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

Letter

Background

Under the Federal Credit Reform Act of 1990 (FCRA), FHA and other federal agencies must estimate the net lifetime costs—known as credit subsidy costs—of their loan insurance or guarantee programs and include the costs to the government in their annual budgets. Credit subsidy costs represent the net present value of expected lifetime cash flows, excluding administrative costs. When estimated cash inflows exceed expected cash outflows, a program is said to have a negative credit subsidy rate and generates offsetting receipts that reduce the federal budget deficit. When the opposite is true, the program is said to have a positive credit subsidy rate—and therefore requires appropriations. Generally, agencies must produce annual updates of their subsidy estimates—reestimates— on the basis of information about actual performance and estimated changes in future loan performance. FCRA recognized the difficulty of making credit subsidy estimates that mirrored actual loan performance and provides permanent and indefinite budget authority for reestimates that reflect increased program costs. Upward reestimates increase the federal budget deficit unless accompanied by reductions in other government spending or an increase in receipts.

The Omnibus Budget Reconciliation Act of 1990 required the Secretary of the Department of Housing and Urban Development (HUD) to take steps to ensure that the Fund attained a capital ratio of at least 2 percent by November 2000 and maintained at least a 2 percent ratio at all times thereafter. It also required an annual independent actuarial review of the economic net worth and soundness of the Fund. The annual actuarial review is now a requirement in the Housing and Economic Recovery Act of 2008, which also requires that the Secretary of HUD annually report to Congress on the results of the review.

Federal agencies face a number of risks. In the case of agencies with loan guarantee or insurance programs, they can face credit risks that include borrower default risk, which arises as borrowers become unable to make payments on insured mortgages. Agencies with these programs also face counterparty risk. That is, an agency may suffer losses due to weaknesses or uncertainties in the work of its counterparties—in this example, lenders and appraisers. And all agencies face operational risks, the risk of loss resulting from inadequate or failed internal processes or people (in terms of staff numbers, training, and skills), or external events. For this statement, we focus on operational risks related to FHA’s staffing and contractor capacity to process increasing workloads.

The Fund’s Financial Condition Continues to Worsen, Increasing the Possibility That FHA Will Require Additional Funds

The Fund’s capital ratio dropped sharply in 2008 and fell below the statutory minimum in 2009, when economic and market developments created conditions that simultaneously reduced the Fund’s economic value (the numerator of the ratio) and increased the insurance-in-force (the denominator of the ratio).the Fund, the capital ratio fell from about 7 percent in 2006 to 3 percent in 2008 and 0.5 percent in 2009 (see fig. 1). For 2010 and 2011, the ratios were 0.5 and 0.24 percent, respectively.

FHA’s Current Methodology for Assessing the Fund’s Condition Does Not Fully Account for Future Economic Volatility

As we reported in September 2010, FHA and its actuarial review contractor enhanced their methods for assessing the Fund’s financial condition but still were addressing other methodological issues that could affect the reliability of estimates of the capital ratio. Annual actuarial reviews of the Fund use statistical models to estimate the probability that loans will prepay or result in insurance claims on the basis of certain loan and borrower characteristics (such as loan-to-value ratios and borrower credit scores) and key economic variables (such as house prices and interest rates). FHA and its contractor have enhanced these models in recent years, by incorporating additional variables related to loan performance and developed an additional model to predict loss rates on insurance claims. Also, consistent with recommendations we made in a prior report, in 2003 the actuarial reviews began to analyze the impact of more pessimistic economic scenarios—for example, nationwide declines in home prices—than they did previously.

However, the current methodology is significantly limited by its reliance on a single economic forecast to produce the estimate of the capital ratio that is used to determine if the Fund is meeting the 2 percent capital reserve requirement. This approach does not fully account for the variability in future house prices and interest rates that the Fund may face. As a result, baseline estimates of the capital ratio may tend to underestimate insurance claims and mortgage prepayments and therefore may tend to overestimate the Fund’s economic value. In a November 2003 report, the Congressional Budget Office concluded that FHA could project the Fund’s cash flows more accurately by using an approach (stochastic modeling) that involves running simulations of hundreds of different economic paths to produce a distribution of capital ratio estimates.

Given the uncertainty that always surrounds estimates of future economic activity, the report we issued last year recommended that HUD require the actuarial review contractor to use stochastic simulation of future economic conditions, including house prices and interest rates, to estimate the Fund’s capital ratio and include the results of this analysis in FHA’s annual report to Congress on the financial status of the Fund. However, the most recent annual report does not include an estimate of the Fund’s capital ratio using this technique. In response to our 2010 report, FHA officials told us that they were planning to require the actuarial review contractor to use a stochastic simulation model for the 2011 actuarial review. But, these officials said that the model would be used to examine the implications of extreme economic scenarios on the Fund and decisions about using the model to estimate the Fund’s capital ratio had not been made.

FHA Has Taken Steps to Address Risks, but Has Yet to Implement a Comprehensive Risk-Assessment Strategy

FHA faces risks resulting from its operations. FHA’s loan volume grew significantly from 2006 to 2010. In 2006, FHA insured almost half a million loans, totaling $70 billion in mortgage insurance. By 2010, it insured 1.7 million loans, or about $319 billion in mortgage insurance. During the same time period, FHA’s single-family staff increased 8 percent, from 932 employees in 2006 to 1,011 employees in 2010, while increases in key workload areas often surpassed 100 percent:

Staff in the homeownership centers’ Processing and Underwriting Division grew at a slower rate (22 percent) than key workload items, particularly volume-driven loan reviews (which increased by more than 100 percent).

Increases in contractor staff and workload related to management of foreclosed or real estate-owned properties were substantial, but noncontractor staff levels increased at more modest levels.

Loss mitigation actions more than doubled from 2006 to 2010, while loss mitigation staff levels remained relatively constant.

Although FHA Worked to Address Credit and Operational Risk, It Has Not Yet Put a Comprehensive Strategy in Place

Although FHA has taken steps to assess credit and operational risks facing its single-family insurance programs, its current risk-assessment strategy is not comprehensive because it is not integrated across the agency and lacks annual assessments and mechanisms to anticipate changing conditions. To address credit risk and help improve the financial condition of the Fund (which is supported by borrower premiums), FHA raised premiums and made or proposed policy or underwriting changes. For example, in April 2011 FHA increased its annual insurance premiums from 0.85 percent to 1.10 percent for borrowers with 30-year loans with initial loan-to-value ratios of 95 percent or less and from 0.90 percent to 1.15 percent for borrowers with 30-year loans with initial loan-to-value ratios greater than 95 percent. Additionally, FHA increased down- payment requirements for borrowers with lower credit scores. FHA also has proposed reducing allowable seller contributions at closing, thereby helping to ensure that buyers put more of their own funds into the home purchase. In addition, FHA is in the process of revising its mortgage scorecard algorithm, to recognize the effect of various risk elements not currently discerned by the scorecard and determine what cases warrant manual underwriting. According to FHA, these revisions are in the early stages, and no completion date has been set.

To address operational risks and improve its risk-assessment strategy, in 2010 FHA received congressional approval to establish the Office of Risk Management and Regulatory Affairs and create the position of Deputy Assistant Secretary for Risk Management and Regulatory Affairs, which reports directly to the Assistant Secretary for Housing-FHA Commissioner. To provide assistance to the Office of Risk Management (one of the offices within the Office of Risk Management and Regulatory Affairs) in developing a risk-management strategy and organizational structure and establishing risk-management policies and processes, FHA hired a consultant to produce a comprehensive report and recommend best practices for its operation. adopt the consultant’s recommendation to establish an enterprise risk committee to address overall risk to the organization and a second tier of committees to address program and operational risks. In addition, in 2009 the Office of Single Family Housing implemented an internal quality control initiative at headquarters and the four homeownership centers. For the areas identified as high-risk, headquarters and the homeownership center divisions developed plans to document control objectives and established a monitoring strategy in which each homeownership center submits quarterly reports to headquarters on the effectiveness of the controls, including the status of any mitigation efforts.

McKinsey & Company, Building the ORM Organization, Close-out Materials, a report prepared at the request of the Department of Housing and Urban Development, December 2010. the consultant would not be possible. In the meantime, they stated that every effort was being made to help ensure that the Office of Risk Management’s activities complemented program office activities. Second, contrary to HUD guidance, Single Family Housing has not conducted an annual, systematic review of risks to its program and administrative functions. According to an official in the Office of Single Family Housing, although management intended to conduct an annual assessment, the dates slipped because of changes in senior leadership in Single Family Housing and few staff were available to perform assessments (because of attrition and increased workload). Finally, Single Family Housing’s current risk-assessment efforts do not include procedures for anticipating potential risks presented by changing conditions. The consultant’s report proposes a reporting process and templates for identifying emerging risks and provides specific examples. Office of Risk Management officials told us that once they are operational the risk committees eventually would determine the exact design and content of the reports and templates.

Moreover, implementation and integration of the new risk-assessment strategy and planned tools has been slow because of delays in defining the Office of Risk Management’s authority, difficulty filling new staff positions in the Office of Risk Management, and changes in FHA leadership.

All these factors limit FHA’s effectiveness in identifying, planning for, and addressing risk. More specifically, without an integrated risk-assessment strategy, certain risks may not be fully addressed at the operational level in a way that minimizes risk to the insurance programs; without annual reassessments of its risks, Single Family Housing lacks assurance that its quality control efforts address all its risks; and without ongoing mechanisms in place to anticipate and address new or emerging risks, FHA lacks a systematic approach to help the agency identify, analyze, and formulate timely plans to respond most effectively to changed conditions and risks. Therefore, we recommended that FHA (1) integrate the internal quality control initiative of the Office of Single Family Housing into the operational risk processes of the Office of Risk Management, (2) conduct an annual risk assessment, and (3) establish ongoing mechanisms—such as use of the report templates from the 2010 consultant’s report—to anticipate and address risks that might be caused by changing conditions. FHA agreed with the recommendations and stated that it either was working toward achieving the recommendations or had plans to do so in the very near future. For example, FHA said it would leverage or integrate existing risk management efforts as soon as the Office of Risk Management’s final governance structure and risk management strategies were in place. The agency also stated that the Office of Risk Management would conduct an annual risk assessment as a component of its overall risk management strategy. It stressed that ongoing mechanisms to anticipate and address risks related to changing conditions would be part of the office’s strategy.

FHA Has Taken Steps to Address Counterparty Risks, but Continues to Face Human Capital Challenges

With growth in loan volume, the number of lenders and appraisers (or counterparties) participating in FHA’s single-family programs also has grown. The total number of FHA-approved lenders increased 24 percent, from 10,370 in 2006 to 12,844 in 2010. The number of FHA-approved appraisers increased approximately 67 percent from 33,553 in 2006 to 56,192 in 2010.

However, FHA has made recent changes to address risks posed by its lenders and appraisers. For example, on May 20, 2010, FHA stopped approving new loan correspondents. As of January 1, 2011, existing loan correspondents could no longer participate in FHA programs. Former loan correspondents now can participate only as third-party originators through sponsorship by FHA-approved lenders. As a result, as of September 2011, FHA had almost 3,700 approved lenders. Furthermore, the agency has increased the net worth requirement for approved lenders. On May 20, 2011, FHA increased the requirement for existing lenders to $1 million, except for lenders classified as small under the Small Business Administration’s size standards (their requirement increased to $500,000). As of May 20, 2013, FHA will require a net worth of $1 million for all lenders, plus 1 percent of the total loan volume in excess of $25 million, to a maximum required net worth of $2.5 million. To help ensure that lenders and appraisers follow its policies and procedures, FHA also has enhanced the criteria used to select loans for technical reviews. Specifically, since May 3, 2010, the agency has considered high-risk loan or borrower characteristics, such as certain types of refinanced loans and loans to borrowers with low credit scores. Additionally, FHA increased the number of risk factors used to target lenders for review. FHA also has revised its approach for overseeing appraisers.

FHA has addressed staffing and training needs and succession planning to some extent, but it lacks plans that strategically address future workforce needs, including replacing retiring staff. Although workforce planning practices used by leading organizations include defining critical skills and skill gaps, FHA’s current approach does not have mechanisms for doing so. FHA previously had a multiyear workforce plan that identified the critical competencies; analyzed skills and competencies, including gaps; and proposed comprehensive strategies to address these gaps, but has not created another such plan. Instead, FHA has relied on occasional Resource Estimation and Allocation Process studies and annual managerial assessments of staffing and training needs.

FHA also currently does not have a succession plan, although a HUD plan for 2006–2009 identified mission-critical positions, analyzed existing staff competencies, assessed the number of retirement-eligible employees, and determined the probability of near-term retirements. Succession planning is particularly important because almost 50 percent of Single Family Housing headquarters staff are eligible to retire in the next 3 years. The percentage of staff eligible to retire at the homeownership centers is even higher—63 percent.

While FHA has taken some steps to address succession planning, they have been limited. FHA implemented two initiatives focused on succession planning. The first, begun in 2010, was intended to help ensure that, at any given time, at least two additional supervisors, managers, or executives could perform the work of each supervisor, manager, or executive. However, this does not apply to staff positions beyond management. The second initiative also began in 2010. Its goal is to train and develop staff. Neither initiative assesses the number of retirement-eligible employees in critical positions as required by HUD guidance. According to FHA officials, as resources have dwindled, they have considered all their positions to be critical.

According to FHA officials, plans to update their workforce and succession plans were suspended. In 2007–2009, FHA had a workforce planning process designed to identify critical skill gaps and a strategy for addressing these gaps. According to the officials, HUD told FHA to stop this initiative in 2009 because HUD was going to implement a workforce planning process for the entire department. However, the effort never came to fruition because of funding shortages. Without a more comprehensive workforce planning process that includes succession planning, FHA’s ability to systematically identify the workforce needed for the future and plan for upcoming retirements is limited. Therefore, we recommended that FHA develop workforce and succession plans for the Office of Single Family Housing. FHA agreed, stating that it would develop a formal workforce plan and had efforts underway to develop a succession plan.

Ginnie Mae’s Risk Management and Cost Modeling Require Continuing Attention

We released a report today about Ginnie Mae, which has experienced a substantial increase in the volume of its business since 2007 as the volume of federally insured or guaranteed mortgages increased. Ginnie Mae is a wholly owned government corporation in HUD, which guarantees the timely payment of principal and interest on mortgage- backed securities (MBS) backed by pools of federally insured or guaranteed mortgage loans, such as FHA loans. As of 2010, Ginnie Mae guaranteed more than $1 trillion in outstanding MBS composed primarily of FHA-insured mortgages. The growth in outstanding Ginnie Mae- guaranteed MBS resulted in an increased financial exposure for the federal government. Nonetheless, Ginnie Mae’s revenues exceeded its costs, and it has accumulated a capital reserve of about $14.6 billion.

Ginnie Mae has taken steps to better manage operational and counterparty risks and has several initiatives planned or underway. The operational risks the agency may face include limited staff, substantial reliance on contractors, and the need for modernized information systems. Ginnie Mae plans to increase its staff levels, complete a reorganization, and implement recommendations related to contracting. For Ginnie Mae, counterparty risk is the risk that issuers of Ginnie Mae MBS fail to provide investors with monthly principal and interest payments. To manage its counterparty risk, Ginnie Mae has processes in place to oversee MBS issuers that include approval, monitoring, and enforcement and has revised its approval and monitoring procedures. For example, in 2010 Ginnie Mae increased the minimum net worth requirement for issuers of Ginnie Mae-guaranteed MBS to $2.5 million. But, planned initiatives to enhance its risk-management processes for issuers, including its tracking and reporting systems, have not been fully implemented. It will be important for Ginnie Mae to complete its initiatives related to operational and counterparty risk as soon as practicable.

In developing inputs and procedures for the model used to forecast costs and revenues, Ginnie Mae did not consider certain practices identified in Federal Accounting Standards Advisory Board (FASAB) guidance for preparing cost estimates of federal credit programs. Ginnie Mae has not developed estimates based on the best available data, performed sensitivity analyses to determine which assumptions have the greatest impact on the model, or documented why it used management assumptions rather than available data. By not fully implementing practices in FASAB guidance that GAO believes represent sound internal controls for models, Ginnie Mae’s model may not use critical data that could affect the agency’s ability to provide well-informed budgetary cost estimates and financial statements. This may limit Ginnie Mae’s ability to accurately report to Congress the extent to which its programs represent a financial exposure to the government.

We recommended that the Secretary of Housing and Urban Development direct Ginnie Mae to take steps to ensure its model more closely follows certain practices identified in Federal Accounting Standards Advisory Board guidance for estimating subsidy costs of credit programs. More specifically, Ginnie Mae should (1) assess and document that it is using the best available data in its model and most appropriate modeling approach, (2) conduct and document sensitivity analyses to determine which cash flow assumptions have the greatest impact on the model, (3) document how management assumptions are determined, such as those for issuer defaults and mortgage buyout rates, and (4) assess the extent to which management assumptions, such as those for issuer defaults and mortgage buyout rates, can be replaced with quantitative estimates. The President of Ginnie Mae wrote that Ginnie Mae is working towards implementing our recommendation for conducting sensitivity analyses relating to issuer risk and behavior, but neither agreed nor disagreed with our other specific recommendations. In addition, Ginnie Mae agreed with our observation about the importance of completing ongoing and planned initiatives for enhancing its risk-management processes, as soon as practicable, to improve operations.

Mr. Chairman, Ranking Member Frank, and Members of the Committee, this concludes my prepared statement. I would be happy to respond to any questions that you may have at this time.

GAO Contact and Staff Acknowledgments

For further information about this testimony, please contact Mathew J. Scirè, Director, at 202-512-8678 or sciremj@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this statement. Individuals making key contributions to this testimony include Paige Smith (Assistant Director), Andy Pauline (Assistant Director), Steve Westley (Assistant Director), Dan Alspaugh, Nadine Garrick Raidbard, John McGrail, Marc Molino, José R. Peña, Beth Reed Fritts, Paul G. Revesz, and Barbara Roesmann.

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