During the 1980s, a decline in the production of affordable housing, coupled with an increase in the number of low-income households,reduced the availability of affordable housing for low-income households. Although the federal government wished to expand the availability of affordable housing, particularly multifamily housing, reductions in federal spending precluded increases in housing subsidies—the federal government’s primary means of making rental housing affordable to low-income households. In addition, federal credit enhancements, such as mortgage insurance or reinsurance, came under increased public scrutiny after the federal government lost nearly $2.4 billion by 1992 from defaults on multifamily mortgage loans insured through its former coinsurance program—a program delegating federal loan-processing and asset management functions to approved lenders that HUD implemented in 1983 to meet the market’s demands for multifamily mortgage insurance. To stimulate the production of affordable multifamily housing and to gain the administrative efficiencies but avoid the risks of the coinsurance program, the Congress, in the Housing and Community Development Act of 1992, authorized two new risk-sharing demonstration programs. These programs (1) provide credit enhancements to encourage the financing of affordable multifamily housing and (2) divide the financial liability for any default between the federal government and the financial institutions and agencies selected to become its risk-sharing partners. This report responds to a requirement in the 1992 legislation that we review these two risk-sharing demonstration programs as well as identify any opportunities for improvement. More specifically, the report looks at how well the programs are meeting their goals, identifies their benefits for participating financial institutions and the Department of Housing and Urban Development (HUD), and considers opportunities for improving the programs and HUD’s administration of them. In establishing the risk-sharing demonstration programs, the Congress recognized that the production of multifamily housing had been declining steadily since the mid-1980s. According to Senate Report 102-332 and studies of the multifamily mortgage markets conducted in the early 1990s, several key factors were responsible for this decline. Among the more important were (1) changes in government policies and regulations on taxation, banking, and housing subsidies; (2) a sharp decline in multifamily mortgage credit enhancement by the Federal Housing Administration (FHA); and (3) the withdrawal from the multifamily secondary market by Freddie Mac (formerly the Federal Home Loan Mortgage Corporation). As we reported in 1993, more households were seeking affordable multifamily housing at the same time as the production of such housing declined. Studies issued since 1993 have identified the types of multifamily properties that are needed and the areas where multifamily housing is needed. According to a 1995 HUD analysis, unmet capital needs include smaller properties, larger rehabilitation projects, and housing for the elderly. Affordable new construction is also needed in high-growth markets. Inner-city neighborhoods and rural areas are commonly identified as “underserved housing markets” that often require smaller properties, both subsidized and unsubsidized. However, because these smaller properties have proportionally high transaction costs and low fees, they are less attractive to lenders than larger properties when interest rates are equivalent. The complexity often associated with the multiple subsidies needed to finance affordable housing also acts as a deterrent. According to HUD’s 1995 analysis, the secondary market has generally not been active in purchasing rehabilitation loans. Such loans are needed in inner-city neighborhoods to preserve low-cost housing units, stabilize neighborhoods, and improve housing conditions for low-income residents. The study concludes that without rehabilitation loans, many properties in inner-city neighborhoods will be demolished or abandoned. Governments have several tools, apart from public housing, that they can use to make multifamily housing more affordable—(1) rental subsidies to make up the shortfall between the rents that tenants can afford and the rents that landlords must charge to cover their costs and earn a profit, (2) grants and favorable tax treatment to lower the costs of building or operating housing, and (3) credit enhancements, such as mortgage insurance, to facilitate the financing of affordable housing. While subsidies are the government’s primary means of making multifamily housing affordable for low-income households, credit enhancements can complement subsidies by increasing the financing available for such housing. Credit enhancements transfer some of the risk of loss from the lender to the credit enhancer, making loans more secure and encouraging both mortgage lending and investment in mortgage loans. Specifically, credit enhancements encourage primary lenders, such as commercial banks, to make long-term, fixed-rate mortgage loans that they otherwise might not make, and investors, such as pension funds, to buy these loans in the secondary market. The sale of individual loans, or of securities backed by pools of loans, returns funds to primary lenders, creating liquidity and allowing the lenders to make additional loans or otherwise reinvest the funds. Credit enhancement can occur when a loan is originated or when it is sold in the secondary market. If it occurs at the time of origination, such as when a housing finance agency sells bonds to raise capital to lend to developers of affordable multifamily housing, it can affect the terms of the loan. Because the enhancement provides additional support—usually through mortgage insurance—it improves the housing finance agency’s bond rating. The housing finance agency can then obtain a lower interest rate and/or a longer-term loan, the benefits of which it can pass along to the affordable multifamily housing developer. In turn, the developer can convey these benefits to tenants in the form of lower monthly rents. If the credit enhancement occurs when the loan is sold in the secondary market, it transfers the credit risk from the investor purchasing the loan to the credit enhancer. At the same time as this transfer reduces the purchaser’s credit risk, it reduces the seller’s reserve requirements, freeing capital for further investment. The credit enhancement that occurs when a loan is sold in the secondary market is called reinsurance. Under the traditional mortgage insurance programs, FHA is involved in all aspects of lending—loan underwriting, loan servicing, asset management, and property disposition. These tasks are time consuming and resource intensive. As a result, FHA has traditionally been slow to approve loans through these programs, and it incurs substantial staff costs. In 1983, FHA implemented the coinsurance program to expedite loan processing and gain administrative efficiencies by delegating many of its mortgage underwriting, processing, monitoring, and foreclosure functions to approved lenders. The coinsurance program achieved these objectives, but it also resulted in substantial losses to the federal government. Even though the lenders assumed a portion of the credit risk for the loans they approved, this portion was not supported by sufficient reserves to ensure sound underwriting. In addition, the program’s fee structure created incentives for the lenders to focus on the volume rather than the quality of the loans they made. Furthermore, the lenders’ losses were insured by the Government National Mortgage Administration (Ginnie Mae), a government-sponsored enterprise. Thus, when defaults occurred and the lenders’ reserves were not adequate to cover them, Ginnie Mae paid the remaining balance and the federal government was ultimately responsible for the losses. Like the coinsurance program, the risk-sharing demonstration programs are designed to expedite loan processing and gain administrative efficiencies by delegating many of FHA’s traditional loan-processing and asset management responsibilities to other entities. The demonstration programs also resemble the coinsurance program in that they are designed to share the risk of loss from default. However, the demonstration programs differ from the coinsurance program in important ways, reflecting lessons learned about flaws in the design of the coinsurance program. First, the demonstration programs establish higher standards for participation than the coinsurance program. Entry into the demonstration programs is limited to qualified financial institutions, such as government-sponsored enterprises and state and local housing finance agencies with strong track records in multifamily lending. The housing finance agencies must meet standards of financial soundness and capable management established by a nationally recognized credit rating agency or have a dedicated reserve account with sufficient capital to meet the agency’s outstanding obligations under the programs. The participating institutions are either publicly chartered or are regulated by a state or federal agency. In addition, their mission, like FHA’s, includes supporting affordable housing. Thus, they are held accountable to public entities other than FHA for ensuring that they have the financial capacity and integrity to implement the risk-sharing programs. In contrast, FHA’s partners in the coinsurance program were mortgage bankers unaccountable to a third party. Second, the risk-sharing partners generally bear a larger share of the risk under the demonstration programs than under the coinsurance program. In most instances, the risk is divided equally under the demonstration programs, whereas, under the coinsurance program, the lenders assumed the first 5 percent of the losses on loans and shared any remaining losses with FHA on a 15-percent/85-percent basis. The more equal division of risk for most loans currently insured under the demonstration programs creates stronger incentives for FHA’s risk-sharing partners to use sound underwriting terms and service their loans diligently. Third, the demonstration programs provide for FHA’s oversight of compliance with their requirements for maintaining a high credit rating or sufficient reserves. While the coinsurance program established reserve requirements for lenders, these requirements were not adequate, and neither FHA nor any other HUD authority monitored the lenders’ reserves. Fourth, the demonstration programs explicitly preclude the use of Ginnie Mae’s insurance with risk-sharing loans. Section 542 of the Housing and Community Development Act of 1992 directs HUD, through FHA, to test the use of risk sharing as a means of providing federal credit enhancements for multifamily loans. Through two demonstration programs, HUD is to evaluate the effectiveness and efficiency of entering into partnerships or other contractual arrangements, including risk-sharing agreements, with qualified financial institutions (subsection b) and with state and local housing finance agencies (subsection c).