Federal Housing Administration: Managing Risks from a New Zero Down Payment Product
Published: 2005-06-30T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: To assist Congress in considering legislation to authorize the Secretary of the Department of Housing and Urban Development (HUD) to carry out a pilot program to insure zero down payment mortgages, this testimony provides information about practices mortgage institutions use in designing and implementing low and no down payment products. It also contains information about how these practices could be instructive for FHA in managing risks associated with a zero down payment product--a product for which the risks are not well understood. This testimony is primarily based on GAO's February 2005 report, Mortgage Financing: Actions Needed to Help FHA Manage Risks from New Mortgage Loan Products, (GAO-05-194).
section_title: What GAO Found
paragraphs: In recent years, many mortgage institutions have become increasingly active in supporting low and even no down payment mortgage products. In considering the risks of these new products, a substantial amount of research GAO reviewed indicates that loan-to-value (LTV) ratio and credit score are among the most important factors when estimating the risk level associated with individual mortgages. GAO's analysis of the performance of low and no down payment mortgages supported by FHA and others corroborates key findings in the literature. Generally, mortgages with higher LTV ratios (smaller down payments) and lower credit scores are riskier than mortgages with lower LTV ratios and higher credit scores. Some practices of other mortgage institutions offer a framework that could help FHA manage the risks associated with introducing new products or making significant changes to existing products. Mortgage institutions sometimes require additional credit enhancements, such as higher insurance coverage, and stricter underwriting, such as credit score thresholds, when introducing a new low or no down payment product. FHA is authorized to require an additional credit enhancement, but does not currently use this authority. FHA has used stricter underwriting criteria, but told us it is unlikely they would use a credit score threshold for a new zero down payment product. Mortgage institutions may also impose limits on the volume of the new products they will permit and on who can sell and service these products. FHA officials question the circumstances in which they can limit volumes for their products and believe they do not have sufficient resources to manage a product with limited volumes, but the potential costs of making widely available a product with risk that is not well understood could exceed the cost of initially implementing such a product on a limited basis.

section_title: Letter
paragraphs: I am pleased to be here today to provide the committee with information  and perspectives as it considers legislation that would authorize the  Secretary of Housing and Urban Development (HUD) to carry out a pilot  program to insure zero down payment mortgages. The Federal Housing  Administration (FHA) at HUD currently insures low down payment  mortgages to homebuyers across the nation. FHA requires homebuyers to  make a 3 percent contribution toward the purchase of the home, though  some of this may come in the form of a gift from others. FHA also permits  some closing costs to be financed. My testimony today is primarily based  on a report we completed for this Subcommittee on managing risks  associated with low and no down payment loans, which was issued in  February, 2005. I will focus my discussion on the practices mortgage  institutions use in designing and implementing low and no down payment  products and how these practices could be instructive for the FHA in  managing risks associated with a zero down payment product. A  substantial body of research indicates that loans with lower down  payments are generally riskier than those with higher down payments.
To obtain information for our report, we interviewed officials from FHA;  staff at selected conventional mortgage providers; private mortgage  insurers; and two government-sponsored enterprises (GSE), Fannie Mae  and Freddie Mac. We obtained information about the standards of low and  no down payment mortgage products they support and the steps they take  to design, implement, and monitor these products. However, we did not  verify that these institutions, in fact, used these practices. We conducted  this work from January through December 2004 in accordance with  generally accepted government auditing standards.
In summary, there are several risk-management practices mortgage  institutions use in designing, implementing, and monitoring low and no  down payment products, and we believe these practices could be  instructive for FHA in managing risks associated with a zero down  payment product.
Mortgage institutions can mitigate the risk of low and no down payment  products by requiring additional credit enhancements such as higher  mortgage insurance coverage. For example, Fannie Mae and Freddie Mac  require higher mortgage insurance for loans with a loan-to-value ratio  (LTV) of great than 95 percent. While FHA already will pay up to 100  percent of the losses from a foreclosure on a house, it does have the  authority to share risk but does not currently use this authority.
Mortgage institutions sometimes implement stricter underwriting to  manage the additional risks associated with a new mortgage product. For  example, institutions can require a higher credit score or higher reserves  from the borrower. FHA has made adjustments to its underwriting criteria  on its existing products but FHA officials told us that FHA is unlikely to  mandate a credit score threshold for a zero down payment product.
Mortgage institutions increase fees and charge higher premiums to  compensate for the additional risks associated with a new mortgage  product. 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 the higher insurance coverage. FHA is authorized to make,  and has made, adjustments to its up-front and annual premiums on its  existing products. The administration proposed higher premiums as part  of its 2006 budget proposal for a zero-down payment product.
Mortgage institutions sometimes use pilots or limit the initial availability of  new products to build experience or better understand the factors that  contribute to risk for these products. For example, Freddie Mac limited  the initial availability of its 100 LTV product. Some mortgage institutions  also may limit the origination and servicing of the product to their better  lenders and servicers. However, FHA officials told us they face challenges  in piloting and limiting mortgage products to certain approved lenders or  servicers.
According to officials of mortgage institutions, including FHA, they also  often put in place more substantial monitoring and oversight mechanisms  for their new products and then make changes based on what they learn.  Some mortgage institutions, such as Fannie Mae, told us that they may  conduct rigorous quality control sampling of new acquisitions, early  payment defaults, and nonperforming loans. Depending on the scale of a  new initiative, and its perceived risk, these quality control reviews could  include a review of up to 100 percent of the loans that are part of the new  product. FHA officials told us they also more closely monitor loans  underwritten under revised guidelines.
In light of the risks that new lending products present and in recognition  of established risk management practices, in our report, we suggested that  Congress consider limiting the initial availability of any new single-family  insurance product it may authorize, including a zero down payment  product. We also suggested that Congress consider directing HUD to  consider using various techniques for mitigating risks for a no down  payment product, or products about which the risks are not well  understood. We recommended that FHA consider using pilots for new  products and for making significant changes to its existing products,  regardless of any new products Congress may authorize. Additionally, we  recommended that FHA explore various techniques for mitigating risks  when implementing new products that have greater risk or for which risk  is not well understood, such as a zero down payment product.
However, during the course of our work, HUD officials told us that they  face challenges in administering a pilot program and they question the  circumstances in which they can limit the availability of a new product.  We believe that HUD needs to further consider piloting or limiting volume  of new or changed products, including a zero down payment product.  There are several available techniques for limiting an initial product that  could help to address HUD’s concerns, including limiting the time period  in which it is available. Further we believe that in some circumstances the  potential costs of making widely available a product when the risks of that  product are not well understood could exceed the cost of initially  implementing such a product on a limited basis. To the extent HUD  believes it does not have the authority for exercising the options we  describe, we recommend it seek the authority from Congress.
subsections: section_title: Background
paragraphs: Mortgage insurance, a commonly used credit enhancement, protects  lenders against losses in the event of default, and FHA is a government  mortgage insurer in a market that also includes private insurers. During  fiscal years 2001 to 2003, FHA insured a total of about 3.7 million  mortgages with a total value of about $425 billion. FHA plays a  particularly large role in certain market segments, including low-income  and first-time homebuyers. In 2000, almost 90 percent of FHA-insured  home purchase mortgages had an LTV higher than 95 percent. FHA insures  most of its mortgages for single-family housing under its Mutual Mortgage  Insurance (MMI) Fund. To cover lender’s losses, FHA collects premiums  from borrowers. These premiums, along with proceeds from the sale of  foreclosed properties, pay for claims that FHA pays lenders as a result of  foreclosures.
In recent years, other members of the conventional mortgage market  (such as private mortgage insurers, government-sponsored enterprises  such as Fannie Mae and Freddie Mac, and large private lenders) have been  increasingly active in supporting low and even no down payment mortgage  products. For example, Fannie Mae and Freddie Mac’s no down payment  mortgage products were introduced in 2000; and many private mortgage  insurers will now insure a mortgage up to 100 percent LTV. However, the  characteristics and standards for low and no down payment products vary  among mortgage institutions. Currently, homebuyers with FHA-insured  loans need to make a 3 percent contribution toward the purchase of the  property and may finance some of the closing costs associated with the  loan. As a result, an FHA-insured loan could equal nearly 100 percent of  the property’s value or sales price. In recent years, a growing proportion of  borrowers have received down payment assistance, which further helps  them meet the hurdle of accumulating sufficient funds to purchase a  home. Based on our preliminary analysis of FHA-insured loans that had  LTVs above 95 percent, use of down payment assistance has grown to over  half of such loans insured during the first seven months of 2005.
When considering the risk of mortgages, a substantial amount of research  GAO reviewed indicates that the LTV ratio and the borrower’s credit score  are among the most important factors when estimating the risk level  associated with individual mortgages. We also analyzed the performance,  expressed by the percent of borrowers defaulting within four years of  mortgage origination, of low and no down payment mortgages supported  by FHA and others. Our analysis supports the findings we found in the  research literature. Generally, mortgages with higher LTV ratios (smaller  down payments) and lower credit scores are riskier than mortgages with  lower LTV ratios and higher credit scores. As can be seen in Figure 1,  when focusing only on LTV for FHA loans, default rates increase as the  LTV ranges increase. In theory, LTV ratios are important 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 more likely  it is that they may default on mortgage obligations, especially during times  of economic hardship (e.g., unemployment, divorce, home price  depreciation).
Risk assessment is a very important component of issuing and insuring  mortgages, particularly when introducing a mortgage product that has the  risk associated with a higher LTV. To help assess the risks associated with  mortgages, the mortgage industry has moved toward greater use of  mortgage scoring and automated underwriting systems. Mortgage scoring  is a technology-based 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, the property characteristics, and the  terms of the mortgage note affect future loan performance.
During the 1990s, private mortgage insurers, the GSEs, and larger financial  institutions developed automated underwriting systems. Automated  underwriting systems refer to the process of collecting and processing the  data used in the underwriting process. These systems rely, in part, on  individuals’ credit scores or credit history, and they have played an  integral role in the provision of low and no down payment mortgage  products. These systems allow lenders to quickly assess the riskiness of  mortgages by simultaneously considering multiple factors including the  credit score and credit history of borrowers. FHA has developed and  recently implemented a mortgage scoring tool, called the FHA TOTAL  Scorecard, to be used in conjunction with existing automated  underwriting systems. More than 60 percent of all mortgages— conventional and government-insured—were underwritten by an  automated underwriting system, as of 2002, and this percentage continues  to rise.
section_title: Several Practices Mortgage Institutions Use in Designing and Implementing Low and No Down Payment Products Could Be Instructive for FHA in Managing Risk of a No Down Payment Product
paragraphs: According to representatives of mortgage institutions we interviewed, they  use a number of similar practices in designing and implementing new  products. These practices can be especially important when designing and  implementing new products with higher or less well understood risk, such  as low and no down payment products. Some of these practices could be  helpful to FHA in its design and implementation of a zero down payment  product, as well as other new products. More specifically, mortgage  institutions often establish additional requirements for new products such  as additional credit enhancements or underwriting requirements. Although  FHA has less flexibility in imposing additional credit enhancements it does  have the authority to seek co-insurance, which it is not currently using.  FHA makes adjustments to underwriting criteria and to its premiums, but  told us that it is unlikely to use a credit score threshold for a new zero  down payment product.  Further, mortgage institutions also use different  means to limit how widely they make available a new product, particularly  during its early years. FHA does sometimes use practices for limiting a  new product but usually does not pilot products on its own initiative. FHA  officials with whom we spoke question the circumstances in which they  can limit the availability of a program and told us they do not have the  resources to manage programs with limited availability. Finally, according  to officials of mortgage institutions, including FHA, they also often put in  place more substantial monitoring and oversight mechanisms for their  new products including lender oversight. In an earlier report, we made  recommendations designed to improve HUD’s oversight of FHA lenders.
subsections: section_title: Mortgage Institutions Require Additional Credit Enhancements
paragraphs: Some mortgage institutions require additional credit enhancements— mechanisms for transferring risk from one party to another such as  mortgage insurance—on low and no down payment products. Mortgage  institutions such as 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. Fannie Mae  and Freddie Mac believe that the higher-LTV loans represent a greater risk  to them and they seek to partially mitigate this risk by requiring higher  mortgage insurance coverage on these loans. For example, Fannie Mae  and Freddie Mac require insurance coverage of 35 percent of the claim  amount (on individual loans that foreclose) for loans that have an LTV of  greater than 95 percent and require lower insurance coverage for loans  with LTVs below 95 percent.
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 co-insurance, 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). FHA has used co-insurance before, primarily in  its multifamily programs, but does not currently use co-insurance at all.  FHA officials told us they tried to put together a co-insurance agreement  with Fannie Mae and Freddie Mac and, while they were able to come to  agreement on the sharing of premiums, they could not reach agreement on  the sharing of losses and it was never implemented.
section_title: Mortgage Institutions May Require Stricter Underwriting for New Low and No Down Payment Products
paragraphs: Mortgage institutions also can mitigate risk through stricter underwriting.  For example, mortgage institutions such as Fannie Mae and Freddie Mac  sometimes introduce stricter underwriting standards as part of the  development of new low and no down payment products (or products  about which they do not fully understand the risks). Institutions can do  this in a number of ways, including requiring a higher credit score  threshold for certain products, or requiring greater borrower reserves or  more documentation of income or assets from the borrower. Once the  mortgage institution has learned enough about the risks that were  previously not understood, it can change the underwriting requirements  for these new products. FHA could also benefit from mitigating risk such  as through stricter underwriting. Although FHA has to meet some  statutory standards, it retains some flexibility in how it implements a  newly authorized product or changes an existing product. The HUD  Secretary has latitude within statutory limitations in changing  underwriting requirements for new and existing products and has done  this many times.
The requirements in H.R. 3043 that prospective zero down payment loans  go through FHA’s TOTAL Scorecard and that borrowers receive  prepurchase counseling are consistent with stricter underwriting.  However, in addressing the final recommendations in our February report,  FHA wrote that is unlikely to mandate a credit score threshold for a new  zero down payment product because the new product is intended to serve  borrowers who are underserved by the conventional market including  those who lack credit scores. Also, FHA wrote that it is unlikely to  mandate borrower reserve requirements since the purpose of a zero down  payment product is to serve borrowers with little wealth or personal  savings.
section_title: Mortgage Institutions May Increase Fees or Charge Higher Premiums
paragraphs: Mortgage institutions can increase fees or charge higher premiums to help  offset the potential costs of a program that is 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. FHA could set higher premiums in  anticipation of higher claims from no down payment loans. Within  statutory limits, the HUD Secretary has the authority to set up-front and  annual premiums that are charged to borrowers who have FHA-insured  loans. In fact, in the administration’s 2006 budget proposal for a zero down  payment product, it included higher up front and annual premiums for  these loans.
section_title: Before Fully Implementing New Products, Some Mortgage Institutions May Limit Their Availability
paragraphs: Some mortgage institutions may limit in some way a new product before  fully implementing the new product. For example, Fannie Mae and  Freddie Mac sometimes use pilots, or limited offerings of new products, to  build experience with a new product type or to learn about particular  variables that can help them better understand the factors that contribute  to risk for these products. Freddie Mac and Fannie Mae also sometimes  set volume limits for the percentage of their business that could be low  and no down payment lending. Fannie Mae and Freddie Mac officials  provided numerous examples of products that they now offer as standard  products but which began as part of underwriting experiments. These  include the Fannie Mae Flexible 97® product, as well as the Freddie Mac  100 product.
FHA has utilized pilots or demonstrations as well when making changes to  its single-family mortgage insurance. Generally, HUD has done this in  response to legislation that requires a pilot and not on its own initiative.  For example, FHA’s Home Equity Conversion Mortgage (HECM) insurance  program started as a pilot. Congress initiated HECM in 1987; the program  is designed to provide elderly homeowners a financial vehicle to tap the  equity in their homes without selling or moving from their homes  (sometimes called a “reverse mortgage”). Through statute, HECM started  as a demonstration program that authorized FHA to insure 2,500 reverse  mortgages. Through subsequent legislation, FHA was authorized to insure  an increasing number of these mortgages until Congress made the  program permanent in 1998. Under the National Housing Act, the HECM  program was required to undergo a series of evaluations and it has been  evaluated four times since its inception. FHA officials told us that  administering this demonstration for 2,500 loans was difficult because of  the challenges of selecting a limited number of lenders and borrowers.  FHA ultimately had to use a lottery to limit loans to lenders.
H.R. 3043 also would mandate that FHA pilot the zero down payment  program: it limits the annual number of zero down mortgages to 10  percent of the aggregate number of loans insured during the previous  fiscal year, and sets an aggregate limit of 50,000 loans. The appropriate  size for a pilot program depends on several factors. For example, the  precise number of loans needed to detect a difference in performance  between standard loans and loans of a new product type depends in part  on how great the differences are in loan performance. If delinquencies  early in the life of a mortgage were about 10 percent for FHA’s standard  high LTV loans, and FHA wished to determine whether loans in the pilot  had delinquency rates no more than 20 percent greater that the standard  loans (delinquency no more than 12 percent), a sample size of about 1,000  loans would be sufficient to detect this difference with 95 percent  confidence. If delinquency rates or FHA’s desired degree of precision were  different, a different sample size would be appropriate.
FHA officials told us they have conducted pilot programs when Congress  has authorized them, but they questioned the circumstances under which  pilot programs are needed. FHA officials also said that they lacked  sufficient resources to appropriately manage a pilot.
Additionally, some mortgage institutions may also limit the initial  implementation of a new product by limiting the origination and servicing  of the product to their better lenders and servicers. Mortgage institutions  may also limit servicing on the loans to servicers with particular product  expertise, regardless of who originates the loans. Fannie Mae and Freddie  Mac both reported that these were important steps in introducing a new  product and noted that lenders tend to take a more conservative approach  when first implementing a new product. FHA officials agreed that they  could, under certain circumstances, envision piloting or limiting the ways  in which a new or changed product would be available but pointed to the  practical limitations in doing so. FHA approves the sellers and services  that are authorized to support FHA’s single-family product, but FHA  officials told us they face challenges in offering any of their programs only  in certain regions of the country or in limiting programs to certain  approved lenders or servicers. FHA generally offers products on a national  basis and, when they do not, specific regions of the county or lenders  might question why they are not able to receive the same benefit (even on  a demonstration or pilot basis). However, these officials did provide  examples in which their products had been initially limited to particular  regions of the country or to particular lenders, including the rollout of the  HECMs and their TOTAL Scorecard.
section_title: Mortgage Institutions Establish Enhanced Monitoring and Oversight for New Low and No Down Payment Products and Make Changes Based on What They Learn
paragraphs: Mortgage institutions, including FHA, may take several steps related to  increased monitoring of new products and subsequently make changes  based on what they learned. Fannie Mae and Freddie Mac officials  described processes in which they monitor actual versus expected loan  performance for new products, sometimes including enhanced monitoring  of early loan performance. Some mortgage institutions, such as Fannie  Mae, told us that they may conduct rigorous quality control sampling of  new acquisitions, early payment defaults, and nonperforming loans.  Depending on the scale of a new initiative, and its perceived risk, these  quality control reviews could include a review of up to 100 percent of the  loans that are part of the new product. FHA officials told us they also  monitor more closely loans underwritten under revised guidelines.  Specifically, FHA officials told us that FHA routinely conducts a review of  underwriting for approximately 6 to 7 percent of loans it insures.  According to FHA officials, as part of the review, it may place greater  emphasis on reviewing those aspects of the insurance product that are the  subject of a recent change.
Fannie Mae and Freddie Mac also reported that they conduct more regular  reviews at mortgage servicer sites for new products. In some cases, Fannie  Mae and Freddie Mac have staff who conduct on-site audits at the sellers  and servicers to provide an extra layer of oversight. According to FHA  officials, they have staff that conduct reviews of lenders that they have  identified as representing higher risk to FHA programs. However, we  recently reported that HUD’s oversight of lenders could be improved and  identified a number of recommendations for improving this oversight.
section_title: Conclusions
paragraphs: Loans with low or no down payments carry greater risk. Without any  compensating measures such as offsetting credit enhancements and  increased risk monitoring and oversight of lenders, introducing a new FHA  no down payment product would expose FHA to greater credit risk. The  administration’s proposal for a zero down product included increased  premiums to help compensate for an increase in the cost of the FHA  program which would permit FHA to potentially offset additional costs  stemming from a new product that entails greater risk or not well  understood risk. The proposed bill also requires that borrowers receive  prepurchase counseling.
Although FHA appears to follow many key practices used by mortgage  institutions in designing and implementing new products, several practices  not currently or consistently followed by FHA stand out as appropriate  means to manage the risks associated with introducing new products or  significantly changing existing products. Moreover, these practices can be  viewed as part of a formal framework used by some mortgage institutions  for managing the risks associated with new or changed products. The  framework includes techniques such as limiting the availability of a new  product until it is better understood and establishing stricter underwriting  standards—all of which would help FHA to manage risk associated with  any new product it may introduce. For example, FHA could set volume  limits or limit the initial number of participating lenders in the product.  Further, changes in FHA’s premiums, an important element of the  administration’s 2006 budget proposal for a zero down payment product  would permit FHA to potentially offset additional costs stemming from a  new product that entails greater risk or not well understood risk.
However, FHA officials believe that the agency does not have sufficient  resources to implement products with limited volumes, such as through a  pilot program. Yet, when FHA makes new products widely available or  makes significant changes to existing products with less-understood risks,  these products or actions also can introduce significant risks. Products  that would introduce significant risks can impose significant costs. We  believe that FHA could mitigate these risks and potential costs by using  techniques such as piloting. Moreover, FHA told us that it believes that  pilot programs are not needed because the risks of every new year of loans  are assessed annually as part of credit subsidy budgetary transactions and  in its annual actuarial study, and it could terminate the program early in its  life if it identified problems. However, because it may take a few years to  determine the risks of a new loan product, early termination could still  expose the government to significant financial risk without some type of  limits on the number of loans insured. If FHA is unsure about its authority  to conduct pilots or concerned about expectations of equitable  distribution of its products, Congress can make clear that FHA has this  authority by requiring a product to be implemented as part of a pilot, or by  explicitly giving the HUD Secretary the authority to establish and  implement pilots for new products.
If Congress authorizes FHA to insure a no down payment product or any  other new single-family insurance products, Congress may want to provide  guidance and clear authority to FHA on this new product. Congress may  want to consider a number of means to mitigate the additional risks that  these loans may pose. Such means may include limiting the initial  availability of such a new product, requiring higher premiums, requiring  stricter underwriting standards, or requiring enhanced monitoring. Such  risk mitigation techniques would serve to help protect the Mutual  Mortgage Insurance Fund while allowing FHA the time to learn more  about the performance of loans using this new product. Limits on the  initial availability of the new product would be consistent with the  approach Congress took in implementing the HECM program. The limits  could also come in the form of an FHA requirement to limit the new  product to better performing lenders and servicers as part of a  demonstration program or to limit the time period during which the  product is first offered.
Mr. Chairman, this completes my prepared statement. I would be pleased  to respond to any questions you or other members of the Committee may  have at this time.
section_title: GAO Contacts and Staff Acknowledgments
paragraphs: For more information regarding this testimony, please contact William B.  Shear at (202) 512-8678 or shearw@gao.gov or Mathew Scirè at (202) 512- 6794 or sciremj@gao.gov. Contact points for our Offices of Congressional  Relations and Public Affairs may be found on this last page of this  testimony.  Individuals making key contributions to this testimony also  included Anne Cangi, Bert Japikse, Austin Kelly, Andy Pauline, Susan  Etzel, and Barbara Roesmann.
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