United States Government Accountability Office

GAO Testimony 

Before the Subcommittee on Housing and 

Transportation, Committee on Banking, 

Housing, and Urban Affairs, United States 

Senate

FEDERAL HOUSING 

ADMINISTRATION 

Proposed Reforms Will 

Heighten the Need for 

Continued Improvements in 

Managing Risks and 

Estimating Program Costs 

Statement of William B. Shear, Director 

Financial Markets and Community Investment 

For Release on Delivery

Expected at 2:30 p.m. EDT

Tuesday, June 20, 2006

 

GAO-06-868T 
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

June 20, 2006

FEDERAL HOUSING ADMINISTRATION

Proposed Reforms Will Heighten the 

Need for Continued Improvements in 

Managing Risks and Estimating Program 

Costs 

Highlights of GAO-06-868T, a testimony 

before the Subcommittee on Housing and 

Transportation, Committee on Banking, 

Housing, and Urban Affairs, United States 

Senate 

The Department of Housing and 

Urban Development’s (HUD)

Federal Housing Administration 

(FHA) has faced several challenges

in recent years, including rising

default rates, higher-than-expected 

program costs, and a sharp decline 

in program participation. To help 

FHA adapt to market changes, 

HUD has proposed a number of 

changes to the National Housing 

Act that would raise FHA’s 

mortgage limits, allow greater 

flexibility in setting insurance 

premiums, and reduce downpayment requirements. 

Implementing the proposed

reforms would require FHA to 

manage new risks and estimate the

costs of program changes. To

assist Congress in considering

issues faced by FHA, this testimony

provides information from recent 

reports GAO has issued that

address FHA’s risk management

and cost estimates. Specifically, 

this testimony looks at (1) FHA’s 

development and use of its

mortgage scorecard, (2) FHA’s 

consistent underestimation of 

program costs, (3) instructive 

practices for managing risks of new 

mortgage products, and (4)

weaknesses in FHA’s management 

of risks related to loans with downpayment assistance. 

Recent trends in mortgage lending have significantly affected FHA, including

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

loans, increased competition from lenders offering low-and no-downpayment products, and a growing proportion of FHA-insured loans with 

down-payment assistance. Although FHA has taken steps to improve its risk 

management, in a series of recent reports, GAO identified a number of 

weaknesses in FHA’s ability to manage risk and estimate program costs 

during this period of change. For example: 

• The way that FHA developed and uses its mortgage scorecard, while

generally reasonable, limits how effectively it assesses the default risk of 

borrowers. 

• With one exception, FHA’s reestimates of program costs have been less 

favorable than originally estimated, including a $7 billion reestimate for 

fiscal year 2003. 

• FHA has not consistently implemented practices used by other mortgage

institutions to help manage the risks associated with new mortgage 

products. 

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

associated with insuring a growing proportion of loans with downpayment assistance. 

GAO made several recommendations in its recent reports, including that 

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

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

loan performance models that have been found to influence credit risk, and 

(3) consider piloting new mortgage products. FHA has taken actions in 

response to GAO’s recommendations, but additional improvements in 

managing risk and estimating program costs will be important if FHA is to 

successfully implement its proposed program changes. 

www.gao.gov/cgi-bin/getrpt?GAO-06-868T.

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. 
Mr. Chairman and Members of the Subcommittee: 

I am pleased to have the opportunity to share information and 

perspectives with the committee as it considers issues facing the 

Department of Housing and Urban Development’s (HUD) Federal Housing 

Administration (FHA). FHA provides insurance for single-family home 

mortgages made by private lenders and in fiscal year 2005 insured about 

480,000 mortgages, representing $58 billion in mortgage insurance. The 

insurance program is supported by the Mutual Mortgage Insurance Fund

(Fund), which is financed through insurance premiums that FHA charges 

to borrowers. According to HUD’s estimates, FHA’s mortgage insurance 

program is currently a negative subsidy program, meaning that the Fund is

self-financed and currently operates at a profit. However, the program has 

faced several challenges in recent years, including rising default rates, 

higher-than-expected program costs, and a sharp decline in program 

participation due, in part, to increased competition from conventional 

mortgage providers. 

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

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

FHA’s maximum 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, to implement this legislative proposal, FHA would have to 

manage new risks and accurately estimate the costs of program changes. 

For example, to set risk-based insurance premiums, FHA would need to

understand the relationships between borrower and loan characteristics 

and the likelihood of default, as well as how the premiums would affect 

the Fund’s financial condition. Further, reducing the down-payment 

requirements for certain borrowers (and thus increasing the loan-to-value

ratios) has important implications for the risks of these loans. Loans with 

low or no down payments carry greater risk, partly because the higher the 

loan-to-value ratio, the less cash borrowers will have invested in their 

homes and the more likely that they may default on mortgage obligations,

especially during times of economic hardship.1

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

examined different aspects of FHA’s ability to manage risks and estimate 

 1

Loan-to-value ratio is the loan amount divided by the sales price or appraised value of the 

property. 

Page 1 GAO-06-868T 
program costs. Specifically, I will discuss (1) FHA’s development and use 

of a mortgage scorecard to assess the default risk of borrowers, (2) FHA’s 

consistent underestimation of subsidy costs for its single-family insurance 

program and particularly large subsidy reestimate for fiscal year 2003, (3)

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

mortgage products, and (4) weaknesses in how FHA has managed risks 

associated with growth in the proportion of loans with down-payment 

assistance. 

In preparing these reports, we reviewed and analyzed information 

concerning FHA’s approach to developing its mortgage scorecard and the

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

the factors underlying the agency’s subsidy reestimates; steps mortgage 

industry participants take to design and implement low- and no-downpayment mortgage products; and the standards and controls FHA uses to 

manage the risks of loans with down-payment assistance. We interviewed

officials at FHA, the U.S. Department of Agriculture, and U.S. Department 

of Veteran Affairs (VA); and staff at selected mortgage providers, private 

mortgage insurers; Fannie Mae and Freddie Mac; the Office of Federal 

Housing Enterprise Oversight; selected state housing finance agencies; and 

nonprofit down-payment assistance providers. We conducted this work in 

Boston, Massachusetts, and Washington, D.C., from January 2004 through 

February 2006 in accordance with generally accepted government auditing 

standards. 

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

ability to manage risk and estimate program costs: 

• While generally reasonable, the way that FHA developed and uses its 

mortgage scorecard—an automated tool that evaluates the default risk 

of borrowers—limits the scorecard’s effectiveness. FHA and its 

contractor used variables that reflected borrower and loan

characteristics to create the scorecard, as well as an accepted

modeling process to test the variables’ accuracy in predicting default. 

However, the data used to develop the scorecard were 12 years old by 

the time that FHA began using the scorecard in 2004, and the mortgage 

market has changed significantly since then. In addition, the scorecard 

does not include certain key variables that could help explain expected 

loan performance such as the source of the down payment. 

• FHA’s subsidy reestimates reflect a consistent underestimation of the 

costs of its single-family insurance program. For example, as of the end 

of fiscal year 2003, FHA submitted a $7 billion reestimate for the Fund, 

Page 2 GAO-06-868T 
reflecting a reduction in estimated profits. Increases in the expected 

level of insurance claims—potentially stemming from changes in 

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

the $7 billion reestimate. 

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

that could help FHA manage the risks associated with new products 

such as no-down-payment mortgages. For example, mortgage 

institutions may limit the volume of new products issued—that is, pilot 

a product—and sometimes require stricter underwriting on these 

products. While FHA has utilized pilots or demonstrations when 

making changes to its single-family mortgage insurance, it generally has 

done so in response to a legislative requirement and not on its own 

initiative. Moreover, FHA officials have questioned the circumstances 

under which pilot programs were needed and also said that they lacked 

sufficient resources to appropriately manage a pilot. 

• FHA has not developed sufficient standards and controls to manage 

risks associated with the growing proportion of loans with downpayment assistance. Unlike other mortgage industry participants, FHA 

does not restrict homebuyers’ use of down-payment assistance from 

nonprofit organizations that receive part of their funding from home 

sellers. However, our analysis of a national sample of FHA-insured 

loans found that the probability that loans with seller-funded nonprofit 

down-payment assistance would result in an insurance claim was 76 

percent higher than comparable loans without such assistance. 

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

made several recommendations designed to improve FHA’s risk 

management and cost estimates. For example, to improve its assessment 

of borrowers’ default risk, we recommended that FHA develop policies for 

updating the scorecard, incorporate the risks posed by down-payment 

assistance into the scorecard, and explore additional uses for this tool. 

To more reliably estimate subsidy costs, we recommended that FHA study 

and report in the annual actuarial review of the Fund the impact of 

variables not in the agency’s loan performance models (used in estimating 

subsidy costs) that have been found in other studies to influence credit 

risk. 2 In light of the risks that new mortgage products present and in 

 2

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

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

Page 3 GAO-06-868T 
recognition of established risk management practices, we also suggested 

that Congress consider (1) limiting the initial availability of any new singlefamily insurance product it might authorize and (2) directing FHA to 

consider using various techniques for mitigating risks for a no-downpayment product, or products about which the risks were not well 

understood. 

FHA has taken actions in response to some of our recommendations. For 

example, FHA agreed to consider incorporating a variable for downpayment assistance in its mortgage scorecard. To more accurately assess 

subsidy costs, an FHA contractor is considering the specific variables that

we recommended FHA include in its annual actuarial review and 

incorporated the source of down payment in the 2005 actuarial review of 

the Fund. FHA also has agreed to improve its oversight of down-payment 

assistance lending, including modifying its information systems to 

document assistance from seller-funded nonprofits. 

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

additional improvements will be important if FHA is to successfully 

implement some of the program changes HUD has proposed. Accordingly,

consideration of this proposal should include serious deliberation of the 

associated risks and the capacity of FHA to mitigate them. 

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

479) to broaden homeownership, shore up and protect lending institutions, 

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

program insures private lenders against losses (up to almost 100 percent 

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

criteria. In 2004, more than three-quarters of the loans that FHA insured 

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

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

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

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

accounted for less than 4 percent of the single-family mortgage market, 

compared with about 13 percent a decade ago. Additionally, default rates

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

a period during which home prices have appreciated rapidly and default 

rates for conventional and VA-guaranteed mortgages have been relatively 

stable. 

Background 

Page 4 GAO-06-868T 
FHA determines the expected cost of its insurance program, known as the 

credit subsidy cost, by estimating the program’s future performance.3

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

costs annually to reflect actual loan performance and expected changes in

estimates of future loan performance. FHA’s mortgage insurance program 

is currently a negative subsidy program, meaning that the present value of

estimated cash inflows to the Fund exceed the present value of estimated 

cash outflows. FHA has estimated that the loans it expects to insure in 

2007 will have a subsidy rate of -0.37, a rate closer to zero (the point at 

which estimated cash inflows equal estimated cash outflows) than any 

previous estimate. The economic value, or net worth, of the Fund that 

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

and inflows over time. Cash flows out of the Fund for payments associated 

with claims on defaulted loans and refunds of up-front premiums on 

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

from borrowers’ insurance premiums and net proceeds from recoveries on 

defaulted loans. If the Fund were to be exhausted, the U.S. Treasury would 

have to cover lenders’ claims directly. 

Two major trends in the conventional mortgage market have significantly 

affected FHA.4

 First, in recent years, members of the conventional 

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

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

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

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

assess the default risk of borrowers, particularly those with high loan-tovalue ratios, the mortgage industry has increasingly used mortgage scoring 

and automated underwriting systems.5

 Mortgage scoring is a technologybased tool that relies on the statistical analysis of millions of previously 

originated mortgage loans to determine how key attributes such as the 

borrower’s credit history, property characteristics, and terms of the 

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

mortgage industry is able to process loan applications more quickly and 

 3

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

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

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

administrative costs. 

4

Conventional mortgages do not carry government insurance or guarantees. 

5

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

origination process to decide whether to approve a loan. 

Page 5 GAO-06-868T 
consistently than in the past. In 2004, FHA implemented a mortgage

scoring tool, called the FHA Technology Open to Approved Lenders 

(TOTAL) Scorecard, to be used in conjunction with existing automated

underwriting systems. 

HUD’s legislative proposal is intended to modernize FHA, in part, to 

respond to the changes in the mortgage market. The proposal, among 

other things, would authorize FHA to change the way it sets insurance 

premiums, insure larger loans, and reduce down-payment requirements. 

The proposed legislation would enable FHA to depart from its current, 

essentially flat, premium structure and charge a wider range of premiums 

based on individual borrowers’ risk of default. Currently, FHA also 

requires homebuyers to make a 3 percent contribution toward the 

purchase of a property. HUD’s proposal would eliminate this contribution 

requirement and enable FHA to offer some borrowers a no-down-payment 

product. FHA is subject to limits in the size of the loans it can insure. For 

example, for a one-family property in a high-cost area, the FHA limit is 87

percent of the limit established by Freddie Mac. The legislative proposal 

would raise this limit to 100 percent of the Freddie Mac limit. 

If Congress authorizes the reforms HUD has proposed, FHA’s ability to 

assess the default risk of borrowers will take on increased importance 

because FHA would be adjusting insurance premiums based on its 

assessments of the credit risk of borrowers and insure potentially larger 

and riskier mortgages with low or no down payments. A primary tool that 

FHA uses to assess the default risk of borrowers who apply for FHAinsured mortgages is its TOTAL scorecard. 

The Way FHA 

Developed and Uses 

TOTAL Limits the 

Scorecard’s 

Effectiveness in 

Assessing the Default 

Risk of Borrowers 

Page 6 GAO-06-868T 
In reports we issued in November 2005 and April 2006, we noted that while 

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

the choices FHA made in the development process could limit the 

scorecard’s effectiveness.6

 FHA and its contractor used variables that 

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

accepted modeling process to test the variables’ accuracy in predicting 

default. However, we also found that: 

Age of Data, Lack of Key 

Variables, and Lack of 

Policy for Updating TOTAL 

Could Limit Its 

Effectiveness 

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

implemented the scorecard. Specifically, when FHA began developing 

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

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

attributed to a borrower’s poor creditworthiness. However, FHA did 

not implement TOTAL until 2004 and has not subsequently updated the 

data used in the scorecard. Best practices of private-sector 

organizations call for scorecards to be based on data that are 

representative of the current mortgage market—specifically, relevant 

data that are no more than several years old. In the past 12 years, 

significant changes—growth in the use of down-payment assistance, 

for example—have occurred in the mortgage market that have affected 

the characteristics of those applying for FHA-insured loans. As a result, 

the relationships between borrower and loan characteristics and the 

likelihood of default also may have changed. 

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

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

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

contractors, HUD’s Inspector General, and our work have all identified 

the source of a down payment as an important indicator of risk, and the 

use of down-payment assistance in the FHA program has grown rapidly 

over the last 5 years. Further, TOTAL does not include other important 

variables—such as a variable for generally riskier adjustable rate 

loans—included in other scorecards used by private-sector entities. 

• Although FHA has a contract to update TOTAL by 2007, the agency did 

not develop a formal plan for updating TOTAL on a regular basis. Best 

practices in the private sector and reflected in bank regulator guidance

call for having formal policies to ensure that scorecards are routinely 

 6

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

Scorecard, GAO-06-435 (Washington, D.C.: April 13, 2006). GAO, Mortgage Financing:

Additional Action Needed to Manage Risks of FHA-Insured Loans with Down Payment 

Assistance, GAO-06-24 (Washington, D.C.: November 9, 2005). 

Page 7 GAO-06-868T 
updated. Without policies and procedures for routinely updating 

TOTAL, the scorecard may become less reliable and, therefore, less 

effective at predicting the likelihood of default.

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

that HUD develop policies and procedures for regularly updating TOTAL 

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

underwriting loans by including the presence and source of down-payment 

assistance as a loan variable in the scorecard. In response, FHA agreed to

consider incorporating a variable for down-payment assistance in TOTAL.

HUD Could Realize 

Additional Benefits from 

an Expanded Use of 

TOTAL 

Despite potential limitations in the use of TOTAL, HUD still could realize 

additional benefits from the scorecard, if, like private-sector lenders and 

mortgage insurers, it put TOTAL to other uses. Based on its current use of 

TOTAL, FHA lenders and borrowers have seen two added benefits—less 

paperwork and more consistent underwriting decisions. However, private 

lenders and mortgage insurers put their scorecards to other uses, 

including to help price products based on risk and launch new products. 

For example, to set risk-based prices, private-sector organizations use 

scorecards to rank the relative risk of borrowers and price products 

according to that ranking. By increasing their use of scorecards, these 

organizations are able to broaden their customer base and improve their 

financial performance. Adopting these best practices from the private 

sector could generate similar kinds of benefits for FHA, particularly if FHA 

were to implement risk-based pricing.

To the extent that conventional mortgage lenders and insurers are better 

able than FHA to use mortgage scoring to identify and approve relatively 

low-risk borrowers and charge fees based on default risk, FHA may face 

adverse selection—that is, conventional providers may approve lower-risk 

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

borrowers for FHA. Accordingly, the greater the effectiveness of TOTAL, 

the greater the likelihood that FHA will be able to effectively manage the 

risks posed by borrowers seeking FHA-insured loans. 

To improve how FHA benefits from TOTAL, we recommended that the 

agency explore additional uses for the scorecard, including using it to 

implement risk-based pricing of mortgage insurance and to develop new 

products. These actions could enhance FHA’s ability to effectively 

compete in the mortgage market. In response to our recommendations, 

FHA indicated that it planned to explore these uses for TOTAL. 

Page 8 GAO-06-868T 
If implemented, HUD’s legislative proposal could affect the Fund’s cash 

inflows and outflows and, as a result, significantly affect the credit subsidy 

costs of the insurance program. For example, changes in FHA’s insurance 

premiums could affect the revenues FHA receives, and changes in the 

composition and riskiness of the loan portfolio (as a result of larger loans 

or more loans with no down payments) could affect the size and number 

of insurance claims FHA pays. 

As previously noted, FHA, like other federal agencies, is required to 

reestimate credit subsidy costs annually to reflect actual loan performance 

and expected changes in estimates of future loan performance. FHA has 

estimated negative credit subsidies for the Fund since 1992, when federal

credit reform became effective. However, as we reported in September 

2005, with the exception of the 1992 reestimate, FHA’s subsidy reestimates 

have been less favorable than the original estimates.7

 In particular, FHA’s 

$7 billion reestimate for fiscal year 2003 was more than twice the size of 

any other reestimate from fiscal years 2000 through 2004. 

FHA’s Reestimates 

Reflect Consistent 

Underestimation of 

Program Costs, 

Primarily Because of 

Higher Claims than 

Initially Estimated 

The $7 billion reestimate for fiscal year 2003 had three main components. 

The first component was the $3.9 billion difference between FHA’s fiscal 

year 2003 estimates of the net present value of future cash flows and the 

estimates it made one year earlier. Most of this difference stemmed from

changes in FHA’s estimates of claims and, to a lesser extent, prepayments 

(the payment of a loan before its maturity date). That is, FHA changed its 

estimate of future loan performance based on its observation of actual 

loan performance during fiscal year 2003 and revised economic 

assumptions. The second component was the $2.1 billion difference 

between estimated and actual cash flows occurring during fiscal year 2003. 

Underestimation of claims (net of recoveries on claims) and an 

overestimation of net fees (insurance premium receipts less premium 

refunds) for loans made prior to fiscal year 2003 largely account for the 

difference. The third component was an interest adjustment on the 

reestimate required by Office of Management and Budget guidance that 

increased the total reestimate by $1.1 billion. 

Several recent policy changes and trends may have contributed to changes 

in the expected claims underlying the $7 billion reestimate. For example:

 7

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

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

Page 9 GAO-06-868T 
• Revised underwriting guidelines made it easier for borrowers who are 

more susceptible to changes in economic conditions—and therefore 

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

loan. 

• Competition from conventional mortgage providers could have 

resulted in FHA insuring more risky borrowers. 

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

assistance, which generally have a greater risk of default. 

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

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

2005, the source of down payment. 

The major factors underlying the surge in prepayment activity that also 

contributed to the reestimate were declining interest rates and rapid 

appreciation of housing prices. These trends created incentives and 

opportunities for borrowers to refinance using conventional loans. 

To more reliably estimate program costs, we recommended that FHA 

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

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

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

also recommended that when changing the definitions of key variables, 

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

In response, FHA indicated, among other things, that its contractor was 

considering the specific variables that we had recommended FHA include 

in its annual actuarial review and had incorporated the source of downpayment assistance in the 2005 actuarial review of the Fund. 

Page 10 GAO-06-868T 
If Congress authorized FHA to insure mortgages with smaller or no down 

payments, practices used by other mortgage institutions could help FHA to 

design and implement these new products. In a February 2005 report, we 

identified steps that mortgage institutions take when introducing new 

products.8

 Specifically, mortgage institutions often utilize special 

requirements when introducing new products, such as requiring additional 

credit enhancements (mechanisms for transferring risk from one party to

another) or implementing stricter underwriting requirements, and limiting 

how widely they make available a new product. 

Practices Used by 

Other Mortgage 

Institutions Could 

Help FHA Manage 

Risks from Low- or 

No-Down-Payment 

Products 

Mortgage Institutions 

Require Additional Credit 

Enhancements, Stricter 

Underwriting, and Higher 

Premiums for Low- and 

No-Down-Payment 

Products

Some mortgage institutions require additional credit enhancements on 

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

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

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

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

enhancements such as higher mortgage insurance coverage. Although FHA 

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

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

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

they originated (lenders would generally use private mortgage insurance 

for risk sharing). 

Mortgage institutions also can mitigate the risk of low- and no-downpayment products through stricter underwriting. Institutions can do this in

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

certain products, requiring greater borrower reserves, or requiring more 

documentation of income or assets from the borrower. Although the 

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

benefit from similar approaches. The HUD Secretary has latitude within 

statutory limitations to change underwriting requirements for new and 

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

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

income when calculating payment-to-income ratios. However, FHA 

officials told us that they were unlikely to mandate a credit score 

threshold or borrower reserve requirements for a no-down-payment 

 8

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

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

Page 11 GAO-06-868T 
product because the product was intended to serve borrowers who are 

underserved by the conventional market, including those who lack credit

scores and have little wealth or personal savings.

Finally, mortgage institutions can increase fees or charge higher premiums 

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

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

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

were not able to require higher insurance coverage.9

 FHA, if authorized to 

implement risk-based pricing, could set higher premiums on FHA-insured

loans understood to have greater risk. 

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

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

understood, the agency should (1) consider incorporating stricter 

underwriting criteria such as appropriate credit score thresholds or 

borrower reserve requirements and (2) utilize other techniques for 

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

FHA said it agreed that these techniques should be evaluated when 

considering or proposing a new FHA product. 

Before Fully Implementing 

New Products, Some 

Mortgage Institutions May 

Limit Availability 

Some mortgage institutions initially may offer new products on a limited 

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

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

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

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

lending. FHA has utilized pilots or demonstrations when making changes 

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

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

example, FHA’s Home Equity Conversion Mortgage insurance program 

started as a pilot that authorized FHA to insure 2,500 reverse mortgages.10 

Additionally, some mortgage institutions may limit the origination and 

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

and Freddie Mac both reported that these were important steps in 

introducing a new product. 

 9

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

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

10Under this program, homeowners borrow against equity in their home and receive 

payments from their lenders. 

Page 12 GAO-06-868T 
We recommended that when FHA releases new products or makes 

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

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

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

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

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

administering the Home Equity Conversion Mortgage pilot program was 

difficult because of the challenges of equitably selecting a limited number 

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

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

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

told us they have conducted pilot programs when Congress has authorized 

them, but they questioned the circumstances under which pilot programs 

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

appropriately manage a pilot. However, if FHA does not limit the 

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

higher claims from products whose risks may not be well understood. 

HUD’s legislative proposal would represent a significant change to the 

agency’s single-family mortgage insurance program and presents new risk 

management challenges. In our November 2005 report examining FHA’s 

actions to manage the new risks associated with the growing proportion of 

loans with down-payment assistance, we found that the agency did not

implement sufficient standards and controls to manage the risks posed by 

these loans.11

FHA Has Not 

Implemented 

Sufficient Standards 

and Controls to 

Manage Risks 

Associated with the 

Growing Proportion 

of Loans with DownPayment Assistance 

 11GAO-06-24. 

Page 13 GAO-06-868T 
Homebuyers who receive FHA-insured mortgages often have limited funds 

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

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

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

The proportion of FHA-insured loans that are financed in part by downpayment assistance from various sources has increased substantially in 

the last few years, while the overall number of loans that FHA insures has 

fallen dramatically. Money from nonprofits funded by seller contributions 

has accounted for a growing percentage of that assistance. From 2000 to

2004, the total proportion of FHA-insured purchase loans that had a loanto-value ratio greater than 95 percent and that also involved downpayment assistance, from any source, grew from 35 to nearly 50 percent. 

Approximately 6 percent of FHA-insured purchase loans in 2000 received

down-payment assistance from nonprofits (the large majority of which 

were funded by property sellers), but by 2004 nonprofit assistance grew to 

about 30 percent. 

The Percentage of Loans 

with Down-Payment 

Assistance in FHA’s 

Portfolio Has Been 

Increasing and These 

Loans Do Not Perform as 

Well as Similar Loans 

without Assistance 

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

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

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

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

national sample and a sample from three Metropolitan Statistical Areas 

(MSA) with high rates of down-payment assistance.12 Holding other 

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

down-payment assistance had higher delinquency and claim rates than 

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

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

assistance would result in insurance claims was 49 percent higher in the 

national sample and 45 percent higher in the MSA sample than it was for 

comparable loans without assistance. Similarly, the probability that loans 

with nonprofit seller-funded, down-payment assistance would result in 

insurance claims was 76 percent higher in the national sample and 166 

percent higher in the MSA sample than it was for comparable loans 

without assistance. The poorer performance of loans with nonprofit sellerfunded, down-payment assistance may be explained, in part, by the sales 

prices of the homes bought with such assistance. More specifically, our 

analysis indicated that FHA-insured homes bought with seller-funded 

 12The data (current as of June 30, 2005) consisted of purchase loans insured by FHA’s 

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

three MSAs were Atlanta, Indianapolis, and Salt Lake City. 

Page 14 GAO-06-868T 
nonprofit assistance were appraised and sold for about 2 to 3 percent 

more than comparable homes bought without such assistance. The 

difference in performance also may be partially explained by the 

homebuyer having less equity in the transaction. 

Stricter Standards and 

Additional Controls Could 

Help FHA Manage the 

Risks Posed by Loans with 

Down-Payment Assistance 

FHA has implemented some standards and internal controls to manage the 

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

standards and additional controls could help FHA better manage risks 

posed by these loans while meeting its mission of expanding 

homeownership opportunities. Like other mortgage industry participants, 

FHA generally applies the same underwriting standards to loans with 

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

One important exception is that FHA, unlike others, does not limit the use 

of down-payment assistance from seller-funded nonprofits. Some 

mortgage industry participants view assistance from seller-funded 

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

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

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

otherwise places on contributions from sellers. However, due in part to 

concerns about loans with nonprofit seller-funded, down-payment 

assistance, FHA has proposed legislation that could help eliminate the 

need for such assistance by allowing some FHA borrowers to make no 

down payments for an FHA-insured loan. 

FHA has taken some steps to assess and manage the risks associated with

loans with down-payment assistance, but additional controls may be 

warranted. For example, FHA has contracted for two studies to assess the 

use of such assistance with FHA-insured loans and conducted ad hoc 

performance analyses of loans with down-payment assistance but has not 

routinely assessed the impact that the widespread use of down-payment 

assistance has had on loan performance. Also, FHA has targeted its 

monitoring of appraisers to those that do a high volume of loans with 

down-payment assistance, but FHA has not targeted its monitoring of 

lenders to those that do a high volume of loans with down-payment 

assistance, even though FHA holds lenders, as well as appraisers, 

accountable for ensuring a fair valuation of the property it insures. 

Our report made several recommendations designed to better manage the 

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

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

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

Page 15 GAO-06-868T 
including down-payment assistance as a factor when underwriting loans or 

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

assistance providers that receive funding from property sellers, we 

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

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

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

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

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

seller-funded nonprofits and (2) requiring lenders to inform appraisers 

when assistance is provided by seller-funded nonprofits. In addition, HUD 

has proposed a zero down-payment program as an alternative to sellerfunded, down-payment assistance. 

In May 2006, the Internal Revenue Service issued a ruling stating that 

organizations that provide seller-funded, down-payment assistance to 

home buyers do not qualify as tax-exempt charities. FHA permitted these 

organizations to provide down-payment assistance because they qualified 

as charities. Accordingly, the ruling could significantly reduce the number 

of FHA-insured loans with seller-funded down payments. 

The risks FHA faces in today’s mortgage market are growing. For example, 

the agency has seen increased competition from conventional mortgage 

and insurance providers, many of which offer low- and no-down-payment 

products and that may be better able than FHA to identify and approve 

relatively low-risk borrowers. Additionally, FHA is insuring a greater 

proportion of loans with down-payment assistance. These loans are more 

likely to result in insurance claims than loans without such assistance. 

Observations 

To effectively manage the risks posed by FHA’s existing products, we have 

concluded from our prior work that the agency must significantly improve 

its risk management and cost estimation practices. We are encouraged by

a variety of steps FHA has taken to enhance its capabilities in these areas, 

such as developing and implementing a mortgage scorecard and improving 

its loan performance models. However, FHA needs to take additional 

steps, such as establishing policies and procedures for updating TOTAL 

scorecard on a regular basis, more fully considering the risks posed by 

down-payment assistance when underwriting loans, developing a 

framework for introducing new products in a way that mitigates risk, and 

studying and reporting on the impact of variables found to influence credit 

risk that are not currently in the agency’s loan performance models. 

Page 16 GAO-06-868T 
HUD’s legislative proposal could help FHA serve more low-income and 

first-time homebuyers, but also would introduce additional risks to the 

Fund. Consideration of this proposal should include serious deliberation 

of the associated risks and the capacity of FHA to mitigate them. 

Mr. Chairman, this concludes my prepared statement. I would be happy to

answer any questions at this time. 

For further information on this testimony, please contact William B. Shear 

at (202) 512-8678. Individuals making key contributions to this testimony 

included Triana Bash, Anne Cangi, Marcia Carlsen, John Fisher, Austin 

Kelly, John McGrail, Andrew Pauline, Barbara Roesmann, Mathew Scirè,

Katherine Trimble, and Steve Westley.

Page 17 GAO-06-868T 

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