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 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. 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 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 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.