Residential Care Facilities Mortgage Insurance Program: Opportunities to Improve Program and Risk Management
Published: 2006-05-24T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Through its Section 232 program, the Department of Housing and Urban Development's (HUD) Federal Housing Administration (FHA) insures approximately $12.5 billion in mortgages for residential care facilities. In response to a requirement in the 2005 Consolidated Appropriations Conference Report and a congressional request, GAO examined (1) HUD's management of the program, including loan underwriting and monitoring; (2) the extent to which HUD's oversight of insured facilities is coordinated with the states' oversight of quality of care; (3) the financial risks the program poses to HUD's General Insurance/Special Risk Insurance (GI/SRI) Fund; and (4) how HUD estimates the annual credit subsidy cost for the program.
section_title: What GAO Found
paragraphs: While HUD's decentralized program management allows its 51 field offices flexibility in their specific practices, GAO found differences in the extent to which staff in the five field offices it visited were aware of current program requirements. For example, four offices were unaware of required addendums to the programs' standard regulatory agreement. Further, while individual offices had developed useful practices for loan underwriting and monitoring, they lacked a mechanism for systematically sharing such practices with other offices. Also, field office officials were concerned about adequate current or future levels of staff expertise--a critical factor in managing program risk in that health care facility loans are complicated and require specialized knowledge and expertise. FHA requires a review of the most recent annual state-administered inspection report for state-licensed facilities applying for program insurance, and recommends, but does not require, continued monitoring of such reports for facilities once it has insured them. Four of the five HUD field offices GAO visited do not routinely collect annual inspection reports for their insured facilities. While the reports are but one of several monitoring tools, they provide potential indicators of future financial risk. HUD has proposed revising its standard regulatory agreements to require insured facility owners or operators to submit annual inspection reports and to report notices of violations. However, the proposed revisions have been awaiting approval since August 2004, and the implementation date is uncertain. The Section 232 program accounts for only about 16 percent of the GI/SRI Fund's total unpaid principal balance, but program and industry trends pose potential risks to the Section 232 program and to the GI/SRI Fund. For example, in recent years the program has insured increasing numbers of assisted living facility loans and refinancing loans, for which there are limited data available to assess long-term performance. Other potential risk factors include increasing prepayments (full repayment before loan maturity) and loan concentration in several large markets and among relatively few lenders. Projected shifts in demand for residential care facilities could affect currently insured facilities and the overall market for the types of facilities that HUD insures under the program. To estimate the program subsidy cost, HUD uses a model to project cash flows for each loan cohort (the loans originated in a given fiscal year) over its entire life. HUD's model does not explicitly or fully consider certain factors, such as loan prepayment penalties, interest rate changes, or differences in loans to different types of facilities, and uses some proxy data that is not comparable to Section 232 loans. The model's exclusion of potentially relevant factors and it use of this proxy data could affect the reliability of HUD's credit subsidy estimates.

section_title: Letter
paragraphs: Through its Section 232 Mortgage Insurance for Residential Care Facilities  program (Section 232 program), the Department of Housing and Urban  Development’s (HUD) Federal Housing Administration (FHA) insures  mortgages for nursing homes, assisted living facilities, board and care  homes, and intermediate care facilities. As of December 31, 2005, the  program insured mortgages with an unpaid principal balance of  approximately $12.5 billion. The program insures HUD-approved private  lenders against financial losses from loan defaults; insured loans can be  used to finance the purchase, construction, or rehabilitation of a facility,  enable borrowers to refinance projects that do not need substantial  rehabilitation, or to install fire safety equipment.
For budget and accounting purposes, the Section 232 program is part of  HUD’s General Insurance/Special Risk Insurance (GI/SRI) Fund; other  programs in the GI/SRI Fund provide mortgage insurance for various types  of multifamily housing projects and for hospitals. HUD is required to  annually estimate the subsidy cost, or the cost to the federal government of  guaranteeing credit to residential care facilities over the life of the loans.  This estimate requires FHA to forecast future cash flows associated with  the loans, which can be influenced by factors that are associated with the  potential risks facing the program’s loan portfolio.
While private lenders may finance the purchase or construction of nursing  homes, public funding, including Medicare and Medicaid, has accounted  for an increasing percentage of spending on nursing home care. For  example, in 2000 Medicare and Medicaid financed 39 percent of the nation’s  spending on nursing home care, up 28 percent from 1990. In 2004,  Medicare accounted for 14 percent and Medicaid accounted for 44 percent  of the nation’s spending on nursing home care, and the total of all public  funds, including Medicare and Medicaid, accounted for approximately 61  percent. Federal and state governments share responsibility for oversight  of nursing homes that participate in the Medicare and Medicaid programs.  The U.S. Department of Health and Human Services defines standards that  nursing homes must meet to participate in the Medicare and Medicaid  programs and contracts with states to conduct annual inspections.  Generally, states license nursing homes (and in some cases related  facilities) and oversee their operations through inspections.
The 2005 Consolidated Appropriations Conference Report mandated that  we review the design and management of two FHA mortgage insurance  programs —those for the Section 232 program and the Section 242 Hospital  Mortgage Insurance program. In addition, the Ranking Member of the  Subcommittee on Housing and Transportation, Senate Committee on  Banking, and others requested that we review several aspects of the  Section 232 program. Accordingly, this report provides both the results of  the mandated review and our response to the request. Specifically, we  examined: (1) HUD’s management of the program, including loan  underwriting and monitoring; (2) the extent to which HUD’s oversight of  insured residential care facilities is coordinated with the states’ oversight  of the quality of care provided by those facilities that are subject to state  licensing or inspection; (3) the financial implications of the program to the  GI/SRI Fund, including risk posed by program and market trends; and (4)  how HUD estimates the annual credit subsidy for the program, including  the factors and assumptions used. In addition, we examined HUD’s action  in response to a HUD Inspector General report that concluded that HUD’s  Office of Housing did not have adequate controls to effectively manage the  Section 232 program; this information is summarized in appendix III.
To address these objectives, we reviewed program manuals and  documentation of loan processing procedures and underwriting  requirements and analyzed program financial data that we tested and found  reliable for our purposes. In examining HUD’s management of the  program, we focused on how underwriting and loan monitoring activities  were carried out through visits to five of HUD’s field offices (Atlanta,  Georgia; Buffalo, New York; Chicago, Illinois; Los Angeles, California; and  San Francisco, California), where we interviewed program officials and  obtained relevant documents in each office. We also reviewed  documentation of the model HUD uses to estimate program subsidy costs,  applicable program laws, regulations, and policy statements. We obtained  relevant program documentation and interviewed headquarters officials in  HUD’s Office of Multifamily Development and Office of Asset Management  and HUD’s Office of Evaluation and Office of Inspector General. We also  interviewed representatives of residential care associations; lenders with  loans insured by the program, as well as other private lenders that offer  non-FHA-insured residential care loans; and representatives of nursing  homes and assisted living facilities. Our review did not include an  evaluation of the need for the Section 232 program. See appendix I for  more detailed information on our objectives, scope, and methodology.
We conducted our work in Washington, D.C., and the HUD field office  locations noted above between February 2005 and April 2006 in accordance  with generally accepted government auditing standards.
subsections: section_title: Background
paragraphs: Section 232 of the National Housing Act, as amended, authorizes FHA to  insure mortgages made by private lenders to finance the construction or  renovation of nursing homes, intermediate care facilities, board and care  homes, and assisted living facilities. Congress established the Section 232  program in 1959 to provide mortgage insurance for the construction and  rehabilitation of nursing homes. The Housing and Community  Development Act of 1987 expanded the program to allow for the insuring of  refinancing or purchase of FHA-insured facilities and, in 1994, HUD issued  regulations implementing legislation to expand the program to allow for  the insuring of assisted living facilities and the refinancing of loans for  facilities not previously insured by FHA. Since 1960, FHA has insured 4,372  loans through the Section 232 program in all 50 states, the District of  Columbia, the U.S. Virgin Islands, and Puerto Rico. As of the end of fiscal  year 2005, there were 2,054 currently insured loans.
FHA does not insure all residential care facilities, as there are  approximately 16,500 nursing home facilities and over 36,000 assisted living  facilities in operation. We did not identify any private mortgage insurance  that is currently available for loans made to nursing homes or other similar  facilities. According to HUD officials, in recent times, the Section 232  program exists, in part, to support the market for residential care facilities  when the private market is reluctant to finance such projects due to market  conditions. The loans are advantageous to borrowers because they are  nonrecourse loans whereby the lender (in this case the lender and the  insurer, FHA) has no claim against the borrower in the event of default and  can only recover the property. The loans are also generally long term (in  some cases up to 40 years) and, according to HUD and lender officials,  offer an interest rate that is, in many cases, lower than what private lenders  offer for non-FHA insured loans made to nursing homes and other similar  facilities. Additionally, FHA insures 99 percent of the unpaid principal  balance plus accrued interest.
HUD administers the Section 232 program through its field offices, with  HUD headquarters oversight. HUD’s field structure consists of 18 Hub  offices and 33 program centers. Generally, each Hub office has a number of  program centers that report to it. Program centers administer multifamily  programs within the states in which they are located or portions thereof.  Hub offices also administer multifamily programs, as well as augment the  operations of and coordinate workload between their program centers.
Under Medicaid, states set their own nursing home payment rates  (reimbursement rates), and the federal government provides funds to  match states’ share of spending as determined by a federal formula. Within  broad federal guidelines, states have considerable flexibility to set  reimbursement rates for nursing homes that participate in Medicaid but are  required to ensure that payments are consistent with efficiency, economy,  and quality of care. Under Medicare, skilled nursing facilities receive a  federal per diem payment that reflects the resident’s care needs and is  adjusted for geographic differences in costs.
section_title: HUD’s Decentralized Management Provides Field Offices Flexibility, but Varying Awareness of Underwriting and Monitoring Practices and Concerns Over Insufficient Staff Expertise Increase Program’s Potential Risks
paragraphs: While the decentralization of the program allows field offices some  flexibility in their specific practices, the results of our visits to five field  offices revealed differences in the extent to which field office staff were  aware of current program requirements. Further, while individual offices  had developed useful practices for implementing the program’s loan  underwriting and monitoring requirements, they lack a mechanism for  systematically sharing practices with other offices. We also found that field  office officials were concerned about adequate current or future levels of  staff expertise—a critical factor in avoiding unwarranted risk in the Section  232 program, in that health care facility loans are generally more  complicated and require specialized expertise compared with loans insured  under HUD’s other multifamily programs. Lack of awareness of current  requirements and insufficient staff expertise can contribute to insuring  loans with increased risks. Both factors are related to recommendations  made in the HUD Office of Inspector General’s 2002 report that HUD has  not fully addressed (see app. III for further information on weaknesses  identified by HUD’s Inspector General).
subsections: section_title: Some Field Offices Were Not Aware of All Current Program Requirements
paragraphs: FHA has numerous underwriting requirements for loans insured under the  Section 232 program; for example, facilities must provide evidence of  market need; a (real estate) appraisal; and be in compliance with limits on  loan-to-value and debt service coverage ratios. FHA also requires a variety  of reviews for monitoring Section 232 loans. (Loan underwriting and  monitoring requirements, which can involve fairly complex reviews and  analyses, are described in more detail in app. II.)
According to HUD headquarters officials, the field offices that administer  the Section 232 program are required to follow all program statutes and  regulations, but the decentralization of the program allows field offices  some flexibility in their specific practices. For example, individual field  offices can designate how to staff the underwriting and monitoring of  Section 232 loans, depending on such factors as loan volume relative to  other multifamily programs, to fully utilize resources. HUD headquarters  provides guidance on program policies and requirements; when necessary,  reviews applications for certain types of loans, such as those submitted by  nonprofit entities; and provides technical assistance or additional guidance  and support if contacted by field offices. HUD headquarters staff also  conduct Quality Management Reviews, which are management reviews of  field offices administering HUD programs and services. For these reviews,  evaluators visit offices and coordinate subsequent reports. The process  also involves reporting the status of follow-up corrective actions. While not  focused on the Section 232 program, this process helps to oversee the  program by reviewing the management of the field offices that administer  it.
We found that the five field offices that we visited varied in their  understanding and awareness of policies related to the Section 232  program. For example, staff in two field offices said that their standard  regulatory agreement (that serves as the basic insurance contract and  spells out the respective obligations of FHA, the lender, and the borrower)  did not include language that would require operators of insured facilities  to submit financial statements on new loans. According to officials at  HUD headquarters, field offices should be using language requiring these  financial statements. HUD and most lender officials we interviewed told us  that operator financial statements provide information on the legal entity  operating the facility in cases where the borrower and the operator of the  residential care facility are different entities. These officials also stated  that, in such situations, borrower financial statements may not disclose  expenses, income, and other financial information, and may only show the  transactions between the borrower and operator, thus making operator  financial statements a necessity. Also, HUD’s Inspector General identified  HUD’s lack of a requirement for operators to submit financial statements  electronically to be part of an internal control weakness for the Section 232  program.
Additionally, we found that the field offices that we visited were not always  aware of specific notices that established new requirements or processes  for the Section 232 program. For example:  Four of the five field offices that we visited were not aware of a notice  that disqualifies potential Section 232 borrowers if they have had a  bankruptcy in their past. According to a HUD headquarters officials, this  policy is intended to protect HUD from insuring a potentially risky loan  based on a borrower’s financial history.
Officials at four of the five field offices we visited did not know about  required addendums to the regulatory agreement regarding state  licensing requirements for nursing homes. HUD developed these  addendums to place a lien on a property’s operational documents, such  as a Certificate of Need and state licenses, to prevent operators from  taking these documents with them upon termination of a property’s  lease. Without these documents, a facility may not be able to operate  and, consequently, the property’s value would be greatly diminished.
According to HUD headquarters officials, HUD headquarters  communicates changes in the Section 232 program’s policies and  procedures to field offices in a variety of ways besides sending formal  notices. For example, HUD headquarters also posts some notices on a  “frequently-asked questions” section of a Web site available to field offices,  lenders, attorneys, and others. HUD headquarters officials also conduct  nationwide conference calls with the field offices in which various HUD  multifamily programs, including the Section 232 program, are discussed.  The conference calls are conducted separately for loan development staff  and asset management staff that work, respectively, on the underwriting  and monitoring of loans. HUD headquarters officials stated that these  conference calls provide a forum to disseminate information to the field  offices and for individual field offices to discuss any issues, questions, or  concerns regarding any multifamily programs, including the Section 232  program.
HUD headquarters officials stated that they plan to address the lack of  awareness we observed by updating the “Multifamily Asset Management  and Project Servicing Handbook” to clarify current policies and  requirements for the Section 232 program. HUD is also planning to update  the handbook to address the 2002 HUD Inspector General report that  identified that HUD's current handbook was not specific to Section 232  nursing home operations. However, HUD officials told us the updates to the  handbook would not be completed until the proposed revisions to the  applicable regulatory agreements have been approved. The proposed  revisions have been awaiting approval since August 2004, and it is not clear  when the revised agreements will be approved.
section_title: Field Offices Do Not Systematically Share Information on Practices
paragraphs: As discussed earlier, field offices have some flexibility in practices that  they use in administering the Section 232 program. In our visits to five field  offices, we found a variety of practices that could be useful in the  underwriting and monitoring of Section 232 loans if shared with other field  offices. However, currently, HUD does not have systematic means by which  to share this information among field offices.
Officials in two of the five field offices we visited identified specific  practices they had developed to carry out loan underwriting requirements.  For example:  Asset management staff, whose focus is monitoring the performance of  loans that are already insured, are asked to review a variety of  documents submitted in the underwriting process, such as financial  statements and information on the occupancy of the facility.
In one of the offices, staff members may contact relevant state officials,  just before the closing of a loan, to verify that the state has not identified  any quality of care deficiencies since the facility submitted the  application for mortgage insurance.
Officials in one office stated that they conduct an additional review  before approving a loan application for mortgage insurance to ensure  that all required steps, such as mortgage credit analysis and valuation,  have been properly performed.
According to the officials in these two offices, it is necessary to take these  additional steps in order to adequately underwrite a loan under this  program. They stated that the additional steps result in the better screening  of loan risk and could result in the rejection of a risky loan they might  otherwise approve.
We found a similar variety of practices in the monitoring of Section 232  loans. In some cases, field offices we visited had taken additional steps  beyond those required by HUD. For example:  While HUD requires a review of the annual financial statements of  insured facilities, two field offices that we visited require monthly  financial accounting reports from facilities either for the first year of the  loan or until the facility has reached stable occupancy.
Two field offices had developed their own specialized checklists for  monitoring Section 232 loans. These checklists were specifically  designed for the oversight of residential care facility loans and included  items such as the facility’s replacement reserve accounts and  professional liability insurance, among other items.
One of the offices had established a Section 232 working group, where  underwriting and asset management staff met periodically to discuss  loans in the portfolio and issues related to the overall management of  the program in the field office. Additionally, three of the five field offices  we visited had specialized staff with expertise in overseeing residential  care facility loans. These were asset management staff whose primary  or sole responsibility was oversight of the Section 232 portfolio.
While HUD headquarters officials stated that they do not require  management reviews of Section 232 facilities, three of the five field  offices we visited conducted management reviews on some part of their  Section 232 portfolios.
One field office obtained the state annual inspection reports on its  Section 232 facilities on a regular basis.
According to officials in these offices, the unique characteristics associated  with residential care facilities make the additional measures necessary.
Officials in field offices we visited that had developed these specific  practices stated that the practices result in better underwriting and  monitoring of loans and could potentially help to prevent claims. However,  HUD field offices do not have a systematic means by which to share  information with other field offices about practices they have developed.  While field office officials can raise concerns and issues through  conference calls with HUD headquarters officials, most explained that  these conference calls are not particularly designed for field offices to  share practices with other field offices. Officials in the five field offices that  we visited told us that they occasionally contact their counterparts in other  field offices regarding loan processing or asset management questions or  issues. Additionally, officials in some field offices said that they  occasionally see their counterparts at regional lender conferences.  However, aside from these forms of contact, there was no systematic  method by which to learn about other field office practices. Consequently,  officials in one field office are likely to be unaware of additional steps or  practices taken by another field office that are intended to help officials  improve underwriting or monitoring of Section 232 loans. Officials at all  field offices that we visited told us that they could benefit from the sharing  of such practices regarding underwriting and monitoring procedures  established by different offices.
section_title: Officials Cited Concerns about Adequate Levels of Staff Expertise
paragraphs: Officials in two of the five field offices stated that a lack of expertise on  residential care facility loans, either in underwriting or loan oversight, is a  current concern in their office. They specifically noted a lack of expertise  in residential care facilities and their overall management. Officials in all of  the field offices that we visited stated that additional training on Section  232 loans would be beneficial to provide more knowledge and expertise, as  there has been very little Section 232-specific training. In its 2002 report,  HUD’s Office of Inspector General also identified that field office project  managers did not have sufficient training on reviewing Section 232 loans  and dealing with the issues unique to Section 232 properties.
All of the private lenders we interviewed—those that offer non-FHA  insured loans to residential care facilities and face similar risks to FHA— had a specialized group that conducted the underwriting of these loans. All  of the individuals that conducted the underwriting of these loans were part  of a health care lending unit that focused exclusively on loans made to  health care facilities. According to the lenders, they believed it was  necessary to have specialized staff underwriting such loans due to the  unique nature of lending money to a facility that was designed for a  residential health care business. Additionally, almost all of the private  lenders we interviewed had specialized staff that monitored their  residential care facility loans. According to lender staff we interviewed,  nursing home and assisted living facility loans require an understanding of  the market, trends, expenses, income, and other such unique  characteristics associated with these types of facilities.
While officials in only two of the five offices expressed concern about the  expertise of current staff, officials in all field offices we visited stated that  they are concerned about the ability to adequately staff the Section 232  program in the next 5 years. They stated that as older staff retire in the next  5 years or so, any expertise that such staff currently have will take time to  replace. All of the field offices that we visited staffed the underwriting  process for Section 232 loans similar to that of other multifamily programs,  based on workload and staff resources. However, while two field offices  assigned their Section 232 properties, along with other multifamily  properties, to general asset management staff for oversight, three field  offices designated specific staff to oversee Section 232 properties. This was  due to the latter field office officials’ belief, similar to that of the private  lenders we interviewed, that the properties require a certain level of  knowledge and expertise associated with residential care facilities.  Expertise in Section 232 loans allows for a better understanding of the  distinct issues associated with oversight of residential care facilities. In one  of the offices that had general asset management staff overseeing the  portfolio, eight project managers shared responsibility for monitoring  Section 232 properties in conjunction with other multifamily program  properties. In contrast, in one of the offices with staff designated  specifically for the Section 232 program, one member of the asset  management staff was responsible for the entire Section 232 portfolio.  Officials from the two field offices that have experienced staff specialized  in monitoring Section 232 loans stated that they are concerned about losing  their specialized staff over time and acknowledged that they will need to  find replacements in order to continue to adequately monitor Section 232  loans. Their concern stems in part from the fact that Section 232 facilities,  unlike other multifamily properties, require specialized knowledge and an  understanding of the marketing, trends, and revenue streams associated  with residential care facilities.
According to officials in all of the field offices that we visited, monitoring of  Section 232 loans, when compared with other FHA-insured multifamily  programs, requires additional measures. Section 232 loans contain a  complex business component—the actual assisted living service or the  nursing service operating in a facility—making them different from other  multifamily programs that are solely realty loans. Consequently, for Section  232 loans, field office officials monitor the financial health of the business,  including expenses, income, and other such items. Some field office  officials also stated that it is important to monitor the operator to ensure  that the facility is adequately managed. Additionally, some field office  officials stated that to ensure the facility is generating enough income, they  have to monitor Medicare and Medicaid reimbursement rates, as well as  occupancy rates.
According to HUD headquarters officials, as part of its overall strategic  human capital efforts, HUD is currently assessing the loss of human capital  in field offices over time. However, this effort is not focused on the Section  232 program specifically but is intended to examine general human capital  issues and needs.
section_title: FHA’s Coordination with States’ Oversight of Quality of Care for Section 232 Residential Care Facilities Is Limited
paragraphs: FHA requires field office officials, when processing applications for  Section 232 mortgage insurance from existing state-licensed facilities to  review the most recent annual state-administered inspection report for the  facilities, but does not require the continued monitoring of annual  inspection reports for state-licensed facilities once it has insured them.  Four of the five HUD field offices we visited do not routinely collect annual  inspection reports for the insured facilities they oversee. While such  reports are but one of several means of monitoring insured properties,  FHA’s limited use of them may lead the agency to overlook potential  indicators of risk for some of its insured loans.
subsections: section_title: FHA Requires Some Coordination with States’ Oversight of Quality of Care for Section 232 Residential Care Facilities
paragraphs: State inspections or surveys of residential care facilities may stem from  state licensing requirements or the facilities’ participation in Medicare or  Medicaid. Nursing homes are state licensed, while states vary in their  licensing requirements for assisted living facilities. The Department of  Health and Human Services’ Centers for Medicare & Medicaid Services  requires that nursing homes receiving Medicare and Medicaid funding be  federally certified, and all certified facilities are subject to annual federal  inspections administered by the states. State survey agencies, under  agreements between the states and the Secretary of Health and Human  Services, conduct the annual federally required inspections. To complete  the annual inspections, teams of state surveyors visit Medicare and  Medicaid participating facilities and assess compliance with federal facility  requirements, particularly whether care and services provided meet the  assessed needs of the residents. These teams also assess the quality of care  provided to residents of the facilities, looking at indicators such as  preventing avoidable pressure sores, weight loss, or accidents. Overall,  annual inspections provide a regular review of quality of care by officials  with relevant backgrounds, such as, registered nurses, social workers,  dieticians, and other specialists. For facilities that are applying for  mortgage insurance under the Section 232 program, FHA requires a copy of  the state license needed to operate the facility and a copy of the latest state  annual inspection report on the facilities’ operation.
HUD’s “Multifamily Asset Management and Servicing Handbook”  recommends that, once nursing home loans are insured under the program,  HUD officials responsible for loan monitoring continue to review state  annual inspection reports if they do not undertake management reviews of  the facility. Management reviews focus on an insured facility’s financial  indicators and general management practices, but, particularly if  conducted on-site, could provide some information on issues related to the  quality of care at a facility. Because of their wider scope, however,  management reviews would not likely go into the same depth on quality of  care issues as annual inspections. HUD headquarters officials told us that  the handbook’s recommendation applies to all Section 232 facilities;  further, HUD headquarters officials stated that management reviews for  Section 232 properties should be conducted based on need and available  resources. We found that two of five field offices we visited did not  regularly conduct any regular management reviews and did not review  annual inspection reports during loan monitoring. Of the three field offices  that did conduct management reviews on some Section 232 properties, one  also reviewed annual inspection reports during loan monitoring.  Additionally, the offices that did not review annual inspection reports had  little direct interaction with the state agencies. Private lenders overseeing  non-FHA insured residential care facilities told us that they regularly  conduct various levels of management reviews and review annual  inspection reports on a consistent basis.
FHA has emphasized the importance of ongoing coordination with state  oversight agencies in its proposed revisions to its regulatory agreements,  which require owners or operators of insured facilities to report any state  or federal violations to FHA. HUD’s proposed revisions to the regulatory  agreements also include a requirement that the owner or operator provide  HUD with copies of annual inspection reports that can be used as part of  loan monitoring. However, the proposed revisions to the regulatory  agreements have yet to be approved.
section_title: FHA’s Limited Coordination with States on Oversight Issues May Lead to Missed Identification of Risk Indicators
paragraphs: Serious quality of care deficiencies can have a variety of implications that  affect cash flow streams, ranging from a related reduction in occupancy to  the potential for civil money penalties and loss of licensing and  reimbursements. Consequently, quality of care concerns can ultimately  affect a facility’s financial condition. For many Section 232 properties, in  particular nursing homes, state oversight of quality of care helps to  determine whether a facility is licensed and eligible to receive Medicaid  and Medicare reimbursements. This is particularly important to the Section  232 program because, as noted earlier in this report, Medicaid and  Medicare reimbursements typically account for a significant portion of  nursing home income.
Federal or state annual inspection reports, to the extent that they are  available for facilities, provide regular evaluations of nursing homes and  other residential care facilities. As discussed earlier, annual inspections  provide a review of quality of care by officials with relevant backgrounds.  In a 2005 report, we found inconsistencies across states in conducting  surveys and state surveyors understating serious deficiencies in quality of  care. Nonetheless, annual inspection reports serve as an important  indicator of a property’s risk related to problems with the quality of care to  residents.
Annual inspection reports, coupled with other information such as facility  staffing profiles, resident turnover, and data from financial statements,  could assist HUD’s field offices in overseeing loan performance.  Additionally, reviewing facilities’ quality of care records over time, as well  as any corrective action plans needed to come into compliance with state  and federal quality of care requirements could further the field offices’  ability to identify loan performance risks. The reports may also prompt  HUD field office officials to communicate with federal or state nursing  home regulatory agencies for further information on facilities that appear  to be high risk. These agencies may have available information on civil  money penalties and sanctions, which serve as additional indicators of  quality of care risk. Private lenders we spoke with acknowledged that  annual inspection reports provided insight into the management of a  facility and coupled with other information could help to assess financial  risk.
section_title: Program and Industry Trends Show Sources of Potential Risks to the GI/SRI Fund
paragraphs: The Section 232 program represents a relatively small share of the broader  GI/ SRI Fund. However, program and industry trends show sources of  potential risks that could affect the future performance of the Section 232  portfolio and the GI/SRI Fund. FHA uses a number of tools to mitigate risk  to the program and to the fund.
subsections: section_title: The Section 232 Program Represents a Small Percentage of the GI/SRI Fund
paragraphs: The Section 232 program is a relatively small share of the total GI/SRI  Fund. HUD estimated that the program would represent only about 5.3  percent of the fund’s fiscal year 2006 commitment authority. Similarly, the  Section 232 program represents a little less than 16 percent or a little more  than $12.5 billion of the nearly $80 billion in unpaid principle balance in the  GI/SRI Fund (see fig. 1). Despite its small size, a significant worsening in  the performance of the Section 232 program could negatively affect the  performance of the GI/SRI Fund. The extent, though, of the impact on the  overall performance of the GI/SRI Fund would depend upon numerous  factors including changes in the size and performance of the other  programs in the fund.
section_title: Program Trends Show Sources of Potential Risk
paragraphs: As discussed below, several trends exist within the Section 232 program  that pose potential risks to the Section 232 portfolio and, therefore, to the  GI/SRI Fund.
subsections: section_title: Higher Claim Rates for Recent Loan Cohorts
paragraphs: To identify potential trends in loan performance, we analyzed 5- and 10- year claim rates for Section 232 loans based on data that spanned from  fiscal year 1960 through the end of fiscal year 2005, for the entire portfolio,  as well as by type of loan purpose and type of insured facility. The analysis  of the entire portfolio showed that the 10-year claim rates for more recent  loan cohorts (loans originated between 1987 and 1991 and loans originated  between 1992 and 1996) ranked among the highest historical cohort claim  rates (see fig. 2). The 5-year claim rate for loans originated between 1997  and 2001 also ranked among the highest historical cohort claim rates. A  continued increase in claim rates could have a negative effect on the  performance of the GI/SRI Fund.
Section 232 loans can have a loan purpose in one of two categories—new  construction/substantial rehabilitation loans or refinance/purchase loans.  New construction loans are for loans that involve the construction of a new  residential care facility. Substantial rehabilitation loans are for loans that  meet HUD criteria for substantial rehabilitation of a residential care facility,  such as two or more building components being substantially replaced.  Purchase loans are for loans in which the borrower is acquiring an existing  residential care facility, while refinance loans are the refinancing of an  existing HUD insured loan or a loan not previously insured by HUD. As  described earlier in the report, HUD began to allow for the refinancing of  FHA-insured facilities and non-FHA insured facilities in 1987 and 1994,  respectively. When analyzing Section 232 loan data by loan purpose, we  found that new construction/substantial rehabilitation loans have a higher  5-year claim rate than refinance/purchase loans for the most recent cohort  for which data are available (see fig. 3). New construction/substantial  rehabilitation loans originated between 1997 and 2001 also have the highest  historical 5-year cohort claim rate for these type of loans. Because of the  higher claim rates in recent years, continued monitoring will be important.  In contrast, the number of refinance and purchase loans endorsed in the  last 5 years is more than double those endorsed in the previous 5 years. The  future impact of the refinance and purchase loans on the overall  performance of the Section 232 program is uncertain since they have  existed for a shorter period of time and thus there is currently limited data  available to assess the relative risk of claims.
As discussed earlier in the report, HUD insures different types of  residential care facilities that include nursing homes, intermediate care  facilities, assisted living facilities, and board and care facilities. Assisted  living facilities are relatively new to the portfolio, and the number of these  loans have been increasing. Our analysis of Section 232 loan data by facility  type found that board and care facilities had a slightly higher 10-year claim  rate than nursing home facilities in the most recent cohorts; however, these  loans remain a very small percentage of the active portfolio and are being  made in decreasing numbers. There are limited data to observe claim  trends on assisted living facilities, making their risk difficult to assess, but  the 5-year claim rates for assisted living facilities have increased  significantly in the most recent cohort years for which claim rate data are  available (see fig. 4). A continued high claim rate in assisted living facilities  could negatively affect the performance of the Section 232 program and the  GI/SRI Fund. However, lenders and HUD officials told us that, although  assisted living facilities had high claim rates in the past, they believe the  market has stabilized and lessons have been learned.
Another observable trend is the increase in the portion of loans in each  cohort that is prepaid. (Prepayment occurs when a borrower pays a loan in  full before the loan reaches maturity.) There have been 1,688 prepayments  in the Section 232 program from 1960 through the end of fiscal year 2005  and loans that terminate do so overwhelmingly because of prepayment.  Moreover, the proportion of loans that terminate due to prepayment within  10 years of origination is increasing. Specifically, the 10-year prepayment  rates for the three most recent cohorts for which 10-year claim rates are  available are more than double that of some earlier cohorts. As more  borrowers prepay their loans, HUD loses future cash flows from premiums;  thus, higher prepayment rates will likely make the net present value of cash  flows decrease. However, the decrease could be offset to the extent that  higher prepayment rates result in fewer claims (a prepaid loan cannot  result in a claim).
section_title: Concentration of Loans
paragraphs: Market concentration also poses some risks to the GI/SRI Fund. The  Section 232 program is concentrated in several large markets and in loans  made by relatively few lenders. As of 2005, five states (California, Illinois,  Massachusetts, New York, and Ohio) held 51 percent of active Section 232  loan dollars and 38 percent of active loan properties (see fig. 5). New York  holds close to 24 percent of the active loan dollars in the portfolio. This is  an improvement since 1995 when we found that eight states accounted for  70 percent of the portfolio, and New York accounted for 32 percent of the  portfolio. However, the current market concentration could still pose risk  to the portfolio if a sudden market change took place in one or more of the  states with a larger percentage of the insured Section 232 loans. We also  found significant loan concentration among a small group of lenders. While  a total of 109 lenders held active loans, 6 hold over half of the active loan  portfolio. GMAC Commercial Mortgage Corporation holds more than 17  percent of all active mortgages in the Section 232 program, the single  largest share of any lender. This concentration among lenders potentially  makes the program more vulnerable if one or a few large lenders encounter  financial difficulty.
section_title: Industry Faces Uncertainties
paragraphs: The Section 232 program may also face risks from trends in the residential  care industry at large that include uncertainty about sources of revenue  and occupancy. Nursing home revenue is generated in large part from the  Medicare and Medicaid programs, which make up 58 percent of national  nursing home spending. Private lenders we interviewed that offer non- FHA-insured residential care facility loans explained that one of the  primary reasons their loans are shorter-term loans than those of HUD is  due to their perception of the potential, long-term uncertainty in the  funding of the Medicaid and Medicare programs, which generally account  for a large share of patient payments in nursing homes. We and others have  reported that Medicare and Medicaid spending may not be sustainable at  current levels. In our 2003 report on the impact of fiscal pressures on  state reimbursement rates, however, we found that even in states that  recently faced fiscal pressures, reimbursement rates remained largely  unaffected. At that time, we concluded that any future changes to state  reimbursement rates remain uncertain. If program cuts occur in federal  spending on Medicaid that result in shifting costs from the federal  government to state governments, states could contain costs by taking a  number of steps, including freezing or reducing reimbursement rates to  providers. An ongoing tension exists, however, between what federal and  state governments and the nursing home industry believe to be reasonable  Medicare and Medicaid reimbursement rates to operate efficient and  economic facilities that provide quality care to public beneficiaries. As the  federal and state governments face growing long-term financial pressure on  their budgets, these budgetary pressures may have some spillover effects  on Medicare and Medicaid revenue streams for the nursing home industry.
Uncertainty also exists about the future demand for residential care  facilities and the corresponding effects on occupancy. As the number of  Americans aged 65 and older increases at a rapid pace, lenders we  interviewed projected an increased need for residential care facilities.  Industry officials also noted a rise in alternatives to nursing home care,  such as assisted living facilities and home and community-based care  options. As patients choose alternative care options, traditional nursing  homes may face occupancy challenges. Overall, these changes to the  nursing home facilities patient base may lower occupancy and income  levels for nursing homes, including those in the Section 232 portfolio.  However, these changes may positively affect the occupancy and income  levels of other types of residential care facilities, including those in the  Section 232 portfolio.
section_title: FHA Uses a Number of Tools to Mitigate Risks
paragraphs: As described elsewhere in this report, FHA uses a number of tools to  mitigate risks to the program and to the GI/SRI Fund. These tools include  imposing requirements prior to insuring loans to help prevent riskier loans  from entering the Section 232 portfolio. FHA also uses various tools—such  as reports on physical inspections of facilities, and financial and other  information captured in data systems—to monitor the status of insured  facilities and the performance of their loans. Additionally, FHA officials use  quality control reviews to mitigate the risk for the program as a whole using  two processes: Quality Management Reviews and Lender Qualifications  and Monitoring Division reviews (the latter reviews are described in app.  II).
section_title: HUD’s Model for Estimating Credit Subsidy Costs Excludes Some Potentially Relevant Factors
paragraphs: HUD’s model for estimating annual credit subsidies—which incorporates  assessments of various risks that loan cohorts will face and includes  assumptions consistent with the Office of Management and Budget (OMB)  guidance—does not explicitly consider the impacts of some potentially  important factors. These factors include: variables to capture the impact of  prepayment penalties or restrictions on prepayments, the loan-to-value  ratio and debt service coverage ratios of Section 232 properties at the time  of loan origination and differences between types of residential care  facilities. Further, the model does not fully capture the effects on existing  loans to changes in market interest rates, and it uses proxy data that are  not comparable to the loans in the Section 232 program. As a result, HUD’s  model for estimating the program’s credit subsidy may result in over- or  underestimation of costs.
subsections: section_title: HUD Uses a Model to Estimate Credit Subsidy Costs
paragraphs: Federal law requires HUD to estimate a credit subsidy for its loan  guarantees. The credit subsidy cost is the estimated long-term cost to the  government of a loan guarantee calculated on a net present value basis and  excluding administrative costs. HUD estimates a credit subsidy for each  loan cohort. This estimate reflects HUD’s assessment of various risks,  based in part on the performance of loans already insured. Since 2000, HUD  has annually estimated two credit subsidy rates for the Section 232  program, reflecting its two largest risk categories: loans for new  construction and substantial rehabilitation, and loans for refinance and  purchase loans. HUD uses an identical methodology for each estimate.
To estimate the initial subsidy cost of the Section 232 program, HUD uses a  cash flow model to project the cash flows for all identified loans over their  expected life. The cash flow model incorporates regression models and  uses assumptions based on historical and projected data to estimate the  amount and timing of claims, subsequent recoveries from these claims,  prepayments, and premiums and fees paid by the borrower. The regression  models incorporate various economic variables such as changes in GDP,  unemployment rate, and 10-year bond rates. The model also has broken out  claim and prepayment data into new construction and refinance loans  since these loans are expected to perform differently.
HUD inputs its estimated cash flows into OMB’s credit subsidy calculator,  which calculates the present value of the cash flows and produces the  official credit subsidy rate. A positive credit subsidy rate means that the  present value of cash outflows is greater than inflows, and a negative credit  subsidy rate means that the present value of cash inflows is greater than  cash outflows. For the Section 232 program, cash inflows include  premiums and fees, servicing and repayment income from notes held in  inventory, rental income from properties held in inventory, and sale income  from notes and properties sold from inventory. Cash outflows include claim  payments and expenses related to properties held in inventory.
Since HUD began estimating the initial subsidy cost of the Section 232  program, it has estimated that the present value of cash inflows would  exceed the outflows. As a result, the initial credit subsidy rates for the  Section 232 program were negative. However, estimates from more recent  years showed that the negative subsidy rates on new construction and  substantial rehabilitation loans have generally been shrinking, meaning  that the projected difference between the program’s cash inflows and cash  outflows was decreasing. In HUD’s most recent estimate (for the fiscal year  2007 cohort), the estimated cash inflows exceed the estimated cash  outflows by a considerably greater margin than in any previous year’s  estimate. This may reflect increased premiums for Section 232 loans; the  President’s proposed budget for fiscal year 2007 specifies increases in  mortgage insurance premiums for almost all FHA programs, including  increasing the rate for Section 232 refinance and new construction loans to  80 basis points from 57 basis points. Figure 6 shows changes in the initial  estimated credit subsidy rate over time for both loan categories.
section_title: Features of the Credit Subsidy Model May Lead to Unreliable Credit Subsidy Estimates
paragraphs: HUD’s model for estimating credit subsidy rates incorporates numerous  variables, but the model’s exclusion of potentially relevant factors and its  use of proxy data from another FHA loan program may negatively affect  the quality of the estimates. Including additional information in the model  could enhance the predictive value of the model.
subsections: section_title: Prepayment Penalties or Restrictions
paragraphs: According to some economic studies, prepayment penalties, or penalties  associated with the payment of a loan before its maturity date, can  significantly affect borrowers’ prepayment patterns. This is also  important for claims, since if a loan is prepaid it can no longer go to claim.  HUD’s model does not explicitly consider the potential impact of  prepayment penalties or restrictions, even though they can influence the  timing of prepayments and claims and collections of premiums. According  to FHA officials, FHA does not place prepayment penalties on FHA-insured  nursing home loans. However, according to the Section 232 program’s  regulations, a lender can impose a prepayment penalty charge and place a  prepayment restriction on the mortgage’s term, amount, and conditions.  We reviewed a sample of Section 232 loans and found that prepayment  penalties and restrictions were consistently applied to these loans.
According to FHA officials and mortgage bankers, prepayment restrictions  on Section 232 loans typically range from 2 to 10 years of prepayment  restrictions and 2 to 8 years of prepayment penalties. While FHA does not  specifically maintain data on insured residential care facility financing  terms, prepayment restrictions are specified on the mortgage note, which is  available to FHA. Incorporation of such data into the Section 232 program’s  credit subsidy rate model could refine HUD’s credit subsidy estimate by  enhancing the model’s ability to account for estimated changes in cash  flows as a result of prepayment restrictions.
According to HUD officials responsible for HUD’s cash flow model,  prepayment penalties and restrictions are not incorporated into the model  because HUD does not collect such data. HUD officials added that even  though the cash flow model does not explicitly account for prepayment  penalties and restrictions, its use of historic data implicitly captures trends  that may occur as a result of prepayment penalties and restrictions. The  model’s projections are influenced by the average level of prepayment  protection in the historical data but not by the trend. If prepayment  penalties and other restrictions have changed over time in the past, or  change in the future, then not incorporating this information could lead to  less reliable estimates.
section_title: Debt Service Coverage Ratio at Point of Loan Origination
paragraphs: Initial debt service coverage ratios are another important factor that may  affect cash flows, as loans with lower initial debt service coverage ratios  may be more likely to default and result in a claim payment. HUD’s cash  flow model does not consider the initial debt service coverage ratio of  Section 232 loans at the point of loan origination. By initial debt service  coverage ratio, we are referring to the projected debt service coverage ratio  that is considered during loan underwriting. According to the HUD official  responsible for HUD’s cash flow model, the initial debt service coverage  ratio of a residential care facility is not included as a part of the cash flow  model because it (1) is not a cash flow, (2) does not vary, and (3) has no  predictive value. We agree that a debt service coverage ratio is not a cash  flow. However, initial debt service coverage ratios potentially affect  relevant cash flows, as do other factors that are included in HUD’s model  but are also not cash flows to HUD, such as prepayments. For example, the  model considers estimated prepayments because they potentially affect  future cash inflows from fees and future cash outflows from claim  payments.
Our analysis of available projected debt service coverage ratios, which  include the amount of new debt being insured, shows that these ratios  varied from 1.1 to 3.6. All other factors being equal, loans with debt  service coverage ratios of 3.6 are generally considered to have less risk  than a loan with only a 1.1 debt service coverage ratio.
Economic theory suggests that the debt service coverage ratio is an  important factor in commercial mortgage defaults. However, empirical  studies show mixed results regarding the significance of the impact of debt  service coverage ratios upon commercial mortgage defaults. Some studies  indicate that debt service coverage ratios are meaningful factors in  modeling default risk and are helpful in predicting commercial mortgage  terminations. Other studies find initial debt service coverage ratios to be  statistically insignificant in modeling commercial mortgage defaults.  These mixed results may be the consequence of relatively small sample  sizes and model specification issues.
section_title: Loan-to-Value Ratio at Point of Loan Origination
paragraphs: Initial loan-to-value ratios are another important factor that may affect cash  flows, as loans with higher initial loan-to-value ratios may be more likely to  default and result in a claim payment. By initial loan-to-value ratio, we are  referring to the projected loan-to-value ratio that is considered during loan  underwriting. HUD’s cash flow model also does not consider the initial  loan-to-value ratio of Section 232 loans at the point of loan origination.
According to the HUD official responsible for HUD’s cash flow model, the  initial loan-to-value ratio of a Section 232 property is not included as a part  of the cash flow model because it does not vary and has no predictive  value. However, our analysis of available projected loan-to-value ratios,  which include the amount of new debt being insured, shows that these  ratios varied from 66 percent to 95 percent. All other factors being equal,  loans with loan-to-value ratios of 66 percent are generally considered to  have less risk than a loan with only a 95 percent loan-to-value ratio. While  economic theory suggests that the loan-to-value ratio is an important factor  in commercial mortgage defaults, empirical studies show mixed results  regarding its significance. Some studies indicate that loan-to-value ratios  are meaningful factors in modeling default risk and are helpful in predicting  commercial mortgage terminations. Other studies find initial loan-to-value  ratios to be statistically insignificant in modeling commercial mortgage  defaults. These mixed results may be the consequence of relatively small  sample sizes and model specification issues.
section_title: Types of Facilities Insured and Changes in Interest Rates
paragraphs: The model’s ability to reliably forecast claim rates may be enhanced by  incorporating a variable indicating facility type into the regression analysis.  HUD’s cash flow model does not explicitly consider differences in loan  performance between types of facilities, such as nursing homes, assisted  living facilities, and board and care facilities. However, when looking at the  most recent cohorts for which 5-year claim rates are available, our analysis  found the 5-year claim rates for assisted living facilities to be significantly  higher than the 5-year claim rates for nursing homes (6.7 percent 5-year  claim rate for nursing homes versus 13.6 percent for assisted living  facilities).
In addition, we found that HUD’s cash flow model generally incorporates  the interest rate on the individual loans (the contract rate) and the  prevailing market interest rate (captured by the 10-year bond rate) as  separate variables. Economic theory suggests, when modeling mortgage  terminations, that considering these two variables jointly as a single  variable in the form of a ratio is the best way to capture the effects on  existing loans when market interest rates change. For example, if market  rates fall below the contract rate on existing Section 232 loans, then it may  become more attractive for borrowers to prepay. However, if market rates  fall but remain above the contract rates, then it may not become more  attractive for borrowers to prepay. Using a ratio captures the distinction  between these two examples because it considers the relative cost to the  borrower of the mortgage given the contract rate, as compared to the  mortgage with the market interest rate. By generally considering the  contract rate and market interest rate separately, HUD potentially loses the  ability to capture this distinction and predict large responses when market  rates fall and small responses when market rates rise.
section_title: Use of Proxy Data
paragraphs: HUD’s use of Section 207 loans as a proxy for Section 232 refinance loans  could lead to less reliable credit subsidy estimates for the Section 232  program. HUD uses certain Section 207 loans—refinance loans for existing  multifamily housing properties—as proxy data for the claim regression for  Section 232 refinance loans. The Section 207 loans are not residential  health care facility loans. According to HUD officials, HUD uses the Section  207 loans because there are insufficient data on Section 232 refinance  loans. A HUD official told us that Section 207 loans were selected as proxy  data because they are refinance loans and because they have similar  performance to the Section 232 refinance loans, as indicated by the  cumulative claim rates they calculated.
Consideration of the basis for using proxy data is important. When using  the experience of another agency or a private lender as a proxy, the Federal  Accounting Standards Advisory Board (FASAB) suggests that an agency  explain why this experience is applicable to the agency's credit program  and examine possible biases for which an adjustment is needed, such as  different borrower characteristics. HUD could reasonably be expected to  follow the FASAB guidance when using data from a different program at  HUD. HUD told us that they did not compare borrower characteristics for  Section 207 loans and Section 232 loans. A HUD official told us that HUD  agreed that they would not expect borrowers of Section 207 loans to have  similar characteristics to borrowers of Section 232 loans.
HUD analyzed the comparability of Section 207 and Section 232 refinance  loans using cumulative claim rate analysis, but we question the  methodology the agency used to make this comparison. Additionally, we  compared the refinance loans for each of the programs by calculating  conditional claim and prepayment rates as well as 5-year cumulative claim  and prepayment rates, and we found significant differences between the  programs (see app. IV for a further description of HUD’s methodology and  our comparison of the two programs).
We question HUD’s use of Section 207 loans as a proxy for Section 232  loans, given the differences we observed. We cannot fully estimate the  overall impact on the credit subsidy estimate, and the effects of the claim  and prepayment rates could partially offset each other. The higher  prepayment rates for Section 207 loans could lead to HUD underestimating  future revenues for Section 232 loans (HUD would project that many of  these loans would terminate, although they would actually remain active  and pay premium revenue to HUD.) The lower claim rates on Section 207  loans could result in HUD estimating that fewer of its Section 232 loans  would result in a claim and thus lead it to underestimate future costs.
In the future, more data will be available on the actual performance of  Section 232 refinance loans that can be used in estimating credit subsidy  needs. To avoid using questionable proxy data in the interim, one possible  approach, among others, would be to use a simpler estimation method,  such as using average claim and prepayment rates over time as is done in  estimating credit subsidy rates for the Section 242 Hospital Mortgage  Insurance program.
section_title: Conclusions
paragraphs: The Section 232 program is the only source of mortgage insurance for  residential care facilities. Accordingly, it is important to ensure good  program and risk management practices. While some field offices we  visited had adopted practices to better manage risks of their Section 232  loans, varying awareness of program requirements and insufficient levels  of staff expertise contribute to increased financial risk in the Section 232  program loan portfolio and thus the GI/SRI Fund. HUD has numerous  underwriting and monitoring guidelines and policies to manage the risks of  Section 232 loans. However, to the extent that field office staff do not  accurately implement current underwriting and monitoring guidelines and  policies, they potentially allow loans with unwarranted risks to enter the  portfolio and may miss opportunities to identify problems with already- insured loans early enough to help prevent claims. Revising the  “Multifamily Asset Management and Project Servicing Handbook” to  include monitoring requirements specific to the Section 232 program, as  the Office of Inspector General noted in its 2002 report, would help in this  regard. So too would the sharing of additional practices, such as involving  asset management staff in the underwriting process, undertaken by some  field offices to better manage risks in their program loans. Moreover,  adequately training staff to develop expertise on residential care loans and  industry could help assure proper underwriting and oversight of Section  232 loans, which tend to be more complex than those in other HUD  multifamily programs. Field office officials’ concerns about their existing  levels of staff expertise heighten the need for appropriate guidance and  additional training specific to the Section 232 program, while the potential  loss of specialized staff within the next 5 years underscores the need for  HUD, in the context of its strategic human capital efforts, to assure  adequate program expertise in the future.
Although HUD recommends that field offices obtain and review annual  inspection reports for licensed facilities insured by the program, four of  five offices we visited did not do so. By not routinely using, in combination  with other performance indicators, the results of annual inspection reports  on insured facilities subject to such inspections, HUD may be missing  important indicators of problems that could result in claims that might  otherwise have been prevented. Reviewing inspection reports is also a  means of obtaining relevant information about insured facilities that have  not been the subject of FHA management reviews. HUD’s long-proposed  revisions to its residential care facility regulatory agreement recognize the  potential usefulness of information on state-administered inspections by  requiring that owners or operators report inspection violations and supply  HUD with copies of annual inspection reports. The proposed revisions  would also address a number of the internal control weaknesses identified  by the HUD Inspector General’s 2002 report, but it remains unclear when  the proposed revisions will be approved, leaving the program exposed to  identified weaknesses in the interim.
While the Section 232 program represents a relatively small portion of the  GI/SRI Fund, it faces risks that could affect the performance of the loan  portfolio and the fund. HUD uses a number of tools to mitigate risks, and it  will be important to continue monitoring program trends and industry  developments. Recent increases in the numbers of assisted living facility  loans and refinance loans are a source of uncertainty, in that there is as yet  little data with which to assess their long-term performance. Similarly,  industry trends and the availability of future Medicaid and Medicare funds  are sources of uncertainty, and heighten the need for HUD to have  sufficient staff expertise with which to monitor future developments that  could affect the program and ultimately the GI/SRI Fund.
HUD’s model for estimating the program’s credit subsidy incorporates  assessments of various risks that loan cohorts face, but it does not  explicitly consider certain factors that could result in over- or  underestimation of costs. These factors include prepayment penalties,  lockout provisions, facility type, loan-to-value ratio, the debt service  coverage ratio of loans at commitment, and the ratio of contract rates to  markets rates, which some economic studies suggest are potentially useful  in modeling risks. Including such factors could enhance the credit subsidy  estimates and provide HUD and the Congress with better cost data with  which to assess the program. Additionally, HUD’s use of Section 207  refinance loans, which we do not find to be a good proxy for Section 232  refinance loans, could specifically contribute to over- or underestimation of  the credit subsidy for the refinance loans in the program.
section_title: Recommendations for Executive Action
paragraphs: To ensure that field offices are aware of and implement current  requirements and policies for the Section 232 Mortgage Insurance for  Residential Care Facilities program, and reduce risk to the GI/SRI Fund, we  recommend that the Secretary of Housing and Urban Development direct  the FHA Commissioner to take the following actions:   Revise the “Multifamily Asset Management and Project Servicing  Handbook” in a timely manner to include monitoring requirements  specific to Section 232 properties;  Establish a process for systematically sharing loan underwriting and  monitoring practices among field offices involved with the Section 232  program;  Assure, as part of the department’s strategic human capital management  efforts, sufficient levels of staff with appropriate training and expertise  for Section 232 loans;  Incorporate a review of annual inspection reports for insured Section  232 facilities that are subject to federal or state inspections, even in the  absence of a revised regulatory agreement; and   Complete and implement the revised regulatory agreements in a timely  manner.
To potentially improve HUD’s estimates of the program’s annual credit  subsidy, we recommend that the Secretary of Housing and Urban  Development explore the value of explicitly factoring additional  information into its credit subsidy model, such as prepayment penalties  and restrictions, debt service coverage and loan-to-value ratios of facilities  as they enter the program, facility type, and the ratio of contract rates to  market rates. We also recommend that the Secretary of Housing and Urban  Development specifically explore other means of modeling the  performance of Section 232 refinance loans.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to HUD for their review and comment. In  written comments from HUD’s Assistant Secretary for Housing-Federal  Housing Commissioner, HUD generally concurred with our  recommendations intended to ensure that field offices are aware of and  implement current program requirements and policies. However, the  agency disagreed with most parts of our recommendation related to HUD’s  credit subsidy model. The Assistant Secretary’s letter appears in appendix  V.
HUD stated that it has initiated a full review of the Section 232 program and  that GAO’s recommendations related to ensuring that field offices are  aware of and implement current requirements are being incorporated into  plans for revising the program. More specifically, HUD stated that it:  will draft and implement changes to the program handbook;  will initiate staff training and assure that staff is adequately trained in  underwriting and servicing policies; and  plans to prepare a report addressing state and federal inspections,  among other things, to enhance FHA participation in and oversight of  insured health care mortgages.
HUD also provided a timeline by which to complete and implement the  revised regulatory agreements.
Concerning our recommendation that HUD explore the value of explicitly  factoring in additional information into its credit subsidy model, HUD  stated that it agreed to take into account differences among types of  residential care facilities in its modeling, when it has sufficient historical  data and if the data indicate that loan performance varies sufficiently by  type of facility. However, HUD disagreed with considering other factors we  suggested, as follows:  Initial loan-to-value and debt service coverage ratios. HUD stated that  (1) studies we cited in our draft report found these ratios to be  statistically insignificant in predicting commercial mortgage defaults  and (2) that data are unavailable for this analysis. We agree, as our draft  report stated, that economic studies have shown mixed results  regarding the significance of the impact of loan-to-value and debt  service coverage ratios on commercial mortgage defaults, with some  studies finding them to be significant predictors and others finding them  to be insignificant predictors. We further stated that these mixed results  may be the result of small sample sizes and model specification issues.  Nevertheless, we continue to believe that HUD should explore the value  of factoring initial loan-to-value ratio and debt service coverage ratio  into its credit subsidy model, and we did not change our  recommendation. Regarding the second point, HUD has the data for  analyzing loan-to-value and debt service coverage ratios in individual  loan files and could include these data in its credit subsidy modeling by  creating an electronic record of this information either for its entire  portfolio or for a sample of the portfolio. Consequently, we did not  change the recommendation.
Factors potentially affecting prepayments. HUD disagreed with our  suggestion that its credit subsidy model does not fully capture the  effects of prepayment penalties, stating that its use of historical data  captures the effect of prepayment penalties on project owners’ behavior.  However, as we stated in the draft report, HUD’s use of historic data  would not fully capture trends related to changes in prepayments. HUD  also stated that it has tested using the difference between mortgage  interest rates and the 10-year Treasury bond rates in its modeling of  prepayments. However, our recommendation was to consider a ratio of  these two interest rates, not the difference. As we noted in our report,  economic theory suggests that the use of a ratio is the best way to  capture the effects on existing loans when market interest rates change.  Consequently, we did not change the recommendation.
Use of Section 207 loans as proxy data for refinance loans. HUD stated  that it did not believe that the differences between Section 207 and  Section 232 loans that our report noted justify concerns that residential  care refinance loans are being improperly modeled and noted a lack of  available data. We agree that sufficient relevant data on Section 232  refinance loan performance do not yet exist, but we continue to  question the use of Section 207 loan data as a proxy. While we did not  change the recommendation, we added language to our report  suggesting that, until enough Section 232 refinance loan data are  available, one possible approach, among others, would be to use a  simpler estimation method, such as using average claim and prepayment  rates over time as is done in estimating credit subsidy rates for the  Section 242 Hospital Mortgage Insurance program.
We are sending copies of this report to the Secretary of the Department of  Housing and Urban Development (HUD). We also will make copies  available to others upon request. In addition, the report will be available at  no charge on the GAO Web site at http://www.gao.gov.
If you or your staff have any questions about this report or need additional  information, please contact me at 202-512-8678 or woodd@gao.gov. Contact  points for our offices of Congressional Relations or Public Affairs may be  found on the last page of this report. GAO staff who made major  contributions to this report are listed in appendix V.
section_title: Objectives, Scope, and Methodology
paragraphs: Our objectives were to examine (1) the Department of Housing and Urban  Development’s (HUD) overall management of the program, including loan  underwriting and monitoring; (2) the extent to which HUD’s oversight of  insured health care facilities is coordinated with the states’ oversight of the  quality of care provided by facilities; and (3) the financial implications of  the program to the General Insurance/Special Risk Insurance (GI/SRI)  Fund, including risk posed by program and market trends; and (4) how  HUD estimates the annual credit subsidy for the program, including the  factors and assumptions used. In addition, we examined HUD’s action in  response to a HUD Inspector General report that concluded that HUD’s  Office of Housing did not have adequate controls to effectively manage the  Section 232 program; this information is summarized in appendix III.
To examine HUD’s overall management of the Section 232 program, we  obtained and reviewed program manuals, guidance, and documentation,  including the “MAP Guide,” HUD’s Section 232 “Mortgage Insurance for  Residential Care Facilities Handbook,” and HUD’s “Multifamily Asset  Management and Project Servicing Handbook,” for loan processing  procedures, underwriting policies and requirements, and oversight policies  and requirements. We also interviewed HUD officials at HUD headquarters  who are responsible for providing guidance and policies on loan  underwriting and oversight and three private lenders that offered FHA- insured Section 232 loans. In addition, we conducted site visits to five HUD  field offices (Atlanta, Georgia; Buffalo, New York; Chicago, Illinois; Los  Angeles, California; and San Francisco, California) and conducted  interviews with HUD officials, including the Hub or acting Hub director,  appraisers, mortgage credit analysts, and project managers that are  responsible for Section 232 loan applications, underwriting, and oversight,  as well as other Federal Housing Administration (FHA) programs. We  gathered relevant program documentation from each site visit. We also  interviewed an official from one of HUD’s Multifamily Property Disposition  Centers during our site visit to Atlanta. To capture a variety of Section 232  loan activity, we selected five HUD field offices on the basis of (1) the  volume of Section 232 loans the field office had processed during fiscal  year 2004 up to September 2005; (2) the dollar amount of Section 232 loans  processed in the field office during fiscal year 2004 up to September 2005;  (3) the timeliness of processing Section 232 loans during the last 2 years;  (4) historical claim-rate data for the field office—that is, the rate at which  Section 232 loans processed by the field office have gone to claim; (5)  HUD’s suggestions for field office site visits; and (6) geographical  dispersion.
To better understand how private lenders that do not participate in the  Section 232 program manage risks, we interviewed five private lenders that  offered non-FHA insured loans to residential health care facilities. We also  interviewed representatives of three residential care facilities with FHA- insured Section 232 loans to better understand the borrowers perspective  of the Section 232 program.
To examine the extent to which HUD coordinated with states’ oversight of  quality of care provided by facilities, we reviewed FHA requirements for  conducting management reviews and reviewing annual inspection reports.  We also interviewed officials in FHA’s Office of Multifamily Development  and Office of Asset Management and field office officials about policies for  coordination between FHA and state residential care oversight and rate  setting agencies, as well as policies for review of annual inspection reports.  In addition, we interviewed private lenders of FHA-insured and non-FHA  insured residential care facilities to better understand common industry  practices for coordination between lenders and state residential care  oversight and rate setting agencies.
To examine the financial risks that the program poses to the GI/SRI Fund,  we interviewed and obtained documentation from HUD’s Office of  Evaluation and analyzed HUD data on program portfolio characteristics,  including number of loans by cohort, current insurance in force,  geographic and lender concentration of loans, and claims. We also analyzed  HUD data used for their refinance credit subsidy regression model.  Specifically:  To obtain the number of active and terminated loans and claim rate  history, we analyzed data from extracts of HUD’s F47 database, a  multifamily database. We obtained extracts from HUD in May 2005,  September 2005, and February 2006. Unless otherwise indicated, all  analyses from the F47 data in the report utilized the May 2005 extract  with subsequent updates from the other extracts and was current as of  the end of fiscal year 2005. To assess the reliability of the F47 database  extract, we reviewed relevant documentation, interviewed agency  officials who worked with the database, and conducted manual data  testing, including comparison to published data. Because of the small  number of loans endorsed in individual fiscal years, we conducted  analyses of cohorts that were created by combining data from 5 to 6  fiscal years. For claim rate analyses, we analyzed 5- and 10-year claim  rates for the data based on the date of loan termination.
Our analyses found 13 loans for which facility type information was not  able to be determined from the extract. FHA administrators were able to  determine the facility type for all but one of these loans using the  Development Application Processing (DAP) system. This one  terminated loan was excluded from facility type endorsement and claim  rate analysis and, therefore, had little impact on this report. We also  determined final endorsement date information to be missing from 799  records. Our analyses only used initial endorsement date information  for which data was available for every record; therefore, there was no  impact on this report. We also determined there were nine loans for  which the facility type information was incorrect based on the  endorsement date. FHA administrators checked in the DAP system and  confirmed the correct facility type for these loans; therefore, there was  no impact on the report. We determined the data to be sufficiently  reliable for analysis of number of active and terminated loans, as well as  claim rates.
To determine the proportion of the Section 232 Mortgage Insurance  program’s commitment authority to the larger GI/SRI Fund’s  commitment authority, we reviewed HUD’s fiscal year 2006 budget.
To determine the proportion of the Section 232 Mortgage Insurance  program’s unpaid principal balance to the larger GI/SRI Fund unpaid  principal balance, we obtained the GI/SRI Fund’s unpaid principal  balance as of December 31, 2005 from HUD’s Office of Evaluation. We  also analyzed data from HUD’s Multifamily Data Web site, which is  extracted from HUD’s F47 database, to determine the unpaid principal  balance of Nursing Home Mortgage Insurance program loans as of  December 31, 2005.
To determine the geographic concentration of loan properties in the  program, we analyzed data current as of the end of fiscal year 2005 from  our extract of HUD’s F47 database. Our analysis determined property  state data was missing for 270 project numbers. FHA administrators  informed us that loans endorsed more than 20 years ago, before  electronic records were maintained, may have missing data that is  unavailable. Our analyses of geographic concentration of loan  properties utilized only one record with missing property state data;  therefore, there was little impact on our findings. We determined the  data to be sufficiently reliable for analysis of geographic loan  concentration.
To determine the geographic concentration of loan dollars in the  program we analyzed data current as of December 31, 2005, from HUD’s  Multifamily Housing Data Web site.
To determine prepayment history in the program, we analyzed data from  our F47 extract, current as of the end of fiscal year 2005. We also  analyzed 5-and 10-year prepayment rates for the data based on the date  of loan termination.
To determine the appropriateness of using Section 207 refinance loans  as proxy data in the Section 232 refinance loan credit subsidy estimate  regression model, we analyzed data from several extracts from HUD’s  Office of Evaluation. The extracts contained the loan data used by HUD  to calculate cumulative claim rates for Section 232 and 207 refinance  loans for loans endorsed from fiscal year 1992 through fiscal year 2005.  The extracts did not include termination codes for all terminated loans.  We determined termination code data for these loans from HUD data  current as of December 31, 2005, from HUD’s Multifamily Housing Data  Web site. We also combined the extracts to include all loans in one  larger extract. In addition, we performed manual data reliability  assessments of these extracts and determined that three loans should  not have been included in the extracts because they had section of the  act codes that were not within the parameters of our analysis as defined  by the notes included in HUD’s extracts. These loans were not included  in our analysis and, therefore, had no impact on our findings. We  determined the data to be sufficiently reliable for analysis of the  comparability of Section 207 refinance loans to Section 232 refinance  loans.
We conducted a literature review and interviewed numerous officials of  lenders, residential care associations, and HUD to obtain information on  risks due to health care market trends. We also searched for Inspectors  General and agency reports through HUD Web sites. Finally, we conducted  a search on our internal Web site to identify previous work on the Section  232 program.
To determine how HUD estimates the annual credit subsidy rate for the  program, we reviewed documentation of HUD’s credit subsidy estimation  procedures, reviewed the cash flow model for the program, and we  interviewed program officials from HUD’s Office of Evaluation and  program auditors from the Office of Management and Budget (OMB). We  also compared the assumptions used in HUD’s cash flow model with  relevant OMB guidance and reviewed economic literature on modeling  defaults to identify factors that are important for estimation. Additionally,  we analyzed data provided by HUD field offices on initial loan-to-value  ratios and debt service coverage ratios (at the time of loan application). We  obtained the credit subsidy rates from the Federal Credit Supplement of  the United States Budget.
To review the actions HUD has taken in response to the HUD Inspector  General’s 2002 report on the Section 232 program, we interviewed officials  in HUD’s Office of Inspector General. In addition, we reviewed the HUD  Inspector General’s 2002 report, as well as HUD’s Management Plan Status  Reports for Implementation of Recommendation 1A of audit 2002-KC-0002.  We also interviewed HUD headquarters officials, as well as field office  officials during our site visits.
Our review did not include an evaluation of underwriting criteria or the  need for the program. We conducted our work in Atlanta, Georgia; Buffalo,  New York; Chicago, Illinois; Los Angeles, California; San Francisco,  California, and Washington, D.C., between February 2005 and April 2006, in  accordance with generally accepted government auditing standards.
section_title: Information on the Application Processing, Underwriting, and Oversight of Section 232 Loans
subsections: section_title: Application Processing and Underwriting for Section 232 Loans
paragraphs: The Department of Housing and Urban Development (HUD) currently  processes a majority of the Section 232 loans using the Multifamily  Accelerated Processing (MAP) program and processes some loans under  Traditional Application Processing (TAP). Under MAP, the lender conducts  the underwriting of the loan and submits a package directly to the Hub or  program center for mortgage insurance. The Hub or program center  reviews the lender’s underwriting and makes a decision whether or not to  provide mortgage insurance for the loan. New construction and substantial  rehabilitation loans require a preapplication meeting where HUD reviews  required documentation up front. Under TAP, HUD, not the lender, is  primarily responsible for the underwriting of the loan and determines  whether or not to accept the loan.
FHA has numerous underwriting requirements for loans made under the  Section 232 program. Some examples include:  Requiring documentation of a state-issued Certificate of Need (CON) for  skilled nursing facilities and intermediate care facilities, and in states  without a certificate of needs procedure, an alternative study of market  needs and feasibility.
Requiring an appraisal of the facility (prepared by the lender under the  MAP program) and a market study with comparable properties.
Reviewing current or prospective operators of the residential care  facility and ensuring that they meet certain standards. For example,  FHA has a requirement that operators of an assisted living facility have a  proven track record of at least 3 years in developing, marketing, and  operating either an assisted living facility or a board and care home.
For new construction facilities specifically, FHA requires a business  plan along with an estimate of occupancy rates and prospective  reimbursement rates with the percentage of population for patients  whose costs are reimbursed through Medicare and Medicaid.
For existing facilities applying for a refinance loan, FHA requires the  submission of vacancy and turnover rates and current provider  agreements for Medicare and Medicaid, 3 years of balance sheet and  operating statements, as well as the latest inspection report on the  project’s operation.
Requiring limits on loan-to-value and debt service coverage ratios, ratios  identified by field office officials we interviewed as two of the more  important financial ratios in the underwriting process. For example, for  Section 232 loans, the loan-to-value ratio cannot exceed 90 percent for  new construction loans, and 85 percent loan-to-value for refinance  loans.
For loans processed under MAP, HUD field office officials are required to  use MAP Guide checklists to ensure that lenders follow FHA’s underwriting  requirements. These checklists contained guidelines for reviewing lender  submissions and overall parameters that an application must meet. For  example, field office officials use an appraisal review checklist in the MAP  Guide to ensure that the submitted market study complies with MAP  requirements. For applications processed under TAP, field office officials  stated that they use similar checklists to the ones included in the MAP  Guide as the MAP Guide incorporates many of the Section 232  underwriting requirements.
For MAP loans, HUD headquarters has a Lender Qualifications and  Monitoring Division (LQMD) that conducts reviews of loans. LQMD is  responsible for evaluating lender qualifications and lender performance. It  reviews and ultimately approves lenders requesting MAP lender approval  for loan underwriting. The division reviews a sample of lenders when a  loan has defaulted or there is a need for additional lender oversight. While  LQMD reviews are not specific to the Section 232 program, they help to  monitor lenders participating in the program and ultimately help to reduce  the number of risky loans that enter the portfolio.
section_title: Oversight and Monitoring of Section 232 Loans
paragraphs: FHA requires field office staff to conduct a number of reviews for oversight  of Section 232 loans. For example, staff address noncompliance items that  are identified by HUD’s Financial Assessment Sub-System (FASS) for each  facility. Noncompliance items can include items such as unauthorized  distribution of project funds or unauthorized loans from project funds.  Using information from the annual financial statement, FASS’s computer  model statistically calculates financial ratios, or indicators, for each facility,  and applies acceptable ranges of performance, weights, and thresholds for  each indicator. FASS then generates a score for each facility based on these  indicators, and this financial score represents a single aggregate financial  measure of the facility. However, a HUD draft contractor study found that  FASS did not adequately account for the unique nature of nursing homes in  the Section 232 portfolio and, therefore, was a poor predictor of a nursing  home going to claim. Field office officials we interviewed also review  physical inspections conducted by HUD’s Real Estate Assessment Center  (REAC), which is responsible for conducting physical assessments of all  HUD-insured properties. Officials also ensure that the professional liability  requirement for facilities is met and conduct file reviews to identify any  activities that warrant additional oversight. Additionally, officials in each  field office we visited stated that they are required to monitor projects in  HUD’s Real Estate Management System, the official source of data on  HUD’s multifamily housing portfolio that maintains data on properties and  to conduct risk assessments on their properties at least once a year to  identify those facilities that are designated as troubled or potentially  troubled based on their physical inspection, financial condition, and other  factors.
Field offices also varied in the utilization of HUD’s Online Property  Integrated Information Suite (OPIIS), a centralized resource for HUD  multifamily data and property analysis. According to officials at HUD  headquarters, field office officials can use OPIIS to conduct a variety of  portfolio analysis and view risk assessments on their properties to better  assist them in overseeing their portfolios. For example, OPIIS contains an  Integrated Risk Assessment score that combines financial, physical, loan  payment status history, and other data into a score that can be used to  identify at-risk properties and prioritize workloads. However, four of the  five field offices that we visited did not frequently use OPIIS. Some of these  offices used the system to develop risk rankings for their properties or in  trying to obtain data about a property, but none of them regularly used the  system for the monitoring of Section 232 loans. The one field office that  utilized OPIIS more frequently did so because the system partly  incorporates a loan risk and rankings system that the field office had  previously developed for its own use. Officials in this field office stated that  an issue with OPIIS is that it is not designed to capture important, specific  financial information that is unique to some Section 232 loans, such as  expenses on food or medication.
section_title: HUD Officials Addressed Some Issues Raised by the Agency’s Inspector General in 2002, but Several Key Items Remain Unresolved
paragraphs: In a 2002 report, the Department of Housing and Urban Development’s  (HUD) Inspector General found that HUD’s Office of Housing did not have  adequate controls to effectively manage the Section 232 program. Because  of these weaknesses, the Inspector General found that HUD lacked  assurance of the effective operation of Section 232 properties. The  Inspector General noted that the Office of Housing had already taken steps  to develop an action plan to address the weaknesses identified by a task  force, but that time frames had not yet been established. The Inspector  General recommended that the Office of Housing establish specific time  frames for implementing the corrective actions for the 10 weaknesses  identified by the task force and that it monitor the actions to ensure timely  and effective completion.
HUD officials developed a plan to correct the 10 control weaknesses  identified by the Office of Housing, which included the current status of  each action and specific target dates to complete the corrective actions.  According to the Inspector General, HUD has taken action to address 2 of  the 10 control weakness findings identified by the Office of Housing Task  force and for which the Inspector General recommended that timelines for  corrective actions be established.
The eight unresolved control weaknesses identified by the Office of  Housing task force are all contingent upon approval of the proposed  revisions to the regulatory agreements. However, the proposed revisions  have been awaiting approval since August 2, 2004. According to HUD  officials, the delay is a result of numerous administrative issues, which  include changes in FHA management and extended public comment  periods.
The addressed control weaknesses and respective corrective actions  involved loan underwriting. The Inspector General agreed with the Office  of Housing task force, which found that HUD’s underwriting process for  Section 232 properties needed to be strengthened and that HUD needed to  complete market studies and background checks of applicants as part of  the process. The Inspector General also agreed with the Office of Housing  task force’s finding of potential problems associated with the nonrecourse  nature of HUD Section 232 loans. In particular, it found that HUD needed to  strengthen the regulatory agreements and underwriting process for Section  232 loans if these mortgages were to remain nonrecourse and to avoid  potential increase in the portfolio claim rate. HUD addressed these findings  by adding requirements for operators, reviews of operators’ financial  statements, and professional liability insurance. Furthermore, applications  for projects that are considered marginal are rejected.
The eight remaining control weaknesses for which HUD has not fully  completed its corrective actions are as follows:  HUD lacks a handbook detailing monitoring requirements for nursing  homes and assisted living facilities. The Inspector General found that  HUD did not have a handbook specific to the Section 232 program  monitoring requirements ensuring that all facilities follow the applicable  regulatory agreements and state and federal requirements. In our site visits  to five field offices, we found inconsistencies in the extent to which  oversight procedures were followed, such as requiring operators to submit  financial statements. HUD plans to include Section 232 project monitoring  requirements in the “Multifamily Asset Management and Project Servicing  Handbook” once the proposed revisions to the applicable regulatory  agreements have been approved. In addition, HUD headquarters officials  told us that they plan to issue updated guidance on loan oversight for  Section 232 properties while awaiting approval of the proposed revisions to  the regulatory agreements.
HUD’s regulatory agreement does not include specific requirements for  Section 232 properties. The Inspector General found that the regulatory  agreement for owners lacked requirements for Section 232 properties, such  as compliance with Medicare and Medicaid guidelines. The Inspector  General also found inconsistencies between the requirements for facilities  operated by the owners and those operated by a separate entity. The  Inspector General recognized that these omissions created an inability for  HUD to control the activities of operators and ultimately created risk to the  General Insurance/Special Risk Insurance Fund. HUD’s proposed revisions  to the regulatory agreements have provisions that address these concerns;  however, they are still awaiting approval.
The Financial Assessment Subsystem (FASS) does not allow the owner  and operator to submit annual financial statements electronically,  denying HUD the ability to use the financial check and compliance  feature in the system. The Inspector General found that the Real Estate  Assessment Center’s (REAC) FASS did not include all Section 232  properties. Furthermore, operators were not required to submit annual  financial statements electronically through the system. HUD headquarters  officials agreed that, while operators are unable to submit annual financial  statements electronically, FASS has allowed electronic submissions from  owners since the system’s inception. However, the Inspector General found  that because operator financial statements are not required to be submitted  electronically, HUD is unable to utilize the financial and compliance checks  performed within the system to identify and follow up on deficiencies.  HUD plans to modify FASS to allow electronic submission of operator  financial statements; however, implementation has been delayed by  funding problems and approval of the proposed revision to the operator  regulatory agreement.
The Office of Housing needs to improve monitoring and legal tools to  provide early indication of possible default. The Office of Housing task  force identified a need for improved monitoring and legal tools to provide  early indication of potential default. To better understand issues related to  monitoring loans, HUD’s Office of Evaluation completed several studies on  Section 232 program performance. As of April 2006, all of these studies  remain in draft form. Also, to aid in monitoring, HUD has proposed  revisions to the applicable regulatory agreements to require that owners  and operators submit annual inspection reports and inform HUD of state or  federal violations. These reports can be an early indicator of quality of care  concerns and possible claim. However, the proposed revisions to the  regulatory agreements have not been made final.
The Office of Housing staff needs additional training on servicing  nursing homes and assisted living facilities. The Inspector General  identified that project managers did not have sufficient training on  reviewing Section 232 properties and dealing with the issues unique to  Section 232 properties. HUD’s management plan states that, as of  September 2004, REAC has conducted financial statement analysis for  HUD hubs for the last 2 fiscal years. HUD has also proposed training  specific to Section 232 program financial analysis upon approval of  revisions to the applicable regulatory agreements and subject to the  availability of funds. However, HUD headquarters officials stated that there  were very limited funds available for training.
Certain conditions lead to loss of Certificate of Need (CON) or license.  The HUD Inspector General identified that, in some states, the CON and  operating licenses may not transfer with the property. Consequently, an  operator may hold these operational documents and take them with them  upon termination of the lease. Without these documents, a facility is not  viable as a residential care facility and its value is significantly diminished.  This presents a large risk to HUD should the loan go to claim or should  HUD have to acquire the property. HUD’s proposed revisions to the  applicable regulatory agreements address this concern by categorizing  these operational documents as part of the mortgaged properties.
Receivables need to be included in the relevant legal documents to  strengthen HUD's control over assets of the property in case of regulatory  agreement violations. The Inspector General established that the Section  232 security agreement language was too broad to ensure that all property  assets are covered by the mortgage. To address this concern, HUD  proposed revisions to the applicable regulatory agreements to include  receivables in the personalty pledged as security for the mortgage.  Additionally, HUD proposed added language in the owner regulatory  agreement requiring the owner to execute a security agreement and  financial statement upon all items of equipment and receivables.
Field offices do not have consistent procedures for using different  addendums for mortgages, regulatory agreements, and security  agreements. The Office of Housing’s task force found inconsistencies in the  field offices’ use of legal agreements between HUD and owners and  operators, such as differing addendums to mortgages, regulatory  agreements, and security agreements. We also found similar discrepancies  during our five site visits. For example, only one office used addendums to  HUD’s legal agreements to prevent operators from keeping these  operational documents once the lease terminates. HUD has proposed  revisions to the regulatory agreements, and once they are approved and  implemented all offices will use the same legal documentation. In the  interim, HUD headquarters officials told us they plan to provide field  offices with updated guidance on Section 232 loan oversight.
section_title: HUD’s Use of Proxy Data for Refinance Loans
paragraphs: As discussed earlier in this report, we question the Department of Housing  and Urban Development’s (HUD) use of Section 207 loans as a proxy for  Section 232 loans in the claim regression that is part of HUD’s credit  subsidy estimates. This appendix provides greater detail on our analysis.
subsections: section_title: HUD’s Comparison Did Not Allow for Differences in the Age of Loans
paragraphs: Cumulative claim rates are generally compared for a set period of time and  for loans from the same years of origination. However, HUD calculated the  cumulative claim rates without making these adjustments, which  confounds claim differences between programs with differences due solely  to timing. HUD calculated the cumulative claim rates for each program by  taking the total number of loans that went to claim during a 14- year time  period and dividing this by the total number of loans in that same time  period. In this case, HUD was comparing a program that has been  expanding over time, the Section 232 program, with a program that has had  less loan volume in recent years, the Section 207 program. From 1992 to  1998, HUD insured 1,434 Section 207 loans. From 1999 to 2005, HUD  insured 870 Section 207 loans. As a result, HUD has been comparing the  claim rate of loans that have had very little time in which to default  (Section 232 loans had an average age of 4 years) with the claim rate of  loans that have had substantial time in which to default (Section 207 loans  had an average age of 7.5 years). A comparison between two programs’  claim rates should allow for differences in the age of the loans. HUD  officials also told us that they have not analyzed the comparability of these  two loan types in terms of their prepayment rates.
section_title: Substantial Differences Exist between Section 207 and Section 232 Loans
paragraphs: To examine the comparability of the Section 207 and Section 232 loans, we  compared the conditional claim and prepayment rates of the two types of  loans. An analysis of conditional claim and prepayment rates compares  claim and prepayment probabilities for loans of the same age, so that  comparisons based on loans of widely varying ages are avoided.
We found that the Section 207 loans generally had lower and, in some  cases, significantly lower conditional claim rates than the Section 232  loans. The differences were greater in the later years when loans more  often go to claim. (see fig. 7). For example, the conditional claim rate for  Section 207 loans in fiscal year 8 was .14 percent as compared with a  conditional claim rate of 3.88 percent for Section 232 loans in fiscal year 8.
We found that Section 207 loans had generally higher, and sometimes  significantly higher, conditional prepayment rates compared to Section 232  loans. The differences were greater in the later years when loans more  often are prepaid. (see fig. 8). For example, the conditional prepayment  rate for Section 207 loans in fiscal year 8 was 21.72 percent as compared to  a conditional prepayment 11.25 percent for Section 232 loans in fiscal year  8 (making the conditional prepayment rate for the Section 207 loans 93  percent higher than the conditional prepayment rate for Section 232 loans).
Additionally, we examined and compared cumulative 5-year claim and  prepayment rates. Section 207 loans had a 5-year cumulative claim rate of 3  percent, while for the Section 232 loans it was approximately 6.7 percent.  The 5-year cumulative prepayment rate for Section 207 loans was about 27  percent, while for Section 232 loans it was about 11 percent.
section_title: Comments from the Department of Housing and Urban Development
section_title: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the individual named above, Paul Schmidt, Assistant  Director; Austin Kelly; Tarek Mahmassani; John McGrail; Andy Pauline;  Carl Ramirez; Richard Vagnoni; Wendy Wierzbicki; and Amber Yancey- Carroll made key contributions to this report.