FHA was established in 1934 under the National Housing Act (P.L. 73-479) to broaden homeownership, shore up and protect lending institutions, and stimulate employment in the building industry. FHA insures private lenders against losses on mortgages that finance purchases of properties with one to four housing units. Many FHA-insured loans are made to low-income, minority, and first-time homebuyers. Generally, lenders require borrowers to purchase mortgage insurance when the value of the mortgage is large relative to the price of the house. FHA provides most of its single-family insurance through a program supported by the Mutual Mortgage Insurance Fund. The economic value of the Fund, which consists of the sum of existing capital resources plus the net present value of future cash flows, depends on the relative size of cash outflows and inflows over time. Cash flows out of the Fund from payments associated with claims on foreclosed properties, refunds of up-front premiums on mortgages that are prepaid, and administrative expenses for management of the program. To cover these outflows, FHA deposits cash inflows—up-front and annual insurance premiums from participating homebuyers and the net proceeds from the sale of foreclosed properties— into the Fund. If the Fund were to be exhausted, the U.S. Treasury would have to cover lenders’ claims and administrative costs directly. The Fund remained relatively healthy from its inception until the 1980s, when losses were substantial, primarily because of high foreclosure rates in regions experiencing economic stress, particularly the oil-producing states in the West South Central section of the United States. These losses prompted the reforms that were first enacted in November 1990 as part of the Omnibus Budget Reconciliation Act of 1990 (P.L. 101-508). The reforms, designed to place the Fund on an actuarially sound basis, required the Secretary of HUD to, among other things, take steps to ensure that the Fund attained a capital ratio of 2 percent of the insurance-in-force by November 2000 and to maintain or exceed that ratio at all times thereafter. As a result of the 1990 housing reforms, the Fund must meet not only the minimum capital ratio requirement but also operational goals before the Secretary of HUD can take certain actions that might reduce the value of the Fund. These operational goals include meeting the mortgage credit needs of certain homebuyers while maintaining an adequate capital ratio, minimizing risk, and avoiding adverse selection. However, the legislation does not define what constitutes adequate capital or specify the economic conditions that the Fund should withstand. The 1990 reforms also required that an independent contractor conduct an annual actuarial review of the Fund. These reviews have shown that during the 1990s the estimated value of the Fund grew substantially. At the end of fiscal year 1995, the Fund attained an estimated economic value that slightly exceeded the amount required for a 2 percent capital ratio. Since that time, the estimated economic value of the Fund continued to grow and always exceeded the amount required for a 2 percent capital ratio. In the most recent actuarial review, Deloitte & Touche estimated the Fund’s economic value at about $18.5 billion at the end of fiscal year 2001. This represents about 3.75 percent of the Fund’s insurance-in-force. In February 2001 we reported that the Fund had an economic value of $15.8 billion at the end of fiscal year 1999. This estimate implied a capital ratio of 3.20 percent of the unamortized insurance-in-force. The relatively large economic value and high capital ratio reported for the Fund reflected the strong economic conditions that prevailed during most of the 1990s, the good economic performance that was expected for the future, and the increased insurance premiums put in place in 1990. In our February 2001 report we also reported that, given the economic value of the Fund and the state of the economy at the end of fiscal year 1999, a 2 percent capital ratio appeared sufficient to withstand moderately severe economic scenarios that could lead to worse-than-expected loan performance. These scenarios were based upon recent regional experiences and the national recession that occurred in 1981 and 1982. Specifically, we found that such conditions would not cause the economic value of the Fund at the end of fiscal year 1999 to decline by more than 2 percent of the Fund’s insurance-in-force. Although a 2 percent capital ratio also appeared sufficient to allow the Fund to withstand some more severe scenarios, we found that three of the most severe scenarios we tested would cause the economic value of the Fund to decline by more than 2 percent of the Fund’s insurance-in-force. These results suggest that the existing capital ratio was more than sufficient to protect the Fund from many worse-than-expected loan performance scenarios. However, we cautioned that factors not fully captured in our economic models could affect the Fund’s ability to withstand worse-than-expected experiences over time. These factors include recent changes in FHA’s insurance program and the conventional mortgage market that could affect the likelihood of poor loan performance and the ability of the Fund to withstand that performance. In deciding whether to approve a loan, lenders rely upon underwriting standards set by FHA or the private sector. FHA’s underwriting guidelines require lenders to establish that prospective borrowers have the ability and willingness to repay a mortgage. In order to establish a borrower’s willingness and ability to pay, these guidelines require lenders to evaluate four major elements: qualifying ratios and compensating factors; stability and adequacy of income; credit history; and funds to close. In recent years, private mortgage insurers and conventional lenders have begun to offer alternatives to borrowers who want to make small or no down payments. Private lenders have also begun to use automated underwriting as a means to better target low-risk borrowers for conventional mortgages. Automated underwriting relies on the statistical analysis of hundreds of thousands of mortgage loans that have been originated over the past decade to determine the key attributes of the borrower’s credit history, the property characteristics, and the terms of the mortgage note that affect loan performance. The results of this analysis are arrayed numerically in what is known as a “mortgage score.” A mortgage score is used as an indicator of the foreclosure or loss risk to the lender. During their early years, FHA loans insured from fiscal year 1995 through fiscal year 1998 have shown somewhat higher cumulative foreclosure rates than FHA loans insured from fiscal year 1990 through fiscal year 1994, but these rates are well below comparable rates for FHA loans insured in the 1980s. To better understand how foreclosure rates might vary, we compared the rates for different types of loans—fixed-rate and adjustable rate mortgages (ARMs)—locations of properties, and loan-to-value (LTV) ratios. For loans made in recent years, FHA has been experiencing particularly high foreclosure rates for ARMs and mortgages on properties located in California. One measure of the initial risk of a loan, its LTV, can partly explain the difference over time in foreclosure rates. That is, FHA insured relatively more loans with high LTVs later in the decade than it insured earlier in the decade. However, the same pattern of higher foreclosure rates in the later 1990s exists even after differences in LTV are taken into account. We compared the four-year cumulative foreclosure rates across books of business to measure the performance of FHA’s insured loans. As shown in figure 1, the 4-year cumulative foreclosure rate for FHA-insured loans was generally higher for loans originated later in the 1990s than for loans originated earlier in that decade. Through their fourth year, loans originated during fiscal years 1990 through 1994 had an average cumulative foreclosure rate of 2.23 percent, while loans originated during fiscal years 1995 through 1998 had an average cumulative foreclosure rate of 2.93 percent. Although the 4-year cumulative foreclosure rates for loans that FHA insured in the later part of the 1990s were higher than that for loans that FHA insured earlier in that decade, those rates were still well below the high levels experienced for loans that FHA insured in the early- to mid- 1980s, as shown in figure 2. The 4-year cumulative foreclosure rates for FHA loans originated between 1981 and 1985, a period of high interest and unemployment rates and low house price appreciation rates, ranged between 5 and 10 percent, while the rates for loans originated during the 1990s, when economic conditions were better, have consistently been below 3.5 percent. Since fiscal year 1993, FHA has experienced higher 4-year cumulative foreclosure rates for ARMs than it has for long-term (generally 30-year) fixed-rate mortgages, as shown in figure 3. In addition, between 1990 and 1994 the 4-year cumulative foreclosure rate for ARMs averaged 2.53 percent, as compared with a 3.90 percent average 4-year cumulative foreclosure rate for ARMs originated between 1995 and 1998. These higher foreclosures have occurred even though mortgage interest rates have been generally stable or declining during this period. In the early 1990s, when ARMs were performing better than fixed-rate mortgages, the performance of ARMs had relatively little impact on the overall performance of loans FHA insured because FHA insured relatively few ARMs. However, as shown in figure 4, later in the decade ARMs represented a greater share of the loans that FHA insured, so their performance became a more important factor affecting the overall performance of FHA loans. FHA is studying its ARM program and has contracted with a private consulting firm to examine the program’s design and performance. FHA insured a greater dollar value of loans in the 1990s in California than in any other state. Among the states in which FHA does the largest share of its business, 4-year cumulative foreclosure rates for both long-term, fixed- rate mortgages and ARMs were typically highest in California.