine risk-based premiums, but we 

have identified weaknesses in the scorecard that could limit its 

effectiveness as a pricing tool. As previously noted, FHA plans to use 

TOTAL to make the final determination regarding premium rates if 

authorized to implement risk-based pricing. However, we reported in April 

2006 that TOTAL excludes a number of important variables included in 

other mortgage scoring systems.25 For example, TOTAL does not 

distinguish between adjustable- and fixed-rate mortgages. However, 

adjustable-rate mortgages generally are considered to be higher risk than 

otherwise comparable fixed-rate mortgages because borrowers are subject 

to higher payments if interest rates rise. Unlike the mortgage scorecards of

other institutions, TOTAL also does not include an indicator for property 

type (single-family detached homes or condominiums, for example).26

While currently a small component of FHA’s business, FHA expects that it 

would insure more condominium loans if the condominium program were 

moved to the Fund, as set forth in its legislative proposal. Additionally, 

TOTAL does not indicate the source of the down payment. We have 

reported that the source of a down payment is an important indicator of 

risk, and the use of down-payment assistance in the FHA program has 

grown substantially since 2000. Finally, our April 2006 report noted that 

the data used to develop TOTAL were not current and FHA had no plans 

to update the scorecard on a regular basis. 

 24See GAO, Mortgage Financing: FHA’s $7 Billion Reestimate Reflects Higher Claims and

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

While loan performance models are critical to subsidy cost estimation, other factors such 

as assumptions about the losses per insurance claim and economic conditions also 

influence subsidy estimates. 

25GAO-06-435. 

26FHA indicated that variables for adjustable-rate mortgages and property type were not

included in TOTAL because the risk associated with them did not differ significantly in the 

data sample used to develop the model. However, the modeling effort may have failed to 

find significant effects for these variables because of the small numbers of loans with these 

characteristics in the development sample. 

Page 26 GAO-07-708 FHA Modernization Efforts 
Consistent with our recommendations concerning TOTAL, FHA developed 

policies and procedures that call for (1) an annual evaluation of the 

scorecard’s predictive ability, (2) testing of additional predictive variables 

to include in the scorecard, and (3) populating the scorecard with more 

recent loan performance data. An FHA contractor is helping the agency to

implement these procedures and is scheduled to issue a final report on its 

work in August 2007. After receiving the contractor’s report, FHA will 

decide what changes to TOTAL are necessary. Because the magnitude of 

these changes has not yet been determined, FHA does not have a 

completion date for this effort. FHA officials indicated that they would 

initially implement risk-based pricing using the current version of TOTAL 

but would use the updated version when it became available. 

FHA Has Identified 

Needed Changes in 

Information Technology 

but Faces Funding and 

Implementation 

Challenges 

FHA has identified changes needed in its information technology to 

implement the legislative proposals. FHA has divided these changes into 

two phases. The first phase consists of simpler changes that it can make in 

the short term, such as revising the system used to originate FHA-insured 

loans to allow for down payments of less than 3 percent. FHA also would 

need to make other changes to the system to support the new loan limits, 

such as allowing the loan amount to equal 100 percent of the conforming 

loan limit in applicable areas. The second phase includes modifications to

the computer programs that calculate the up-front and annual insurance 

premiums to reflect risk-based pricing and revisions related to the 

proposed changes to the HECM and condominium programs. 

FHA has not yet obtained some of the funding needed to make the 

technology changes and does not have estimates for how long it would 

take to complete all of the changes. In fiscal year 2006, the agency

obligated $2.8 million of the $10.9 million it estimated was needed to make 

all anticipated changes. Specifically, FHA plans to use funds 

reprogrammed from HUD’s salaries and expense account and other 

available funds to complete the first phase of changes. FHA estimates that 

most of this work could be completed in a few months. The President’s 

fiscal year 2008 budget requests an additional $8.1 million to fund the 

second phase of changes needed to implement the legislative proposals. 

However, FHA officials told us that they did not have an implementation 

schedule for this phase and were waiting until the legislative proposals 

were approved and they had secured the funding to develop one. 

Although FHA officials indicated that they could implement the legislative 

proposals after making these minor information technology changes, they 

also told us that major systems changes and integration would be needed 

Page 27 GAO-07-708 FHA Modernization Efforts 
to bring FHA’s systems up to levels comparable with other mortgage 

institutions. Currently, over 40 systems support FHA’s single-family 

business activity. While a thorough evaluation of large-scale systems 

changes was outside the scope of our review, FHA has indicated that its 

systems are poorly integrated, expensive to maintain, and do not fully 

support the agency’s operations and business requirements.27 For example, 

the systems cannot easily share or provide critical information because 

they use different database platforms with varying capabilities; some of 

the older systems use an outdated programming language; and the 

creation of ad hoc systems that do not interface with other systems has 

resulted in duplicate data entry. However, FHA has limited resources to 

devote to the development of new systems for two main reasons. First, it 

has to compete with other divisions within HUD for information 

technology resources. Of the approximately $300 million that HUD has 

requested for information technology development and maintenance in 

fiscal year 2008, about 5 percent would be for FHA’s single-family 

operations. Second, FHA spends what resources it has primarily on 

systems maintenance. Of the $19 million that FHA has budgeted for singlefamily information technology in fiscal year 2007, FHA officials estimate 

that $15 million would be devoted to systems maintenance. 

In contrast with FHA, officials from other mortgage institutions with 

whom we spoke indicated that they devote substantial resources to 

developing new systems and enhancing existing systems that help them 

price products and manage risk. To illustrate, officials from one mortgage 

institution stated that they had a $15 million annual budget for capital 

improvements in information technology. Officials from another mortgage 

institution told us that 17 percent of the company’s total expenses were 

related to information technology and that they recently spent about $15 

million to develop a new system to price a mortgage product for the 

foreign market. These and other mortgage industry officials stressed that 

investments in state-of-the-art information systems were critical to 

operating successfully in the highly competitive mortgage market. 

 27These views are consistent with our October 2001 report on FHA’s single-family 

information systems. See GAO, Single-Family Housing: Current Information Systems Do

Not Fully Support the Business Processes at HUD’s Homeownership Centers, GAO-02-44 

(Washington, D.C.: Oct. 24, 2001). 

Page 28 GAO-07-708 FHA Modernization Efforts 
According to FHA officials, the legislative proposals would not 

fundamentally alter how the agency administers its single-family mortgage 

insurance program and, therefore, would not require major increases in 

staff above the approximately 950 single-family housing employees it had

as of March 2007. Although implementing the legislative proposals would 

require considerable program analysis and monitoring, much of the 

analysis required to develop the proposals was performed primarily by 

staff from FHA’s Offices of Finance and Budget and Single Family Housing 

with assistance from several contractors, who will continue to support the 

implementation. FHA officials told us that marketing any new products 

authorized and explaining program changes to lenders would be their next

major challenge if the legislative proposals were passed. They also noted 

that successful implementation would require them to stay abreast of 

developments in the mortgage market. Therefore, the President’s fiscal 

year 2008 budget requests an additional 21 full-time equivalent (FTE) 

positions to help promote new FHA products, analyze industry trends, and 

align the agency’s single-family business processes with current mortgage 

industry practices. 

FHA Has Sought Limited 

Staff Increases to Help 

Implement Proposals, but 

Other Workforce 

Challenges Remain 

Although a detailed assessment of FHA’s staffing needs was outside the 

scope of our review, a HUD contractor’s 2004 workforce analysis suggests 

that FHA faces broader challenges that could affect the agency’s 

operations going forward.28 The analysis projected that FHA would have 78 

fewer FTEs than needed to handle anticipated work demands by fiscal 

year 2008, assuming hires and transfers equal to the average numbers for 

2001 through 2003. In addition to anticipated FTE shortfalls, the report 

also identified existing and projected deficits of FHA staff with certain 

important competencies such as technical credibility and knowledge of 

single-family programs, policies, and regulations.29 For example, the 

consultant projected a difference of 28 percentage points between the 

percentage of staff requiring technical credibility and the percentage that

would meet this requirement in fiscal year 2008. FHA officials have 

acknowledged the agency’s staffing challenges and have developed plans 

to address the projected gaps. In fiscal years 2005 and 2006, FHA gained 

228 staff through hiring or transfers. However, the contractor had assumed 

 28LMI Government Consulting for the U.S. Department of Housing and Urban Development,

Strategic Workforce Plan (McLean, Va.: November 2004). 

29The analysis defined technical credibility as demonstrating programmatic, financial, and 

technical knowledge and expertise that is commensurate with the demands of the position 

and understanding requirements for the administration of federal grants and loan

guarantees. 

Page 29 GAO-07-708 FHA Modernization Efforts 
gains of 362 staff during those years, which means that the projected fiscal

year 2008 shortfall will be worse than originally estimated without 

substantial staff accessions in fiscal years 2007 and 2008. 

FHA also faces hiring and salary constraints that other mortgage 

institutions do not. FHA’s hiring authority is limited by statute and 

congressional appropriations. Federal statute (Title 5 of the U.S. Code) 

restricts the amounts that FHA can pay staff, and each year’s 

appropriation determines how many staff it can hire. Further, FHA must 

compete with other divisions within HUD for staffing resources and may 

not always receive its full request. Other mortgage institutions have 

greater flexibility in their ability to hire and compensate staff. For 

example, Fannie Mae and Freddie Mac are not subject to federal pay and

hiring restrictions. These restrictions create challenges for FHA as it 

competes for qualified staff in the competitive mortgage labor market. 

FHA’s Prior Risk 

Management Did Not 

Always Utilize Common 

Industry Practices Such as 

Piloting, but Some Planned 

Actions Could Help 

Address New Risks and 

Challenges 

Although FHA has not always utilized risk-management practices that 

other mortgage institutions use, it plans to take some steps to help address 

the new risks and challenges associated with the legislative proposals. In 

November 2005, we reported that HUD needed to take additional actions 

to manage risks related to the approximately one-third of its loans with 

down-payment assistance from seller-funded nonprofits.30 Unlike other 

mortgage industry participants, FHA does not restrict homebuyers’ use of 

such assistance. Our 2005 analysis found that the probability that these 

loans would result in an insurance claim was 76 percent higher than for 

comparable loans without such assistance, and we recommended that 

FHA revise its underwriting standards to consider such assistance as a 

seller contribution (which cannot be used to meet the borrower 

contribution requirement).31 Despite the detrimental impact of these loans 

on the Fund, FHA did not act promptly to mitigate the problem by 

adjusting underwriting standards or using its existing authority to raise 

 30GAO, Mortgage Financing: Additional Action Needed to Manage Risks of FHA-Insured

Loans with Down Payment Assistance, GAO-06-24 (Washington, D.C.: Nov. 9, 2005). 

31We reviewed a national sample of FHA-insured home purchase loans from 2000, 2001, and

2002. 

Page 30 GAO-07-708 FHA Modernization Efforts 
premiums. However, in May 2007, FHA published a proposed rule that 

would prohibit seller-funded down-payment assistance.32

In addition, as we reported in February 2005, other mortgage institutions 

limit the availability of or pilot new products to manage risks associated 

with changing or expanding product lines.33 We have previously indicated 

that, if Congress authorizes FHA to insure new products, it should 

consider a number of means, including limiting their initial availability, to 

mitigate the additional risks these loans may pose. We also recommended 

that FHA consider similar steps for any new or revised products. However, 

in response, FHA officials told us that they lacked the resources to 

effectively manage a program with limited volumes. We noted that if FHA 

did not limit the availability of new or changed products, the potential 

costs of making widely available a product with risks that may not be well

understood could exceed the cost of a pilot program. With respect to its 

legislative proposal, FHA officials told us that they do not plan to pilot or

limit the initial availability of any zero-down-payment product the agency 

was authorized to offer. They also indicated that they expected that a zerodown-payment product would perform similarly to loans with sellerfunded down-payment assistance. While the experience of loans with this 

type of assistance is informative, a zero-down-payment product could be

utilized by a different population of borrowers and may not perform the 

same as these loans. 

Nevertheless, if the legislative proposals were to be enacted, FHA plans to 

take some steps to help address risks and challenges associated with 

(1) managing the risks of no-down-payment loans, (2) setting premiums to 

achieve a modestly negative subsidy rate, and (3) modifying oversight of 

lenders. First, loans with low or no down payments carry greater risk 

because of the direct relationship that exists between the amount of equity 

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

ratio, the less cash borrowers will have invested in their homes and the 

 32See 72 Fed. Reg. 27048 (May 11, 2007). FHA also has been anticipating a reduction in the

number of loans with down-payment assistance from seller-funded nonprofit organizations

as a result of actions taken by the Internal Revenue Service (IRS). IRS issued a ruling in

May 2006 stating that these organizations do not qualify as tax-exempt charities, effectively

making loans with such assistance ineligible for FHA insurance. According to FHA, as of

June 2007, IRS had rescinded the charitable status of three of the 185 organizations that 

IRS is examining. 

33GAO, Mortgage Financing: Actions Needed to Help FHA Manage Risks from New 

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

Page 31 GAO-07-708 FHA Modernization Efforts 
more likely it is that they may default on mortgage obligations, especially

during times of economic hardship or price depreciation in the housing 

market. No-down-payment loans became common in the conventional 

market when rapid appreciation in home prices helped mitigate the risk of 

these loans. However, if authorized to offer a zero-down-payment 

mortgage in the near future, FHA would be introducing this product at a 

time when home prices have stagnated or are declining in some parts of 

the country. And because FHA would continue to allow borrowers to 

finance some portion of closing costs and up-front insurance premiums, 

the effective LTV ratio for loans with very low or no down payments could 

be greater than 100 percent, further increasing FHA’s insurance risk. To 

mitigate the risks associated with loans with no down payments, FHA 

plans to impose stricter underwriting criteria for such loans:

• FHA would limit the amount of up-front premium and closing costs 

that could be financed; therefore, all borrowers would be making some 

minimum cash contribution. 

• FHA plans to require a minimum credit score of 640 to obtain FHA 

insurance on loans with no down payments.34

• FHA would limit its zero-down-payment product to loans for owneroccupied, one-unit properties. 

Second, FHA’s legislative proposal would fundamentally change the way 

the agency manages the Fund in that FHA would set premiums to achieve 

a modestly negative overall subsidy rate, representing the weighted 

average of the subsidy rates for the different risk-based pricing categories. 

The President’s budget for fiscal year 2008 estimates that the weighted 

average subsidy rate would be -0.6 percent (meaning that the Fund would 

generate negative subsidies amounting to 0.6 percent of the total dollars 

insured for loans originated that year).35 Achieving a modestly negative 

credit subsidy rate would depend on FHA’s ability to price new products 

whose risks may not be well understood, although risk-based pricing could 

help FHA be more precise in setting and adjusting premiums for different 

segments of its portfolio. FHA officials told us that they would monitor the 

proportion of loans in its two highest-risk categories and consider raising 

 34Private mortgage insurers also set credit score thresholds for zero-down-payment loans. 

35If the HECM program were moved to the Fund, as FHA has proposed, the weighted 

average subsidy rate would be -0.82 percent.

Page 32 GAO-07-708 FHA Modernization Efforts 
premiums or tightening underwriting standards if unexpectedly high 

demand exposed FHA to excessive financial risk. Fannie Mae, Freddie 

Mac, and the four private mortgage insurers we interviewed noted that 

they carefully monitor their portfolios to make sure that they do not have 

too many loans in any given risk category and take similar steps when they 

determine that this is the case. 

Third, FHA may need to modify the way that it oversees lenders if the 

legislative proposals were enacted. FHA has indicated that its legislative 

proposals would help the agency to expand service to higher-risk 

borrowers in a financially sound manner. However, FHA may need to 

revise its Credit Watch program if it is to achieve this end. Under Credit 

Watch, FHA terminates the loan origination authority of any lender branch 

office that has a default and claim rate on mortgages insured by FHA in the 

prior 24 months that exceeded both the national average and 200 percent

of the average rate for lenders in its geographic area. Because termination 

currently is based on how a lender’s loans perform relative to other 

lenders in its geographic area, lenders that chose to make loans to higherrisk borrowers could suffer in comparison with lenders that served only 

lower-risk borrowers. To encourage lenders to serve borrowers in the 

higher-risk categories, FHA officials told us that they would consider 

taking into account the mix of borrowers in the various risk categories 

when evaluating a lender’s performance. Because higher-risk loans can be

expected to incur higher default and claim rates, they stated that FHA 

would not want to penalize lenders with larger shares of these loans as 

long as the loans were performing within expected risk parameters. FHA 

also has improved the accuracy and timeliness of the loan performance 

data it uses to evaluate lenders by requiring lenders to update the 

delinquency status of their loans more frequently.

Mortgage industry participants and researchers have suggested additional

options that Congress and FHA could consider to help FHA adapt to 

changes in the mortgage market, but some changes could have budget and 

oversight implications. FHA already has authority to undertake some of 

these options. Other options would require additional authorities from 

Congress to increase the agency’s operational flexibility. Congress also 

could consider alternative approaches to the provision of federal mortgage 

insurance such as converting FHA to a government corporation or 

implementing risk-sharing arrangements with private partners.

Congress and FHA 

Could Consider Other 

Administrative and 

Legislative Changes to 

Help FHA Adapt to 

Changes in the 

Mortgage Market 

Page 33 GAO-07-708 FHA Modernization Efforts 
Although FHA already has made several administrative changes to 

streamline the agency’s insurance processes, additional administrative 

changes within FHA’s existing authority could alleviate, to some extent, 

the need for a positive subsidy in fiscal year 2008. More specifically, FHA 

could exercise its existing authority to raise up-front premiums up to 2.25 

percent and, for borrowers with down payments of less than 5 percent,

annual premiums to 0.55 percent. 

To moderate the need for a positive subsidy in fiscal year 2008, FHA could 

use its existing authority to increase premiums in one of three ways: 

(1) FHA could raise premiums for all borrowers, as the President’s fiscal 

year 2008 budget suggests will be necessary; (2) FHA could charge the 

higher 0.55 percent annual premium to borrowers with lower down 

payments; or (3) FHA could implement a more limited form of risk-based 

pricing than it has proposed by adjusting premiums within the current 

statutory limits. HUD’s Office of General Counsel determined in March 

2006 that FHA has the authority to structure premiums for programs under 

the Fund on the basis of risk. FHA could implement premium adjustments, 

either for all or some borrowers, through the regulation process. However, 

according to FHA officials, the current statutory limits on premiums are 

too low to allow FHA to implement a risk-based pricing plan that would 

allow the agency to set prices high enough to compensate for the expected 

losses from the highest-risk borrowers or a new zero-down-payment 

product. And while raising premiums for some higher-risk borrowers 

could improve the Fund’s credit subsidy rate, raising premiums for all 

borrowers might exacerbate FHA’s adverse selection problem. That is, 

FHA could lose higher credit quality borrowers, resulting in fewer 

borrowers to subsidize lower credit quality borrowers. This, in turn, could 

require FHA to raise premiums again.

According to mortgage industry participants and researchers, Congress 

also could consider granting FHA additional authorities to increase the 

agency’s ability to invest in technology and staff or offer new insurance 

products. First, Congress could grant FHA specific authority to invest a 

portion of the Fund’s current resources—that is, negative subsidies that 

accrue in the Fund’s reserves—in technology enhancement. The 

congressionally-appointed Millennial Housing Commission (MHC) found 

that FHA’s dependence on the appropriations process for budgetary 

resources and competition for funds within HUD had led to underFHA Has Existing 

Authority to Make More 

Administrative Changes 

Additional Authorities for 

Investment in Technology,

Pay and Hiring, and 

Introduction of Products 

Could Increase FHA’s 

Operational Flexibility 

Page 34 GAO-07-708 FHA Modernization Efforts 
investment in technology, increasing the agency’s operational risk and 

making it difficult for FHA to work efficiently with lenders and other 

industry partners.36 Because FHA’s single-family insurance program 

historically has generated estimated negative subsidies, FHA and some 

mortgage industry officials have suggested that the agency be given the 

authority to use a portion of the Fund’s current resources to upgrade and

maintain its technology.

One benefit of this option is that the technology enhancements could 

improve FHA’s operations. As previously noted, FHA has more than 40 

single-family information systems that are poorly integrated, expensive to 

maintain, and do not fully support the agency’s business requirements. 

However, according to FHA, the option would require a statutory change

to allow FHA to use the Fund’s current resources to pay for technology 

improvements. Also, the Fund is required by law to operate on an 

actuarially sound basis. Because the soundness of the Fund is measured 

by an estimate of its economic value—an estimate that is subject to 

inherent uncertainty and professional judgment—the Fund’s current 

resources should be used with caution. Spending the Fund’s current 

resources would lower the Fund’s reserves, which in turn would lower the 

economic value of the Fund. As a result, the Fund’s ability to withstand 

severe economic conditions could be diminished. Also, using the Fund’s 

current resources would increase the federal budget deficit unless 

accompanied by corresponding reductions in other government spending 

or an increase in receipts. 

Second, Congress could consider allowing FHA to manage its employees 

outside of federal pay scales. Some federal agencies, such as the Securities

and Exchange Commission, the Office of Thrift Supervision, and the 

Federal Deposit Insurance Corporation, are permitted to pay salaries 

above normal federal pay scales in recognition of the special skills 

 36The MHC, established by Congress in 2000, studied the federal role in meeting the nation’s 

housing challenges and issued a report in 2002, which included recommendations for a

variety of reforms to federal housing programs. See Meeting Our Nation’s Housing

Challenges: Report of the Bipartisan Millennial Housing Commission (Washington, D.C.:

May 30, 2002). 

Page 35 GAO-07-708 FHA Modernization Efforts 
demanded by sophisticated financial market operations.37 The MHC and 

mortgage industry officials have suggested that FHA be given similar 

authority. This option could help FHA to recruit experienced staff to help

the agency adapt to market changes. Like the authority to invest in 

technological enhancement, this option could be funded with the Fund’s 

current resources but would have similar implications for the financial 

health of the Fund and the federal budget deficit.

Third, Congress could authorize FHA to offer and pilot new insurance 

products without prior congressional approval. A variety of new mortgage 

products have appeared in the mortgage market in recent years, but FHA’s 

ability to keep pace with market innovations is limited. For example, the 

MHC found that the statutes and regulations to which FHA is subject 

dramatically increase the time necessary to develop and implement new 

products. The MHC and mortgage industry officials have recommended 

that Congress expressly authorize FHA to introduce new products without 

requiring a new statute for each. Such authority would offer FHA greater 

flexibility to keep pace with a rapidly changing mortgage market. 

However, Congress would have less control over FHA’s product offerings

and, in some cases, it might take years before a new product’s risks were 

well understood. 

To manage the risks of new products, mortgage institutions may impose 

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

sell and service those products. Limits on the availability of new or revised 

FHA mortgage insurance products are sometimes set through legislation 

and focus on the volume of loans that FHA may insure. In a prior report, 

we recommended that FHA consider using pilots for new products and 

making significant changes to its existing products.

38 Since FHA officials 

questioned the circumstances in which they could use pilots or limit 

volumes when not required by Congress, we also recommended that FHA 

seek the authority to offer new products on a limited basis, such as 

through pilots, if the agency determines it currently lacks sufficient 

authority. However, FHA has not sought this authority. Furthermore, while 

 37In 1989, the Financial Institutions Reform, Recovery and Enforcement Act (P. L. 101-73) 

authorized certain financial regulators to determine their own compensation and benefits

so that they could more effectively compete in the marketplace for qualified applicants. In 

2002, the Investor and Capital Markets Fee Relief Act (P. L. 107-123) gave SEC similar 

authority as those federal banking regulatory agencies. These agencies are permitted by 

statute to pay salaries in excess of the Title 5 ceilings. 

38GAO-05-194. 

Page 36 GAO-07-708 FHA Modernization Efforts 
piloting could help FHA manage the risks associated with implementing 

new products, FHA officials told us that they lack the resources to manage 

a program with limited volumes effectively.39

Finally, Congress could authorize FHA to insure less than 100 percent of 

the value of the loans it guarantees. Unlike private mortgage insurers, 

which offer several levels of insurance coverage up to a maximum of 40 or 

42 percent (depending on the company) of the value of the loan, FHA 

insures 100 percent of the value of the loan. But since most FHA insurance 

claims are offset by some degree of loss recovery, some mortgage industry 

observers have suggested that covering 100 percent of the value of the 

loan may not be necessary. In prior work, we examined the potential 

effects of reducing FHA’s insurance coverage and found that while lower 

coverage would cause a reduction in the volume of FHA-insured loans and

a corresponding decline in income from premiums, it would also result in 

reduced losses and ultimately have a beneficial effect on the Fund.40

However, we also noted that partial FHA coverage could lessen FHA’s 

ability to stabilize local housing markets when regional economies decline 

and may increase the cost of FHA-insured loans as lenders set higher 

prices to cover their risk. 

Alternative Approaches for 

Providing Federal 

Mortgage Insurance 

Include Converting FHA to 

a Government Corporation 

The MHC, HUD officials, and other mortgage industry participants have 

suggested alternative approaches to provide federal mortgage insurance in

a changing mortgage market. First, since the mid-1990s, several groups 

including HUD and the MHC have proposed converting FHA into either an 

independent or a HUD-owned government corporation—that is, an agency 

of government, established by Congress to perform a public purpose, 

which provides a market-oriented service and produces revenue that 

meets or approximates its expenditures. Government corporations operate 

more independently than other agencies of government and can be 

exempted from executive branch budgetary regulations and personnel and 

compensation ceilings. Therefore, converting FHA to a corporation could 

provide the corporation’s managers with the flexibility to determine the 

best ways to meet policy goals set by Congress or HUD. 

 39FHA officials reported difficulties administering the HECM program initially as a 

demonstration for only 2,500 loans because of the challenges of selecting a limited number 

of lenders and borrowers.

40GAO, Homeownership: Potential Effects of Reducing FHA’s Insurance Coverage for 

Home Mortgages, GAO/RCED-97-93 (Washington, D.C.: May 1, 1997).

Page 37 GAO-07-708 FHA Modernization Efforts 
This option could have budgetary and oversight implications that would 

need to be considered when setting up the new corporation. For example, 

Congress would have to determine the extent to which (1) the 

corporation’s earnings in excess of those needed for operations and 

reserves would be available for other government activities and (2) the 

corporation would be subject to federal budget requirements. Also, if the 

corporation were created outside of HUD, Congress would have to 

consider whether oversight of the corporation would require a new 

oversight institution or could be performed by an existing organization. 

Alternatively, rather than maintaining all the functions of a mortgage 

insurer within a government entity, the MHC and private mortgage 

insurers have suggested that the federal government could provide 

mortgage insurance through risk-sharing agreements with private 

partners.41 FHA already works with partners to conduct various activities 

related to its operations. For example, FHA has delegated underwriting 

authority to approved lenders, and contractors perform many day-to-day 

activities (such as marketing foreclosed properties) that once were 

performed by FHA employees. A public-private risk-sharing arrangement 

would recognize that government has a better ability to spread risk, while 

private mortgage industry participants generally are more flexible and 

responsive to market pressures and better able to innovate and adopt new 

technologies quickly. There are many different possible ways to structure 

a risk-sharing approach, with variables such as the amount of insurance 

coverage provided, the number and type of risk-sharing partners, the 

degree of risk accepted by each partner, and the roles and responsibilities 

of the partners. 

Whatever the structure, a risk-sharing approach could result in greater 

efficiency and allow FHA to reach new borrowers through new partner 

channels. However, risk sharing also could diminish the federal 

government’s ability to stabilize markets if private partners lacked 

incentive to serve markets where economic conditions were deteriorating.

Additionally, implementing risk-sharing arrangements might require more 

specialized expertise than FHA currently has among its staff. For example, 

careful analysis in both program design and monitoring would be needed 

to ensure that FHA’s financial interests were adequately protected. 

 41FHA has implemented risk-sharing arrangements in its multifamily insurance program.

Page 38 GAO-07-708 FHA Modernization Efforts 
Finally, Congress and FHA could elect to make no changes at this time and 

allow the private market to play the definitive role in determining the 

future need for federal mortgage insurance. The recent decline in FHA’s 

market share occurred at a time when interest rates were low, house price 

appreciation was high, and mortgage credit was widely available. 

However, changes in the mortgage market, such as higher interest rates 

and stricter underwriting standards for subprime loans, may lead to an 

increasing role for FHA in the future or at least a continued role for the 

federal government in guaranteeing mortgage credit for some borrowers. 

Therefore, even if Congress and FHA were to make no changes at this 

time, FHA’s market share might increase due to the recent change in

market conditions. Or it might eventually become so small as to indicate 

that there is no longer a need for a federal role in providing mortgage 

insurance. If FHA’s market share continues to decline to such a level, FHA 

might be eliminated or critical functions reassigned to maintain a minimal 

federal role in guaranteeing mortgage credit. 

Making no changes to FHA at this time would acknowledge the substantial 

role the private market now plays in meeting the mortgage credit needs of

borrowers. However, some home buyers might find it more difficult and 

more costly to obtain mortgages if FHA were eliminated or its functions 

reduced and reassigned to another federal agency.

42 And allowing FHA to 

become too small could impact the federal government’s ability to play a 

role in stabilizing mortgage markets during an economic downturn. Also, 

any option that might lead to the eventual elimination of FHA’s singlefamily mortgage insurance program would have broader implications for 

FHA and its other programs, such as the multifamily mortgage insurance 

and regulatory programs, which this report does not address. Such 

implications would, therefore, require further study. 

Recent trends in the mortgage market, including the prevalence of lowand no-down-payment mortgages and increased competition from 

conventional mortgage and insurance providers, have posed challenges for 

FHA. FHA’s market share has declined substantially over the years, and 

Observations 

 42In 1995, legislation was introduced in the House and Senate (but never enacted) that 

proposed to abolish FHA and replace FHA’s single-family mortgage insurance program 

with a program in which risk would be shared between qualified mortgage insurers and a

Federal Home Mortgage Insurance Fund within the Department of the Treasury. The

federal government would have provided partial mortgage insurance on some single-family 

homes (and would no longer have insured multifamily mortgages). 

Page 39 GAO-07-708 FHA Modernization Efforts 
what was a negative subsidy rate for the single-family insurance program 

has crept toward zero. To adapt to market changes, FHA has implemented 

new administrative procedures and proposed legislation designed to 

modernize its mortgage insurance processes, introduce product changes, 

and provide additional risk-management tools. To its credit, FHA has 

performed considerable analysis to support its legislative proposal and has 

made or planned enhancements to many of the specific tools and 

resources that would be important to its implementation. 

However, the proposals present risks and challenges and should be viewed 

with caution for several reasons. First, FHA has not always effectively 

managed risks associated with product changes, most notably the growth

in the proportion of FHA-insured loans with seller-funded down-payment 

assistance. In that case, FHA did not use the risk-management tools 

already at its disposal to mitigate adverse loan performance that has had a 

detrimental impact on the Fund. Second, the proposal to lower downpayment requirements potentially to zero raises concerns given the greater 

default risk of loans with high LTVs, policies that could result in effective 

LTV ratios of over 100 percent, and housing market conditions that could 

put borrowers with such loans in a negative equity position. Sound 

management of very low or no-down-payment products would be 

necessary to help ensure that FHA and borrowers do not experience 

financial losses. Piloting or otherwise limiting the availability of new 

products would allow FHA the time to learn more about the performance 

of these loans and could help avoid unanticipated insurance claims. 

Despite the potential benefits of this practice, FHA generally has not 

implemented pilots, unless directed to do so by Congress. We have 

previously indicated that, if Congress authorizes FHA to insure new 

products, Congress and FHA should consider a number of means, 

including limiting their initial availability, to mitigate the additional risks 

these loans may pose. We continue to believe that piloting would be a 

prudent approach to introducing the products authorized by FHA’s 

legislative proposal. Finally, FHA would face the challenge of setting riskbased premiums—potentially for products whose risks may not be well 

understood—to achieve a specific financial outcome, a relatively small 

negative subsidy. Because the estimated subsidy rate is close to zero and 

FHA has consistently underestimated its subsidy costs, FHA runs some 

risk of missing its target and requiring a positive subsidy. Additionally, 

limitations we have identified in FHA’s TOTAL scorecard, which would be 

a key tool used in risk-based pricing, could reduce the agency’s ability to 

set prices commensurate with the risk of the loans. Accordingly, it will be 

important for FHA to continue making progress in addressing these 

limitations. 

Page 40 GAO-07-708 FHA Modernization Efforts 
Our recent report on trends in FHA’s market share underscores the 

challenges that FHA has faced in adapting to the changing mortgage 

market. For example, we noted that FHA’s share of the market for home 

purchase mortgages has declined precipitously since 2001 due in part to 

FHA product restrictions and a lack of process improvements relative to 

the conventional market. While FHA has taken some steps to improve its 

processes and enhance the tools and resources that it would use to 

implement the modernization proposals, additional changes may be 

necessary for FHA to operate successfully in the long run in a competitive 

and dynamic mortgage market. Other mortgage industry participants have 

greater flexibility to hire and compensate staff, invest in information 

technology, and introduce new products, enhancing their ability to adapt 

to market changes and manage risk. A number of policy options that go 

beyond FHA’s modernization proposals would give FHA similar flexibility 

but would have other implications that would require careful deliberation.

We provided HUD with a draft of this report for review and comment. 

HUD provided comments in a letter from the Assistant Secretary for 

Housing-Federal Housing Commissioner (see app. II). HUD said that the 

draft report provided a balanced assessment but also that the report’s 

concerns about FHA’s risk management and emphasis on the need for 

piloting lower-down-payment products were unwarranted. 

Agency Comments 

and Our Evaluation 

HUD said that it welcomed the draft report’s acknowledgement of FHA’s 

improvements in program administration and risk management but 

questioned the report’s concerns about FHA’s ability to understand and 

manage risk. HUD indicated that its proposal to diversify FHA’s product 

offerings and pricing structure grew out of recognition that FHA was 

subject to adverse selection, as evidenced by the loss of borrowers with 

better credit profiles and growth in seller-funded down-payment 

assistance loans. In addition, HUD listed steps it had taken to curtail sellerfunded down-payment assistance, including publishing a proposed rule in

May 2007 that would effectively eliminate seller-funded down-payment 

assistance in conjunction with FHA-insured loans. Our draft report cited a 

number of improvements in FHA’s risk management, such as 

enhancements to its loan performance models. However, we continue to 

believe that our concerns about FHA’s ability to manage risk are 

warranted. As our draft report noted, FHA did not take prompt action to 

mitigate the adverse financial impact of loans with seller-funded downpayment assistance. Furthermore, our draft report identified additional 

steps, such as improvements to TOTAL scorecard, that would help address 

the risks and challenges associated with the legislative proposals. 

Page 41 GAO-07-708 FHA Modernization Efforts 
With regard to piloting, HUD said that pilot programs are appropriate 

where a concept is untested but that the concept of zero- or lower-downpayments was well understood. HUD indicated that it had a firm basis for 

anticipating the performance of zero- and lower-down-payment loans as a 

result of its experience with mortgages with seller-funded down-payment 

assistance. HUD said it used this experience to establish risk-based 

insurance premiums and minimum credit scores for zero- and lower-downpayment borrowers. Additionally, HUD said that it had recently started to 

collect 30-day and 60-day delinquency data, giving the agency the 

capability to track performance trends for different segments of its loan 

portfolio on a monthly basis. HUD stated that, for these reasons, the risks 

of zero- or lower-down-payment loans were sufficiently well known or 

knowable to not warrant a pilot program. 

As our draft report noted, we previously have reported that other 

mortgage institutions limit the availability of, or pilot, new products to 

manage the risks associated with changing or expanding their product 

lines and have recommended that FHA consider adopting this practice. 

Our draft report also acknowledged that FHA’s experience with sellerfunded down-payment assistance could inform assessment of how a zerodown-payment product would perform. However, we continue to believe 

that FHA should consider limiting the availability of a loan product with 

no down payment. In particular, our draft report discussed two factors 

that indicate the need for caution in introducing such a product. First, a 

zero-down-payment product could be utilized by a different population of 

borrowers than seller-funded down-payment assistance loans and may not 

perform similarly to these loans. Second, zero-down-payment loans 

became common in the conventional mortgage market when rapid 

appreciation in home prices helped mitigate the risks of these loans. If 

authorized to offer a zero-down-payment product in the near future, FHA 

would be introducing it at a time when home prices have stagnated or are 

declining in some parts of the country. Because of these risks and 

uncertainties, we continue to believe that a prudent way to introduce a 

zero-down-payment product would be to limit its initial availability such as 

through a pilot program. 

We are sending copies of this report to the Chairman, Senate Committee 

on Banking, Housing, and Urban Affairs; Chairman and Ranking Member, 

Subcommittee on Housing and Transportation, Senate Committee on 

Banking, Housing, and Urban Affairs; Chairman and Ranking Member, 

House Committee on Financial Services; and Chairman and Ranking 

Member, Subcommittee on Housing and Community Opportunity, House 

Page 42 GAO-07-708 FHA Modernization Efforts 
Committee on Financial Services. We will also send copies to the 

Secretary of Housing and Urban Development and to other interested 

parties and make copies available to others upon request. In addition, the 

report will be made available at no charge on the GAO Web site at 

http://www.gao.gov. 

Please contact me at (202) 512-8678 or shearw@gao.gov if you or your staff 

have any questions about this report. Contact points for our Offices of 

Congressional Relations and Public Affairs may be found on the last page 

of this report. Key contributors to this report are listed in appendix III. 

William B. Shear 

Director, Financial Markets and 

 Community Investment 

Page 43 GAO-07-708 FHA Modernization Efforts 
Appendix I: Objectives, Scope, and 

Methodology 

Page 44 GAO-07-708 FHA Modernization Efforts 

Appendix I: Objectives, Scope, and 

Methodology 

The Ranking Member of the Senate Committee on Banking, Housing, and 

Urban Affairs and Senator Wayne Allard requested that we evaluate FHA’s 

modernization efforts, which include administrative and proposed 

legislative changes. Specifically, we examined (1) the likely program and 

budgetary impacts of FHA’s modernization efforts, (2) the tools, resources, 

and risk-management practices important to FHA’s implementation of the 

legislative proposals, if passed, and (3) other options that FHA and 

Congress could consider to help FHA adapt to changes in the mortgage 

market and the pros and cons of these options. 

To determine the likely program and budgetary impacts of FHA’s 

modernization efforts, we reviewed FHA guidance on three administrative 

changes implemented in 2006: the Lender Insurance Program and 

revisions to the agency’s appraisal protocols and closing cost guidelines. 

To determine the extent to which these administrative changes have 

affected the processing of FHA-insured loans, we interviewed

representatives of Countrywide Financial, Wells Fargo, Bank of America, 

and Lenders One (a mortgage co-operative representing about 90 

independent mortgage bankers). We selected Countrywide Financial and 

Wells Fargo because they are large FHA lenders, Bank of America because

it had recently decided to grow its FHA business, and Lenders One 

because some of its members make FHA loans. We also interviewed 

representatives of three mortgage and real estate industry groups—

Mortgage Bankers Association, National Association of Realtors, and 

National Association of Home Builders. To determine how the Lender 

Insurance Program has affected the processing of FHA insurance, we 

interviewed FHA officials and obtained documentation from them on the 

extent of lender participation in the program and its effect on insurance 

processing time and costs. 

In evaluating the likely program impacts of FHA’s proposed legislative 

changes, we focused on the proposals to raise FHA loan limits, institute 

risk-based pricing of mortgage insurance premiums, and lower downpayment requirements. To examine the effect of raising loan limits on 

demand for FHA-insured loans, we analyzed 2005 HMDA data (the most 

current available). Specifically, we analyzed the home purchase loans 

recorded in 2005 to determine the number of loans in each of 380 core 

based statistical areas (CBSA) and used that data to calculate FHA’s 
Appendix I: Objectives, Scope, and 

Methodology 

market share in each CBSA.1 (These 380 CBSAs were those for which we 

had data and included one aggregate “nonmetro” category.) We then 

determined the number of additional loans that, based on their loan 

amounts, would have been eligible for FHA insurance in 2005 had the 

higher proposed loan limits been in effect. Finally, we estimated the 

percentage of the newly-eligible loans in each CBSA that FHA would have 

insured using the following range of assumptions: (1) that FHA’s market 

share would have been approximately the same as it was among all loans 

in that CBSA under the actual 2005 loans limits, (2) that FHA’s market 

share would have been approximately the same as its share of loans with 

loan amounts ranging from 70 to 100 percent of the actual 2005 loan limits 

in that CBSA, (3) that FHA’s market share would have been approximately 

the same as its share of loans with loan amounts ranging from 75 to 100 

percent of the actual 2005 loan limits in that CBSA, and (4) that FHA’s 

market share would be approximately the same as its share of loans with 

loan amounts ranging from 80 to 100 percent of the actual 2005 loan limits 

in that CBSA.2

For each of these four scenarios, we calculated the total number and 

dollar amount of new loans across all 380 CBSAs that could have been 

insured by FHA had the higher loan limits been in effect. All four 

assumptions yielded similar results. After arriving at an estimate of an 

overall increase in the number of FHA-insured loans, we then determined 

the proportions of the increase that would have resulted from raising the 

loan limit floor in low-cost areas, raising the loan limit ceiling in high-cost 

areas, or raising the limits in areas that fell between the floor and the 

ceiling. Finally, we calculated the average FHA-insured loan amount in 

2005, as well as the average loan amount that FHA might have insured had 

the loan limits been increased. We assessed the reliability of the HMDA 

data we used by reviewing information about the data, performing 

electronic data testing to detect errors in completeness and 

 1

We excluded second liens and non-owner-occupied properties from our analysis because 

they are not a substantial part of FHA’s business. As defined by the Office of Management

and Budget, CBSAs are statistical geographic entities consisting of the county or counties

associated with at least one core (urbanized area or urban cluster) of at least 10,000 

population, plus adjacent counties having a high degree of social and economic integration 

with the core. 

2

Our analysis was based on an earlier FHA analysis. This analysis assumed that FHA would 

achieve a market share for newly eligible loans of (1) at least 50 percent of FHA’s national 

market share for loans in areas with median home prices exceeding the 87 percent

conforming limit and (2) 75 percent of FHA’s current market share in an area that was not 

constrained by the 87 percent conforming loan limit. 

Page 45 GAO-07-708 FHA Modernization Efforts 
Appendix I: Objectives, Scope, and 

Methodology 

reasonableness, and interviewing a knowledgeable official regarding the 

quality of the data. We determined that the data were sufficiently reliable 

for the purposes of this report. 

To estimate the effects of risk-based pricing on borrowers’ eligibility for 

FHA insurance and the premiums they would pay, we reviewed FHA’s 

risk-based pricing proposal and interviewed FHA officials regarding their 

plans to implement risk-based pricing, if authorized. We then analyzed 

SFDW data on FHA’s 2005 home purchase borrowers to determine how 

they would have been affected by FHA’s risk-based pricing proposal. (We 

focused on 2005 borrowers because that was the most recent year for 

which we had complete data, and we restricted our analysis to purchase 

loans because they comprise the bulk of FHA’s business.) First, we 

assigned borrowers to one of seven categories (FHA’s six proposed riskbased pricing categories and one category for those who would not have 

been eligible for FHA insurance) based upon their LTV ratio and credit 

score. Since FHA does not currently insure loans without a down payment, 

we identified borrowers with down-payment assistance and determined 

the source and amount of assistance to approximate borrowers with LTV 

ratios of 100 percent. We recalculated the LTV ratio of their loans by 

adding the amount of their assistance to the principal balance of their 

loan. We then examined the demographic characteristics (race, income, 

and first-time home buyer status) of borrowers in each of the six pricing 

categories, as well as those borrowers who would no longer qualify for 

FHA insurance. We assessed the reliability of the SFDW data we used by 

reviewing information about the system and performing electronic data 

testing to detect errors in completeness and reasonableness. We 

determined that the data were sufficiently reliable for the purposes of this 

report. 

We also interviewed representatives of the following consumer advocacy 

groups to obtain their views on FHA’s proposed legislative changes: 

Center for Responsible Lending, Consumer Action, Consumer Federation 

of America, National Association of Consumer Advocates, National 

Community Reinvestment Coalition, National Consumer Law Center, and 

National Council of La Raza. We examined the potential budgetary impacts 

of the legislative proposals by reviewing the President’s fiscal year 2008 

budget and FHA cost estimates as shown in the 2008 Federal Credit 

Supplement. (The Federal Credit Supplement provides summary 

information about federal direct loan and loan guarantee programs, 

including current subsidy rates and reestimated subsidy rates.) 

Page 46 GAO-07-708 FHA Modernization Efforts 
Appendix I: Objectives, Scope, and 

Methodology 

To determine the tools, resources, and risk-management practices 

important to FHA’s implementation of the legislative proposals, we 

interviewed and reviewed documentation from FHA officials regarding the 

agency’s plans for implementing the legislative proposals, if passed. We 

focused on completed and planned enhancements to FHA’s SFDW data, 

loan performance models, TOTAL mortgage scorecard, information 

technology, human capital, and risk-management practices. To help us 

evaluate the need for enhancements to FHA’s tools, resources, and 

practices, we followed up on our past work on (1) FHA’s development and 

use of TOTAL, (2) FHA’s estimation of subsidy costs for its single-family 

insurance program, (3) practices that could be instructive for FHA in 

managing the risks of new mortgage products, and (4) FHA’s management 

of loans with down-payment assistance.3

 To obtain information on the 

tools and resources that other mortgage institutions use to set prices and 

manage risk, we interviewed Fannie Mae, Freddie Mac, the Mortgage 

Insurance Companies of America (the industry group that represents the 

private mortgage insurance industry), and four private mortgage insurance 

companies—AIG United Guaranty, Genworth Mortgage Insurance 

Company, Mortgage Guaranty Insurance Corporation, and PMI Mortgage 

Insurance Company. 

To determine other options that FHA and Congress could consider and the 

pros and cons of these options, we reviewed relevant literature, including

the report of the Millennial Housing Commission,4

 articles discussing past 

FHA restructuring proposals,5

 and our past work on various options for 

FHA.6

 We also interviewed FHA officials, academic experts, FHA lenders, 

and private mortgage insurance companies. 

We conducted this work in Washington, D.C., from September 2006 to

June 2007 in accordance with generally accepted government auditing 

standards. 

 3

See GAO-06-435, GAO-05-875, GAO-05-194, and GAO-06-24. 

4

Meeting Our Nation’s Housing Challenges: Report of the Bipartisan Millennial Housing 

Commission (Washington, D.C.: May 30, 2002). 

5

See, for example, Kerry D. Vandell, “FHA Restructuring Proposals: Alternatives and 

Implications,” Housing Policy Debate, volume 6, issue 2 (1995). 

6

See, for example, GAO/RCED-97-93. 

Page 47 GAO-07-708 FHA Modernization Efforts 
Appendix II: Comments from the Department 

of Housing and Urban Development 

Page 48 GAO-07-708 FHA Modernization Efforts 

Appendix II: Comments from the Department 

of Housing and Urban Development 
Appendix II: Comments from the Department 

of Housing and Urban Development 

Page 49 GAO-07-708 FHA Modernization Efforts 
Appendix II: Comments from the Department 

of Housing and Urban Development 

Page 50 GAO-07-708 FHA Modernization Efforts 
Appendix III: GAO

A

 Contact and Staff 

cknowledgments 

Page 51 GAO-07-708 FHA Modernization Efforts 

Appendix III: GAO Contact and Staff 

Acknowledgments 

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

In addition, Steve Westley (Assistant Director), Steve Brown, Laurie 

Latuda, John McGrail, Barbara Roesmann, Paige Smith, and Richard 

Vagnoni made key contributions to this report. 

GAO Contact 

Staff 

Acknowledgments 

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