When considering the risk of mortgages, a substantial amount of research  GAO reviewed indicates that the LTV ratio and the borrower’s credit score  are among the most important factors when estimating the risk level  associated with individual mortgages. Generally, mortgages with higher LTV ratios (smaller  down payments) and lower credit scores are riskier than mortgages with  lower LTV ratios and higher credit scores. Several Practices Mortgage Institutions Use in Designing and Implementing Low and No Down Payment Products Could Be Instructive for FHA in Managing Risk of a No Down Payment Product

According to representatives of mortgage institutions we interviewed, they  use a number of similar practices in designing and implementing new  products. Some of these practices could be  helpful to FHA in its design and implementation of a zero down payment  product, as well as other new products. Although  FHA has less flexibility in imposing additional credit enhancements it does  have the authority to seek co-insurance, which it is not currently using. FHA makes adjustments to underwriting criteria and to its premiums, but  told us that it is unlikely to use a credit score threshold for a new zero  down payment product. FHA  officials with whom we spoke question the circumstances in which they  can limit the availability of a program and told us they do not have the  resources to manage programs with limited availability. Mortgage  institutions such as Fannie Mae and Freddie Mac mitigate the risk of low  and no down payment products by requiring additional credit  enhancements such as higher mortgage insurance coverage. For example, mortgage institutions such as Fannie Mae and Freddie Mac  sometimes introduce stricter underwriting standards as part of the  development of new low and no down payment products (or products  about which they do not fully understand the risks). Mortgage institutions  may also limit servicing on the loans to servicers with particular product  expertise, regardless of who originates the loans. The  administration’s proposal for a zero down product included increased  premiums to help compensate for an increase in the cost of the FHA  program which would permit FHA to potentially offset additional costs  stemming from a new product that entails greater risk or not well  understood risk. Yet, when FHA makes new products widely available or  makes significant changes to existing products with less-understood risks,  these products or actions also can introduce significant risks.
Why GAO Did This Study

To assist Congress in considering legislation to authorize the Secretary of the Department of Housing and Urban Development (HUD) to carry out a pilot program to insure zero down payment mortgages, this testimony provides information about practices mortgage institutions use in designing and implementing low and no down payment products. It also contains information about how these practices could be instructive for FHA in managing risks associated with a zero down payment product--a product for which the risks are not well understood. This testimony is primarily based on GAO's February 2005 report, Mortgage Financing: Actions Needed to Help FHA Manage Risks from New Mortgage Loan Products, (GAO-05-194).

What GAO Found

In recent years, many mortgage institutions have become increasingly active in supporting low and even no down payment mortgage products. In considering the risks of these new products, a substantial amount of research GAO reviewed indicates that loan-to-value (LTV) ratio and credit score are among the most important factors when estimating the risk level associated with individual mortgages. GAO's analysis of the performance of low and no down payment mortgages supported by FHA and others corroborates key findings in the literature. Generally, mortgages with higher LTV ratios (smaller down payments) and lower credit scores are riskier than mortgages with lower LTV ratios and higher credit scores. Some practices of other mortgage institutions offer a framework that could help FHA manage the risks associated with introducing new products or making significant changes to existing products. Mortgage institutions sometimes require additional credit enhancements, such as higher insurance coverage, and stricter underwriting, such as credit score thresholds, when introducing a new low or no down payment product. FHA is authorized to require an additional credit enhancement, but does not currently use this authority. FHA has used stricter underwriting criteria, but told us it is unlikely they would use a credit score threshold for a new zero down payment product. Mortgage institutions may also impose limits on the volume of the new products they will permit and on who can sell and service these products. FHA officials question the circumstances in which they can limit volumes for their products and believe they do not have sufficient resources to manage a product with limited volumes, but the potential costs of making widely available a product with risk that is not well understood could exceed the cost of initially implementing such a product on a limited basis.