	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. Two major trends in the conventional mortgage market have significantly  affected FHA. The proposal, among  other things, would authorize FHA to change the way it sets insurance  premiums, insure larger loans, and reduce down-payment requirements. The Way FHA Developed and Uses TOTAL Limits the Scorecard’s Effectiveness in Assessing the Default Risk of Borrowers

If Congress authorizes the reforms HUD has proposed, FHA’s ability to  assess the default risk of borrowers will take on increased importance  because FHA would be adjusting insurance premiums based on its  assessments of the credit risk of borrowers and insure potentially larger  and riskier mortgages with low or no down payments. To improve how FHA benefits from TOTAL, we recommended that the  agency explore additional uses for the scorecard, including using it to  implement risk-based pricing of mortgage insurance and to develop new  products. However, as we reported in September  2005, with the exception of the 1992 reestimate, FHA’s subsidy reestimates  have been less favorable than the original estimates. In particular, FHA’s  $7 billion reestimate for fiscal year 2003 was more than twice the size of  any other reestimate from fiscal years 2000 through 2004. 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. FHA Has Not Implemented Sufficient Standards and Controls to Manage Risks Associated with the Growing Proportion of Loans with Down- Payment Assistance

HUD’s legislative proposal would represent a significant change to the  agency’s single-family mortgage insurance program and presents new risk  management challenges. Stricter Standards and Additional Controls Could Help FHA Manage the Risks Posed by Loans with Down-Payment Assistance

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 risks  posed by these loans while meeting its mission of expanding  homeownership opportunities. Observations

The risks FHA faces in today’s mortgage market are growing. For example,  the agency has seen increased competition from conventional mortgage  and insurance providers, many of which offer low- and no-down-payment  products and that may be better able than FHA to identify and approve  relatively low-risk borrowers. Additionally, FHA is insuring a greater  proportion of loans with down-payment assistance. To effectively manage the risks posed by FHA’s existing products, we have  concluded from our prior work that the agency must significantly improve  its risk management and cost estimation practices. However, FHA needs to take additional  steps, such as establishing policies and procedures for updating TOTAL  scorecard on a regular basis, more fully considering the risks posed by  down-payment assistance when underwriting loans, developing a  framework for introducing new products in a way that mitigates risk, and  studying and reporting on the impact of variables found to influence credit  risk that are not currently in the agency’s loan performance models.
Why GAO Did This Study

The Department of Housing and Urban Development's (HUD) Federal Housing Administration (FHA) has faced several challenges in recent years, including rising default rates, higher-than-expected program costs, and a sharp decline in program participation. To help FHA adapt to market changes, HUD has proposed a number of changes to the National Housing Act that would raise FHA's mortgage limits, allow greater flexibility in setting insurance premiums, and reduce down-payment requirements. Implementing the proposed reforms would require FHA to manage new risks and estimate the costs of program changes. To assist Congress in considering issues faced by FHA, this testimony provides information from recent reports GAO has issued that address FHA's risk management and cost estimates. Specifically, this testimony looks at (1) FHA's development and use of its mortgage scorecard, (2) FHA's consistent underestimation of program costs, (3) instructive practices for managing risks of new mortgage products, and (4) weaknesses in FHA's management of risks related to loans with down-payment assistance.

What GAO Found

Recent trends in mortgage lending have significantly affected FHA, including increased use of automated tools (e.g., mortgage scoring) to underwrite loans, increased competition from lenders offering low-and no-down-payment products, and a growing proportion of FHA-insured loans with down-payment assistance. 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 manage risk and estimate program costs during this period of change. The way that FHA developed and uses its mortgage scorecard, while generally reasonable, limits how effectively it assesses the default risk of borrowers. With one exception, FHA's reestimates of program costs have been less favorable than originally estimated, including a $7 billion reestimate for fiscal year 2003. FHA has not consistently implemented practices used by other mortgage institutions to help manage the risks associated with new mortgage products. FHA has not developed sufficient standards and controls to manage risks associated with insuring a growing proportion of loans with down-payment assistance. GAO made several recommendations in its recent reports, including that FHA (1) incorporate the risks posed by down-payment assistance into its mortgage 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 mortgage products. FHA has taken actions in response to GAO's recommendations, but additional improvements in managing risk and estimating program costs will be important if FHA is to successfully implement its proposed program changes.