Federal Housing Administration: Proposed Reforms Will Heighten the Need for Continued Improvements in Managing Risks and Estimating Program Costs
Published: 2006-06-20T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The Department of Housing and Urban Development's (HUD) Federal Housing Administration (FHA) has faced several challenges in recent years, including rising default rates, higher-than-expected program costs, and a sharp decline in program participation. To help FHA adapt to market changes, HUD has proposed a number of changes to the National Housing Act that would raise FHA's mortgage limits, allow greater flexibility in setting insurance premiums, and reduce down-payment requirements. Implementing the proposed reforms would require FHA to manage new risks and estimate the costs of program changes. To assist Congress in considering issues faced by FHA, this testimony provides information from recent reports GAO has issued that address FHA's risk management and cost estimates. Specifically, this testimony looks at (1) FHA's development and use of its mortgage scorecard, (2) FHA's consistent underestimation of program costs, (3) instructive practices for managing risks of new mortgage products, and (4) weaknesses in FHA's management of risks related to loans with down-payment assistance.
section_title: What GAO Found
paragraphs: Recent trends in mortgage lending have significantly affected FHA, including increased use of automated tools (e.g., mortgage scoring) to underwrite loans, increased competition from lenders offering low-and no-down-payment products, and a growing proportion of FHA-insured loans with down-payment assistance. 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 manage risk and estimate program costs during this period of change. The way that FHA developed and uses its mortgage scorecard, while generally reasonable, limits how effectively it assesses the default risk of borrowers. With one exception, FHA's reestimates of program costs have been less favorable than originally estimated, including a $7 billion reestimate for fiscal year 2003. FHA has not consistently implemented practices used by other mortgage institutions to help manage the risks associated with new mortgage products. FHA has not developed sufficient standards and controls to manage risks associated with insuring a growing proportion of loans with down-payment assistance. GAO made several recommendations in its recent reports, including that FHA (1) incorporate the risks posed by down-payment assistance into its mortgage 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 mortgage products. FHA has taken actions in response to GAO's recommendations, but additional improvements in managing risk and estimating program costs will be important if FHA is to successfully implement its proposed program changes.

section_title: Letter
paragraphs: I am pleased to have the opportunity to share information and  perspectives with the committee as it considers issues facing 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 and in fiscal year 2005 insured about  480,000 mortgages, representing $58 billion in mortgage insurance. The  insurance program is supported by the Mutual Mortgage Insurance Fund  (Fund), which is financed through insurance premiums that FHA charges  to borrowers. According to HUD’s estimates, FHA’s mortgage insurance  program is currently a negative subsidy program, meaning that the Fund is  self-financed and currently operates at a profit. However, the program has  faced several challenges in recent years, including rising default rates,  higher-than-expected program costs, and a sharp decline in program  participation due, in part, to increased competition from conventional  mortgage providers.
To help FHA adapt to market changes, HUD has proposed a number of  changes to the National Housing Act that would, among other things, raise  FHA’s maximum mortgage limits, give the agency flexibility to set  insurance premiums based on the credit risk of borrowers, and reduce  down-payment requirements from the current 3 percent to potentially  zero. However, to implement this legislative proposal, FHA would have to  manage new risks and accurately estimate the costs of program changes.  For example, to set risk-based insurance premiums, FHA would need to  understand the relationships between borrower and loan characteristics  and the likelihood of default, as well as how the premiums would affect  the Fund’s financial condition. Further, reducing the down-payment  requirements for certain borrowers (and thus increasing the loan-to-value  ratios) has important implications for the risks of these loans. Loans with  low or no down payments carry greater risk, partly because the higher the  loan-to-value ratio, the less cash borrowers will have invested in their  homes and the more likely that they may default on mortgage obligations,  especially during times of economic hardship.
My testimony today discusses four reports that we issued since 2005 that  examined different aspects of FHA’s ability to manage risks and estimate  program costs. Specifically, I will discuss (1) FHA’s development and use  of a mortgage scorecard to assess the default risk of borrowers, (2) FHA’s  consistent underestimation of subsidy costs for its single-family insurance  program and particularly large subsidy reestimate for fiscal year 2003, (3)  practices that could be instructive for FHA in managing the risks of new  mortgage products, and (4) weaknesses in how FHA has managed risks  associated with growth in the proportion of loans with down-payment  assistance.
In preparing these reports, we reviewed and analyzed information  concerning FHA’s approach to developing its mortgage scorecard and the  scorecard’s benefits and limitations; FHA’s estimates of subsidy costs and  the factors underlying the agency’s subsidy reestimates; steps mortgage  industry participants take to design and implement low- and no-down- payment mortgage products; and the standards and controls FHA uses to  manage the risks of loans with down-payment assistance. We interviewed  officials at FHA, the U.S. Department of Agriculture, and U.S. Department  of Veteran Affairs (VA); and staff at selected mortgage providers, private  mortgage insurers; Fannie Mae and Freddie Mac; the Office of Federal  Housing Enterprise Oversight; selected state housing finance agencies; and  nonprofit down-payment assistance providers. We conducted this work in  Boston, Massachusetts, and Washington, D.C., from January 2004 through  February 2006 in accordance with generally accepted government auditing  standards.
In summary, our past work identified a number of weaknesses in FHA’s  ability to manage risk and estimate program costs:    While generally reasonable, the way that FHA developed and uses its  mortgage scorecard—an automated tool that evaluates the default risk  of borrowers—limits the scorecard’s effectiveness. FHA and its  contractor used variables that reflected borrower and loan  characteristics to create the scorecard, as well as an accepted  modeling process to test the variables’ accuracy in predicting default.  However, the data used to develop the scorecard were 12 years old by  the time that FHA began using the scorecard in 2004, and the mortgage  market has changed significantly since then. In addition, the scorecard  does not include certain key variables that could help explain expected  loan performance such as the source of the down payment.
FHA’s subsidy reestimates reflect a consistent underestimation of the  costs of its single-family insurance program. For example, as of the end  of fiscal year 2003, FHA submitted a $7 billion reestimate for the Fund,  reflecting a reduction in estimated profits. Increases in the expected  level of insurance claims—potentially stemming from changes in  underwriting guidelines, among other factors—were a major cause of  the $7 billion reestimate.
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.
FHA has not developed sufficient standards and controls to manage  risks associated with the growing 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 that loans with seller-funded nonprofit  down-payment assistance would result in an insurance claim was 76  percent higher than comparable loans without such assistance.
On the basis of our findings from the four reports I have summarized, we  made several recommendations designed to improve FHA’s risk  management and cost estimates. 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 subsidy 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 (used in estimating  subsidy costs) that have been found in other studies to influence credit  risk. In light of the risks that new mortgage products present and in  recognition of established risk management practices, we also suggested  that Congress consider (1) limiting the initial availability of any new single- family insurance product it might authorize and (2) directing FHA to  consider using various techniques for mitigating risks for a no-down- payment product, or products about which the risks were not well  understood.
FHA has taken actions in response to some of our recommendations. For  example, FHA agreed to consider incorporating a variable for down- payment assistance in its mortgage scorecard. To more accurately assess  subsidy costs, an FHA contractor is considering the specific variables that  we recommended FHA include in its annual actuarial review and  incorporated the source of down payment in the 2005 actuarial review of  the Fund. FHA also has agreed to improve its oversight of down-payment  assistance lending, including modifying its information systems to  document assistance from seller-funded nonprofits.
While these actions represent improvements in FHA’s risk management,  additional improvements will be important if FHA is to successfully  implement some of the program changes HUD has proposed. Accordingly,  consideration of this proposal should include serious deliberation of the  associated risks and the capacity of FHA to mitigate them.
subsections: section_title: Background
paragraphs: Congress established FHA in 1934 under the National Housing Act (P.L. 73- 479) to broaden homeownership, shore up and protect lending institutions,  and stimulate employment in the building industry. FHA’s single-family  program insures private lenders against losses (up to almost 100 percent  of the loan amount) from borrower defaults on mortgages that meet FHA  criteria. In 2004, more than three-quarters of the loans that FHA insured  went to first-time homebuyers, and more than 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 less than 4 percent of the single-family mortgage market,  compared with about 13 percent a decade ago. Additionally, default rates  for FHA-insured mortgages have risen steeply over the past several years,  a period during which home prices have appreciated rapidly and default  rates for conventional and VA-guaranteed mortgages have been relatively  stable.
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’s mortgage insurance program  is currently a negative subsidy program, meaning that the present value of  estimated cash inflows to the Fund exceed the present value of estimated  cash outflows. FHA has estimated that the loans it expects to insure in  2007 will have a subsidy rate of -0.37, a rate closer to zero (the point at  which estimated cash inflows equal estimated cash outflows) than any  previous estimate. 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. 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, 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.
HUD’s legislative proposal is intended to modernize FHA, in part, to  respond to the changes in the mortgage market. The proposal, among  other things, would authorize FHA to change the way it sets insurance  premiums, insure larger loans, 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 a property. HUD’s proposal would eliminate this contribution  requirement and enable FHA to offer some borrowers a no-down-payment  product. FHA is subject to limits in the size of the loans it can insure. For  example, for a one-family property in a high-cost area, the FHA limit is 87  percent of the limit established by Freddie Mac. The legislative proposal  would raise this limit to 100 percent of the Freddie Mac limit.
section_title: The Way FHA Developed and Uses TOTAL Limits the Scorecard’s Effectiveness in Assessing the Default Risk of Borrowers
paragraphs: If Congress authorizes the reforms HUD has proposed, FHA’s ability to  assess the default risk of borrowers will take on increased importance  because FHA would be adjusting insurance premiums based on its  assessments of the credit risk of borrowers and insure potentially larger  and riskier mortgages with low or no down payments. A primary tool that  FHA uses to assess the default risk of borrowers who apply for FHA- insured mortgages is its TOTAL scorecard.
subsections: section_title: Age of Data, Lack of Key Variables, and Lack of Policy for Updating TOTAL Could Limit Its Effectiveness
paragraphs: 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 has a contract to update TOTAL by 2007, the agency did  not develop a formal plan for updating TOTAL on a regular basis. Best  practices in the private sector and 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 by including the presence and source of down-payment  assistance as a loan variable in the scorecard. In response, FHA agreed to  consider incorporating a variable for down-payment assistance in TOTAL.
section_title: HUD Could Realize Additional Benefits from an Expanded Use of TOTAL
paragraphs: Despite potential limitations in the use of TOTAL, HUD still could realize  additional benefits from the scorecard, if, like private-sector lenders and  mortgage insurers, it put TOTAL to other uses. Based on its current use of  TOTAL, FHA lenders and borrowers have seen two added benefits—less  paperwork and more consistent underwriting decisions. However, private  lenders and mortgage insurers put their scorecards to other uses,  including to help price products based on risk and launch new products.  For example, to set risk-based prices, private-sector organizations use  scorecards to rank the relative risk of borrowers and price products  according to that ranking. By increasing their use of scorecards, these  organizations are able to broaden their customer base and improve their  financial performance. Adopting these best practices from the private  sector could generate similar kinds of benefits for FHA, particularly if FHA  were to implement risk-based pricing.
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 seeking FHA-insured loans.
To improve how FHA benefits from TOTAL, we recommended that the  agency explore additional uses for the scorecard, 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. In response to our recommendations,  FHA indicated that it planned to explore these uses for TOTAL.
section_title: FHA’s Reestimates Reflect Consistent Underestimation of Program Costs, Primarily Because of Higher Claims than Initially Estimated
paragraphs: If implemented, HUD’s legislative proposal could affect the Fund’s cash  inflows and outflows and, as a result, significantly affect the credit subsidy  costs of the insurance program. For example, changes in FHA’s insurance  premiums could affect the revenues FHA receives, and changes in the  composition and riskiness of the loan portfolio (as a result of larger loans  or more loans with no down payments) could affect the size and number  of insurance claims FHA pays.
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. FHA has  estimated negative credit subsidies for the Fund since 1992, when federal  credit reform became effective. However, as we reported in September  2005, with the exception of the 1992 reestimate, FHA’s subsidy reestimates  have been less favorable than the original estimates. In particular, FHA’s  $7 billion reestimate for fiscal year 2003 was more than twice the size of  any other reestimate from fiscal years 2000 through 2004.
The $7 billion reestimate for fiscal year 2003 had three main components.  The first component was the $3.9 billion difference between FHA’s fiscal  year 2003 estimates of the net present value of future cash flows and the  estimates it made one year earlier. Most of this difference stemmed from  changes in FHA’s estimates of claims and, to a lesser extent, prepayments  (the payment of a loan before its maturity date). That is, FHA changed its  estimate of future loan performance based on its observation of actual  loan performance during fiscal year 2003 and revised economic  assumptions. The second component was the $2.1 billion difference  between estimated and actual cash flows occurring during fiscal year 2003.  Underestimation of claims (net of recoveries on claims) and an  overestimation of net fees (insurance premium receipts less premium  refunds) for loans made prior to fiscal year 2003 largely account for the  difference. The third component was an interest adjustment on the  reestimate required by Office of Management and Budget guidance that  increased the total reestimate by $1.1 billion.
Several recent policy changes and trends may have contributed to changes  in the expected claims underlying the $7 billion reestimate. For example:    Revised underwriting guidelines made it easier for borrowers who are  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 that also  contributed to the reestimate 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, FHA indicated, among other things, that its contractor was  considering the specific variables that we had recommended FHA include  in its annual actuarial review and had incorporated the source of down- payment assistance in the 2005 actuarial review of the Fund.
section_title: Practices Used by Other Mortgage Institutions 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 used by other mortgage institutions could help FHA to  design and implement 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.
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. However, 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 are  underserved by the conventional market, including those who lack credit  scores and have little wealth or personal savings.
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. FHA, if authorized to  implement risk-based pricing, could set higher premiums on FHA-insured  loans understood to have greater risk.
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. 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: FHA Has Not Implemented Sufficient Standards and Controls to Manage Risks Associated with the Growing Proportion of Loans with Down- Payment Assistance
paragraphs: HUD’s legislative proposal would represent a significant change to the  agency’s single-family mortgage insurance program and presents new risk  management challenges. 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.
subsections: section_title: The Percentage of Loans with Down-Payment Assistance in FHA’s Portfolio Has Been Increasing and These Loans Do Not Perform as Well as 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 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 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.
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 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. The poorer performance of loans with nonprofit seller- funded, down-payment assistance may be explained, in part, by the sales  prices of the homes bought with such assistance.  More specifically, 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 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 viewed such assistance as a seller  inducement and, therefore, does not subject this assistance to the limits it  otherwise places on contributions from sellers. However, due in part to  concerns about loans with nonprofit seller-funded, down-payment  assistance, FHA has proposed legislation that could help eliminate the  need for such assistance by allowing some FHA borrowers to make no  down payments for an FHA-insured loan.
FHA has taken some steps to assess and manage the risks associated with  loans with down-payment assistance, but additional controls may be  warranted. For example, FHA has contracted for two studies to assess the  use of such assistance with FHA-insured loans and conducted ad hoc  performance analyses of loans with down-payment assistance but has not  routinely assessed the impact that the widespread use of down-payment  assistance has had on loan performance. Also, FHA has targeted its  monitoring of appraisers to those that do a high volume of loans with  down-payment assistance, but FHA has not targeted its monitoring of  lenders to those that do a high volume of loans with down-payment  assistance, even though FHA holds lenders, as well as appraisers,  accountable for ensuring a fair valuation of the property it insures.
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) requiring lenders to inform appraisers  when assistance is provided by seller-funded nonprofits. In addition, HUD  has proposed a zero down-payment program as an alternative to seller- funded, down-payment assistance.
In May 2006, the Internal Revenue Service 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.
section_title: Observations
paragraphs: 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, FHA is insuring a greater  proportion of loans with down-payment assistance. These loans are more  likely to result in insurance claims than loans without such assistance.
To effectively manage the risks posed by FHA’s existing products, we have  concluded from our prior work that the agency must significantly improve  its risk management and cost estimation practices. We are encouraged by  a variety of steps FHA has taken to enhance its capabilities in these areas,  such as developing and implementing a mortgage scorecard and improving  its loan performance models. However, FHA needs to take additional  steps, such as establishing policies and procedures for updating TOTAL  scorecard on a regular basis, more fully considering the risks posed by  down-payment assistance when underwriting loans, developing a  framework for introducing new products in a way that mitigates risk, and  studying and reporting on the impact of variables found to influence credit  risk that are not currently in the agency’s loan performance models.
HUD’s legislative proposal could help FHA serve more low-income and  first-time homebuyers, but also would introduce additional risks to the  Fund. Consideration of this proposal should include serious deliberation  of the associated risks and the capacity of FHA to mitigate them.
Mr. Chairman, this concludes my prepared statement. I would be happy to  answer any questions at this time.
section_title: Contacts and Acknowledgments
paragraphs: For further information on this testimony, please contact William B. Shear  at (202) 512-8678. Individuals making key contributions to this testimony  included Triana Bash, Anne Cangi, Marcia Carlsen, John Fisher, Austin  Kelly, John McGrail, Andrew Pauline, Barbara Roesmann, Mathew Scirè,  Katherine Trimble, and Steve Westley.
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