Congress established FHA in 1934 under the National Housing Act (P.L. 73- 479) to broaden homeownership, protect and sustain lending institutions, and stimulate employment in the building industry. FHA’s single-family program insures private lenders against losses from borrower defaults on mortgages that meet FHA criteria for properties with one to four housing units. FHA has played a particularly large role among minority, lower- income, and first-time homebuyers and generally is thought to promote stability in the market by ensuring the availability of mortgage credit in areas that may be underserved by the private sector or are experiencing economic downturns. In fiscal year 2006, 79 percent of FHA-insured home purchase loans went to first-time homebuyers, 31 percent of whom were minorities. The Title I Manufactured Home Loan program was created to reduce the risk to lenders through insurance or a guarantee, and thereby expand access to funding for buyers of manufactured homes. According to data from FHA, the majority of its Title I borrowers from 2004 to 2007 were lower-income and 34 years of age or younger. FHA insures most of its single-family mortgages under its Mutual Mortgage Insurance Fund, which is supported by borrowers’ insurance premiums. The single-family insurance program has maintained a negative overall credit subsidy rate, meaning that the present value of estimated cash inflows from premiums and recoveries exceeds estimated cash outflows for claim payments (excluding administrative costs). In addition to insuring mortgages on single-family homes, FHA has insured loans for manufactured housing since 1969. FHA insures its manufactured home loans under the General Insurance Fund, which is supported by lenders’ insurance premiums (currently an annual premium of 1 percent, based on the initial loan amount). Borrowers insured under FHA’s single-family program are required to make a cash investment of a minimum of 3 percent. FHA allows down- payment assistance from third-party sources, including nonprofit organizations that receive contributions from property sellers. When a homebuyer receives down-payment assistance from one of these organizations, the organization requires the property seller to make a financial payment to their organization. These nonprofits are commonly called “seller-funded” down-payment assistance providers. Partly in response to changes in the mortgage market, HUD has proposed legislation intended to modernize FHA. Provisions in the proposal relating to its single-family insurance program would among other things authorize FHA to change the way it sets insurance premiums, reduce down-payment requirements, and insure larger loans. The proposed legislation would enable FHA to depart from its current, essentially flat, premium structure and charge a wider range of premiums based on individual borrowers’ risk of default. HUD’s proposal also would eliminate the minimum cash investment requirement and enable FHA to offer some borrowers a no- down-payment product. FHA is subject to limits in the size of the loans it can insure. For example, for a one-family property in a high-cost area, the FHA limit is 87 percent of the limit established by Freddie Mac. In a low- cost area, the limit is 48 percent of the Freddie Mac limit. The legislative proposal would raise these limits to 100 percent and 65 percent of the Freddie Mac limit, respectively. In addition, Congress has proposed changes to FHA’s Title I Manufactured Home Loan program that would increase loan limits and index them annually; insure each loan made instead of capping insurance at 10 percent of the value of a lender’s portfolio; incorporate stricter underwriting requirements; and establish up- front and annual premiums. In a report we issued in June 2007, we noted that a combination of factors created conditions that favored conventional mortgages over FHA products resulting in FHA losing a considerable market share to the conventional market, especially to the subprime market. Based on our analysis of HMDA data, FHA’s share of the market for home purchase mortgages (in terms of numbers of loans) declined 13 percentage points from 1996 through 2005, while the prime share increased slightly, and the subprime share grew 13 percentage points. In addition, the agency experienced a sharp decrease among minority and lower-income populations where it traditionally has had a strong presence. Specifically, we found that: From 1996 through 2005, FHA’s share of the home purchase mortgage market declined while the conventional share increased. As shown in figure 1, FHA’s market share fell from almost 19 percent (about 583,000 loans) in 1996 to about 6 percent (about 295,000 loans) in 2005, with almost all of the decline occurring after 2001. Over the 10-year period, the market share for conventional mortgages rose from almost 75 percent (about 2.3 million loans in 1996) to about 91 percent (about 4.2 million loans in 2005), with much of the increase due to growth in subprime lending. More specifically, prime market share increased from 73 percent to 76 percent overall, falling somewhat from 1996 through 2000 but then increasing about 5 percentage points after 2000. Subprime market share increased substantially over the 10- year period, from 2 percent to 15 percent, with most of the increase occurring after 2001 (growing from 5 percent in 2001 to 15 percent in 2005). FHA traditionally played a major role among minority borrowers. However, over the 10-year period, FHA’s share of this submarket fell substantially. Specifically, FHA’s market share dropped from 32 to 7 percent among minority borrowers. In contrast, prime market share increased from 59 to 65 percent among minority borrowers and subprime market share increased from 2 to 26 percent. Lower-income (that is, low- and moderate-income) borrowers historically relied heavily on FHA products, but FHA’s market share dropped in this submarket as well. From 1996 through 2005, FHA’s market share decreased among borrowers of all income levels, but particularly among lower-income borrowers, where it declined from 26 to 10 percent. Over the same period, prime market share increased from 65 to 72 percent and subprime market share increased from 1 to 15 percent. The decline in FHA’s market share was associated with a number of factors and has been accompanied by higher ultimate costs for certain conventional borrowers. FHA’s lack of process improvements and product restrictions relative to the conventional market provided conditions that favored conventional over FHA-insured mortgages. According to mortgage industry officials that we interviewed, processing FHA-insured loans is more costly, time consuming, and labor intensive than processing conventional mortgages. FHA and mortgage industry officials with whom we spoke also cited FHA loan limits as a factor that contributed to the decline in FHA market share. In some areas of the country, particularly in parts of California and the Northeast, the loan limits were significantly lower than the median home price. Some mortgage industry officials also pointed to other product restrictions as a reason why FHA loans have been less competitive than conventional loans. For example, many borrowers do not or cannot make a down payment, and unlike FHA, in recent years members of the conventional mortgage market have been increasingly active in supporting low- and no-down-payment mortgages. During the 10-year period we examined, several developments occurred in the conventional market that contributed to FHA’s declining market share. I will discuss four of these developments. First, the conventional market offered products that increased consumer choices for borrowers, including those who may have previously chosen an FHA-insured loan. These products—interest-only loans, no- and low-documentation mortgages, piggyback loans, and hybrid adjustable rate mortgages (ARM)—became popular, especially during the subprime market’s rapid growth after 2001, because they featured flexible payment and interest options that increased initial affordability. In combination with historically low interest rates, these products made it easier for homebuyers to purchase homes in a period of strong house price appreciation. Second, advances in underwriting technology, particularly mortgage scoring and automated underwriting systems, allowed conventional mortgage providers to process loan applications more quickly and consistently than in the past and broaden their customer base. FHA implemented its own mortgage scoring tool, called the Technology Open to Approved Lenders (TOTAL) scorecard, in 2004. However, in prior work we found that the way FHA developed TOTAL may limit the scorecard’s effectiveness. To the extent that conventional mortgage providers were better able than FHA to use scoring tools to identify lower-risk borrowers in FHA’s traditional market segment, these borrowers may have migrated toward conventional products, contributing to the decline in FHA’s market share. Third, there was an increase in mortgage originations through third parties such as loan correspondents and mortgage brokers, particularly in the subprime market. This trend has been associated with the decline in FHA’s market share because the third-party originators primarily market non- FHA products. Finally, the growth in private mortgage securitization (the bundling of mortgage loans into bond-like securities that can be bought and sold on the secondary market), particularly for subprime loans, allowed lenders to sell loans from their portfolios, transferring credit risk to investors, and use the proceeds to make more loans. As a result of these developments and lower interest rates, more homebuyers—especially minority and lower-income families—were able to obtain conventional loans, but many of these loans had high ultimate costs. As previously discussed, much of the increase in mortgages to minorities and lower-income borrowers was due to the growth in subprime lending, and many of these loans offered lower initial costs through their interest-only features and low introductory interest rates. However, these mortgages became more costly as the interest rates on many of these loans reset to higher rates, typically 2 to 3 percentage points higher in a relatively short period.