Congress established FHA in 1934 under the National Housing Act (P.L. 73- 479) to broaden homeownership, protect lending institutions, and stimulate employment in the building industry. FHA’s single-family programs insure private lenders against losses (up to almost 100 percent of the loan amount) from borrower defaults on mortgages that meet FHA criteria. In 2005, more than three-quarters of the loans that FHA insured went to first-time homebuyers, and about one-third of these loans went to minorities. From 2001 through 2005, FHA insured about 5 million mortgages with a total value of about $590 billion. However, FHA’s loan volume fell sharply over that period, and in 2005 FHA-insured loans accounted for about 5 percent of single-family home purchase mortgages, compared with about 19 percent in 2001. Additionally, default rates for FHA-insured mortgages have risen steeply over the past several years, a period during which home prices have generally appreciated rapidly. FHA determines the expected cost of its insurance program, known as the credit subsidy cost, by estimating the program’s future performance. Similar to other agencies, FHA is required to reestimate credit subsidy costs annually to reflect actual loan performance and expected changes in estimates of future loan performance. FHA has estimated negative credit subsidies for the Fund from 1992, when federal credit reform became effective, through 2007. However, FHA has estimated that, assuming no program changes, the loans it expects to insure in fiscal year 2008 would require a positive subsidy, meaning that the present value of estimated cash inflows would be less than the present value of estimated cash outflows. The economic value, or net worth, of the Fund that supports FHA’s insurance depends on the relative size of cash outflows and inflows over time. Cash flows out of the Fund for payments associated with claims on defaulted loans and refunds of up-front premiums on prepaid mortgages. To cover these outflows, FHA receives cash inflows from borrowers’ insurance premiums and net proceeds from recoveries on defaulted loans. An independent contractor’s actuarial review of the Fund for fiscal year 2006 estimated that the Fund’s capital ratio—the economic value divided by the insurance-in-force—is 6.82 percent, well above the mandated 2 percent minimum. If the Fund were to be exhausted, the U.S. Treasury would have to cover lenders’ claims directly. Two major trends in the conventional mortgage market have significantly affected FHA. First, in recent years, members of the conventional mortgage market (such as private mortgage insurers, Fannie Mae, and Freddie Mac) increasingly have been active in supporting low- and even no-down-payment mortgages, increasing consumer choices for borrowers who may have previously chosen an FHA-insured loan. Second, to help assess the default risk of borrowers, particularly those with high loan-to- value ratios (loan amount divided by sales price or appraised value), the mortgage industry has increasingly used mortgage scoring and automated underwriting systems. Mortgage scoring is a technology-based tool that relies on the statistical analysis of millions of previously originated mortgage loans to determine how key attributes such as the borrower’s credit history, property characteristics, and terms of the mortgage affect future loan performance. As a result of such tools, the mortgage industry is able to process loan applications more quickly and consistently than in the past. In 2004, FHA implemented a mortgage scoring tool, called the FHA Technology Open to Approved Lenders (TOTAL) Scorecard, to be used in conjunction with existing automated underwriting systems. Partly in response to changes in the mortgage market, HUD has proposed legislation intended to modernize FHA. Provisions in the proposal would authorize FHA to change the way it sets insurance premiums and reduce down-payment requirements. 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. Currently, FHA also requires homebuyers to make a 3 percent contribution toward the purchase of the property. HUD’s proposal would eliminate this contribution requirement and enable FHA to offer some borrowers a no- down-payment product. In our November 2005 report examining FHA’s actions to manage the new risks associated with the growing proportion of loans with down-payment assistance, we found that the agency did not implement sufficient standards and controls to manage the risks posed by these loans. Unlike other mortgage industry participants, FHA does not restrict homebuyers’ use of down-payment assistance from nonprofit organizations that receive part of their funding from home sellers. According to FHA, high claim and loss rates for loans with this type of down-payment assistance were major reasons for changing the estimated credit subsidy rate from negative to positive for fiscal year 2008 (in the absence of any program changes). Furthermore, incorporating the impact of such loans into the actuarial study of the Fund for fiscal year 2005 resulted in almost a $2 billion (7 percent) decrease in the Fund’s estimated economic value. Homebuyers who receive FHA-insured mortgages often have limited funds and, to meet the 3 percent borrower investment FHA currently requires, may obtain down-payment assistance from a third party, such as a relative or a charitable organization (nonprofit) that is funded by the property sellers. The proportion of FHA-insured loans that are financed in part by down-payment assistance from various sources has increased substantially in the last few years, while the overall number of loans that FHA insures has fallen dramatically. Money from nonprofits funded by seller contributions has accounted for a growing percentage of that assistance. From 2000 to 2004, the total proportion of FHA-insured purchase loans that had a loan-to-value ratio greater than 95 percent and that also involved down-payment assistance, from any source, grew from 35 percent to nearly 50 percent. Approximately 6 percent of FHA-insured purchase loans in 2000 received down-payment assistance from nonprofits (the large majority of which were funded by property sellers), but by 2004 nonprofit assistance grew to about 30 percent. The corresponding percentages for 2005 and 2006 were about the same. We and others have found that loans with down-payment assistance do not perform as well as loans without down-payment assistance. We analyzed loan performance by source of down-payment assistance, using two samples of FHA-insured purchase loans from 2000, 2001, and 2002—a national sample and a sample from three metropolitan statistical areas (MSA) with high rates of down-payment assistance. Holding other variables constant, our analysis indicated that FHA-insured loans with down-payment assistance had higher delinquency and claim rates than similar loans without such assistance. For example, we found that the probability that loans with nonseller-funded sources of down-payment assistance (e.g., gifts from relatives) would result in insurance claims was 49 percent higher in the national sample and 45 percent higher in the MSA sample than it was for comparable loans without assistance. Similarly, the probability that loans with nonprofit seller-funded down-payment assistance would result in insurance claims was 76 percent higher in the national sample and 166 percent higher in the MSA sample than it was for comparable loans without assistance. This difference in performance may be explained, in part, by the higher sales prices of comparable homes bought with seller-funded down-payment assistance. Our analysis indicated that FHA-insured homes bought with seller-funded nonprofit assistance were appraised and sold for about 2 to 3 percent more than comparable homes bought without such assistance. The difference in performance also may be partially explained by the homebuyer having less equity in the transaction. FHA has implemented some standards and internal controls to manage the risks associated with loans with down-payment assistance, but stricter standards and additional controls could help FHA better manage the financial risks posed by these loans while meeting its mission of expanding homeownership opportunities. Like other mortgage industry participants, FHA generally applies the same underwriting standards to loans with down-payment assistance that it applies to loans without such assistance. One important exception is that FHA, unlike others, does not limit the use of down-payment assistance from seller-funded nonprofits. Some mortgage industry participants view assistance from seller-funded nonprofits as a seller inducement to the sale and, therefore, either restrict or prohibit its use. FHA has not treated such assistance as a seller inducement and, therefore, does not subject this assistance to the limits it otherwise places on contributions from sellers. Concerns about loans with nonprofit seller-funded down-payment assistance have prompted FHA and IRS to initiate steps that could curb their use. For example, FHA has begun drafting a proposed rule that, as described by FHA, would appear to prohibit down-payment assistance from seller-funded nonprofits. FHA’s legislative proposal could also eliminate the need for such assistance by allowing some FHA borrowers to make no down payments for an FHA-insured loan. Finally, in May 2006, IRS issued a ruling stating that organizations that provide seller-funded down-payment assistance to home buyers do not qualify as tax-exempt charities. FHA permitted these organizations to provide down-payment assistance because they qualified as charities. Accordingly, the ruling could significantly reduce the number of FHA-insured loans with seller- funded down payments. However, FHA officials told us that as of March 2007, they were not aware of IRS rescinding the charitable status of any of these organizations. Our report made several recommendations designed to better manage the risks of loans with down-payment assistance generally, and more specifically from seller-funded nonprofits.