As we have stated in the past, there is considerable uncertainty associated with any estimate of the economic value of the Fund because of uncertainty about the performance of FHA’s loan portfolio over the life of the existing loans, which, in some cases, can be for 30 years. We believe that our models make good use of historical experience in identifying the key factors that influence loan foreclosures and prepayments and estimating the relationships between those factors and loan performance. In addition, we have relied on reasonable, and in some cases conservative, forecasts of economic variables, such as the rate of house price appreciation and the unemployment rate, in finding that the Fund’s economic value in fiscal year 1999 appeared higher than necessary to withstand many adverse economic scenarios.

Nonetheless, several additional factors lead us to believe that Congress and others should apply caution in concluding that the estimated value of the Fund today implies that the Fund could withstand the economic scenarios that we examined under all circumstances. Our estimates and those of others are valid only under a certain set of conditions, including that loans FHA insured in recent years and loans it insured in the more distant past have a similar response to economic conditions, and that cash inflows associated with future loans at least offset cash outflows associated with those loans. Some specific factors beyond those incorporated in our models that could determine the extent to which the Fund will be able to withstand adverse economic conditions are as follows:

• The performance of recent loans—Over 40 percent of FHA’s loan portfolio at the end of fiscal year 1999 consisted of loans originated in fiscal years 1998 and 1999. As a result, the performance of these loans will have an important effect on the overall performance of FHA’s loan portfolio. However, because these loans are so new, we do not have a lot of data yet showing how well they will perform over their lifetimes, which is often 30 years. Our model is based on data on loan performance for loans originating from 1975 through 1999. As long as the influences of key predictive factors on the probabilities of foreclosure and prepayment have not changed much over time, then we can be reasonably confident that the estimates of these relationships generated by our models will apply to these recent loans. However, in recent years, FHA’s competitors in the conventional mortgage market—private mortgage insurers and conventional mortgage lenders—are increasingly offering to selected homebuyers products that compete with FHA’s for those homebuyers who are borrowing more than 95 percent of the value of their homes. By lowering the required down payment, conventional mortgage lenders and private mortgage insurers may have attracted some less risky borrowers who might otherwise have insured their mortgages with FHA. And this may have increased the average risk of FHA-insured loans in the late 1990s. However, because these loans are relatively new, the increased risk would not yet be observable in the data on foreclosures and prepayments. If this effect, known as adverse selection, has been substantial, the economic value of the Fund may be lower than we estimate, and it may be more difficult for the Fund to withstand worse-than-expected loan performance than our estimates suggest.

• Changes in FHA’s insurance program—A number of changes that FHA has made or might make in the future could affect the future cash flows associated with loans in FHA’s portfolio as of the end of fiscal year 1999 and, therefore, the Fund’s economic value, in ways that are not accounted for in our models. For example, if HUD reinstitutes paying distributive shares to borrowers when they pay their mortgages in full or voluntarily terminate their insurance, cash outflows might be higher than our estimates. FHA’s loss mitigation program might either reduce or increase cash outflows, depending on whether the program succeeds in reducing foreclosures or whether the program mainly results in delayed foreclosures that lead to larger losses for FHA in the long run. On the other hand, if FHA’s financial counseling program reduces foreclosures for those homebuyers who received such counseling, then losses to the Fund will be less than we have estimated. Steps taken by HUD to improve the oversight of lenders and the disposition of properties could also reduce the level of losses to FHA below what we have estimated.

• The impact of new loans—Our models do not look at cash flows associated with loans that FHA would insure after fiscal year 1999. Our analysis of the ability of the Fund to withstand adverse economic conditions requires making the assumption that the adverse conditions would not also cause loans insured by FHA after fiscal year 1999 to be an economic drain on the Fund. Since the 1990 FHA reforms, the cash flows associated with each year’s loans have been estimated to have a positive economic value, thereby adding to the economic value of the entire Fund. However, during adverse economic times, new loans might perform worse than loans that were insured by FHA during the 1990s. Furthermore, recent and future changes in FHA’s insurance program may cause these loans to perform differently from how past experience suggests that they will. If, for example, FHA loosens underwriting standards, future loans may perform worse than past experience suggests. In addition, the recent reduction in up-front premiums could reduce cash inflows into the Fund, although it could also lower the riskiness of the loans that FHA insures. If the newly insured loans perform so poorly that they have a negative economic value, then the loss to the Fund in any of the adverse economic scenarios that we have considered would be greater than what we have estimated. Alternatively, if the newly issued loans have positive economic values, then they would contribute to further growth of the Fund.

Caution also needs to be applied in making changes to FHA’s insurance program because of the current uncertainty about their impact on the Fund. In analyzing the impact of changes in FHA’s programs and policies on the Fund, it is important to recognize that such changes can affect the volume and riskiness of loans that FHA insures. Although the models currently used in the annual actuarial reviews of the Fund can be used to estimate the direct impact that some policy changes may have on the Fund’s economic value, these models cannot isolate indirect effects on the volume and riskiness of FHA's loans. Accordingly, in our report, we recommended that the Secretary of HUD develop better tools for assessing the impacts that these changes may have on the volume and riskiness of loans that it insures.

Given the recent growth in the economic value of the Fund, several proposals have been made to use what some are calling excess reserves or take other actions that could result in a change in the value of the Fund. If Congress or the Secretary of HUD believes that the economic value of the Fund is higher than the amount needed to ensure actuarial soundness, several changes to the FHA single-family loan program could be adopted. The impact that these actions might have on the capital ratio and FHA borrowers is difficult to assess without using tools designed to estimate the multiple impacts that policy changes often have. However, any actions that influence the Fund’s reserve levels will also affect the federal budget. In short, any proposal that seeks to use reserves, if not accompanied by a reduction in other spending or an increase in receipts, would result in either a reduction in the surplus or an increase in any existing deficit.

Several changes to the FHA single-family loan program could be adopted if Congress or the Secretary of HUD believes that the economic value of the Fund is higher than the amount needed to meet its definition of actuarial soundness. For example, actions that the Secretary could take that could reduce the value of the Fund include lowering insurance premiums, adjusting underwriting standards, and reinstituting distributive shares. However, congressional action in the form of new legislation would be required to make other program changes that are not now authorized by the statute. These would include such actions as changing the maximum amount FHA-insured homebuyers may borrow relative to the price of the house they are purchasing and using the Fund’s reserves for other federal programs.

Reliably estimating the potential effect of various options on the Fund’s capital ratio and FHA borrowers is difficult because the impacts of these policy changes are complex, and tools available for handling these complexities may not be adequate. Policy changes have not only immediate, straightforward impacts on the Fund and FHA’s borrowers, they also have more indirect impacts that may intensify or offset the original effect. Implementing these options could affect both the volume and the average riskiness of loans made, which, in turn, could affect any future estimate of the Fund’s economic value. As a result of this complexity, obtaining a reliable estimate would likely require that economic models be used to estimate the indirect effects of policy changes. At this time, however, neither the models used by HUD to assess the financial health of the Fund, nor those used by others, explicitly recognize the indirect effects of policy changes on the volume and riskiness of FHA’s loans. As a result, HUD cannot reliably estimate the impact of policy changes on the Fund.

Although it is difficult to predict the overall impact of a change on the Fund’s capital ratio and thus on FHA borrowers as a whole, different options would likely have different impacts on current and prospective FHA-insured borrowers. Some proposals would more likely benefit existing and future FHA-insured borrowers, while others would benefit only future borrowers, and still others would benefit neither of these groups. One interpretation of the higher premiums that borrowers paid during the period in which the economic value of the fund has been rising is that borrowers during the 1990s "overpaid" for their insurance. Some options for reducing the capital ratio, such as reinstituting distributive shares, would be more likely to compensate these borrowers. The payment of distributive shares would benefit certain existing borrowers who voluntarily terminate their mortgages. If these policies continued into the future, they would also benefit future policyholders. Alternatively, reducing up-front premiums, reducing the number of years over which annual insurance premiums must be paid, or relaxing underwriting standards would tend to benefit only future borrowers.

Under 1990 credit reform legislation, FHA’s budget is required to reflect the subsidy cost to the government of FHA’s loan insurance activities for that year. Credit reform was intended to ensure that the full cost of credit activities for the current budget year would be reflected in the federal budget so that Congress and the executive branch could consider these costs when making annual budget decisions. For FHA’s Mutual Mortgage Insurance Fund, the subsidy cost is negative; that is, the program is operating at a profit. Under credit reform, the negative subsidy receipts would be available for appropriation for other uses, and a balance would not be permitted to accumulate in the liquidating account. However, to accommodate the differing statutory requirements of budgeting for the subsidy cost of insuring the loans and maintaining a 2-percent reserve, the Office of Management and Budget (OMB) and FHA have allowed reserves to accumulate in the Fund in the form of interest-bearing Treasury securities. At the end of fiscal year 1999, FHA held nearly $15 billion in Treasury securities. These securities represent a claim on the U.S. Treasury to cover future losses to the Fund. From the perspective of the U.S. Treasury, these securities represent a liability. From the standpoint of the government as a whole, the securities represent a debt owed by one part of the federal government to another. By investing in nonmarketable Treasury securities, FHA makes funds available to other federal programs. Each year that the Fund runs a surplus, the budget surplus for the federal government, as a whole, is higher than it would otherwise have been if FHA had not been insuring profitable loans. When the total federal budget was in a deficit (as it was for most of the 1990s), that deficit was lower than it would have been if the Fund had not been realizing a surplus at the same time.

Because of the difficulty in reliably measuring the effect of most actions that could be taken either by Congress or the Secretary of HUD on the Fund’s capital ratio, we cannot precisely measure the effect of these policies on the budget. However, any actions taken by Congress or the Secretary that influence the Fund’s capital ratio will have a similar effect on the federal budget. If Congress or the Secretary of HUD adopts policies, such as lowering premiums, paying distributive shares, or loosening underwriting standards, that reduce the profitability of the Fund, the negative subsidy amount reported in FHA’s budget submission and the Fund’s reserve will both be lower. Some of these policies—lowering premiums and paying distributive shares—would affect FHA’s cash flows immediately. Thus, the amount of money available for FHA to invest in Treasury securities would be lower. Treasury in turn would have less money available for other purposes, and the overall surplus would decline. If the amounts of cash flowing out of the Fund exceeded current receipts, FHA would be required to redeem its investments in Treasury securities to make the required payments. Assuming no changes in other spending and taxes, Treasury then would be required to either increase borrowing from the public or use general tax revenues to meet its financial obligations to FHA. In either case, the annual budget surplus would be lower.

Budgetary scoring for budget control purposes under the 1990 Budget Enforcement Act is required only when a law is enacted; actions taken by the Secretary under existing authorities are not scored for budget control purposes, even though they may affect the budget surplus or deficit. Whether and how the proposals under discussion would be scored depend on the exact wording of the new law and are determined by OMB for Budget Enforcement Act purposes. However, any action taken by Congress or the administration to reduce FHA’s reserves, if not accompanied by a similar reduction in other government spending or by an increase in receipts, will result in either a reduction in the surplus or an increase in any existing deficit.

Whether actions should be taken to change the value of the Fund depends on whether the Fund's capital resources and expected revenues exceed the amount needed to meet its expected cash outflows under designated stressful conditions; that is, whether it is actuarially sound. Assessing whether this condition exists requires that the degree of risk that the Fund is expected to be able to withstand must be specified. If the Fund is expected to withstand what Price Waterhouse called reasonably adverse economic downturns, then our results could be construed to mean that the Fund is taking in more revenue than it needs. Alternatively, if the Fund is expected to never exhaust its reserves, the current Fund might not be adequate.

The 1990 reforms did not specify the amount of risk that the Fund needed to withstand. Instead, the reforms specified a minimum capital ratio and required that the Fund achieve actuarial soundness before the secretary of HUD could take certain actions that might reduce the value of the Fund. Because we believe that actuarial soundness depends on a variety of factors that could vary over time, setting a minimum or target capital ratio will not guarantee that the Fund will be actuarially sound over time. For example, if the Fund comprised primarily seasoned loans with known characteristics, a capital ratio below the current 2-percent minimum might be adequate. But under conditions such as those that prevail today, when the Fund is composed of many new loans, a 2-percent ratio might be inadequate if recent and future loans perform considerably worse than expected.

We believe that to evaluate the actuarial soundness of the Fund, one or more scenarios that the Fund is to withstand would need to be specified. Then it would be appropriate to calculate the economic value of the Fund or the capital ratio under the scenario(s). As long as the estimated economic value of the Fund is positive when the desired stress scenario(s) is used to make that estimate, the Fund could be said to be actuarially sound. However, it might be appropriate to leave a cushion to account for the factors not captured by the model and the inherent uncertainty attached to any forecast. In any event, we believe that a single, static capital ratio does not measure actuarial soundness.

For these reasons, Mr. Chairman, Congress may wish to consider taking action to specify criteria for determining when the Fund is actuarially sound. More specifically, Congress may want to consider defining the types of economic conditions under which the Fund would be expected to meet its commitments without borrowing from the Treasury.

Mr. Chairman, this concludes my statement. We would be pleased to respond to any questions that you or Members of the Subcommittee may have.

For further information regarding this testimony, please contact Thomas J. McCool at (202) 512-8678. Individuals making key contributions to this testimony included Nancy Barry, Jay Cherlow, and Mathew Scire.

Mortgage Financing: FHA’s Fund Has Grown, but Options for Drawing on the Fund Have Uncertain Outcomes (GAO-01-460, Feb. 28, 2001).

Mortgage Financing: Financial Health of the Federal Housing Administration’s Mutual Mortgage Insurance Fund (GAO/T-RCED-00-287, Sept. 12, 2000).

Mortgage Financing: Level of Annual Premiums That Place a Ceiling on Distributions to FHA Policyholders (GAO/RCED-00-280R, Sept. 8, 2000).

Single-Family Housing: Stronger Measures Needed to Encourage Better Performance by Management and Marketing Contractors (GAO/T-RCED-00-180, May 16, 2000, and GAO/RCED-00-117, May 12, 2000).

Single-Family Housing: Stronger Oversight of FHA Lenders Could Reduce HUD’s Insurance Risk (GAO/RCED-00-112, Apr. 28, 2000).

Homeownership: Information on Single-Family Loans Sold by HUD (GAO/RCED-99-145, June 15, 1999).

Homeownership: Achievements of and Challenges Faced by FHA’s Single-Family Mortgage Insurance Program (GAO/T-RCED-98-217, June 2, 1998).

Homeownership: Results of and Challenges Faced by FHA’s Single-Family Mortgage Insurance Program (GAO/T-RCED-99-133, Mar. 25, 1999).

Homeownership: Management Challenges Facing FHA’s Single-Family Housing Operations (GAO/T-RCED-98-121, Apr. 1, 1998).

Homeownership: Information on Foreclosed FHA-Insured Loans and HUD-Owned Properties in Six Cities (GAO/RCED-98-2, Oct. 8, 1997).

Homeownership: Potential Effects of Reducing FHA’s Insurance Coverage for Home Mortgages (GAO/RCED-97-93, May 1, 1997).

Homeownership: FHA’s Role in Helping People Obtain Home Mortgages (GAO/RCED-96-123, Aug. 13, 1996).

Mortgage Financing: FHA Has Achieved Its Home Mortgage Capital Reserve Target (GAO/RCED-96-50, Apr. 12, 1996).

Homeownership: Mixed Results and High Costs Raise Concerns about HUD’s Mortgage Assignment Program (GAO/RCED-96-2, Oct. 18, 1995).

Mortgage Financing: Financial Health of FHA’s Home Mortgage Insurance Program Has Improved (GAO/RCED-95-20, Oct. 18, 1994).

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