FHA Mortgage Insurance: Applicability of Industry Requirements Is Limited, but Certain Features Could Enhance Oversight
Published: 2013-09-09T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: FHA insures private lenders against losses from defaults on single-family mortgages that meet FHA criteria. FHA's insured portfolio was more than $1 trillion at the end of fiscal year 2012. The mortgage insurance market also includes PMIs regulated by the states. Since 2009, FHA's Fund (under which FHA insures almost all its single-family mortgages) has not met its statutory 2 percent capital requirement. GAO was asked to examine the financial condition requirements that apply to FHA and PMIs. This report examines (1) how reserving practices and capital requirements for FHA's Fund compare with those for PMIs, and (2) how applicable PMI practices and requirements could enhance Fund oversight.
To address these objectives, GAO reviewed accounting standards, federal and state laws, regulations, and policies; analyzed FHA data; and interviewed federal officials and PMI industry officials and analysts.
section_title: What GAO Found
paragraphs: Reserving practices and capital requirements for the Mutual Mortgage Insurance Fund (Fund) of the Federal Housing Administration (FHA) differ in key respects from those for private mortgage insurers (PMI). These differences stem from the distinct environments in which FHA and PMIs operate, including the particular accounting principles and statutory provisions that they must follow. For example, statutory accounting principles (developed to meet the needs of insurance regulators in assessing financial condition) require PMIs to establish several reserve components, including a reserve for estimated losses expected in the near term on loans that are delinquent (loss reserve). In contrast, generally accepted accounting principles for federal entities (developed to align financial statement reporting with federal budget requirements) require FHA to reserve for the present value of estimated losses for all outstanding loans net of anticipated revenues (liability for loan guarantees). For both FHA and PMIs, capital requirements are expressed as comparisons of risk to capital, but the calculations measure risk and capital differently. Like FHA, PMIs have struggled to meet their capital requirements in recent years.
The PMI regulatory framework has limited applicability to FHA's Fund, but it has certain features that could enhance Fund oversight. Some of the purposes and concepts underlying PMI reserving practices and capital requirements are not pertinent to FHA. For example, two of the PMI reserve components (the unearned premium reserve and the contingency reserve) are intended, in part, to prevent PMIs from reducing capital through payment of excessive dividends to stockholders. However, the concept of separately disclosing reserve components as PMIs do could be applied to the Fund. The PMI loss reserve and unearned premium reserve focus on the timing of specific cash flows--the loss reserve on near-term insurance claims for delinquent loans and the unearned premium reserve on insurance premiums as they are earned over time. In contrast, FHA's liability for loan guarantees combines 30-year estimates of future claims, premiums, and recoveries into a single number, as required, and does not disclose the timing of each type of cash flow. Disclosing the timing of specific cash flows would help illustrate the extent to which estimates of claims payments, premiums, and recoveries in the liability for loan guarantees are concentrated in the near term or longer term and therefore more or less certain. Such disclosure could enhance congressional oversight of FHA and would be consistent with reporting practices of other federal programs and federal internal control guidance for communicating externally about an agency's risks. Accountability features of the PMI regulatory framework also could be applied to FHA. Unlike FHA, PMIs must take certain actions for noncompliance with their capital requirements. These actions may include remediation plans to restore capital to required levels and additional reporting. In 2012, FHA provided Congress with a set of planned actions to address its capital shortfall, but had not done so in prior years. Producing a capital restoration plan when the capital ratio fell below the required level could help ensure prompt action by FHA. This type of requirement is contained in legislative proposals currently before Congress and would be consistent with requirements Congress has enacted for the Federal Deposit Insurance Corporation and certain financial institutions.
section_title: What GAO Recommends
paragraphs: Congress should consider requiring FHA to submit a capital restoration plan and regular updates on implementation whenever the Fund's capital ratio does not meet required levels. Also, FHA should disclose estimates of specific cash flows (premiums, claims, and recoveries) over time to provide additional perspective on the Fund's financial status. FHA generally agreed with GAO's recommendation.

section_title: Letter
paragraphs: The Federal Housing Administration (FHA), within the Department of  Housing and Urban Development (HUD), administers single-family  mortgage insurance programs, which insure private lenders against  losses on mortgages that finance purchases of properties or that  refinance existing mortgages. FHA’s insured portfolio was more than $1  trillion at the end of fiscal year 2012. The insured mortgage market also  includes private mortgage insurers (PMI), which typically insure loans that  are sold to either of two housing-related enterprises, Fannie Mae and  Freddie Mac (the enterprises). In recent years, FHA has faced fiscal  challenges, as has the rest of the mortgage insurance industry. Since  2009, the Mutual Mortgage Insurance Fund (Fund)—under which FHA  insures almost all of its single-family mortgages—has not met minimum  statutory capital requirements. Also, declining balances in the Fund’s  capital reserve account and higher-than-expected claims on loans insured  before 2010 have increased the possibility that FHA will require additional  funds to have sufficient resources for all future insurance claims on its  existing portfolio.
You asked us to examine the financial condition requirements that apply  to FHA and PMIs. This report discusses (1) how the reserving practices  and capital requirements of FHA’s Fund compare with those for the PMI  industry and (2) how, if at all, applicable PMI reserving practices and  capital requirements could enhance oversight of FHA’s Fund. In a  companion report, we discuss options for improving FHA’s long-term  viability and their implications.
To compare FHA’s reserving practices and capital requirements with  those of the PMI industry, we identified and reviewed accounting  standards and federal statutes that apply to FHA’s Fund, limiting our  scope to forward mortgages. We identified and reviewed accounting  standards, Fannie Mae and Freddie Mac policies, and state statutes and  regulations that apply to PMIs. We also reviewed information on the  capital positions of FHA and PMIs from 2001 through 2012, as well as  PMI financial statements and regulatory reports. In addition, we  interviewed mortgage market participants and stakeholders, including  federal officials, state regulators, and major PMIs, to confirm our  understanding of the practices and requirements. To assess how  applicable industry practices and requirements could enhance oversight  of FHA’s Fund, we determined the extent to which they would provide  information to enhance Fund oversight, considering factors such as the  compatibility of concepts and calculations with FHA operations. We  interviewed insurance regulators in three states—North Carolina,  Pennsylvania, and Wisconsin—to identify the information PMIs report that  regulators use in assessing financial condition. We selected these states  based on criteria including market share of PMIs domiciled in the states  and diversity of regulatory requirements. We also interviewed FHA  officials, regulators, major PMIs, and other industry analysts to obtain  perspectives on applying PMI practices and requirements to FHA’s Fund  and the implications for increased transparency and understanding of the  Fund’s financial condition. Furthermore, we reviewed annual actuarial  reviews of the Fund, HUD appendixes to the President’s budget, and  FHA’s audited financial statements to provide additional perspectives on  the Fund’s financial condition. To assess the reliability of unaudited data  we obtained from FHA, we conducted reasonableness checks on data  elements and discussed the sources and interpretation of the data with  FHA officials. We determined that this information was sufficiently reliable  for purposes of characterizing the financial condition of the Fund. See  appendix I for additional information on our scope and methodology.
We conducted this performance audit from February 2013 to September  2013 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
subsections: section_title: Background
subsections: section_title: Federal Housing Administration
paragraphs: Established in 1934 under the National Housing Act, FHA operates the  largest federal mortgage insurance program, which is backed by the full  faith and credit of the federal government. FHA primarily insures forward  mortgages for initial home purchases and refinancing. Generally, lenders  require borrowers to purchase mortgage insurance when the initial loan- to-value ratio (the amount of the mortgage loan divided by the value of  the home) exceeds 80 percent. In fiscal year 2012, FHA reported that it  insured almost 1.2 million forward mortgages representing approximately  $213 billion in mortgage insurance-in-force. Its reported total amortized  insurance-in-force on forward loans at the end of fiscal year 2012 was  $1.07 trillion.
Three different reviews of the financial condition of the Fund are  conducted annually. First, the Omnibus Budget Reconciliation Act of 1990  required an annual independent actuarial study of the economic net worth  and soundness of FHA’s Fund. As part of this review, an independent  actuary estimates the economic value of the Fund, which FHA uses to  calculate the Fund’s capital ratio. The actuary’s analysis considers the  net current resources available to the Fund; historical performance of  existing loans; projected claim, loss, and prepayment rates; and projected  future economic conditions. The actuarial study is now a requirement in  the Housing and Economic Recovery Act of 2008 (HERA), which also  requires that the Secretary of HUD submit an annual report to Congress  on the results of the actuarial study, as well as quarterly status reports on  the Fund.
Second, estimates that FHA prepares for the federal budget provide  another review of the financial condition of the Fund. Specifically, under  the Federal Credit Reform Act of 1990 (FCRA), FHA and other federal  agencies must estimate the net lifetime costs (known as credit subsidy  costs) of their loan insurance or guarantee programs and include the  costs to the government in their annual budgets. Agencies annually  estimate credit subsidy costs by cohort—the loans agencies commit to  insure or guarantee in a given fiscal year. The initial credit subsidy cost in  the year the loans are insured is equal to the net present value of  estimated lifetime cash flows, excluding administrative costs. For a  mortgage insurance program, cash inflows consist primarily of premiums  charged to insured borrowers and recoveries from sales of foreclosed  properties, and cash outflows consist mostly of claim payments to  lenders. A balance equal to the amount needed to cover estimated net  future costs is held in the Fund’s financing account. Estimated lifetime  revenues in excess of this amount are recorded in the Fund’s capital  reserve account. Historically, FHA has estimated that its loan insurance  program is a negative subsidy program—that is, the present value of  estimated cash inflows exceeds the present value of estimated cash  outflows. On the basis of these negative subsidy estimates, FHA built up  substantial balances over the years in the capital reserve account.  Generally, agencies must produce annual updates of their subsidy  estimates—known as reestimates—for each cohort on the basis of  updated information on actual performance and new estimates of future  loan performance. Upward reestimates reflect increases in credit subsidy  costs (or lower lifetime net revenues) and downward reestimates  represent decreases in credit subsidy costs (or higher lifetime net  revenues). Balances in the capital reserve account are transferred to the  financing account to cover upward reestimates (see fig. 1). However,  since 2009 higher-than-expected claims have depleted funds in FHA’s  capital reserve account to just over $3 billion at the end of fiscal year  2012. If the capital reserve account were to be depleted and FHA  required additional funds in the financing account to meet budget  reestimate requirements, HUD would need to draw on permanent and  indefinite budget authority, as authorized by FCRA. The President’s fiscal  year 2014 budget contained a $22 billion upward credit subsidy  reestimate for the Fund and indicated that the reestimate would deplete  FHA’s capital reserve account in 2013, potentially causing FHA to draw  on $943 million in permanent and indefinite budget authority.
Third, FHA’s audited financial statements also include a review of the  Fund. FHA’s financial statements are prepared according to generally  accepted accounting principles in the United States applicable to federal  agencies (federal GAAP) as promulgated by the Federal Accounting  Standards Advisory Board (FASAB). Federal GAAP requires that FHA  calculate its liability for loan guarantees for its loan insurance  commitments on a present value basis. The liability for loan guarantees  represents net losses FHA expects on its outstanding insurance  portfolio. The use of the present value accounting method is consistent  with budgeting requirements under FCRA. Under federal GAAP, FHA  recognizes potential lifetime losses and revenues at the point it insures a  loan.
section_title: Private Mortgage Insurance Industry
paragraphs: The private mortgage insurance industry dates to the 1880s. According to  an industry consultant report, the industry went bankrupt during the  housing collapse of the early 1930s but reemerged in the mid-1950s after  drawing on lessons learned from its prior failure. These lessons included  the need for laws and regulations to help ensure that PMIs were prepared  for economic shocks. Most residential mortgages insured by PMIs are  sold to the enterprises. The enterprises have a statutory requirement to  obtain credit enhancement on single-family residential mortgages  purchased with loan-to-value ratios of over 80 percent, and private  mortgage insurance is the major credit enhancement they use. In 2012,  the PMI industry, which consisted of six active PMIs and their affiliates,  reported that PMIs insured about 416,000 mortgages representing  approximately $175 billion in mortgage insurance.
PMIs are regulated by the states in which they do business, with the state  of domicile (that is, the state in which a PMI is chartered) providing  primary regulatory oversight. Each state conducts financial oversight of  the companies operating in its jurisdiction to help ensure that  policyholders receive the insurance benefits they are entitled to receive.
State laws and regulations limit the risk PMIs can assume through means  such as reserve and capital requirements, investment and risk  concentration restrictions, and restrictions on activities other than  mortgage-related insurance. The PMIs also must comply with the  enterprises’ requirements in order for the mortgages they insure to be  eligible for sale to the enterprises.
PMIs file audited financial statements, which are prepared in accordance  with statutory accounting principles, with insurance regulators. Statutory  accounting principles historically have been those practices or procedures  prescribed or permitted by an insurer’s domiciliary state through statutes,  regulations, and practices. The National Association of Insurance  Commissioners has standardized and incorporated these principles in its  Accounting Practices and Procedures manuals (which provide a  comprehensive guide of statutory principles) and other publications.  Statutory accounting principles were developed to meet the needs of  insurance regulators, who are focused on insurers’ solvency and ability to  satisfy their obligations to policyholders and creditors—in particular, to  pay future claims. Under statutory accounting principles, PMIs recognize  potential losses once loans become delinquent and recognize premium  revenues over the period the insurance is outstanding.
In addition to reporting based on statutory accounting principles, many of  the parent companies of PMIs also publicly report their financial results  using private-sector GAAP in quarterly and annual filings with the  Securities and Exchange Commission. The objectives of GAAP reporting  differ from the objectives of statutory accounting principles reporting.  GAAP is designed to meet the varying needs of different users of financial  statements, while statutory accounting principles are designed to address  concerns of regulators, as previously noted. Although statutory  accounting principles incorporate private-sector GAAP guidance for  certain principles, the two sets of accounting principles have differences.  Statutory accounting principles are more conservative than private-sector  GAAP—for example, they do not recognize certain assets recognized  under private-sector GAAP.
section_title: Differences between FHA and Private Insurer Programs and Market Roles
paragraphs: Although FHA and PMIs both provide mortgage insurance to first-time  home buyers and others seeking low down-payment mortgages, their  mortgage insurance programs differ in several respects. Some of these  differences include:
Coverage. FHA insurance covers 100 percent of the principal balance  of each loan, whereas PMIs generally cover from 20 to 30 percent of  the loan balance, usually based on what the enterprises require.
Premiums. FHA collects both an up-front premium (paid at loan  origination) and annual premiums (paid in monthly installments) from  all borrowers. PMIs generally charge either premiums paid in monthly  installments or a single premium (one payment at loan origination that  fully pays for the insurance policy).
Minimum down payment. To meet the requirements of the  enterprises, PMI-insured loans generally have higher down payments  than those insured by FHA. One PMI representative told us that a  small portion of PMIs’ insured loans have a down payment of less  than 5 percent. In contrast, more than 70 percent of the loans FHA  insured in 2012 had a down payment of less than 5 percent.
Borrower qualifications. PMIs generally require their borrowers to  have higher credit scores and lower debt service-to-income ratios  than does FHA.
Recoveries. FHA generally receives significant recoveries on the sale  of foreclosed properties. According to officials from one PMI, it is  generally not in a PMI’s best interest to take possession of foreclosed  properties. Instead, PMIs usually pay their coverage percentage  multiplied by the sum of the unpaid loan balance and allowable  foreclosure related expenses.
FHA and PMIs also have different operational goals and market roles.  Most PMIs are publicly traded companies or subsidiaries of such  companies, which have a responsibility to provide a return on investment  to their shareholders. FHA’s statutory operational goals are to minimize  the default risk to the Fund and homeowners and provide mortgage  insurance to traditionally underserved borrowers, which FHA defines as  including first-time homebuyers, minorities, low-income families, and  residents of underserved communities. FHA traditionally has played a  particularly large role among such borrowers. FHA generally is thought to  promote stability in the market by ensuring the availability of mortgage  credit in areas that may be underserved by the private sector or  experiencing economic downturns. By expanding its presence when the  private market contracts, FHA plays a countercyclical role in the mortgage  market. FHA typically does not restrict its business or change the terms  under which it provides mortgage insurance in economically distressed  geographic locations. FHA must ensure that any changes to the terms  and conditions for mortgage insurance comply with fair lending laws and  its obligation to affirmatively further fair housing. However, PMIs may  change the conditions under which they will provide new insurance in a  geographic area to reflect the increased risk of losses in an area  experiencing economic hardship. For example, in previous work we found  that by tightening the terms of the insurance they would provide, PMIs  may have decreased their share of the market in economically stressed  regions of the country during regional economic downturns in the late  1980s.
Consistent with its countercyclical role, FHA’s market share expanded  during the recent mortgage crisis. According to HUD’s U.S. Housing  Market Conditions, FHA’s share of the market for home purchase  mortgages (in terms of loan originations) grew sharply, rising from  approximately 4.5 percent in 2006 to approximately 26.1 percent in 2012.  In addition, FHA’s share of the entire mortgage market (including  refinance activity) rose dramatically after 2007, and stood at 14.6 percent  in 2012 (see fig. 2). According to data from Inside Mortgage Finance,  FHA’s share of the insured mortgage market as of the end of 2012 was  45 percent as measured by annual dollar volume, down from 71 percent  in 2009.
section_title: FHA and Private Insurers Follow Distinct Reserving Practices and Capital Requirements
paragraphs: Reserving practices and capital requirements for FHA’s Fund differ in key  respects from those for PMIs. These differences stem from the distinct  environments in which FHA and PMIs operate, including the particular  accounting principles and statutory provisions that they must follow. For  both FHA and PMIs, capital requirements are expressed as ratios that  compare risk and capital, but these terms have different meanings in the  PMI and FHA contexts.
subsections: section_title: FHA and Private Mortgage Insurers Establish Different Types of Reserves under Their Respective Accounting Principles
paragraphs: From an accounting perspective, certain reserves are recorded as  liabilities on an entity’s balance sheet to account for net future obligations  and unearned revenue. Under their respective accounting principles, FHA  and PMIs follow different reserving practices to prepare their audited  financial statements. Under federal GAAP, FHA effectively has one  reserve, the liability for loan guarantees. It is calculated by estimating the  net present value of expected future cash flows for all outstanding loans  (anticipated losses less anticipated future revenue).
In contrast, under statutory accounting principles, PMIs establish up to  four separate reserve components, as follows:
Unearned premium reserve. This reserve represents the amount of  insurance premiums that have been collected but not yet earned.  Premiums paid in advance (single premiums) generally would be  earned over time based on a schedule specified by a PMI’s  domiciliary state.
Contingency reserve. This reserve represents half of the insurance  premiums earned each year for the previous 10 years in order to build  up a countercyclical capital buffer. This reserve also prevents a PMI  from paying out excessive dividends to shareholders during profitable  times to preserve its ability to pay claims during economic downturns.  A PMI may release funds, with regulatory approval, if necessary, from  this reserve to increase its statutory surplus when losses incurred in a  year exceed 35 percent of premiums earned that year.
Loss reserve. This reserve represents expected losses on loans that  become delinquent. Because the reserve is for loans that are already  delinquent, it represents an estimate of losses that are likely to occur  in the near term.
Premium deficiency reserve. This reserve is intended to cover the  difference between future losses and existing reserves plus future  premiums, if future losses are greater. More specifically, it represents  the amount by which the present value of estimated future losses  (less future uncollected premium revenues on all loans outstanding)  exceeds the sum of the contingency reserve, loss reserve, and  unearned premium reserve.
The differences between FHA and PMI reserving practices stem from the  different accounting principles these entities are required to follow and the  different purposes these principles serve. Table 1 shows how FHA and  PMI reserves are calculated. FHA’s practice of reserving for anticipated  net losses follows federal GAAP, which emphasizes the consistent  calculation of long-term costs to the government of the subsidies  associated with insurance, direct loans, and loan guarantees and  supports budgeting under FCRA. As previously noted, federal GAAP  accounts for estimated lifetime losses and revenues on insurance, direct  loans, and guarantee activities on a present value basis in the fiscal year  in which the commitment to insure, originate, or guarantee a loan occurs.  In contrast, PMIs follow statutory accounting principles under which  potential losses are recognized in the loss reserve component when  loans become delinquent and revenues are recognized as they are  earned over the coverage period.
Despite these differences, a present value calculation of future cash flows  is used in both the PMI premium deficiency reserve and the FHA liability  for loan guarantees. Specifically, FHA’s liability for loan guarantees is  equal to the net present value of expected future cash flows for all  outstanding loans (anticipated losses less anticipated future revenue).  PMIs also calculate the net present value of expected future cash flows,  but rather than establishing reserves equal to this amount, PMIs compare  it with the sum of their existing loss reserves, contingency reserves, and  unearned premium reserves. If the net present value of expected future  losses exceed the combination of these three reserve components, PMIs  establish a premium deficiency reserve to make their total reserves equal  to their anticipated net losses (if not, there is no liability for a premium  deficiency). PMIs generally have not had to establish premium  deficiency reserves because the sum of their existing reserves has been  greater than the net present value of expected future losses. This reflects  the conservative nature of reserving practices under statutory accounting  principles.
section_title: FHA’s Statutory Capital Requirement Differs from Private Insurers’ Requirements
paragraphs: FHA and PMIs both calculate ratios for capital relative to risk outstanding,  but the calculations measure capital and risk differently (see table 2). As  noted earlier, the capital position of FHA’s Fund is assessed annually by  an independent actuary. By statute, the Fund’s economic value—existing  net capital resources plus the present value of future net cash flows of all  currently insured loans—must be at least 2 percent of the remaining  principal balance on all insured loans in the Fund (amortized insurance- in-force). In contrast, PMIs are subject to two capital requirements—a  risk-to-capital ratio not to exceed 25 to 1 and a minimum policyholders  position (MPP) that varies based on the loan-to-value ratio and coverage  percentage of the mortgages insured. The risk-to-capital ratio, which is  required by 12 states, compares statutory surplus and contingency  reserves with the insured portion of the remaining balance on performing  loans (risk-in-force). The MPP, which is required by four states,  establishes the amount of funds a PMI must have currently available to  pay claims using a percentage of the initial balances of insured loans.  PMIs may use a combination of statutory surplus, contingency reserves,  and unearned premium reserves to meet the MPP requirement. PMIs’  statutory surplus includes premium revenues earned to date. Consistent  with how revenues are recognized under their respective accounting  principles, capital in the PMI context does not include estimated future  revenues for existing insurance, while capital in the FHA context does. In  addition, for the PMI risk-to-capital ratio, risk is assessed based on  performing loans (because the risk for nonperforming loans has been  reserved for), while for the FHA capital ratio, risk is assessed based on all  loans.
FHA has not met its capital requirement for the last 4 years (see fig. 3).  FHA met the 2 percent capital ratio from fiscal years 2001 through 2008,  with a high of 6.82 percent for forward mortgages in the Fund. However,  the ratio fell below the statutory minimum in 2009 when economic and  market developments created conditions that simultaneously reduced the  insurance fund’s economic value (the numerator of the capital ratio) and  increased the amortized insurance-in-force (the denominator of the  capital ratio). By the end of fiscal year 2012, the ratio had fallen to a  negative 1.28 percent for single family forward loans (and a negative 1.44  percent for forward and reverse loans combined). The 2012 actuarial  report shows that the negative economic value for forward loans is  composed of capital assets of $25.6 billion and estimated future cash  flows of negative $39.1 billion. Forward loans guaranteed prior to fiscal  year 2011 have estimated negative future cash flows and loans  guaranteed in fiscal years 2011 and later have estimated positive future  cash flows. According to the baseline estimate in the 2012 actuarial  report, the Fund’s capital ratio is not estimated to rise above the statutory  2 percent level until fiscal year 2017. In 2001, we found that setting a  minimum or target capital ratio may not be appropriate for all of the  circumstances the Fund may face. We therefore recommended that  Congress or HUD determine the economic conditions the Fund would be  expected to withstand without drawing on permanent and indefinite  budget authority. Congress has considered but not enacted legislation  consistent with this recommendation. In addition, HUD disagreed with  this recommendation at the time of the report and has not acted upon it.
As shown in figure 4, PMIs also have struggled to meet their capital  requirements in recent years, and regulators forced three large PMIs to  cease writing new business for failing to meet these requirements. PMIs  have relied heavily on capital and surplus contributions from outside  investors and their parent companies to meet their capital requirements.  To illustrate, from 2008 through 2012, three of the four largest PMIs  received capital and surplus contributions that were greater than their  total capital as of the end of 2012. In addition, these PMIs completely  exhausted their contingency reserves. Ceding risk to reinsurance  companies and higher-quality books of business in recent years also  have helped PMIs to lower their risk-to-capital ratios. In contrast, FHA  (which has not met its capital requirement) has continued to write new  business, as authorized through annual appropriations acts, and would  not receive additional funding through permanent and indefinite budget  authority until it is needed to help cover an upward credit subsidy  reestimate.
PMIs face several potential consequences when their risk-to-capital ratios  rise above the statutory ceiling of 25:1. When a PMI fails to meet state  regulatory requirements, it must stop writing new business or receive a  waiver from the state to continue operating. If a PMI is forced to stop  writing new business, the PMI continues to insure existing business  (collecting premiums and paying claims) until all current business is  extinguished. If a PMI receives a waiver, the PMI still can write new  business, but the regulator imposes restrictions and conditions on the  PMI. According to state regulators we interviewed, they consider a  number of factors when deciding to grant a waiver. In general, waivers  are granted if the state regulator decides that the PMI can return to  profitability. Requirements for PMIs that have been granted waivers differ  by state, but may include increased frequency of financial reporting,  actuarial reviews, remediation plans, and regulatory approval of dividend  payments. Prior to breaching the 25:1 ceiling or MPP requirement, three  of the four largest PMIs applied for and were granted waivers by many of  the 16 states that require them.
The enterprises also impose financial requirements on PMIs. Before the  financial crisis, the enterprises required PMIs to maintain at least an AA-  rating from two credit rating agencies. However, the enterprises consider  this requirement to be obsolete because no PMIs currently meet the  rating level. Instead, the enterprises have established remediation plans  that include alternative requirements for the PMIs. These remediation  plans allow the PMIs to continue insuring loans that are eligible for  purchase by the enterprises, but include provisions intended to increase  PMI transparency and reporting. Although each plan is different, the  enterprises and PMIs told us that the plans generally required enhanced  disclosure, regular meetings with the enterprises, and specific actions,  including maintaining a minimum level of liquid assets; obtaining waivers from state capital requirements; or creating subsidiaries licensed in states where waivers were not  granted.
In contrast to the PMIs, the statute that established FHA’s 2 percent  capital ratio requirement does not define consequences if the ratio falls  below the required level. In 2012 and again in 2013, legislation was  introduced that would require FHA to develop an emergency capital plan  to restore the Fund’s fiscal solvency and provide monthly reports to  Congress on the condition of the Fund and any remediation steps taken  that month. However, as of August 2013, this legislation had not been  enacted.
State regulators and the Federal Housing Finance Agency (the regulator  and conservator for the enterprises) have been considering ways to  strengthen the financial condition requirements for PMIs, including capital  requirements. The National Association of Insurance Commissioners has  formed a working group that has been considering proposed capital  requirements that would vary depending on the risk characteristics of the  loans being insured (such as the loan-to-value ratio and borrower credit  score). More specifically, PMIs would need to hold more capital for riskier  loans than for loans with less risk. This approach contrasts with the fixed  risk-to-capital ratio that currently applies. Eight PMIs issued a joint  statement to the working group agreeing with this basic approach. The  Federal Housing Finance Agency also has been working with the  enterprises to develop new capital requirements for PMIs. Agency  officials told us that the current risk-to-capital ratio requirements were not  sufficient because they do not account for differences in loan risks,  provide assurance of financial viability under severe stress scenarios, or  differentiate between liquid and illiquid capital (that is, capital readily  available to pay claims or not). The officials said that they expect to issue  the new requirements by the end of 2013.
section_title: Features of the Regulatory Framework for Private Insurers Could Enhance Oversight of FHA
paragraphs: Certain features of the states’ regulatory framework for PMIs could  enhance oversight of FHA by increasing transparency and accountability.  Although the PMI industry’s reserving practices have limited applicability  to FHA, separately disclosing reserve components for FHA would provide  additional insight into FHA’s financial condition that is not readily apparent  with current reporting. PMI capital requirements also have limited  applicability to FHA because they involve concepts that are not  meaningful in the context of a federal program. However, certain  consequences PMIs face for not meeting capital requirements— remediation plans and additional reporting—could be applied to FHA to  enhance agency accountability.
subsections: section_title: Industry Practices and Requirements Have Limited Applicability to FHA’s Fund
paragraphs: The PMI industry’s reserving practices and capital requirements have  limited applicability to FHA’s Fund because some of the underlying  purposes and concepts are not pertinent to a federal credit program. For  example, two of the liabilities that PMIs record under statutory accounting  principles—unearned premium reserves and contingency reserves—are  intended, in part, to protect policyholders by limiting payment of excessive  dividends to stockholders, which reduce capital. The unearned premium  reserve does this by matching revenues with the time periods in which  they are earned rather than when they are received. This prevents PMIs  from using unearned premiums to increase the surplus from which they  pay dividends. The contingency reserve serves a similar purpose by  setting aside half of earned premiums for 10 years. Because FHA does  not pay dividends and virtually all of the premium revenues FHA receives  remain in the Fund, a reserve for the purpose of preserving capital by  preventing dividend payments is not needed.
A third liability that PMIs record, the loss reserve, also has limited  applicability to FHA’s Fund because its purpose is to demonstrate to  regulators that PMIs have sufficient resources today to pay claims to  policyholders for anticipated losses on already-delinquent loans. The loss  reserve is therefore a tool to mitigate a PMI’s liquidity risk—the risk of not  having the capacity and perceived capacity to meet demands for cash.  FHA does not face the same liquidity risk that PMIs do because the  Fund’s financing account holds balances to cover expected future claims  on existing loans, and FHA can draw upon permanent and indefinite  budget authority to pay claims, if necessary. In addition, FHA includes  estimates of losses on delinquent loans (and performing loans) in its  liability for loan guarantees.
Certain PMI reserves have other purposes that are pertinent to FHA, but  FHA addresses them by other means. Although most unearned premium  is not refundable, an additional purpose of the unearned premium reserve  is to reflect a PMI’s refund liability in the event that the mortgage  insurance policy is cancelled before premiums are fully earned. FHA  accounts for premium refunds by including the amount of premiums that  are expected to be refunded in its estimates of future cash flows. One  purpose of the contingency reserve is to build up a capital buffer to help  cover claims during economic downturns. While not fixed to a percentage  of premiums like the contingency reserve, FHA’s capital reserve account  holds all premiums in excess of anticipated claims and is available to pay  higher-than-anticipated claims. Furthermore, calculating the current levels  of these reserves would be difficult. For example, determining FHA’s  contingency reserve liability is complicated by the fact that this liability  may be reduced if incurred losses exceed 35 percent of earned  premiums—a threshold FHA likely exceeded in recent years.
PMI capital requirements also have limited applicability to FHA because  they rely on definitions and components of capital that are not directly  relevant to FHA’s operating environment. Specifically, PMIs use  statutory surplus and contingency reserves from the statutory financial  statements they file with insurance regulators to determine their capital.  Statutory surplus includes components that FHA’s Fund does not have,  including capital stock and gross paid-in and contributed surplus, which  reflect the various means that PMIs use to raise capital. FHA’s capital  does not have these components and consequently, they cannot be  calculated for FHA. For example, as a federal agency, FHA does not  have stock or stockholders. FHA’s capital comes almost exclusively from  premiums and minimal interest income. For PMIs, retained earnings—an  entity’s net income since its inception—increase statutory surplus, and  dividends paid to stockholders decrease it. The retained earnings or  losses component of PMIs’ capital is somewhat similar to the net position  of FHA’s Fund. However, FHA’s net position reflects estimates of  lifetime premiums net of claims, while PMIs’ retained earnings reflect,  among other things, revenues earned and losses incurred (on delinquent  loans) to date.
section_title: Industry Practice of Separately Disclosing Reserve Components Could Increase Transparency of Risks Facing FHA’s Fund
paragraphs: Although specific PMI reserving practices have limited applicability to  FHA, the concept of separately disclosing reserve components as PMIs  do could be applied to the Fund. For example, the PMI loss reserve and  unearned premium reserve focus on the timing of specific cash flows— the loss reserve on claims that are likely to be paid on delinquent loans in  the near-term and the unearned premium reserve on premiums as they  are earned over time. In contrast, FHA has a single reserve from a  financial accounting perspective, the liability for loan guarantees, which  combines estimates of future claims payments with estimates of future  premiums and recoveries over a 30-year period into a single number.  While a single number is a useful measure of lifetime costs and aligns  with federal budget requirements, it provides limited insight into the timing  of specific cash flows and, therefore, the degree of uncertainty in the  estimate.
As of September 30, 2012, the liability for loan guarantees for forward  mortgages in FHA’s Fund was $37 billion. That is, claims payments on  loans that were insured as of that date were expected to exceed future  premiums and recoveries on foreclosed properties by $37 billion on a  present value basis over the next 30 years. However, the timing of claims  payments, premiums, and recoveries is not evident from this figure. This  information is important for more fully understanding the Fund’s financial  status because estimates of near-term cash flows are inherently more  certain than estimates of longer-term cash flows. Disclosing the timing of  specific cash flows would help illustrate the extent to which estimates of  claims payments, premiums, and recoveries in the liability for loan  guarantees are concentrated in the near term or longer term and  therefore more or less certain.
The uncertainty of longer-term cash flow estimates also applies to FHA’s  future business activity, which is estimated to help offset losses on its  existing loans. The fiscal year 2012 actuarial review found that the  economic value of the Fund’s forward mortgages without the fiscal year  2013 book of business was negative $13 billion, meaning that the present  value of estimated future cash flows on the existing portfolio exceeded  current resources available to pay claims by that amount. The actuary  estimated that FHA’s future business will generate positive economic  value, which will help rebuild the Fund’s capital resources. In its fiscal  year 2012 annual report to Congress, FHA said it foresaw little risk that it  would not be able to pay claims based on projections of its future  business. However, like all long-term projections, the actuary’s  estimates rest on assumptions that are inherently uncertain.
As previously noted, differences in the level of certainty between near- term and longer-term cash flows underscore the importance of this  information for assessing financial condition. The liability for loan  guarantees is built upon a 30-year schedule of key cash flows—claims,  premiums, and recoveries. Accordingly, separately disclosing these  component parts and showing how they vary over time could provide  additional insight into the financial condition of the Fund. Such disclosure  would be consistent with information reported on the timing of cash flows  for federal social insurance programs, which also rely on long-term  estimates. It would also be consistent with federal internal control  guidance for communicating with external groups. This guidance  discusses the importance of communicating relevant information to  Congress and others so that they can better understand the agency,  including its mission, goals, objectives, and risks.
section_title: Accountability Component of Industry Capital Requirements Could Strengthen Oversight of FHA
paragraphs: Unlike PMIs, which may be required to undertake actions such as  remediation plans and additional reporting to state regulators as  conditions of doing business when they do not meet capital requirements,  FHA is not subject to such enhanced accountability measures. As  previously stated, PMIs that have not met their capital or other  requirements have had to provide additional reporting, more frequently  meet with regulators, and in some cases develop remediation plans to  continue writing new business. For example, remediation plans may lay  out a PMI’s plan for restoring its capital to the required level through  capital contributions from the parent company, premium increases, and  underwriting changes. In contrast, FHA has not been in compliance with  its capital ratio requirement since 2009 and is not estimated to reach  compliance until 2017. Yet failure to comply with the requirement does  not trigger a defined process or set of steps to be taken by FHA. FHA’s  annual reports to Congress in 2009 through 2011 described steps it  already had taken to improve the Fund’s financial condition, including  premium and underwriting changes. However, FHA did not issue a plan of  action to restore the Fund’s capital ratio, including implementation time  frames and estimated outcomes, until it submitted its 2012 annual report  to Congress.
Requiring a capital restoration plan when the capital ratio approaches or  falls below the required level could strengthen oversight of FHA by  prompting the timely development and analysis of corrective actions and  by providing benchmarks against which Congress could monitor progress  of implementation. As noted earlier, legislative proposals that contain  such a requirement have been introduced but have not been enacted. In  addition, past congressional actions have emphasized the importance of  remediation plans for financial institutions. For example, the Deficit  Reduction Act of 2005 required the Federal Deposit Insurance  Corporation to establish and implement a restoration plan when its  Deposit Insurance Fund was either projected to fall or actually fell below  the minimum level. The Dodd-Frank Wall Street Reform and Consumer  Protection Act required the establishment of remediation requirements,  including capital restoration plans, for certain institutions facing financial  distress.
section_title: Conclusions
paragraphs: FHA, like other mortgage market participants, suffered major losses as a  result of the recent housing crisis and may require additional funds in the  near future. These circumstances have focused attention on oversight of  FHA’s single-family mortgage programs, including the practices and  requirements FHA follows in managing the Fund. Although PMIs also  experienced financial distress and some stopped issuing new policies, the  PMI regulatory framework provides a basis for comparison and offers  alternative practices and requirements to consider in deliberating on  potential FHA reforms. However, the applicability of certain PMI practices  and requirements to FHA is fundamentally limited because their  underlying purposes or components are not directly relevant in FHA’s  operating environment.
Nonetheless, the PMI regulatory framework has features that, if applied to  FHA, could enhance transparency of the Fund’s financial condition and  congressional oversight of FHA’s operations. First, the concept of  separately disclosing reserve components as PMIs do could be applied to  the Fund. FHA’s liability for loan guarantees—which FHA calculates and  reports annually as required—has certain limitations. In particular, it does  not show the timing of the different cash flows that comprise the liability  for loan guarantees—claims, premiums, and recoveries—and therefore  does not reveal the extent to which FHA may be relying on less certain  future revenue to offset more certain near-term losses. Disclosing this  information could enhance congressional oversight of FHA’s financial  condition and would be consistent with reporting practices of other federal  programs and federal internal control guidance. Second, accountability  mechanisms like those included in PMI capital requirements also could  enhance congressional oversight of the Fund. Unlike PMIs, which must  obtain waivers and submit remediation plans when they have not met or  are at risk of not meeting capital requirements, FHA does not have a  defined process it must follow. In 2012, FHA provided Congress with a  set of planned actions to address its capital shortfall, but had not done so  in prior years. A capital restoration plan requirement triggered by  noncompliance with the Fund’s statutory capital requirements could help  ensure prompt action by FHA and focus Congress’s monitoring efforts  should this situation arise in the future. This type of requirement is  contained in legislative proposals currently before Congress and would be  consistent with prior congressional actions for certain financial institutions  and government entities.
section_title: Matter for Congressional Consideration
paragraphs: To strengthen FHA accountability for complying with the Fund’s statutory  capital requirement, Congress should consider requiring that FHA submit  a capital restoration plan and regular updates on plan implementation  whenever the capital ratio falls below 2 percent as calculated in the  annual actuarial review of the Fund, or the Fund’s financial condition does  not meet other congressionally-defined requirements.
section_title: Recommendation for Executive Action
paragraphs: To provide additional perspective on the Fund’s financial status, FHA  should disclose estimates of the individual cash flows associated with the  liability for loan guarantees (premiums, claims, and recoveries), including  their value for each year of the 30-year estimation period.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to HUD and the Federal Housing  Finance Agency for their review and comment. We received written  comments from HUD, which are reprinted in appendix II. HUD also  provided a technical comment, which we incorporated into the final report.  The Federal Housing Finance Agency had no comments on the draft  report.
In its letter, HUD agreed with our recommendation to disclose the  component parts of the liability for loan guarantees—claims, premiums,  and recoveries. However, HUD suggested an alternative to disclosing  cash flows for each year of the 30-year estimation period, as we  recommended. Specifically, HUD proposed separately disclosing the  liability for loan guarantees for delinquent loans and performing loans,  which would implicitly break down losses into the near term (those arising  from currently delinquent loans) and the longer term (reflecting potential  loss projections on currently performing loans). HUD said that this  approach would give a clearer picture of the Fund’s financial status at a  given point in time. HUD’s suggestion is broadly consistent with our  recommendation and could provide useful information. However, it does  not clearly include the separate disclosure of claims, premiums, and  recoveries and would not provide as much perspective on the timing of  cash flows as the approach we recommend. Our recommendation, which  calls for a more detailed disclosure of cash flow values for each year over  the 30-year estimation period, would provide greater insight into the  Fund’s financial condition by illustrating the uncertainty of future losses  and revenue. For this reason, we made no change to our  recommendation.
We also provided excerpts of the draft report to the National Association  of Insurance Commissioners, the Mortgage Insurance Companies of  America and its three member companies (Radian Guaranty, Genworth,  and Mortgage Guaranty Insurance Corporation), and United Guaranty for  technical review. We received technical comments from the Mortgage  Insurance Companies of America on behalf of its members and from  United Guaranty, which we incorporated into the final report as  appropriate.
As agreed with your offices, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies to the Secretary of Housing  and Urban Development and the Acting Director of the Federal Housing  Finance Agency. In addition, the report will be available at no charge on  the GAO website at http://www.gao.gov.
If you or your offices have any questions about this report, please contact  me at (202) 512-8678 or sciremj@gao.gov. Contact points for our Offices  of Congressional Relations and Public Affairs may be found on the last  page of this report. Key contributors to this report are listed in appendix  III.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: We examined the Federal Housing Administration’s (FHA) financial  condition requirements for the Mutual Mortgage Insurance Fund (Fund)  and compared them with those used by private mortgage insurers (PMI).  Specifically, we discuss (1) how the reserving practices and capital  requirements of FHA’s Fund compare with those for the PMI industry and  (2) how, if at all, applicable PMI reserving practices and capital  requirements could enhance oversight of FHA’s Fund.
To address the first objective, we identified and reviewed reserving  practices and capital requirements pertinent to FHA and PMIs. We  reviewed generally accepted accounting principles for federal entities and  federal statutes that apply to FHA’s Fund. We also reviewed statutory  accounting principles, generally accepted accounting principles for  nongovernmental entities, Fannie Mae and Freddie Mac policies, and  state statutes and regulations that apply to PMIs. We interviewed  mortgage market participants and stakeholders, including officials from  FHA, insurance regulatory agencies in three selected states (North  Carolina, Pennsylvania, and Wisconsin), the National Association of  Insurance Commissioners, major PMIs, a PMI trade association, Fannie  Mae, Freddie Mac, and the Federal Housing Finance Agency to confirm  our understanding of the practices and requirements. We selected the  three states based on the market share of PMIs domiciled in those states  and the diversity of state requirements for PMIs. These states were the  domiciliary states and primary regulators for PMIs that accounted for 90  percent of the PMI market. We compared and contrasted the practices  and requirements for FHA and PMIs along several dimensions, including  the financial measures used, the frequency of associated reporting, and  the regulatory consequences of noncompliance. In addition, we examined  scholarly articles and industry reports to determine possible reasons for  any differences between FHA and PMI practices and requirements.  Finally, to provide additional context, we reviewed actuarial and financial  reports showing the extent to which FHA and selected PMIs met their  respective capital requirements from 2001 through 2012. For this  analysis, we reviewed the four largest PMIs, which accounted for 78  percent of the PMI market in 2012, as well as three PMIs that ceased  writing new business due to capital constraints during the time frame. We  obtained these data from FHA’s annual actuarial reviews, PMIs’ public  reports, and PMI officials.
To address the second objective, we reviewed statutes, regulations, and  accounting standards that currently apply to FHA and PMIs. We also  reviewed information FHA currently reports on the Fund’s financial  condition, including annual actuarial reviews of the Fund, HUD  appendixes to the President’s budget, and FHA’s audited financial  statements. To determine the extent to which PMI reserving practices and  capital requirements could be applied to FHA’s Fund, we considered  factors such as the compatibility of underlying concepts and calculations  with FHA’s operations. We analyzed data from FHA on the volume and  performance of the mortgages it has insured through the end of fiscal  year 2012 to calculate a loss reserve for FHA in the manner of a PMI.  Specifically, FHA provided data on the amortized insurance-in-force on  loans that were 90 or more days delinquent or in foreclosure as well as  the assumptions used in the President’s budget on the percentage of  those loans that will eventually result in a claim and the estimated loss  severity. We also analyzed FHA data on its risk-in-force on performing  loans, estimated recovery rates, and total amortized insurance-in-force as  of the end of fiscal year 2012 to calculate the dollar amount of capital that  FHA would need under PMI capital requirements. To assess the reliability  of the data we obtained from FHA, we conducted reasonableness checks  on data elements and discussed the sources and interpretation of the  data with FHA officials. We determined that the data we used were  sufficiently reliable for purposes of characterizing the financial condition of  the Fund. In addition, we interviewed mortgage insurance regulators in  the selected states to identify the information PMIs report under their  current practices and requirements that regulators find useful in  assessing financial condition. Additionally, to determine whether features  of the PMI regulatory framework could enhance Fund oversight, we  interviewed FHA officials, major PMIs, and other industry analysts to  obtain their perspectives on the potential for increasing transparency and  better understanding the Fund’s financial condition. We also identified  relevant criteria in GAO’s Standards for Internal Control in the Federal  Government and Internal Control Management and Evaluation Tool as  well as examples of remediation plan requirements enacted by Congress  for other financial institutions and government entities.
We conducted this performance audit from February 2013 to September  2013 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
section_title: Appendix II: Comments from the Department of Housing and Urban Development
section_title: Appendix III: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Robert Dacey (Chief  Accountant), Marcia Carlsen and Steve Westley (Assistant Directors),  Anne Akin, Don Brown, Stephen Brown, Jason Kelly, Melissa Kornblau,  Aaron Livernois, John McGrail, Barbara Roesmann, Jena Sinkfield,  Andrew Stavisky, and Frank Todisco made key contributions to this  report.