In 1968, the Congress added Section 242 to the National Housing Act establishing the Hospital Mortgage Insurance Program. In considering this amendment to the National Housing Act, the House Committee on Banking and Currency cited a serious shortage of hospitals and the need for existing hospitals to expand and renovate. Private lenders seemed reluctant to provide capital financing at reasonable terms. The purpose of the program is to “assist the provision of urgently needed hospitals for the care and treatment of persons who are acutely ill . . ..” Consequently, Section 242 authorized HUD to provide insurance for hospital mortgages secured from lenders to finance the construction and renovation of hospitals. Many hospitals need to borrow money from lenders to finance construction and renovation projects. Lenders often raise capital by selling bonds to investors and use the hospitals’ mortgage payments to pay bondholders. Mortgage insurance, like private bond insurance, guarantees that bondholders will be paid if the hospital stops making payments on its loan. According to the Health Care Financing Study Group, about 60 percent of hospitals that seek financing require insurance to enhance their credit because they cannot get a loan on their own financial strength. Eighty-three percent of these hospitals can get private bond insurance but about 17 percent cannot because private insurers consider them too risky. Some hospitals that cannot get private mortgage insurance apply to FHA’s hospital insurance program. FHA’s Hospital Mortgage Insurance Program staff and HHS’ Division of Facilities Loans staff jointly manage the hospital program. The Congress gave HUD statutory responsibility for the program. The House Committee on Banking and Currency, in recommending that HUD be given this responsibility, cited FHA’s more than 35 years of experience with promoting housing construction through its housing insurance programs. The Committee was concerned, however, that HUD’s staff did not have specialized knowledge of health care needed to administer this program. As a result, the Committee recommended and the Congress enacted the requirement that a state agency must certify that a hospital is needed before it can participate in the program. Also, the Committee expected HUD to draw upon HHS’ hospital expertise to devise standards for insuring hospitals’ mortgages. Through a memorandum of agreement, HUD formally delegated authority to HHS to review and approve proposals for hospitals’ mortgage insurance. HUD retained authority to make the final insurance commitment and endorse the mortgage note. The Hospital Mortgage Insurance Program requires hospitals to have the state certify the need for the proposed projects and then meet underwriting criteria before insurance applications can be approved. Since 1988, hospitals have obtained FHA insurance approval to construct acute care facilities, ambulatory care centers, and operating rooms and to renovate maternity and emergency departments and surgical suites. In addition, hospitals have obtained approval to purchase equipment, install new computer and fire alarm systems, and build parking facilities. The use of hospital inpatient services, however, has declined over time. Current trends indicate a greater focus on cost containment and delivering health care on an outpatient basis. Overall, the financial performance of the hospital program has reflected a net positive cash flow from operations over the past 25 years, according to HUD data. However, in several years, the program has experienced financial losses. The bulk of the losses occurred between 1989 and 1991, when HUD had to pay lenders about $147 million because of hospital defaults. The current composition of the program’s portfolio with the concentration of insured loans in New York, changes in state policies, trends in the health care market, and the probability of future changes in federal health care policies pose risks that may threaten the future stability of the program. Two reasons given in a 1992 HUD study for why some hospitals defaulted on their loans were changes in the policies and practices of state and local governments and changes in Medicare and Medicaid reimbursement. The hospital program has made a positive net contribution of $221 million to HUD’s General Insurance Fund, even though there have been years with negative cash flows (see fig. 1). Information obtained from FHA shows that from fiscal year 1969 through 1994, FHA collected $370 million in premiums and fees and paid $200 million in insurance claims and $13 million in salaries and other administrative expenses. FHA recovered about $64 million of claim payments from mortgage payments and the sale of the mortgages or properties. As of September 30, 1994, 19 hospitals had defaulted; FHA disposed of 10 and retained loan management responsibility for the remaining 9 hospitals. For these 9 hospitals, the total unpaid principal balance is $108 million and accrued delinquent interest is $44 million. (See app. I for a description of the hospital program’s financial performance from fiscal year 1969 through 1994.) As of August 1995, the hospital program portfolio was comprised of 100 projects in 18 states and Puerto Rico (see fig. 2). The portfolio has an aggregate unpaid principal balance of about $5 billion. (See app. II for individual unpaid principal balances of FHA-insured hospital projects, by state.) (Figure notes on next page) The majority of the hospital program projects, 63 percent, are in New York. The unpaid principal balance on mortgages for these projects is about $4.2 billion or 87 percent of the portfolio’s aggregate unpaid principal balance. Also, 9 of the 10 largest hospital mortgages are in New York. These mortgages account for about $2.4 billion or 50 percent of the portfolio’s total unpaid principal balance. Included in these mortgages is a $591 million loan, the largest single loan amount FHA has insured in the history of the program. Since 1988, 17 of the 20 projects that FHA insured have been for New York hospitals. In addition, as of August 1995, 6 of the 10 mortgage insurance applications under review by HHS and FHA were for projects in New York. The hospital program has become a major financing vehicle for many New York hospitals. Several officials stated that New York hospitals rely on FHA mortgage insurance, in part, because the state’s reimbursement system hinders hospitals’ ability to access capital in the private market. “New York’s restrictive reimbursement system makes it the most regulated nationwide,” according to a Moody’s Investors Service report. Except for Medicare, New York utilizes an all-payer fixed rate system to reimburse hospitals. The state controls all third-party payers’ rates of payments by setting a fixed payment for each hospital based on patient diagnoses. The rate-setting system is a regulatory method of budgeting for hospitals. The goals of the rate-setting system are cost containment and access to hospital care. However, New York state officials said that this system constrains hospitals’ profitability, which weakens their creditworthiness. According to a Moody’s Investors Service report, New York hospitals’ credit ratings are the weakest in the nation. In other states, hospitals’ credit ratings are generally stronger, which enables many of them to access capital in the private market. These hospitals primarily rely on bond financing backed by their revenues and projected ability to make loan payments or by commercial bond insurance instead of FHA’s Hospital Mortgage Insurance Program. In contrast, private insurers are reluctant to back bond sales to finance some New York hospital projects because the hospitals are considered too risky. The lack of portfolio geographic diversification and the large individual unpaid loan balances in New York pose a risk to the program. The concentration of the portfolio in New York makes the program susceptible to New York policies and other factors specific to the state. The strength of a portfolio lies in its diversity because portfolio diversification decreases the risk from losses. In addition, a single default of a large loan could lead to insurance claims that could significantly burden the program. A 1992 HUD report stated that the concentration of FHA-insured projects in a single state and large loan amounts are major controllable risks to the program that should be avoided or minimized. FHA does not limit the number of projects in a particular state nor does it cap individual loan amounts it insures as a means of controlling risks to the program. The legislation authorizes the Secretary of HUD to set the terms and conditions under which HUD will insure projects, but the law does not specifically authorize FHA to limit the number of projects accepted into the program from a geographic area or to limit the loan amounts it insures. In fact, in 1974, the Congress removed existing caps on loan amounts. FHA officials stated that they are taking action to diversify the portfolio by marketing the program to attract hospitals from other states. For example, FHA officials reported working with mortgage bankers to increase program awareness to hospitals outside New York. They reported that, as of August 1995, they had received four applications from hospitals in Illinois, New Jersey, Pennsylvania, and Puerto Rico. By expanding the portfolio, FHA also increases the program’s total outstanding mortgage amount. Officials involved in the financing of hospital projects told us that hospitals in other states may not be interested in the FHA program for several reasons, including the program’s high premiums, lengthy application process, and a lack of program awareness. For some future hospital projects, FHA is considering ways to reduce the risk of financial losses. For example, FHA is considering a proposal to establish risk-sharing arrangements with the public and private sector. According to FHA officials, the risk-sharing partner would assume underwriting responsibilities, have an equity position in the hospital, and share in any losses that result from defaults. In an October 1993 report, we noted that HUD terminated FHA’s multifamily housing coinsurance program in January 1990. The program enabled FHA to share the risk of insuring a multifamily mortgage with participating lenders. However, problems with the program resulted from deficient conceptual design and failures in administration. Changes in state health care policies that reduce hospitals’ revenues can negatively affect the financial stability of hospitals, particularly the financially weaker hospitals in FHA’s hospital program. Recent changes in New York’s Medicaid policy would reduce hospitals’ patient revenues and could increase program hospitals’ risk of default.