Senate Banking, Housing and Urban Affairs Committee

Subcommittee on Housing and Transportation

Hearing on Challenges Facing the FHA Single Family Insurance Fund

Prepared Testimony of Mr. Timohty F. Kenny

2:00 p.m., Tuesday, March 25, 1999

Chairman Allard, Ranking Member Kerry, and Members of the Subcommittee, I appreciate the opportunity to appear before you today to discuss the Fiscal Year 19987 Financial Statement Financial Statement Audit of the Federal Housing Administration (FHA). My name is Timothy Kenny and I am a partner with KPMG Peat Marwick LLP (KPMG), a certified public accountant, and the engagement partner for KPMG’s 19987 financial statement audit of FHA. TThis is the seventh year FHA has obtained a financial statement audit as required under the Chief Financial Officer’s Act of 1990, and and the fourth year in which KPMG has conducted the audit. However, fiscal year 1998 is the first year in which FHA has prepared their financial statements in conformity with the hierarchy of accounting principles and standards recommended by the principals of the Federal Accounting Standards Advisory Board. In other words, FHA’s financial statements were prepared in accordance with federal accounting requirements, including the Federal Credit Reform Act of 1990, which requires assets and liabilities to be accounted for on the net present value basis versus net realizable value. This hierarchy is a comprehensive basis of accounting other than generally accepted accounting principles, which accounts for assets and liabilities based upon their net realizable value. These audited financial statements are referred to as ‘federal basis’ financial statements.

The initial phase of our audit was performed in November and December 1998 and consisted of reviewing the operations at three Single Family Homeownership Centers (HOCs), three Multifamily HUB’s, one Multifamily Property Disposition Center, and one Multifamily Program CenterSeptember 1997. The final phase of our audit, conducted at Headquarters, was performed from December 1998November 1997 through March 19998. Our opinion is dated March 56, 19998, and the FHA Audit Report of Fiscal Year 1998 Federal Basis Financial Statements (herein referred to as the FHA Audit Report) was released by the Financial Audits Division of the Department of Housing and Urban Development (HUD) Office of Inspector General on March 129, 19998. It is important to emphasize that the period covered by our audit report was the period as of and for the year ended September 30, 1998.


Our responsibility was to express an opinion on the 199897 and 1996 financial statements of FHA of FHA based on our audit. We conducted our audit in accordance with generally accepted auditing standards; the standards applicable to financial audits contained in Government Auditing Standards, issued by the Comptroller General of the United States; and OMB Bulletin No. 93-0698-08, as amended, except for those portions of the Bulletin that relate to the review of performance measures.

We issued a combined report that includes our opinion on FHA’s financial statements, our consideration of FHA’s internal controls over financial reporting, and our assessment of FHA’s compliance with certain laws and regulations. In our opinion, FHA’s financial statements as of and for the year ended September 30, 1998, are presented fairly, in all material respects, in conformity with the hierarchy of accounting principles and standards described in the first paragraph. This represents the highest level of assurance that can be obtained in a financial statement audit and is also known as an unqualified or "clean" opinion. An unqualified opinion on the financial statements of FHA means that FHA was able to produce complete and reliable financial statements for fiscal year 1998. Judgement is exercised by FHA management in the preparation of the financial statements and underlying estimates, and by us in the conduct of our audit. As a result, we rely on evidence that is persuasive rather than convincing. In turn, the reader of the financial statements must recognize that an unqualified opinion means the financial statements are not misleading, although estimates have been made.

Although we issued an unqualified or clean opinion on FHA’s 1998 financial statements, we noted certain matters involving internal control over financial reporting and its operation that we consider to be material weaknesses under standards established by the American Institute of Certified Public Accountants (AICPA) and OMB Bulletin No. 98-08, Audit Requirements for Federal Financial Statements, as amended. We noted three three reportable conditions and four material weaknesses. Reportable conditions are matters coming to our attention that, in our judgment, represent significant deficiencies in the design or operation of FHA’s internal control over financial reporting and could adversely affect FHA’s ability to record, process, summarize, and report financial data consistent with the assertions of management in the consolidated financial statements.

A material weakness is a reportable condition in which the design of specific internal control components does not reduce to a relatively low level the risk that misstatements in amounts that would be material to the consolidated financial statements of FHA may occur and not be detected within a timely period by employees in the normal course of performing their assigned functions.

Last, we noted one issue of noncompliance with certain provisions of laws and regulations during our fiscal year 19987 audit.

Because of the existence of these conditions, we did not rely on internal controls in determining the nature, timing, and extent of our tests of details. In fact, we extensively tested FHA’s supporting account balance detailed records, to satisfy ourselves that the financial statement amounts were materially correct as stated. Our tests of detailed account balances indicated that despite the material weaknesses and reportable conditions we identified, the financial statement amounts and related disclosures were fairly presented to support the issuance of an unqualified opinion. However, we did include these conditions in the FHA Audit Report, along with our recommendations for improvements.

With the exception of one material weakness related to budgetary accounting, each of these matters was previously reported in our fiscal year 19976 audit report of FHA’s financial statements prepared in accordance with generally accepted accounting principles. Table 1 presents a historical summary of these material weaknesses, reportable conditions and instance of noncompliance. The deficiencies noted in the FHA Audit Report are interrelated, and when taken together, describe many of the internal challenges that FHA faces.


FY 1995

FY 1996

FY 1997

FY 1998

Type of Opinion on FHA’s Financial Statements





Internal Control Issues Reported (MW - Material Weakness, RC - Reportable Condition):


FHA must address staff and administrative resource issues.





FHA must continue to place more emphasis on early warning and loss prevention for insured mortgages.





FHA must improve Federal basis and budgetary accounting.





Information technology systems must be improved in order to support business processes more effectively.





FHA must continue actions to quickly resolve Secretary-held mortgage note assignments and note servicing responsibilities.





FHA must sufficiently monitor and account for Single Family property inventory.





FHA/HUD must enhance the design/operation of information systems general and application controls.





Compliance Issues Reported


FHA is not in compliance with the Credit Reform Act of 1990.





Material Weaknesses

Material weaknesses in FHA’s internal control, as of and for the year ended September 30, 1998, are summarized in the four categories discussed below:

The first two and the fourth material weakness, all repeat conditions from our prior year audit report, are interrelated in that none can be effectively addressed without addressing the others. Additionally, these weaknesses apply to the single family and multifamily programs in varying degrees.

The internal control weaknesses discussed in the FHA Audit Report, and FHA’s progress toward correcting these weaknesses, are discussed in the context of FHA’s existing statutory and organizational structure. As of the date of the FHA audit report, it is unclear (1) how legislative and budgetary changes will impact FHA, and (2) what effect such changes may have on FHA’s ability to implement existing or future corrective action plans.

As reported in prior years, implementing sufficient change to mitigate the internal control weaknesses is a multiyear task due to the complexity of the issues and impediments to change that FHA and HUD face. These impediments involve interaction with large numbers of relevant constituencies outside of HUD and resource constraining actions, which can affect the timing of corrective action plan implementation.

The following sections describe each material weakness as of and for the period ended September 30, 1998. FHA management’s response and KPMG’s assessment of their response follows the description of each material weakness. The full text of FHA management’s response is included in Appendix D of the FHA Audit Report.

FHA Must Address Staffing and Administrative Resource Issues

Unlike private institutions or government-sponsored enterprises involved in housing credit, FHA does not have the authority to hire staff or the ability to quickly invest more resources in automated tools or staff training when transaction volume increases. Nor can FHA quickly or easily change the structure of its mortgage insurance programs to reduce staff-intensive functions and promote efficiency. In such an environment, critical credit and asset management functions suffer. Resource restrictions increase the risk of borrower default, inhibit effective servicing, and lengthen time necessary for the disposition of assets.

FHA’s staffing issues are multifaceted and include: (1) mismatches between workload, staff resources, and efficient performance; (2) mismatches between skill sets and skill needs; (3) barriers to effective staff redeployment; and (4) collective bargaining agreements. These staff and administrative resource issues have been and will continue to be compounded by workforce reductions. Staffing and administrative resource issues adversely affect both single family and multifamily programs.

Planned reductions in single family staffing levels were predicated on significant assumptions and programmatic changes, including streamlining or outsourcing Real Estate Owned (REO) property, selling single family Secretary-held notes, and consolidating single family functions into four Home Ownership Centers (HOC). While staffing reforms occurred under HUD 2020, programmatic reforms related to single family REO and note operations did not keep pace, creating obstacles to the effective monitoring and servicing of FHA’s portfolios during fiscal year 1998.

FHA made progress in consolidating single family operations from 81 field offices into four HOCs. However, FHA experienced delays in the consolidation and implementation of REO and note servicing program reforms. Since fiscal year end 1998, FHA has completed several critical milestones necessary to implement these program reforms.

In February 1999, FHA awarded Management and Marketing (M&M) contracts to outsource the single family REO operation, nationwide, to 16 private sector real estate firms. The M&M contracts are slated to start providing management, marketing, and disposition services in March 1999. Additionally, FHA awarded a contract, in February 1999, to a private sector group to service all single family Secretary-held notes.

During fiscal year 1998, FHA recognized a need to retain REO personnel as the M&M contracts were not yet in place. However, buyouts and attrition depleted staff at a number of sites. Because significant programmatic reforms were slow to be implemented, single family operations were adversely impacted during fiscal year 1998. As the Office of the Inspector General (OIG) noted in its September 30, 1998 Semiannual Report to Congress, "It was never intended that the HOCs would handle the full range of loan management and property management and disposition functions that they are currently handling." These factors also contributed to reportable conditions related to single family notes and single family property.

FHA’s business related to its single family programs has changed significantly over the years. Improvements in automated technology and electronic data interchange have created efficiencies. Additionally, the single family Secretary-held notes inventory has decreased dramatically. However, the effort to service post-insurance portfolios, including single family property and notes, has drawn necessary resources away from focusing on the primary responsibility of program oversight and portfolio management, during a period when business volume has grown dramatically.

Single family staffing levels are decreasing. Since 1996, buyouts and downsizing reduced single family staff by approximately 50 percent. During the same period, single family business volume increased, as summarized below.

FHA’s reduced single family workforce and personnel inexperienced with their current responsibilities, due to FHA’s consolidation and reorganization efforts, have hindered FHA’s ability to manage its portfolios, service Secretary-held notes, and manage its REO inventory during fiscal year 1998. Due to downsizing, staffing reassignments, and delays in timely contracting for outsourced processes, there was (1) a premature migration of workload; (2) a mismatch between workloads, skill sets and skill needs; and (3) a shift in workload among offices that had the capacity to assist regardless of experience.

For the Office of Multifamily Housing, a decrease in staffing has been coupled with an increase in the workload at the Multifamily Hubs and Program Centers. During fiscal year 1998, approximately 880 Section 8 contracts expired and were processed for annual renewal. This increase in workload will continue during fiscal year 1999 with the expiration of over 8,200 Section 8 contracts, and the requirement to renew fiscal year 1998 and prior year annual contracts.

Currently, Multifamily Hubs and Program Centers Administer over 20,000 Section 8 contracts. In the fiscal year 2000 Budget, the President has requested the resources to outsource the Section 8 contract renewal and contract management process to local contract administrators. However, until the contract administrators are in place, multifamily personnel must manually process contract expirations and renewals, and continue to administer Section 8 contracts.

In addition to the Section 8 contract renewal process, Section 221(g)(4) of the National Housing Act enables mortgagees to automatically assign current mortgages to the Secretary after 20 years. Section 221(g)(4) assignments comprised approximately 29 percent (43 out of 159) and 46 percent (76 out of 170) of all multifamily assignments during fiscal years 1998 and 1997, respectively. The aging of the Section 221(g)(4) portfolio over the next three years could result in over 1,800 additional claims to the Secretary. Although the servicing of assigned notes was outsourced during fiscal year 1998, managing the disposition of these assigned notes will increase the administrative burden on the FHA staff.

HUD 2020 contained sweeping changes to the way the Office of Multifamily Housing conducts business, including the establishment of the Real Estate Assessment Center (REAC), the Enforcement Center, and the Financial Management Center. These centers are designed to consolidate (and automate, where applicable) risk assessment, enforcement, and processing activities, and remove some responsibilities from project managers in the field. While these centers should decrease the current workload in multifamily’s field operations, they had not become fully operational during fiscal year 1998. Until these centers are fully operational, the new Multifamily Hubs and Program Centers must continue performing functions that were not originally envisioned when the new field organization was created (i.e., initial review and analysis of physical and financial information).

Another initiative included in HUD 2020 is the movement of Multifamily Housing from a retail to a wholesale operation by delegating some production responsibilities to mortgagees or contractors. One of the important aspects of this plan is the Development Application Processing (DAP) system to facilitate the insurance application process and reduce labor-intensive processes. However, the reassignment of production responsibilities to other parties has not occurred, and full implementation of the DAP system is yet to occur. As a result, the Hubs and Program Centers are required to continue performing labor-intensive production activities.

Management’s Response

FHA management states that at the time that KPMG performed its visits to HUD field offices for the audit, many of the critical HUD 2020 reforms addressing staff and administrative resources were underway but not complete. Since those visits, management asserts that FHA has continued to make strong progress in implementing these reforms. Management represents that most of the changes and improvements envisioned under HUD 2020 are now in place. The reforms most relevant to these concerns fall under five categories: reorganization, consolidation, increasing staff capacity, increasing use of technology, and contracting.

Our Assessment of Management’s Response

KMPG recognizes that FHA has been in the process of implementing a number of major initiatives included in HUD 2020. Since fiscal year end 1998, FHA has completed several critical milestones that address staffing and administrative resource issues noted in this report. However, these initiatives are new, many had not been implemented during fiscal year 1998, the period covered by our audit, and it is too early to determine their impact on resolving this weakness in its entirety.

FHA Must Continue to Place More Emphasis on Early Warning and Loss Prevention for Insured Mortgages

FHA does not have adequate systems, processes, or resources to identify and manage risks in its insured portfolios effectively. Timely identification of troubled insured mortgages and mortgagees with risky underwriting practices are key elements of FHA’s efforts to target resources to insured mortgages and lenders that represent the greatest financial risks to FHA. Troubled insured mortgages and potentially problem lenders must be identified before FHA can institute loss mitigation techniques and lender enforcement measures that can reduce eventual claims.

The Office of Multifamily Housing has progressed with several major initiatives that are in the process of being implemented. These initiatives include:

However, because these centers were not fully operational in fiscal year 1998, they had not yet affected the Hubs and program centers ability to perform risk assessment over the portfolio.

In addition, both KPMG and the HUD Office of Inspector General continued to notice problems in monitoring the insured and Secretary-held portfolios in the areas of management reviews, financial statement reviews, and physical inspections. Only 30 percent of troubled and potentially troubled projects tested during the audit had management reviews completed by FHA during the fiscal year. For financial statement reviews, unaudited data provided by the Office of Housing stated that less than 85 percent of financial statements submitted were reviewed; the standard is 100 percent. Only 26 percent of troubled and potentially troubled projects reviewed had physical inspections. Failure to monitor and manage the portfolio on a proactive basis increases the risk of projects becoming troubled, thereby escalating the risk of future claims and placing additional stress on limited resources.

The Office of Insured Single Family Housing made significant progress towards taking a proactive and preventive role in monitoring insured single family mortgages during fiscal year 1998. This progress includes:

While FHA has made significant progress monitoring the insured single family portfolio, these initiatives are relatively new, several are still developing, and the benefits have not yet been fully recognized. Additional steps should be taken to effectively monitor the insured single family portfolio as described below.

FHA performs post-endorsement technical reviews on a case level basis to monitor the quality of underwriting and valuations performed by lenders and appraisers. We found that while HOC staff performed these reviews during fiscal year 1998, there was little analysis and lender follow up based on the results of these reviews, even though certain lenders were identified with risky underwriting practices. Identifying deficient underwriting practices before loans go to default or claim is FHA’s best defense against risky lenders.

During a review of the Santa Ana HOC’s production division, the HUD Office of Inspector General identified both understaffing and lack of experienced staff as primary contributors to FHA’s inability to monitor lenders and take immediate action against lenders identified with poor underwriting practices. In January 1999, GAO also reported that HUD has an insufficient mix of staff with the proper skills that hamper the effective monitoring and oversight of HUD’s programs.

Additional problems have been identified in appraisals obtained on FHA insured mortgages. A recent GAO report, dated May 1998, noted that (1) FHA was not adequately monitoring the performance of appraisers tasked with valuing property securing FHA-insured mortgages, and (2) appraisals did not reflect property conditions noted upon subsequent house inspections. Because FHA did not immediately act on indicators of risky underwriting and appraisal practices, certain of these lenders and appraisers continue to do business with FHA.

Management’s Response

FHA Management represents that during the past year, FHA has made tremendous progress in implementing new approaches and strategies for reducing the frequency and loss severity of defaults on insured mortgages. Their response discusses a number of functional centers, including REAC, the Enforcement Center, the Property Disposition Hubs, and the Quality Assurance Center. Management asserts that staff in these centers are pursuing a number of highly-focused strategies to better monitor, and ultimately mitigate defaults on, FHA-insured mortgages. In addition, management discusses the new loan loss mitigation program and enhanced lender monitoring and enforcement activities in the single family program, as critical elements in monitoring and mitigating overall default frequency and severity.

Our Assessment of Management’s Response

As with the previous material weakness relating to staffing and administrative resources, we recognize that FHA has been in the process of implementing initiatives included in its HUD 2020 management reforms. The initiatives implemented by FHA, including the Real Estate Assessment Center, should assist Housing in improving its risk assessment capabilities, and result in better monitoring of the insured portfolio. However, the most significant initiatives had not been implemented at the end of fiscal year 1998, subsequent to the year under audit. KPMG continues to believe, based on the results of our audit, that early warning and loss prevention capabilities and performance could be improved in the future.

Federal Basis and Budgetary Accounting Must be Improved

FHA has historically maintained accounting records in accordance with generally accepted accounting principles (GAAP). Fiscal year 1998 is the first year that FHA prepared financial statements in accordance with the hierarchy of accounting principles and standards recommended by the principals of the Federal Accounting Standards Advisory Board and OMB Bulletin 97-01, Form and Content of Agency Financial Statements. This hierarchy is a comprehensive basis of accounting that differs from GAAP. With the exception of the U.S. Treasury Standard General Ledger (SGL) each of the issues presented herein was initially identified during the independent audit process, rather than by FHA’s internal controls over financial reporting. During the fiscal year ended September 30, 1998, we noted the following weaknesses with FHA’s budgetary and Federal basis accounting:

Obligations needed to be reviewed and reconciled. At our request, FHA identified 194 contracts and approximately 1,300 purchase orders, which appeared to have been fulfilled, but not de-obligated. FHA de-obligated those contracts and purchase orders for a total adjustment to the financial statements of approximately $29,700,000. Also at our request, FHA reconciled the commitments and endorsements in the accounting system to those in the budget system, and identified nine items, which had not been recorded in the budget system. In addition FHA identified errors in mortgage amounts and subsidy rates between the accounting and budget systems. As a result, FHA recorded $7,500,000 in additional obligations in the budget system. Finally, FHA identified approximately $6,900,000 of unrecorded unliquidated obligations related to contractor processed disbursements and adjusted the financial statements, accordingly.

FHA’s general ledger was not compliant with the SGL at the transaction level and preparation of the Report on Budget Execution (SF133) was not well documented. The FHA general ledger does not use the series of accounts required by U.S. Treasury to record budgetary activity, i.e., the U.S. Government Standard General Ledger. FHA analyzed the GAAP accounts and translated those accounts to the Federal basis to prepare both the financial statements and the SF-133s, Report on Budget Execution.

Methodology for allocating costs in accordance with Statement of Federal Financial Accounting Standard No. 4, Managerial Cost Accounting, was not documented and implemented throughout the year. The current method of allocating costs between FHA’s programs is based on a survey of Housing employees. All supervisors are surveyed and requested to allocate the costs of their staff among three programs: (1) unsubsidized, (2) subsidized, and (3) non-FHA. Difficulties encountered in this initial process included receiving timely responses and reconciling those responses to ensure all employees were accounted for properly.

Methodology for calculation of the liability for loan guarantees (LLG) required refinement. Based on our audit, FHA’s methodology and assumptions for calculation of the LLG required refinement. The need for additional refinement was not consistently identified through FHA’s own review process. FHA has developed an action plan to address identified financial management issues related to the LLG. This plan included accumulating supporting data for estimating the cost of its loan programs and reviewing its cash flow models to identify additional improvements that could reduce the chance of error. Additionally, the plan included establishing formal policies and procedures that include a formal supervisory review process. This plan, if fully implemented, should help FHA further refine its liability for loan guarantee calculation. FHA plans to continue use of contract resources to perform this calculation for fiscal year 1999.

Management’s Response

FHA management agrees with the finding and the associated recommendations. Management has already developed workplans to implement each recommendation provided in the report.

Our Assessment of Management’s Response

KPMG agrees with management’s response.

Information Technology Systems Must be Improved in Order to Support Business Processes More Effectively

For a number of years, weaknesses have been reported in FHA’s financial management systems. Systems are not linked and integrated, or configured to meet all financial reporting requirements. Additionally, many of FHA’s financial management systems do not share a common data architecture, and not all systems provide the appropriate case level detail required for credit reform compliance. FHA’s inability to quickly develop or acquire more modern information technology will continue to deter its efforts to be a more efficient and effective housing credit provider. Until new information technology is implemented and available throughout the agency, FHA must collect data and develop information in less efficient ways. FHA must aggressively pursue system development, modernization, and improvement.

There are a number of other critical system priorities at HUD. As a result, FHA’s past systems plans centered on enhancing existing systems, and actual implementation of the plans was often a long, tedious process that did not produce timely results. HUD continues to report material system non-conformances in its Fiscal Year 1998 Accountability Report several of which relate to FHA systems. HUD’s OIG reports that general ledger and subsidiary systems at the case level and other incomplete program and geographical information continue to be problems. In addition, OIG addresses the project planning, cost and management of the Financial Systems Integration (FSI) project, of which FHA is a part.

Management’s Response

Although FHA agrees with KPMG’s assessment of the problem, they believe emphasizing new technology and modernization alone will not fix the problem. FHA suggests instead that more attention be placed on proper integration of systems to resolve weaknesses. They believe the need exists to ensure that the methods of providing accounting information are standard in all systems.

FHA management states that its systems will have achieved significant improvement in the availability of needed management information with a measurable level of confidence in the quality and reliability of the information within the next two fiscal years. Better information systems will support strategic decision-making and make monitoring more productive and staff more efficient. Management further discusses the implementation of the US Standard General Ledger; system development, enhancement and integration; and the ‘umbrella system’ in their response.

Our Assessment of Management’s Response

KPMG agrees with management’s response.

Reportable Conditions

In addition to the four material weaknesses, the FHA Audit Report identifies three reportable conditions, or matters coming to our attention relating to significant deficiencies in the design or operation of FHA’s internal controls, as of and for the year ended September 30, 1998. These reportable conditions are described in the following sections.

FHA Must Continue Actions to Quickly Resolve Secretary-held Mortgage Notes and Minimize Additional Mortgage Note Assignments and Note Servicing Responsibilities

Since 1994, FHA has made significant progress to reduce its Secretary-held note portfolio. However, efforts to reduce the single family and multifamily note inventory ceased during fiscal year 1998. Furthermore, note servicing weaknesses contributed to adverse changes in the performance of the single family notes portfolio during fiscal year 1998. Inadequate servicing:

At September 30, 1998, FHA had approximately 12,000 single family notes with an outstanding balance of $731 million. Although FHA has considerably reduced the single family notes portfolio in recent years (refer to Exhibit 6) and is currently under contract with a special servicer who will assume the portfolio in April 1999, we noted the following weaknesses in fiscal year 1998: (1) an inability to consolidate servicing into one location; (2) restricted servicing efforts; and (3) shifts in the portfolio to substantially non-performing notes.

As we reported last year, FHA planned to improve asset management for the remaining single family mortgage notes portfolio by consolidating servicing functions into one location, Oklahoma City. However, this plan was not implemented during fiscal year 1998. FHA determined that there were too many notes to consolidate into one location as a result of the cancellation of note sale number six. Furthermore, the servicing of these notes was limited during fiscal year 1998 due to staffing changes, workload transitions, the anticipated note sale, and programmatic reforms. We were told this occurred because workload shifts were based on available staffing resources and not servicing experience. The HUD Office of Inspector General also noted deficiencies in servicing and found that many of the HUD staff possessed little or no knowledge of HUD servicing requirements.

Because asset sales and consolidation plans were not implemented during fiscal year 1998, FHA began the concept of ‘limited’ or ‘interim’ servicing. Under these guidelines, FHA continued to issue standard delinquency letters. However, if borrowers were unresponsive after the issuance of the 120-day delinquent letter, no foreclosure action was taken. Additionally, FHA did not aggressively pursue other servicing alternatives, such as workout plans or increased collection efforts.

The composition of the single family notes portfolio shifted dramatically between performing and non-performing notes. The non-performing portion of the single family notes portfolio typically ranged between 55 and 60 percent in recent fiscal years. However, at September 30, 1998, over 70 percent of the single family notes portfolio was classified as non-performing, representing notes that were delinquent under either the terms of the original mortgage or subsequent forbearance agreements. Troubled assets are more difficult to manage and typically require a greater number of experienced staff to service.

FHA has been successful in the past with reducing the Secretary-held multifamily note inventory, from over 2,300 mortgages with an unpaid principal balance (UPB) of $7 billion in 1994 to the current level of 1,150 mortgages with a UPB of $2.1 billion. As depicted in Exhibit 7, the number of multifamily notes and unpaid principal balance on hand have remained steady from fiscal year end 1997 to fiscal year end 1998, primarily as a result of the discontinuation of the note sale program in 1997. Further reductions in the number and unpaid principal balance of Secretary-held multifamily notes must be made to improve FHA’s ability to monitor the insured portfolio and multifamily mortgagees and reduce the risk of further losses. Also, despite the strategy developed to manage Section 221(g)(4) projects, the risk of assignment still exists.

Management’s Response

FHA management states that the multifamily mortgage inventory is not growing and, given that 55 percent of the inventory is either current or not significantly in arrears, these mortgages do not present an undue management/servicing burden. In addition, management believes their ongoing efforts as related to the first material weakness, many of which they assert have been completed in fiscal year 1999, will reduce future mortgage note assignments and insurance claims and thereby protect the FHA insurance fund.

Single family management points to the dramatic reduction of the number of Secretary-held single family notes from more than 100,000 in 1994 to approximately 12,000 in 1998 through several successful note sales. They further state that FHA is now in the process of retaining private sector professionals to assume all functions related to servicing remaining single family notes. Finally, management states that the plan was always to partially implement the servicing consolidation during fiscal year 1998, using outstationed staff, and to complete implementation during fiscal year 1999 when a contract was in place for the servicing.

Our Assessment of Management’s Response

While KPMG agrees with FHA’s assessment that significant progress has been made to reduce the Secretary-held note portfolio, several significant initiatives to resolve this issue were not completed during fiscal year 1998. Due to problems experienced with contractors and pending litigation, no mortgage note auctions were performed during fiscal year 1998, and FHA does not currently have a financial advisor in place to assist with future note sales. Despite the progress made during the previous fiscal years, the number of notes has not been reduced significantly in the last fiscal year. Additionally, the limited note servicing efforts during fiscal year 1998 lead to a deterioration of the Single Family Secretary-held note portfolio.



FHA Must Sufficiently Monitor and Account for Single Family Property Inventory

FHA continues to experience control weaknesses in its single family property acquisition, management, and disposition functions. Examples of control weaknesses noted by KPMG and others include:

Fiscal year 1998 key portfolio statistics confirm the deficiencies noted above. An aging of single family REO reveals that properties remained in inventory for longer periods of time. The average disposition lag time increased from 5.4 months during fiscal year 1997, to 6.6 months during fiscal year 1998, and continues to rise. The number of on-hand REO properties increased over 25 percent between fiscal year end 1997 and 1998. At some field offices, inventory more than doubled between fiscal year 1997 and 1998. Over 35 percent of the single family REO inventory exceeded SAMS standard processing times at fiscal year end 1998. Additionally, property loss rates based on FHA’s acquisition cost increased significantly during fiscal year 1998 (refer to Exhibit 8). Finally, FHA is incurring additional costs as a result of increases in property disposition lag time, on-hand inventory, and property holding costs.

The control weaknesses noted above have:


Management’s Response

FHA management thoroughly discusses the implementation of the Management and Marketing (M&M) contracting model nationwide in their response to this reportable condition. Under this new approach, FHA will rely on private sector real estate professionals to perform all property management, marketing and sales activities related to the single family REO inventory. FHA has awarded contracts for each of sixteen geographic areas covering the entire country, and M&M contractors are scheduled to begin providing services in the Spring of 1999. During more than two years of pilot testing of the M&M contracting model, private contractors proved able to sell REO properties more quickly and at a higher rate of return. Following transition to the M&M contracting environment, FHA REO field staff will focus exclusively on monitoring and evaluating contractor activities.

Our Assessment of Management’s Response

KPMG agrees with the information presented in management’s response. However, this important initiative was not implemented during the period covered by our audit, and it is too early to determine the overall benefits of outsourcing REO nationwide.

FHA/HUD Must Enhance the Design/Operation of Information Systems General and Application Controls.

FHA management must rely heavily on computerized information systems to process the large volume of data required for such a diverse insurance operation. These systems not only process accounting data for functions including insurance processing, servicing, and asset disposition, but for sensitive cash receipt and disbursement transactions. Therefore, it is essential that FHA ensure a proper control environment to prevent errors and unauthorized access.

Control weaknesses regarding FHA’s general and application level security systems were identified in three areas, as summarized below:

Entity-Wide Security Program. There are several areas in the enterprise-wide security program that need improvement. Without a well designed security program, security controls may be inadequate; responsibilities may be unclear, misunderstood, and improperly implemented; and controls may be inconsistently applied. Examples of weaknesses include:


Access Control. Certain access controls need improvement to provide a more secure EDP environment. These controls include controls over physical access to computer resources, and controls that prevent unauthorized access to sensitive files. Examples of weaknesses include:


Application Change Control and Systems Development. Controls over the modification of application software programs are deficient. Without proper controls, there is a risk that security features could be inadvertently or deliberately omitted or "turned off" or that processing irregularities or malicious code could be introduced. Examples of weaknesses include:

Management’s Response

FHA agrees that "application change request forms are not completed and approved prior to programmers accessing source code in the production environment" and has taken steps to create and institutionalize procedures that will address this problem. Project Management Procedures, which represented a joint effort of Housing/FHA and the Department’s Information Technology group were finalized in February, 1999. These procedures will address KPMG’s recommendation that "controls should be designed to ensure that only authorized programs and modifications are implemented."

Our Assessment of Management’s Response

KPMG agrees with management’s response.


Noncompliance with Credit Reform

FHA is not in full compliance with certain data requirements of the Federal Credit Reform Act of 1990 (Public Law 101-508) (Credit Reform). The major objectives of Credit Reform and the implementing Office of Management and Budget (OMB) guidance are to (1) more accurately measure the costs of federal credit programs; (2) place the cost of credit programs on a budgetary basis; (3) encourage the delivery of benefits to beneficiaries; and (4) improve the allocation of resources among credit programs.

To facilitate the measurement and recognition of credit subsidies, losses, and program performance, Credit Reform requires each direct loan and loan guarantee to be categorized into a cohort and a risk category. A cohort (book of business) is defined as all direct loans obligated or loan guarantees committed by a program in the same year, even if the disbursements occur in later fiscal years or if the loan is modified. A risk category (projects with similar risk assessments) is a subdivision of a cohort for loans that are somewhat homogenous in cost, based on known facts at the time of the obligation or commitment. Risk categories are used to estimate long-term costs, to control budget authority during budget execution, and to make annual reestimates of costs.

FHA’s single family periodic premiums systems cannot generate the required case-specific cash flow data required to reestimates its subsidies. Therefore, this data is allocated to cohorts and risk categories using estimates of cash flows (rather than actual cash flows). Credit Reform requires FHA to track the cash flows related to cohorts and risk categories at the case level. FHA maintains all other data used to calculate Credit Reform subsidies at the required case specific level.


Conclusion as to the FHA Audit Report

Many of the issues discussed in the FHA Audit Report are not new to FHA or to federal agencies in general. They are "legacy" issues that have compounded in their effects over many years. Significant management efforts are being directed towards improvements in these areas. However, progress toward correcting these weaknesses has been slow because the issues are multifaceted, interrelated, and require diligent multiyear efforts to resolve. FHA management has responded to the challenge and has developed and is implementing action plans that address each of the issues identified in this report. Since fiscal year end 1998, the period covered in the audit, FHA continued with the process of implementing initiatives contained in the its HUD 2020 management reform plan. Many of these significant initiatives reached critical milestones after fiscal year end 1998. However, since these initiatives were not implemented during the period covered by our audit, we have not yet assessed their benefits.


Additional Information Requested by the Subcommittee

We understand that in addition to the FHA Audit Report, the Subcommittee is interested in additional information about the financial status of FHA. We provide additional information about the financial status of FHA in the following sections.

Financial Position and Results

As shown on page 47 of the FHA Audit Report, the Consolidated Balance Sheet demonstrates the current solvency of FHA’s financial position. FHA currently has liquid assets of $6 billion at the U.S. Treasury as well as $14 billion in investments in U.S. government securities. The net position of FHA is almost $6 billion of which $4 billion results from the operation of the funds rather than Federal appropriations.

On page 48 of the FHA Audit Report, the Consolidated Statement of Net Cost shows a surplus in the unsubsidized Mutual Mortgage Insurance fund of $417 million. This means that the unsubsidized fund earned more revenue (primarily premiums) than is expected to be needed to cover expenses (primarily claims). Historically, the unsubsidized fund has generated surpluses. The Consolidated Statement of Net Cost subsidized (General and Special Risk Insurance) funds show a net cost of $298 million. This results from less revenue being earned than is needed to cover expenses. This means the federal government has chosen to subsidize these funds in order to provide these programs to the public.



Economic Value and Capital Ratio of the Mutual Mortgage Insurance Fund

The Cranston-Gonzalez National Affordable Housing Act (NAHA) requires an independent actuarial analysis of the economic net worth and soundness of FHA’s Mutual Mortgage Insurance (MMI) Fund. The primary purpose of this review, performed by Pricewaterhouse Coopers for fiscal year 1998, is to estimate two key financial indicators, described below, that are used to determine the financial strength of the MMI fund.

The economic value of the MMI fund changes based on market conditions and economic assumptions at the time of valuation. Our audit was performed at September 30, 1998, and therefore, we cannot address the current market value of the fund. However, economic value of the MMI fund, estimated by Pricewaterhouse Coopers, was $11.36 billion at September 30, 1998. As illustrated in Exhibit 9, this economic value has grown over the past seven years.

The NAHA mandated that the MMI fund achieve a capital ratio of at least 2.0 percent by fiscal year 2000. The capital ratio, projected by Pricewaterhouse Coopers, continues to be above that mandated by the NAHA. The capital ratio was 2.71 percent at September 30, 1998. As depicted by Exhibit 10, FHA has been in compliance with this requirement since fiscal year 1995.

Insurance in force

Insurance in force has been increasing since 1993, primarily as a result of growth in the single family programs. Single family insurance in force increased to $417 billion at September 30, 1998, from $313 billion at September 30, 1993. Fiscal year 1998 was a record year for FHA single family endorsements. Approximately 1,084,000 single family loans amounting to $100 billion were insured by FHA during fiscal year 1998. Multifamily insurance in force increased at a lesser rate to $52 billion at September 30, 1998, from $44 billion at September 30, 1993.

Single Family Delinquencies and Claims

As single family insurance in force has increased so have the delinquency and claim rates. The number of single family claims has increased to 76,086, a mid-point between a high of 90,927 in fiscal year 1989 and a low of 60,884 in fiscal year 1996 (refer to Exhibit 2). More significantly, the default rate has increased approximately one point in the last three fiscal years, from 2.24 percent at September 30, 1995 to 3.24 at September 30, 1998 (refer to Exhibit 3).


Single Family Property Disposition

FHA acquires single family properties through the payment of conveyance claims. FHA is then responsible for managing, marketing, and selling the property. As of September 30, 1998, FHA had approximately 40,000 properties in inventory (refer to Exhibit 4). The single family property inventory level has risen over 25 percent during the last two fiscal years. Acquisition costs are also rising and increased 9 percent, from $74,200 during fiscal 1997 to $79,700 during fiscal year 1998. Furthermore, the average appraised value, $60,700 per property, kept pace with the average sales price, $57,600 per property, for fiscal year 1998. However, the loss rates based on acquisition cost have been increasing as the minimal increases in the average sales price have not kept pace with the significant increases in average acquisition cost incurred by FHA.


We would like to acknowledge FHA management and personnel for their cooperation during the course of our audit. Their timely response to our audit inquiries helped to ensure that the fiscal year 1998 audit was completed within the required timeframe.

I would like to thank the Chairman and the Subcommittee Members for the opportunity to appear before you and report on this important matter.

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