FHA Mortgage Insurance: Applicability of Industry Requirements Is Limited, but Certain Features Could Enhance Oversight
Released: 2013-10-22T00:00:00

Letter

Background

Federal Housing Administration

Established in 1934 under the National Housing Act, FHA operates the largest federal mortgage insurance program, which is backed by the full faith and credit of the federal government. FHA primarily insures forward mortgages for initial home purchases and refinancing. Generally, lenders require borrowers to purchase mortgage insurance when the initial loan- to-value ratio (the amount of the mortgage loan divided by the value of the home) exceeds 80 percent. In fiscal year 2012, FHA reported that it insured almost 1.2 million forward mortgages representing approximately $213 billion in mortgage insurance-in-force. Its reported total amortized insurance-in-force on forward loans at the end of fiscal year 2012 was $1.07 trillion.

Three different reviews of the financial condition of the Fund are conducted annually. First, the Omnibus Budget Reconciliation Act of 1990 required an annual independent actuarial study of the economic net worth and soundness of FHA’s Fund. As part of this review, an independent actuary estimates the economic value of the Fund, which FHA uses to calculate the Fund’s capital ratio. The actuary’s analysis considers the net current resources available to the Fund; historical performance of existing loans; projected claim, loss, and prepayment rates; and projected future economic conditions. The actuarial study is now a requirement in the Housing and Economic Recovery Act of 2008 (HERA), which also requires that the Secretary of HUD submit an annual report to Congress on the results of the actuarial study, as well as quarterly status reports on the Fund.

Second, estimates that FHA prepares for the federal budget provide another review of the financial condition of the Fund. Specifically, under the Federal Credit Reform Act of 1990 (FCRA), FHA and other federal agencies must estimate the net lifetime costs (known as credit subsidy costs) of their loan insurance or guarantee programs and include the costs to the government in their annual budgets. Agencies annually estimate credit subsidy costs by cohort—the loans agencies commit to insure or guarantee in a given fiscal year. The initial credit subsidy cost in the year the loans are insured is equal to the net present value of estimated lifetime cash flows, excluding administrative costs. For a mortgage insurance program, cash inflows consist primarily of premiums charged to insured borrowers and recoveries from sales of foreclosed properties, and cash outflows consist mostly of claim payments to lenders. A balance equal to the amount needed to cover estimated net future costs is held in the Fund’s financing account. Estimated lifetime revenues in excess of this amount are recorded in the Fund’s capital reserve account. Historically, FHA has estimated that its loan insurance program is a negative subsidy program—that is, the present value of estimated cash inflows exceeds the present value of estimated cash outflows. On the basis of these negative subsidy estimates, FHA built up substantial balances over the years in the capital reserve account. Generally, agencies must produce annual updates of their subsidy estimates—known as reestimates—for each cohort on the basis of updated information on actual performance and new estimates of future loan performance. Upward reestimates reflect increases in credit subsidy costs (or lower lifetime net revenues) and downward reestimates represent decreases in credit subsidy costs (or higher lifetime net revenues). Balances in the capital reserve account are transferred to the financing account to cover upward reestimates (see fig. 1). However, since 2009 higher-than-expected claims have depleted funds in FHA’s capital reserve account to just over $3 billion at the end of fiscal year 2012. If the capital reserve account were to be depleted and FHA required additional funds in the financing account to meet budget reestimate requirements, HUD would need to draw on permanent and indefinite budget authority, as authorized by FCRA. The President’s fiscal year 2014 budget contained a $22 billion upward credit subsidy reestimate for the Fund and indicated that the reestimate would deplete FHA’s capital reserve account in 2013, potentially causing FHA to draw on $943 million in permanent and indefinite budget authority.

Third, FHA’s audited financial statements also include a review of the Fund. FHA’s financial statements are prepared according to generally accepted accounting principles in the United States applicable to federal agencies (federal GAAP) as promulgated by the Federal Accounting Standards Advisory Board (FASAB). Federal GAAP requires that FHA calculate its liability for loan guarantees for its loan insurance commitments on a present value basis. The liability for loan guarantees represents net losses FHA expects on its outstanding insurance portfolio. The use of the present value accounting method is consistent with budgeting requirements under FCRA. Under federal GAAP, FHA recognizes potential lifetime losses and revenues at the point it insures a loan.

Private Mortgage Insurance Industry

The private mortgage insurance industry dates to the 1880s. According to an industry consultant report, the industry went bankrupt during the housing collapse of the early 1930s but reemerged in the mid-1950s after drawing on lessons learned from its prior failure. These lessons included the need for laws and regulations to help ensure that PMIs were prepared for economic shocks. Most residential mortgages insured by PMIs are sold to the enterprises. The enterprises have a statutory requirement to obtain credit enhancement on single-family residential mortgages purchased with loan-to-value ratios of over 80 percent, and private mortgage insurance is the major credit enhancement they use. In 2012, the PMI industry, which consisted of six active PMIs and their affiliates, reported that PMIs insured about 416,000 mortgages representing approximately $175 billion in mortgage insurance.

PMIs are regulated by the states in which they do business, with the state of domicile (that is, the state in which a PMI is chartered) providing primary regulatory oversight. Each state conducts financial oversight of the companies operating in its jurisdiction to help ensure that policyholders receive the insurance benefits they are entitled to receive.

State laws and regulations limit the risk PMIs can assume through means such as reserve and capital requirements, investment and risk concentration restrictions, and restrictions on activities other than mortgage-related insurance. The PMIs also must comply with the enterprises’ requirements in order for the mortgages they insure to be eligible for sale to the enterprises.

PMIs file audited financial statements, which are prepared in accordance with statutory accounting principles, with insurance regulators. Statutory accounting principles historically have been those practices or procedures prescribed or permitted by an insurer’s domiciliary state through statutes, regulations, and practices. The National Association of Insurance Commissioners has standardized and incorporated these principles in its Accounting Practices and Procedures manuals (which provide a comprehensive guide of statutory principles) and other publications. Statutory accounting principles were developed to meet the needs of insurance regulators, who are focused on insurers’ solvency and ability to satisfy their obligations to policyholders and creditors—in particular, to pay future claims. Under statutory accounting principles, PMIs recognize potential losses once loans become delinquent and recognize premium revenues over the period the insurance is outstanding.

In addition to reporting based on statutory accounting principles, many of the parent companies of PMIs also publicly report their financial results using private-sector GAAP in quarterly and annual filings with the Securities and Exchange Commission. The objectives of GAAP reporting differ from the objectives of statutory accounting principles reporting. GAAP is designed to meet the varying needs of different users of financial statements, while statutory accounting principles are designed to address concerns of regulators, as previously noted. Although statutory accounting principles incorporate private-sector GAAP guidance for certain principles, the two sets of accounting principles have differences. Statutory accounting principles are more conservative than private-sector GAAP—for example, they do not recognize certain assets recognized under private-sector GAAP.

Differences between FHA and Private Insurer Programs and Market Roles

Although FHA and PMIs both provide mortgage insurance to first-time home buyers and others seeking low down-payment mortgages, their mortgage insurance programs differ in several respects. Some of these differences include:

Coverage. FHA insurance covers 100 percent of the principal balance of each loan, whereas PMIs generally cover from 20 to 30 percent of the loan balance, usually based on what the enterprises require.

Premiums. FHA collects both an up-front premium (paid at loan origination) and annual premiums (paid in monthly installments) from all borrowers. PMIs generally charge either premiums paid in monthly installments or a single premium (one payment at loan origination that fully pays for the insurance policy).

Minimum down payment. To meet the requirements of the enterprises, PMI-insured loans generally have higher down payments than those insured by FHA. One PMI representative told us that a small portion of PMIs’ insured loans have a down payment of less than 5 percent. In contrast, more than 70 percent of the loans FHA insured in 2012 had a down payment of less than 5 percent.

Borrower qualifications. PMIs generally require their borrowers to have higher credit scores and lower debt service-to-income ratios than does FHA.

Recoveries. FHA generally receives significant recoveries on the sale of foreclosed properties. According to officials from one PMI, it is generally not in a PMI’s best interest to take possession of foreclosed properties. Instead, PMIs usually pay their coverage percentage multiplied by the sum of the unpaid loan balance and allowable foreclosure related expenses.

FHA and PMIs also have different operational goals and market roles. Most PMIs are publicly traded companies or subsidiaries of such companies, which have a responsibility to provide a return on investment to their shareholders. FHA’s statutory operational goals are to minimize the default risk to the Fund and homeowners and provide mortgage insurance to traditionally underserved borrowers, which FHA defines as including first-time homebuyers, minorities, low-income families, and residents of underserved communities. FHA traditionally has played a particularly large role among such borrowers. FHA generally is 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 experiencing economic downturns. By expanding its presence when the private market contracts, FHA plays a countercyclical role in the mortgage market. FHA typically does not restrict its business or change the terms under which it provides mortgage insurance in economically distressed geographic locations. FHA must ensure that any changes to the terms and conditions for mortgage insurance comply with fair lending laws and its obligation to affirmatively further fair housing. However, PMIs may change the conditions under which they will provide new insurance in a geographic area to reflect the increased risk of losses in an area experiencing economic hardship. For example, in previous work we found that by tightening the terms of the insurance they would provide, PMIs may have decreased their share of the market in economically stressed regions of the country during regional economic downturns in the late 1980s.

Consistent with its countercyclical role, FHA’s market share expanded during the recent mortgage crisis. According to HUD’s U.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. In addition, FHA’s share of the entire mortgage market (including refinance activity) rose dramatically after 2007, and stood at 14.6 percent in 2012 (see fig. 2). According to data from Inside Mortgage Finance, FHA’s share of the insured mortgage market as of the end of 2012 was 45 percent as measured by annual dollar volume, down from 71 percent in 2009.

FHA and Private Insurers Follow Distinct Reserving Practices and Capital Requirements

Reserving practices and capital requirements for FHA’s Fund differ in key respects from those for PMIs. These differences stem from the distinct environments in which FHA and PMIs operate, including the particular accounting principles and statutory provisions that they must follow. For both FHA and PMIs, capital requirements are expressed as ratios that compare risk and capital, but these terms have different meanings in the PMI and FHA contexts.

FHA and Private Mortgage Insurers Establish Different Types of Reserves under Their Respective Accounting Principles

From an accounting perspective, certain reserves are recorded as liabilities on an entity’s balance sheet to account for net future obligations and unearned revenue. Under their respective accounting principles, FHA and PMIs follow different reserving practices to prepare their audited financial statements. Under federal GAAP, FHA effectively has one reserve, the liability for loan guarantees. It is calculated by estimating the net present value of expected future cash flows for all outstanding loans (anticipated losses less anticipated future revenue).

In contrast, under statutory accounting principles, PMIs establish up to four separate reserve components, as follows:

Unearned premium reserve. This reserve represents the amount of insurance premiums that have been collected but not yet earned. Premiums paid in advance (single premiums) generally would be earned over time based on a schedule specified by a PMI’s domiciliary state.

Contingency reserve. This reserve represents half of the insurance premiums earned each year for the previous 10 years in order to build up a countercyclical capital buffer. This reserve also prevents a PMI from paying out excessive dividends to shareholders during profitable times to preserve its ability to pay claims during economic downturns. A PMI may release funds, with regulatory approval, if necessary, from this reserve to increase its statutory surplus when losses incurred in a year exceed 35 percent of premiums earned that year.

Loss reserve. This reserve represents expected losses on loans that become delinquent. Because the reserve is for loans that are already delinquent, it represents an estimate of losses that are likely to occur in the near term.

Premium deficiency reserve. This reserve is intended to cover the difference between future losses and existing reserves plus future premiums, if future losses are greater. More specifically, it represents the amount by which the present value of estimated future losses (less future uncollected premium revenues on all loans outstanding) exceeds the sum of the contingency reserve, loss reserve, and unearned premium reserve.

The differences between FHA and PMI reserving practices stem from the different accounting principles these entities are required to follow and the different purposes these principles serve. Table 1 shows how FHA and PMI reserves are calculated. FHA’s practice of reserving for anticipated net losses follows federal GAAP, which emphasizes the consistent calculation of long-term costs to the government of the subsidies associated with insurance, direct loans, and loan guarantees and supports budgeting under FCRA. As previously noted, federal GAAP accounts for estimated lifetime losses and revenues on insurance, direct loans, and guarantee activities on a present value basis in the fiscal year in which the commitment to insure, originate, or guarantee a loan occurs. In contrast, PMIs follow statutory accounting principles under which potential losses are recognized in the loss reserve component when loans become delinquent and revenues are recognized as they are earned over the coverage period.

Despite these differences, a present value calculation of future cash flows is used in both the PMI premium deficiency reserve and the FHA liability for loan guarantees. Specifically, FHA’s liability for loan guarantees is equal to the net present value of expected future cash flows for all outstanding loans (anticipated losses less anticipated future revenue). PMIs also calculate the net present value of expected future cash flows, but rather than establishing reserves equal to this amount, PMIs compare it with the sum of their existing loss reserves, contingency reserves, and unearned premium reserves. If the net present value of expected future losses exceed the combination of these three reserve components, PMIs establish a premium deficiency reserve to make their total reserves equal to their anticipated net losses (if not, there is no liability for a premium deficiency). PMIs generally have not had to establish premium deficiency reserves because the sum of their existing reserves has been greater than the net present value of expected future losses. This reflects the conservative nature of reserving practices under statutory accounting principles.

FHA’s Statutory Capital Requirement Differs from Private Insurers’ Requirements

FHA and PMIs both calculate ratios for capital relative to risk outstanding, but the calculations measure capital and risk differently (see table 2). As noted earlier, the capital position of FHA’s Fund is assessed annually by an independent actuary. By statute, the Fund’s economic value—existing net capital resources plus the present value of future net cash flows of all currently insured loans—must be at least 2 percent of the remaining principal balance on all insured loans in the Fund (amortized insurance- in-force). In contrast, PMIs are subject to two capital requirements—a risk-to-capital ratio not to exceed 25 to 1 and a minimum policyholders position (MPP) that varies based on the loan-to-value ratio and coverage percentage of the mortgages insured. The risk-to-capital ratio, which is required by 12 states, compares statutory surplus and contingency reserves with the insured portion of the remaining balance on performing loans (risk-in-force). The MPP, which is required by four states, establishes the amount of funds a PMI must have currently available to pay claims using a percentage of the initial balances of insured loans. PMIs may use a combination of statutory surplus, contingency reserves, and unearned premium reserves to meet the MPP requirement. PMIs’ statutory surplus includes premium revenues earned to date. Consistent with how revenues are recognized under their respective accounting principles, capital in the PMI context does not include estimated future revenues for existing insurance, while capital in the FHA context does. In addition, for the PMI risk-to-capital ratio, risk is assessed based on performing loans (because the risk for nonperforming loans has been reserved for), while for the FHA capital ratio, risk is assessed based on all loans.

FHA has not met its capital requirement for the last 4 years (see fig. 3). FHA met the 2 percent capital ratio from fiscal years 2001 through 2008, with a high of 6.82 percent for forward mortgages in the Fund. However, the ratio fell below the statutory minimum in 2009 when economic and market developments created conditions that simultaneously reduced the insurance fund’s economic value (the numerator of the capital ratio) and increased the amortized insurance-in-force (the denominator of the capital ratio). By the end of fiscal year 2012, the ratio had fallen to a negative 1.28 percent for single family forward loans (and a negative 1.44 percent for forward and reverse loans combined). The 2012 actuarial report shows that the negative economic value for forward loans is composed of capital assets of $25.6 billion and estimated future cash flows of negative $39.1 billion. Forward loans guaranteed prior to fiscal year 2011 have estimated negative future cash flows and loans guaranteed in fiscal years 2011 and later have estimated positive future cash flows. According to the baseline estimate in the 2012 actuarial report, the Fund’s capital ratio is not estimated to rise above the statutory 2 percent level until fiscal year 2017. In 2001, we found that setting a minimum or target capital ratio may not be appropriate for all of the circumstances the Fund may face. We therefore recommended that Congress or HUD determine the economic conditions the Fund would be expected to withstand without drawing on permanent and indefinite budget authority. Congress has considered but not enacted legislation consistent with this recommendation. In addition, HUD disagreed with this recommendation at the time of the report and has not acted upon it.

As shown in figure 4, PMIs also have struggled to meet their capital requirements in recent years, and regulators forced three large PMIs to cease writing new business for failing to meet these requirements. PMIs have relied heavily on capital and surplus contributions from outside investors and their parent companies to meet their capital requirements. To illustrate, from 2008 through 2012, three of the four largest PMIs received capital and surplus contributions that were greater than their total capital as of the end of 2012. In addition, these PMIs completely exhausted their contingency reserves. Ceding risk to reinsurance companies and higher-quality books of business in recent years also have helped PMIs to lower their risk-to-capital ratios. In contrast, FHA (which has not met its capital requirement) has continued to write new business, as authorized through annual appropriations acts, and would not receive additional funding through permanent and indefinite budget authority until it is needed to help cover an upward credit subsidy reestimate.

PMIs face several potential consequences when their risk-to-capital ratios rise above the statutory ceiling of 25:1. When a PMI fails to meet state regulatory requirements, it must stop writing new business or receive a waiver from the state to continue operating. If a PMI is forced to stop writing new business, the PMI continues to insure existing business (collecting premiums and paying claims) until all current business is extinguished. If a PMI receives a waiver, the PMI still can write new business, but the regulator imposes restrictions and conditions on the PMI. According to state regulators we interviewed, they consider a number of factors when deciding to grant a waiver. In general, waivers are granted if the state regulator decides that the PMI can return to profitability. Requirements for PMIs that have been granted waivers differ by state, but may include increased frequency of financial reporting, actuarial reviews, remediation plans, and regulatory approval of dividend payments. Prior to breaching the 25:1 ceiling or MPP requirement, three of the four largest PMIs applied for and were granted waivers by many of the 16 states that require them.

The enterprises also impose financial requirements on PMIs. Before the financial crisis, the enterprises required PMIs to maintain at least an AA- rating from two credit rating agencies. However, the enterprises consider this requirement to be obsolete because no PMIs currently meet the rating level. Instead, the enterprises have established remediation plans that include alternative requirements for the PMIs. These remediation plans allow the PMIs to continue insuring loans that are eligible for purchase by the enterprises, but include provisions intended to increase PMI transparency and reporting. Although each plan is different, the enterprises and PMIs told us that the plans generally required enhanced disclosure, regular meetings with the enterprises, and specific actions, including maintaining a minimum level of liquid assets; obtaining waivers from state capital requirements; or creating subsidiaries licensed in states where waivers were not granted.

In contrast to the PMIs, the statute that established FHA’s 2 percent capital ratio requirement does not define consequences if the ratio falls below the required level. In 2012 and again in 2013, legislation was introduced that would require FHA to develop an emergency capital plan to restore the Fund’s fiscal solvency and provide monthly reports to Congress on the condition of the Fund and any remediation steps taken that month. However, as of August 2013, this legislation had not been enacted.

State regulators and the Federal Housing Finance Agency (the regulator and conservator for the enterprises) have been considering ways to strengthen the financial condition requirements for PMIs, including capital requirements. The National Association of Insurance Commissioners has formed a working group that has been considering proposed capital requirements that would vary depending on the risk characteristics of the loans being insured (such as the loan-to-value ratio and borrower credit score). More specifically, PMIs would need to hold more capital for riskier loans than for loans with less risk. This approach contrasts with the fixed risk-to-capital ratio that currently applies. Eight PMIs issued a joint statement to the working group agreeing with this basic approach. The Federal Housing Finance Agency also has been working with the enterprises to develop new capital requirements for PMIs. Agency officials told us that the current risk-to-capital ratio requirements were not sufficient because they do not account for differences in loan risks, provide assurance of financial viability under severe stress scenarios, or differentiate between liquid and illiquid capital (that is, capital readily available to pay claims or not). The officials said that they expect to issue the new requirements by the end of 2013.

Features of the Regulatory Framework for Private Insurers Could Enhance Oversight of FHA

Certain features of the states’ regulatory framework for PMIs could enhance oversight of FHA by increasing transparency and accountability. Although the PMI industry’s reserving practices have limited applicability to FHA, separately disclosing reserve components for FHA would provide additional insight into FHA’s financial condition that is not readily apparent with current reporting. PMI capital requirements also have limited applicability to FHA because they involve concepts that are not meaningful in the context of a federal program. However, certain consequences PMIs face for not meeting capital requirements— remediation plans and additional reporting—could be applied to FHA to enhance agency accountability.

Industry Practices and Requirements Have Limited Applicability to FHA’s Fund

The PMI industry’s reserving practices and capital requirements have limited applicability to FHA’s Fund because some of the underlying purposes and concepts are not pertinent to a federal credit program. For example, two of the liabilities that PMIs record under statutory accounting principles—unearned premium reserves and contingency reserves—are intended, in part, to protect policyholders by limiting payment of excessive dividends to stockholders, which reduce capital. The unearned premium reserve does this by matching revenues with the time periods in which they are earned rather than when they are received. This prevents PMIs from using unearned premiums to increase the surplus from which they pay dividends. The contingency reserve serves a similar purpose by setting aside half of earned premiums for 10 years. Because FHA does not pay dividends and virtually all of the premium revenues FHA receives remain in the Fund, a reserve for the purpose of preserving capital by preventing dividend payments is not needed.

A third liability that PMIs record, the loss reserve, also has limited applicability to FHA’s Fund because its purpose is to demonstrate to regulators that PMIs have sufficient resources today to pay claims to policyholders for anticipated losses on already-delinquent loans. The loss reserve is therefore a tool to mitigate a PMI’s liquidity risk—the risk of not having the capacity and perceived capacity to meet demands for cash. FHA does not face the same liquidity risk that PMIs do because the Fund’s financing account holds balances to cover expected future claims on existing loans, and FHA can draw upon permanent and indefinite budget authority to pay claims, if necessary. In addition, FHA includes estimates of losses on delinquent loans (and performing loans) in its liability for loan guarantees.

Certain PMI reserves have other purposes that are pertinent to FHA, but FHA addresses them by other means. Although most unearned premium is not refundable, an additional purpose of the unearned premium reserve is to reflect a PMI’s refund liability in the event that the mortgage insurance policy is cancelled before premiums are fully earned. FHA accounts for premium refunds by including the amount of premiums that are expected to be refunded in its estimates of future cash flows. One purpose of the contingency reserve is to build up a capital buffer to help cover claims during economic downturns. While not fixed to a percentage of premiums like the contingency reserve, FHA’s capital reserve account holds all premiums in excess of anticipated claims and is available to pay higher-than-anticipated claims. Furthermore, calculating the current levels of these reserves would be difficult. For example, determining FHA’s contingency reserve liability is complicated by the fact that this liability may be reduced if incurred losses exceed 35 percent of earned premiums—a threshold FHA likely exceeded in recent years.

PMI capital requirements also have limited applicability to FHA because they rely on definitions and components of capital that are not directly relevant to FHA’s operating environment. Specifically, PMIs use statutory surplus and contingency reserves from the statutory financial statements they file with insurance regulators to determine their capital. Statutory surplus includes components that FHA’s Fund does not have, including capital stock and gross paid-in and contributed surplus, which reflect the various means that PMIs use to raise capital. FHA’s capital does not have these components and consequently, they cannot be calculated for FHA. For example, as a federal agency, FHA does not have stock or stockholders. FHA’s capital comes almost exclusively from premiums and minimal interest income. For PMIs, retained earnings—an entity’s net income since its inception—increase statutory surplus, and dividends paid to stockholders decrease it. The retained earnings or losses component of PMIs’ capital is somewhat similar to the net position of FHA’s Fund. However, FHA’s net position reflects estimates of lifetime premiums net of claims, while PMIs’ retained earnings reflect, among other things, revenues earned and losses incurred (on delinquent loans) to date.

Industry Practice of Separately Disclosing Reserve Components Could Increase Transparency of Risks Facing FHA’s Fund

Although specific PMI reserving practices have limited applicability to FHA, the concept of separately disclosing reserve components as PMIs do could be applied to the Fund. For example, the PMI loss reserve and unearned premium reserve focus on the timing of specific cash flows— the loss reserve on claims that are likely to be paid on delinquent loans in the near-term and the unearned premium reserve on premiums as they are earned over time. In contrast, FHA has a single reserve from a financial accounting perspective, the liability for loan guarantees, which combines estimates of future claims payments with estimates of future premiums and recoveries over a 30-year period into a single number. While a single number is a useful measure of lifetime costs and aligns with federal budget requirements, it provides limited insight into the timing of specific cash flows and, therefore, the degree of uncertainty in the estimate.

As of September 30, 2012, the liability for loan guarantees for forward mortgages in FHA’s Fund was $37 billion. That is, claims payments on loans that were insured as of that date were expected to exceed future premiums and recoveries on foreclosed properties by $37 billion on a present value basis over the next 30 years. However, the timing of claims payments, premiums, and recoveries is not evident from this figure. This information is important for more fully understanding the Fund’s financial status because estimates of near-term cash flows are inherently more certain than estimates of longer-term cash flows. Disclosing the timing of specific cash flows would help illustrate the extent to which estimates of claims payments, premiums, and recoveries in the liability for loan guarantees are concentrated in the near term or longer term and therefore more or less certain.

The uncertainty of longer-term cash flow estimates also applies to FHA’s future business activity, which is estimated to help offset losses on its existing loans. The fiscal year 2012 actuarial review found that the economic value of the Fund’s forward mortgages without the fiscal year 2013 book of business was negative $13 billion, meaning that the present value of estimated future cash flows on the existing portfolio exceeded current resources available to pay claims by that amount. The actuary estimated that FHA’s future business will generate positive economic value, which will help rebuild the Fund’s capital resources. In its fiscal year 2012 annual report to Congress, FHA said it foresaw little risk that it would not be able to pay claims based on projections of its future business. However, like all long-term projections, the actuary’s estimates rest on assumptions that are inherently uncertain.

As previously noted, differences in the level of certainty between near- term and longer-term cash flows underscore the importance of this information for assessing financial condition. The liability for loan guarantees is built upon a 30-year schedule of key cash flows—claims, premiums, and recoveries. Accordingly, separately disclosing these component parts and showing how they vary over time could provide additional insight into the financial condition of the Fund. Such disclosure would be consistent with information reported on the timing of cash flows for federal social insurance programs, which also rely on long-term estimates. It would also be consistent with federal internal control guidance for communicating with external groups. This guidance discusses the importance of communicating relevant information to Congress and others so that they can better understand the agency, including its mission, goals, objectives, and risks.

Accountability Component of Industry Capital Requirements Could Strengthen Oversight of FHA

Unlike PMIs, which may be required to undertake actions such as remediation plans and additional reporting to state regulators as conditions of doing business when they do not meet capital requirements, FHA is not subject to such enhanced accountability measures. As previously stated, PMIs that have not met their capital or other requirements have had to provide additional reporting, more frequently meet with regulators, and in some cases develop remediation plans to continue writing new business. For example, remediation plans may lay out a PMI’s plan for restoring its capital to the required level through capital contributions from the parent company, premium increases, and underwriting changes. In contrast, FHA has not been in compliance with its capital ratio requirement since 2009 and is not estimated to reach compliance until 2017. Yet failure to comply with the requirement does not trigger a defined process or set of steps to be taken by FHA. FHA’s annual reports to Congress in 2009 through 2011 described steps it already had taken to improve the Fund’s financial condition, including premium and underwriting changes. However, FHA did not issue a plan of action to restore the Fund’s capital ratio, including implementation time frames and estimated outcomes, until it submitted its 2012 annual report to Congress.

Requiring a capital restoration plan when the capital ratio approaches or falls below the required level could strengthen oversight of FHA by prompting the timely development and analysis of corrective actions and by providing benchmarks against which Congress could monitor progress of implementation. As noted earlier, legislative proposals that contain such a requirement have been introduced but have not been enacted. In addition, past congressional actions have emphasized the importance of remediation plans for financial institutions. For example, the Deficit Reduction Act of 2005 required the Federal Deposit Insurance Corporation to establish and implement a restoration plan when its Deposit Insurance Fund was either projected to fall or actually fell below the minimum level. The Dodd-Frank Wall Street Reform and Consumer Protection Act required the establishment of remediation requirements, including capital restoration plans, for certain institutions facing financial distress.

Conclusions

FHA, like other mortgage market participants, suffered major losses as a result of the recent housing crisis and may require additional funds in the near future. These circumstances have focused attention on oversight of FHA’s single-family mortgage programs, including the practices and requirements FHA follows in managing the Fund. Although PMIs also experienced financial distress and some stopped issuing new policies, the PMI regulatory framework provides a basis for comparison and offers alternative practices and requirements to consider in deliberating on potential FHA reforms. However, the applicability of certain PMI practices and requirements to FHA is fundamentally limited because their underlying purposes or components are not directly relevant in FHA’s operating environment.

Nonetheless, the PMI regulatory framework has features that, if applied to FHA, could enhance transparency of the Fund’s financial condition and congressional oversight of FHA’s operations. First, the concept of separately disclosing reserve components as PMIs do could be applied to the Fund. FHA’s liability for loan guarantees—which FHA calculates and reports annually as required—has certain limitations. In particular, it does not show the timing of the different cash flows that comprise the liability for loan guarantees—claims, premiums, and recoveries—and therefore does not reveal the extent to which FHA may be relying on less certain future revenue to offset more certain near-term losses. Disclosing this information could enhance congressional oversight of FHA’s financial condition and would be consistent with reporting practices of other federal programs and federal internal control guidance. Second, accountability mechanisms like those included in PMI capital requirements also could enhance congressional oversight of the Fund. Unlike PMIs, which must obtain waivers and submit remediation plans when they have not met or are at risk of not meeting capital requirements, FHA does not have a defined process it must follow. In 2012, FHA provided Congress with a set of planned actions to address its capital shortfall, but had not done so in prior years. A capital restoration plan requirement triggered by noncompliance with the Fund’s statutory capital requirements could help ensure prompt action by FHA and focus Congress’s monitoring efforts should this situation arise in the future. This type of requirement is contained in legislative proposals currently before Congress and would be consistent with prior congressional actions for certain financial institutions and government entities.

Matter for Congressional Consideration

To strengthen FHA accountability for complying with the Fund’s statutory capital requirement, Congress should consider requiring that FHA submit a capital restoration plan and regular updates on plan implementation whenever the capital ratio falls below 2 percent as calculated in the annual actuarial review of the Fund, or the Fund’s financial condition does not meet other congressionally-defined requirements.

Recommendation for Executive Action

To provide additional perspective on the Fund’s financial status, FHA should disclose estimates of the individual cash flows associated with the liability for loan guarantees (premiums, claims, and recoveries), including their value for each year of the 30-year estimation period.

Agency Comments and Our Evaluation

We provided a draft of this report to HUD and the Federal Housing Finance Agency for their review and comment. We received written comments from HUD, which are reprinted in appendix II. HUD also provided a technical comment, which we incorporated into the final report. The Federal Housing Finance Agency had no comments on the draft report.

In its letter, HUD agreed with our recommendation to disclose the component parts of the liability for loan guarantees—claims, premiums, and recoveries. However, HUD suggested an alternative to disclosing cash flows for each year of the 30-year estimation period, as we recommended. Specifically, HUD proposed separately disclosing the liability for loan guarantees for delinquent loans and performing loans, which would implicitly break down losses into the near term (those arising from currently delinquent loans) and the longer term (reflecting potential loss projections on currently performing loans). HUD said that this approach would give a clearer picture of the Fund’s financial status at a given point in time. HUD’s suggestion is broadly consistent with our recommendation and could provide useful information. However, it does not clearly include the separate disclosure of claims, premiums, and recoveries and would not provide as much perspective on the timing of cash flows as the approach we recommend. Our recommendation, which calls for a more detailed disclosure of cash flow values for each year over the 30-year estimation period, would provide greater insight into the Fund’s financial condition by illustrating the uncertainty of future losses and revenue. For this reason, we made no change to our recommendation.

We also provided excerpts of the draft report to the National Association of Insurance Commissioners, the Mortgage Insurance Companies of America and its three member companies (Radian Guaranty, Genworth, and Mortgage Guaranty Insurance Corporation), and United Guaranty for technical review. We received technical comments from the Mortgage Insurance Companies of America on behalf of its members and from United Guaranty, which we incorporated into the final report as appropriate.

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 the Acting Director of the Federal Housing Finance Agency. In addition, the report will be available at no charge on the GAO website at http://www.gao.gov.

If you or your offices 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 may be found on the last page of this report. Key contributors to this report are listed in appendix III.

Appendix I: Objectives, Scope, and Methodology

We examined the Federal Housing Administration’s (FHA) financial condition requirements for the Mutual Mortgage Insurance Fund (Fund) and compared them with those used by private mortgage insurers (PMI). Specifically, we discuss (1) how the reserving practices and capital requirements of FHA’s Fund compare with those for the PMI industry and (2) how, if at all, applicable PMI reserving practices and capital requirements could enhance oversight of FHA’s Fund.

To address the first objective, we identified and reviewed reserving practices and capital requirements pertinent to FHA and PMIs. We reviewed generally accepted accounting principles for federal entities and federal statutes that apply to FHA’s Fund. We also reviewed statutory accounting principles, generally accepted accounting principles for nongovernmental entities, Fannie Mae and Freddie Mac policies, and state statutes and regulations that apply to PMIs. We interviewed mortgage market participants and stakeholders, including officials from FHA, insurance regulatory agencies in three selected states (North Carolina, Pennsylvania, and Wisconsin), the National Association of Insurance Commissioners, major PMIs, a PMI trade association, Fannie Mae, Freddie Mac, and the Federal Housing Finance Agency to confirm our understanding of the practices and requirements. We selected the three states based on the market share of PMIs domiciled in those states and the diversity of state requirements for PMIs. These states were the domiciliary states and primary regulators for PMIs that accounted for 90 percent of the PMI market. We compared and contrasted the practices and requirements for FHA and PMIs along several dimensions, including the financial measures used, the frequency of associated reporting, and the regulatory consequences of noncompliance. In addition, we examined scholarly articles and industry reports to determine possible reasons for any differences between FHA and PMI practices and requirements. Finally, to provide additional context, we reviewed actuarial and financial reports showing the extent to which FHA and selected PMIs met their respective capital requirements from 2001 through 2012. For this analysis, we reviewed the four largest PMIs, which accounted for 78 percent of the PMI market in 2012, as well as three PMIs that ceased writing new business due to capital constraints during the time frame. We obtained these data from FHA’s annual actuarial reviews, PMIs’ public reports, and PMI officials.

To address the second objective, we reviewed statutes, regulations, and accounting standards that currently apply to FHA and PMIs. We also reviewed information FHA currently reports on the Fund’s financial condition, including annual actuarial reviews of the Fund, HUD appendixes to the President’s budget, and FHA’s audited financial statements. To determine the extent to which PMI reserving practices and capital requirements could be applied to FHA’s Fund, we considered factors such as the compatibility of underlying concepts and calculations with FHA’s operations. We analyzed data from FHA on the volume and performance of the mortgages it has insured through the end of fiscal year 2012 to calculate a loss reserve for FHA in the manner of a PMI. Specifically, FHA provided data on the amortized insurance-in-force on loans that were 90 or more days delinquent or in foreclosure as well as the assumptions used in the President’s budget on the percentage of those loans that will eventually result in a claim and the estimated loss severity. We also analyzed FHA data on its risk-in-force on performing loans, estimated recovery rates, and total amortized insurance-in-force as of the end of fiscal year 2012 to calculate the dollar amount of capital that FHA would need under PMI capital requirements. To assess the reliability of the data we obtained from FHA, we conducted reasonableness checks on data elements and discussed the sources and interpretation of the data with FHA officials. We determined that the data we used were sufficiently reliable for purposes of characterizing the financial condition of the Fund. In addition, we interviewed mortgage insurance regulators in the selected states to identify the information PMIs report under their current practices and requirements that regulators find useful in assessing financial condition. Additionally, to determine whether features of the PMI regulatory framework could enhance Fund oversight, we interviewed FHA officials, major PMIs, and other industry analysts to obtain their perspectives on the potential for increasing transparency and better understanding the Fund’s financial condition. We also identified relevant criteria in GAO’s Standards for Internal Control in the Federal Government and Internal Control Management and Evaluation Tool as well as examples of remediation plan requirements enacted by Congress for other financial institutions and government entities.

We conducted this performance audit from February 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.

Appendix II: Comments from the Department of Housing and Urban Development

Appendix III: GAO Contact and Staff Acknowledgments

GAO Contact

Staff Acknowledgments

In addition to the contact named above, Robert Dacey (Chief Accountant), Marcia Carlsen and Steve Westley (Assistant Directors), Anne Akin, Don Brown, Stephen Brown, Jason Kelly, Melissa Kornblau, Aaron Livernois, John McGrail, Barbara Roesmann, Jena Sinkfield, Andrew Stavisky, and Frank Todisco made key contributions to this report.