Federal Housing Administration: Ability to Manage Risks and Program Changes Will Affect Financial Performance
Published: 2007-03-15T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The Federal Housing Administration (FHA) has seen increased competition from conventional mortgage and insurance providers. Additionally, because of the worsening performance of the mortgages it insures, FHA has estimated that its single-family insurance program would require a subsidy--that is, appropriations--in fiscal year 2008 in the absence of program changes. To help FHA adapt to the evolving market, proposed changes to the National Housing Act would allow greater flexibility in setting insurance premiums and reduce down-payment requirements. To assist Congress in considering the financial challenges facing FHA, this testimony provides information from recent reports GAO has issued and ongoing work concerning the proposed legislation that address different aspects of FHA's risk management. Specifically, this testimony looks at (1) FHA's management of risk related to loans with down-payment assistance, (2) instructive practices for managing risks of new products, (3) FHA's development and use of its mortgage scorecard, and (4) FHA's estimation of program costs.
section_title: What GAO Found
paragraphs: Recent trends in mortgage lending have significantly affected FHA, including growth in the proportion of FHA-insured loans with down-payment assistance, wider availability of low- and no-down-payment products, and increased use of automated tools (e.g., mortgage scoring) to underwrite loans. Although FHA has taken steps to improve its risk management, in a series of recent reports, GAO identified a number of weaknesses in FHA's ability to estimate and manage risk that may affect its financial performance. For example, FHA has not developed sufficient standards and controls to manage risks associated with the substantial proportion of loans with down-payment assistance, including assistance from nonprofit organizations funded by home sellers. According to FHA, high claim and loss rates for loans with such assistance were major reasons for the estimated positive subsidy cost (meaning that the present value of estimated cash inflows would be less than the present value of estimated cash outflows) for fiscal year 2008, absent any program changes. FHA has not consistently implemented practices--such as stricter underwriting or piloting--used by other mortgage institutions to help manage the risks associated with new product offerings. Although FHA has indicated that it would impose stricter underwriting standards for a no-down-payment mortgage if the legislative changes were enacted, it does not plan to pilot the product. The way that FHA developed its mortgage scorecard, while generally reasonable, limits how effectively it assesses the default risk of borrowers. With increased competition from conventional mortgage providers, limitations in its scorecard could cause FHA to insure mortgages that are relatively more risky. FHA's reestimates of the costs of its single-family mortgage program have generally been less favorable than originally estimated. Increases in the expected level of claims were a major cause of a particularly large reestimate that FHA submitted as of the end of fiscal year 2003. GAO made several recommendations in its recent reports, including that FHA (1) incorporate the risks posed by down-payment assistance into its scorecard, (2) study and report on the impact of variables not in its loan performance models that have been found to influence credit risk, and (3) consider piloting new products. FHA has taken actions in response to GAO's recommendations, but continued focus on risk management will be necessary for FHA to operate in a financially sound manner in the face of market and program changes.

section_title: Letter
paragraphs: I am pleased to have the opportunity to share information and  perspectives with the committee as it examines issues concerning the  financial performance of the Department of Housing and Urban  Development’s (HUD) Federal Housing Administration (FHA). FHA  provides insurance for single-family home mortgages made by private  lenders. In fiscal year 2006, it insured about 426,000 mortgages,  representing $55 billion in mortgage insurance. According to FHA’s  estimates, the insurance program currently operates with a negative  subsidy, meaning that the present value of estimated cash inflows (such as  borrower premiums) to FHA’s Mutual Mortgage Insurance Fund (Fund)  exceeds the present value of estimated cash outflows (such as claims).
But, the risks FHA faces in today’s mortgage market are growing. For  example, the agency has seen increased competition from conventional  mortgage and insurance providers, many of which offer low- and no-down- payment products, and that may be better able than FHA to identify and  approve relatively low-risk borrowers. Additionally, because of the  worsening performance of the mortgages it insures, FHA has estimated  that the program would require a positive subsidy—that is, an  appropriation of budget authority—in fiscal year 2008 if no program  changes were made.
To help FHA adapt to market changes, HUD has proposed a number of  changes to the National Housing Act that, among other things, would give  FHA flexibility to set insurance premiums based on the credit risk of  borrowers and reduce down-payment requirements from the current 3  percent to potentially zero. Whether under its existing authority or using  any additional flexibility that Congress may grant, FHA’s ability to manage  risks and program changes will affect the financial performance of the  insurance program.
My testimony today discusses four reports that we have issued since 2005  on different aspects of FHA’s risk management, as well as ongoing work  we are conducting on FHA’s proposed legislative changes and the tools  and resources it would use to implement them, if passed. This body of  work addresses a number of issues relevant to FHA’s financial  performance. Specifically, I will discuss (1) weaknesses in how FHA has  managed the risks of loans with down-payment assistance, (2) practices  that could be instructive for FHA in managing the risks of new mortgage  products, (3) FHA’s development and use of a mortgage scorecard, and (4)  FHA’s estimation of subsidy costs for its single-family insurance program.
In conducting this work, we reviewed and analyzed information  concerning the standards and controls FHA uses to manage the risks of  loans with down-payment assistance; steps mortgage industry participants  take to design and implement low- and no-down-payment mortgage  products; FHA’s approach to developing its mortgage scorecard and the  scorecard’s benefits and limitations; FHA’s estimates of program costs and  the factors underlying the agency’s cost reestimates; and FHA’s plans and  resources for implementing its proposed legislative changes. We  interviewed officials from FHA, the U.S. Department of Agriculture, and  U.S. Department of Veterans Affairs; and staff at selected private mortgage  providers and insurers, Fannie Mae, Freddie Mac, the Office of Federal  Housing Enterprise Oversight, selected state housing finance agencies, and  nonprofit down-payment assistance providers. We conducted this work  from January 2004 to March 2007 in accordance with generally accepted  government auditing standards.
In summary, our work identified a number of weaknesses in FHA’s ability  to estimate and manage risk that may affect the financial performance of  the insurance program:    FHA has not developed sufficient standards and controls to manage risks  associated with the substantial proportion of loans with down-payment  assistance. Unlike other mortgage industry participants, FHA does not  restrict homebuyers’ use of down-payment assistance from nonprofit  organizations that receive part of their funding from home sellers.  However, our analysis of a national sample of FHA-insured loans found  that the probability of loans with this type of down-payment assistance  resulting in an insurance claim was 76 percent higher than comparable  loans without such assistance. Additionally, the financial risks of these  loans recently have been realized in effects on the credit subsidy  estimates. According to FHA, high claim and loss rates for loans with this  type of down-payment assistance were major reasons why the estimated  credit subsidy rate—the expected cost—for the single-family insurance  program would be positive, or less favorable, in fiscal year 2008 (absent  any program changes).
Some of the practices of other mortgage institutions offer a framework  that could help FHA manage the risks associated with new products such  as no-down-payment mortgages. For example, mortgage institutions may  limit the volume of new products issued—that is, pilot a product—and  sometimes require stricter underwriting on these products. While FHA has  utilized pilots or demonstrations when making changes to its single-family  mortgage insurance, it generally has done so in response to a legislative  requirement and not on its own initiative. Moreover, FHA officials have  questioned the circumstances under which pilot programs were needed  and also said that they lacked sufficient resources to appropriately manage  a pilot. However, FHA officials have indicated that they would institute  stricter underwriting standards for any no-down-payment mortgage  authorized by their legislative proposal.
While generally reasonable, the way that FHA developed its mortgage  scorecard—an automated tool that evaluates the default risk of  borrowers—limits the scorecard’s effectiveness. More specifically, FHA  and its contractor used variables that reflected borrower and loan  characteristics to create the scorecard and an accepted modeling process  to test the variables’ accuracy in predicting default. But, the data used to  develop the scorecard were 12 years old by the time that FHA began using  the scorecard in 2004, and the market has changed significantly since then.  In addition, the scorecard does not include all the important variables that  could help explain expected loan performance such as the source of the  down payment. With competition from conventional providers, limitations  in the scorecard could cause FHA to insure mortgages that are relatively  more risky. Our ongoing work indicates that FHA plans to use the  scorecard to help set insurance premiums if legislative changes are  enacted. Accordingly, any limitations in the scorecard’s ability to predict  defaults could result in FHA mispricing its products.
Although FHA has improved its ability to estimate the subsidy costs for its  single-family insurance program, it generally has underestimated these  costs. To meet federal requirements, FHA annually reestimates subsidy  costs for each loan cohort. The current reestimated subsidy costs for all  except the fiscal year 1992 and 1993 cohorts are less favorable—that is,  higher—than originally estimated. Increases in the expected level of  insurance claims—potentially stemming from changes in underwriting  guidelines, among other factors—were a major cause of a particularly  large reestimate that FHA submitted as of the end of fiscal year 2003.
On the basis of our findings from the reports I have summarized, we made  several recommendations designed to improve FHA’s risk management.  For example, to improve its assessment of borrowers’ default risk, we  recommended that FHA develop policies for updating the scorecard,  incorporate the risks posed by down-payment assistance into the  scorecard, and explore additional uses for this tool. To more reliably  estimate program costs, we recommended that FHA study and report in  the annual actuarial review of the Fund the impact of variables not in the  agency’s loan performance models (the results of which are used in  estimating and reestimating program costs) that have been found in other  studies to influence credit risk.
FHA has taken actions in response to some of our findings and  recommendations. For example, FHA has developed and begun putting in  place policies for annually updating the scorecard and testing additional  predictive variables. To more reliably assess program costs, an FHA  contractor incorporated the source of down-payment assistance and  borrower credit scores in recent actuarial reviews of the Fund.
While these actions represent improvements in FHA’s risk management,  sustained management attention to the issues that we have identified and  continued Congressional oversight of FHA will play an important role in  ensuring that FHA is able to expand homeownership opportunities for  low- and middle-income families while operating in a manner that is  financially sound.
subsections: section_title: Background
paragraphs: Congress established FHA in 1934 under the National Housing Act (P.L. 73- 479) to broaden homeownership, protect lending institutions, and  stimulate employment in the building industry. FHA’s single-family  programs insure private lenders against losses (up to almost 100 percent  of the loan amount) from borrower defaults on mortgages that meet FHA  criteria. In 2005, more than three-quarters of the loans that FHA insured  went to first-time homebuyers, and about one-third of these loans went to  minorities. From 2001 through 2005, FHA insured about 5 million  mortgages with a total value of about $590 billion. However, FHA’s loan  volume fell sharply over that period, and in 2005 FHA-insured loans  accounted for about 5 percent of single-family home purchase mortgages,  compared with about 19 percent in 2001. Additionally, default rates for  FHA-insured mortgages have risen steeply over the past several years, a  period during which home prices have generally appreciated rapidly.
FHA determines the expected cost of its insurance program, known as the  credit subsidy cost, by estimating the program’s future performance.  Similar to other agencies, FHA is required to reestimate credit subsidy  costs annually to reflect actual loan performance and expected changes in  estimates of future loan performance. FHA has estimated negative credit  subsidies for the Fund from 1992, when federal credit reform became  effective, through 2007. However, FHA has estimated that, assuming no  program changes, the loans it expects to insure in fiscal year 2008 would  require a positive subsidy, meaning that the present value of estimated  cash inflows would be less than the present value of estimated cash  outflows. The economic value, or net worth, of the Fund that supports  FHA’s insurance depends on the relative size of cash outflows and inflows  over time. Cash flows out of the Fund for payments associated with claims  on defaulted loans and refunds of up-front premiums on prepaid  mortgages. To cover these outflows, FHA receives cash inflows from  borrowers’ insurance premiums and net proceeds from recoveries on  defaulted loans. An independent contractor’s actuarial review of the Fund  for fiscal year 2006 estimated that the Fund’s capital ratio—the economic  value divided by the insurance-in-force—is 6.82 percent, well above the  mandated 2 percent minimum. If the Fund were to be exhausted, the U.S.  Treasury would have to cover lenders’ claims directly.
Two major trends in the conventional mortgage market have significantly  affected FHA. First, in recent years, members of the conventional  mortgage market (such as private mortgage insurers, Fannie Mae, and  Freddie Mac) increasingly have been active in supporting low- and even  no-down-payment mortgages, increasing consumer choices for borrowers  who may have previously chosen an FHA-insured loan. Second, to help  assess the default risk of borrowers, particularly those with high loan-to- value ratios (loan amount divided by sales price or appraised value), the  mortgage industry has increasingly used mortgage scoring and automated  underwriting systems. Mortgage scoring is a technology-based tool that  relies on the statistical analysis of millions of previously originated  mortgage loans to determine how key attributes such as the borrower’s  credit history, property characteristics, and terms of the mortgage affect  future loan performance. As a result of such tools, the mortgage industry is  able to process loan applications more quickly and consistently than in the  past. In 2004, FHA implemented a mortgage scoring tool, called the FHA  Technology Open to Approved Lenders (TOTAL) Scorecard, to be used in  conjunction with existing automated underwriting systems.
Partly in response to changes in the mortgage market, HUD has proposed  legislation intended to modernize FHA. Provisions in the proposal would  authorize FHA to change the way it sets insurance premiums and reduce  down-payment requirements. The proposed legislation would enable FHA  to depart from its current, essentially flat, premium structure and charge a  wider range of premiums based on individual borrowers’ risk of default.  Currently, FHA also requires homebuyers to make a 3 percent contribution  toward the purchase of the property. HUD’s proposal would eliminate this  contribution requirement and enable FHA to offer some borrowers a no- down-payment product.
section_title: FHA Has Not Implemented Sufficient Standards and Controls to Manage Financial Risks of Loans with Down-Payment Assistance
paragraphs: In our November 2005 report examining FHA’s actions to manage the new  risks associated with the growing proportion of loans with down-payment  assistance, we found that the agency did not implement sufficient  standards and controls to manage the risks posed by these loans. Unlike  other mortgage industry participants, FHA does not restrict homebuyers’  use of down-payment assistance from nonprofit organizations that receive  part of their funding from home sellers. According to FHA, high claim and  loss rates for loans with this type of down-payment assistance were major  reasons for changing the estimated credit subsidy rate from negative to  positive for fiscal year 2008 (in the absence of any program changes).  Furthermore, incorporating the impact of such loans into the actuarial  study of the Fund for fiscal year 2005 resulted in almost a $2 billion (7  percent) decrease in the Fund’s estimated economic value.
subsections: section_title: Loans with Down-Payment Assistance Are a Substantial Portion of FHA’s Portfolio and Pose Greater Financial Risks Than Similar Loans without Assistance
paragraphs: Homebuyers who receive FHA-insured mortgages often have limited funds  and, to meet the 3 percent borrower investment FHA currently requires,  may obtain down-payment assistance from a third party, such as a relative  or a charitable organization (nonprofit) that is funded by the property  sellers. The proportion of FHA-insured loans that are financed in part by  down-payment assistance from various sources has increased  substantially in the last few years, while the overall number of loans that  FHA insures has fallen dramatically. Money from nonprofits funded by  seller contributions has accounted for a growing percentage of that  assistance. From 2000 to 2004, the total proportion of FHA-insured  purchase loans that had a loan-to-value ratio greater than 95 percent and  that also involved down-payment assistance, from any source, grew from  35 percent to nearly 50 percent. Approximately 6 percent of FHA-insured  purchase loans in 2000 received down-payment assistance from nonprofits  (the large majority of which were funded by property sellers), but by 2004  nonprofit assistance grew to about 30 percent. The corresponding  percentages for 2005 and 2006 were about the same.
We and others have found that loans with down-payment assistance do not  perform as well as loans without down-payment assistance. We analyzed  loan performance by source of down-payment assistance, using two  samples of FHA-insured purchase loans from 2000, 2001, and 2002—a  national sample and a sample from three metropolitan statistical areas  (MSA) with high rates of down-payment assistance. Holding other  variables constant, our analysis indicated that FHA-insured loans with  down-payment assistance had higher delinquency and claim rates than  similar loans without such assistance. For example, we found that the  probability that loans with nonseller-funded sources of down-payment  assistance (e.g., gifts from relatives) would result in insurance claims was  49 percent higher in the national sample and 45 percent higher in the MSA  sample than it was for comparable loans without assistance. Similarly, the  probability that loans with nonprofit seller-funded down-payment  assistance would result in insurance claims was 76 percent higher in the  national sample and 166 percent higher in the MSA sample than it was for  comparable loans without assistance. This difference in performance may  be explained, in part, by the higher sales prices of comparable homes  bought with seller-funded down-payment assistance. Our analysis  indicated that FHA-insured homes bought with seller-funded nonprofit  assistance were appraised and sold for about 2 to 3 percent more than  comparable homes bought without such assistance. The difference in  performance also may be partially explained by the homebuyer having less  equity in the transaction.
section_title: Stricter Standards and Additional Controls Could Help FHA Manage the Risks Posed by Loans with Down-Payment Assistance
paragraphs: FHA has implemented some standards and internal controls to manage the  risks associated with loans with down-payment assistance, but stricter  standards and additional controls could help FHA better manage the  financial risks posed by these loans while meeting its mission of  expanding homeownership opportunities. Like other mortgage industry  participants, FHA generally applies the same underwriting standards to  loans with down-payment assistance that it applies to loans without such  assistance. One important exception is that FHA, unlike others, does not  limit the use of down-payment assistance from seller-funded nonprofits.  Some mortgage industry participants view assistance from seller-funded  nonprofits as a seller inducement to the sale and, therefore, either restrict  or prohibit its use. FHA has not treated such assistance as a seller  inducement and, therefore, does not subject this assistance to the limits it  otherwise places on contributions from sellers.
Concerns about loans with nonprofit seller-funded down-payment  assistance have prompted FHA and IRS to initiate steps that could curb  their use. For example, FHA has begun drafting a proposed rule that, as  described by FHA, would appear to prohibit down-payment assistance  from seller-funded nonprofits. FHA’s legislative proposal could also  eliminate the need for such assistance by allowing some FHA borrowers to  make no down payments for an FHA-insured loan. Finally, in May 2006,  IRS issued a ruling stating that organizations that provide seller-funded  down-payment assistance to home buyers do not qualify as tax-exempt  charities. FHA permitted these organizations to provide down-payment  assistance because they qualified as charities. Accordingly, the ruling  could significantly reduce the number of FHA-insured loans with seller- funded down payments. However, FHA officials told us that as of March  2007, they were not aware of IRS rescinding the charitable status of any of  these organizations.
Our report made several recommendations designed to better manage the  risks of loans with down-payment assistance generally, and more  specifically from seller-funded nonprofits. Overall, we recommended that  in considering the costs and benefits of its policy permitting down- payment assistance, FHA also consider risk-mitigation techniques such as  including down-payment assistance as a factor when underwriting loans or  more closely monitoring loans with such assistance. For down-payment  assistance providers that receive funding from property sellers, we  recommended that FHA take additional steps to mitigate the risks of these  loans, such as treating such assistance as a seller contribution and,  therefore, subject to existing limits on seller contributions. In response,  FHA agreed to improve its oversight of down-payment assistance lending  by (1) modifying its information systems to document assistance from  seller-funded nonprofits and (2) more routinely monitoring the  performance of loans with down-payment assistance. Also, as previously  noted, HUD has initiated steps to curb and provide alternatives to seller- funded down-payment assistance.
section_title: Practices That Other Mortgage Institutions Use Could Help FHA Manage Risks from Low- or No-Down- Payment Products
paragraphs: If Congress authorized FHA to insure mortgages with smaller or no down  payments, practices that other mortgage institutions use could help FHA  to design and manage the financial risks of these new products. In a  February 2005 report, we identified steps that mortgage institutions take  when introducing new products. Specifically, mortgage institutions often  utilize special requirements when introducing new products, such as  requiring additional credit enhancements (mechanisms for transferring  risk from one party to another) or implementing stricter underwriting  requirements, and limiting how widely they make available a new product.  By adopting such practices, FHA could reduce the potential for higher  claims on products whose risks may not be well understood.
subsections: section_title: Mortgage Institutions Require Additional Credit Enhancements, Stricter Underwriting, and Higher Premiums for Low- and No-Down-Payment Products
paragraphs: Some mortgage institutions require additional credit enhancements on  low- and no-down payment products, which generally are riskier because  they have higher loan-to-value ratios than loans with larger down  payments. For example, Fannie Mae and Freddie Mac mitigate the risk of  low- and no-down payment products by requiring additional credit  enhancements such as higher mortgage insurance coverage. Although FHA  is required to provide up to 100 percent coverage of the loans it insures,  FHA may engage in co-insurance of its single-family loans. Under co- insurance, FHA could require lenders to share in the risks of insuring  mortgages by assuming some percentage of the losses on the loans that  they originated (lenders would generally use private mortgage insurance  for risk sharing).
Mortgage institutions also can mitigate the risk of low- and no-down- payment products through stricter underwriting. Institutions can do this in  a number of ways, including requiring a higher credit score threshold for  certain products, requiring greater borrower reserves, or requiring more  documentation of income or assets from the borrower. Although the  changes FHA could make are limited by statutory standards, it could  benefit from similar approaches. The HUD Secretary has latitude within  statutory limitations to change underwriting requirements for new and  existing products and has done so many times. For example, FHA  expanded its definition of what could be included as borrower’s effective  income when calculating payment-to-income ratios. In commenting on our  February 2005 report, FHA officials told us that they were unlikely to  mandate a credit score threshold or borrower reserve requirements for a  no-down-payment product because the product was intended to serve  borrowers who were underserved by the conventional market, including  those who lacked credit scores and had little wealth or personal savings.  However, in the course of our ongoing work on FHA’s legislative proposal,  FHA officials indicated that they would likely set a credit score threshold  for any no-down-payment product.
Finally, mortgage institutions can increase fees or charge higher premiums  to help offset the potential costs of products that are believed to have  greater risk. For example, Fannie Mae officials stated that they would  charge higher guarantee fees on low- and no-down payment loans if they  were not able to require higher insurance coverage. Our ongoing work  indicates that FHA, if authorized to implement risk-based pricing, would  charge higher premiums for loans with higher loan-to-value ratios, all  other things being equal.
We recommended that if FHA implemented a no-down-payment mortgage  product or other new products about which the risks were not well  understood, the agency should (1) consider incorporating stricter  underwriting criteria such as appropriate credit score thresholds or  borrower reserve requirements and (2) utilize other techniques for  mitigating risks, including the use of credit enhancements. In response,  FHA said it agreed that these techniques should be evaluated when  considering or proposing a new FHA product.
section_title: Before Fully Implementing New Products, Some Mortgage Institutions May Limit Availability
paragraphs: Some mortgage institutions initially may offer new products on a limited  basis. For example, Fannie Mae and Freddie Mac sometimes use pilots, or  limited offerings of new products, to build experience with a new product  type. Fannie Mae and Freddie Mac also sometimes set volume limits for  the percentage of their business that could be low- and no-down-payment  lending. FHA has utilized pilots or demonstrations when making changes  to its single-family mortgage insurance but generally has done so in  response to legislative requirement rather than on its own initiative. For  example, FHA’s Home Equity Conversion Mortgage insurance program  started as a pilot that authorized FHA to insure 2,500 reverse mortgages.  Additionally, some mortgage institutions may limit the origination and  servicing of new products to their better lenders and servicers. Fannie Mae  and Freddie Mac both reported that these were important steps in  introducing a new product.
We recommended that when FHA releases new products or makes  significant changes to existing products, it consider similar steps to limit  the initial availability of these products. FHA officials agreed that they  could, under certain circumstances, envision piloting or limiting the ways  in which a new product would be available, but pointed to the practical  limitations of doing so. For example, FHA officials told us that  administering the Home Equity Conversion Mortgage pilot program was  difficult because of the challenges of equitably selecting a limited number  of lenders and borrowers. FHA generally offers products on a national  basis and, if they did not, specific regions of the county or lenders might  question why they were not able to receive the same benefit. FHA officials  told us they have conducted pilot programs when Congress has authorized  them, but they questioned the circumstances under which pilot programs  were needed, and also said that they lacked sufficient resources to  appropriately manage a pilot. Consistent with these views, FHA officials  told us more recently that they would not limit the initial availability of any  products authorized by its legislative proposal. However, if FHA does not  limit the availability of new or changed products, the agency runs the risk  of facing higher claims from products whose risks may not be well  understood.
section_title: The Way FHA Developed TOTAL Limits the Scorecard’s Effectiveness in Assessing the Default Risk of Borrowers
paragraphs: A primary tool that FHA uses to assess the default risk of borrowers who  apply for FHA-insured mortgages is its TOTAL scorecard. TOTAL’s  capabilities are important, because to the extent that conventional  mortgage lenders and insurers are better able than FHA to use mortgage  scoring to identify and approve relatively low-risk borrowers and charge  fees based on default risk, FHA may face adverse selection. That is,  conventional providers may approve lower-risk borrowers in FHA’s  traditional market segment, leaving relatively high-risk borrowers for FHA.  Accordingly, the greater the effectiveness of TOTAL, the greater the  likelihood that FHA will be able to effectively manage the risks posed by  borrowers and operate in a financially sound manner.
In reports we issued in November 2005 and April 2006, we noted that while  FHA’s process for developing TOTAL generally was reasonable, some of  the choices FHA made in the development process could limit the  scorecard’s effectiveness. FHA and its contractor used variables that  reflected borrower and loan characteristics to create TOTAL, as well as an  accepted modeling process to test the variables’ accuracy in predicting  default. However, we also found that    The data used to develop TOTAL were 12 years old by the time FHA  implemented the scorecard. Specifically, when FHA began developing  TOTAL in 1998, the agency chose to use 1992 loan data, which would be  old enough to provide a sufficient number of defaults that could be  attributed to a borrower’s poor creditworthiness. However, FHA did not  implement TOTAL until 2004 and has not subsequently updated the data  used in the scorecard. Best practices of private-sector organizations call  for scorecards to be based on data that are representative of the current  mortgage market—specifically, relevant data that are no more than several  years old. In the past 12 years, significant changes—growth in the use of  down-payment assistance, for example—have occurred in the mortgage  market that have affected the characteristics of those applying for FHA- insured loans. As a result, the relationships between borrower and loan  characteristics and the likelihood of default also may have changed.
TOTAL does not include certain key variables that could help explain  expected loan performance. For example, TOTAL does not include a  variable for the source of the down payment. However, FHA contractors,  HUD’s Inspector General, and our work have all identified the source of a  down payment as an important indicator of risk, and the use of down- payment assistance in the FHA program has grown rapidly over the last 5  years. Further, TOTAL does not include other important variables—such  as a variable for generally riskier adjustable rate loans—included in other  scorecards used by private-sector entities.
Although FHA had a contract to update TOTAL, the agency did not  develop a formal plan for updating TOTAL on a regular basis. Best  practices in the private sector, also reflected in bank regulator guidance,  call for having formal policies to ensure that scorecards are routinely  updated. Without policies and procedures for routinely updating TOTAL,  the scorecard may become less reliable and, therefore, less effective at  predicting the likelihood of default.
To improve TOTAL’s effectiveness, we recommended, among other things,  that HUD develop policies and procedures for regularly updating TOTAL  and more fully consider the risks posed by down-payment assistance when  underwriting loans, such as including the presence and source of down- payment assistance as a loan variable in the scorecard. In response, FHA  has developed and begun putting in place policies and procedures that call  for annual (1) monitoring of the scorecard’s ability to predict loan default,  (2) testing of additional predictive variables to include in the scorecard,  and (3) updating the scorecard with recent loan performance data.
We also recommended that HUD explore additional uses for TOTAL,  including using it to implement risk-based pricing of mortgage insurance  and to develop new products. These actions could enhance FHA’s ability  to effectively compete in the mortgage market and avoid adverse  selection. Our ongoing work indicates that FHA plans to use borrowers’  TOTAL scores to help set insurance premiums. Accordingly, any  limitations in TOTAL’s ability to predict defaults could result in FHA  mispricing its products.
section_title: FHA’s Current Reestimated Subsidy Costs Are Generally Less Favorable than its Original Estimates
paragraphs: As previously noted, FHA, like other federal agencies, is required to  reestimate credit subsidy costs annually to reflect actual loan performance  and expected changes in estimates of future loan performance. In doing  so, FHA reestimates subsidy costs for each loan cohort.
As we reported in September 2005, FHA’s subsidy reestimates generally  have been less favorable (i.e., higher) than the original estimates since  federal credit reform became effective in 1992. The current reestimated  subsidy costs for all except the fiscal year 1992 and 1993 cohorts are  higher than the original estimates. For example, the current reestimated  cost for the fiscal year 2006 cohort is about $800 million less favorable  than originally estimated.
With respect to reestimates across cohorts, our report examined factors  contributing to an unusually large $7 billion reestimate (more than twice  the size of other recent reestimates) that FHA submitted as of the end of  fiscal year 2003 for the fiscal year 1992 through 2003 cohorts.  These  factors included increases in estimated claims and prepayments (the  payment of a loan before its maturity date). Several policy changes and  trends may have contributed to changes in the expected claims. For  example:    Revised underwriting guidelines made it easier for borrowers who were  more susceptible to changes in economic conditions—and therefore more  likely to default on their mortgages—to obtain an FHA-insured loan.
Competition from conventional mortgage providers could have resulted in  FHA insuring more risky borrowers.
FHA insured an increasing number of loans with down-payment  assistance, which generally have a greater risk of default.
FHA’s loan performance models did not include key variables that help  estimate loan performance, such as credit scores, and as of September  2005, the source of down payment.
The major factors underlying the surge in prepayment activity were  declining interest rates and rapid appreciation of housing prices. These  trends created incentives and opportunities for borrowers to refinance  using conventional loans.
To more reliably estimate program costs, we recommended that FHA  study and report on how variables found to influence credit risk, such as  payment-to-income ratios, credit scores, and down-payment assistance  would affect the forecasting ability of its loan performance models. We  also recommended that when changing the definitions of key variables,  FHA report the impact of such changes on the models’ forecasting ability.  In response, HUD indicated that its contractor was considering the  specific variables that we had recommended FHA include in its annual  actuarial review of the Fund. The contractor subsequently incorporated  the source of down-payment assistance in the fiscal year 2005 actuarial  review and borrower credit scores in the fiscal year 2006 review.
Madam Chairman, this concludes my prepared statement. I would be  happy to answer any questions at this time.
section_title: Contacts and Acknowledgments
paragraphs: For further information on this testimony, please contact William B. Shear  at (202) 512-8678 or shearw@gao.gov. Individuals making key  contributions to this testimony included Barbara Roesmann, Paige Smith,  Laurie Latuda, and Steve Westley.
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