Federal Housing Administration: Risks to the Mutual Mortgage Insurance Fund and the Agency's Operations
Published: 2011-12-01T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The Federal Housing Administration (FHA) has helped millions purchase homes by insuring private lenders against losses from defaults on single-family mortgages. In recent years, FHA has experienced a dramatic increase in its market role due, in part, to the contraction of other mortgage market segments. The increased reliance on FHA mortgage insurance highlights the need for FHA to ensure that it has the proper controls in place to minimize financial risks while meeting the housing needs of borrowers. This statement discusses (1) changes in the financial condition of FHA's fund used to insure mortgages--the Mutual Mortgage Insurance Fund (Fund)--and the budgetary implications of these changes; (2) how FHA evaluates the financial condition of the Fund; and (3) steps FHA has taken to assess and manage risks. This statement is drawn from a recent report on FHA's oversight capacity (GAO-12-15) as well as a report issued in September 2010 on the financial condition of the Fund (GAO-10-827R). GAO also obtained updated information on the status of the Fund from the recently issued actuarial report on the Fund.
section_title: What GAO Found
paragraphs: For the third consecutive year, FHA reported that the Fund's capital ratio (the ratio of economic value to insurance-in-force) has not met the 2 percent statutory minimum (see below). FHA cites declines in the Fund's economic value due to higher-than-expected defaults, claims, and losses. At the same time, the other component of the ratio, FHA's insurance-in-force, has grown rapidly. The Fund's condition also worsened from a budgetary perspective, with balances in the Fund's capital reserve account reaching new lows. If the account were depleted, FHA would require more funds to help cover costs on insurance issued to date. FHA enhanced methods for assessing the Fund's financial condition but has not yet addressed GAO's 2010 recommendation for improving the reliability of its estimates. It relies on a single economic forecast, which does not fully account for variability in future house prices and interest rates. An approach that would simulate hundreds of economic paths for house prices and interest rates would improve the reliability of its capital ratio estimates. FHA has taken or plans a number of steps to better assess and manage risk. It created a risk office in 2010 and hired a consultant to recommend best practices. FHA plans to charter committees to evaluate risks at enterprise-wide and programmatic levels. It began a quality control initiative in the Office of Single Family Housing, in which program and field offices assess and report on risks. FHA also enhanced lender and appraiser reviews. While FHA's consultant recommended integrating risk assessments, the quality control and risk office activities currently remain separate efforts. Also, the Office of Single Family Housing has not annually updated assessments since 2009 as required. Without integrated and updated risk assessments that identify emerging risks, FHA lacks assurance it has identified all its risks. GAO previously made recommendations on modeling the Fund's financial condition, risk assessments, and human capital. FHA agreed with these recommendations and told GAO they have efforts underway to implement them.

section_title: Letter
paragraphs: I am pleased to be here to participate in today’s hearing on the financial  condition of the Federal Housing Administration’s (FHA) Mutual Mortgage  Insurance Fund (Fund). As you know, FHA has helped millions of families  purchase homes through its single-family mortgage insurance programs  and insures almost all of its single-family mortgages under the Fund.
FHA reported in November 2011 that for the third consecutive year, the  Fund was not meeting the statutory 2 percent capital reserve requirement,  as measured by the Fund’s estimated capital ratio—that is, the Fund’s  economic value divided by the insurance-in-force. Although the Fund  historically has produced budgetary receipts for the federal government, a  weakening in the performance of FHA-insured loans has heightened the  possibility that FHA could require additional funds to help cover its costs on  insurance issued to date. The increased reliance on FHA mortgage  insurance highlights the need for FHA to ensure that it has the proper  controls in place to minimize financial risks while meeting the housing  needs of borrowers.
My statement today is based on a September 2010 report about FHA’s  financial condition and a report issued in November of this year about the  agency’s risk assessment and human capital management. Specifically,  I will discuss (1) how estimates of the Fund’s capital ratio changed in  recent years and the budgetary implications of changes in the Fund’s  financial condition, (2) how FHA and its actuarial review contractor  evaluate the financial condition of the Fund, and (3) steps FHA has taken  to manage and assess risks. I also will briefly discuss our report on the  risks faced by the Government National Mortgage Association (Ginnie  Mae), which was released today.
To do this work, we analyzed actuarial reviews of the Fund and federal  budget documents, and interviewed FHA officials, staff from FHA’s  actuarial review contractor, and selected housing market researchers. We  also analyzed data on FHA’s business volume, market share, workload,  and staff and contractor resources. We reviewed documentation on the  proposed structure and functions of FHA’s Office of Risk Management  and Regulatory Affairs and the Office of Single Family Housing’s internal  quality control initiative. Finally, we reviewed changes to FHA guidance  that address risks associated with lenders and appraisers and  documentation related to workforce and succession planning. Our study  of Ginnie Mae assessed operational risks and financial exposure. We  reported on Ginnie Mae volume and market share, reviewed guidance  and Ginnie Mae’s credit subsidy calculations and estimation model, and  interviewed agency officials and others. The reports include a detailed  description of our scope and methodology.
The work on which this statement was based was performed from  September 2009 to November 2011 in accordance with generally  accepted government auditing standards. Those standards require that  we plan and perform the audit to obtain sufficient, appropriate evidence to  provide a reasonable basis for our findings and conclusions based on our  audit objectives. We believe that the evidence obtained provides a  reasonable basis for our findings and conclusions based on our audit  objectives.
subsections: section_title: Background
paragraphs: Under the Federal Credit Reform Act of 1990 (FCRA), FHA and other  federal agencies must estimate the net lifetime costs—known as credit  subsidy costs—of their loan insurance or guarantee programs and include  the costs to the government in their annual budgets. Credit subsidy costs  represent the net present value of expected lifetime cash flows, excluding  administrative costs. When estimated cash inflows exceed expected  cash outflows, a program is said to have a negative credit subsidy rate  and generates offsetting receipts that reduce the federal budget deficit.  When the opposite is true, the program is said to have a positive credit  subsidy rate—and therefore requires appropriations. Generally, agencies  must produce annual updates of their subsidy estimates—reestimates— on the basis of information about actual performance and estimated  changes in future loan performance. FCRA recognized the difficulty of  making credit subsidy estimates that mirrored actual loan performance  and provides permanent and indefinite budget authority for reestimates  that reflect increased program costs. Upward reestimates increase the  federal budget deficit unless accompanied by reductions in other  government spending or an increase in receipts.
The Omnibus Budget Reconciliation Act of 1990 required the Secretary of  the Department of Housing and Urban Development (HUD) to take steps  to ensure that the Fund attained a capital ratio of at least 2 percent by  November 2000 and maintained at least a 2 percent ratio at all times  thereafter. It also required an annual independent actuarial review of the  economic net worth and soundness of the Fund. The annual actuarial  review is now a requirement in the Housing and Economic Recovery Act  of 2008, which also requires that the Secretary of HUD annually report to  Congress on the results of the review.
Federal agencies face a number of risks. In the case of agencies with  loan guarantee or insurance programs, they can face credit risks that  include borrower default risk, which arises as borrowers become unable  to make payments on insured mortgages. Agencies with these programs  also face counterparty risk. That is, an agency may suffer losses due to  weaknesses or uncertainties in the work of its counterparties—in this  example, lenders and appraisers. And all agencies face operational risks,  the risk of loss resulting from inadequate or failed internal processes or  people (in terms of staff numbers, training, and skills), or external events.  For this statement, we focus on operational risks related to FHA’s staffing  and contractor capacity to process increasing workloads.
section_title: The Fund’s Financial Condition Continues to Worsen, Increasing the Possibility That FHA Will Require Additional Funds
paragraphs: The Fund’s capital ratio dropped sharply in 2008 and fell below the  statutory minimum in 2009, when economic and market developments  created conditions that simultaneously reduced the Fund’s economic  value (the numerator of the ratio) and increased the insurance-in-force  (the denominator of the ratio).the Fund, the capital ratio fell from about 7 percent in 2006 to 3 percent in  2008 and 0.5 percent in 2009 (see fig. 1). For 2010 and 2011, the ratios  were 0.5 and 0.24 percent, respectively.
section_title: FHA’s Current Methodology for Assessing the Fund’s Condition Does Not Fully Account for Future Economic Volatility
paragraphs: As we reported in September 2010, FHA and its actuarial review  contractor enhanced their methods for assessing the Fund’s financial  condition but still were addressing other methodological issues that could  affect the reliability of estimates of the capital ratio. Annual actuarial  reviews of the Fund use statistical models to estimate the probability that  loans will prepay or result in insurance claims on the basis of certain loan  and borrower characteristics (such as loan-to-value ratios and borrower  credit scores) and key economic variables (such as house prices and  interest rates). FHA and its contractor have enhanced these models in  recent years, by incorporating additional variables related to loan  performance and developed an additional model to predict loss rates on  insurance claims. Also, consistent with recommendations we made in a  prior report, in 2003 the actuarial reviews began to analyze the impact of  more pessimistic economic scenarios—for example, nationwide declines  in home prices—than they did previously.
However, the current methodology is significantly limited by its reliance on  a single economic forecast to produce the estimate of the capital ratio that  is used to determine if the Fund is meeting the 2 percent capital reserve  requirement. This approach does not fully account for the variability in  future house prices and interest rates that the Fund may face. As a result,  baseline estimates of the capital ratio may tend to underestimate  insurance claims and mortgage prepayments and therefore may tend to  overestimate the Fund’s economic value. In a November 2003 report, the  Congressional Budget Office concluded that FHA could project the Fund’s  cash flows more accurately by using an approach (stochastic modeling)  that involves running simulations of hundreds of different economic paths  to produce a distribution of capital ratio estimates.
Given the uncertainty that always surrounds estimates of future economic  activity, the report we issued last year recommended that HUD require  the actuarial review contractor to use stochastic simulation of future  economic conditions, including house prices and interest rates, to  estimate the Fund’s capital ratio and include the results of this analysis in  FHA’s annual report to Congress on the financial status of the Fund.  However, the most recent annual report does not include an estimate of  the Fund’s capital ratio using this technique. In response to our 2010  report, FHA officials told us that they were planning to require the  actuarial review contractor to use a stochastic simulation model for the  2011 actuarial review. But, these officials said that the model would be  used to examine the implications of extreme economic scenarios on the  Fund and decisions about using the model to estimate the Fund’s capital  ratio had not been made.
section_title: FHA Has Taken Steps to Address Risks, but Has Yet to Implement a Comprehensive Risk-Assessment Strategy
paragraphs: FHA faces risks resulting from its operations. FHA’s loan volume grew  significantly from 2006 to 2010. In 2006, FHA insured almost half a million  loans, totaling $70 billion in mortgage insurance. By 2010, it insured 1.7  million loans, or about $319 billion in mortgage insurance. During the  same time period, FHA’s single-family staff increased 8 percent, from 932  employees in 2006 to 1,011 employees in 2010, while increases in key  workload areas often surpassed 100 percent:
Staff in the homeownership centers’ Processing and Underwriting  Division grew at a slower rate (22 percent) than key workload items,  particularly volume-driven loan reviews (which increased by more  than 100 percent).
Increases in contractor staff and workload related to management of  foreclosed or real estate-owned properties were substantial, but  noncontractor staff levels increased at more modest levels.
Loss mitigation actions more than doubled from 2006 to 2010, while  loss mitigation staff levels remained relatively constant.
subsections: section_title: Although FHA Worked to Address Credit and Operational Risk, It Has Not Yet Put a Comprehensive Strategy in Place
paragraphs: Although FHA has taken steps to assess credit and operational risks  facing its single-family insurance programs, its current risk-assessment  strategy is not comprehensive because it is not integrated across the  agency and lacks annual assessments and mechanisms to anticipate  changing conditions. To address credit risk and help improve the financial  condition of the Fund (which is supported by borrower premiums), FHA  raised premiums and made or proposed policy or underwriting changes.  For example, in April 2011 FHA increased its annual insurance premiums  from 0.85 percent to 1.10 percent for borrowers with 30-year loans with  initial loan-to-value ratios of 95 percent or less and from 0.90 percent to  1.15 percent for borrowers with 30-year loans with initial loan-to-value  ratios greater than 95 percent. Additionally, FHA increased down- payment requirements for borrowers with lower credit scores. FHA also  has proposed reducing allowable seller contributions at closing, thereby  helping to ensure that buyers put more of their own funds into the home  purchase. In addition, FHA is in the process of revising its mortgage  scorecard algorithm, to recognize the effect of various risk elements not  currently discerned by the scorecard and determine what cases warrant  manual underwriting. According to FHA, these revisions are in the early  stages, and no completion date has been set.
To address operational risks and improve its risk-assessment strategy, in  2010 FHA received congressional approval to establish the Office of Risk  Management and Regulatory Affairs and create the position of Deputy  Assistant Secretary for Risk Management and Regulatory Affairs, which  reports directly to the Assistant Secretary for Housing-FHA  Commissioner. To provide assistance to the Office of Risk Management  (one of the offices within the Office of Risk Management and Regulatory  Affairs) in developing a risk-management strategy and organizational  structure and establishing risk-management policies and processes, FHA  hired a consultant to produce a comprehensive report and recommend  best practices for its operation. adopt the consultant’s recommendation to establish an enterprise risk  committee to address overall risk to the organization and a second tier of  committees to address program and operational risks. In addition, in 2009  the Office of Single Family Housing implemented an internal quality  control initiative at headquarters and the four homeownership centers.  For the areas identified as high-risk, headquarters and the  homeownership center divisions developed plans to document control  objectives and established a monitoring strategy in which each  homeownership center submits quarterly reports to headquarters on the  effectiveness of the controls, including the status of any mitigation efforts.
McKinsey & Company, Building the ORM Organization, Close-out Materials, a report  prepared at the request of the Department of Housing and Urban Development,  December 2010. the consultant would not be possible. In the meantime, they stated that  every effort was being made to help ensure that the Office of Risk  Management’s activities complemented program office activities. Second,  contrary to HUD guidance, Single Family Housing has not conducted an  annual, systematic review of risks to its program and administrative  functions. According to an official in the Office of Single Family Housing,  although management intended to conduct an annual assessment, the  dates slipped because of changes in senior leadership in Single Family  Housing and few staff were available to perform assessments (because  of attrition and increased workload). Finally, Single Family Housing’s  current risk-assessment efforts do not include procedures for anticipating  potential risks presented by changing conditions. The consultant’s report  proposes a reporting process and templates for identifying emerging risks  and provides specific examples. Office of Risk Management officials told  us that once they are operational the risk committees eventually would  determine the exact design and content of the reports and templates.
Moreover, implementation and integration of the new risk-assessment  strategy and planned tools has been slow because of delays in defining  the Office of Risk Management’s authority, difficulty filling new staff  positions in the Office of Risk Management, and changes in FHA  leadership.
All these factors limit FHA’s effectiveness in identifying, planning for, and  addressing risk. More specifically, without an integrated risk-assessment  strategy, certain risks may not be fully addressed at the operational level  in a way that minimizes risk to the insurance programs; without annual  reassessments of its risks, Single Family Housing lacks assurance that its  quality control efforts address all its risks; and without ongoing  mechanisms in place to anticipate and address new or emerging risks,  FHA lacks a systematic approach to help the agency identify, analyze,  and formulate timely plans to respond most effectively to changed  conditions and risks. Therefore, we recommended that FHA (1) integrate  the internal quality control initiative of the Office of Single Family Housing  into the operational risk processes of the Office of Risk Management, (2)  conduct an annual risk assessment, and (3) establish ongoing  mechanisms—such as use of the report templates from the 2010  consultant’s report—to anticipate and address risks that might be caused  by changing conditions. FHA agreed with the recommendations and  stated that it either was working toward achieving the recommendations  or had plans to do so in the very near future. For example, FHA said it  would leverage or integrate existing risk management efforts as soon as  the Office of Risk Management’s final governance structure and risk  management strategies were in place. The agency also stated that the  Office of Risk Management would conduct an annual risk assessment as  a component of its overall risk management strategy. It stressed that  ongoing mechanisms to anticipate and address risks related to changing  conditions would be part of the office’s strategy.
section_title: FHA Has Taken Steps to Address Counterparty Risks, but Continues to Face Human Capital Challenges
paragraphs: With growth in loan volume, the number of lenders and appraisers (or  counterparties) participating in FHA’s single-family programs also has  grown. The total number of FHA-approved lenders increased 24 percent,  from 10,370 in 2006 to 12,844 in 2010. The number of FHA-approved  appraisers increased approximately 67 percent from 33,553 in 2006 to  56,192 in 2010.
However, FHA has made recent changes to address risks posed by its  lenders and appraisers. For example, on May 20, 2010, FHA stopped  approving new loan correspondents. As of January 1, 2011, existing  loan correspondents could no longer participate in FHA programs. Former  loan correspondents now can participate only as third-party originators  through sponsorship by FHA-approved lenders. As a result, as of  September 2011, FHA had almost 3,700 approved lenders. Furthermore,  the agency has increased the net worth requirement for approved  lenders. On May 20, 2011, FHA increased the requirement for existing  lenders to $1 million, except for lenders classified as small under the  Small Business Administration’s size standards (their requirement  increased to $500,000). As of May 20, 2013, FHA will require a net worth  of $1 million for all lenders, plus 1 percent of the total loan volume in  excess of $25 million, to a maximum required net worth of $2.5 million.  To help ensure that lenders and appraisers follow its policies and  procedures, FHA also has enhanced the criteria used to select loans for  technical reviews. Specifically, since May 3, 2010, the agency has  considered high-risk loan or borrower characteristics, such as certain  types of refinanced loans and loans to borrowers with low credit scores.  Additionally, FHA increased the number of risk factors used to target  lenders for review. FHA also has revised its approach for overseeing  appraisers.
FHA has addressed staffing and training needs and succession planning  to some extent, but it lacks plans that strategically address future  workforce needs, including replacing retiring staff. Although workforce  planning practices used by leading organizations include defining critical  skills and skill gaps, FHA’s current approach does not have mechanisms  for doing so. FHA previously had a multiyear workforce plan that identified  the critical competencies; analyzed skills and competencies, including  gaps; and proposed comprehensive strategies to address these gaps, but  has not created another such plan. Instead, FHA has relied on  occasional Resource Estimation and Allocation Process studies and  annual managerial assessments of staffing and training needs.
FHA also currently does not have a succession plan, although a HUD  plan for 2006–2009 identified mission-critical positions, analyzed existing  staff competencies, assessed the number of retirement-eligible  employees, and determined the probability of near-term retirements.  Succession planning is particularly important because almost 50 percent  of Single Family Housing headquarters staff are eligible to retire in the  next 3 years. The percentage of staff eligible to retire at the  homeownership centers is even higher—63 percent.
While FHA has taken some steps to address succession planning, they  have been limited. FHA implemented two initiatives focused on  succession planning. The first, begun in 2010, was intended to help  ensure that, at any given time, at least two additional supervisors,  managers, or executives could perform the work of each supervisor,  manager, or executive. However, this does not apply to staff positions  beyond management. The second initiative also began in 2010. Its goal is  to train and develop staff. Neither initiative assesses the number of  retirement-eligible employees in critical positions as required by HUD  guidance. According to FHA officials, as resources have dwindled, they  have considered all their positions to be critical.
According to FHA officials, plans to update their workforce and  succession plans were suspended. In 2007–2009, FHA had a workforce  planning process designed to identify critical skill gaps and a strategy for  addressing these gaps. According to the officials, HUD told FHA to stop  this initiative in 2009 because HUD was going to implement a workforce  planning process for the entire department. However, the effort never  came to fruition because of funding shortages. Without a more  comprehensive workforce planning process that includes succession  planning, FHA’s ability to systematically identify the workforce needed for  the future and plan for upcoming retirements is limited. Therefore, we  recommended that FHA develop workforce and succession plans for the  Office of Single Family Housing. FHA agreed, stating that it would  develop a formal workforce plan and had efforts underway to develop a  succession plan.
section_title: Ginnie Mae’s Risk Management and Cost Modeling Require Continuing Attention
paragraphs: We released a report today about Ginnie Mae, which has experienced a  substantial increase in the volume of its business since 2007 as the  volume of federally insured or guaranteed mortgages increased. Ginnie  Mae is a wholly owned government corporation in HUD, which  guarantees the timely payment of principal and interest on mortgage- backed securities (MBS) backed by pools of federally insured or  guaranteed mortgage loans, such as FHA loans. As of 2010, Ginnie Mae  guaranteed more than $1 trillion in outstanding MBS composed primarily  of FHA-insured mortgages. The growth in outstanding Ginnie Mae- guaranteed MBS resulted in an increased financial exposure for the  federal government. Nonetheless, Ginnie Mae’s revenues exceeded its  costs, and it has accumulated a capital reserve of about $14.6 billion.
Ginnie Mae has taken steps to better manage operational and  counterparty risks and has several initiatives planned or underway. The  operational risks the agency may face include limited staff, substantial  reliance on contractors, and the need for modernized information  systems. Ginnie Mae plans to increase its staff levels, complete a  reorganization, and implement recommendations related to contracting.  For Ginnie Mae, counterparty risk is the risk that issuers of Ginnie Mae  MBS fail to provide investors with monthly principal and interest  payments. To manage its counterparty risk, Ginnie Mae has processes in  place to oversee MBS issuers that include approval, monitoring, and  enforcement and has revised its approval and monitoring procedures. For  example, in 2010 Ginnie Mae increased the minimum net worth  requirement for issuers of Ginnie Mae-guaranteed MBS to $2.5 million.  But, planned initiatives to enhance its risk-management processes for  issuers, including its tracking and reporting systems, have not been fully  implemented. It will be important for Ginnie Mae to complete its initiatives  related to operational and counterparty risk as soon as practicable.
In developing inputs and procedures for the model used to forecast costs  and revenues, Ginnie Mae did not consider certain practices identified in  Federal Accounting Standards Advisory Board (FASAB) guidance for  preparing cost estimates of federal credit programs. Ginnie Mae has not  developed estimates based on the best available data, performed  sensitivity analyses to determine which assumptions have the greatest  impact on the model, or documented why it used management  assumptions rather than available data. By not fully implementing  practices in FASAB guidance that GAO believes represent sound internal  controls for models, Ginnie Mae’s model may not use critical data that  could affect the agency’s ability to provide well-informed budgetary cost  estimates and financial statements. This may limit Ginnie Mae’s ability to  accurately report to Congress the extent to which its programs represent  a financial exposure to the government.
We recommended that the Secretary of Housing and Urban Development  direct Ginnie Mae to take steps to ensure its model more closely follows  certain practices identified in Federal Accounting Standards Advisory  Board guidance for estimating subsidy costs of credit programs. More  specifically, Ginnie Mae should (1) assess and document that it is using  the best available data in its model and most appropriate modeling  approach, (2) conduct and document sensitivity analyses to determine  which cash flow assumptions have the greatest impact on the model,   (3) document how management assumptions are determined, such as  those for issuer defaults and mortgage buyout rates, and (4) assess the  extent to which management assumptions, such as those for issuer  defaults and mortgage buyout rates, can be replaced with quantitative  estimates. The President of Ginnie Mae wrote that Ginnie Mae is working  towards implementing our recommendation for conducting sensitivity  analyses relating to issuer risk and behavior, but neither agreed nor  disagreed with our other specific recommendations. In addition, Ginnie  Mae agreed with our observation about the importance of completing  ongoing and planned initiatives for enhancing its risk-management  processes, as soon as practicable, to improve operations.
Mr. Chairman, Ranking Member Frank, and Members of the Committee,  this concludes my prepared statement. I would be happy to respond to  any questions that you may have at this time.
section_title: GAO Contact and Staff Acknowledgments
paragraphs: For further information about this testimony, please contact Mathew J.  Scirè, Director, at 202-512-8678 or sciremj@gao.gov. Contact points for  our Offices of Congressional Relations and Public Affairs may be found  on the last page of this statement. Individuals making key contributions to  this testimony include Paige Smith (Assistant Director), Andy Pauline  (Assistant Director), Steve Westley (Assistant Director), Dan Alspaugh,  Nadine Garrick Raidbard, John McGrail, Marc Molino, José R. Peña,   Beth Reed Fritts, Paul G. Revesz, and Barbara Roesmann.
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