Federal Housing Administration: Proposed Legislative Changes Would Affect Borrower Benefits and Risks to the Insurance Funds
Published: 2007-07-18T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Fewer borrowers are using the Federal Housing Administration's (FHA) single-family and manufactured housing insurance programs. To help counter this trend, proposed changes to the single-family program would raise loan limits, allow risk-based pricing of premiums, and reduce down payments. Changes such as higher loan limits also were proposed for the manufactured housing program. To assist Congress in considering the impact of these changes, this testimony provides information from recently issued GAO reports and preliminary views from ongoing work. Specifically, GAO discusses (1) trends in FHA's share of the mortgage market, (2) likely impacts of proposed changes to the single-family program, (3) practices important to implementing the changes to the single-family program, if passed, and (4) preliminary observations from our work on the manufactured housing program. To conduct this work, GAO analyzed agency, Home Mortgage Disclosure Act, and Census data and interviewed agency and lending industry officials and other stakeholders.
section_title: What GAO Found
paragraphs: FHA's share of the single-family mortgage market declined 13 percentage points from 1996 through 2005, with conventional lenders gaining notably increased percentages of lower-income and minority borrowers. This decline in market share was associated with a number of factors, including FHA's product restrictions and product innovations in the conventional market. The proposed changes to the single-family program could affect borrowers as well as program costs. For example, GAO estimated that in 2005 FHA could have insured 9 to 10 percent more loans if proposed mortgage limits were in effect. But, if the risk-based pricing proposal had been in effect in 2005, 20 percent of borrowers would not have qualified for FHA insurance. FHA determined that the expected claim rates of these borrowers were higher than it found tolerable for either the borrower or the Mutual Mortgage Insurance Fund. Absent any program changes, FHA estimates that the fund would require an appropriation of approximately $143 million in fiscal year 2008. If proposed changes were passed, FHA estimates that the fund would generate $342 million in negative subsidies (i.e., net cash inflows). Although FHA is taking steps to enhance tools important to implementing the proposed changes to its single-family program, it does not plan to use a common industry practice, piloting, to mitigate the risks of any zero-downpayment product. In response to prior GAO recommendations, FHA improved its loan performance models and is refining its mortgage scorecard (which evaluates the default risk of borrowers). However, the proposals would introduce new risks and challenges. The proposal to lower down payments is of particular concern given the greater default risk of these loans and the difficulty of setting prices for new products whose risks may not be well understood. One of the ways FHA plans to mitigate new or increased risks is through stricter underwriting standards, but it does not plan to pilot any zero-down-payment product. Other mortgage institutions use pilots to manage risks associated with changing or expanding product lines. Proposals for the manufactured home loan program would increase loan limits, insure each loan made, incorporate stricter underwriting requirements, and set premium rates. While the changes could benefit borrowers, according to FHA and the Congressional Budget Office, the potential costs could expand the government's liability. However, FHA has not articulated which borrowers would be targeted if the program were expanded, specified changes in its underwriting requirements, developed a risk-based pricing structure for the proposed legislation, or estimated costs to the General Insurance Fund. As a result, the potential effects of the changes on the program and the insurance fund are unclear.

section_title: Letter
paragraphs: I am pleased to have the opportunity to share information and  perspectives with the committee as it considers modernization proposals  for the Department of Housing and Urban Development’s (HUD) Federal  Housing Administration (FHA). FHA provides insurance for single-family  home mortgages made by private lenders. In fiscal year 2006, it insured  almost 426,000 mortgages representing $55 billion in mortgage insurance.  According to FHA’s estimates, the single-family insurance program  currently operates with a negative subsidy, meaning that the present value  of estimated cash inflows (such as borrower premiums) to FHA’s Mutual  Mortgage Insurance Fund exceeds the present value of estimated cash  outflows (such as insurance claims). However, absent any program  changes, FHA has estimated that the program would require a positive  subsidy—that is, an appropriation of budget authority—in fiscal year 2008.  In addition to single-family home mortgages, FHA insures loans for  manufactured housing—that is, factory-built housing designed to meet  HUD’s national building code. Comparatively, this is a much smaller  program than the single-family insurance program, insuring 1,438 loans in  2006 representing $54 million in mortgage insurance. FHA insures its  manufactured home loans under the General Insurance Fund.
FHA has faced several challenges in recent years. Its single-family  insurance program has experienced rising delinquency rates and a sharp  decline in the number of participating borrowers, due partly to increased  competition from conventional mortgage providers. The conventional  market has prime and subprime segments. Prime borrowers typically have  strong credit scores and obtain the most competitive interest rates and  mortgage terms. In contrast, subprime borrowers typically have  blemished credit and lower credit scores, may have difficulty providing  income documentation, and generally pay higher interest rates and fees  than prime borrowers. As conventional providers have improved their  ability to evaluate risk, FHA has experienced adverse selection—that is,  conventional providers have identified and approved relatively lower-risk  borrowers in FHA’s traditional market segment, leaving relatively higher- risk borrowers for FHA.
Additionally, the lending market associated with manufactured homes has  undergone significant changes over the last 15 years. Market growth in the  1990s was followed by a large number of repossessions from 2000 to 2002  due to the deteriorating credit quality of borrowers, and many lenders  exited the manufactured home loan market. The FHA-insured segment of  the market experienced a dramatic decline over this period. The number  of manufactured home loans insured by FHA decreased from 23,897 loans  in 1990 to 1,438 loans in 2006, a 94 percent decline.
To adapt to market changes, FHA has implemented new administrative  procedures in its single-family insurance program and proposed legislation  designed to modernize its insurance processes and products. FHA’s recent  administrative changes include allowing higher-performing single-family  lenders to endorse, or approve, loans for FHA insurance without prior  review by FHA and adopting conventional market appraisal requirements.  The legislative proposals for the single-family insurance program also  would raise FHA’s mortgage limits, give the agency flexibility to set  insurance premiums based on the credit risk of borrowers, and reduce  down-payment requirements from the current 3 percent to potentially  zero. In addition, legislative changes have been proposed for FHA’s Title I  Manufactured Home Loan program that include increasing the loan limits,  incorporating stricter underwriting requirements, and revising the  premium structure.
My testimony today discusses two reports that we issued in June 2007 on  FHA’s share of the single-family mortgage market and FHA’s proposals to  modernize its single-family insurance program, as well as preliminary  views from ongoing work we are conducting on FHA’s Title I  Manufactured Home Loan program. Specifically, I will discuss (1) trends  in FHA’s share of the home purchase mortgage market and factors  underlying these trends; (2) likely program and budgetary impacts of  proposed changes to FHA’s single-family insurance program; (3) tools,  resources, and risk-management practices important to FHA’s  implementation of the legislative proposals for its single-family insurance  program, if passed; and (4) preliminary observations from our ongoing  work on the Manufactured Home Loan program.
In conducting this work, we analyzed loan data from 1996 through 2005  collected under the Home Mortgage Disclosure Act (HMDA) to assess  trends in the overall market for home purchase mortgages and used 2005  HMDA data (the most current available) to examine the effect of raising  loan limits on demand for FHA-insured single-family loans. We estimated  the effects of risk-based pricing on borrowers’ eligibility for FHA single- family insurance and the premiums they would pay by analyzing Single  Family Data Warehouse (SFDW) data on FHA’s 2005 home purchase  borrowers. We also analyzed data from the Manufactured Home Loan  program, Census data from the Manufactured Housing and American  Housing Surveys, and other sources. We interviewed officials from FHA,  Ginnie Mae, Fannie Mae, and Freddie Mac; FHA lenders, private mortgage  insurers, and mortgage and real estate industry groups; and academic  researchers. We conducted this work from September 2006 to July 2007 in  accordance with generally accepted government auditing standards.
In summary, we found that:    From 1996 through 2005, FHA’s share of the market for home purchase  mortgages declined from 19 to 6 percent, while the prime and subprime  shares increased 3 and 13 percentage points, respectively. The agency  experienced a sharp decrease among minority and lower-income  populations where it traditionally has had a strong presence. This decline  in market share was associated with a number of factors—including FHA’s  product restrictions and product innovations in the conventional market,  particularly in the subprime market—and has been accompanied by higher  ultimate costs for certain conventional subprime borrowers.
FHA’s proposed changes to its single-family insurance program could  affect borrower demand and the cost and availability of its insurance as  well as the budgetary costs of the program. Based on our analysis of 2005  HMDA data, we estimated that the number of FHA-insured loans in 2005  could have been from 9 to 10 percent greater had the higher, proposed  mortgage limits been in effect. In addition, our analysis of data for FHA  home purchase borrowers in 2005 showed that, under FHA’s risk-based  pricing proposal, about 43 percent of those borrowers would have paid the  same or less than they actually paid, 37 percent would have paid more, and  20 percent would not have qualified for FHA insurance based on FHA’s  plans as of May 2007. The 20 percent were borrowers with expected  lifetime claim rates more than 2.5 times greater than the average claim  rate. Finally, while to be viewed with caution, FHA has made estimates  indicating that the loans it expects to insure in 2008 would result in  negative subsidies of $342 million if the major legislative changes were  enacted, rather than requiring an appropriation of $143 million absent any  program changes.
FHA has taken or has planned steps to enhance the tools and resources  important to implementing the proposed changes to its single-family  insurance program—and help address risks and challenges associated  with the proposals. However, it does not intend to use a common industry  practice, piloting, to mitigate the risks of any zero-down-payment product  it is authorized to offer. To implement its risk-based pricing proposal, FHA  would rely on statistical models that estimate the performance of loans  and its mortgage scorecard (an automated tool that evaluates the default  risk of borrowers). In response to our prior recommendations, FHA has  improved its loan performance models by incorporating additional  variables and is in the process of addressing a number of limitations in its  mortgage scorecard. Although FHA has taken actions to enhance key tools  and resources, the legislative proposals would introduce new risks and  challenges. The proposal to lower down-payment requirements is of  particular concern given the greater default risk of these loans and the  difficulty of setting prices for new products whose risks may not be well  understood. FHA plans to take steps, such as instituting stricter  underwriting standards, to mitigate these risks. However, while other  mortgage institutions use pilot programs to manage the risks associated  with changing or expanding their product lines, FHA has indicated that it  does not plan to pilot any zero-down-payment product it is authorized to  offer.
In response to the dramatic decline in FHA-insured manufactured home  loans, legislative proposals for the Manufactured Home Loan program  would increase loan limits, insure each loan made, incorporate stricter  underwriting requirements, and establish up-front and adjust annual  insurance premiums. According to FHA and some industry officials, the  potential benefits of proposed changes for borrowers include obtaining  larger loans and additional financing with lower interest rates as more  lenders likely would participate because a greater portion of their  portfolios could be insured. The Congressional Budget Office (CBO) and  FHA also noted potential costs, such as expanded liability for the General  Insurance Fund. Additionally, risk factors unique to manufactured home  lending affect loan performance. But, FHA has not yet articulated which  borrowers would be targeted or undertaken risk assessments to estimate  the effects of the proposed legislation on the volume of lending and claims  and the overall financial soundness of the program.
While the two reports I have summarized make no new recommendations,  they include observations about how developments in the different  segments of the mortgage market could affect FHA’s market share in the  future and the need for careful implementation of the legislative proposals,  if passed. We noted that, notwithstanding the actions of conventional  providers, FHA could be a vehicle to provide lower-priced and more  sustainable mortgage options for some borrowers who are considering or  struggling to maintain higher-priced subprime loans. However, careful  assessment and management of the risks associated with serving these  borrowers would be necessary to avoid exacerbating problems in the  financial performance of FHA’s single-family insurance program. We also  acknowledged that FHA has performed considerable analysis to support  its legislative proposals for the single-family insurance program and has  made or planned enhancements to many of the specific tools and  resources that would be important to its implementation of them, but  stated that the proposals present risks and challenges and should be  viewed with caution. Continued management attention to our prior  recommendations, including piloting new products and improving its  mortgage scorecard, could help FHA address these risks.
subsections: section_title: Background
paragraphs: Congress established FHA in 1934 under the National Housing Act (P.L. 73- 479) to broaden homeownership, protect and sustain lending institutions,  and stimulate employment in the building industry. FHA’s single-family  program insures private lenders against losses from borrower defaults on  mortgages that meet FHA criteria for properties with one to four housing  units. FHA has played a particularly large role among minority, lower- income, and first-time homebuyers and generally is thought to promote  stability in the market by ensuring the availability of mortgage credit in  areas that may be underserved by the private sector or are experiencing  economic downturns. In fiscal year 2006, 79 percent of FHA-insured home  purchase loans went to first-time homebuyers, 31 percent of whom were  minorities. The Title I Manufactured Home Loan program was created to  reduce the risk to lenders through insurance or a guarantee, and thereby  expand access to funding for buyers of manufactured homes. According to  data from FHA, the majority of its Title I borrowers from 2004 to 2007  were lower-income and 34 years of age or younger.
FHA insures most of its single-family mortgages under its Mutual Mortgage  Insurance Fund, which is supported by borrowers’ insurance premiums.  The single-family insurance program has maintained a negative overall  credit subsidy rate, meaning that the present value of estimated cash  inflows from premiums and recoveries exceeds estimated cash outflows  for claim payments (excluding administrative costs). In addition to  insuring mortgages on single-family homes, FHA has insured loans for  manufactured housing since 1969. FHA insures its manufactured home  loans under the General Insurance Fund, which is supported by lenders’  insurance premiums (currently an annual premium of 1 percent, based on  the initial loan amount).
Borrowers insured under FHA’s single-family program are required to  make a cash investment of a minimum of 3 percent. FHA allows down- payment assistance from third-party sources, including nonprofit  organizations that receive contributions from property sellers. When a  homebuyer receives down-payment assistance from one of these  organizations, the organization requires the property seller to make a  financial payment to their organization. These nonprofits are commonly  called “seller-funded” down-payment assistance providers.
Partly in response to changes in the mortgage market, HUD has proposed  legislation intended to modernize FHA. Provisions in the proposal relating  to its single-family insurance program would among other things authorize  FHA to change the way it sets insurance premiums, reduce down-payment  requirements, and insure larger loans. The proposed legislation would  enable FHA to depart from its current, essentially flat, premium structure  and charge a wider range of premiums based on individual borrowers’ risk  of default. HUD’s proposal also would eliminate the minimum cash  investment requirement and enable FHA to offer some borrowers a no- down-payment product. FHA is subject to limits in the size of the loans it  can insure. For example, for a one-family property in a high-cost area, the  FHA limit is 87 percent of the limit established by Freddie Mac. In a low- cost area, the limit is 48 percent of the Freddie Mac limit. The legislative  proposal would raise these limits to 100 percent and 65 percent of the  Freddie Mac limit, respectively. In addition, Congress has proposed  changes to FHA’s Title I Manufactured Home Loan program that would  increase loan limits and index them annually; insure each loan made  instead of capping insurance at 10 percent of the value of a lender’s  portfolio; incorporate stricter underwriting requirements; and establish up- front and annual premiums.
section_title: Decline in FHA’s Market Share Was Associated with Product and Process Developments of Other Mortgage Market Participants
paragraphs: In a report we issued in June 2007, we noted that a combination of factors  created conditions that favored conventional mortgages over FHA  products resulting in FHA losing a considerable market share to the  conventional market, especially to the subprime market. Based on our  analysis of HMDA data, FHA’s share of the market for home purchase  mortgages (in terms of numbers of loans) declined 13 percentage points  from 1996 through 2005, while the prime share increased slightly, and the  subprime share grew 13 percentage points. In addition, the agency  experienced a sharp decrease among minority and lower-income  populations where it traditionally has had a strong presence.
Specifically, we found that:    From 1996 through 2005, FHA’s share of the home purchase mortgage  market declined while the conventional share increased. As shown in  figure 1, FHA’s market share fell from almost 19 percent (about 583,000  loans) in 1996 to about 6 percent (about 295,000 loans) in 2005, with  almost all of the decline occurring after 2001. Over the 10-year period, the  market share for conventional mortgages rose from almost 75 percent  (about 2.3 million loans in 1996) to about 91 percent (about 4.2 million  loans in 2005), with much of the increase due to growth in subprime  lending. More specifically, prime market share increased from 73 percent  to 76 percent overall, falling somewhat from 1996 through 2000 but then  increasing about 5 percentage points after 2000. Subprime market share  increased substantially over the 10- year period, from 2 percent to 15  percent, with most of the increase occurring after 2001 (growing from 5  percent in 2001 to 15 percent in 2005).
FHA traditionally played a major role among minority borrowers.
However, over the 10-year period, FHA’s share of this submarket fell  substantially. Specifically, FHA’s market share dropped from 32 to 7  percent among minority borrowers. In contrast, prime market share  increased from 59 to 65 percent among minority borrowers and subprime  market share increased from 2 to 26 percent.
Lower-income (that is, low- and moderate-income) borrowers historically  relied heavily on FHA products, but FHA’s market share dropped in this  submarket as well. From 1996 through 2005, FHA’s market share  decreased among borrowers of all income levels, but particularly among  lower-income borrowers, where it declined from 26 to 10 percent. Over the  same period, prime market share increased from 65 to 72 percent and  subprime market share increased from 1 to 15 percent.
The decline in FHA’s market share was associated with a number of  factors and has been accompanied by higher ultimate costs for certain  conventional borrowers. FHA’s lack of process improvements and product  restrictions relative to the conventional market provided conditions that  favored conventional over FHA-insured mortgages. According to mortgage  industry officials that we interviewed, processing FHA-insured loans is  more costly, time consuming, and labor intensive than processing  conventional mortgages. FHA and mortgage industry officials with whom  we spoke also cited FHA loan limits as a factor that contributed to the  decline in FHA market share. In some areas of the country, particularly in  parts of California and the Northeast, the loan limits were significantly  lower than the median home price. Some mortgage industry officials also  pointed to other product restrictions as a reason why FHA loans have  been less competitive than conventional loans. For example, many  borrowers do not or cannot make a down payment, and unlike FHA, in  recent years members of the conventional mortgage market have been  increasingly active in supporting low- and no-down-payment mortgages.
During the 10-year period we examined, several developments occurred in  the conventional market that contributed to FHA’s declining market share.  I will discuss four of these developments. First, the conventional market  offered products that increased consumer choices for borrowers,  including those who may have previously chosen an FHA-insured loan.  These products—interest-only loans, no- and low-documentation  mortgages, piggyback loans, and hybrid adjustable rate mortgages  (ARM)—became popular, especially during the subprime market’s rapid  growth after 2001, because they featured flexible payment and interest  options that increased initial affordability. In combination with  historically low interest rates, these products made it easier for  homebuyers to purchase homes in a period of strong house price  appreciation.
Second, advances in underwriting technology, particularly mortgage  scoring and automated underwriting systems, allowed conventional  mortgage providers to process loan applications more quickly and  consistently than in the past and broaden their customer base. FHA  implemented its own mortgage scoring tool, called the Technology Open  to Approved Lenders (TOTAL) scorecard, in 2004. However, in prior work  we found that the way FHA developed TOTAL may limit the scorecard’s  effectiveness. To the extent that conventional mortgage providers were  better able than FHA to use scoring tools to identify lower-risk borrowers  in FHA’s traditional market segment, these borrowers may have migrated  toward conventional products, contributing to the decline in FHA’s market  share.
Third, there was an increase in mortgage originations through third parties  such as loan correspondents and mortgage brokers, particularly in the  subprime market. This trend has been associated with the decline in FHA’s  market share because the third-party originators primarily market non- FHA products. Finally, the growth in private mortgage securitization (the  bundling of mortgage loans into bond-like securities that can be bought  and sold on the secondary market), particularly for subprime loans,  allowed lenders to sell loans from their portfolios, transferring credit risk  to investors, and use the proceeds to make more loans.
As a result of these developments and lower interest rates, more  homebuyers—especially minority and lower-income families—were able  to obtain conventional loans, but many of these loans had high ultimate  costs. As previously discussed, much of the increase in mortgages to  minorities and lower-income borrowers was due to the growth in  subprime lending, and many of these loans offered lower initial costs  through their interest-only features and low introductory interest rates.  However, these mortgages became more costly as the interest rates on  many of these loans reset to higher rates, typically 2 to 3 percentage points  higher in a relatively short period.
Highly leveraged and weaker credit borrowers—the typical subprime  borrowers who have obtained nontraditional mortgage products such as  hybrid ARMs—are the most vulnerable to payment shocks. As a result,  borrowers who obtained subprime mortgages have experienced relatively  high rates of default (defined as payments more than 90 days past due)  and foreclosure (in any stage of the foreclosure process). According to the  Mortgage Bankers Association, as of December 31, 2006, the cumulative  default and foreclosure rates for all subprime mortgages were 7.78 and  4.53 percent, respectively. Some mortgage industry researchers predict  that subprime default and foreclosure rates likely will worsen as the loans  age; a substantial portion of these loans have yet to reach the age when  loans tend to experience the highest rates of default and foreclosure— between 4 and 7 years. Furthermore, because most recent subprime loans  have adjustable-rate features, default and foreclosure rates for ARMs are  in particular danger of increasing as resetting interest rates cause monthly  mortgage payments on the loans to rise.
section_title: Single-Family Modernization Proposals Likely Would Affect Program Participation and Costs
paragraphs: In our June 2007 report on FHA’s modernization efforts, we noted that  FHA’s proposed legislative changes to its single-family insurance program  likely would affect program participation and costs. For example, we  estimated that raising the FHA loan limits could increase demand for FHA- insured loans, all other things being equal. The risk-based pricing proposal  would decrease premiums for lower-risk borrowers, increase them for  higher-risk borrowers, and disqualify other potential borrowers. In  addition, FHA estimates that the legislative proposals would have a  favorable budgetary impact.
subsections: section_title: Raising Loan Limits Likely Would Increase Demand for FHA Loans
paragraphs: Our analysis indicated that raising the loan limits for FHA’s single-family  insurance program likely would increase the number of loans insured by  FHA by making more loans eligible for FHA insurance. In some areas of  the country, median home prices have been well above FHA’s maximum  loan limits, reducing the agency’s ability to serve borrowers in those  markets. For example, the 2005 loan limit in high-cost areas was $312,895  for one-unit properties, while the median home price was about $399,000  in Boston, Massachusetts; about $432,000 in Newark, New Jersey; and  about $646,000 in San Francisco, California. If the limits were increased,  FHA insurance would be available to a greater number of potential  borrowers.
Our analysis of HMDA data indicated that the agency could have insured  from 9 to 10 percent more loans in 2005 had the higher mortgage limits  been in place. The greatest portion of this increase resulted from raising  the loan limit floor in low-cost areas from 48 to 65 percent of the  conforming loan limit. In particular, 82 percent of the additional loans that  would have been insured by FHA were in areas where the loan limits were  set at the floor. Only 14 percent of the new loans would have resulted from  increasing the loan limit ceiling. Our analysis also found that the average  size of an FHA-insured loan in 2005 would have increased from  approximately $123,000 to about $132,000 had the higher loan limits been  in place.
section_title: Risk-Based Pricing Could Help Address Adverse Selection but Would Affect the Cost and Availability of FHA Insurance for Some Borrowers
paragraphs: To help address the problem of adverse selection, FHA has sought  authority to price insurance premiums based on borrower risk, which  would affect the cost and availability of FHA insurance for some  borrowers. Currently, all FHA-insured borrowers pay the same premium  rates. Under this flat pricing structure, lower-risk borrowers subsidize  higher-risk borrowers. In recent years, innovations in the mortgage market  have allowed conventional mortgage lenders and insurers to identify and  approve relatively low-risk borrowers and charge fees based on default  risk. As relatively lower-risk borrowers in FHA’s traditional market  segment have selected conventional financing, FHA has been left with  more high-risk borrowers who require a subsidy and fewer low-risk  borrowers to provide that subsidy. FHA has proposed risk-based pricing as  a solution to the adverse selection problem.
As of May 2007, FHA’s risk-based pricing proposal established six different  risk categories, each with a different premium rate, for purchase and  refinance loans. FHA used data from its most recent actuarial review to  establish the six risk categories and corresponding premiums based on the  relative performance of loans with various combinations of loan-to-value  (LTV) ratio (loan amount divided by sales price or appraised value) and  credit score. Borrowers in categories with higher expected lifetime claim  rates would have higher premiums than those in categories with lower  claim rates. If FHA were granted the authority to implement its risk-based  pricing proposal, the agency would publish a pricing matrix that would  allow borrowers to identify their likely premiums based on their credit  scores and LTV ratios. However, FHA would use its TOTAL mortgage  scorecard to make the final determination of a borrower’s placement in a  particular risk category. Because TOTAL takes into account more  borrower and loan characteristics than LTV ratio and credit score (such as  borrower reserves and payment-to-income ratio), a borrower’s TOTAL  score could indicate that a borrower belongs in a higher risk category than  would be suggested by LTV ratio and credit score alone.
Our analysis of how the proposed pricing structure would affect home  purchase borrowers similar to those insured by FHA in 2005 found that  approximately 43 percent of borrowers would have paid the same or less  while 37 percent would have paid more. Twenty percent would not have  qualified for FHA insurance had the risk-based pricing proposal been in  effect. As shown in figure 2, risk-based pricing would have had a similar  impact on first-time and low-income homebuyers FHA served in 2005.
Risk-based pricing also would affect the availability of FHA insurance for  some borrowers. Approximately 20 percent of FHA’s 2005 borrowers  would not have qualified for FHA mortgage insurance under the  parameters of the risk-based pricing proposal we evaluated. FHA  determined that the expected claim rates of these borrowers were higher  than it found tolerable for either the borrower or the Mutual Mortgage  Insurance Fund. Those borrowers who would not have qualified had high  LTV ratios and low credit scores. Their average credit score was 584, and  their expected lifetime claim rates are more than 2.5 times higher than the  average claim rate of all FHA loans. FHA officials stated that setting risk- based premiums for potential future FHA borrowers with similar  characteristics would require prices higher than borrowers might be able  to afford.
section_title: Legislative Proposals Likely Would Have a Beneficial Budgetary Impact
paragraphs: According to FHA’s estimates, the three major legislative proposals would  have a beneficial impact on HUD’s budget due to higher estimated  negative subsidies. According to the President’s fiscal year 2008 budget,  the credit subsidy rate for the Mutual Mortgage Insurance Fund would be  more favorable if the legislative proposals were enacted. Absent any  program changes, FHA estimates that the fund would require an  appropriation of approximately $143 million. If the legislative proposals  were not enacted, FHA would consider raising premiums to avoid the need  for appropriations. If the major legislative proposals were passed, FHA  estimates that the fund would generate $342 million in negative subsidies.
FHA’s subsidy estimates for fiscal year 2008 should be viewed with  caution given that FHA has generally underestimated the subsidy costs for  the Mutual Mortgage Insurance Fund. To meet federal requirements, FHA  annually reestimates subsidy costs for each loan cohort dating back to  fiscal year 1992. The current reestimated subsidy costs for all except the  fiscal year 1992 and 1993 cohorts are higher than the original estimates.  For example, the current reestimated cost for the fiscal year 2006 cohort is  about $800 million higher than originally estimated. As discussed below,  FHA has taken some steps to improve its subsidy estimates.
section_title: FHA Has Enhanced Tools and Resources Important to Implementing Single- Family Proposals but Does Not Intend to Mitigate Risks by Piloting New Products
paragraphs: FHA has planned or taken steps to enhance the tools and resources that  would be important to implementing the legislative proposals for its  single-family insurance program. For example, we found that:    FHA has improved the loan performance models it would use to  implement risk-based pricing by adding factors that have been found to  influence credit risk. In a September 2005 report, we recommended that  FHA study and report the impact (on the forecasting ability of its loan  performance models) of variables that have been found in other studies to  influence credit risk, such as payment-to-income ratios, credit scores, and  the presence of down-payment assistance. In response, HUD’s contractor  subsequently incorporated the source of down-payment assistance in the  fiscal year 2005 actuarial review and borrower credit scores in the fiscal  year 2006 review.
FHA is in the process of addressing a number of limitations in its mortgage  scorecard that could reduce its effectiveness for risk-based pricing. For  instance, as we reported in April 2006, the scorecard does not include a  number of important variables included in other mortgage institutions’  scorecards, such as the source of the down payment, whether the loan is  an adjustable-rate mortgage, and property type. An FHA contractor is  helping the agency test additional variables to include in the scorecard and  is scheduled to issue a final report on its work in August 2007.
FHA has identified changes in information systems needed to implement  the legislative proposals and has obligated or requested a total of $11  million for this purpose.
To address human capital needs, the President’s fiscal year 2008 budget  requests 21 additional staff for FHA to help analyze industry trends, align  the agency’s business processes with current mortgage industry practices,  and promote new FHA products.
Although FHA has taken actions to enhance key tools and resources, the  legislative proposals would introduce new risks. Our past work has shown  that FHA has not always utilized risk-management practices used by other  mortgage institutions. For example, we reported in November 2005 that  HUD needed to take additional actions to manage risks related to the  approximately one-third of its loans with down-payment assistance from  seller-funded nonprofits. Unlike other mortgage industry participants,  FHA does not restrict homebuyers’ use of such assistance. Our 2005  analysis found that the probability that these loans would result in an  insurance claim was 76 percent higher than for comparable loans without  such assistance, and we recommended that FHA revise its underwriting  standards to consider such assistance as a seller contribution (which  cannot be used to meet the borrower contribution requirement). Despite  the detrimental impact of these loans on the Mutual Mortgage Insurance  Fund, FHA did not act promptly to mitigate the problem by adjusting  underwriting standards or using its existing authority to raise premiums.  However, in May 2007, FHA published a proposed rule that would prohibit  seller-funded down-payment assistance.
While FHA plans to take some steps, such as instituting stricter  underwriting standards, to mitigate the risks associated with lowering  down-payment requirements, it does not plan to pilot any zero-down- payment product the agency is authorized to offer. The proposal to lower  down-payment requirements is of particular concern given the greater  default risk of low-down-payment loans, housing market conditions that  could put borrowers with such loans in a negative equity position, and the  difficulty of setting prices for new products whose risks may not be well  understood. As we reported in February 2005, other mortgage institutions  limit the availability of or pilot new products to manage risks associated  with changing or expanding product lines. We indicated that, if Congress  authorizes FHA to insure new products, it should consider a number of  means, including limiting their initial availability, to mitigate the additional  risks these loans may pose. We also recommended that FHA consider  similar steps for any new or revised products.
section_title: FHA Has Not Assessed the Effects of Proposed Changes to Its Manufactured Home Loan Program
paragraphs: Now I will make some preliminary observations based on our ongoing  work for you and Senators Reed and Schumer on FHA’s Manufactured  Home Loan program. Our objectives are to (1) describe selected  characteristics of manufactured housing and the demographics of the  owners, (2) compare federal and state consumer and tenant protections  for owners of manufactured homes, and (3) describe the proposed  changes to the Manufactured Home Loan program and assess potential  benefits and costs to borrowers and the federal government.
Currently, this is the only active federal loan program that includes an  option for a “home-only” product; that is, a personal property loan for the  purchase of a manufactured home without the land on which the home  will be located. Available data on selected characteristics of manufactured  homes and their owners in 2005 indicate that manufactured homes can be  an affordable housing option, with monthly housing costs considerably  lower than other housing types. In addition, we found most manufactured  homes were located in rural areas and more were located in Southern  states than in other regions. Further, owners of manufactured homes have  more consumer protections if homes are considered real rather than  personal property, but the laws in the eight states we visited provide  varying protections.
Legislative proposals for the Manufactured Home Loan program would  increase loan limits, insure each loan made, incorporate stricter  underwriting requirements, establish up-front insurance premiums, and  adjust the annual premium. For instance, limits for a home-only loan   would rise from $48,600 to $69,678, loan guarantees would apply to  individual loans rather than be capped at 10 percent of the value of a  lender’s portfolio, and underwriting requirements would be revised with  the stated intent of strengthening the financial soundness of the program.
According to FHA and some industry officials, the potential benefits of  proposed changes for borrowers include obtaining loan amounts sufficient  to buy larger homes, additional financing with lower interest rates as more  lenders would likely participate in a program where a greater portion of  their portfolios could be insured, and an expansion of the secondary  market that could provide more liquidity for lenders to make more loans.
According to FHA and CBO, the potential costs of the proposed changes  could involve an expansion of the government’s liability under the  program because FHA would be insuring individual loans rather than a  limited portion of a lender’s portfolio. Additionally, industry officials  identified risk factors unique to manufactured housing that affect loan  performance, which in turn could affect claims to FHA’s General  Insurance Fund. For instance, the ability of the owner of a manufactured  home to build equity may be limited when the land is leased, which also  often increases the risks associated with the loan. If a borrower with a  home on leased land were to default, lenders could face higher costs and  lower recoveries (relative to site-built homes) in trying to repossess, move,  and resell the personal property.
To gain an understanding of the effects of the proposed changes, we  developed a model with various scenarios based on the experience of FHA  loans and loan performance data from manufactured home lenders.  Although risk factors unique to manufactured home lending (such as  placement on leased land) as well as commonly used predictors of loan  performance (such as credit scores) are associated with default risk, these  data were not available. Instead, we presented low, medium, and high  levels of borrower default risk and incorporated other factors (such as  premiums and lender recovery) to illustrate how variations in these key  factors affect potential gains and losses to FHA’s General Insurance Fund.  The preliminary results of our analysis show that in all cases when  borrowers had medium or high default risk, the fund experienced a loss.
While our scenario analysis offers a very general illustration of how the  proposed changes could affect the General Insurance Fund, the effects of  the proposed changes are unclear because FHA has not articulated which  borrowers would be targeted if the program were expanded, specified  changes in its underwriting requirements, developed a risk-based pricing  structure for the proposed legislation, or estimated costs to the General  Insurance Fund. Our internal control standards for federal agencies  require that an agency identify risks that may be posed by new  legislation. FHA has stated that it has not yet made these risk  assessments because the legislation has not yet passed and that they chose  to focus their resources on the much larger single-family insurance  program. As a result, FHA has yet to determine the effects the proposed  legislation may have on the volume of lending and claims and the overall  financial soundness of the program.
Mr. Chairman, this concludes my prepared statement. I would be happy to  answer any questions at this time.
section_title: Contacts and Acknowledgments
paragraphs: For further information on this testimony, please contact William B. Shear  at (202) 512-8678 or shearw@gao.gov. Individuals making key  contributions to this testimony included Triana Bash, Andy Finkel, Nadine  Garrick, Tina Paek, Barbara Roesmann, Paige Smith, and Steve Westley.
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