In 1968, the Congress added Section 242 to the National Housing Act establishing the Hospital Mortgage Insurance Program. In considering this amendment to the National Housing Act, the House Committee on Banking and Currency cited a serious shortage of hospitals and the need for existing hospitals to expand and renovate. Private lenders seemed reluctant to provide capital financing at reasonable terms. The purpose of the program is to “assist the provision of urgently needed hospitals for the care and treatment of persons who are acutely ill . . ..” Consequently, Section 242 authorized HUD to provide insurance for hospital mortgages secured from lenders to finance the construction and renovation of hospitals. Many hospitals need to borrow money from lenders to finance construction and renovation projects. Lenders often raise capital by selling bonds to investors and use the hospitals’ mortgage payments to pay bondholders. Mortgage insurance, like private bond insurance, guarantees that bondholders will be paid if the hospital stops making payments on its loan. According to the Health Care Financing Study Group, about 60 percent of hospitals that seek financing require insurance to enhance their credit because they cannot get a loan on their own financial strength. Eighty-three percent of these hospitals can get private bond insurance but about 17 percent cannot because private insurers consider them too risky. Some hospitals that cannot get private mortgage insurance apply to FHA’s hospital insurance program. FHA’s Hospital Mortgage Insurance Program staff and HHS’ Division of Facilities Loans staff jointly manage the hospital program. The Congress gave HUD statutory responsibility for the program. The House Committee on Banking and Currency, in recommending that HUD be given this responsibility, cited FHA’s more than 35 years of experience with promoting housing construction through its housing insurance programs. The Committee was concerned, however, that HUD’s staff did not have specialized knowledge of health care needed to administer this program. As a result, the Committee recommended and the Congress enacted the requirement that a state agency must certify that a hospital is needed before it can participate in the program. Also, the Committee expected HUD to draw upon HHS’ hospital expertise to devise standards for insuring hospitals’ mortgages. Through a memorandum of agreement, HUD formally delegated authority to HHS to review and approve proposals for hospitals’ mortgage insurance. HUD retained authority to make the final insurance commitment and endorse the mortgage note. The Hospital Mortgage Insurance Program requires hospitals to have the state certify the need for the proposed projects and then meet underwriting criteria before insurance applications can be approved. Since 1988, hospitals have obtained FHA insurance approval to construct acute care facilities, ambulatory care centers, and operating rooms and to renovate maternity and emergency departments and surgical suites. In addition, hospitals have obtained approval to purchase equipment, install new computer and fire alarm systems, and build parking facilities. The use of hospital inpatient services, however, has declined over time. Current trends indicate a greater focus on cost containment and delivering health care on an outpatient basis. Overall, the financial performance of the hospital program has reflected a net positive cash flow from operations over the past 25 years, according to HUD data. However, in several years, the program has experienced financial losses. The bulk of the losses occurred between 1989 and 1991, when HUD had to pay lenders about $147 million because of hospital defaults. The current composition of the program’s portfolio with the concentration of insured loans in New York, changes in state policies, trends in the health care market, and the probability of future changes in federal health care policies pose risks that may threaten the future stability of the program. Two reasons given in a 1992 HUD study for why some hospitals defaulted on their loans were changes in the policies and practices of state and local governments and changes in Medicare and Medicaid reimbursement. The hospital program has made a positive net contribution of $221 million to HUD’s General Insurance Fund, even though there have been years with negative cash flows (see fig. 1). Information obtained from FHA shows that from fiscal year 1969 through 1994, FHA collected $370 million in premiums and fees and paid $200 million in insurance claims and $13 million in salaries and other administrative expenses. FHA recovered about $64 million of claim payments from mortgage payments and the sale of the mortgages or properties. As of September 30, 1994, 19 hospitals had defaulted; FHA disposed of 10 and retained loan management responsibility for the remaining 9 hospitals. For these 9 hospitals, the total unpaid principal balance is $108 million and accrued delinquent interest is $44 million. (See app. I for a description of the hospital program’s financial performance from fiscal year 1969 through 1994.) As of August 1995, the hospital program portfolio was comprised of 100 projects in 18 states and Puerto Rico (see fig. 2). The portfolio has an aggregate unpaid principal balance of about $5 billion. (See app. II for individual unpaid principal balances of FHA-insured hospital projects, by state.) (Figure notes on next page) The majority of the hospital program projects, 63 percent, are in New York. The unpaid principal balance on mortgages for these projects is about $4.2 billion or 87 percent of the portfolio’s aggregate unpaid principal balance. Also, 9 of the 10 largest hospital mortgages are in New York. These mortgages account for about $2.4 billion or 50 percent of the portfolio’s total unpaid principal balance. Included in these mortgages is a $591 million loan, the largest single loan amount FHA has insured in the history of the program. Since 1988, 17 of the 20 projects that FHA insured have been for New York hospitals. In addition, as of August 1995, 6 of the 10 mortgage insurance applications under review by HHS and FHA were for projects in New York. The hospital program has become a major financing vehicle for many New York hospitals. Several officials stated that New York hospitals rely on FHA mortgage insurance, in part, because the state’s reimbursement system hinders hospitals’ ability to access capital in the private market. “New York’s restrictive reimbursement system makes it the most regulated nationwide,” according to a Moody’s Investors Service report. Except for Medicare, New York utilizes an all-payer fixed rate system to reimburse hospitals. The state controls all third-party payers’ rates of payments by setting a fixed payment for each hospital based on patient diagnoses. The rate-setting system is a regulatory method of budgeting for hospitals. The goals of the rate-setting system are cost containment and access to hospital care. However, New York state officials said that this system constrains hospitals’ profitability, which weakens their creditworthiness. According to a Moody’s Investors Service report, New York hospitals’ credit ratings are the weakest in the nation. In other states, hospitals’ credit ratings are generally stronger, which enables many of them to access capital in the private market. These hospitals primarily rely on bond financing backed by their revenues and projected ability to make loan payments or by commercial bond insurance instead of FHA’s Hospital Mortgage Insurance Program. In contrast, private insurers are reluctant to back bond sales to finance some New York hospital projects because the hospitals are considered too risky. The lack of portfolio geographic diversification and the large individual unpaid loan balances in New York pose a risk to the program. The concentration of the portfolio in New York makes the program susceptible to New York policies and other factors specific to the state. The strength of a portfolio lies in its diversity because portfolio diversification decreases the risk from losses. In addition, a single default of a large loan could lead to insurance claims that could significantly burden the program. A 1992 HUD report stated that the concentration of FHA-insured projects in a single state and large loan amounts are major controllable risks to the program that should be avoided or minimized. FHA does not limit the number of projects in a particular state nor does it cap individual loan amounts it insures as a means of controlling risks to the program. The legislation authorizes the Secretary of HUD to set the terms and conditions under which HUD will insure projects, but the law does not specifically authorize FHA to limit the number of projects accepted into the program from a geographic area or to limit the loan amounts it insures. In fact, in 1974, the Congress removed existing caps on loan amounts. FHA officials stated that they are taking action to diversify the portfolio by marketing the program to attract hospitals from other states. For example, FHA officials reported working with mortgage bankers to increase program awareness to hospitals outside New York. They reported that, as of August 1995, they had received four applications from hospitals in Illinois, New Jersey, Pennsylvania, and Puerto Rico. By expanding the portfolio, FHA also increases the program’s total outstanding mortgage amount. Officials involved in the financing of hospital projects told us that hospitals in other states may not be interested in the FHA program for several reasons, including the program’s high premiums, lengthy application process, and a lack of program awareness. For some future hospital projects, FHA is considering ways to reduce the risk of financial losses. For example, FHA is considering a proposal to establish risk-sharing arrangements with the public and private sector. According to FHA officials, the risk-sharing partner would assume underwriting responsibilities, have an equity position in the hospital, and share in any losses that result from defaults. In an October 1993 report, we noted that HUD terminated FHA’s multifamily housing coinsurance program in January 1990. The program enabled FHA to share the risk of insuring a multifamily mortgage with participating lenders. However, problems with the program resulted from deficient conceptual design and failures in administration. Changes in state health care policies that reduce hospitals’ revenues can negatively affect the financial stability of hospitals, particularly the financially weaker hospitals in FHA’s hospital program. Recent changes in New York’s Medicaid policy would reduce hospitals’ patient revenues and could increase program hospitals’ risk of default. The New York state fiscal year 1996 budget contains health care cost-cutting measures that are estimated to reduce state Medicaid hospital spending by $138 million, resulting in an estimated total hospital revenue loss of $553 million. State analyses of the reduction in Medicaid spending for individual hospitals estimate that FHA-insured hospitals will lose $170 million in Medicaid revenue. Also, individual program hospitals may lose between 0.31 percent and 4.25 percent of total revenues. Some New York hospitals’ already marginal operating margins may deteriorate further as a result of the loss in Medicaid revenue. Our analysis of 1994 Health Care Financing Administration data for 52 program hospitals in New York indicates that 49 had negative operating margins. The average operating margin for the 52 hospitals was –5.6 percent. Our analysis shows that, on average, operating margins for the 52 hospitals would deteriorate by 26 percent in 1 year because of the state’s reduction in Medicaid spending. Thus, the ability of some of these hospitals to absorb the cuts and possible future state Medicaid spending reductions without defaulting on their FHA-insured loans is questionable. In the past, state policy changes have precipitated hospital defaults. For example, three hospital defaults in Illinois resulted in a $27 million loss to the program. According to a 1992 HUD report, two of these defaults were caused, in part, by the state setting a Medicaid reimbursement rate that was too low to cover the hospital’s cost of treating Medicaid patients or the state delaying Medicaid reimbursement to hospitals. The extent to which New York hospitals are able to reduce expenses will affect their ability to withstand revenue losses. According to FHA, HHS, and New York health care officials, hospitals are expected to reduce expenses and implement revenue enhancers to mitigate Medicaid revenue losses and remain viable. Hospitals with large Medicaid caseloads are particularly vulnerable to reductions in Medicaid spending. Our analysis of 1994 data from 52 New York program hospitals shows that for about one-third of the hospitals, their Medicaid inpatient days were greater than 25 percent. Plans developed by New York program hospitals to respond to the state’s Medicaid cuts include cost-containment measures, such as reducing staff, salaries, and benefits and revenue enhancement measures, such as decreasing the length of stay and increasing admissions. Hospital and hospital organization officials reported that some hospitals had already begun taking cost-cutting measures before the budget decision was made. In reaction to the cuts, FHA required New York hospitals awaiting application approval to submit sensitivity analyses on the impact of the cuts. In addition, HHS required New York program hospitals to submit an action plan for responding to the cuts. After evaluating the hospitals’ responses, FHA and HHS increased their monitoring efforts for those hospitals identified as most vulnerable to the cuts. In addition to changes in state policies, future changes in federal health care policies can also restrict hospitals’ revenues. For example, the Fiscal Year 1996 Congressional Budget Resolution proposes cumulative Medicare reductions of $270 billion, from current law projections, over the next 7 years. In addition, the Budget Resolution proposes reducing Medicaid outlays by about $180 billion. As the congressional debate on deficit reduction continues, other proposals for containing the cost of federal health care spending on Medicare and Medicaid could surface. Changes in the delivery of health care can adversely affect the viability of hospitals that do not take action to successfully control costs and compete in the marketplace. One major shift in the way health care is delivered is the change from a focus on hospital inpatient care to outpatient care. From 1983 through 1993, there were 5.4 million or 15 percent fewer community hospital admissions nationwide. Over the same period, the average length of stay for patients admitted to hospitals declined from 7.6 to 7.0 days. American Hospital Association (AHA) data show for the same 10-year period that hospital occupancy rates declined by 10 percent and 522 community hospitals closed—a decline of 9 percent. In contrast, more dramatic than the decline in inpatient hospital use was the increase in hospital outpatient visits. Community outpatient visits increased about 75 percent over the 10-year period. This change in outpatient volume reflects an overall restructuring of the health care delivery system. Some of the factors driving the trends in health care include advances in technology that allow more care to be delivered in outpatient settings; changes in reimbursement incentives, such as the introduction of diagnostic related groups under the prospective payment system in the early 1980s; and the growth of enrollment in managed care health plans. As these trends continue, the need for hospital acute care beds will continue to decline. Health care association representatives cite managed care as a significant trend facing some hospitals. Because of the increased enrollment in managed care plans, hospitals that cannot become a part of a managed care network or compete in this environment stand to suffer financially from a loss of market share. Understanding the overall impact of these health care trends on the future need of the program would require further analysis which was beyond the scope of this review. Any such analysis should have to consider, at a minimum, (1) the characteristics of program hospitals compared with nonprogram hospitals accessing capital, (2) the ability of program hospitals to obtain financing on the private market without FHA mortgage insurance, (3) the costs and benefits of the program including the public good that the program serves, and (4) the program’s underwriting criteria and premium structure. The growth of managed care in New York can negatively affect some FHA-insured hospitals’ financial condition and, as a result, increase the risk of financial loss to the insurance program. In 1993, the penetration of managed care plans in New York was more than 24 percent. Also, there is a push in the state for the adoption of mandatory Medicaid managed care. Managed care emphasizes health care cost control, which includes avoiding unnecessary admissions and lengthy stays. Managed care also focuses on cost and utilization control measures. However, few New York hospitals have experienced managed care pricing and utilization controls. New York hospitals may be at a disadvantage in a managed care market because they generally have high lengths of stay. In addition, according to a Moody’s Investors Service report, “in a managed care market where the key variable is cost, the generally high-cost urban teaching facilities which are disproportionately located in New York, will definitely be at a disadvantage.” In addition, these hospitals have large teaching and research costs and significant fixed costs tied to their large physical plants and debt loads. The potential effect on teaching hospitals can be important to the program because, according to FHA data, the program insures 44 teaching hospitals of which 34, or 77 percent, are in New York. Hospitals that reduce costs and develop cooperative relationships with other health care providers may be able to mitigate the negative financial impact of managed care. Some program hospitals in New York and other states are affiliating and forming networks with other health care providers to reduce costs and increase service area. For example, one hospital reduced costs by establishing an affiliate in which financial and support services were consolidated and shared within its provider network. In addition, several hospitals reported affiliating with community hospitals and physician groups, as well as developing satellite clinics to broaden their patient base. An HHS official stated that, in reviewing hospitals’ applications, HHS considers whether the hospitals are preparing for managed care and addressing other health care trends. In addition, according to an HHS official, HHS examines affiliate contracts and insures that the contracts are not a drain on the hospitals’ finances. Also, program hospitals are required to obtain FHA approval for some mergers and affiliate transactions. FHA officials also reported that FHA consultants consider health care trends in their review of hospitals’ applications. FHA’s loan loss reserve estimate of $458.25 million, as of September 30, 1994, is not reliable because of weaknesses in the methodology that FHA used to calculate the estimated loan losses. The assumptions that FHA used to estimate key variables such as default probabilities and the actual loss rates were not directly linked to or justified by a detailed documented analysis of loss exposure in the hospital mortgage insurance portfolio. In an October 1994 report we discuss this principle as it applies to depositary institutions. Further, FHA’s methodology did not incorporate some health care market trends that are likely to impact the future financial performance of program hospitals. The net effect of the methodological flaws on the reserve estimate is unclear because FHA’s default assumptions and their exclusion of market trends could overstate or understate the loan loss reserve estimate. In estimating loan loss reserves, FHA—which is subject to the Government Corporation Control Act—is required to follow generally accepted accounting principles (GAAP) for financial statement reporting purposes. However, in our October 1994 report, we stated that this authoritative accounting guidance, established for private sector institutions, does not provide sufficiently detailed direction for establishing loan loss reserves. As a result, our evaluation of the methodology used by FHA is based on this general GAAP principle for loss recognition and our experience in applying other principles in other situations involving the estimation of loan loss reserves. FHA’s assumptions regarding default probabilities and loss rates were not supported by analysis of the loss exposure of each individual insured loan or other evidence that justified the estimates used. Specifically, FHA computed the probability of each program hospital appearing on HHS’ Credit Watch List and then used these probabilities as proxies to measure the default probability of each hospital in the portfolio. The probability of a hospital being on the Credit Watch List, however, is not a valid proxy for estimating the default probabilities for the entire portfolio because a hospital appearing on this list is a more common occurrence than a hospital defaulting. HHS’ data show that from 1984 to 1994 there were on average 167 hospitals in FHA’s portfolio. During this period, 16 hospitals (or 9.6 percent) defaulted on their loans and there were 82 hospitals on the Credit Watch List (49 percent). HHS data indicate that the majority of the default probabilities that FHA used to calculate the loan loss reserve were higher than the actual default rate of hospitals in the program. FHA’s approach for measuring default probabilities resulted in estimates of program hospitals’ default probabilities that ranged from about 3 to 80 percent with the majority of the default probabilities in the 10 to 40 percent range. However, FHA’s approach may have underreserved for loans that have high default probabilities because FHA did not consider the full unpaid principle balance when applying the loss percentages.Moreover, FHA’s use of the Credit Watch List overstates the hospitals’ default probabilities for loans less likely to default. FHA officials reported that they preferred to use the Credit Watch List as an indicator of the probability of default because, in their view, the Credit Watch List provides a prospective approach to estimating defaults. Regarding the loss rates, FHA applied percentages that were in some instances arbitrarily set and not linked to documented evidence of the individual insured loan’s likely losses. For example, FHA assigned the historical average loss rate of 70 percent to the hospitals it predicted were most likely to default on their mortgages (that is, hospitals with estimated default probabilities of 50 percent or more) and graduated downward the loss rate for hospitals that had estimated default probabilities lower than 50 percent. The 70-percent loss rate was based on losses HUD experienced from the sale at foreclosure or property disposition of eight of the nine hospital mortgages taken into inventory and sold since 1974. However, a better method for estimating the loan loss reserve would be to do a comprehensive analysis of the individual loss exposure for defaults considered probable—hospital loans with 50 percent or higher default probabilities. This entails not only reviewing the financial condition of the hospital, which FHA did, but considering other factors such as the likelihood of foreclosure versus FHA continuing to carry the loan. Further, FHA had no justifiable basis for the loss rate percentages applied to the hospitals that had default probabilities lower than 50 percent. FHA’s rationale was that in the future it could recover more from disposing of hospitals with default probabilities below 50 percent because these hospitals are considered to be stronger financially, based on the hospitals’ financial condition in 1994. FHA arbitrarily assumed that these hospitals would default later and have a higher value at the time of sale because they would have a broader patient base and higher net patient revenue. We question the validity of these assumptions because FHA provided no analysis to support the loss rates applied to hospitals with a lower than 50 percent probability of default. Because FHA had no basis for the loss rate percentages used for these categories of loans, it may be misstating the loan loss reserve estimate. FHA’s loan loss reserve methodology did not incorporate newly developed events, such as health care market trends, that can affect the future financial condition of program hospitals. For example, by omitting analyses of the potential impact of managed care, the loan loss reserve did not consider developing events that can impact program hospitals’ revenues. A reduction in revenue related to managed care could result in program losses. Overall, FHA’s exclusion of health care market trends in its methodology may have understated or overstated the loan loss reserve estimate depending on the impact that the specific market trend has on the program hospitals. While FHA officials acknowledged the importance of health care trends, they stated that they had not developed an approach to incorporate such factors into their analysis. HUD’s mission is broad enough to encompass the purpose of the hospital program. HUD’s overall mission includes increasing opportunities for housing and community development and, through FHA, providing mortgage insurance for construction projects. The purpose of the program is to assist with providing for urgently needed hospitals. In the report supporting the establishment of the hospital program, the House Committee on Banking and Currency cited FHA’s experience with promoting construction through its insurance programs. Subsequently, the Congress made providing mortgage insurance for hospital construction a part of HUD’s mission by giving the department statutory responsibility for the program. HUD officials reported that through FHA the program supports the department’s mission because it (1) provides an opportunity for hospitals to obtain financing for construction and renovation projects that they may not otherwise obtain in the private market and (2) promotes one of the department’s goals of economic lift by increasing employment, economic development, and neighborhood stabilization. The program also has as one of its specific goals promoting neighborhood stability and economic lift. Although FHA officials believe that the hospital program is consistent with HUD’s mission, the extent to which the program accomplishes the department’s goals and thereby supports its mission is not routinely measured. For example, HUD does not measure the extent to which local employment increased as a result of the program or the effect an insured project had on stabilizing a community. Performance measurement data would be useful for HUD to determine the strategic importance of the program to its mission and to evaluate the extent to which program benefits or outcomes outweigh program risks. Although no legal requirement existed for performance measurement, the Government Performance Results Act (GPRA) of 1993 requires federal agencies to submit a strategic plan to the Congress in the fall of 1997 and an annual performance plan in fiscal year 1999. In response to GPRA requirements, HUD officials stated that HUD established performance measures for some of its major programs. These measures include increasing the number of first-time home buyers and increasing benefits to low- and moderate-income home buyers. However for the hospital program, HUD officials stated that the agency has not developed performance measures, in part, because of the program’s relatively small size and HUD’s lack of data systems to track specific performance measures. FHA has limited health care expertise to independently manage the program. FHA’s headquarters staff has overall responsibility but shares program responsibilities with HHS staff because of HHS’ experience with hospitals and health care. Managing the program requires, in part, (1) familiarity with health care regulations, insurance practices, reimbursement systems, and trends; (2) an understanding of the indicators of a hospital’s financial condition; and (3) knowledge of the unique construction guidelines that apply to hospitals. According to a 1992 HUD report, HHS has staff with skills and experience in business administration, financial analysis, and accounting in the health care industry, as well as architects and engineers who specialize in overseeing the construction of health care facilities. The majority of the tasks related to managing the initial phases of the program’s loan cycle—loan development and management—have been delegated to HHS. FHA has primary responsibility for managing the latter stages of the program’s loan cycle—loan assignment and property disposition (see app. III for a description of each agency’s responsibilities during the phases of the loan cycle). A 1992 HUD report shows that FHA and HHS’ efforts to manage the program have produced mixed results. The report raised some concern about their past performance in loan development and management and the management of assigned loans and disposition of HUD-owned hospitals. However, the report concluded that, for the most part, HHS staff had done a good job and HUD’s staff was getting more involved and gaining experience in working with troubled hospitals. As agreed with your staff, our review did not include an evaluation of FHA and HHS’ performance in program management. The hospital and finance agency officials we interviewed raised concerns about the length of time it takes to get mortgage insurance applications and loan modifications approved by HHS and FHA. Our analysis of 12 loan applications approved since September 1990 shows that the average time from the date an application was first submitted to HHS to FHA’s final approval was more than 18 months. In contrast, a Price Waterhouse study reported that private insurers approve mortgage insurance applications for health facilities in 2 to 4 weeks. In addition, according to HUD’s 1992 report, the median timeframe for selected modification approvals was more than 9 months. Several hospital and finance agency officials said that the application and loan modification processes are lengthy primarily because of the number of offices involved in reviewing the applications. FHA and HHS officials attribute some of the delay to hospitals not responding to their questions in a timely manner. The lengthy approval processes may hinder hospitals’ ability to take advantage of favorable market interest rates, several officials said. One hospital reported that it had to pay an additional 65 basis points on its interest rate because of the time that elapsed between HHS’ recommendation to approve the application and FHA’s final approval. FHA recognizes that the approval processes are lengthy and stated that a reasonable goal for approving applications is 6 months. FHA and HHS recently initiated efforts to streamline the application process. These efforts include using a team approach to analyze applications and involving FHA’s field staff earlier in the process. However, FHA officials stated that their approval timeframes will generally never match those of private sector insurers because the hospitals that FHA insures are financially weaker and require closer screening and evaluation. Although the hospital program had made a positive dollar contribution to the General Insurance Fund as of fiscal year 1994, the accumulation of more than $4 billion of insured projects and the large loan amounts in New York pose risks to the future stability of the program. The continued buildup in New York may further exacerbate this risk. Further, trends in health care and changes in state and federal health care policies that reduce hospitals’ revenues will impact program hospitals. FHA officials are aware of the risks of concentration and health care changes associated with the current portfolio. Portfolio concentration is a controllable program risk for the future. But the law that authorizes the Secretary of HUD to set the terms and conditions under which HUD will insure projects does not specifically authorize FHA to use as options for diversifying the portfolio, limiting the number of projects accepted into the program from a geographic area, or limiting the amounts it insures. Health care trends and changes in health care policies are risks beyond FHA’s control. Hospitals currently in the FHA program must make adjustments to respond to these changes or they could suffer significant financial losses. To reduce the potential financial losses associated with future insured mortgages, FHA is considering risk sharing with the public and private sectors. However, the risk to the current portfolio remains. Flaws in FHA’s methodology for estimating loan losses limit the reliability of FHA’s loan loss reserve estimate. The implications of health care trends for program hospitals were not factored into FHA’s methodology for estimating potential loan losses. In addition, the approach that FHA used to determine default and loss rate assumptions was not reliable. FHA did not consider the full loss exposure in estimating reserves for hospitals that it identified as having high default probabilities. As a result of these flaws, the loan loss reserve estimate could be understated or overstated. While FHA has developed performance measures for some of its major programs in response to GPRA, it has not developed performance measures for the hospital program. Performance measures would help HUD evaluate the program’s effectiveness. Given the risks associated with the portfolio’s geographic concentration and the possible implications for the program of current health care trends, the Congress may wish to explore further with HUD officials options for reducing the program’s risk by, for example, limiting the program’s risk exposure in a particular state and capping mortgage insurance amounts. To improve the reliability of FHA’s loan loss reserve estimate, insure future compliance with federal performance measurement requirements, and minimize potential financial losses from future projects, we recommend that the Secretary of HUD perform a comprehensive analysis of individual loan loss exposure when default is considered probable; link the loan loss reserve estimate to documented analyses that justifiably support loss rates and default percentages; and consider newly developed events, such as health care trends and policy changes, that can affect the performance of loans in estimating loan loss reserves; develop performance measures and begin collecting the data needed to track the performance of the Hospital Mortgage Insurance Program; and pursue risk-sharing arrangements in which a private or public entity would share in potential financial losses from hospital defaults on future FHA-insured projects only after a thorough evaluation of the benefits and drawbacks of risk-sharing ventures, taking into account past experiences of FHA’s multifamily housing programs. On November 22, 1995, we provided a draft of this report to HUD and HRSA for comment. Although HRSA did not provide comments, HUD generally agreed with the report’s findings and conclusions. In response to our recommendations, HUD reported that it will (1) incorporate additional data on market trends and health care policy changes into FHA’s loan loss reserve methodology as such data become available and can be quantified; (2) develop and implement performance measures for the program in fiscal year 1997; and (3) conduct front-end risk analysis and incorporate multifamily’s risk-sharing experience into its plans for the hospital risk-sharing program. (See app. V.). HUD did not, however, concur with our evaluation of its 1994 loan loss reserve methodology. Contrary to what we concluded, HUD stated that it (1) used the financial position of the hospitals, not their appearance on the Credit Watch List to predict the probability of default, (2) based its loss rates on a review of all losses incurred in foreclosure or property disposition sales since the beginning of the program, (3) considered the full unpaid principal balance in estimating the loan loss reserve, and (4) included health care market trends through its analysis of the current financial condition and trends in the financial condition of individual hospitals. HUD’s comment that FHA used the financial condition of the hospitals, not appearance on the Credit Watch List, to predict probability of default is inconsistent with the documentation that FHA provided on the method used for estimating the program’s loan loss reserves. FHA’s documentation states that financial indicators “were used to predict the probability that a hospital would appear on HHS’ Watch List.” FHA averaged the probabilities estimated by these indicators to convert “the predictors of appearance on the Watch List to a likelihood of default.” Further, as stated in the report, our review of HHS data showed that the majority of default probabilities that FHA used were higher than the actual default rate of hospitals in the program. Clearly, FHA did not adjust the predicted probabilities of default for this difference. Regarding the loss rates, HUD commented that FHA’s analysis was based on all losses incurred in foreclosure and property disposition since the inception of the program. HUD also stated that the loss rates were adjusted downward for mortgages with probabilities of default lower than 50 percent based on the assumption that hospitals with a better financial condition would be worth more at foreclosure. As discussed in our report, the 70-percent average loss rate that FHA used for hospitals with high default probabilities was based on actual losses experienced in the foreclosure or property disposition of only eight mortgages taken into inventory and sold since 1974. Thus, FHA’s historical analysis was not statistically significant and was based on information that was not adjusted for current real estate market trends. We believe that FHA’s use of this historical analysis to determine loss reserves for loans where default is considered more likely than not (that is, hospital loans with 50-percent or higher default probabilities) may overstate or understate the reserves on these loans. We believe that individual loan analysis of mortgages in the current portfolio provides for a more accurate means to measure loss exposure on loans where default is considered more likely than not. Although as a matter of generally accepted practice, using historical data may under some circumstances be appropriate for groups of loans with a lower than 50-percent default probability, FHA arbitrarily adjusted a questionable 70-percent loss rate downward for such loans and provided no supporting analysis to justify the resultant loss rates. We believe that this analysis was inappropriate for this group of loans with lower default probabilities. Therefore, these loss rates do not provide a reliable basis for estimating FHA’s reserves. With respect to accounting for the full unpaid principal balance in estimating potential losses, HUD stated that it “multiplied the full unpaid principal balance by the probability of default and then by the loss rate—a standard approach to factoring the probability of default into a loss estimate.” However, this approach has the effect of reducing the unpaid principal balance. Proper application of GAAP requires 100 percent of the unpaid principle balance for reserving purposes when default is more likely than not to occur. Including default probabilities in the reserve calculation may be appropriate for loans where default is not considered more likely than not, but once that threshold has been determined, the full amount of the loan balance should be considered in calculating the loss estimate. HUD stated that its methodology reflected current health care market trends. We agree that some health care market trends may be reflected in hospitals’ financial statements. However, some rapidly evolving health care market trends, such as managed care, may not be reflected in the hospitals’ financial statements that HUD uses because of the time lag in financial reporting. FHA’s loan loss reserve methodology does not include a mechanism to identify and adjust for such trends. Historical trends should be adjusted to reflect changes in economic and business conditions, such as managed care, in order to provide a reasonable estimate of current loss exposure. Data on hospitals’ utilization rates may be used in analyzing health care trends. HUD also commented on other issues that did not accurately reflect the information presented in our report. For example, HUD commented that we found the program to be “consistent with and contributing towards the mission of HUD.” However, this is not a conclusion of our report. Our report cites the statements of HUD officials that the program supports and is consistent with the Department’s mission. We concluded that HUD’s mission is broad enough to encompass the purpose of the hospital program, not that it contributes to the mission of HUD. (See p. 18.) HUD also commented that it agreed with our concern that the proposed federal Medicare and Medicaid cuts could have a “significant adverse impact on the hospital industry, including some hospitals with mortgages insured by FHA.” Our report does not make a value judgment about the proposed federal Medicare and Medicaid reductions on the hospital industry or hospitals in the program. Instead, we report that future changes in federal health care policies can restrict hospital revenues and increase risks to the program. (See p. 12.) While HUD commented that our report noted “many urban community and teaching hospitals need credit enhancement but cannot meet all of the standards of the private insurers,” we did not differentiate among which types of hospitals need credit enhancement. HUD provided additional reasons for the program’s concentration in New York other than the state’s reimbursement system. Despite these reasons and recent actions taken in efforts to address these risks, the program’s concentration and the large individual unpaid loan balances in New York continue to pose program risks. Specifically, the concentration of the portfolio in New York makes the program susceptible to New York policies and other factors specific to the state. (See p. 10.) HUD also noted actions that it is initiating to geographically and economically diversify its portfolio. According to HUD comments, these actions include increasing program awareness and developing new products to meet market demands. Although we recommended that HUD pursue risk-sharing arrangements and suggested that the Congress consider exploring with HUD options for reducing program risks; for example, by limiting the program’s risk exposure in a particular state and capping mortgage insurance amounts, we do not endorse expanding FHA’s Hospital Mortgage Insurance Program. By expanding the program, FHA increases the program’s total outstanding mortgage amount. In fact, because the overall impact of health care trends and policy changes is unclear, we stated that to understand the overall impact of these changes on the future of the program would require further analysis given its original purpose and the current composition of the portfolio. (See p. 13.) We are sending copies of this report to appropriate congressional committees; the Secretary of HUD; the Secretary of HHS; the Director, Office of Management and Budget; and other interested parties. We also will make copies available to others on request. Please contact me at (202) 512-7119 if you or your staff have any questions. Other major contributors are listed in appendix VI. Net cash flow from operations for the year ($1) (12) (50) (86) (133) (26,867) (159) (21,985) (169) (243) (337) (363) (378) (12,105) (418) (516) (548) (663) (673) (869) (876) (5,351) (898) (901) (34,606) (844) (11,324) (21,240) (872) (91,179) (883) (66,687) (828) (4,202) (773) (4,180) (714) $370,110 ($199,730) ($13,207) (continued) (continued) (continued) Total (100 projects) Provide applicant guidance and assistance (including preapplication conference) Conduct initial site visit to hospital Review and approve construction plans, specifications, and contracts Recommend to HUD approval or disapproval of hospital’s application Make final underwriting determinations, conduct any needed legal reviews, issue firm commitment, close and initially endorse loan Conduct preconstruction conference, monitor construction work, and process requests for advances of mortgage proceeds Review cost certification, inform lender of maximum insurable mortgage amount, and process final advance Arrange final closing and finally endorse mortgage Monitor hospital’s financial performance by reviewing financial statements and conducting periodic site visits Receive, review, and recommend to HUD approval or disapproval of special requests and loan modifications (for example, partial release of security, transfer of physical assets, bond refundings, or major capital projects) Approve special requests and loan modifications Conduct site visits to troubled hospitals to determine actions needed to prevent or cure defaults Review quality and condition of insured hospital loan portfolio and determine amount of loan loss reserve Receive/process assignment of loan and pay insurance claim Review assigned hospital’s operational performance and financial condition and conduct site visits as needed Receive, review, and recommend to HUD approval or disapproval of proposed workout agreements or mortgage modifications Bill for and collect mortgage payments Analyze hospital’s situation, evaluate alternative uses, secure appraisal, make decision to foreclose, and arrange and hold foreclosure sale (continued) The specific objectives of our review were to (1) identify factors, including those related to health care market trends, that could affect the stability of the program’s portfolio and provide information on the program’s financial performance; (2) evaluate the methodology FHA used to estimate the program’s fiscal year 1994 loan loss reserve; (3) evaluate the relationship between the purpose of the hospital mortgage insurance program and HUD’s mission; and (4) determine whether FHA has the expertise to manage the program. To identify factors that could affect the stability of the program’s portfolio, we (1) researched the literature and used HUD’s 1992 internal report on the hospital mortgage insurance program; (2) interviewed program officials in FHA and HHS headquarters and field offices; (3) interviewed senior financial officers from seven hospitals in New Jersey, New York, Puerto Rico, and Texas; (4) interviewed representatives from the Health Care Financing Study Group, New Jersey Health Care Facilities Financing Authority, New York State Medical Care Facilities Finance Agency, Goldman, Sachs & Co., Merrill Lynch and Co., AMBAC Indemnity Corp., Municipal Bond Investors Assurance Insurance Corp., Greater New York Hospital Association, Healthcare Association of New York State, State of New York Department of Health, the law firm of Krooth & Altman, and other state health and hospital organizations that are knowledgeable about or involved with the program; and (5) convened a panel of investment bankers and hospital financial officers. We used the Health Care Financing Administration’s Health Care Provider Cost Report Information System, the New York State Department of Social Services Medicaid Provider Ranking List, and the New York State Department of Health’s estimation of Medicaid cost containment to demonstrate the effect of New York’s fiscal year 1996 Medicaid spending reductions on program hospitals. We calculated 1994 operating margins for 48 of 57 New York program hospitals. Nine hospitals did not have 1994 cost report information available or did not have the state’s estimation of Medicaid cost containment. We reduced calendar year 1994 net patient revenues by the New York State Department of Health estimation of Medicaid cost containment. Two assumptions of our analysis were that (1) the effects of the proposed changes on net patient revenue would be the same in each year and (2) the hospitals took no action to reduce expenses. To evaluate the methodology FHA used to estimate its 1994 hospital loan loss reserve, we reviewed the description of the hospital loan loss analysis and other related documents. We evaluated the methodology and discussed the statistical estimation model and assumptions FHA used with FHA and HHS officials. Also, we interviewed investment bankers and bond insurers to determine conventional approaches private industry uses in estimating loss reserves. As agreed with Committee staff, we did not assess the accuracy of the estimated amount of the program’s loan loss reserve. To evaluate the relationship between the purpose of the hospital program and HUD’s mission, we reviewed and analyzed the applicable laws, regulations, and policy statements related to the Department’s and FHA’s missions. We reviewed the legislative history to determine the purpose of the program. We also interviewed FHA officials to discuss how the program’s purpose supports HUD’s mission. To determine whether FHA has the expertise to manage the program, we interviewed agency officials and representatives from hospitals and state health and hospital organizations, as previously mentioned. Our review of FHA’s expertise to manage the program did not involve an evaluation of risks to the program resulting from program management or organization. Our 1990 report and internal HUD studies have previously addressed organizational issues. The approach to accomplishing the objectives of this review was discussed with and agreed to by staff from both the Senate and House Banking Committees. In addition to those named above, the following individuals also made important contributions to this report as advisors and technical assistants: Linda Calbom, Robert C. DeRoy, Austin J. Kelly, Ann McDermott, Luann M. Moy, David Patrick Redmon, Mary W. Reich, Daynah K. Shah, and William J. Carter-Woodbridge. The first copy of each GAO report and testimony is free. Additional copies are $2 each. Orders should be sent to the following address, accompanied by a check or money order made out to the Superintendent of Documents, when necessary. VISA and MasterCard credit cards are accepted, also. Orders for 100 or more copies to be mailed to a single address are discounted 25 percent. U.S. General Accounting Office P.O. Box 6015 Gaithersburg, MD 20884-6015 Room 1100 700 4th St. NW (corner of 4th and G Sts. NW) U.S. General Accounting Office Washington, DC Orders may also be placed by calling (202) 512-6000 or by using fax number (301) 258-4066, or TDD (301) 413-0006. Each day, GAO issues a list of newly available reports and testimony. To receive facsimile copies of the daily list or any list from the past 30 days, please call (202) 512-6000 using a touchtone phone. A recorded menu will provide information on how to obtain these lists.

Summary: Pursuant to a legislative requirement, GAO reviewed the Federal Housing Administration's (FHA) Hospital Mortgage Insurance Program, focusing on: (1) factors that could affect the stability of the program's portfolio and financial performance; (2) FHA 1994 loan loss reserve estimate; (3) how the program relates to the Department of Housing and Urban Development's (HUD) mission; and (4) whether FHA has the expertise to manage the program. GAO found that: (1) although the Hospital Mortgage Insurance Program has had a net positive cash flow since its inception, the program faces financial risks that could affect its future stability; (2) New York hospitals account for 87 percent of the program's $5 billion in unpaid principal and have 9 of the 10 largest unpaid principal balances; (3) New York hospitals unduly rely on the FHA mortgage insurance program because the state's restrictive reimbursement system hinders their ability to attract private-sector capital; (4) state actions and future health care policy changes and trends could further threaten hospital solvency; (5) FHA loan loss reserve estimates are unreliable because FHA used questionable assumptions about default probabilities and loss rates and did not consider health care market trends; (6) the extent to which the mortgage program contributes to the HUD mission is unclear because HUD does not routinely measure program outcomes; (7) FHA staff do not have sufficient health care expertise to manage key program functions and must rely on Health and Human Services staff experience to monitor hospitals' financial performance; and (8) hospital officials and program users are concerned about the length of the program's application and loan modification processes.