	Background

Congress established FHA in 1934 under the National Housing Act (P.L. FHA determines the expected cost of its insurance program, known as the  credit subsidy cost, by estimating the program’s future performance. 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. Two major trends in the conventional mortgage market have significantly  affected FHA. FHA Has Not Implemented Sufficient Standards and Controls to Manage Financial Risks of Loans with Down-Payment Assistance

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. 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). 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. 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. Practices That Other Mortgage Institutions Use Could Help FHA Manage Risks from Low- or No-Down- Payment Products

If Congress authorized FHA to insure mortgages with smaller or no down  payments, practices that other mortgage institutions use could help FHA  to design and manage the financial risks of these new products. In a  February 2005 report, we identified steps that mortgage institutions take  when introducing new products. Although FHA  is required to provide up to 100 percent coverage of the loans it insures,  FHA may engage in co-insurance of its single-family loans. Mortgage institutions also can mitigate the risk of low- and no-down- payment products through stricter underwriting. FHA has utilized pilots or demonstrations when making changes  to its single-family mortgage insurance but generally has done so in  response to legislative requirement rather than on its own initiative. The Way FHA Developed TOTAL Limits the Scorecard’s Effectiveness in Assessing the Default Risk of Borrowers

A primary tool that FHA uses to assess the default risk of borrowers who  apply for FHA-insured mortgages is its TOTAL scorecard. Accordingly, the greater the effectiveness of TOTAL, the greater the  likelihood that FHA will be able to effectively manage the risks posed by  borrowers and operate in a financially sound manner. In the past 12 years, significant changes—growth in the use of  down-payment assistance, for example—have occurred in the mortgage  market that have affected the characteristics of those applying for FHA- insured loans. In response, FHA  has developed and begun putting in place policies and procedures that call  for annual (1) monitoring of the scorecard’s ability to predict loan default,  (2) testing of additional predictive variables to include in the scorecard,  and (3) updating the scorecard with recent loan performance data. Our ongoing work indicates that FHA plans to use borrowers’  TOTAL scores to help set insurance premiums. For example, the current reestimated  cost for the fiscal year 2006 cohort is about $800 million less favorable  than originally estimated. Competition from conventional mortgage providers could have resulted in  FHA insuring more risky borrowers. To more reliably estimate program costs, we recommended that FHA  study and report on how variables found to influence credit risk, such as  payment-to-income ratios, credit scores, and down-payment assistance  would affect the forecasting ability of its loan performance models.
Why GAO Did This Study

The Federal Housing Administration (FHA) has seen increased competition from conventional mortgage and insurance providers. Additionally, because of the worsening performance of the mortgages it insures, FHA has estimated that its single-family insurance program would require a subsidy--that is, appropriations--in fiscal year 2008 in the absence of program changes. To help FHA adapt to the evolving market, proposed changes to the National Housing Act would allow greater flexibility in setting insurance premiums and reduce down-payment requirements. To assist Congress in considering the financial challenges facing FHA, this testimony provides information from recent reports GAO has issued and ongoing work concerning the proposed legislation that address different aspects of FHA's risk management. Specifically, this testimony looks at (1) FHA's management of risk related to loans with down-payment assistance, (2) instructive practices for managing risks of new products, (3) FHA's development and use of its mortgage scorecard, and (4) FHA's estimation of program costs.

What GAO Found

Recent trends in mortgage lending have significantly affected FHA, including growth in the proportion of FHA-insured loans with down-payment assistance, wider availability of low- and no-down-payment products, and increased use of automated tools (e.g., mortgage scoring) to underwrite loans. Although FHA has taken steps to improve its risk management, in a series of recent reports, GAO identified a number of weaknesses in FHA's ability to estimate and manage risk that may affect its financial performance. For example, FHA has not developed sufficient standards and controls to manage risks associated with the substantial proportion of loans with down-payment assistance, including assistance from nonprofit organizations funded by home sellers. According to FHA, high claim and loss rates for loans with such assistance were major reasons for the estimated positive subsidy cost (meaning that the present value of estimated cash inflows would be less than the present value of estimated cash outflows) for fiscal year 2008, absent any program changes. FHA has not consistently implemented practices--such as stricter underwriting or piloting--used by other mortgage institutions to help manage the risks associated with new product offerings. Although FHA has indicated that it would impose stricter underwriting standards for a no-down-payment mortgage if the legislative changes were enacted, it does not plan to pilot the product. The way that FHA developed its mortgage scorecard, while generally reasonable, limits how effectively it assesses the default risk of borrowers. With increased competition from conventional mortgage providers, limitations in its scorecard could cause FHA to insure mortgages that are relatively more risky. FHA's reestimates of the costs of its single-family mortgage program have generally been less favorable than originally estimated. Increases in the expected level of claims were a major cause of a particularly large reestimate that FHA submitted as of the end of fiscal year 2003. GAO made several recommendations in its recent reports, including that FHA (1) incorporate the risks posed by down-payment assistance into its scorecard, (2) study and report on the impact of variables not in its loan performance models that have been found to influence credit risk, and (3) consider piloting new products. FHA has taken actions in response to GAO's recommendations, but continued focus on risk management will be necessary for FHA to operate in a financially sound manner in the face of market and program changes.