MORTGAGE 

FINANCING 

Actuarial Soundness of 

the Federal Housing 

Administration's Mutual 

Mortgage Insurance 

Fund 

Statement of Thomas J. McCool, Managing Director 

Financial Markets and Community Investment 

United States General Accounting Office 

GAO Testimony

Before the Subcommittee on Housing and Transportation

Committee on Banking, Housing and Urban Affairs 

U.S. Senate 

For Release on Delivery 

Expected at 

1:00 p.m., EST 

Monday 

March 19, 2001 

GAO-01-526T 
1 GAO-01-526T 

Mr. Chairman and Members of the Subcommittee: 

We are here today to discuss the results of our analysis of the financial health of the Mutual 

Mortgage Insurance Fund (Fund) of the Department of Housing and Urban Development’s 

(HUD) Federal Housing Administration (FHA). Through the Fund, FHA operates a single-family 

insurance program that helps millions of Americans buy homes. The Fund, which is financed 

through insurance premiums, has operated without cost to the American taxpayer. Last year, 

the Fund’s economic value appeared to have reached its highest level in at least 20 years—

prompting proposals to spend some of the Fund’s current resources or reduce net cash flows 

into the Fund. Concerned about how the soundness of the Fund is measured and proposals to 

spend what some were calling “excess reserves,” you requested that we analyze the financial 

health of the Fund. 

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

of the Fund—its capital resources plus the net present value of future cash flows—and the 

related capital ratio—the economic value as a percent of the Fund’s insurance-in-force. For 

most of its history, the Fund was relatively healthy; however, in fiscal year 1990 the Fund was 

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

Fund on a financially sound basis, Congress enacted legislation in November 1990 that required 

the Secretary of HUD to, among other things, take steps to achieve a capital ratio of 2 percent by 

November 20001

 and to maintain or exceed that ratio at all times thereafter. The legislation also 

required the Secretary to raise insurance premiums and suspend the rebates, called distributive 

shares, that FHA borrowers had been eligible to receive under certain circumstances. As a 

result of the 1990 housing reforms, the Fund must not only meet capital ratio requirements, it 

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

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

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

profession defines actuarial soundness. 

The 1990 FHA reforms required that an independent contractor conduct an annual actuarial 

review of the Fund. These reviews have shown that during the 1990s, the estimated economic 

value of the Fund grew substantially. As figure 1 shows, by the end of fiscal year 1995, the Fund 

attained an estimated economic value that slightly exceeded the amount required for a 2-percent 

capital ratio. Since that time, the estimated economic value of the Fund continued to grow and 

always exceeded the amount required for a 2-percent capital ratio. In the most recent review, 

Deloitte & Touche (Deloitte) estimated the Fund’s economic value at about $17.0 billion at the 

end of fiscal year 2000. This represents about 3.51 percent of the Fund’s insurance-in-force—

well above the required minimum of 2 percent. 

 

1

The act defined the capital ratio as the ratio of the Fund’s capital, or economic net worth, to its unamortized insurance-in-force. 

However, the act defined unamortized insurance-in-force as the remaining obligation on outstanding mortgages—a definition 

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

insurance-in-force as it is generally understood—which is the initial amount of mortgages. All capital ratios reported here are 

measured using unamortized insurance-in-force as it is generally understood. 
2 GAO-01-526T 

Figure 1: Comparison of Estimated Economic Value and 2 Percent of Insurance-in-Force, 1989-2000 

Source: GAO analysis of Price Waterhouse (now PricewaterhouseCoopers) and Deloitte & Touche data. 

Concerned about the adequacy of the minimum 2-percent requirement and about proposals to 

spend what some were calling excess reserves, you asked us to determine the conditions under 

which an estimated capital ratio of 2 percent would be adequate to maintain the actuarial 

soundness of the Fund. Specifically, you asked us to (1) estimate the value of the Fund at the 

end of fiscal year 1999, given expected economic conditions, and compare our estimate to the 

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

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

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

size of the Fund if the estimated capital ratio is different from the amount needed and describe 

the impact that these options might have on the Fund, FHA mortgagors, and the federal budget. 

In summary: 

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

year 1999. This estimate implies a capital ratio of 3.20 percent of the unamortized insurancein-force. Although we did not evaluate the quality of the 1999 estimates prepared by 

Deloitte, using a different method of analysis, we believe that Deloitte's estimates and ours 

are comparable because of the uncertainty inherent in forecasting and the professional 

judgements made in this type of analysis. Both of these estimates easily exceed the 

minimum required capital ratio of 2 percent that Congress set in 1990. 

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

1999, a 2-percent capital ratio appears sufficient to withstand moderately severe economic 

downturns that could lead to worse-than-expected loan performance. That is, under 
3 GAO-01-526T 

economic scenarios that we developed to represent regional and national economic 

downturns that the nation experienced between 1975 and 1999, the estimated capital ratio 

fell by only slightly less than 0.4 percentage points. Some more severe downturns that we 

analyzed also did not cause the estimated capital ratio to decline by as much as 2 percentage 

points. However, in three more severe scenarios, an economic value of 2 percent of 

insurance-in-force would not have been adequate. Nonetheless, because of the nature of 

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

implies that the Fund would necessarily withstand any particular economic scenario under 

all circumstances. 

• Congress and the Secretary of HUD have taken and could take a number of actions to 

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

ratio and FHA borrowers is not always certain. However, actions that influence the Fund’s 

reserve levels will also affect the federal budget. In short, any proposal that seeks to use 

reserves, if not accompanied by a reduction in other spending or an increase in receipts, will 

result in a decline in the federal budget surplus. 

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

our estimates compare with estimates prepared by Deloitte & Touche. 

The Fund’s Capital Ratio Exceeds 3 Percent 

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

of future cash flows. Investments in nonmarketable Treasury securities represent the largest 

component of FHA’s current capital resources. Estimating the net present value of future cash 

flows is a complex actuarial exercise that requires extensive professional judgment. Cash flows 

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

to pay claims on foreclosed mortgages, premium refunds, and administrative expenses. (See fig. 

2.) 
4 GAO-01-526T 

Figure 2: Cash Flows of the Mutual Mortgage Insurance Fund 

Refinanced

or sold!

Refunds of 

up-front 

premiums if 

mortgage 

terminated 

voluntarily 

within 7 years 

Sold!

FHA

Administrative

expenses

 

HUD-owned house 

Previously foreclosed

Proceeds from 

sale of 

foreclosed 

property

FHA-insured

mortgage

Insurance

premiums

(up-front 

and annual)

Lender

Claims on 

foreclosed 

properties

MMI 

Fund

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

and forecasts of likely values of key economic variables, we estimated that the Fund had a net 

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

economic value of $15.8 billion and a capital ratio of 3.20 percent. Given the inherent 

uncertainty of these estimates and the professional judgements involved, these numbers are 

comparable to those of Deloitte at the end of 1999, when Deloitte estimated that under expected 

economic conditions the capital value was $16.6 billion and the capital ratio was 3.66 percent. 

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

Because Deloitte performed its analysis before the end of fiscal year 1999, it had to estimate the 
5 GAO-01-526T 

Fund’s capital resources and insurance-in-force, while we were able to use the year-end values. 

In its recent estimates for 2000, Deloitte noted that in the actuarial review for fiscal year 1999, it 

had overestimated the Fund’s capital resources by about $1 billion. However, Deloitte did not 

restate the economic value and capital ratio for 1999; instead it adjusted the starting point for 

the 2000 estimate of economic value. If Deloitte had restated the economic value and capital 

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

estimates for the Fund’s capital resources and insurance-in-force, it is difficult to compare its 

estimates of the Fund’s economic value and capital ratio over time. 

Table 1: Estimates of Capital Ratios for FHA’s Mutual Mortgage Insurance Fund by GAO and Deloitte & 

Touche, End of FY 1999 

Dollars in millions 

Estimate 

Total capital 

resources 

Future cash 

flows 

Economic 

value 

Unamortized 

insurance-inforce Capital ratio 

(percent) 

GAO $14,326 $1,484 $15,810 $493,990 3.20 

Deloitte 15,331 1,306 16,637 454,184 3.66 

Source: GAO analysis and Actuarial Review of MMI Fund as of FY 1999, Deloitte & Touche. 

The Fund’s economic value principally reflects the large amount of capital resources that the 

Fund has accrued. Because current capital resources are the result of previous cash flows, the 

robustness of the economy and the higher premium rates throughout most of the 1990s 

accounted for the accumulation of these substantial capital resources. Good economic times 

that are accompanied by relatively low interest rates and relatively high levels of employment 

are usually associated with high levels of mortgage activity and relatively low levels of 

foreclosure; therefore, cash inflows have been high relative to outflows during this period. 

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

of fiscal 1999. As a result of relatively low interest rates and the robust economy, FHA insured a 

relatively large number of mortgages in fiscal years 1998 and 1999, and these loans make up a 

large portion of FHA's insurance-in-force. Because of their low interest rates and because 

forecasts of economic variables for the near future show house prices rising while 

unemployment and interest rates remain fairly stable, our models predict that these new loans 

will have low levels of foreclosure and prepayment. At the same time, we assume that many 

FHA-insured homebuyers will continue to pay FHA annual insurance premiums.2

 Thus, our 

 

2

 Most borrowers with FHA-insured loans who received them prior to September 1983 were required to pay an annual insurance 

premium for the life of the loan. In addition, most borrowers who received FHA-insured loans after June 1991 are required to pay an 

annual insurance premium for up to the life of the loan, depending on loan type and the initial loan-to-value ratio of the loan. 

Borrowers who received FHA-insured loans between September 1983 and June 1991 were not required to pay annual mortgage 

insurance premiums. 
6 GAO-01-526T 

models predict that cash flowing into the Fund from mortgages already in FHA’s portfolio at the 

end of fiscal year 1999 will be more than sufficient to cover the cash outflows associated with 

these loans. 

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

including predictions of mortgage foreclosures and the likelihood that those holding FHAinsured mortgages will prepay their loans. These predictions are based on elaborate models that 

estimate past relationships between foreclosures and prepayments and certain economic 

variables, such as changes in house prices. To the extent that these relationships are different in 

the future, the actual foreclosures and prepayments will differ from the estimates. The 

estimating procedures make many other assumptions, and I will describe some of these 

limitations in greater detail later in my testimony. 

The Actuarial Soundness of the Fund Depends on the Risks That Congress Wants the 

Fund to Withstand 

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

economic conditions are comparable, we cannot conclude on the basis of these estimates alone 

that the Fund is actuarially sound. Instead, we believe that to determine actuarial soundness 

one should measure the Fund’s ability to withstand certain worse-than-expected conditions. 

According to our estimates, worse-than-expected loan performance that could be brought on by 

moderately severe economic conditions would not cause the estimated value of the fund at the 

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

severe downturns that we analyzed also did not cause the estimated capital ratio to decline by as 

much as 2 percentage points. However, a few more severe economic scenarios could result in 

such poor loan performance that the estimated value of the fund at the end of fiscal year 1999 

could decline by more than 2 percent of insurance-in-force. 

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

generated economic scenarios that were based on economic events in the last 25 years and other 

scenarios that could lead to worse-than-expected loan performance in the future. Under each of 

these scenarios, we used our models to estimate the economic value of the Fund and the related 

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

capital ratio. For example, the worst historical scenario we tested, one based on the 1981-82 

national recession, lowered the capital ratio by less than 0.4 percentage points—about 20 

percent of the required 2 percent minimum capital ratio. To see how the economic value of the 

Fund would change as the extent of adversity increased, we extended regional scenarios that 

were based on historical economic downturns experienced in three states—the west south 

central downturn based on Louisiana in the late 1980s, the New England downturn based on 

Massachusetts in the late 1980s and early 1990s, and the Pacific downturn based on California in 

the 1990s—to the nation as a whole. In extending the west south central and Pacific downturns, 

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

our models estimate that extending the New England downturn to the country as a whole would 

reduce the capital ratio by almost 2.4 percentage points. In another scenario, in which we 

specify that interest rates fall substantially, inducing refinancing, and then a recession sets in, 

leading to increased foreclosures, the estimated capital ratio fell substantially, by over 1.8 

percentage points. 
7 GAO-01-526T 

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

assumed that foreclosure rates in 2000 through 2004 equal foreclosure rates from 1986 through 

1990 for mortgages originated in the 10-year periods prior to 2000 and 1986, respectively. 
8 GAO-01-526T 

Table 2: Capital Ratios Under Expected and More Severe Economic Scenarios in Selected Locations 

Scenario Description 

Capital ratio for 

scenarios in one 

region

(percent) 

Capital ratio for 

national scenarios 

(percent)

Expected economic 

conditions 

Unemployment and interest rates 

vary as DRI forecasts; house 

price growth is adjusted for 

constant quality and slower 

growtha 

NA 3.20

Historical regional downturns 

West south central 

downturn 

House prices and unemployment 

rates change as they did in 

Louisiana from 1986 through 

1990. 

3.06 2.31

New England downturn House prices and unemployment 

rates change as they did in 

Massachusetts from 1988 

through 1992. 

3.14 0.81

Pacific downturn House prices and unemployment 

rates change as they did in 

California from 1991 through 

1995. 

2.89 2.16

Other national scenarios 

1981-82 Recession For each state, house prices, 

unemployment rates, and interest 

rates change as they did from 

1981 through 1985. 

NA 2.81

Induced refinancing 

followed by a recession 

Mortgage interest rates fall, 

inducing borrowers to refinance, 

and then a recession sets in, with 

a rising unemployment rate and 

falling house prices. 

NA 1.37
9 GAO-01-526T 

Rising interest rate 

scenario 

Mortgage and other interest rates 

from 2000 through 2004 are 

higher than under expected 

economic conditions. 

NA 3.36

Scenario with 

foreclosure rates from 

the 1980s 

Foreclosure rates in 2000 through 

2004 equal foreclosure rates from 

1986 to 1990 for mortgages 

originated in most recent 10-year 

period. 

NA 0.92

a

Standard and Poor’s DRI is a private economic forecasting company. 

Source: GAO analysis. 

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

experienced in the west south central states in the late 1980s, we applied these rates directly to 

our models, assuming that for the next 5 years foreclosure rates in most cases would be 

equivalent to those experienced by the west south central states in 1986 through 1990. Then we 

varied the proportion of FHA’s portfolio experiencing these high foreclosure rates. As figure 3 

shows, if about 36 percent of the portfolio experiences these rates, the estimated capital ratio 

would be 2 percentage points lower than the expected case; and if 55 percent of the portfolio 

experienced these rates, the economic value of the Fund would fall to zero. 

Figure 3: Capital Ratios Resulting From Applying the Average 1986-90 Foreclosure Rates in the West South 

Central Census Division to Varying Proportions of FHA’s Insurance Portfolio in 2000-04 

Note: West south central mortgages made up 9 percent of FHA’s portfolio in 1999. This analysis does not change 

foreclosure rates for streamline refinanced or adjustable rate mortgages because there are little data on these 
10 GAO-01-526T 

products for the 10-year period prior to 1986. The west south central Census division includes Arkansas, Louisiana, 

Oklahoma, and Texas. 

 

Source: GAO analysis. 

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

the economic value of the Fund because of uncertainty about the performance of FHA’s loan 

portfolio over the life of the existing loans, which, in some cases, can be for 30 years. We believe 

that our models make good use of historical experience in identifying the key factors that 

influence loan foreclosures and prepayments and estimating the relationships between those 

factors and loan performance. In addition, we have relied on reasonable, and in some cases 

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

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

higher than necessary to withstand many adverse economic scenarios. 

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

caution in concluding that the estimated value of the Fund today implies that the Fund could 

withstand the economic scenarios that we examined under all circumstances. Our estimates 

and those of others are valid only under a certain set of conditions, including that loans FHA 

insured in recent years and loans it insured in the more distant past have a similar response to 

economic conditions, and that cash inflows associated with future loans at least offset cash 

outflows associated with those loans. Some specific factors beyond those incorporated in our 

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

economic conditions are as follows: 

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

fiscal year 1999 consisted of loans originated in fiscal years 1998 and 1999. As a result, the 

performance of these loans will have an important effect on the overall performance of 

FHA’s loan portfolio. However, because these loans are so new, we do not have a lot of data 

yet showing how well they will perform over their lifetimes, which is often 30 years. Our 

model is based on data on loan performance for loans originating from 1975 through 1999. 

As long as the influences of key predictive factors on the probabilities of foreclosure and 

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

estimates of these relationships generated by our models will apply to these recent loans. 

However, in recent years, FHA’s competitors in the conventional mortgage market—private 

mortgage insurers and conventional mortgage lenders—are increasingly offering to selected 

homebuyers products that compete with FHA’s for those homebuyers who are borrowing 

more than 95 percent of the value of their homes. By lowering the required down payment, 

conventional mortgage lenders and private mortgage insurers may have attracted some less 

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

have increased the average risk of FHA-insured loans in the late 1990s. However, because 

these loans are relatively new, the increased risk would not yet be observable in the data on 

foreclosures and prepayments. If this effect, known as adverse selection, has been 

substantial, the economic value of the Fund may be lower than we estimate, and it may be 

more difficult for the Fund to withstand worse-than-expected loan performance than our 

estimates suggest. 

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

make in the future could affect the future cash flows associated with loans in FHA’s portfolio 

as of the end of fiscal year 1999 and, therefore, the Fund’s economic value, in ways that are 
11 GAO-01-526T 

not accounted for in our models. For example, if HUD reinstitutes paying distributive shares 

to borrowers when they pay their mortgages in full or voluntarily terminate their insurance, 

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

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

reducing foreclosures or whether the program mainly results in delayed foreclosures that 

lead to larger losses for FHA in the long run. On the other hand, if FHA’s financial 

counseling program reduces foreclosures for those homebuyers who received such 

counseling, then losses to the Fund will be less than we have estimated. Steps taken by HUD 

to improve the oversight of lenders and the disposition of properties could also reduce the 

level of losses to FHA below what we have estimated. 

• The impact of new loans—Our models do not look at cash flows associated with loans that 

FHA would insure after fiscal year 1999. Our analysis of the ability of the Fund to withstand 

adverse economic conditions requires making the assumption that the adverse conditions 

would not also cause loans insured by FHA after fiscal year 1999 to be an economic drain on 

the Fund. Since the 1990 FHA reforms, the cash flows associated with each year’s loans have 

been estimated to have a positive economic value, thereby adding to the economic value of 

the entire Fund. However, during adverse economic times, new loans might perform worse 

than loans that were insured by FHA during the 1990s. Furthermore, recent and future 

changes in FHA’s insurance program may cause these loans to perform differently from how 

past experience suggests that they will. If, for example, FHA loosens underwriting 

standards, future loans may perform worse than past experience suggests. In addition, the 

recent reduction in up-front premiums could reduce cash inflows into the Fund, although it 

could also lower the riskiness of the loans that FHA insures. If the newly insured loans 

perform so poorly that they have a negative economic value, then the loss to the Fund in any 

of the adverse economic scenarios that we have considered would be greater than what we 

have estimated. Alternatively, if the newly issued loans have positive economic values, then 

they would contribute to further growth of the Fund. 

Caution also needs to be applied in making changes to FHA’s insurance program because of the 

current uncertainty about their impact on the Fund. In analyzing the impact of changes in FHA’s 

programs and policies on the Fund, it is important to recognize that such changes can affect the 

volume and riskiness of loans that FHA insures. Although the models currently used in the 

annual actuarial reviews of the Fund can be used to estimate the direct impact that some policy 

changes may have on the Fund’s economic value, these models cannot isolate indirect effects on 

the volume and riskiness of FHA's loans. Accordingly, in our report, we recommended that the 

Secretary of HUD develop better tools for assessing the impacts that these changes may have on 

the volume and riskiness of loans that it insures.4

 

3

 Between 1943 and 1990, FHA rebated these so-called excess funds to borrowers as distributive shares. In 1990, however, Congress 

suspended the payment of these shares until the Secretary of HUD determines that the Fund is actuarially sound. HUD has 

announced that it will resume paying distributive shares. HUD officials said that they are developing systems to facilitate the 

payment of these shares and expect to be ready to resume paying them in mid-2001. 

4

Mortgage Financing: FHA’s Fund Has Grown, but Options for Drawing on the Fund Have Uncertain Outcomes (GAO-01-460, Feb. 

28, 2001). 
12 GAO-01-526T 

Options for Drawing on the Fund Have Uncertain Outcomes, But Any Use of the Fund’s 

Reserves Will Affect the Federal Budget 

Given the recent growth in the economic value of the Fund, several proposals have been made to 

use what some are calling excess reserves or take other actions that could result in a change in 

the value of the Fund. If Congress or the Secretary of HUD believes that the economic value of 

the Fund is higher than the amount needed to ensure actuarial soundness, several changes to the 

FHA single-family loan program could be adopted. The impact that these actions might have on 

the capital ratio and FHA borrowers is difficult to assess without using tools designed to 

estimate the multiple impacts that policy changes often have. However, any actions that 

influence the Fund’s reserve levels will also affect the federal budget. In short, any proposal that 

seeks to use reserves, if not accompanied by a reduction in other spending or an increase in 

receipts, would result in either a reduction in the surplus or an increase in any existing deficit. 

Several changes to the FHA single-family loan program could be adopted if Congress or the 

Secretary of HUD believes that the economic value of the Fund is higher than the amount 

needed to meet its definition of actuarial soundness. For example, actions that the Secretary 

could take that could reduce the value of the Fund include lowering insurance premiums, 

adjusting underwriting standards, and reinstituting distributive shares. However, congressional 

action in the form of new legislation would be required to make other program changes that are 

not now authorized by the statute. These would include such actions as changing the maximum 

amount FHA-insured homebuyers may borrow relative to the price of the house they are 

purchasing and using the Fund’s reserves for other federal programs.5

Reliably estimating the potential effect of various options on the Fund’s capital ratio and FHA 

borrowers is difficult because the impacts of these policy changes are complex, and tools 

available for handling these complexities may not be adequate. Policy changes have not only 

immediate, straightforward impacts on the Fund and FHA’s borrowers, they also have more 

indirect impacts that may intensify or offset the original effect. Implementing these options 

could affect both the volume and the average riskiness of loans made, which, in turn, could 

affect any future estimate of the Fund’s economic value. As a result of this complexity, 

obtaining a reliable estimate would likely require that economic models be used to estimate the 

indirect effects of policy changes. At this time, however, neither the models used by HUD to 

assess the financial health of the Fund, nor those used by others, explicitly recognize the indirect 

effects of policy changes on the volume and riskiness of FHA’s loans. As a result, HUD cannot 

reliably estimate the impact of policy changes on the Fund. 

Although it is difficult to predict the overall impact of a change on the Fund’s capital ratio and 

thus on FHA borrowers as a whole, different options would likely have different impacts on 

current and prospective FHA-insured borrowers. Some proposals would more likely benefit 

existing and future FHA-insured borrowers, while others would benefit only future borrowers, 

and still others would benefit neither of these groups. One interpretation of the higher 

premiums that borrowers paid during the period in which the economic value of the fund has 

 

5

 During the 106th Congress, legislation was introduced that proposed using the Fund’s resources to fund affordable rental housing 

(see S. 2997). 
13 GAO-01-526T 

been rising is that borrowers during the 1990s “overpaid” for their insurance. Some options for 

reducing the capital ratio, such as reinstituting distributive shares, would be more likely to 

compensate these borrowers. The payment of distributive shares would benefit certain existing 

borrowers who voluntarily terminate their mortgages. If these policies continued into the 

future, they would also benefit future policyholders. Alternatively, reducing up-front premiums, 

reducing the number of years over which annual insurance premiums must be paid, or relaxing 

underwriting standards would tend to benefit only future borrowers. 

Under 1990 credit reform legislation, FHA’s budget is required to reflect the subsidy cost to the 

government of FHA’s loan insurance activities for that year.6

 Credit reform was intended to 

ensure that the full cost of credit activities for the current budget year would be reflected in the 

federal budget so that Congress and the executive branch could consider these costs when 

making annual budget decisions. For FHA’s Mutual Mortgage Insurance Fund, the subsidy cost 

is negative; that is, the program is operating at a profit. Under credit reform, the negative 

subsidy receipts would be available for appropriation for other uses, and a balance would not be 

permitted to accumulate in the liquidating account. However, to accommodate the differing 

statutory requirements of budgeting for the subsidy cost of insuring the loans and maintaining a 

2-percent reserve, the Office of Management and Budget (OMB) and FHA have allowed reserves 

to accumulate in the Fund in the form of interest-bearing Treasury securities. At the end of 

fiscal year 1999, FHA held nearly $15 billion in Treasury securities. These securities represent a 

claim on the U.S. Treasury to cover future losses to the Fund. From the perspective of the U.S. 

Treasury, these securities represent a liability. From the standpoint of the government as a 

whole, the securities represent a debt owed by one part of the federal government to another. 

By investing in nonmarketable Treasury securities, FHA makes funds available to other federal 

programs. Each year that the Fund runs a surplus, the budget surplus for the federal 

government, as a whole, is higher than it would otherwise have been if FHA had not been 

insuring profitable loans. When the total federal budget was in a deficit (as it was for most of 

the 1990s), that deficit was lower than it would have been if the Fund had not been realizing a 

surplus at the same time. 

Because of the difficulty in reliably measuring the effect of most actions that could be taken 

either by Congress or the Secretary of HUD on the Fund’s capital ratio, we cannot precisely 

measure the effect of these policies on the budget. However, any actions taken by Congress or 

the Secretary that influence the Fund’s capital ratio will have a similar effect on the federal 

budget. If Congress or the Secretary of HUD adopts policies, such as lowering premiums, 

paying distributive shares, or loosening underwriting standards, that reduce the profitability of 

the Fund, the negative subsidy amount reported in FHA’s budget submission and the Fund’s 

reserve will both be lower.7

 Some of these policies—lowering premiums and paying distributive 

shares—would affect FHA’s cash flows immediately.8

 Thus, the amount of money available for 

 

6

The subsidy cost is the estimated net cost to the government, in present value terms, of FHA-insured loans over the entire period 

the loans are outstanding. 

7

If Congress were to use the Fund’s reserves to fund other programs, the reserves would be lower, but there would be no effect on 

the negative subsidy amount reported in FHA’s budget submissions. 

8

Assuming that the volume and riskiness of FHA-insured loans will not change, HUD estimates that the recent reductions in up-front 

premiums combined with the introduction of mortgage insurance cancellation policies will lower the estimated value of the Fund by 

almost $6 billion over the next 6 years. 
14 GAO-01-526T 

FHA to invest in Treasury securities would be lower. Treasury in turn would have less money 

available for other purposes, and the overall surplus would decline. If the amounts of cash 

flowing out of the Fund exceeded current receipts, FHA would be required to redeem its 

investments in Treasury securities to make the required payments. Assuming no changes in 

other spending and taxes, Treasury then would be required to either increase borrowing from 

the public or use general tax revenues to meet its financial obligations to FHA. In either case, 

the annual budget surplus would be lower. 

Budgetary scoring for budget control purposes under the 1990 Budget Enforcement Act9

 is 

required only when a law is enacted; actions taken by the Secretary under existing authorities 

are not scored for budget control purposes, even though they may affect the budget surplus or 

deficit. Whether and how the proposals under discussion would be scored depend on the exact 

wording of the new law and are determined by OMB for Budget Enforcement Act purposes. 

However, any action taken by Congress or the administration to reduce FHA’s reserves, if not 

accompanied by a similar reduction in other government spending or by an increase in receipts, 

will result in either a reduction in the surplus or an increase in any existing deficit. 

Actuarial Soundness Should be Defined 

Whether actions should be taken to change the value of the Fund depends on whether the Fund's 

capital resources and expected revenues exceed the amount needed to meet its expected cash 

outflows under designated stressful conditions; that is, whether it is actuarially sound. 

Assessing whether this condition exists requires that the degree of risk that the Fund is expected 

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

Waterhouse called reasonably adverse economic downturns, then our results could be construed 

to mean that the Fund is taking in more revenue than it needs. Alternatively, if the Fund is 

expected to never exhaust its reserves, the current Fund might not be adequate. 

The 1990 reforms did not specify the amount of risk that the Fund needed to withstand. Instead, 

the reforms specified a minimum capital ratio and required that the Fund achieve actuarial 

soundness before the secretary of HUD could take certain actions that might reduce the value of 

the Fund. Because we believe that actuarial soundness depends on a variety of factors that 

could vary over time, setting a minimum or target capital ratio will not guarantee that the Fund 

will be actuarially sound over time. For example, if the Fund comprised primarily seasoned 

loans with known characteristics, a capital ratio below the current 2-percent minimum might be 

adequate. But under conditions such as those that prevail today, when the Fund is composed of 

many new loans, a 2-percent ratio might be inadequate if recent and future loans perform 

considerably worse than expected. 

We believe that to evaluate the actuarial soundness of the Fund, one or more scenarios that the 

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

economic value of the Fund or the capital ratio under the scenario(s). As long as the estimated 

economic value of the Fund is positive when the desired stress scenario(s) is used to make that 

 

9

As part of the effort to control federal budget results, the Budget Enforcement Act of 1990, as amended, created controls over laws 

changing or creating mandatory spending (basically entitlements) and receipts. 
15 GAO-01-526T 

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

leave a cushion to account for the factors not captured by the model and the inherent 

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

does not measure actuarial soundness. 

Matters for Congressional Consideration 

For these reasons, Mr. Chairman, Congress may wish to consider taking action to specify criteria 

for determining when the Fund is actuarially sound. More specifically, Congress may want to 

consider defining the types of economic conditions under which the Fund would be expected to 

meet its commitments without borrowing from the Treasury. 

Mr. Chairman, this concludes my statement. We would be pleased to respond to any questions 

that you or Members of the Subcommittee may have. 

Contact and Acknowledgments 

For further information regarding this testimony, please contact Thomas J. McCool at (202) 512-

8678. Individuals making key contributions to this testimony included Nancy Barry, Jay 

Cherlow, and Mathew Scire.
16 GAO-01-526T 

Related GAO Products

Mortgage Financing: FHA’s Fund Has Grown, but Options for Drawing on the Fund Have 

Uncertain Outcomes (GAO-01-460, Feb. 28, 2001). 

Mortgage Financing: Financial Health of the Federal Housing Administration’s Mutual Mortgage 

Insurance Fund (GAO/T-RCED-00-287, Sept. 12, 2000). 

Mortgage Financing: Level of Annual Premiums That Place a Ceiling on Distributions to FHA 

Policyholders (GAO/RCED-00-280R, Sept. 8, 2000). 

Single-Family Housing: Stronger Measures Needed to Encourage Better Performance by 

Management and Marketing Contractors (GAO/T-RCED-00-180, May 16, 2000, and GAO/RCED00-117, May 12, 2000). 

Single-Family Housing: Stronger Oversight of FHA Lenders Could Reduce HUD’s Insurance Risk

(GAO/RCED-00-112, Apr. 28, 2000). 

Homeownership: Information on Single-Family Loans Sold by HUD (GAO/RCED-99-145, June 

15, 1999). 

Homeownership: Achievements of and Challenges Faced by FHA’s Single-Family Mortgage 

Insurance Program (GAO/T-RCED-98-217, June 2, 1998). 

Homeownership: Results of and Challenges Faced by FHA’s Single-Family Mortgage Insurance 

Program (GAO/T-RCED-99-133, Mar. 25, 1999). 

Homeownership: Management Challenges Facing FHA’s Single-Family Housing Operations

(GAO/T-RCED-98-121, Apr. 1, 1998). 

Homeownership: Information on Foreclosed FHA-Insured Loans and HUD-Owned Properties in 

Six Cities (GAO/RCED-98-2, Oct. 8, 1997). 

Homeownership: Potential Effects of Reducing FHA’s Insurance Coverage for Home Mortgages

(GAO/RCED-97-93, May 1, 1997). 

Homeownership: FHA’s Role in Helping People Obtain Home Mortgages (GAO/RCED-96-123, 

Aug. 13, 1996). 
17 GAO-01-526T 

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

(GAO/RCED-96-50, Apr. 12, 1996). 

Homeownership: Mixed Results and High Costs Raise Concerns about HUD’s Mortgage 

Assignment Program (GAO/RCED-96-2, Oct. 18, 1995). 

Mortgage Financing: Financial Health of FHA’s Home Mortgage Insurance Program Has 

Improved (GAO/RCED-95-20, Oct. 18, 1994). 

(250023)