Federal Housing Administration: Analysis of Options for Modifying Its Products, Market Presence, and Powers
Released: 2013-10-22T00:00:00


Highlights: section_title: Why GAO Did This Study
paragraphs: FHA has historically provided mortgage guarantees for home buyers, particularly first-time, minority, and lower-income borrowers. In 2012, FHA insured about $227 billion in single-family mortgages, and its overall insurance portfolio was about $1.1 trillion. Its market presence expanded during the recent housing crisis as the conventional market contracted and Congress increased the limit on the size of loans FHA may insure. But FHA's financial condition has weakened, and FHA has not met its 2 percent statutory minimum capital ratio since 2009. In its most recent budget, the agency stated that its capital reserve account might require an infusion of federal funds.

FHA, industry participants, and researchers have suggested a number of options for improving FHA's long-term viability or for limiting FHA's market presence. These options have potential implications for taxpayers, borrowers, and others. This report discusses the options--which fall into three broad categories: (1) changes to product terms and conditions, (2) changes that would restrict FHA's market presence, and (3) changes to FHA's operations and powers--and their implications. It also describes the possible effects of broader housing finance reform on FHA.

GAO interviewed a variety of industry stakeholders and researchers and reviewed studies and other documents to identify options for reforming FHA and their implications.

section_title: What GAO Found
paragraphs: GAO identified a number of proposed options for adjusting product terms and conditions to help improve the Federal Housing Administration's (FHA) long-term viability. FHA has raised the premiums that it charges borrowers several times in recent years and has taken steps to tighten its underwriting standards--for example, by setting a minimum required credit score. Some mortgage market observers have argued that further changes such as revising underwriting standards to focus on borrowers' residual income, requiring higher down payments, or reducing seller concessions (that is, funds sellers provide to buyers to help pay for closing costs) could help FHA better manage credit risk. However, such changes would entail trade-offs. For instance, some said that raising down-payment requirements would improve loan performance, but others said that this move would delay homeownership for many borrowers. Similarly, raising premiums could potentially increase revenue, but this potential would be constrained if it caused volume to decline. Further, low-risk borrowers with fewer down-payment constraints could choose less costly loans from other sources, leaving FHA with more high-risk borrowers. These changes could have a direct effect on the availability of credit for borrowers.

GAO also identified options that could either directly or indirectly change FHA's market presence, which increased after the housing crisis, or address its financial viability. Among the proposals that would have a direct effect are those limiting FHA insurance to loans below a lowered ceiling or to borrowers who met new income guidelines. Many stakeholders and FHA itself view FHA's current loan limits, which range from $271,050 to $729,750 for one-unit properties in the contiguous United States, as too high. Some note that the agency may insure larger loans than the housing enterprises Fannie Mae and Freddie Mac. The current FHA limits were put in place in response to declines in mortgage lending during the housing crisis, when the private sector's role in financing mortgages shrank. However, as the market has improved, some have noted that lowering loan limits would allow private capital to return to the market and focus FHA on low- and moderate-income and first-time home buyers, a shift that many observers consider appropriate. Other proposed changes, such as reducing insurance coverage to less than 100 percent of the loan amount or entering into risk-sharing agreements with private partners, may indirectly reduce FHA's market presence. However, applying a partial coverage model would limit availability of credit to some borrowers. For some lenders, the additional exposure might prompt the purchase of additional insurance coverage from third parties, the cost of which would be passed on to borrowers. Some argue that under a risk-sharing structure private partners would assume and better manage credit risk. But creating such a structure would require careful consideration of how risks are borne, how pricing is determined, how incentives are aligned between FHA and its partners, and how FHA's role in stabilizing mortgage markets would be impacted. Others point to the additional counterparty risk posed by risk-sharing arrangements, which would necessitate greater federal oversight. Finally, these options might also affect FHA's ability to respond to changing market conditions.

FHA and industry observers have also suggested changes to FHA’s structure and powers that could enhance its flexibility and capacity to manage risk. Some of these changes would bring FHA’s corporate powers more in line with those of other government corporations and increase its autonomy, providing it with enhanced enforcement powers and greater authority to change program requirements and invest in staff and technology. FHA has already requested additional enforcement authority. FHA and other observers have also argued that FHA needs greater power to change loan products or loan features without a lengthy rulemaking process and additional information technology resources—resources for which FHA must currently compete within HUD. Expanding FHA’s operational and managerial powers would give the agency more flexibility, and increasing its enforcement powers would allow it to more effectively oversee lenders. But any expansion of FHA’s authority may need to be limited and transparency requirements heightened, including for the rulemaking process. Even with no changes to its existing organizational structure and authorities, FHA can do more to enhance program efficiency and effectiveness and protect taxpayers. GAO has made a number of recommendations aimed at improving FHA’s loss mitigation efforts, management of real-estate owned inventories, risk assessment, human capital management, and information technology systems. In response to these recommendations, FHA has taken steps, such as developing a plan for conducting an inaugural risk assessment and a workforce analysis and succession plan.

Finally, efforts to further regulate housing finance and the continuing uncertainty over resolution of Fannie Mae and Freddie Mac present challenges to any efforts to reform FHA. Following the collapse of the mortgage market, Congress passed a number of mortgage reforms that could impact FHA’s market share and role because they could affect the price at which the conventional market will be able to serve future home buyers of varying credit risk profiles. Similarly, the administration has put forth several options for reforming the federal role in the mortgage market, including reform of Fannie Mae and Freddie Mac. Each of these options could have an impact on FHA’s role in the mortgage market. Partly for this reason, GAO identified modernization of the federal role in housing finance as a high-risk area in early 2013. Any changes to the federal tools that support housing finance should be made in concert and with full recognition of the interdependence among FHA, the enterprises, and federal regulation.

section_title: Letter
paragraphs: The Department of Housing and Urban Development’s (HUD) Federal  Housing Administration (FHA) has helped millions of families purchase  homes through its single-family mortgage insurance programs, which  insure private lenders against losses on mortgages that finance  purchases of properties or that refinance existing FHA mortgages. In  2012, FHA insured about $227 billion in single-family mortgages, and its  overall insurance portfolio was about $1.1 trillion. In recent years, FHA  has experienced a dramatic increase in its market share, partly because  the conventional mortgage market contracted during the 2007-2009  financial crisis. At the same time, FHA has faced fiscal challenges. Since  2009, its Mutual Mortgage Insurance Fund (the Fund) has not met  statutory reserve requirements, as measured by the Fund’s estimated  capital ratio. The Fund is required to maintain a capital ratio of at least 2  percent. Also, declining balances in the fund’s capital reserve account  and significant underestimates of program costs have heightened the  possibility that FHA will require additional funds to pay all future insurance  claims on its existing portfolio.

FHA has made a number of changes to address its fiscal challenges.  However, mortgage market observers have stated that further actions are  needed and have proposed options that could improve FHA’s long-term  viability or reduce its market presence. These suggestions range from  changes to its product features to broad changes to its organizational  structure. You asked us to examine these options and their implications.

This report discusses the implications of options related to (1) changing  FHA’s product terms and conditions for single-family mortgage insurance,  (2) restricting FHA’s presence in the single-family housing market, and (3)  altering FHA’s operations and powers within its single-family program. It  also discusses the possible effects of broader housing finance reform on  FHA. Options that included changes to FHA’s capital reserve  requirements were not within the scope of our review. However, we  previously recommended that in place of FHA’s 2-percent capital  requirement, Congress or FHA specify the economic conditions the Fund  would be expected to withstand without drawing on the U.S. Treasury.  Additionally, in another report issued today, we compare the reserving  practices and capital requirements of FHA to those of private mortgage  insurers.

To examine the options that have been proposed for improving FHA’s  long-term viability or limiting its market presence, we identified relevant  academic and industry studies from our previous products and ongoing  work and from a literature search of databases. We reviewed these  studies and other documents—including from FHA and HUD—to  summarize and categorize options for FHA reform. The categories we  indentified were potential changes to product terms and conditions,  changes that affect FHA’s mortgage market presence, and changes to  FHA’s operational powers and structure. We also reviewed studies and  other documents to identify the potential implications of these options,  including how the options affect cost and risk to the taxpayer, borrowers’  access to credit, FHA’s role and the market it serves, and other mortgage  market participants. We conducted interviews with mortgage industry  observers from industry, academic, government, and consumer  organizations to obtain their views on the options and related implications  that we identified and to obtain any additional relevant studies or papers.  Appendix I contains additional information on our scope and  methodology.

We conducted this performance audit from April 2013 to September 2013  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: FHA is a wholly owned government corporation within HUD. It was  established in 1934 under the National Housing Act to broaden  homeownership, shore up and protect lending institutions, and stimulate  employment in the building industry.
subsections: section_title: FHA’s Single-Family Mortgage Insurance
paragraphs: FHA’s single-family programs insure private lenders against losses from  borrower defaults on mortgages that meet FHA criteria for properties with  one to four housing units. FHA primarily insures forward mortgages for  initial home purchases and refinancing, but also insures reverse  mortgages that permit persons 62 years and older to convert their home  equity into cash advances through its Home Equity Conversion  Mortgages for Seniors (HECM) program. single-family mortgage insurance through programs supported by the  Fund.Deputy Assistant Secretary for Single Family Housing, who reports to the  Assistant Secretary for Housing-Federal Housing Commissioner.

With forward mortgages, the borrower’s monthly loan payments to the lender add to the  borrower’s home equity and decrease the loan balance. With reverse mortgages, the  borrower receives payments from the lender. The lender adds the principal and interest to  the loan balance, reducing the homeowner’s equity.

FHA is a government mortgage insurer in a market that also includes  private mortgage insurers. Private mortgage insurance policies provide  lenders coverage on a portion (generally 20 to 30 percent) of the  mortgage balance. However, borrowers who have difficulty meeting  down-payment and credit score requirements for conventional loans may  find it easier to qualify for a loan with FHA insurance, which covers 100  percent of the principal balance of the loan involved in a claim and other  eligible costs. Generally, borrowers are required to purchase mortgage  insurance when the loan-to-value (LTV) ratio (the amount of the mortgage  loan divided by the value of the home multiplied by 100) exceeds 80  percent. FHA-insured borrowers are required to make minimum cash  investments of 3.5 percent, which may come from the borrowers’ own  funds or from certain third-party sources. Borrowers are also permitted to  finance their mortgage insurance premiums, a practice that can create an  effective LTV ratio of close to 100 percent. Congress has set limits on the  size of the forward mortgages FHA may insure, which can vary by county.  For the period from January 1, 2013, through December 31, 2013, the  limits range from $271,050 to $729,750 for one-unit properties in the  contiguous United States.

section_title: FHA’s Role in Mortgage Financing
paragraphs: FHA’s single-family mortgage programs have played a prominent role in  mortgage financing in the wake of the 2007-2009 financial crisis and  housing downturn. In 2012, FHA insured about $227 billion in single- family mortgages, and its overall insurance portfolio was about $1.1  trillion. The agency has played a particularly large role among minority,  lower-income, and first-time homebuyers. In 2012, about 78 percent of  FHA-insured loans went to first-time homebuyers, about 32 percent of  whom were minorities. FHA is generally thought to promote stability in the  market by ensuring the availability of mortgage credit in areas that may  be underserved by the private sector or that are experiencing economic  downturns. As the recent housing crisis and economic recession set in,  the contraction of other segments of the mortgage market and legislated  increases in the loan amounts eligible for FHA insurance resulted in  higher demand for FHA-insured mortgages. FHA officials also noted that  even if their volume had not increased, the agency’s share of the market  would have increased because other segments of the market declined or  were completely eliminated. According to HUD’s Housing Market  Conditions, FHA’s share of the market for home purchase mortgages (in  terms of loan originations) grew sharply, rising from approximately 4.5  percent in 2006 to approximately 26.1 percent in 2012.entire mortgage market (including refinance activity), FHA’s share of the  market also rose dramatically, and stood at 14.6 percent in 2012   (see fig. 1).

A number of other private-sector and government institutions participate  in the mortgage market.

Private lenders offer home purchase and refinance mortgages and  often work with mortgage brokers, independent contractors that  originate the loan products of multiple lenders.

The Department of Veterans Affairs’ (VA) Loan Guaranty Service and  the Department of Agriculture’s (USDA) Rural Housing Service (RHS)  administer federal programs that insure or guarantee single-family  mortgages made by private lenders.

Private mortgage insurance companies offer mortgage insurance that  protects private lenders against losses in the event the borrower  defaults on the mortgage. Fannie Mae and Freddie Mac, two  government-sponsored enterprises (the enterprises), purchase  mortgages from lenders across the country, financing their purchases  through borrowing or by issuing securities backed by the mortgages  (mortgage-backed securities or MBS). The enterprises are currently  under conservatorship.

Ginnie Mae is another wholly owned government corporation in HUD.

It guarantees the timely payment of principal and interest of MBS  backed by pools of federally insured or guaranteed mortgage loans,  such as FHA, VA, or RHS.

section_title: FHA’s Mutual Mortgage Insurance Fund
paragraphs: The Omnibus Budget Reconciliation Act of 1990 required 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 that level thereafter. The  capital ratio is the Fund’s economic value divided by the insurance-in- force (outstanding insurance obligations). The act also required an annual  independent actuarial review of the Fund’s economic net worth and  soundness. This actuarial review is now a requirement in the Housing and  Economic Recovery Act of 2008, which also requires an annual report to  Congress on the results of the review. 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).  According to annual actuarial reviews of the Fund, the capital ratio fell  from about 7 percent in 2006 to 3 percent in 2008 and dropped to below 2  percent in 2009 (see fig. 2). In 2012, the ratio fell below zero to negative  1.44 percent.

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 estimated 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  (such as borrower insurance premiums) exceed expected cash outflows  (such as insurance claims), a program is said to have a negative credit  subsidy rate and generates offsetting receipts that reduce the federal  budget deficit. When the opposite occurs, 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 thus provided permanent and indefinite  budget authority for reestimates that reflected increased program costs.Upward reestimates increase the federal budget deficit unless  accompanied by reductions in other government spending or an increase  in receipts.

As the capital ratio declined, the Fund’s condition also worsened from the  federal budgetary perspective. FHA annually estimates the subsidy costs  of new activity for its loan insurance program and also reestimates, or  annually updates, prior subsidy cost estimates. Historically, FHA  estimated that its loan insurance program had a negative subsidy cost.  On the basis of these estimates, FHA accumulated substantial balances  in a capital reserve account, which represents amounts in excess of those  needed for estimated claims or other costs and was used to cover  reestimates reflecting unanticipated increases to those costs (such as  higher-than-expected claims). In recent years, FHA has transferred  billions of dollars annually from the capital reserve account to cover  increases in estimated credit subsidy costs of the Fund (upward subsidy  reestimates). As a result, balances in the capital reserve account fell  dramatically, from $19.3 billion at the end of 2008 to an estimated $3.3  billion at the end of 2012 (see fig. 3).

If the reserve account were to be depleted, FHA could draw on  permanent and indefinite budget authority to cover reestimates indicating  additional increases in estimated credit subsidy costs. The President’s  budget for 2014 contained a $22.4 billion upward reestimate in FHA’s  credit subsidy costs for the Fund. The budget indicated that the  reestimate would be funded by depleting FHA’s capital reserve account in  2013, using premiums collected in 2013 from new endorsements, and  potentially drawing on $943 million in permanent and indefinite budget  authority. However, to the extent that such premiums collected in 2013  are different than FHA estimated, FHA may need to draw on more or less  permanent and indefinite budget authority.

section_title: Changes to Product Terms and Conditions Could Help Mitigate Risk and Increase Financial Viability but Could Also Limit Borrowers’ Access to Credit
paragraphs: Mortgage industry observers have suggested changes to FHA’s product  terms and conditions to lower its exposure to risk and improve its capital  position. These proposed changes include tightening its underwriting  standards and increasing down payments and premiums charged.  However, implementing one or a combination of these options could  affect borrowers’ access to credit, create an adverse selection problem  for FHA, or affect the agency’s role in terms of the types of borrowers it  serves.
subsections: section_title: Proposed Changes to FHA’s Underwriting Standards Would Involve Trade-offs That Could Affect Target Populations
paragraphs: Lenders must comply with FHA’s underwriting criteria when making FHA- insured loans. Underwriting is a risk analysis that uses information—such  as a borrower’s credit history and cash assets, among other things— collected during the origination process to decide whether to approve a  loan. In order to qualify for an FHA-insured loan, a borrower must have a  decision credit score of at least 500. In addition, a borrower’s payment- to-income (PTI) ratio may exceed 31 percent and debt service-to-income  (DTI) ratio may exceed 43 percent only if compensating factors are  documented.

With some exceptions, lenders are required to use FHA’s Technology  Open to Approved Lenders (TOTAL)—a mortgage scorecard—to  underwrite loans. TOTAL evaluates the overall creditworthiness of an  applicant based on a number of credit variables and determines the  associated risk level for an FHA-insured loan. FHA requires lenders to  manually underwrite loans that are not accepted by TOTAL to determine  if the loan should be accepted or rejected. Among other things, manual  underwriting involves evaluating compensating factors to justify the  approval of an FHA-insured mortgage. Table 1 describes the  compensating factors lenders may consider when manually underwriting  an FHA-insured loan for a borrower whose PTI ratio exceeds 31 percent  or DTI ratio exceeds 43 percent.

FHA recently revised TOTAL to tighten its underwriting standards. For  example, according to FHA officials, the agency revised the cut points— the points of separation within a population of mortgage scores that divide  applications that are accepted in TOTAL from those that are not—in order  to set the lifetime claim rate of its highest-risk loans at about 13 percent.  In addition, some mortgage industry observers we spoke to said that  lenders may apply additional, more stringent underwriting requirements,  known as credit overlays. For example, a lender could require that  borrowers have a minimum credit score of 620 in order to qualify for an  FHA-insured loan.

Some of the literature we reviewed and those we spoke to suggested that  FHA could further tighten its underwriting standards in order to reduce the  risk to the Fund, as well as the agency’s high market share. However, as  described in the following examples, tightening of FHA’s underwriting  requirements may affect certain borrowers’ ability to obtain mortgage  credit and FHA’s ability to serve families that are able to sustain a  mortgage, but do not qualify for conventional financing.

Some mortgage industry observers have suggested raising FHA’s  minimum credit score requirement to, for example, 580 or 620. We  previously found that lower credit scores were associated with a higher  likelihood of default. FHA officials also told us that lower credit scores  increase the likelihood of delinquency and default among borrowers.  Accordingly, increasing the credit score requirement, all else being equal,  could make FHA less subject to adverse selection based on its credit  policy and help to reduce the level of risk in the overall portfolio.

However, FHA data also show that the percentage of borrowers with  FHA-guaranteed loans and credit scores below 620 was relatively small  in 2009—approximately 10 percent of loans endorsed by FHA. Thus,  implementing a credit score floor of 620—the conventional mortgage  standard—likely would not significantly reduce FHA’s market share,  absent any other changes to FHA’s underwriting standards, other  program requirements, or the current lending volume.

Some mortgage industry observers noted that increasing FHA’s credit  score requirement would decrease access to mortgage credit and delay  or prevent homeownership for borrowers with lower credit scores. One  paper we reviewed noted that more restrictive credit score requirements  excluded a larger share of borrowers from the market in relation to the  percentage of defaults they prevented. One mortgage industry observer  also said that a higher minimum credit score requirement likely would  have a disparate impact on minority borrowers. In addition, in a 2007  paper, the Federal Reserve found that different demographic groups had  substantially different credit scores. The study found that on average  blacks and Hispanics have lower credit scores than non-Hispanic whites  and Asians.

Some mortgage industry observers also suggested that FHA implement a  residual income requirement. Residual income is the amount of net  income remaining after the deduction of payments for debts and  obligations (including the mortgage), and is thus a measure of a  borrower’s ability to make such payments without creating a substantial  financial burden on the household. These observers pointed to VA’s  mortgage insurance program, which requires that lenders calculate the  balance available for family support and compare that figure to the  residual income guidelines that are based on family size, loan amount,  and geographic location. For example, the guideline for a family of two  living in the midwest with a loan of $80,000 or more is a minimum of $738  in residual income. For the same family in the west, it is a minimum of  $823. Lenders also consider the borrower’s DTI ratio, but according to  VA, that is a secondary underwriting factor to the residual income.

One industry observer we spoke to said that implementing a residual  income test could be difficult, though not impossible, because determining  whether borrowers were capable of paying for other expenses presented  practical challenges. One paper we reviewed noted the lack of adequate  empirical data and models documenting the relationship between residual  income, DTI ratios, and loan performance. This paper concluded that without such information, it would be difficult to determine the residual  income thresholds that would most effectively produce high-quality  mortgages without excluding lower-income borrowers from access to  credit.

section_title: Increasing FHA’s Down- Payment Requirement and Reducing Seller Concessions Could Increase Borrowers’ Cash Contributions
paragraphs: In addition to meeting the underwriting requirements outlined earlier, a  borrower generally must make a cash investment (down payment) in the  property to obtain an FHA-insured mortgage. The amount of the down  payment required depends on the borrower’s credit score (see table 2).  Down payment funds may come from the borrower’s own savings or from  certain third-party sources.

In addition, borrowers also must pay for related closing costs. Currently,  FHA permits a seller to pay up to 6 percent of the lesser of the purchase  price or the appraised value of a home on behalf of a buyer to help fund  these closing costs. Such payments are referred to as “seller  concessions.” In July 2010, FHA proposed reducing allowable seller  concessions to 3 percent of the lesser of the purchase price or the  appraised value of a home in order to align its policy with conventional  mortgage lenders and reduce the risk exposure to the Fund. In  announcing the change, FHA noted that the then current level exposed  FHA to excess risk by creating incentives to inflate the appraised value of  homes. In February 2012, FHA amended this plan in a proposed rule  that permitted seller concessions in the amount of the lesser of 3 percent  of the purchase price or the appraised value of a home, or $6,000,   According to FHA officials, the agency is in the  whichever was greater.process of addressing comments on the proposed rule. The officials said  that they did not know when the rule would be finalized.

Some of the literature we reviewed and mortgage industry observers we  interviewed suggested increasing FHA’s requirement from 3.5 percent to,  for example, 5 percent. Some said that increasing FHA’s down-payment  requirements would help to decrease risk in its portfolio. A substantial  amount of the research we reviewed for a 2005 report on risks associated  with FHA products indicated that LTV ratios and credit scores were  among the most important factors in estimating the risk level associated  with individual mortgages. findings. We found that, in general, mortgages with higher LTV ratios  (smaller down payments) and lower credit scores were riskier than  mortgages with lower LTV ratios and higher credit scores.

See GAO, Mortgage Financing: Actions Needed to Help FHA Manage Risks from New  Mortgage Loan Products, GAO-05-194 (Washington, D.C.: Feb. 11, 2005).

In addition, one mortgage  information collected from loan applications.industry observer said that increased down-payment requirements could  have a disparate impact on minorities.

Some of those we spoke to and the literature we reviewed said that FHA  should reduce seller concessions. According to FHA, about 21 percent of  loan originations in 2009 and 2010 had seller concessions of more than 3  percent of the property value.  Allowing higher seller concessions makes  FHA-insured loans more accessible than conventional loans because  borrowers do not have to invest as much cash at closing. For example,  according to FHA, under current policy, concessions on higher-priced  homes can reach almost $44,000. FHA and one mortgage industry  observer suggested that reducing seller concessions could reduce the  risk of exposure to the Fund from incentives that inflated the appraised  value of homes. Our work on seller-funded down-payment assistance  demonstrated that funds provided by seller-funded nonprofits had the  effect of increasing the selling price of the home, leaving the borrower  with less equity and FHA with more risk than they would have  otherwise.could result in higher sales prices than would occur without seller  concessions.

This suggests that transactions involving seller concessions  Conversely, some have highlighted the importance of providing  assistance to those borrowers who have difficulty accumulating sufficient  funds to become homeowners. For example, one mortgage industry  observer we spoke with said that reducing allowable seller concessions  would be like increasing the down-payment requirement. In commenting  on FHA’s proposed rule, representatives of this group said that FHA must  strike a balance between managing risks and ensuring that its product is  offered as widely as possible to qualified borrowers. They said that the  proposed changes in seller concessions would adversely impact  homebuyers seeking FHA-insured mortgages. Because of similar  concerns, FHA revised its original proposal for reducing seller  concessions. In its revised proposed rule, FHA noted that an across-the- board reduction to 3 percent would have had a disproportionately  negative impact on borrowers with low and moderate incomes who were  purchasing modestly priced homes. Therefore, the agency revised its  proposal to allow concessions of the greater of 3 percent or $6,000, so  that borrowers purchasing homes valued at less than $200,000 could  receive seller concessions of more than 3 percent.

section_title: Pricing Changes Could Raise the Cost of Credit for Some Borrowers
paragraphs: FHA has raised premiums several times in recent years, but such  increases have not been risk-based. Most recently, FHA increased the  annual insurance premiums most borrowers pay between 0.05 and 0.10  percentage points. FHA now charges the maximum allowable premium  for loans of $625,500 or more, and although FHA also increased  premiums for smaller-value loans, these premiums still remain below the  maximum FHA is permitted to charge (see table 3). FHA can continue to  raise up-front and annual premiums to the statutory maximums (generally  3 percent of the original insured principal mortgage amount for up-front  premiums and between 1.5 and 1.55 percent of the remaining insured  principal amount for annual premiums). In addition, since June 3, 2013,  FHA has required most new borrowers to continue paying annual  premiums, regardless of the value of their loans. Previously, premiums  could be canceled after the first 5 years once the principal amount  declined to 78 percent of the original value. According to FHA, the  reversal of the premium cancelation policy and the increase in premiums  would generate approximately $3 billion for the Fund for every $100  billion in new endorsements.

Some mortgage industry observers said that FHA could raise its up-front  and annual premiums. For example, FHA could raise premiums to the  statutory maximums, as outlined in table 3 above. One mortgage industry  observer we spoke to and some of the literature we reviewed indicated  that increases in FHA’s premiums could result in more revenue for the  Fund, provided that the increases did not reduce the volume of new FHA- insured mortgages enough to offset the increased revenue.

However, we and others have noted that increases in the cost of  mortgage insurance could increase the likelihood of adverse selection for   That is, low-risk  FHA if its pricing were far different from its competitors.borrowers with fewer down-payment constraints could choose less costly  loans from other sources, effectively making private mortgage insurance  more competitive with FHA insurance. This shift in borrowers potentially  could result in an increase in the overall risk of FHA’s portfolio because  FHA would be insuring relatively more high-risk borrowers. In this case,  an increase in premiums can result in both lower premium revenue as  low-risk borrowers no longer purchase FHA insurance, and an increased  claim rate among the remaining higher-risk borrowers.

Further, others have noted that increased premiums could price some  borrowers out of the market. As previously discussed, some mortgage  industry observers have noted that many FHA borrowers have limited  cash assets to pay for down-payment and closing costs. According to  FHA, nearly all FHA-insured borrowers finance the up-front premium, so  the net effect of increasing it would likely be to raise the borrowers’  mortgage payments.

FHA officials said that the agency was unlikely to implement further  increases in annual premiums in the near future. They said that FHA  loans could become unaffordable to some borrowers when interest rates  increase. We also found that FHA’s recently announced policy  lengthening the duration of premium assessments might have an adverse  impact on borrowers. Mortgagee Letter 2013-04, implemented on June 3,  2013, mandates that the monthly mortgage insurance premium on FHA  loans with LTV ratios exceeding 90 percent apply for the life of the loan,  rather than terminating after the first 5 years once the principal amount  declines to 78 percent LTV. FHA has acknowledged that this policy  change will increase the annual percentage rate (APR) on FHA  mortgages and may result in mortgages whose interest rates qualify them  as higher-priced mortgage loans (HPML). Under Regulation Z, HPMLs  must meet certain requirements, including those related to repayment   After consulting with the  ability, prepayment penalties, and escrows.Bureau of Consumer Financial Protection (also known as CFPB), FHA  issued guidance to lenders that explained their responsibilities for  meeting both HPML and FHA requirements.

Some of the literature we reviewed and mortgage industry observers we  spoke to suggested that FHA assess premiums using “risk-based pricing.”  Risk-based pricing takes into account borrowers’ risk attributes such as  credit score, DTI ratio, product type, and LTV ratio. As described earlier,  FHA’s current premiums are based on the size and term of the loan and  the LTV ratio and do not consider credit score and other risk factors, a  practice FHA refers to as “average pricing.” Using this method, low-risk  borrowers pay the same actual price for insurance coverage as high-risk  borrowers. For example, all FHA borrowers with loans at or below  $625,500, LTV ratios less than or equal to 95 percent, and terms of  greater than 15 years pay the same premiums, even though other  measures of risk, such as credit scores, indicate that they represent a  variety of risks. Risk-based pricing could address the adverse selection  problem that is a possibility under average pricing (that is, when  premiums charged do not align with the actual risks of borrowers so that  low-risk borrowers are charged too much for insurance and thus seek it  elsewhere). One mortgage industry observer also noted that it would  more accurately align FHA’s revenues with its potential claims.

Conversely, others have argued that risk-based pricing would place FHA  in the position of having to raise the mortgage financing costs of  borrowers with weaker credit. To the extent that relatively low-risk  borrowers might face lower premiums, they likely would not leave FHA.  But other borrowers could face higher premiums, and those who could  not qualify either for an FHA or conventional mortgage could be priced  out of the market. For example, in 2007 we found that an FHA proposal to  implement risk-based pricing would have affected the availability of FHA  insurance for about 20 percent of the home purchase borrowers that FHA  insured in 2005. This group would not have qualified for mortgage  insurance under the parameters of the proposal because of high LTV  ratios and low credit scores. FHA officials said that they are aware that  the agency risks losing some lower-risk borrowers under its current  pricing scheme. Therefore, they said that the agency has set pricing so  that it covers the expected losses of the highest risk loans that its  underwriting permits, with the idea that if FHA were to face increasing  competition for its lower-risk borrowers, it would be charging a sufficiently  high premium to cover expected losses on all newly insured loans.

section_title: Proposed Changes That Restrict the Borrowers FHA Serves Would Affect the Agency’s Role in the Mortgage Market
paragraphs: As noted earlier, FHA’s share of loan originations has increased in recent  years. During 2006, FHA insured approximately 4.5 percent of purchase  mortgages. At its peak in 2009, it insured 32.6 percent of purchase  mortgages, and in 2012 still insured 26.1 percent of purchase mortgages  originated that year. Mortgage industry observers have proposed options  that would limit FHA’s market presence as a way of either reducing FHA’s  liability or better ensuring that it serves a certain market—that is, low- or  moderate-income borrowers and first-time homebuyers. These options  include changes that would have a direct effect on FHA’s market share,  such as reducing loan limits from current levels and determining borrower  eligibility based on income. Options that could have an indirect effect on  FHA’s market presence include reducing FHA’s insurance coverage to  less than 100 percent of the value of the loan and entering into risk- sharing agreements with private partners. Concerns have been raised  that options affecting FHA’s market presence might also affect its ability  to serve its traditional countercyclical role to stabilize the housing market  during times of increased stress or credit contraction.
subsections: section_title: Reducing Loan Limits Could Focus FHA on Low- to Moderate-Income Borrowers and Reduce Its Market Share
paragraphs: Congress raised the loan limits on FHA-backed forward mortgages  following the recent housing crisis and has continued to extend the higher  limits. Currently, the loan limits vary by county, ranging from $271,050 to  $729,750 for one-unit properties in the contiguous United States. These  limits are set to expire on December 31, 2013. Mortgage industry  observers have recommended that FHA’s loan limits be lowered to  reduce FHA’s market share. Some recommend reducing the loan limits to  what they were prior to the crisis, while others propose reducing them  further. FHA data show that large loans are a small portion of FHA’s  loan pool. Loans that exceeded $450,000 (somewhat higher than the  national conforming loan limit) comprised only 4 percent of active FHA  loans as of October 31, 2011. As of this date, 82 percent of FHA’s  active pool included loans with a balance of $271,050 or less. Because of  the small number of high-value loans that FHA has endorsed, a reduction  in loan limits might not have a large effect on its overall market share.  However, for certain high-cost markets, a reduction in FHA’s loan limits  would have a greater impact. For example, according to FHA, in fiscal  year 2012 about 24 percent of the loans FHA insured in Hawaii and about  10 percent of those it insured in California exceeded $450,000. Further,  more than half of the loans over $450,000 endorsed during this time  period were for properties located in California. We previously found that  a possible reduction in the conforming loan limit could result in certain  homebuyers in high-cost markets such as California needing to either  provide a larger down payment or seek alternate financing.

Industry observers have proposed approaches to reducing the current  loan limits. For example, one researcher suggests limiting loans to no  more than 100 percent of county median house price. The Mortgage  Bankers Association (MBA) testified that Congress should allow the  current limits to expire at the end of 2013 and reduce the loan ceiling to  match the enterprises’ conforming loan limits. FHA officials said that at  the end of 2013 the loan limits would return to the levels established in  HERA—limits that FHA has determined are appropriate for 2014.

Further, a reduction in loan limits would allow FHA to focus on low- to  moderate-income borrowers and first-time homebuyers, the groups that  many industry observers see as FHA’s traditional market. In a February  2013 report, the Bipartisan Policy Center Housing Commission stated that  a key objective for FHA should be to return to what it sees as FHA’s  traditional mission of serving primarily first-time homebuyers—something  that could be achieved in part through a gradual reduction in loan limits.

A number of observers suggest that FHA is serving a population of  borrowers far beyond those targeted by its traditional mission. For  example, one observer noted that reducing FHA’s loan limits by  approximately 50 percent would still enable the agency to reach its  intended population of first-time, minority, and low-income borrowers.  Observers also noted that loan limits act as a proxy for income, with lower  limits focusing FHA’s efforts on low-wealth borrowers. As noted above,  about 78 percent of FHA-insured loans went to first-time homebuyers in  2012.

Bipartisan Policy Center Housing Commission, Housing America’s Future. serious delinquency rates among loans with the highest balances (6  percent and 4 percent, respectively, of all active loans over $625,000 as  of October 31, 2011). In contrast, loans under $271,000 had a  delinquency rate of 17 percent and a serious delinquency rate of 9  percent. Factors other than loan size could contribute to these  delinquency rates. For example, FHA officials noted that many high-value  loans were endorsed following the housing crisis when the economy had  improved and may perform better as a result. FHA officials could not point  to analysis that would support the argument that high-value loans, all else  being equal, perform any differently than smaller loans in terms of default,  or the severity of the resulting losses. Nonetheless, FHA officials stated  that a broader pool of insurable loans helps to better manage portfolio  risk.

According to a number of industry observers, by reducing loan limits the  agency would effectively step back from the high-wealth market, allowing  private lenders to step back into the market during the recovery. Some  industry observers have raised concerns about FHA crowding out private  capital. They note that lower loan limits would not have a significant effect  on FHA lending but would allow high-wealth buyers to be served in the  conventional market, a shift they consider appropriate at this time.  However, some industry observers have noted that the higher loan limits,  which have been in effect since 2008, have allowed FHA to fulfill its  countercyclical role of providing credit to borrowers when the private  market was generally frozen. One organization stressed that the housing  recovery was not complete, that lending remained constrained in many  markets, and that Congress should be cautious about lowering loan limits.  Industry observers also note that the elevated loan limit was particularly  important in high-cost markets and that FHA continues to serve a  significant role in these markets today. One observer argued that the  relatively low FHA loan limits in effect prior to the crisis limited FHA’s  presence in high-value areas that suffered a more severe contraction  during the housing crisis, which helped mitigate FHA’s losses. Some said  that FHA loan limits should be relatively constrained during most years,  but raised when needed to provide stability in housing finance. Others  noted that whatever loan limit FHA might use, it should be adjusted to  allow for the variability in home prices across the country. FHA told us  that it needs to have the flexibility to alter market-limiting policies—for  example, by reinstating high loan limits quickly—to properly execute its  countercyclical role.

section_title: Eligibility Limits Based on Income Rather Than Loan Amount Would Target Lower-Income Borrowers, but Could Also Restrict Access to Credit
paragraphs: Some mortgage industry observers have suggested that eligibility should  be based on borrowers’ income in order to refocus FHA on its traditional  role of providing mortgage credit to low- and moderate-income  borrowers. FHA data show that 64 percent of its purchase loans and 47  percent of its refinance loans in fiscal year 2012 were made to low- and  moderate-income borrowers. As shown in figure 4, the income levels of  borrowers approved for purchase loans have varied over time. During the  recent housing crisis, the proportion of FHA-insured mortgages made to  low-income borrowers dropped substantially just as the proportion to  high-income borrowers increased. Between 2005 and 2008, the share of  FHA borrowers that had low incomes dropped about 16 percent, while the  share that had high incomes increased about 14 percent. FHA has  continued to endorse a larger proportion of high-income loans through  2012. These shifts are consistent with the increased loan limits in effect  during the period. That is, loan limit increases expanded FHA’s portion of  the market that would be sought after by households with relatively higher  income.

According to some of the literature, income limits would affect the market  that FHA serves, targeting FHA’s guaranty to low- and moderate-income  borrowers. In recent congressional hearings, industry observers  encouraged a system of assessing borrowers according to area median  income targets to determine program eligibility.on reforming the housing finance market that was developed by the U.S.  Department of the Treasury (Treasury) and HUD, the administration  presented one option for reform that would strictly limit FHA eligibility to   In a 2011 white paper  low- and moderate-income borrowers, leaving the risk for high-income  borrowers to the private market.

A change to income-based eligibility could restrict certain borrowers’  access to credit. In its white paper, the administration cautioned that  some borrowers, who may be ineligible when their income exceeds a  threshold, may find it difficult to afford the cost of a conventional 30-year  fixed-rate mortgage. Observers point to the additional costs, such as  higher premiums and interest rates, that some borrowers might face if  they must seek conventional mortgage insurance. Multiple observers  have noted that even borrowers with relatively strong incomes have  difficulty accumulating sufficient savings for a down payment, especially  in high-cost areas.

Several industry observers and FHA said that a system of income  verification to determine FHA eligibility would also be difficult to  implement. For example, one observer we interviewed noted that FHA’s  current loan application process required prospective borrowers to  provide documentation of qualifying income, but said that additional  sources of income were not considered. According to this observer, if  maximum income levels were in place, lenders would have to gather  documentation for all income sources and assess the borrower’s income  against all liabilities and expenses, which could give borrowers an  incentive to under report income. FHA officials told us that basing  eligibility on income would create compliance risks for lenders and would  be time consuming. Yet another industry observer added that income  verification could also affect lenders’ behavior, making them fearful of  increased liability under indemnification agreements if they failed to  correctly identify all borrower income to verify a borrower’s eligibility.  The FHA Commissioner noted that income verification was difficult to  implement in other programs, such as the Low-Income Housing Tax  Credit Program.limits, could help FHA focus the market it served.

FHA officials told us that loan limits, rather than income  Further, while income limits could be structured to vary by geographic  area, as loan limits now do, implementation could be difficult. Some  observers described to us the complexity of implementing and monitoring  income limits that vary by geographic area, and one suggested that a  national income ceiling rather than income limits set by area median  income might be a more expedient policy. FHA officials and industry  observers told us that determining program eligibility based on  appropriate loan limits is an effective substitute for income limits in order  to target the program to low- and moderate-income borrowers.

Some observers have further argued that limiting eligibility based on  income could affect FHA’s ability to manage credit risk. Some argue that  FHA-insured loans made to borrowers with higher income perform better  than loans to lower-income borrowers. However, we have not seen  analysis that would support the argument that income alone is a predictor  of credit risk. Limiting eligibility based on income may reduce the number  of insured loans, which could constrain FHA’s ability to manage risk. An  industry observer noted that FHA was intended to be more universally  available than a program for only the lowest-risk borrowers might be. FHA  officials noted the importance of maintaining a broad-based insurance  pool. FHA officials also stated that they were not aware of studies  concluding that serving only low-income borrowers would improve the  agency’s financial condition.

Finally, this option could limit FHA from serving its countercyclical role in  the future. In its white paper, the administration warned that reducing  FHA’s market share too much—for example, by serving only low- and  moderate-income borrowers—could affect its ability to ensure access to  capital during a crisis. The paper emphasized that without sufficient  government support to mitigate a credit crisis, downturns could be more  severe, increasing costs to the taxpayer.

section_title: Reducing FHA’s Insurance Coverage Would Reduce Losses, but Might Not Protect Taxpayers and Could Increase Costs for Borrowers
paragraphs: Currently, FHA insures 100 percent of the principal balance of the loan  involved in a claim and other eligible costs. Some mortgage industry  observers have suggested that FHA’s loan coverage be reduced in order  to limit FHA’s risk and market share. VA’s guaranty program is often cited  as a model, as it insures only 25 to 50 percent of the original principal in  the case of a default. Various levels of reduced loan coverage have been  suggested for FHA, ranging from 90 percent coverage, which some  observers say would have little impact, down to 25 percent coverage.

Industry observers proposing this change point to a reduction in taxpayer  risk as a key benefit. They argue that a lower level of insurance  coverage would reduce FHA’s liability for defaulted loans by reducing the  severity of the agency’s loss. We have also found that a reduction in  insurance coverage could have a beneficial effect on the Fund. In May  1997, we examined the potential effects of reducing FHA’s insurance  coverage and found that lower coverage would reduce both the volume of  FHA-insured loans and income from premiums but would also reduce  FHA’s losses and ultimately have a beneficial effect on the Fund. Others  have noted that a reduction in loan coverage could provide lenders an  incentive to improve underwriting quality, thus reducing the risk of default.  Some have cited the relatively superior delinquency and default rates in  the VA program as evidence of careful origination by lenders that must  assume some credit risk for VA-guaranteed loans. Nonetheless, it is  important to note that VA limits its eligibility to veterans who have served  in a branch of the armed services and received an honorable discharge,  certain currently serving members of the Reserves or National Guard,  and spouses of veterans under certain circumstances. It therefore starts  with a universe of eligible borrowers that are different from the population  that might seek an FHA-insured mortgage. Also, as mentioned in the  previous section, VA underwriting differs somewhat from that of FHA, with  greater attention given to the veteran’s residual income. Further, the VA  program provides supplemental servicing to borrowers that face difficulty  making mortgage payments. These and other differences need to be  considered before it can be concluded that differences in insurance  coverage explain the differences between VA and FHA default rates.

Industry observers also discussed the impact of a reduction in insurance  coverage on borrowers’ access to credit. Because lenders would be  exposed to additional risk, they could increase fees and interest rates,  which some industry observers noted in testimonies to Congress. Also,  for some lenders the additional exposure might prompt the purchase of  additional insurance coverage from third parties, the cost of which could  be passed on to borrowers. We have reported that without the guaranty  for FHA-endorsed mortgages, lenders would likely make fewer and more  costly loans, making homeownership more expensive, limiting borrowers’  access to credit, and reducing FHA’s presence in underserved  communities.underwriting criteria or increased fees and interest rates, high-risk  borrowers would be disproportionately unable to access FHA-endorsed  mortgages. We found that reducing insurance coverage would limit FHA’s  ability to stabilize distressed communities and housing markets during  regional economic downturns.

Our analysis showed that if lenders imposed stricter  Further, some industry observers testified to Congress or told us that  reduced FHA insurance coverage could simply transfer taxpayer risk from  FHA to Ginnie Mae. That is, any additional risk borne by the lender  would pose additional risk to Ginnie Mae as the guarantor of the  securities issued by that lender. This risk would require Ginnie Mae to  provide more intense monitoring of its counterparties’ financial condition,  potentially increasing the fees it required to provide its guarantee. FHA  officials agreed that Ginnie Mae would assume additional counterparty  risk with a reduction in coverage. Ginnie Mae officials noted that issuers  would likely seek additional third-party assurance, most likely through  additional mortgage insurance, to manage the additional risks they might  face. As a result, borrowers could face further costs. Issuers could also  take other steps, such as limiting the amount of FHA-insured lending they  would permit or overlaying additional credit requirements, which would  limit their participation in the program. In addition, MBA testified that this  option would limit the ability of independent mortgage bankers and other  small lenders to manage risk. It noted that small mortgage lenders were  not structured to take on large amounts of credit risk and might restrict  credit to borrowers, or leave the mortgage industry.

Other observers note that reducing FHA’s loan coverage would facilitate  the return of private capital. For example, one stated that the 100 percent  coverage that FHA provides combined with its expanded market share  created a barrier to the reentry of private capital to U.S. residential  mortgage finance. The same observer noted that capital regulations and  other requirements strongly favor obligations with a government  guarantee over those supported by private capital.

section_title: Proposals for Entering into Risk-Sharing Agreements with Private Partners Vary
paragraphs: FHA does not currently engage in single-family risk sharing. To protect  the taxpayer by sharing risk with the private market, various industry  observers have suggested that the agency explore this option. In 2002,  the Millennial Housing Commission recommended that Congress  authorize FHA to initiate single-family risk-sharing demonstration  programs, stating that FHA should have broader authority to choose its  partners, loss position, and types of credit enhancements (including  reinsurance as well as insurance or reinsurance on pooled loans). The  report also stated that while FHA could absorb risk better than private  lenders, potential partners could have superior risk assessment and  management systems and might be able to provide access to new  products and delivery systems targeting communities with underserved  borrowers that FHA did not yet reach. In 2007, we found that a public- private risk-sharing arrangement would recognize the government’s ability  to spread risk. We also found that private mortgage industry participants  generally were more flexible and responsive to market pressures and  better able to innovate and adopt new technologies quickly. Industry  observers have continued to promote various forms of risk sharing to  improve FHA’s financial condition.

Two main approaches for risk sharing have been proposed by industry  observers:

Coinsurance. This approach would create agreements between FHA  and private mortgage insurers. The private mortgage insurer would  conduct an independent underwriting of the borrower and the  mortgage being sought. If the borrower and the mortgage underwriting  terms met the conditions that both FHA and the private insurer agreed  on, the private insurer would take the first loss on the loan, and FHA  would cover the remaining loss. One industry observer suggested that  the agency should reduce taxpayer risk by assuming losses only after  private partners absorbed first losses of 25 to 35 percent. Another  risk-sharing arrangement between FHA and other partners could be a  model similar to FHA’s Multifamily Risk-Sharing Programs through  which the agency shares proportional risk at varying levels between  10 and 90 percent with Fannie Mae, Freddie Mac, and housing  finance agencies among others.

Reinsurance. Large portfolio lenders and the enterprises will at times  enter into reinsurance contracts with approved counterparties to sell  portions of credit risk in their loan portfolios. According to a private  mortgage insurer testifying before a congressional committee, this  approach has the benefit of minimizing impacts on lenders and the  potential to be implemented more quickly than a coinsurance  arrangement. The representative noted that FHA should have the  flexibility to selectively test such arrangements.

Risk sharing could affect taxpayers’ risk, according to industry observers.  It could protect the taxpayer, not only because private partners would  assume some of the risk but also because the quality of the underwriting  might improve because private partners would want to minimize the  likelihood of loss. However, to the extent that FHA would offer both full  mortgage insurance and engage in risk sharing, it could be subject to  adverse selection. That is, private partners could seek relatively low-risk  borrowers for the shared-risk product, leaving FHA with the riskiest  borrowers. One report notes that under risk-sharing agreements, private  partners may act in other ways that are contrary to FHA’s interest. For  example, according to this report, if FHA takes only a catastrophic loss  position, the partner may have little incentive to minimize FHA’s losses  once the partner’s maximum exposure level has been reached. Sharing  risk on a pro rata basis, starting with the first dollar of loss and ending  with the last dollar of loss, creates stronger incentives for FHA’s risk- sharing partners to use sound underwriting terms and service their loans  diligently. We have found that this is particularly true when there is a more  equal division of risk. If FHA agrees to assume the first portion of loss  on default, the partner may not feel the need to protect against a high  incidence of claims as long as the loss severity is not expected to reach  its maximum level of exposure. The partner would also need to be  sufficiently capitalized or otherwise protected to withstand its portion of  the loss. Also, one observer warned that FHA would be at risk because it  lacked the capacity to analyze risk-sharing proposals, which could place it  in a weak position with partners. Consistent with this, FHA officials told us  that FHA would need to increase its staff and analytic capacity to safely  implement risk-sharing agreements.

Risk sharing would also affect the role that Ginnie Mae plays in  guaranteeing timely payment of principal and interest on mortgage- backed securities. That is, like reducing FHA’s loan guarantee coverage  below 100 percent, risk sharing changes the nature of Ginnie Mae’s  exposure to counterparty risk, according to observers. Ginnie Mae would  need to undertake assessment of a new class of counterparties—the  private partner providing the insurance coverage—while continuing to  assess the counterparty risk of its issuers, one observer noted. Ginnie  Mae officials confirmed that any FHA risk-sharing agreements would  increase the agency’s counterparty risk and noted that they would  probably require issuers to hold more capital to mitigate this risk. One  paper emphasized that risk sharing would also require FHA to monitor counterparty risk and provided a number of approaches for doing so.

Ultimately, any risk-sharing arrangement would need to carefully consider  the structure of premiums and the way they were shared between parties.  Identifying the type and level of premium needed by the federal  government requires considering not only expected losses from loans that  default and losses exceeding a predetermined level, but also unexpected  losses from infrequent but costly adverse market conditions on both the  national and regional level. Some argue that the federal government  would still absorb catastrophic risk regardless of how risk sharing and  premiums are structured. In this case, FHA would need to receive  premiums across a broad spectrum of the market.

In addition, like other options for improving FHA’s viability, risk sharing  could impact other mortgage market participants and reduce borrowers’  access to credit, according to observers. Depending on how FHA  structured risk sharing, including how widely it would be applied to FHA’s  future endorsements, this option could reduce participation by smaller  mortgage lenders, particularly community banks, which might have  difficulty meeting the eligibility criteria for such a program, according to  some industry observers. Others have expressed concern that risk  sharing could raise the cost of the mortgage credit, as private investors  would demand a market rate of return. While this trade-off might be  viewed as acceptable in terms of improved underwriting, in times of  market contraction risk sharing could significantly raise the cost and limit  the availability of credit to borrowers, according to one observer. That is,  FHA’s role in stabilizing mortgage markets could be affected by its  partners’ willingness to continue underwriting during market contractions.  This may limit FHA’s ability to serve as a countercyclical force during  such national or regional housing downturns.

Some of the literature we read stressed the importance of FHA serving a  countercyclical role, as it has in the past, including by mitigating the effect  of the 2007-2009 financial crisis on the housing market. One observer  cautioned that broad changes, such as risk sharing, applied to FHA’s  entire portfolio, or too quickly implemented without a full understanding of  the potential effects of the change, could reduce its flexibility to adjust to  larger housing market shifts. Others have stated that risk sharing might  constrain the agency’s countercyclical flexibility because FHA and its  private partners might not have the same incentives. During a downturn,  private partners in risk-sharing arrangements would likely lack the  incentive to serve deteriorating markets. Further, if FHA could endorse  only loans that involved a private partner, a contraction of private credit  could prevent it from expanding when such action was needed most.  Another observer encouraged a small, discretionary or piloted approach  to any risk-sharing program, suggesting that it was not necessary to make  this option mandatory for each new endorsement. FHA officials cautioned  that risk sharing should only be considered in the context of broad  mortgage market reform, which has yet to be resolved.

section_title: Greater Operational and Managerial Powers Could Give FHA Greater Flexibility but Could Limit Congressional Direction
paragraphs: Although FHA is a wholly owned government corporation within HUD, it  does not have the corporate powers other government corporations have.  Some mortgage industry observers have suggested that making FHA an  independent government corporation—more autonomous from HUD— could give it greater operational and managerial flexibility and the ability  to be nimble when faced with changes in the housing market or problems  in its programs. For example, FHA could have enhanced enforcement  powers, greater authority to make changes to program requirements, and  additional authorities to invest in technology and staff. Some of these  authorities would bring FHA’s corporate powers more in line with other  government corporations. However, FHA and others said that these  flexibilities could be implemented within FHA’s existing organizational  structure. But even within the existing structure, many of these options  would require congressional action to implement. Further, these reform  options are not mutually exclusive—that is, one or more options could be  implemented—and implementation of these options would involve trade- offs between, for example, congressional direction and agency flexibility,  or between efforts to minimize costs to borrowers and to make the  program self-sustaining.
subsections: section_title: Making FHA an Independent Government Corporation Could Provide It with More Flexibility
paragraphs: Some mortgage industry observers have suggested that making FHA an  independent government corporation could increase its flexibility to  respond to changing market conditions and mitigate risks. FHA is a wholly  owned government corporation within HUD but does not have some of  the powers that other government corporations have. Specifically,  Congress sometimes exempts government corporations from key  management laws to provide them with greater flexibility than federal  departments and agencies typically have in hiring employees, paying  these employees competitive salaries/benefits, disclosing information  publicly, and procuring goods and services. In 1995, we assessed the  extent to which FHA and other government corporations had to comply  with 15 selected federal statutes. FHA reported that it had to comply  with 14 of the 15 federal statutes, while other government corporations  reported greater flexibility. For example, Amtrak reported full adherence  to two statutes. In addition, when FHA was moved within HUD in 1965,  Congress assigned the corporate powers of FHA to the Secretary of  HUD, who has delegated them to the Assistant Secretary for  Housing/FHA Commissioner.

Some observers have suggested that one way to give FHA increased  flexibility would be to increase its corporate powers. For example, a 1994  National Academy of Public Administration study stated that FHA’s  commissioner did not have the flexibility to adjust FHA products to  respond to changing market conditions, such as fluctuating interest rates,  and that the commissioner had to operate within the budgeting and  administrative parameters of a traditional federal agency. The report  recommended that Congress transfer the corporate powers of FHA from  the HUD secretary to the corporation, permitting it to function with greater  operational autonomy within HUD. It also recommended that Congress  vest management of FHA in a single administrator appointed by the  President, with Senate confirmation for a 6-year term of office. Under this  proposal, the administrator would be compensated at the same level as  the chief executive officer of comparable government corporations. In  2002, the Millennial Housing Commission made a similar proposal, but its  proposal would combine FHA and Ginnie Mae and establish a corporate  board of directors.structures.

Recently, some observers have suggested similar  Other observers have suggested moving FHA outside of HUD. For  example, one paper suggested organizing FHA as an independent  government agency, a government-sponsored enterprise, or even a  privatized entity structured as an assigned risk pool that would spread risk  for otherwise uninsurable borrowers across insurance carriers in  proportion to the size of their portfolios. According to the author, any of  these structures could make underwriting, pricing, and administration  more efficient while achieving what he viewed as the agency’s social  objectives of providing credit enhancements through insurance to serve  otherwise marginal low-income, first-time, and often minority homebuyers.  He further stated that the FHA commissioner should have an appointment  independent of HUD and for a term that would extend beyond a single  administration term. Another observer testified that setting up FHA  outside of HUD would reduce incentives for future administrations to  impose policies on FHA that limited its flexibility and increased risks.  However, two observers we interviewed said that making FHA an  independent corporation outside of HUD would make it more difficult for  Congress to hold it accountable. FHA, which was created in 1934,  operated outside of a cabinet department for decades before becoming  part of HUD, which was created in 1965. In addition, some people we  interviewed said that FHA should remain affiliated with HUD so that it  could collaborate closely with other department offices on housing policy  and remain part of a cabinet-level agency.

According to the literature, making FHA more autonomous could provide  it the flexibility to determine the best way to meet policy goals set by  Congress or HUD and mitigate risk. For example, in a congressional  testimony an observer suggested that FHA be provided the authority,  without further congressional action, to create or alter specific insurance  programs. Such authority, the observer argued, would enable FHA to  react promptly to changes in market and other conditions. In addition, the  observer stated that hiring, salaries, personnel management, and  procurement could be freed from federal government constraints in order  to be more consistent and competitive with the private sector. Some of  the literature we reviewed noted that FHA had exercised greater control  over its resources when it was independent of HUD.

However in June 2007, we found that making FHA an independent  government corporation could have budgetary and oversight implications  that would need to be considered. For example, Congress would have  to determine the extent to which (1) the corporation’s earnings in excess  of those needed for operations and reserves would be available for other  government activities and (2) the corporation would be subject to federal  budget requirements. Also, if the corporation were created outside of  HUD, Congress would have to consider whether oversight of the  corporation would require a new institution or could be done by an  existing organization. In addition, an observer said that making FHA an  independent government corporation or providing it with certain  flexibilities, such as powers to change its products, could make FHA  loans more attractive to borrowers who should be served by the private  sector. Although such autonomy would also permit FHA greater capacity  to manage risk, two observers we interviewed suggested that any  additional autonomy or flexibility should be accompanied by clear  direction on FHA’s mission to serve borrowers not otherwise served by  the private sector.

section_title: FHA Could Gain Greater Flexibility without Changing Its Organizational Structure
paragraphs: FHA and others have said that although making the agency an  independent government corporation could increase the agency’s  flexibility, the agency could be given increased flexibility without such  changes. For example, mortgage industry observers have suggested  giving FHA enhanced enforcement powers, greater authority to make  changes to program requirements, and additional authorities to invest in  technology and staff. Many of these options would require congressional  action to implement. Notwithstanding the potential benefit and costs of  these options, there are a number of steps that FHA could undertake  under its existing authority, including actions we have previously  recommended.

In order to originate FHA-insured loans, lenders must be approved by  FHA to participate in its mortgage insurance programs. Virtually all of the  lending institutions approved to participate in FHA’s single-family  mortgage insurance programs have direct endorsement authority,  meaning that they can underwrite loans and determine their eligibility for  FHA mortgage insurance without HUD’s prior review. Direct endorsement  lenders can apply to participate in the Lender Insurance Program, which  enables high-performing lenders to approve mortgages for FHA insurance  without a pre-endorsement review by HUD. To hold lenders accountable  for program violations or poor performance, FHA may (1) suspend their  direct endorsement authority, (2) terminate their loan origination or  underwriting authority through its Credit Watch program, or (3) take  enforcement action through the Mortgagee Review Board.

In its proposed budget for fiscal year 2014, FHA requested a number of  additional enforcement powers. Specifically:

Since 2010, FHA has asked for enhanced indemnification authority for  direct endorsement lenders. Currently, FHA has authority to require  indemnification only for lenders that participate in FHA’s Lender  Insurance Program. According to FHA, granting the agency this  authority would enable it to obtain indemnification from all of its  approved lenders for loans that do not comply with its guidelines.  Legislation proposed in March 2013 includes a provision intended to  address this issue.

HUD may terminate a lender’s approval to originate or underwrite  FHA-insured loans in a specific geographical area if a lender’s branch  office default and claim rate exceeds the established Credit Watch  Termination thresholds. However, FHA is also seeking authority to  terminate origination and underwriting approval on a broader  geographic basis, stating that such authority would enhance its ability  to review lender performance. If a lender was found to have an  excessive rate of early defaults or claims, FHA would have greater  flexibility in terminating the lender’s ability to originate or underwrite  single-family mortgages for FHA insurance. FHA has been seeking  this authority since 2010. Again, the 2013 proposed legislation  includes such a provision.

To help make loss mitigation more effective, FHA is seeking authority  to, on a case-by-case basis, transfer servicing of loans to institutions  better equipped to reduce losses.allow FHA to require any of the following actions when a servicer  underutilized FHA’s loss-mitigation tools or the agency deemed the  action necessary to protect the interests of the Fund: (1) transfer  servicing from the current servicer to a specialty servicer designated  by FHA; (2) require a servicer to enter into a subservicing  arrangement with an entity identified by FHA; or (3) require a servicer  to engage a third-party contractor to assist in some aspect of loss  mitigation such as borrower outreach. According to FHA, such  authority would permit the agency to better avoid losses from poor  servicing of FHA-insured loans, yielding better results for borrowers  and FHA.

Specifically, this authority would

Finally, FHA is seeking greater flexibility in establishing the metrics it  uses to compare lender performance so that it can more effectively  assess lender performance during all market conditions. As discussed  previously, FHA is currently required by statute to compare lenders’  default and claim rates by geographic area. With enhanced authority  to set alternative performance metrics, FHA said it would be able to  compare a lender’s rate of early defaults and claims (for insured  single-family mortgage loans) with the rates of other lenders on any  basis determined appropriate. Examples of metrics include  geographic area, varying underwriting standards, or populations  served.

The majority of the observers we interviewed said that FHA needed  authority for enhanced enforcement actions. For example, some said that  FHA needed these additional powers to more effectively manage risk and  avoid unnecessary losses. Others suggested additional options—for  example, requiring lenders to take back loans that defaulted within the  first 6 months. However, one observer said that the prospect of tough  administrative and legal actions already provided strong incentives for  lenders to carefully follow FHA program guidelines. Two stakeholders we  interviewed stated that increased scrutiny of lenders by FHA and others  had increased concern among lenders about the risks of litigation. As a  result, lenders have moved to further restrict credit in recent years. Many  FHA lenders have taken the step of imposing additional requirements  (known as credit overlays) on FHA loans, potentially making it more  difficult for borrowers to obtain FHA loans.

FHA and some mortgage industry observers have suggested that the  agency should have more authority to make changes to program  requirements, including emergency powers. Currently, FHA must go  through the rulemaking process or seek legislative authority to make  major changes to its programs. For example, after problems with loans  with seller-funded down-payment assistance were identified, it was  several years before these loans were disallowed. HUD’s latest annual  report on the Fund noted that the effect of loans with seller-funded down- payment assistance on the Fund was expected to be more than $15  billion in losses. Problems associated with these loans are well  documented. A March 2005 HUD contractor study found that property  sellers who provided down-payment assistance through nonprofits often  raised sale prices of the homes involved to recover the required  payments that went to the organizations. As noted previously, in  November 2005, we also found that loans with this type of assistance had  inflated prices and defaulted more often than loans without such  assistance.funded down-payment assistance. Subsequently, the rule was struck  down by the courts on procedural grounds. Congress ultimately prohibited  the use of this assistance in January 2009.

In October 2007, FHA published a rule that prohibited seller- FHA is currently trying to address losses from its HECM program (reverse  mortgages that permit persons 62 years and older to convert their home  equity into cash advances), but has not been able to make programmatic  changes that it has determined might stem them. In a testimony on HUD’s  fiscal year 2014 proposed budget, the Secretary attributed the potential  need for $943 million in permanent and indefinite budget authority for the  Fund in fiscal year 2013 to losses in the HECM program. FHA has  proposed a number of changes to the HECM program, such as  mandating the use of escrow accounts to ensure continued and timely  payment of property charges, including taxes and insurance. However,  FHA officials said that the average time for a rulemaking of this type was  about 18 months—a length of time that exposed the agency and the Fund  to risks that could be avoided if, for example, it could make changes  through a mortgagee letter. Recently, FHA was provided authority to  establish through mortgagee letters any requirements that HUD  “determines are necessary to improve the fiscal safety and soundness” of  the HECM program. FHA officials told us that a mortgagee letter could  be issued within 30 to 60 days. Another approach to dealing with the  issue would be to limit the ability of borrowers to withdraw up-front the  maximum amount allowable under the program. HUD noted that the vast  majority of borrowers in the HECM program take out 80 percent or more  of the maximum amount possible in one initial cash draw, and that this  increases the likelihood that they have insufficient funds to pay items  such as property taxes. In its November 2012 annual report to Congress,  FHA announced that it would take immediate action to reduce the amount  borrowers are permitted to draw out at the time of origination of their  HECM loan. The report notes that the change would protect FHA from  losses and reduce the likelihood of borrower default due to nonpayment  of taxes and insurance. Although FHA points to other actions that will be  needed to reform the HECM program, this example demonstrates the  importance of FHA exercising the authority it already has.

Several proposals have been put forward that would increase FHA’s  ability to make changes to its programs. One observer has recommended  that Congress give the HUD secretary special emergency powers to  suspend FHA insurance programs or make emergency modifications to a  program when the HUD secretary finds that current program terms  expose the taxpayers to an elevated risk of loss and fail to serve the  public interest. In addition, a paper that lays out the current  administration’s plan to reform the nation’s housing finance market stated  that the administration should work with Congress to give FHA more  flexibility to respond to stress in the housing market and manage its risk  more effectively. It added that doing so would mean giving FHA  flexibility to adjust fees and programmatic parameters more quickly than it  can today. Regardless, two observers pointed to the need for offsetting  any additional flexibility that might be afforded to FHA with clear limits to  this authority, such as limits on the duration of such changes absent a  formal rulemaking process.

Two observers we interviewed expressed concern about giving FHA  greater authority to make significant program changes, stating that such  authority should be reserved for Congress. One noted that during the  recent housing crisis Congress showed that it was able to act quickly to  change FHA program requirements when needed by increasing the loan  limit requirements. Also, he told us that FHA did not need congressional  action to change its programs. For instance, FHA could create an interim  rule to quickly handle a problem while going through the official  rulemaking process to make a permanent change. Similarly, the other observer said that FHA could make some changes through mortgagee  letters and the rulemaking process. However, according to FHA, HUD’s  Office of General Counsel has advised that not all procedures or policies  may be changed by interim rule and interim rules can be particularly  sensitive to litigation and a legal stay. Thus it is the General Counsel’s  opinion that statutory authority is often the safest and fastest route to  make changes.

FHA has reported that the more than 40 information systems its single- family programs use are outdated, unable to sustain the increasing  volume of insurance applications, and costly to maintain. In addition,  recent increases in FHA’s business volume have exacerbated its  information technology (IT) constraints. A consultant FHA hired to  examine technology constraints and identify risks related to processing  workloads (for single-family programs) reported in 2009 that critical  elements of IT infrastructure were at capacity, causing work slowdowns  and poor customer service. For example, network overloads slowed  systems in the afternoon, when work hours overlapped at the  homeownership centers (which are in different time zones). To partially  address these issues, HUD upgraded the mainframe’s system capacity  and made changes to certain applications to improve response time.  Nevertheless, during a period in which transaction levels continued to  increase, FHA had reached the limit of hardware and software capacity  on IT systems.

Moreover, the audit of FHA’s 2011 and 2012 financial statements  identified a significant deficiency related to IT systems and stated that  FHA management and the HUD Office of the Chief Information Officer  should mitigate persistent IT control deficiencies. The audit report noted  that expensive and manual compensating controls, including monthly  reconciliations of data among the interfaced systems, were needed to  manage the numerous systems and that security and access controls had  weaknesses. We found in November 2011 that the large number of  systems resulted in hundreds of interfaces, which meant that changing  one system required extensive effort to maintain the interfaces across  systems. The multiple systems and interfaces also presented  challenges for maintaining appropriate accessibility levels, security  controls, and privacy standards.

To address system constraints, FHA has initiated the FHA Transformation  Initiative to improve FHA’s management of insurance programs through  the development and implementation of a modern financial services  information technology environment that is expected to improve loan  endorsement processes, collateral risk capabilities, and fraud  prevention. For fiscal years 2010 and 2011, HUD reported that the Transformation Initiative funding made available was $58.5 million.  According to FHA, the agency maintains an aggressive, robust, and  varied project management and applications development portfolio aimed  at deploying new and modernizing existing mortgage insurance  capabilities and business processes. In June 2013, we found that HUD  had not yet fully implemented key project management practices in  executing and managing the IT projects associated with the FHA  Transformation Initiative. Specifically, while the department had  developed project management documents such as charters and  requirements management plans, none of these documents included all  of the key details that could facilitate effective management of its projects  such as full descriptions of the work necessary to complete the projects,  cost and schedule baselines, or prioritized requirements, among other  things. A lack of project management expertise along with HUD’s  inadequate development and use of a project management framework  and governance structure contributed to these deficiencies. Therefore, we  recommended that HUD establish a plan of action to fully implement best  practices, provide needed project management expertise, and improve  the development and use of its project management framework and  governance structure. HUD agreed with our recommendations to improve  its framework and governance, but did not agree with the entirety of the  recommendation to develop a plan of action or the need for providing  project management expertise. The department described actions it  would take to improve its project management practices in order to  address the deficiencies identified.

However, some mortgage industry observers said FHA should be  provided with additional funding to enhance its information technology.  The congressionally appointed Millennial Housing Commission found that  FHA’s dependence on the appropriations process for budgetary  resources and competition for funds within HUD had led to  underinvestment in technology, increasing the agency’s operational risk  and making it difficult for FHA to work efficiently with lenders and other  industry partners. Some observers we spoke with also cited competition for funds within HUD, and most supported providing FHA additional  funding for these enhancements. One benefit of this option is that the  technology enhancements could improve FHA’s operations. For example,  an observer said that it supported the recent efforts that FHA had taken to  improve its risk management and protect the safety and soundness of the  agency, but added that these efforts could not be sustained without,  among other things, state-of-the-art technology.

FHA officials also told us that the agency’s limited resources meant  implementing technology improvements using a piecemeal approach,  although it would be better if FHA could upgrade and integrate all of its  systems at the same time. Specifically, the agency stated that sustained  and timely funding through using receipts or direct appropriation would  enable FHA to budget and procure support and services more  strategically, systematically, and consistently.

In the current budget environment, funding for technology enhancement  is limited. FHA technology investments must compete with other HUD  technology investments. Some observers argue that FHA should be  granted the authority to use a portion of its insurance premiums for  technology enhancement. In a June 2007 report on FHA modernization,  we found that Congress could grant FHA specific authority to invest a  portion of the Fund’s current resources—that is, negative subsidies that  accrue in the Fund’s reserves—in technology enhancement. However,  FHA has not met its statutory capital ratio requirement since 2009 and  using premium income for technology enhancement would further reduce  the ratio. Even in more prosperous times, using the Fund’s current  resources would have implications. Specifically, in our June 2007 report  we found that using the Fund’s current resources for information  technology would diminish its ability to withstand severe economic  conditions and would also increase the federal government’s budget  deficit, all other things being equal. Further, requiring FHA to use program  revenue to pay for administrative costs could require it to increase the  premiums charged to borrowers. To the extent that having greater control  over resources might improve agency efficiency and effectiveness, FHA  may limit any potential premium increases needed to cover administrative  expenses.

Congress also could consider allowing FHA to compensate its employees  outside of federal pay scales. In November 2011, we reported that from  2006 to 2010, Single Family Housing field staffing levels remained  relatively constant, while key workload items, such as volume-driven loan  reviews and the management of foreclosed homes, grew considerably.  As a result, it may be difficult for FHA staff to mitigate risk. Some federal  agencies, such as the Securities and Exchange Commission, the Federal  Deposit Insurance Corporation, and FHFA, are permitted to pay salaries  above normal federal pay scales in recognition of the special skills  demanded by sophisticated financial market operations. FHA and some  mortgage industry observers have suggested that FHA be given similar  authority. FHA officials told us that in order to appropriately manage the  Fund, FHA needs a mix of staff with industry expertise, including those  with strong operations management, and that flexibility in compensation  would help FHA accomplish the right balance. An observer suggested  that giving the HUD secretary authority to hire risk management, analytic,  and technological system staff on a more generous pay scale could close  some of the gap between private market participants and those charged  with protecting taxpayers from economic harm. In addition, another  observer recommended that FHA have the ability to more broadly use  retention allowances and recruitment bonuses. This option could help  FHA to recruit experienced staff to help the agency adapt to changes.  Some suggest that, as with investments in technological enhancements,  enhancements in compensation could be funded with the Fund’s premium  income. The effect would be to provide FHA greater flexibility, but also  would require program participants to absorb administrative costs that are  currently borne by direct federal appropriation or would reduce resources  available to pay claims and reduce the capital ratio.

Some mortgage industry observers have suggested that Congress give  FHA authority to implement pilot programs. For example, one noted that  too often the statutory and regulatory environment for FHA leads to “all or  nothing” policy changes, although private mortgage industry participants  frequently tested new strategies before applying them to an entire  portfolio. She recommended that FHA be given authority to implement  pilot programs quickly with the goal of better understanding, measuring,  and mitigating risk. In addition, the Millennial Housing Commission found  that the statutes and regulations to which FHA was subject dramatically  increased the time necessary to develop and implement new products. It  recommended that Congress expressly authorize FHA to introduce new  products without requiring a new statute for each. In a June 2007 report,  we found that such authority would offer FHA greater flexibility to keep  pace with the rapidly changing mortgage market.determined that Congress would have less control over FHA’s product  offerings and that in some cases it might take years before a new  product’s risks were well understood.

In a February 2005 report, we recommended that FHA consider using  pilots for new products and for any planned significant changes to its  existing products. Because FHA officials had questioned the  circumstances under which they could use pilots when not required to do  so by Congress, we also recommended that FHA seek the authority to  offer new products on a limited basis, such as through pilots, if the  agency determined that it lacked sufficient authority. In comments on the  report, HUD did not specifically state whether it agreed with the  recommendations. Rather, it stated that it was in basic agreement with  GAO that all policy options, implications, and implementation methods  should be evaluated when considering or proposing a new FHA product.  For this review, however, FHA officials told us that FHA had the  appropriate level of authority to pilot programs and had successfully  piloted several. For example, FHA piloted a program that allowed lenders  to sell foreclosure properties securing nonperforming FHA-insured loans  to third parties at a reserve price slightly below the property value without  conveying the properties to FHA. According to FHA, the agency plans to  expand the program after finding that this method of disposing of  properties yields lower losses for the Fund than FHA’s normal disposition  process.

Even with no changes to its existing organizational structure and  authorities, FHA can do more to enhance program efficiency and  effectiveness and protect taxpayers. We have made a number of  recommendations aimed at improving FHA’s information technology, loss  mitigation efforts, management of real-estate owned inventories, risk  assessment, and human capital management. As previously mentioned,  we recommended in June 2013 that HUD establish a plan of action to  fully implement best practices in management of information technology,  provide needed project management expertise, and improve the  development and use of its project management framework and  governance structure. In addition, in June 2012 we recommended that  FHA periodically analyze the effectiveness and the long-term costs and  benefits of its loss mitigation strategies and actions to more fully  understand their strengths and risks and protect taxpayers from  absorbing avoidable losses to the maximum extent possible. This report  found that several agencies, including FHA, were not conducting  analyses to determine the effectiveness of their loss mitigation actions.  The experiences of Treasury, the enterprises, and our econometric  analysis strongly suggested that such analyses could improve outcomes  and cut program costs. In November 2012, FHA announced revisions that  were designed to reduce the number of full claims against the Fund.  Specifically, FHA changed the steps that loan servicers must take to  assist home buyers in bringing their mortgage payments current. We  requested and plan to assess the analysis HUD completed as the basis  for this change in FHA’s loss mitigation strategies to determine whether it  fully responds to our recommendation. And as noted previously, FHA has  proposed additional revisions to its loss mitigation and foreclosure  processes that would require congressional action.

FHA could also mitigate losses on mortgages that it insures by improving  its recovery rate for foreclosures by, for example, improving the  foreclosure process itself and the process for selling its inventory of  foreclosed properties. In 2002, we found that FHA’s existing procedures  could delay the start of critical steps necessary to preserve the value of  foreclosed properties and sell them quickly. We pointed to the fact that  FHA divided custody of foreclosed properties between servicers and  contractors, which could prevent the initiation of critical maintenance  necessary to make properties attractive to potential buyers. We  recommended that HUD make establishing unified property custody a  priority. In 2012, FHA announced that it was expanding a pilot that would  permit such unified custody. Under the expanded pilot, FHA permitted  loan servicers to maintain custody of properties from foreclosure sales  through final disposition, relieving FHA of the responsibility for managing  and selling these properties. Because this program is a pilot, FHA  continues to take into its inventory foreclosed properties. According to  FHA, it has taken steps to improve recovery through techniques such as  using best execution modeling to ensure an optimal asset disposition  approach. In June 2013, we recommended a number of ways that FHA  could improve on the performance of these properties—for instance, by  ensuring that price reductions were based on an evaluation of market  conditions rather than on standardized schedules. FHA agreed with  these recommendations and identified actions that it had taken or  planned to take in response to them.

In a November 2011 report, we recommended specific improvements that  FHA could make to its risk assessment processes and human capital  management. We recommended that FHA (1) integrate two ongoing  efforts to assess risk, (2) conduct an annual risk assessment, and (3)  establish ongoing mechanisms to anticipate and address risks that might  be caused by changing conditions. To improve human capital  management, we recommended that FHA develop workforce and  succession plans for the Office of Single Family Housing. Since our  report, FHA has taken several actions, including developing a plan for  conducting an inaugural risk assessment and a workforce analysis and  succession plan.

Finally, we previously reported on opportunities to increase collaboration  among the agencies responsible for overlapping and fragmented housing  programs and activities, including those that support homeownership,  with the potential for realizing efficiencies. In 2000, we suggested that  Congress consider requiring RHS and HUD to examine the benefits and  costs of merging programs serving similar markets and providing similar  products. In 2012, we found that the administration had formed a task  force to evaluate the potential for coordinating or consolidating loan   However, we found that the task  programs at HUD, RHS, and VA.force’s efforts had not yet incorporated key collaborative practices. We  therefore recommended that HUD, USDA, and VA, and the Director of the  Office of Management and Budget (OMB) take steps to establish a more  rigorous approach to collaboration. In addition, we recommended that  officials from HUD, Treasury, USDA, and VA evaluate and report on the  specific opportunities for consolidating similar housing programs,  including those that would require statutory changes. HUD and OMB  expressed concern about implementing the recommendations while HUD  was focused on the ongoing housing recovery. As we stated in the report,  in addition to focusing on the ongoing housing crisis and government  support for the housing market, focusing on achieving efficiencies and  cost savings and the delivery of government support for housing is  important. Given its financial condition, now more than ever it is important  that FHA optimize its effectiveness across all aspects of its operations.

section_title: Broader Housing Market Reforms Could Impact FHA’s Role
paragraphs: Following the collapse of the mortgage market, policymakers proposed a  number of mortgage reforms that could impact FHA’s market share and  role. These reforms could affect the willingness of the conventional  market to serve future home buyers of varying credit risk profiles and the  fees that lenders would charge for conventional loans. The administration  has put forth several options for reforming the federal role in the mortgage  market, including reforming the enterprises (Fannie Mae and Freddie  Mac). Each of these options has potential implications for FHA. Some of  our recent work—a 2009 report on options for resolving the enterprises  and our 2013 high-risk series—discussed the trade-offs associated with  options for resolving the enterprises, as well as how these efforts could  affect FHA.
subsections: section_title: Recent Statutory and Regulatory Changes Could Affect FHA’s Market Share
paragraphs: Recent statutory and regulatory changes related to qualified mortgages  (QM) and qualified residential mortgages (QRM) have the potential to  affect FHA’s market share. The 2010 Dodd-Frank Wall Street Reform and  Consumer Protection Act (Dodd-Frank Act) required lenders to make a  reasonable and good faith determination, based on verified and  documented information, that borrowers seeking residential mortgages  have a reasonable ability to repay the loan according to its terms. The  Dodd-Frank Act also established a presumption of compliance with the  ability-to-repay requirements for a certain category of mortgages called  QM. The ability to repay provisions are similar to those implemented by  the Board of Governors of the Federal Reserve System (Federal Reserve  Board) in 2008 but cover all mortgages. The Dodd-Frank Act shifted  rulemaking authority for these provisions and QM from the Federal  Reserve Board to the CFPB. On January 30, 2013, CFPB published its  final rule on ability to repay and QMs (effective January 10, 2014).

Among other things, CFPB’s final rule establishes general underwriting  criteria for QMs, including that the borrower have a DTI ratio of less than  or equal to 43 percent. As previously discussed, FHA underwriting  standards allow some borrowers to have DTI ratios that are greater than  43 percent. While acknowledging that many borrowers with high DTI  ratios likely could afford mortgages, CFPB was concerned that lenders  would not make loans to these consumers in light of the current economic  conditions. As a result, CFPB expanded the definition of a QM to include  any loan that is eligible to be purchased, guaranteed, or insured by  various federal agencies, including FHA, VA, USDA, and USDA’s RHS, or  by the enterprises while they are operating under conservatorship. This  rule is temporary and in general will remain in effect until these agencies  finalize their own QM regulations. According to FHA, the agency is  currently developing its QM regulations.

The Dodd-Frank Act also requires mortgage securitizers to retain a  financial exposure of no less than 5 percent of the credit risk of any  securitized residential mortgage that does not meet a separate set of  criteria (to be defined by regulators) that are associated with a lower risk  of default. Securitized mortgages that meet these criteria are exempt  from this risk retention requirement and are considered QRM. All FHA- insured mortgages are exempt from the risk-retention requirement, and  Fannie Mae and Freddie Mac mortgages are exempt as long as the  agencies are in conservatorship. Federal regulators published a proposed  QRM rule on April 29, 2011, that included a 20 percent down-payment  requirement. However, federal regulators issued another proposed rule  on August 28, 2013. The new proposed rule offers two approaches.  The first approach would define a QRM to have the same meaning as the  term QM defined by the CFPB and, thus, would not include a down- payment requirement. The alternative approach, which according to the  regulators “was not selected as the preferred approach,” would require  lenders to retain risk in any loan with a down payment of less than 30  percent.

Because the QM and QRM regulations will affect whether and at what  price the conventional market will be willing to serve higher-risk  borrowers, some have suggested that they could push these borrowers to  FHA. For example, a recent HUD paper outlined several factors that may  make higher-risk borrowers migrate to FHA: (1) conventional lenders are  unlikely to originate non-QM loans (which by definition are also non-QRM  loans, as QRM is a subset of QM) because they will face significantly  higher capital retention requirements; (2) lenders that are willing to  originate non-QM loans will do so only at a higher cost to the borrower;  and (3) the April 2011 QRM proposal is quite narrow, requiring for  example, that borrowers make a 20 percent down payment, which may  be a difficult threshold for first-time borrowers to meet. Another paper  we reviewed concurred, positing that the April 2011 proposed QRM rule  could make it extremely difficult to securitize high-LTV loans made to first- time home buyers and other borrowers who could prudently manage low  down-payment mortgages, resulting in a flood of loans to the enterprises  and FHA.most of these loans could flow to FHA.

section_title: The Resolution of Fannie Mae and Freddie Mac Could Impact FHA’s Role
paragraphs: On September 6, 2008, FHFA placed Fannie Mae and Freddie Mac into  conservatorship because of concern that their deteriorating financial  condition threatened the stability of the financial markets. According to  FHFA, the two enterprises had a worldwide debt and other financial  obligations totaling $5.4 trillion at the time they were placed in  conservatorship. Defaulting on those obligations would have significantly  disrupted the U.S. financial system. While the conservatorships can  remain in place indefinitely as efforts are undertaken to stabilize Fannie  Mae and Freddie Mac and restore confidence in financial markets, FHFA  has said that the conservatorships were not intended to be permanent.  Recent policy changes and proposals on how to restructure or wind down  the two enterprises are likely to have an impact on FHA’s role in the  mortgage market.

In August 2012, FHFA directed the enterprises to increase their  guarantee fees on single-family mortgages by an average of 10 basis  points. According to FHFA, the increase represented a step toward  encouraging greater participation in the mortgage market by private firms.  One impact of this change could be to push business to FHA.

In addition, in February 2011, Treasury and HUD jointly issued a proposal  for reforming the federal role in housing finance. The proposal would  make private markets the primary source of mortgage credit and would  place the burden of losses on the private market. In addition, banks would  be required to adhere to underwriting standards that were more  conservative than those currently in place and that would require  homeowners to hold more equity in their homes. The plan also includes  proposals for reducing the roles of Fannie Mae and Freddie Mac, and  ultimately winding down both institutions, while at the same time ensuring  access to quality, affordable housing. To this end, the report presents  several proposals for structuring the government’s long-term role in a  housing finance system in which the private sector is the dominant  provider of mortgage credit:

Option 1. A privatized system of housing finance with the government  insurance role limited to FHA, USDA, and VA assistance for narrowly  targeted groups of borrowers.

Option 2. A privatized system of housing finance with assistance from  FHA, USDA, and VA for narrowly targeted groups of borrowers and a  guarantee mechanism that could be scaled up during times of crisis.

Option 3. A privatized system of housing finance with FHA, USDA,   and VA assistance for low- and moderate-income borrowers and  catastrophic reinsurance behind significant private capital.

Under each of these options, FHA would continue to play a central role in  providing mortgage credit to low- and moderate-income borrowers.

In a 2009 report, we also identified several options for revising the  structure of the enterprises and outlined a framework for identifying the  trade-offs associated with them:  reconstitute the enterprises as for-profit corporations with government  sponsorship but place additional restrictions on them, establish the enterprises as government corporations or agencies, or privatize or terminate the enterprises.

In evaluating the trade-offs associated with these options, we noted that  the credit needs of certain groups no longer served by the enterprises  could be met by FHA. However, we also pointed out that some have  questioned FHA’s capacity to manage large increases in its business,  which could raise taxpayer risks. In addition, we previously had identified  “modernizing the U.S. financial regulatory system” as a high-risk area.  Because of continuing uncertainty over the resolution of Fannie Mae and  Freddie Mac, the potential impact of their resolution on FHA, and  concerns about FHA’s financial condition, in February 2013 we included  FHA in this high-risk area, now called “modernizing the U.S. financial  regulatory system and the federal role in housing finance.”

As of March 31, 2013, over 90 percent of new mortgage volume had  federal backing, either through FHA and Ginnie Mae or the enterprises.  The heightened federal role in mortgage lending and the increased  reliance on FHA insurance highlights the need for policymakers to ensure  that changes made to FHA and the enterprises recognize the  interdependence of these entities and that changes to federal regulations  governing the mortgage market consider the interaction between public  and private capital and reflect the roles and capacities of the agencies.  Ultimately, FHA’s place in the housing finance system will depend on how  the private market reacts to new regulations and how the federal  government resolves Fannie Mae and Freddie Mac. It will also depend on  which, if any, of the options outlined in this report policymakers pursue  and how they are implemented.

section_title: Agency Comments
paragraphs: We provided a draft report to HUD for review and comment, and HUD  had no comments.

As agreed with your offices, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies to the Secretary of Housing  and Urban Development and other interested parties. In addition, the  report will be available at no charge on GAO’s website at  http://www.gao.gov.

If you or your staff have any questions about this report, please contact  me at (202) 512-8678 or sciremj@gao.gov. Contact points for our Offices  of Congressional Relations and Public Affairs are listed on the last page  of this report. GAO staff who made major contributions to this report are  listed in appendix II.

section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: Our objectives were to examine options that have been proposed for  improving the long-term viability of the Federal Housing Administration  (FHA) or reducing its market presence and the implications of these  options. Specifically, we discuss the implications of options related to (1)  changing FHA’s product terms and conditions for single-family mortgage  insurance, (2) restricting FHA’s presence in the single-family housing  market, and (3) enhancing FHA’s operations and powers within its single- family program. In addition, we discuss the possible effects of broader  housing finance reform on FHA.

To identify proposed options for improving the long-term viability of FHA  or limiting its market presence, we obtained relevant academic and  industry studies based on our past and ongoing work and conducted a  literature search of relevant databases. We reviewed and summarized the  literature identifying options for change at FHA, including congressional  testimonies and other documents from mortgage market participants  (such as the Mortgage Bankers Association) and researchers (such as  the Urban Institute, Cato Institute, and others). As noted above, we sorted  these options into three categories: changes related to product terms and  conditions, changes that could affect the market FHA serves, and  changes related to FHA’s organizational structure or powers. We also  reviewed and summarized the literature for implications associated with  the proposed options (including the effects on the cost or risk to the  taxpayer, borrowers’ access to credit, FHA’s role and the market it  serves, and other mortgage market participants). Finally, we reviewed  these materials for information on broader housing refinance issues that  may affect FHA, including mortgage reforms and proposals for reform of  Fannie Mae and Freddie Mac, two government-sponsored enterprises.  We assessed the reliability of the key studies we used and determined  them to be reliable for our purposes. We also obtained and reviewed  documentation from the Department of Housing and Urban Development,  FHA, and Ginnie Mae. This documentation included FHA’s mortgagee  letters, which we reviewed to determine existing program policies and  procedures and recent changes.

We obtained FHA data on (1) loans originated in 2009, including credit  scores and down-payment percentages, (2) the effect of a potential  increase in the down-payment requirement on loans for which  applications were submitted in August 2010 through July 2011, (3) the  percentage of loan originations in 2009 and 2010 that had seller  concessions of more than 3 percent of the property value, (4) the  percentage of loans that FHA insured in fiscal year 2012 that were above  $450,000, by state, (5) the income distribution of FHA borrowers in fiscal  years 2000-2013 (October through April), and (6) delinquency rates for all  active loans as of October 31, 2011, by loan size. To determine the  reliability of this information, we reviewed information on the data and  queried FHA officials about how its data are collected, verified, and  maintained to identify potential data limitations. The FHA officials agreed  these data were generally accurate and complete. Based on this work, we  concluded that the data we received from FHA were sufficiently reliable  for our purposes. We also used data published by Inside Mortgage  Finance on mortgage originations for the first quarter of 2013. To  determine the reliability of these data, we reviewed information on the  data source and queried a knowledgeable official about the accuracy of  the data. We determine the data were sufficiently reliable for our  purposes.

Finally, we conducted interviews with mortgage industry participants,  researchers, consumer groups, and three former FHA commissioners to  discuss the proposed options and, in particular, their implications.  Specifically, we interviewed representatives from the following  organizations:

American Enterprise Institute,

Cato Institute,

Center for American Progress,

Center for Responsible Lending,

Harvard Business School,

Harvard University’s Joint Center for Housing Studies,

Hudson Institute,

Independent Community Bankers of America,

Mortgage Bankers Association,

Mortgage Insurance Companies of America,

National Association of Home Builders,

National Association of Realtors,

National Community Reinvestment Coalition,

National Council of State Housing Agencies, and

Urban Institute.

We also interviewed FHA and Ginnie Mae officials. At each interview, we  sought to obtain any additional relevant studies or papers.

We conducted this performance audit from April 2013 to September 2013  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.

section_title: Appendix II: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact

section_title: Staff Acknowledgments
paragraphs: In addition to the individual named above, Paige Smith, Assistant  Director; Stephen Brown; Marcia Carlsen; Emily Chalmers; Cory  Marzullo; John McGrail; Marc Molino; Josephine Pérez; Andrew Stavisky;  Julie Trinder; and Heneng Yu made major contributions to this report.


Question-summary annotations: questions: question: What did GAO identify regarding the FHA?
answer: GAO identified a number of proposed options for adjusting product terms and conditions to help improve the Federal Housing Administration's (FHA) long-term viability.

question: How has the FHA tightened its loan standards in recent years?
answer: FHA has raised the premiums that it charges borrowers several times in recent years and has taken steps to tighten its underwriting standards--for example, by setting a minimum required credit score.
child_questions: question: How could these standards be improved?
answer: Some mortgage market observers have argued that further changes such as revising underwriting standards to focus on borrowers' residual income, requiring higher down payments, or reducing seller concessions (that is, funds sellers provide to buyers to help pay for closing costs) could help FHA better manage credit risk.

question: How could these standards negatively affect the FHA?
answer: However, such changes would entail trade-offs. For instance, some said that raising down-payment requirements would improve loan performance, but others said that this move would delay homeownership for many borrowers. Similarly, raising premiums could potentially increase revenue, but this potential would be constrained if it caused volume to decline.

question: How could these standards affect the risk-level of the FHA's borrowers?
answer: Further, low-risk borrowers with fewer down-payment constraints could choose less costly loans from other sources, leaving FHA with more high-risk borrowers. These changes could have a direct effect on the availability of credit for borrowers.

questions: question: What did GAO identify regarding the FHA's market presence and financial viability?
answer: GAO also identified options that could either directly or indirectly change FHA's market presence, which increased after the housing crisis, or address its financial viability. Among the proposals that would have a direct effect are those limiting FHA insurance to loans below a lowered ceiling or to borrowers who met new income guidelines.

question: To what extent are the FHA's current loan limits at an appropriate level?
answer: Many stakeholders and FHA itself view FHA's current loan limits, which range from $271,050 to $729,750 for one-unit properties in the contiguous United States, as too high.
child_questions: question: How were the current loan limits implemented?
answer: The current FHA limits were put in place in response to declines in mortgage lending during the housing crisis, when the private sector's role in financing mortgages shrank.

question: How might the loan limits be changed to reflect the current market?
answer: However, as the market has improved, some have noted that lowering loan limits would allow private capital to return to the market and focus FHA on low- and moderate-income and first-time home buyers, a shift that many observers consider appropriate.

question: How could proposed changes affect the FHA's market presence?
answer: Other proposed changes, such as reducing insurance coverage to less than 100 percent of the loan amount or entering into risk-sharing agreements with private partners, may indirectly reduce FHA's market presence.
child_questions: question: How could these changes affect the availability of credit?
answer: However, applying a partial coverage model would limit availability of credit to some borrowers.
child_questions: question: How could this lead to a partial-coverage model?
answer: For some lenders, the additional exposure might prompt the purchase of additional insurance coverage from third parties, the cost of which would be passed on to borrowers.

question: What are the considerations that must be taken into account for a risk-sharing structure?
answer: Some argue that under a risk-sharing structure private partners would assume and better manage credit risk. But creating such a structure would require careful consideration of how risks are borne, how pricing is determined, how incentives are aligned between FHA and its partners, and how FHA's role in stabilizing mortgage markets would be impacted.  Others point to the additional counterparty risk posed by risk-sharing arrangements, which would necessitate greater federal oversight. Finally, these options might also affect FHA's ability to respond to changing market conditions.

questions: question: What changes are being proposed to the FHA's structure?
answer: FHA and industry observers have also suggested changes to FHA’s structure and powers that could enhance its flexibility and capacity to manage risk. Some of these changes would bring FHA’s corporate powers more in line with those of other government corporations and increase its autonomy, providing it with enhanced enforcement powers and greater authority to change program requirements and invest in staff and technology.

question: What is the FHA's stance about its level of power?
answer: FHA has already requested additional enforcement authority.
child_questions: question: Why is the FHA requesting additional authority?
answer: FHA and other observers have also argued that FHA needs greater power to change loan products or loan features without a lengthy rulemaking process and additional information technology resources—resources for which FHA must currently compete within HUD. Expanding FHA’s operational and managerial powers would give the agency more flexibility, and increasing its enforcement powers would allow it to more effectively oversee lenders.

question: What caveats would the proposed expansion of power come with?
answer: But any expansion of FHA’s authority may need to be limited and transparency requirements heightened, including for the rulemaking process.

question: How did GAO suggest that FHA improve its risk assessment and efficiency?
answer: GAO has made a number of recommendations aimed at improving FHA’s loss mitigation efforts, management of real-estate owned inventories, risk assessment, human capital management, and information technology systems.
child_questions: question: How has the FHA responded to these recommendations?
answer: In response to these recommendations, FHA has taken steps, such as developing a plan for conducting an inaugural risk assessment and a workforce analysis and succession plan.

questions: question: Why is FHA reform challenging?
answer: Finally, efforts to further regulate housing finance and the continuing uncertainty over resolution of Fannie Mae and Freddie Mac present challenges to any efforts to reform FHA.

question: How did Congress respond to the collapse of the mortgage market?
answer: Following the collapse of the mortgage market, Congress passed a number of mortgage reforms that could impact FHA’s market share and role because they could affect the price at which the conventional market will be able to serve future home buyers of varying credit risk profiles. Similarly, the administration has put forth several options for reforming the federal role in the mortgage market, including reform of Fannie Mae and Freddie Mac.

question: Why is the federal role in housing finance a high-risk area?
answer: Each of these options could have an impact on FHA’s role in the mortgage market. Partly for this reason, GAO identified modernization of the federal role in housing finance as a high-risk area in early 2013.

question: How should changes to federal housing finances be made?
answer: Any changes to the federal tools that support housing finance should be made in concert and with full recognition of the interdependence among FHA, the enterprises, and federal regulation.

questions: question: What historic role has FHA played in in housing financing?
answer: FHA has historically provided mortgage guarantees for home buyers, particularly first-time, minority, and lower-income borrowers.

question: What is the range of the FHA's financial activities?
answer: In 2012, FHA insured about $227 billion in single-family mortgages, and its overall insurance portfolio was about $1.1 trillion.

question: How has the FHA's market presence changed recently?
answer: Its market presence expanded during the recent housing crisis as the conventional market contracted and Congress increased the limit on the size of loans FHA may insure.
child_questions: question: How has this change negatively affected the FHA?
answer: But FHA's financial condition has weakened, and FHA has not met its 2 percent statutory minimum capital ratio since 2009. In its most recent budget, the agency stated that its capital reserve account might require an infusion of federal funds.

questions: question: What have stakeholders suggested regarding improvements to the FHA?
answer: FHA, industry participants, and researchers have suggested a number of options for improving FHA's long-term viability or for limiting FHA's market presence.
child_questions: question: How far-reaching would the implications of these options be?
answer: These options have potential implications for taxpayers, borrowers, and others.

question: What does this report cover?
answer: This report discusses the options--which fall into three broad categories: (1) changes to product terms and conditions, (2) changes that would restrict FHA's market presence, and (3) changes to FHA's operations and powers--and their implications.
child_questions: question: To what extent does this report address possible indirect affects of other legislation?
answer: It also describes the possible effects of broader housing finance reform on FHA.