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 HUD Secretary 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. 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 HUD Secretary annually report to Congress on the results of the review. Pub. L. No. 101-508. risk, which arises as borrowers become unable to make payments on insured mortgages. Agencies also face counterparty risk. That is, an agency may suffer losses due to weaknesses or uncertainties in the work of its counterparties, which include lenders and appraisers for FHA and issuers for Ginnie Mae. And all agencies face operational risks, the risk of loss resulting from inadequate or failed internal processes, deficiencies in staff numbers, training, and skills, or external events. The Fund’s capital ratio dropped sharply in 2008 and fell below the statutory minimum in 2009, when economic and market developments created conditions that simultaneously reduced the Fund’s economic value (the numerator of the ratio) and increased the insurance-in-force (the denominator of the ratio). According to annual actuarial reviews of the Fund, the capital ratio fell from about 7 percent in 2006 to 3 percent in 2008 and 0.5 percent in 2009 (see fig. 1). For 2010 and 2011, the ratios were 0.5 and 0.24 percent, respectively. In its November 2011 report to Congress, HUD cited several reasons for the declines from 2010 to 2011. These included the following: Home prices were expected to continue falling. Forecasts for the 2010 actuarial study predicted house price declines of about 2.8 percent before bottoming out in the middle of 2011. Forecasts for the 2011 actuarial study predicted declines of 5.6 percent for FHA’s single- family portfolio in 2011. Higher-than-expected declines in house values contributed to both higher defaults and claims and higher loss- on-claim than anticipated in 2010. More loans, particularly from the housing bubble years of 2006-2008 were in serious delinquency, and a significant percentage had been there for more than 1 year. Claims become the most likely outcome for extended delinquency loans, many of which are in foreclosure. For the first time, the actuarial calculations built in a factor recognizing the elevated redefault potential from the increased number of active loans with a previous serious delinquency (3 months or more). The independent actuaries also made a decision to treat foreclosure actions likely affected by so called robosigning problems as expected claims in 2012. In reviewing the components of the capital ratio, the combination of a relatively stable economic value (numerator of the ratio) and a declining insurance-in-force (denominator) over much of the decade increased the capital ratio. However, since 2008, the economic value has fallen as the insurance-in-force has risen, dramatically lowering the capital ratio (see fig. 2). At the same time, the Fund’s condition has worsened from a budgetary perspective. Historically, FHA has estimated that its loan insurance program was a negative subsidy program (that is, estimated cash inflows exceeded expected cash outflows). On the basis of these estimates, FHA accumulated substantial balances in a budgetary account known as the capital reserve account, which holds reserves in excess of those needed for estimated credit subsidy costs and helps cover unanticipated increases in those costs such as higher-than-expected claims. Reserves needed to cover estimated subsidy costs are held in the Fund’s financing account. However, in recent years, the capital reserve account has covered large upward reestimates of FHA’s credit subsidy costs through transfers to the financing account. As a result, balances in the capital reserve account fell dramatically—from $22 billion at the end of 2007 to an estimated $4.4 billion by the end of 2010 (see fig. 3). depleted, FHA would need to draw on permanent and indefinite budget authority to cover additional increases in estimated credit subsidy costs. FHA’s latest annual report to Congress raises the possibility that, if house prices were to decline in 2012, the expected future losses on the current, outstanding portfolio could exceed current capital resources. These would be offset by the expected net receipts from the new 2012 cohort of loans. But, according to HUD, if house prices were to decline in 2012 by an amount rivaling that of 2011, these new loans would not be expected to generate sufficient net receipts to offset any potential decline in value of the current outstanding portfolio, potentially necessitating assistance from the Department of the Treasury (Treasury). Under one stress scenario in which house prices decline by 13.7 percent in 2011, rather than the 5.6 percent assumed in the baseline scenario, and house prices decline another 1.3 percent in 2012, HUD estimates that it may require $13 billion in assistance from Treasury to ensure the financing account has sufficient loss reserves. By the end of 2011, the balance in the capital reserve account rose slightly to $4.7 billion. 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 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 simulation) 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 in 2010 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 future actuarial reviews. 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 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 had more than tripled to 1.7 million loans insured 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 as follows: 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.