FHA was established in 1934 under the National Housing Act (P.L. 73-479). The primary purpose of FHA’s Fund is to insure private lenders against losses on mortgages that finance purchases of one to four housing units. There are two primary sources and three uses of cash for the Fund. The two sources of cash are income from mortgagees’ premiums and net proceeds from the sale of foreclosed properties. The three uses of cash are (1) payments associated with claims on foreclosed properties, (2) refunds of premiums on mortgages that are prepaid, and (3) administrative expenses for management of the program. To cover losses, FHA deposits insurance premiums from participating borrowers in the Fund. According to 12 U.S.C. 1711, the Fund must meet or endeavor to meet statutory capital ratio requirements; that is, it must contain sufficient reserves and funding to cover estimated future losses resulting from the payment of claims on defaulted mortgages and administrative costs. A determination of reserves and funding to cover estimated future losses requires the use of an accrual basis of accounting. The accrual concept is particularly important for an entity such as FHA (or any insurance enterprise) because the actual payout or collection of cash may precede or follow the event that gave rise to the cash transaction by a substantial time period. Thus, a favorable cash position, or positive cash flow, at any given point may not reflect the true financial position of the entity. The Fund remained relatively healthy until the 1980s, when losses were substantial primarily because foreclosure rates were high in economically stressed regions, particularly in the Rocky Mountain and Southwest regions. For example, in fiscal year 1988, the Fund lost $1.4 billion. If the Fund were to be exhausted, the U.S. Treasury would have to directly cover lenders’ claims and administrative costs. Reforms designed to restore financial stability to the Fund and to correct problems in loan origination and property disposition were initiated by the Congress and HUD. The Omnibus Budget Reconciliation Act of 1990 (P.L. 101-508), enacted in November 1990, contained reforms to FHA’s single-family mortgage insurance program designed to place the Fund on a financially sound basis. The legislation, among other things, required FHA borrowers to pay more in insurance premiums over the life of the loans by adding a risk-based annual premium to the one-time, up-front premium. It effectively raised the present value of the insurance premium from 3.8 percent of the loan amount to from 5.5 to 6.8 percent, depending on the amount of the down payment made. It accomplished this change via two actions: lowering the up-front premium from 3.8 to 2.25 percent of the loan amount over a 4-year transitional period and, during the same period, phasing in a new annual premium of 0.5 percent of the loan balances. Those borrowers who make higher down payments pay the annual premium for a shorter period. Other changes made by the legislation in response to the Fund’s financial problems included (1) limiting the loan-to-value ratio to a maximum of 97.75 percent of the value of homes appraised at more than $50,000 and (2) effectively suspending the payment of distributive shares (distribution of excess revenues to mortgagors) until the Fund is financially sound. The legislation also required the Secretary of HUD to endeavor to ensure a capital ratio of 2 percent by November 2000 and maintain that ratio or a higher one at all times thereafter. The act defined the capital ratio as the ratio of the Fund’s capital, or economic net worth, to its unamortized insurance-in-force. We and HUD’s Inspector General have been reporting on FHA’s management problems since the early 1980s. We have concluded in previous testimonies and reports that in addition to economic factors, poor program management and waste, fraud, and abuse contributed to the losses sustained by FHA’s Fund. For example, FHA did not have accounting data and internal controls in place to reconcile funds from the sales of government-owned properties with deposits to the U.S. Treasury. As a result, private real estate agents were able to steal millions of dollars by simply retaining the proceeds from the sale of FHA-owned properties rather than transferring the funds to the Treasury. HUD’s efforts to improve the financial stability of the Fund have consisted of initiating several audits of the Fund; modifying the program, primarily to tighten controls and improve monitoring; and developing automated systems. For example, to reduce problems with loan origination, HUD tightened its screening of applicants, took steps to improve how it targets its efforts to monitor lenders, and strengthened appraisal requirements. To reduce problems with property disposition, HUD, among other things, tightened controls over closing agents and area management brokers and took actions to improve property pricing and automated accounting and management systems. Any success achieved by HUD and FHA in reducing FHA’s losses through better management will improve the Fund’s financial health. The Fund had amortized insurance-in-force valued at about $305 billion as of September 30, 1994. To estimate the economic net worth of, and resulting capital ratio for, these loans over their life of up to 30 years, we developed an economic model of FHA’s home loan program. We generated three different economic scenarios, assuming for each a different rate of appreciation in house prices over the next 30 years. The actual economic net worth and capital ratios of the Fund and the validity of our estimates will depend on a number of future economic factors, including the rate of appreciation in house prices over the life of the FHA mortgages of up to 30 years. This factor is significant because, as house prices rise, the borrowers’ equity increases and the probability of defaults and subsequent foreclosures decreases. The house price appreciation, interest, and unemployment rates that we used were based on forecasts from DRI/McGraw-Hill, a private economic forecasting company. Table 1 presents our estimates of the economic net worth and resulting capital ratios for the FHA mortgage loans outstanding as of September 30, 1994, under each of our three economic scenarios. Although future rates of appreciation in house prices are uncertain, to be conservative, we placed greater reliance on our mid-range baseline economic scenario because it assumes slightly lower house price appreciation rates (1 percent annually) than the rates forecasted by DRI/McGraw-Hill. Under this scenario, we estimate that the Fund had an economic net worth of about $6.1 billion and resulting capital ratio of 2.02 percent at the end of fiscal year 1994. This estimate represents an improvement of about $8.8 billion from the lowest level reached by the Fund—a negative $2.7 billion economic net worth estimated by Price Waterhouse at the end of fiscal year 1990. Under our low-case economic scenario, which assumes house price rates of appreciation of 2 percentage points lower than our baseline and a higher unemployment rate, we estimate that the Fund’s economic net worth would be $3 billion. Conversely, under our high-case economic scenario, which assumes house price rates of appreciation of 2 percentage points higher than our baseline, we estimated that the Fund’s economic net worth would be $7.4 billion. We estimate that the economic net worth of the Fund increased under our baseline scenario by about $1.2 billion during fiscal year 1994, from $4.9 billion at the end of fiscal year 1993 to $6.1 billion at the end of fiscal year 1994. This increase occurred even though large numbers of FHA borrowers continued to lower their interest rates during fiscal year 1994 by refinancing their mortgages conventionally, which resulted in partial refunds of their insurance premiums. A detailed discussion of factors contributing to the $1.2 billion growth in the Fund’s economic net worth during fiscal year 1994 appears in appendix I. We estimate that FHA’s Fund, with a capital reserve ratio of 2.02 percent of the amortized insurance-in-force, surpassed the November 2000 capital ratio target of 2 percent during fiscal year 1994. Therefore, the Fund has sufficient capital reserves to meet the capital ratio target. Whether the Fund will be able to maintain the capital ratio will depend on a number of factors that will prevail in the future. These factors include (1) economic conditions, (2) changes to the program that affect the financial condition of the Fund, (3) the performance of FHA’s streamlined refinanced loans, and (4) risks associated with the demand for FHA’s loans. We did not attempt to project the economic net worth and capital ratio of the Fund to fiscal year 2000 because these factors are likely to change. As shown in table 1, our estimates are sensitive to future economic conditions, particularly house price appreciation rates. The Fund will not perform as well if the economic conditions that prevail over the next 30 years replicate those we assumed in our low-case economic scenario. Our estimate of the Fund’s economic net worth for our low-case economic scenario is about $3 billion, or 49 percent, less than that of our baseline scenario. Under economic scenarios having generally favorable economic conditions but lower rates of appreciation in house prices, such as our low-case economic scenario, FHA’s Fund would likely experience higher claims. As a result, its economic net worth would decline. FHA’s support of single-family mortgages could be altered by changes to the program proposed by the administration and others. The administration’s proposals, which are part of its efforts to “reinvent government,” would recreate FHA as a wholly owned government corporation. As such, the single-family insurance operations of a new FHA would be, among other things, free to introduce new product lines, enter into risk-sharing arrangements with private and public entities, and operate under more flexible personnel and procurement practices.