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Opportunities to Improve Program and Risk Management' which was 
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Report to Congressional Addressees: 

May 2006: 

Residential Care Facilities Mortgage Insurance Program: 

Opportunities to Improve Program and Risk Management: 

GAO-06-515: 

GAO Highlights: 

Highlights of GAO-06-515, a report to congressional addressees. 

Why GAO Did This Study: 

Through its Section 232 program, the Department of Housing and Urban 
Developmentís (HUD) Federal Housing Administration (FHA) insures 
approximately $12.5 billion in mortgages for residential care 
facilities. In response to a requirement in the 2005 Consolidated 
Appropriations Conference Report and a congressional request, GAO 
examined (1) HUDís management of the program, including loan 
underwriting and monitoring; (2) the extent to which HUDís oversight of 
insured facilities is coordinated with the statesí oversight of quality 
of care; (3) the financial risks the program poses to HUDís General 
Insurance/Special Risk Insurance (GI/SRI) Fund; and (4) how HUD 
estimates the annual credit subsidy cost for the program. 

What GAO Found: 

While HUDís decentralized program management allows its 51 field 
offices flexibility in their specific practices, GAO found differences 
in the extent to which staff in the five field offices it visited were 
aware of current program requirements. For example, four offices were 
unaware of required addendums to the programsí standard regulatory 
agreement. Further, while individual offices had developed useful 
practices for loan underwriting and monitoring, they lacked a mechanism 
for systematically sharing such practices with other offices. Also, 
field office officials were concerned about adequate current or future 
levels of staff expertiseóa critical factor in managing program risk in 
that health care facility loans are complicated and require specialized 
knowledge and expertise. 

FHA requires a review of the most recent annual state-administered 
inspection report for state-licensed facilities applying for program 
insurance, and recommends, but does not require, continued monitoring 
of such reports for facilities once it has insured them. Four of the 
five HUD field offices GAO visited do not routinely collect annual 
inspection reports for their insured facilities. While the reports are 
but one of several monitoring tools, they provide potential indicators 
of future financial risk. HUD has proposed revising its standard 
regulatory agreements to require insured facility owners or operators 
to submit annual inspection reports and to report notices of 
violations. However, the proposed revisions have been awaiting approval 
since August 2004, and the implementation date is uncertain. 

The Section 232 program accounts for only about 16 percent of the 
GI/SRI Fundís total unpaid principal balance, but program and industry 
trends pose potential risks to the Section 232 program and to the 
GI/SRI Fund. For example, in recent years the program has insured 
increasing numbers of assisted living facility loans and refinancing 
loans, for which there are limited data available to assess long-term 
performance. Other potential risk factors include increasing 
prepayments (full repayment before loan maturity) and loan 
concentration in several large markets and among relatively few 
lenders. Projected shifts in demand for residential care facilities 
could affect currently insured facilities and the overall market for 
the types of facilities that HUD insures under the program. 

To estimate the program subsidy cost, HUD uses a model to project cash 
flows for each loan cohort (the loans originated in a given fiscal 
year) over its entire life. HUDís model does not explicitly or fully 
consider certain factors, such as loan prepayment penalties, interest 
rate changes, or differences in loans to different types of facilities, 
and uses some proxy data that is not comparable to Section 232 loans. 
The modelís exclusion of potentially relevant factors and it use of 
this proxy data could affect the reliability of HUDís credit subsidy 
estimates. 

What GAO Recommends: 

GAO recommends, among other things, that the HUD Secretary establish a 
process for sharing practices among field offices, assure appropriate 
levels of staff with appropriate expertise, and incorporate reviews of 
federal or state inspection reports into loan monitoring. GAO also 
recommends that HUD explore factoring additional information into its 
credit subsidy model. In written comments, HUD agreed with all of GAOís 
recommendations except exploring the value of adding certain factors to 
its credit subsidy model. 

[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-06-515]. 

To view the full product, including the scope and methodology, click on 
the link above. For more information, contact David G. Wood at (202) 
512-6878 or WoodD@gao.gov. 

[End of Section] 

Contents: 

Letter: 

Results in Brief: 

Background: 

HUD's Decentralized Management Provides Field Offices Flexibility, but 
Varying Awareness of Underwriting and Monitoring Practices and Concerns 
Over Insufficient Staff Expertise Increase Program's Potential Risks: 

FHA's Coordination with States' Oversight of Quality of Care for 
Section 232 Residential Care Facilities Is Limited: 

Program and Industry Trends Show Sources of Potential Risks to the GI/ 
SRI Fund: 

HUD's Model for Estimating Credit Subsidy Costs Excludes Some 
Potentially Relevant Factors: 

Conclusions: 

Recommendations for Executive Action: 

Agency Comments and Our Evaluation: 

Appendixes: 

Appendix I: Objectives, Scope, and Methodology: 

Appendix II: Information on the Application Processing, Underwriting, 
and Oversight of Section 232 Loans: 

Appendix III: HUD Officials Addressed Some Issues Raised by the 
Agency's Inspector General in 2002, but Several Key Items Remain 
Unresolved: 

Appendix IV: HUD's Use of Proxy Data for Refinance Loans: 

Appendix V: Comments from the Department of Housing and Urban 
Development: 

Appendix VI: GAO Contact and Staff Acknowledgments: 

Figures Figures: 

Figure 1: The Section 232 Program Comprises a Relatively Small Part of 
the GI/SRI Fund: 

Figure 2: Overall 5-and 10-Year Claim Rates for the Most Recent Cohorts 
of the Section 232 Program Are Among the Highest Historical Claim 
Rates: 

Figure 3: The 5-Year Claim Rate for New Construction Loans Has 
Increased in the Most Recent Cohort for Which Claim Rate Data Are 
Available: 

Figure 4: The 5-Year Claim Rates for Assisted Living and Board and Care 
Facilities Have Increased in the Most Recent Cohorts for Which Claim 
Rate Data Are Available:  

Figure 5: Section 232 Properties Are Concentrated in Several States:  

Figure 6: Initial Credit Subsidy Estimates for Section 232 Program New 
Construction and Substantial Rehabilitation Loans and for Section 232 
Program Refinance and Purchase Loans Have Not Indicated a Need for 
Subsidies: 

Figure 7: Conditional Claim Rates Are Different for Section 232 and 
Section 207 Refinance Loans:  

Figure 8: Conditional Prepayment Rates are Different for Section 232 
and Section 207 Refinance Loans: 

Abbreviations:

CON: Certificate of Need: 

DAP: Development Application Processing: 

FASAB: Federal Accounting Standards Advisory Board: 

FASS: Financial Assessment Subsystem: 

FHA: Federal Housing Administration: 

GI/SRI: General Insurance/Special Risk Insurance: 

HUD: U.S. Department of Housing and Urban Development: 

LQMD: Lender Quality Management Division: 

MAP: Multifamily Accelerated Processing: 

OMB: Office of Management and Budget: 

TAP: Traditional Application Processing: 

OPIIS: Online Property Integrated Information Suite: 

Letter: 
May 24, 2006: 

Congressional Addressees: 

Through its Section 232 Mortgage Insurance for Residential Care 
Facilities program (Section 232 program), the Department of Housing and 
Urban Development's (HUD) Federal Housing Administration (FHA) insures 
mortgages for nursing homes, assisted living facilities, board and care 
homes, and intermediate care facilities. As of December 31, 2005, the 
program insured mortgages with an unpaid principal balance of 
approximately $12.5 billion.[Footnote 1] The program insures HUD- 
approved private lenders against financial losses from loan defaults; 
insured loans can be used to finance the purchase, construction, or 
rehabilitation of a facility, enable borrowers to refinance projects 
that do not need substantial rehabilitation, or to install fire safety 
equipment. 

For budget and accounting purposes, the Section 232 program is part of 
HUD's General Insurance/Special Risk Insurance (GI/SRI) Fund; other 
programs in the GI/SRI Fund provide mortgage insurance for various 
types of multifamily housing projects and for hospitals. HUD is 
required to annually estimate the subsidy cost, or the cost to the 
federal government of guaranteeing credit to residential care 
facilities over the life of the loans.[Footnote 2] This estimate 
requires FHA to forecast future cash flows associated with the loans, 
which can be influenced by factors that are associated with the 
potential risks facing the program's loan portfolio. 

While private lenders may finance the purchase or construction of 
nursing homes, public funding, including Medicare and Medicaid, has 
accounted for an increasing percentage of spending on nursing home 
care.[Footnote 3] For example, in 2000 Medicare and Medicaid financed 
39 percent of the nation's spending on nursing home care, up 28 percent 
from 1990.[Footnote 4] In 2004, Medicare accounted for 14 percent and 
Medicaid accounted for 44 percent of the nation's spending on nursing 
home care, and the total of all public funds, including Medicare and 
Medicaid, accounted for approximately 61 percent.[Footnote 5] Federal 
and state governments share responsibility for oversight of nursing 
homes that participate in the Medicare and Medicaid programs. The U.S. 
Department of Health and Human Services defines standards that nursing 
homes must meet to participate in the Medicare and Medicaid programs 
and contracts with states to conduct annual inspections.[Footnote 6] 
Generally, states license nursing homes (and in some cases related 
facilities) and oversee their operations through inspections. 

The 2005 Consolidated Appropriations Conference Report mandated that we 
review the design and management of two FHA mortgage insurance programs 
--those for the Section 232 program and the Section 242 Hospital 
Mortgage Insurance program.[Footnote 7] In addition, the Ranking Member 
of the Subcommittee on Housing and Transportation, Senate Committee on 
Banking, and others requested that we review several aspects of the 
Section 232 program. Accordingly, this report provides both the results 
of the mandated review and our response to the request. Specifically, 
we examined: (1) HUD's management of the program, including loan 
underwriting and monitoring; (2) the extent to which HUD's oversight of 
insured residential care facilities is coordinated with the states' 
oversight of the quality of care provided by those facilities that are 
subject to state licensing or inspection; (3) the financial 
implications of the program to the GI/SRI Fund, including risk posed by 
program and market trends; and (4) how HUD estimates the annual credit 
subsidy for the program, including the factors and assumptions used. In 
addition, we examined HUD's action in response to a HUD Inspector 
General report that concluded that HUD's Office of Housing did not have 
adequate controls to effectively manage the Section 232 program; this 
information is summarized in appendix III. 

To address these objectives, we reviewed program manuals and 
documentation of loan processing procedures and underwriting 
requirements and analyzed program financial data that we tested and 
found reliable for our purposes.[Footnote 8] In examining HUD's 
management of the program, we focused on how underwriting and loan 
monitoring activities were carried out through visits to five of HUD's 
field offices (Atlanta, Georgia; Buffalo, New York; Chicago, Illinois; 
Los Angeles, California; and San Francisco, California), where we 
interviewed program officials and obtained relevant documents in each 
office.[Footnote 9] We also reviewed documentation of the model HUD 
uses to estimate program subsidy costs, applicable program laws, 
regulations, and policy statements. We obtained relevant program 
documentation and interviewed headquarters officials in HUD's Office of 
Multifamily Development and Office of Asset Management and HUD's Office 
of Evaluation and Office of Inspector General. We also interviewed 
representatives of residential care associations; lenders with loans 
insured by the program, as well as other private lenders that offer non-
FHA-insured residential care loans; and representatives of nursing 
homes and assisted living facilities. Our review did not include an 
evaluation of the need for the Section 232 program. See appendix I for 
more detailed information on our objectives, scope, and methodology. 

We conducted our work in Washington, D.C., and the HUD field office 
locations noted above between February 2005 and April 2006 in 
accordance with generally accepted government auditing standards. 

Results in Brief: 

While HUD's decentralized management of the Section 232 program allows 
field offices some flexibility in their specific practices, in our 
visits to five field offices we found a lack of awareness of some 
current program requirements, potentially useful loan underwriting and 
monitoring practices developed in individual offices that were not 
systematically shared with other offices, and concerns by field office 
managers about current or future levels of staff expertise. For 
example, four of the field offices were not aware of a notice that 
disqualifies potential Section 232 borrowers if they have had a 
bankruptcy in their past, and four offices were unaware of required 
addendums to the programs' standard regulatory agreement regarding 
certain state licensing requirements for nursing homes. While 
individual offices had developed useful practices for implementing the 
program's loan underwriting and monitoring requirements, they lacked a 
mechanism for systematically sharing practices with other offices. For 
example, two field offices included asset management staff--persons 
that monitor and oversee a loan after it has been insured--in the 
underwriting stages of loans to better assess their risks, while the 
other field offices did not. We also found that field office officials 
were concerned about adequate current or future levels of staff 
expertise--a critical factor in avoiding unwarranted risk in the 
Section 232 program, in that health care facility loans are generally 
more complicated and require more specialized knowledge and expertise 
compared with loans insured under HUD's other multifamily programs. 
Lack of awareness of current requirements and insufficient staff 
expertise can contribute to the program insuring loans with increased 
risks. 

FHA's coordination with states' oversight of residential care 
facilities' quality of care provided to residents is limited. FHA 
requires field office officials to review the most recent annual state 
administered inspection report for existing state-licensed facilities 
as part of the application. HUD recommends, but does not require, that 
officials continue monitoring annual inspection reports for a 
residential care facility once it is insured, particularly if the 
officials do not perform an on-site management review (an examination 
of operations, occupancy, financial management, and possible quality of 
care issues) of the facility. Four of the five HUD field offices we 
visited do not routinely review annual inspection reports for the 
insured facilities they oversee; further, HUD field offices conduct a 
limited number of management reviews of Section 232 facilities. While 
annual inspection reports are but one of several means of monitoring 
insured properties, FHA's limited use of them may lead the agency to 
miss potential indicators of risk for some of its insured loans. 
Because serious quality of care deficiencies can have a variety of 
implications that affect cash flow streams, ranging from a related 
reduction in occupancy to the more direct financial implications such 
as civil money penalties and loss of licensing and reimbursements, they 
may ultimately affect a facility's ability to repay the loan. Some 
private lenders told us they use the annual state inspection reports in 
coordination with other financial indicators to assess the financial 
risk of loans to facilities subject to state inspections. HUD is in the 
process of revising its residential care facility regulatory 
agreements--which establish loan conditions applicable to an owner and 
potential operator--to require owners or operators to (1) submit to HUD 
annual inspection reports and (2) report to HUD any notices of 
inspection violations. However, the proposed revisions have been 
awaiting approval since August 2004, and it is not clear when the 
revised agreements will be approved. 

Although the Section 232 program is a small component of the GI/ SRI 
Fund--representing approximately 16 percent of the total unpaid 
principal balance--program and industry trends may pose financial risks 
to the fund. For example: 

* In recent years, HUD has insured increasing numbers of mortgages that 
are refinances of existing loans, as well as loans for assisted living 
facilities. Because these types of loans are relatively new to the 
portfolio, there are limited data to observe long-term claim trends, 
making their risk difficult to assess. However, the 5-year claim rate 
(the portion of loans leading to a claim within 5 years of origination) 
was significantly higher for more recent assisted living facility 
loans. 

* The proportion of loans that terminate due to prepayment within 10 
years of origination is increasing. Prepayment occurs when a borrower 
pays a loan in full before the loan reaches maturity. As more borrowers 
prepay their loans, HUD loses future cash flows of premiums. Such 
losses could be offset to some extent, in that prepayments may 
ultimately result in fewer claims. 

* Program loans are concentrated in several states and among relatively 
few lenders. As of 2005, five states (California, Illinois, 
Massachusetts, New York, and Ohio) accounted for 51 percent of active 
loan amounts, with one state--New York--representing 24 percent. 
Further, while a total of 109 lenders held active loans, just 6 held 
over half of the active loan portfolio. Geographic concentration makes 
the program vulnerable to swings in regional economic conditions, while 
concentration among lenders potentially makes the program more 
vulnerable if one or a few large lenders encounters financial 
difficulty. 

In addition, industry developments and uncertainty in the funding of 
the Medicaid and Medicare programs pose potential risks. Projected 
shifts in demand for residential care facilities could affect not only 
the facilities currently insured by HUD but also the overall market for 
the particular types of facilities that HUD insures under the program. 

To estimate the subsidy cost of the Section 232 program, HUD uses a 
cash flow model to project the expected cash flows for all of these 
loans over their entire life. The cash flow model uses assumptions 
based on historical and projected data to estimate the amount and 
timing of claims, subsequent recoveries from these claims, prepayments, 
and premiums and fees paid by the borrower. We found that HUD's model 
does not explicitly consider certain factors such as loan prepayment 
penalties or lockouts (the period of time during which prepayment is 
prohibited), which can affect whether and when a loan is prepaid and 
may also show changes in the risk of claim and expected collections of 
premiums. HUD's cash flow model also does not fully capture the effects 
on existing loans when market interest rates change, nor explicitly 
consider differences in loan performance between different types of 
facilities. Furthermore, the model includes some proxy data with 
borrower characteristics and performance that is not comparable to 
Section 232 loans. The model's exclusion of potentially relevant 
factors and its use of this proxy data could affect the reliability of 
HUD's credit subsidy estimates. 

This report contains recommendations to HUD designed to ensure that 
field offices understand and implement current program requirements, 
including sharing practices among field offices. We also recommend that 
HUD incorporate reviews of annual inspection reports for nursing homes 
and other residential care facilities into its loan monitoring process, 
complete its proposed revision to the residential care facility 
regulatory agreement in a timely manner, and consider including 
additional variables and methods in its credit subsidy modeling. We 
provided a draft of this report to HUD and received written comments 
from the Assistant Secretary for Housing, which are discussed later in 
this report and in appendix V. In its response, HUD generally concurred 
with our recommendations intended to ensure that field offices are 
aware of and implement current program requirements and policies, but 
disagreed with most parts of our recommendation related to HUD's credit 
subsidy model. Specifically, HUD did not agree to consider factoring 
additional information into its credit subsidy model including 
prepayment penalties and restrictions, initial loan-to-value and debt 
service coverage ratios, and the ratio of contract rates and market 
rates. Because we believe that factoring such information into the 
credit subsidy model could be useful, we did not modify our 
recommendation. 

Background: 

Section 232 of the National Housing Act, as amended, authorizes FHA to 
insure mortgages made by private lenders to finance the construction or 
renovation of nursing homes, intermediate care facilities, board and 
care homes, and assisted living facilities.[Footnote 10] Congress 
established the Section 232 program in 1959 to provide mortgage 
insurance for the construction and rehabilitation of nursing homes. The 
Housing and Community Development Act of 1987 expanded the program to 
allow for the insuring of refinancing or purchase of FHA-insured 
facilities and, in 1994, HUD issued regulations implementing 
legislation to expand the program to allow for the insuring of assisted 
living facilities and the refinancing of loans for facilities not 
previously insured by FHA. Since 1960, FHA has insured 4,372 loans 
through the Section 232 program in all 50 states, the District of 
Columbia, the U.S. Virgin Islands, and Puerto Rico. As of the end of 
fiscal year 2005, there were 2,054 currently insured loans. 

FHA does not insure all residential care facilities, as there are 
approximately 16,500 nursing home facilities and over 36,000 assisted 
living facilities in operation.[Footnote 11] We did not identify any 
private mortgage insurance that is currently available for loans made 
to nursing homes or other similar facilities. According to HUD 
officials, in recent times, the Section 232 program exists, in part, to 
support the market for residential care facilities when the private 
market is reluctant to finance such projects due to market conditions. 
The loans are advantageous to borrowers because they are nonrecourse 
loans whereby the lender (in this case the lender and the insurer, FHA) 
has no claim against the borrower in the event of default and can only 
recover the property. The loans are also generally long term (in some 
cases up to 40 years) and, according to HUD and lender officials, offer 
an interest rate that is, in many cases, lower than what private 
lenders offer for non-FHA insured loans made to nursing homes and other 
similar facilities. Additionally, FHA insures 99 percent of the unpaid 
principal balance plus accrued interest. 

HUD administers the Section 232 program through its field offices, with 
HUD headquarters oversight. HUD's field structure consists of 18 Hub 
offices and 33 program centers. Generally, each Hub office has a number 
of program centers that report to it. Program centers administer 
multifamily programs within the states in which they are located or 
portions thereof. Hub offices also administer multifamily programs, as 
well as augment the operations of and coordinate workload between their 
program centers. 

Under Medicaid, states set their own nursing home payment rates 
(reimbursement rates), and the federal government provides funds to 
match states' share of spending as determined by a federal formula. 
Within broad federal guidelines, states have considerable flexibility 
to set reimbursement rates for nursing homes that participate in 
Medicaid but are required to ensure that payments are consistent with 
efficiency, economy, and quality of care.[Footnote 12] Under Medicare, 
skilled nursing facilities receive a federal per diem payment that 
reflects the resident's care needs and is adjusted for geographic 
differences in costs. 

HUD's Decentralized Management Provides Field Offices Flexibility, but 
Varying Awareness of Underwriting and Monitoring Practices and Concerns 
Over Insufficient Staff Expertise Increase Program's Potential Risks: 

While the decentralization of the program allows field offices some 
flexibility in their specific practices, the results of our visits to 
five field offices revealed differences in the extent to which field 
office staff were aware of current program requirements. Further, while 
individual offices had developed useful practices for implementing the 
program's loan underwriting and monitoring requirements, they lack a 
mechanism for systematically sharing practices with other offices. We 
also found that field office officials were concerned about adequate 
current or future levels of staff expertise--a critical factor in 
avoiding unwarranted risk in the Section 232 program, in that health 
care facility loans are generally more complicated and require 
specialized expertise compared with loans insured under HUD's other 
multifamily programs. Lack of awareness of current requirements and 
insufficient staff expertise can contribute to insuring loans with 
increased risks. Both factors are related to recommendations made in 
the HUD Office of Inspector General's 2002 report that HUD has not 
fully addressed (see app. III for further information on weaknesses 
identified by HUD's Inspector General). 

Some Field Offices Were Not Aware of All Current Program Requirements: 

FHA has numerous underwriting requirements for loans insured under the 
Section 232 program; for example, facilities must provide evidence of 
market need; a (real estate) appraisal; and be in compliance with 
limits on loan-to-value and debt service coverage ratios.[Footnote 13] 
FHA also requires a variety of reviews for monitoring Section 232 
loans. (Loan underwriting and monitoring requirements, which can 
involve fairly complex reviews and analyses, are described in more 
detail in app. II.) 

According to HUD headquarters officials, the field offices that 
administer the Section 232 program are required to follow all program 
statutes and regulations, but the decentralization of the program 
allows field offices some flexibility in their specific practices. For 
example, individual field offices can designate how to staff the 
underwriting and monitoring of Section 232 loans, depending on such 
factors as loan volume relative to other multifamily programs, to fully 
utilize resources. HUD headquarters provides guidance on program 
policies and requirements; when necessary, reviews applications for 
certain types of loans, such as those submitted by nonprofit entities; 
and provides technical assistance or additional guidance and support if 
contacted by field offices. HUD headquarters staff also conduct Quality 
Management Reviews, which are management reviews of field offices 
administering HUD programs and services. For these reviews, evaluators 
visit offices and coordinate subsequent reports. The process also 
involves reporting the status of follow-up corrective actions. While 
not focused on the Section 232 program, this process helps to oversee 
the program by reviewing the management of the field offices that 
administer it. 

We found that the five field offices that we visited varied in their 
understanding and awareness of policies related to the Section 232 
program. For example, staff in two field offices said that their 
standard regulatory agreement (that serves as the basic insurance 
contract and spells out the respective obligations of FHA, the lender, 
and the borrower) did not include language that would require operators 
of insured facilities to submit financial statements on new 
loans.[Footnote 14] According to officials at HUD headquarters, field 
offices should be using language requiring these financial statements. 
HUD and most lender officials we interviewed told us that operator 
financial statements provide information on the legal entity operating 
the facility in cases where the borrower and the operator of the 
residential care facility are different entities. These officials also 
stated that, in such situations, borrower financial statements may not 
disclose expenses, income, and other financial information, and may 
only show the transactions between the borrower and operator, thus 
making operator financial statements a necessity. Also, HUD's Inspector 
General identified HUD's lack of a requirement for operators to submit 
financial statements electronically to be part of an internal control 
weakness for the Section 232 program. 

Additionally, we found that the field offices that we visited were not 
always aware of specific notices that established new requirements or 
processes for the Section 232 program. For example: 

* Four of the five field offices that we visited were not aware of a 
notice that disqualifies potential Section 232 borrowers if they have 
had a bankruptcy in their past. According to a HUD headquarters 
officials, this policy is intended to protect HUD from insuring a 
potentially risky loan based on a borrower's financial history. 

* Officials at four of the five field offices we visited did not know 
about required addendums to the regulatory agreement regarding state 
licensing requirements for nursing homes. HUD developed these addendums 
to place a lien on a property's operational documents, such as a 
Certificate of Need and state licenses, to prevent operators from 
taking these documents with them upon termination of a property's 
lease.[Footnote 15] Without these documents, a facility may not be able 
to operate and, consequently, the property's value would be greatly 
diminished. 

According to HUD headquarters officials, HUD headquarters communicates 
changes in the Section 232 program's policies and procedures to field 
offices in a variety of ways besides sending formal notices. For 
example, HUD headquarters also posts some notices on a "frequently- 
asked questions" section of a Web site available to field offices, 
lenders, attorneys, and others.[Footnote 16] HUD headquarters officials 
also conduct nationwide conference calls with the field offices in 
which various HUD multifamily programs, including the Section 232 
program, are discussed. The conference calls are conducted separately 
for loan development staff and asset management staff that work, 
respectively, on the underwriting and monitoring of loans. HUD 
headquarters officials stated that these conference calls provide a 
forum to disseminate information to the field offices and for 
individual field offices to discuss any issues, questions, or concerns 
regarding any multifamily programs, including the Section 232 program. 

HUD headquarters officials stated that they plan to address the lack of 
awareness we observed by updating the "Multifamily Asset Management and 
Project Servicing Handbook" to clarify current policies and 
requirements for the Section 232 program. HUD is also planning to 
update the handbook to address the 2002 HUD Inspector General report 
that identified that HUD's current handbook was not specific to Section 
232 nursing home operations. However, HUD officials told us the updates 
to the handbook would not be completed until the proposed revisions to 
the applicable regulatory agreements have been approved. The proposed 
revisions have been awaiting approval since August 2004, and it is not 
clear when the revised agreements will be approved. 

Field Offices Do Not Systematically Share Information on Practices: 

As discussed earlier, field offices have some flexibility in practices 
that they use in administering the Section 232 program. In our visits 
to five field offices, we found a variety of practices that could be 
useful in the underwriting and monitoring of Section 232 loans if 
shared with other field offices. However, currently, HUD does not have 
systematic means by which to share this information among field 
offices. 

Officials in two of the five field offices we visited identified 
specific practices they had developed to carry out loan underwriting 
requirements. For example: 

* Asset management staff, whose focus is monitoring the performance of 
loans that are already insured, are asked to review a variety of 
documents submitted in the underwriting process, such as financial 
statements and information on the occupancy of the facility. 

* In one of the offices, staff members may contact relevant state 
officials, just before the closing of a loan, to verify that the state 
has not identified any quality of care deficiencies since the facility 
submitted the application for mortgage insurance. 

* Officials in one office stated that they conduct an additional review 
before approving a loan application for mortgage insurance to ensure 
that all required steps, such as mortgage credit analysis and 
valuation, have been properly performed. 

According to the officials in these two offices, it is necessary to 
take these additional steps in order to adequately underwrite a loan 
under this program. They stated that the additional steps result in the 
better screening of loan risk and could result in the rejection of a 
risky loan they might otherwise approve. 

We found a similar variety of practices in the monitoring of Section 
232 loans. In some cases, field offices we visited had taken additional 
steps beyond those required by HUD. For example: 

* While HUD requires a review of the annual financial statements of 
insured facilities, two field offices that we visited require monthly 
financial accounting reports from facilities either for the first year 
of the loan or until the facility has reached stable occupancy. 

* Two field offices had developed their own specialized checklists for 
monitoring Section 232 loans. These checklists were specifically 
designed for the oversight of residential care facility loans and 
included items such as the facility's replacement reserve accounts and 
professional liability insurance, among other items. 

* One of the offices had established a Section 232 working group, where 
underwriting and asset management staff met periodically to discuss 
loans in the portfolio and issues related to the overall management of 
the program in the field office. Additionally, three of the five field 
offices we visited had specialized staff with expertise in overseeing 
residential care facility loans. These were asset management staff 
whose primary or sole responsibility was oversight of the Section 232 
portfolio. 

* While HUD headquarters officials stated that they do not require 
management reviews of Section 232 facilities, three of the five field 
offices we visited conducted management reviews on some part of their 
Section 232 portfolios. 

* One field office obtained the state annual inspection reports on its 
Section 232 facilities on a regular basis. 

According to officials in these offices, the unique characteristics 
associated with residential care facilities make the additional 
measures necessary. 

Officials in field offices we visited that had developed these specific 
practices stated that the practices result in better underwriting and 
monitoring of loans and could potentially help to prevent claims. 
However, HUD field offices do not have a systematic means by which to 
share information with other field offices about practices they have 
developed. While field office officials can raise concerns and issues 
through conference calls with HUD headquarters officials, most 
explained that these conference calls are not particularly designed for 
field offices to share practices with other field offices. Officials in 
the five field offices that we visited told us that they occasionally 
contact their counterparts in other field offices regarding loan 
processing or asset management questions or issues. Additionally, 
officials in some field offices said that they occasionally see their 
counterparts at regional lender conferences. However, aside from these 
forms of contact, there was no systematic method by which to learn 
about other field office practices. Consequently, officials in one 
field office are likely to be unaware of additional steps or practices 
taken by another field office that are intended to help officials 
improve underwriting or monitoring of Section 232 loans. Officials at 
all field offices that we visited told us that they could benefit from 
the sharing of such practices regarding underwriting and monitoring 
procedures established by different offices. 

Officials Cited Concerns about Adequate Levels of Staff Expertise: 

Officials in two of the five field offices stated that a lack of 
expertise on residential care facility loans, either in underwriting or 
loan oversight, is a current concern in their office. They specifically 
noted a lack of expertise in residential care facilities and their 
overall management. Officials in all of the field offices that we 
visited stated that additional training on Section 232 loans would be 
beneficial to provide more knowledge and expertise, as there has been 
very little Section 232-specific training. In its 2002 report, HUD's 
Office of Inspector General also identified that field office project 
managers did not have sufficient training on reviewing Section 232 
loans and dealing with the issues unique to Section 232 properties. 

All of the private lenders we interviewed--those that offer non-FHA 
insured loans to residential care facilities and face similar risks to 
FHA--had a specialized group that conducted the underwriting of these 
loans. All of the individuals that conducted the underwriting of these 
loans were part of a health care lending unit that focused exclusively 
on loans made to health care facilities. According to the lenders, they 
believed it was necessary to have specialized staff underwriting such 
loans due to the unique nature of lending money to a facility that was 
designed for a residential health care business. Additionally, almost 
all of the private lenders we interviewed had specialized staff that 
monitored their residential care facility loans. According to lender 
staff we interviewed, nursing home and assisted living facility loans 
require an understanding of the market, trends, expenses, income, and 
other such unique characteristics associated with these types of 
facilities. 

While officials in only two of the five offices expressed concern about 
the expertise of current staff, officials in all field offices we 
visited stated that they are concerned about the ability to adequately 
staff the Section 232 program in the next 5 years. They stated that as 
older staff retire in the next 5 years or so, any expertise that such 
staff currently have will take time to replace. All of the field 
offices that we visited staffed the underwriting process for Section 
232 loans similar to that of other multifamily programs, based on 
workload and staff resources. However, while two field offices assigned 
their Section 232 properties, along with other multifamily properties, 
to general asset management staff for oversight, three field offices 
designated specific staff to oversee Section 232 properties. This was 
due to the latter field office officials' belief, similar to that of 
the private lenders we interviewed, that the properties require a 
certain level of knowledge and expertise associated with residential 
care facilities. Expertise in Section 232 loans allows for a better 
understanding of the distinct issues associated with oversight of 
residential care facilities. In one of the offices that had general 
asset management staff overseeing the portfolio, eight project managers 
shared responsibility for monitoring Section 232 properties in 
conjunction with other multifamily program properties. In contrast, in 
one of the offices with staff designated specifically for the Section 
232 program, one member of the asset management staff was responsible 
for the entire Section 232 portfolio. Officials from the two field 
offices that have experienced staff specialized in monitoring Section 
232 loans stated that they are concerned about losing their specialized 
staff over time and acknowledged that they will need to find 
replacements in order to continue to adequately monitor Section 232 
loans. Their concern stems in part from the fact that Section 232 
facilities, unlike other multifamily properties, require specialized 
knowledge and an understanding of the marketing, trends, and revenue 
streams associated with residential care facilities. 

According to officials in all of the field offices that we visited, 
monitoring of Section 232 loans, when compared with other FHA-insured 
multifamily programs, requires additional measures. Section 232 loans 
contain a complex business component--the actual assisted living 
service or the nursing service operating in a facility--making them 
different from other multifamily programs that are solely realty loans. 
Consequently, for Section 232 loans, field office officials monitor the 
financial health of the business, including expenses, income, and other 
such items. Some field office officials also stated that it is 
important to monitor the operator to ensure that the facility is 
adequately managed. Additionally, some field office officials stated 
that to ensure the facility is generating enough income, they have to 
monitor Medicare and Medicaid reimbursement rates, as well as occupancy 
rates. 

According to HUD headquarters officials, as part of its overall 
strategic human capital efforts, HUD is currently assessing the loss of 
human capital in field offices over time. However, this effort is not 
focused on the Section 232 program specifically but is intended to 
examine general human capital issues and needs. 

FHA's Coordination with States' Oversight of Quality of Care for 
Section 232 Residential Care Facilities Is Limited: 

FHA requires field office officials, when processing applications for 
Section 232 mortgage insurance from existing state-licensed facilities 
to review the most recent annual state-administered inspection report 
for the facilities, but does not require the continued monitoring of 
annual inspection reports for state-licensed facilities once it has 
insured them. Four of the five HUD field offices we visited do not 
routinely collect annual inspection reports for the insured facilities 
they oversee. While such reports are but one of several means of 
monitoring insured properties, FHA's limited use of them may lead the 
agency to overlook potential indicators of risk for some of its insured 
loans. 

FHA Requires Some Coordination with States' Oversight of Quality of 
Care for Section 232 Residential Care Facilities: 

State inspections or surveys of residential care facilities may stem 
from state licensing requirements or the facilities' participation in 
Medicare or Medicaid. Nursing homes are state licensed, while states 
vary in their licensing requirements for assisted living facilities. 
The Department of Health and Human Services' Centers for Medicare & 
Medicaid Services requires that nursing homes receiving Medicare and 
Medicaid funding be federally certified, and all certified facilities 
are subject to annual federal inspections administered by the states. 
State survey agencies, under agreements between the states and the 
Secretary of Health and Human Services, conduct the annual federally 
required inspections. To complete the annual inspections, teams of 
state surveyors visit Medicare and Medicaid participating facilities 
and assess compliance with federal facility requirements, particularly 
whether care and services provided meet the assessed needs of the 
residents. These teams also assess the quality of care provided to 
residents of the facilities, looking at indicators such as preventing 
avoidable pressure sores, weight loss, or accidents. Overall, annual 
inspections provide a regular review of quality of care by officials 
with relevant backgrounds, such as, registered nurses, social workers, 
dieticians, and other specialists. For facilities that are applying for 
mortgage insurance under the Section 232 program, FHA requires a copy 
of the state license needed to operate the facility and a copy of the 
latest state annual inspection report on the facilities' operation. 

HUD's "Multifamily Asset Management and Servicing Handbook" recommends 
that, once nursing home loans are insured under the program, HUD 
officials responsible for loan monitoring continue to review state 
annual inspection reports if they do not undertake management reviews 
of the facility. Management reviews focus on an insured facility's 
financial indicators and general management practices, but, 
particularly if conducted on-site, could provide some information on 
issues related to the quality of care at a facility. Because of their 
wider scope, however, management reviews would not likely go into the 
same depth on quality of care issues as annual inspections. HUD 
headquarters officials told us that the handbook's recommendation 
applies to all Section 232 facilities; further, HUD headquarters 
officials stated that management reviews for Section 232 properties 
should be conducted based on need and available resources. We found 
that two of five field offices we visited did not regularly conduct any 
regular management reviews and did not review annual inspection reports 
during loan monitoring. Of the three field offices that did conduct 
management reviews on some Section 232 properties, one also reviewed 
annual inspection reports during loan monitoring. Additionally, the 
offices that did not review annual inspection reports had little direct 
interaction with the state agencies. Private lenders overseeing non-FHA 
insured residential care facilities told us that they regularly conduct 
various levels of management reviews and review annual inspection 
reports on a consistent basis. 

FHA has emphasized the importance of ongoing coordination with state 
oversight agencies in its proposed revisions to its regulatory 
agreements, which require owners or operators of insured facilities to 
report any state or federal violations to FHA. HUD's proposed revisions 
to the regulatory agreements also include a requirement that the owner 
or operator provide HUD with copies of annual inspection reports that 
can be used as part of loan monitoring. However, the proposed revisions 
to the regulatory agreements have yet to be approved. 

FHA's Limited Coordination with States on Oversight Issues May Lead to 
Missed Identification of Risk Indicators: 

Serious quality of care deficiencies can have a variety of implications 
that affect cash flow streams, ranging from a related reduction in 
occupancy to the potential for civil money penalties and loss of 
licensing and reimbursements. Consequently, quality of care concerns 
can ultimately affect a facility's financial condition. For many 
Section 232 properties, in particular nursing homes, state oversight of 
quality of care helps to determine whether a facility is licensed and 
eligible to receive Medicaid and Medicare reimbursements. This is 
particularly important to the Section 232 program because, as noted 
earlier in this report, Medicaid and Medicare reimbursements typically 
account for a significant portion of nursing home income. 

Federal or state annual inspection reports, to the extent that they are 
available for facilities, provide regular evaluations of nursing homes 
and other residential care facilities. As discussed earlier, annual 
inspections provide a review of quality of care by officials with 
relevant backgrounds. In a 2005 report, we found inconsistencies across 
states in conducting surveys and state surveyors understating serious 
deficiencies in quality of care.[Footnote 17] Nonetheless, annual 
inspection reports serve as an important indicator of a property's risk 
related to problems with the quality of care to residents. 

Annual inspection reports, coupled with other information such as 
facility staffing profiles, resident turnover, and data from financial 
statements, could assist HUD's field offices in overseeing loan 
performance. Additionally, reviewing facilities' quality of care 
records over time, as well as any corrective action plans needed to 
come into compliance with state and federal quality of care 
requirements could further the field offices' ability to identify loan 
performance risks. The reports may also prompt HUD field office 
officials to communicate with federal or state nursing home regulatory 
agencies for further information on facilities that appear to be high 
risk. These agencies may have available information on civil money 
penalties and sanctions, which serve as additional indicators of 
quality of care risk. Private lenders we spoke with acknowledged that 
annual inspection reports provided insight into the management of a 
facility and coupled with other information could help to assess 
financial risk. 

Program and Industry Trends Show Sources of Potential Risks to the GI/ 
SRI Fund: 

The Section 232 program represents a relatively small share of the 
broader GI/ SRI Fund. However, program and industry trends show sources 
of potential risks that could affect the future performance of the 
Section 232 portfolio and the GI/SRI Fund. FHA uses a number of tools 
to mitigate risk to the program and to the fund. 

The Section 232 Program Represents a Small Percentage of the GI/SRI 
Fund: 

The Section 232 program is a relatively small share of the total GI/SRI 
Fund. HUD estimated that the program would represent only about 5.3 
percent of the fund's fiscal year 2006 commitment authority.[Footnote 
18] Similarly, the Section 232 program represents a little less than 16 
percent or a little more than $12.5 billion of the nearly $80 billion 
in unpaid principle balance in the GI/SRI Fund (see fig. 1). Despite 
its small size, a significant worsening in the performance of the 
Section 232 program could negatively affect the performance of the GI/ 
SRI Fund. The extent, though, of the impact on the overall performance 
of the GI/SRI Fund would depend upon numerous factors including changes 
in the size and performance of the other programs in the fund. 

Figure 1: The Section 232 Program Comprises a Relatively Small Part of 
the GI/SRI Fund: 

[See PDF for image] 

Note: Numbers have been rounded to closest whole number. 

[End of figure] 

Program Trends Show Sources of Potential Risk: 

As discussed below, several trends exist within the Section 232 program 
that pose potential risks to the Section 232 portfolio and, therefore, 
to the GI/SRI Fund. 

Higher Claim Rates for Recent Loan Cohorts: 

To identify potential trends in loan performance, we analyzed 5-and 10- 
year claim rates for Section 232 loans based on data that spanned from 
fiscal year 1960 through the end of fiscal year 2005, for the entire 
portfolio, as well as by type of loan purpose and type of insured 
facility. The analysis of the entire portfolio showed that the 10-year 
claim rates for more recent loan cohorts (loans originated between 1987 
and 1991 and loans originated between 1992 and 1996) ranked among the 
highest historical cohort claim rates (see fig. 2).[Footnote 19] The 5- 
year claim rate for loans originated between 1997 and 2001 also ranked 
among the highest historical cohort claim rates. A continued increase 
in claim rates could have a negative effect on the performance of the 
GI/SRI Fund. 

Figure 2: Overall 5-and 10-Year Claim Rates for the Most Recent Cohorts 
of the Section 232 Program Are Among the Highest Historical Claim 
Rates: 

[See PDF for image] 

[End of figure] 

Changes in Claim Rates by Loan Purpose: 

Section 232 loans can have a loan purpose in one of two categories--new 
construction/substantial rehabilitation loans or refinance/purchase 
loans. New construction loans are for loans that involve the 
construction of a new residential care facility. Substantial 
rehabilitation loans are for loans that meet HUD criteria for 
substantial rehabilitation of a residential care facility, such as two 
or more building components being substantially replaced. Purchase 
loans are for loans in which the borrower is acquiring an existing 
residential care facility, while refinance loans are the refinancing of 
an existing HUD insured loan or a loan not previously insured by HUD. 
As described earlier in the report, HUD began to allow for the 
refinancing of FHA-insured facilities and non-FHA insured facilities in 
1987 and 1994, respectively. When analyzing Section 232 loan data by 
loan purpose, we found that new construction/substantial rehabilitation 
loans have a higher 5-year claim rate than refinance/purchase loans for 
the most recent cohort: 

for which data are available (see fig. 3).[Footnote 20] New 
construction/substantial rehabilitation loans originated between 1997 
and 2001 also have the highest historical 5-year cohort claim rate for 
these type of loans. Because of the higher claim rates in recent years, 
continued monitoring will be important. In contrast, the number of 
refinance and purchase loans endorsed in the last 5 years is more than 
double those endorsed in the previous 5 years. The future impact of the 
refinance and purchase loans on the overall performance of the Section 
232 program is uncertain since they have existed for a shorter period 
of time and thus there is currently limited data available to assess 
the relative risk of claims. 

Figure 3: The 5-Year Claim Rate for New Construction Loans Has 
Increased in the Most Recent Cohort for Which Claim Rate Data Are 
Available: 

[See PDF for image] 

[End of figure] 

Changes in Claim Rates by Facility Type: 

As discussed earlier in the report, HUD insures different types of 
residential care facilities that include nursing homes, intermediate 
care facilities, assisted living facilities, and board and care 
facilities. Assisted living facilities are relatively new to the 
portfolio, and the number of these loans have been increasing. Our 
analysis of Section 232 loan data by facility type found that board and 
care facilities had a slightly higher 10-year claim rate than nursing 
home facilities in the most recent cohorts; however, these loans remain 
a very small percentage of the active portfolio and are being made in 
decreasing numbers. There are limited data to observe claim trends on 
assisted living facilities, making their risk difficult to assess, but 
the 5-year claim rates for assisted living facilities have increased 
significantly in the most recent cohort years for which claim rate data 
are available (see fig. 4). A continued high claim rate in assisted 
living facilities could negatively affect the performance of the 
Section 232 program and the GI/SRI Fund. However, lenders and HUD 
officials told us that, although assisted living facilities had high 
claim rates in the past, they believe the market has stabilized and 
lessons have been learned. 

Figure 4: The 5-Year Claim Rates for Assisted Living and Board and Care 
Facilities Have Increased in the Most Recent Cohorts for Which Claim 
Rate Data Are Available: 

[See PDF for image] 

[End of figure] 

Increase in Loan Prepayments: 

Another observable trend is the increase in the portion of loans in 
each cohort that is prepaid. (Prepayment occurs when a borrower pays a 
loan in full before the loan reaches maturity.) There have been 1,688 
prepayments in the Section 232 program from 1960 through the end of 
fiscal year 2005 and loans that terminate do so overwhelmingly because 
of prepayment. Moreover, the proportion of loans that terminate due to 
prepayment within 10 years of origination is increasing. Specifically, 
the 10-year prepayment rates for the three most recent cohorts for 
which 10-year claim rates are available are more than double that of 
some earlier cohorts. As more borrowers prepay their loans, HUD loses 
future cash flows from premiums; thus, higher prepayment rates will 
likely make the net present value of cash flows decrease. However, the 
decrease could be offset to the extent that higher prepayment rates 
result in fewer claims (a prepaid loan cannot result in a claim). 

Concentration of Loans: 

Market concentration also poses some risks to the GI/SRI Fund. The 
Section 232 program is concentrated in several large markets and in 
loans made by relatively few lenders. As of 2005, five states 
(California, Illinois, Massachusetts, New York, and Ohio) held 51 
percent of active Section 232 loan dollars and 38 percent of active 
loan properties (see fig. 5). New York holds close to 24 percent of the 
active loan dollars in the portfolio. This is an improvement since 1995 
when we found that eight states accounted for 70 percent of the 
portfolio, and New York accounted for 32 percent of the portfolio. 
However, the current market concentration could still pose risk to the 
portfolio if a sudden market change took place in one or more of the 
states with a larger percentage of the insured Section 232 loans. We 
also found significant loan concentration among a small group of 
lenders. While a total of 109 lenders held active loans, 6 hold over 
half of the active loan portfolio. GMAC Commercial Mortgage Corporation 
holds more than 17 percent of all active mortgages in the Section 232 
program, the single largest share of any lender. This concentration 
among lenders potentially makes the program more vulnerable if one or a 
few large lenders encounter financial difficulty. 

Figure 5: Section 232 Properties Are Concentrated in Several States: 

[See PDF for image] 

Note: Active loan dollars are from F47 as of the end of calendar year 
2005, and number of loans are from F47 as of the end of fiscal year 
2005. This also does not include one loan for which property state 
information was not available in F47. Numbers have been rounded to 
closest whole number. 

[End of figure] 

Industry Faces Uncertainties: 

The Section 232 program may also face risks from trends in the 
residential care industry at large that include uncertainty about 
sources of revenue and occupancy. Nursing home revenue is generated in 
large part from the Medicare and Medicaid programs, which make up 58 
percent of national nursing home spending. Private lenders we 
interviewed that offer non-FHA-insured residential care facility loans 
explained that one of the primary reasons their loans are shorter-term 
loans than those of HUD is due to their perception of the potential, 
long-term uncertainty in the funding of the Medicaid and Medicare 
programs, which generally account for a large share of patient payments 
in nursing homes. We and others have reported that Medicare and 
Medicaid spending may not be sustainable at current levels.[Footnote 
21] In our 2003 report on the impact of fiscal pressures on state 
reimbursement rates, however, we found that even in states that 
recently faced fiscal pressures, reimbursement rates remained largely 
unaffected.[Footnote 22] At that time, we concluded that any future 
changes to state reimbursement rates remain uncertain. If program cuts 
occur in federal spending on Medicaid that result in shifting costs 
from the federal government to state governments, states could contain 
costs by taking a number of steps, including freezing or reducing 
reimbursement rates to providers. An ongoing tension exists, however, 
between what federal and state governments and the nursing home 
industry believe to be reasonable Medicare and Medicaid reimbursement 
rates to operate efficient and economic facilities that provide quality 
care to public beneficiaries. As the federal and state governments face 
growing long-term financial pressure on their budgets, these budgetary 
pressures may have some spillover effects on Medicare and Medicaid 
revenue streams for the nursing home industry. 

Uncertainty also exists about the future demand for residential care 
facilities and the corresponding effects on occupancy. As the number of 
Americans aged 65 and older increases at a rapid pace, lenders we 
interviewed projected an increased need for residential care 
facilities.[Footnote 23] Industry officials also noted a rise in 
alternatives to nursing home care, such as assisted living facilities 
and home and community-based care options. As patients choose 
alternative care options, traditional nursing homes may face occupancy 
challenges. Overall, these changes to the nursing home facilities 
patient base may lower occupancy and income levels for nursing homes, 
including those in the Section 232 portfolio. However, these changes 
may positively affect the occupancy and income levels of other types of 
residential care facilities, including those in the Section 232 
portfolio. 

FHA Uses a Number of Tools to Mitigate Risks: 

As described elsewhere in this report, FHA uses a number of tools to 
mitigate risks to the program and to the GI/SRI Fund. These tools 
include imposing requirements prior to insuring loans to help prevent 
riskier loans from entering the Section 232 portfolio. FHA also uses 
various tools--such as reports on physical inspections of facilities, 
and financial and other information captured in data systems--to 
monitor the status of insured facilities and the performance of their 
loans. Additionally, FHA officials use quality control reviews to 
mitigate the risk for the program as a whole using two processes: 
Quality Management Reviews and Lender Qualifications and Monitoring 
Division reviews (the latter reviews are described in app. II). 

HUD's Model for Estimating Credit Subsidy Costs Excludes Some 
Potentially Relevant Factors: 

HUD's model for estimating annual credit subsidies--which incorporates 
assessments of various risks that loan cohorts will face and includes 
assumptions consistent with the Office of Management and Budget (OMB) 
guidance--does not explicitly consider the impacts of some potentially 
important factors. These factors include: variables to capture the 
impact of prepayment penalties or restrictions on prepayments, the loan-
to-value ratio and debt service coverage ratios of Section 232 
properties at the time of loan origination and differences between 
types of residential care facilities. Further, the model does not fully 
capture the effects on existing loans to changes in market interest 
rates, and it uses proxy data that are not comparable to the loans in 
the Section 232 program. As a result, HUD's model for estimating the 
program's credit subsidy may result in over-or underestimation of 
costs. 

HUD Uses a Model to Estimate Credit Subsidy Costs: 

Federal law requires HUD to estimate a credit subsidy for its loan 
guarantees. The credit subsidy cost is the estimated long-term cost to 
the government of a loan guarantee calculated on a net present value 
basis and excluding administrative costs. HUD estimates a credit 
subsidy for each loan cohort. This estimate reflects HUD's assessment 
of various risks, based in part on the performance of loans already 
insured. Since 2000, HUD has annually estimated two credit subsidy 
rates for the Section 232 program, reflecting its two largest risk 
categories: loans for new construction and substantial rehabilitation, 
and loans for refinance and purchase loans.[Footnote 24] HUD uses an 
identical methodology for each estimate. 

To estimate the initial subsidy cost of the Section 232 program, HUD 
uses a cash flow model to project the cash flows for all identified 
loans over their expected life. The cash flow model incorporates 
regression models and uses assumptions based on historical and 
projected data to estimate the amount and timing of claims, subsequent 
recoveries from these claims, prepayments, and premiums and fees paid 
by the borrower. The regression models incorporate various economic 
variables such as changes in GDP, unemployment rate, and 10-year bond 
rates. The model also has broken out claim and prepayment data into new 
construction and refinance loans since these loans are expected to 
perform differently. 

HUD inputs its estimated cash flows into OMB's credit subsidy 
calculator, which calculates the present value of the cash flows and 
produces the official credit subsidy rate. A positive credit subsidy 
rate means that the present value of cash outflows is greater than 
inflows, and a negative credit subsidy rate means that the present 
value of cash inflows is greater than cash outflows. For the Section 
232 program, cash inflows include premiums and fees, servicing and 
repayment income from notes held in inventory, rental income from 
properties held in inventory, and sale income from notes and properties 
sold from inventory. Cash outflows include claim payments and expenses 
related to properties held in inventory. 

Since HUD began estimating the initial subsidy cost of the Section 232 
program, it has estimated that the present value of cash inflows would 
exceed the outflows. As a result, the initial credit subsidy rates for 
the Section 232 program were negative. However, estimates from more 
recent years showed that the negative subsidy rates on new construction 
and substantial rehabilitation loans have generally been shrinking, 
meaning that the projected difference between the program's cash 
inflows and cash outflows was decreasing. In HUD's most recent estimate 
(for the fiscal year 2007 cohort), the estimated cash inflows exceed 
the estimated cash outflows by a considerably greater margin than in 
any previous year's estimate. This may reflect increased premiums for 
Section 232 loans; the President's proposed budget for fiscal year 2007 
specifies increases in mortgage insurance premiums for almost all FHA 
programs, including increasing the rate for Section 232 refinance and 
new construction loans to 80 basis points from 57 basis points. Figure 
6 shows changes in the initial estimated credit subsidy rate over time 
for both loan categories. 

Figure 6: Initial Credit Subsidy Estimates for Section 232 Program New 
Construction and Substantial Rehabilitation Loans and for Section 232 
Program Refinance and Purchase Loans Have Not Indicated a Need for 
Subsidies: 

[See PDF for image] 

Note: Initial credit subsidy estimates were not available for 1997 for 
new construction and substantial rehabilitation loans and for 1996-1999 
for refinance and purchase loans. 

[End of figure] 

Features of the Credit Subsidy Model May Lead to Unreliable Credit 
Subsidy Estimates: 

HUD's model for estimating credit subsidy rates incorporates numerous 
variables, but the model's exclusion of potentially relevant factors 
and its use of proxy data from another FHA loan program may negatively 
affect the quality of the estimates. Including additional information 
in the model could enhance the predictive value of the model. 

Prepayment Penalties or Restrictions: 

According to some economic studies, prepayment penalties, or penalties 
associated with the payment of a loan before its maturity date, can 
significantly affect borrowers' prepayment patterns.[Footnote 25] This 
is also important for claims, since if a loan is prepaid it can no 
longer go to claim. HUD's model does not explicitly consider the 
potential impact of prepayment penalties or restrictions, even though 
they can influence the timing of prepayments and claims and collections 
of premiums. According to FHA officials, FHA does not place prepayment 
penalties on FHA-insured nursing home loans. However, according to the 
Section 232 program's regulations, a lender can impose a prepayment 
penalty charge and place a prepayment restriction on the mortgage's 
term, amount, and conditions.[Footnote 26] We reviewed a sample of 
Section 232 loans and found that prepayment penalties and restrictions 
were consistently applied to these loans.[Footnote 27] 

According to FHA officials and mortgage bankers, prepayment 
restrictions on Section 232 loans typically range from 2 to 10 years of 
prepayment restrictions and 2 to 8 years of prepayment penalties. While 
FHA does not specifically maintain data on insured residential care 
facility financing terms, prepayment restrictions are specified on the 
mortgage note, which is available to FHA. Incorporation of such data 
into the Section 232 program's credit subsidy rate model could refine 
HUD's credit subsidy estimate by enhancing the model's ability to 
account for estimated changes in cash flows as a result of prepayment 
restrictions. 

According to HUD officials responsible for HUD's cash flow model, 
prepayment penalties and restrictions are not incorporated into the 
model because HUD does not collect such data. HUD officials added that 
even though the cash flow model does not explicitly account for 
prepayment penalties and restrictions, its use of historic data 
implicitly captures trends that may occur as a result of prepayment 
penalties and restrictions. The model's projections are influenced by 
the average level of prepayment protection in the historical data but 
not by the trend. If prepayment penalties and other restrictions have 
changed over time in the past, or change in the future, then not 
incorporating this information could lead to less reliable estimates. 

Debt Service Coverage Ratio at Point of Loan Origination: 

Initial debt service coverage ratios are another important factor that 
may affect cash flows, as loans with lower initial debt service 
coverage ratios may be more likely to default and result in a claim 
payment. HUD's cash flow model does not consider the initial debt 
service coverage ratio of Section 232 loans at the point of loan 
origination. By initial debt service coverage ratio, we are referring 
to the projected debt service coverage ratio that is considered during 
loan underwriting. According to the HUD official responsible for HUD's 
cash flow model, the initial debt service coverage ratio of a 
residential care facility is not included as a part of the cash flow 
model because it (1) is not a cash flow, (2) does not vary, and (3) has 
no predictive value. We agree that a debt service coverage ratio is not 
a cash flow. However, initial debt service coverage ratios potentially 
affect relevant cash flows, as do other factors that are included in 
HUD's model but are also not cash flows to HUD, such as prepayments. 
For example, the model considers estimated prepayments because they 
potentially affect future cash inflows from fees and future cash 
outflows from claim payments. 

Our analysis of available projected debt service coverage ratios, which 
include the amount of new debt being insured, shows that these ratios 
varied from 1.1 to 3.6.[Footnote 28] All other factors being equal, 
loans with debt service coverage ratios of 3.6 are generally considered 
to have less risk than a loan with only a 1.1 debt service coverage 
ratio. 

Economic theory suggests that the debt service coverage ratio is an 
important factor in commercial mortgage defaults. However, empirical 
studies show mixed results regarding the significance of the impact of 
debt service coverage ratios upon commercial mortgage defaults. Some 
studies indicate that debt service coverage ratios are meaningful 
factors in modeling default risk and are helpful in predicting 
commercial mortgage terminations.[Footnote 29] Other studies find 
initial debt service coverage ratios to be statistically insignificant 
in modeling commercial mortgage defaults.[Footnote 30] These mixed 
results may be the consequence of relatively small sample sizes and 
model specification issues. 

Loan-to-Value Ratio at Point of Loan Origination: 

Initial loan-to-value ratios are another important factor that may 
affect cash flows, as loans with higher initial loan-to-value ratios 
may be more likely to default and result in a claim payment. By initial 
loan-to-value ratio, we are referring to the projected loan-to-value 
ratio that is considered during loan underwriting. HUD's cash flow 
model also does not consider the initial loan-to-value ratio of Section 
232 loans at the point of loan origination. 

According to the HUD official responsible for HUD's cash flow model, 
the initial loan-to-value ratio of a Section 232 property is not 
included as a part of the cash flow model because it does not vary and 
has no predictive value. However, our analysis of available projected 
loan-to-value ratios, which include the amount of new debt being 
insured, shows that these ratios varied from 66 percent to 95 
percent.[Footnote 31] All other factors being equal, loans with loan- 
to-value ratios of 66 percent are generally considered to have less 
risk than a loan with only a 95 percent loan-to-value ratio. While 
economic theory suggests that the loan-to-value ratio is an important 
factor in commercial mortgage defaults, empirical studies show mixed 
results regarding its significance. Some studies indicate that loan-to- 
value ratios are meaningful factors in modeling default risk and are 
helpful in predicting commercial mortgage terminations.[Footnote 32] 
Other studies find initial loan-to-value ratios to be statistically 
insignificant in modeling commercial mortgage defaults.[Footnote 33] 
These mixed results may be the consequence of relatively small sample 
sizes and model specification issues. 

Types of Facilities Insured and Changes in Interest Rates: 

The model's ability to reliably forecast claim rates may be enhanced by 
incorporating a variable indicating facility type into the regression 
analysis. HUD's cash flow model does not explicitly consider 
differences in loan performance between types of facilities, such as 
nursing homes, assisted living facilities, and board and care 
facilities. However, when looking at the most recent cohorts for which 
5-year claim rates are available, our analysis found the 5-year claim 
rates for assisted living facilities to be significantly higher than 
the 5-year claim rates for nursing homes (6.7 percent 5-year claim rate 
for nursing homes versus 13.6 percent for assisted living facilities). 

In addition, we found that HUD's cash flow model generally incorporates 
the interest rate on the individual loans (the contract rate) and the 
prevailing market interest rate (captured by the 10-year bond rate) as 
separate variables. Economic theory suggests, when modeling mortgage 
terminations, that considering these two variables jointly as a single 
variable in the form of a ratio is the best way to capture the effects 
on existing loans when market interest rates change.[Footnote 34] For 
example, if market rates fall below the contract rate on existing 
Section 232 loans, then it may become more attractive for borrowers to 
prepay. However, if market rates fall but remain above the contract 
rates, then it may not become more attractive for borrowers to prepay. 
Using a ratio captures the distinction between these two examples 
because it considers the relative cost to the borrower of the mortgage 
given the contract rate, as compared to the mortgage with the market 
interest rate. By generally considering the contract rate and market 
interest rate separately, HUD potentially loses the ability to capture 
this distinction and predict large responses when market rates fall and 
small responses when market rates rise.[Footnote 35] 

Use of Proxy Data: 

HUD's use of Section 207 loans as a proxy for Section 232 refinance 
loans could lead to less reliable credit subsidy estimates for the 
Section 232 program. HUD uses certain Section 207 loans--refinance 
loans for existing multifamily housing properties--as proxy data for 
the claim regression for Section 232 refinance loans. The Section 207 
loans are not residential health care facility loans. According to HUD 
officials, HUD uses the Section 207 loans because there are 
insufficient data on Section 232 refinance loans. A HUD official told 
us that Section 207 loans were selected as proxy data because they are 
refinance loans and because they have similar performance to the 
Section 232 refinance loans, as indicated by the cumulative claim rates 
they calculated. 

Consideration of the basis for using proxy data is important. When 
using the experience of another agency or a private lender as a proxy, 
the Federal Accounting Standards Advisory Board (FASAB) suggests that 
an agency explain why this experience is applicable to the agency's 
credit program and examine possible biases for which an adjustment is 
needed, such as different borrower characteristics.[Footnote 36] HUD 
could reasonably be expected to follow the FASAB guidance when using 
data from a different program at HUD. HUD told us that they did not 
compare borrower characteristics for Section 207 loans and Section 232 
loans. A HUD official told us that HUD agreed that they would not 
expect borrowers of Section 207 loans to have similar characteristics 
to borrowers of Section 232 loans. 

HUD analyzed the comparability of Section 207 and Section 232 refinance 
loans using cumulative claim rate analysis, but we question the 
methodology the agency used to make this comparison. Additionally, we 
compared the refinance loans for each of the programs by calculating 
conditional claim and prepayment rates as well as 5-year cumulative 
claim and prepayment rates, and we found significant differences 
between the programs (see app. IV for a further description of HUD's 
methodology and our comparison of the two programs). 

We question HUD's use of Section 207 loans as a proxy for Section 232 
loans, given the differences we observed. We cannot fully estimate the 
overall impact on the credit subsidy estimate, and the effects of the 
claim and prepayment rates could partially offset each other. The 
higher prepayment rates for Section 207 loans could lead to HUD 
underestimating future revenues for Section 232 loans (HUD would 
project that many of these loans would terminate, although they would 
actually remain active and pay premium revenue to HUD.) The lower claim 
rates on Section 207 loans could result in HUD estimating that fewer of 
its Section 232 loans would result in a claim and thus lead it to 
underestimate future costs. 

In the future, more data will be available on the actual performance of 
Section 232 refinance loans that can be used in estimating credit 
subsidy needs. To avoid using questionable proxy data in the interim, 
one possible approach, among others, would be to use a simpler 
estimation method, such as using average claim and prepayment rates 
over time as is done in estimating credit subsidy rates for the Section 
242 Hospital Mortgage Insurance program. 

Conclusions: 

The Section 232 program is the only source of mortgage insurance for 
residential care facilities. Accordingly, it is important to ensure 
good program and risk management practices. While some field offices we 
visited had adopted practices to better manage risks of their Section 
232 loans, varying awareness of program requirements and insufficient 
levels of staff expertise contribute to increased financial risk in the 
Section 232 program loan portfolio and thus the GI/SRI Fund. HUD has 
numerous underwriting and monitoring guidelines and policies to manage 
the risks of Section 232 loans. However, to the extent that field 
office staff do not accurately implement current underwriting and 
monitoring guidelines and policies, they potentially allow loans with 
unwarranted risks to enter the portfolio and may miss opportunities to 
identify problems with already-insured loans early enough to help 
prevent claims. Revising the "Multifamily Asset Management and Project 
Servicing Handbook" to include monitoring requirements specific to the 
Section 232 program, as the Office of Inspector General noted in its 
2002 report, would help in this regard. So too would the sharing of 
additional practices, such as involving asset management staff in the 
underwriting process, undertaken by some field offices to better manage 
risks in their program loans. Moreover, adequately training staff to 
develop expertise on residential care loans and industry could help 
assure proper underwriting and oversight of Section 232 loans, which 
tend to be more complex than those in other HUD multifamily programs. 
Field office officials' concerns about their existing levels of staff 
expertise heighten the need for appropriate guidance and additional 
training specific to the Section 232 program, while the potential loss 
of specialized staff within the next 5 years underscores the need for 
HUD, in the context of its strategic human capital efforts, to assure 
adequate program expertise in the future. 

Although HUD recommends that field offices obtain and review annual 
inspection reports for licensed facilities insured by the program, four 
of five offices we visited did not do so. By not routinely using, in 
combination with other performance indicators, the results of annual 
inspection reports on insured facilities subject to such inspections, 
HUD may be missing important indicators of problems that could result 
in claims that might otherwise have been prevented. Reviewing 
inspection reports is also a means of obtaining relevant information 
about insured facilities that have not been the subject of FHA 
management reviews. HUD's long-proposed revisions to its residential 
care facility regulatory agreement recognize the potential usefulness 
of information on state-administered inspections by requiring that 
owners or operators report inspection violations and supply HUD with 
copies of annual inspection reports. The proposed revisions would also 
address a number of the internal control weaknesses identified by the 
HUD Inspector General's 2002 report, but it remains unclear when the 
proposed revisions will be approved, leaving the program exposed to 
identified weaknesses in the interim. 

While the Section 232 program represents a relatively small portion of 
the GI/SRI Fund, it faces risks that could affect the performance of 
the loan portfolio and the fund. HUD uses a number of tools to mitigate 
risks, and it will be important to continue monitoring program trends 
and industry developments. Recent increases in the numbers of assisted 
living facility loans and refinance loans are a source of uncertainty, 
in that there is as yet little data with which to assess their long- 
term performance. Similarly, industry trends and the availability of 
future Medicaid and Medicare funds are sources of uncertainty, and 
heighten the need for HUD to have sufficient staff expertise with which 
to monitor future developments that could affect the program and 
ultimately the GI/SRI Fund. 

HUD's model for estimating the program's credit subsidy incorporates 
assessments of various risks that loan cohorts face, but it does not 
explicitly consider certain factors that could result in over-or 
underestimation of costs. These factors include prepayment penalties, 
lockout provisions, facility type, loan-to-value ratio, the debt 
service coverage ratio of loans at commitment, and the ratio of 
contract rates to markets rates, which some economic studies suggest 
are potentially useful in modeling risks. Including such factors could 
enhance the credit subsidy estimates and provide HUD and the Congress 
with better cost data with which to assess the program. Additionally, 
HUD's use of Section 207 refinance loans, which we do not find to be a 
good proxy for Section 232 refinance loans, could specifically 
contribute to over-or underestimation of the credit subsidy for the 
refinance loans in the program. 

Recommendations for Executive Action: 

To ensure that field offices are aware of and implement current 
requirements and policies for the Section 232 Mortgage Insurance for 
Residential Care Facilities program, and reduce risk to the GI/SRI 
Fund, we recommend that the Secretary of Housing and Urban Development 
direct the FHA Commissioner to take the following actions: 

* Revise the "Multifamily Asset Management and Project Servicing 
Handbook" in a timely manner to include monitoring requirements 
specific to Section 232 properties; 

* Establish a process for systematically sharing loan underwriting and 
monitoring practices among field offices involved with the Section 232 
program; 

* Assure, as part of the department's strategic human capital 
management efforts, sufficient levels of staff with appropriate 
training and expertise for Section 232 loans; 

* Incorporate a review of annual inspection reports for insured Section 
232 facilities that are subject to federal or state inspections, even 
in the absence of a revised regulatory agreement; and: 

* Complete and implement the revised regulatory agreements in a timely 
manner. 

To potentially improve HUD's estimates of the program's annual credit 
subsidy, we recommend that the Secretary of Housing and Urban 
Development explore the value of explicitly factoring additional 
information into its credit subsidy model, such as prepayment penalties 
and restrictions, debt service coverage and loan-to-value ratios of 
facilities as they enter the program, facility type, and the ratio of 
contract rates to market rates. We also recommend that the Secretary of 
Housing and Urban Development specifically explore other means of 
modeling the performance of Section 232 refinance loans. 

Agency Comments and Our Evaluation: 

We provided a draft of this report to HUD for their review and comment. 
In written comments from HUD's Assistant Secretary for Housing-Federal 
Housing Commissioner, HUD generally concurred with our recommendations 
intended to ensure that field offices are aware of and implement 
current program requirements and policies. However, the agency 
disagreed with most parts of our recommendation related to HUD's credit 
subsidy model. The Assistant Secretary's letter appears in appendix V. 

HUD stated that it has initiated a full review of the Section 232 
program and that GAO's recommendations related to ensuring that field 
offices are aware of and implement current requirements are being 
incorporated into plans for revising the program. More specifically, 
HUD stated that it: 

* will draft and implement changes to the program handbook; 

* will initiate staff training and assure that staff is adequately 
trained in underwriting and servicing policies; and: 

* plans to prepare a report addressing state and federal inspections, 
among other things, to enhance FHA participation in and oversight of 
insured health care mortgages. 

HUD also provided a timeline by which to complete and implement the 
revised regulatory agreements. 

Concerning our recommendation that HUD explore the value of explicitly 
factoring in additional information into its credit subsidy model, HUD 
stated that it agreed to take into account differences among types of 
residential care facilities in its modeling, when it has sufficient 
historical data and if the data indicate that loan performance varies 
sufficiently by type of facility. However, HUD disagreed with 
considering other factors we suggested, as follows: 

* Initial loan-to-value and debt service coverage ratios. HUD stated 
that (1) studies we cited in our draft report found these ratios to be 
statistically insignificant in predicting commercial mortgage defaults 
and (2) that data are unavailable for this analysis. We agree, as our 
draft report stated, that economic studies have shown mixed results 
regarding the significance of the impact of loan-to-value and debt 
service coverage ratios on commercial mortgage defaults, with some 
studies finding them to be significant predictors and others finding 
them to be insignificant predictors. We further stated that these mixed 
results may be the result of small sample sizes and model specification 
issues. Nevertheless, we continue to believe that HUD should explore 
the value of factoring initial loan-to-value ratio and debt service 
coverage ratio into its credit subsidy model, and we did not change our 
recommendation. Regarding the second point, HUD has the data for 
analyzing loan-to-value and debt service coverage ratios in individual 
loan files and could include these data in its credit subsidy modeling 
by creating an electronic record of this information either for its 
entire portfolio or for a sample of the portfolio. Consequently, we did 
not change the recommendation. 

* Factors potentially affecting prepayments. HUD disagreed with our 
suggestion that its credit subsidy model does not fully capture the 
effects of prepayment penalties, stating that its use of historical 
data captures the effect of prepayment penalties on project owners' 
behavior. However, as we stated in the draft report, HUD's use of 
historic data would not fully capture trends related to changes in 
prepayments. HUD also stated that it has tested using the difference 
between mortgage interest rates and the 10-year Treasury bond rates in 
its modeling of prepayments. However, our recommendation was to 
consider a ratio of these two interest rates, not the difference. As we 
noted in our report, economic theory suggests that the use of a ratio 
is the best way to capture the effects on existing loans when market 
interest rates change. Consequently, we did not change the 
recommendation. 

* Use of Section 207 loans as proxy data for refinance loans. HUD 
stated that it did not believe that the differences between Section 207 
and Section 232 loans that our report noted justify concerns that 
residential care refinance loans are being improperly modeled and noted 
a lack of available data. We agree that sufficient relevant data on 
Section 232 refinance loan performance do not yet exist, but we 
continue to question the use of Section 207 loan data as a proxy. While 
we did not change the recommendation, we added language to our report 
suggesting that, until enough Section 232 refinance loan data are 
available, one possible approach, among others, would be to use a 
simpler estimation method, such as using average claim and prepayment 
rates over time as is done in estimating credit subsidy rates for the 
Section 242 Hospital Mortgage Insurance program. 

We are sending copies of this report to the Secretary of the Department 
of Housing and Urban Development (HUD). We also will make copies 
available to others upon request. In addition, the report will be 
available at no charge on the GAO Web site at [Hyperlink, 
http://www.gao.gov]. 

If you or your staff have any questions about this report or need 
additional information, please contact me at 202-512-8678 or w 
[Hyperlink, woodd@gao.gov] oodd@gao.gov. Contact points for our offices 
of Congressional Relations or Public Affairs may be found on the last 
page of this report. GAO staff who made major contributions to this 
report are listed in appendix V. 

Signed by: 

David G. Wood, Director: 
Financial Markets and Community Investment: 

List of Congressional Addressees: 

The Honorable Christopher Bond: 
Chairman: 
The Honorable Patty Murray: 
Ranking Member: 
Subcommittee on Transportation, Treasury, the Judiciary, Housing and 
Urban Development, and Related Agencies: 
Committee on Appropriations: 
United States Senate: 

The Honorable Jack Reed: 
Ranking Minority Member: 
Subcommittee on Housing and Transportation: 
Committee on Banking, Housing, and Urban Affairs: 
United States Senate: 

The Honorable Joe Knollenberg: 
Chairman: 
The Honorable John W. Olver: 
Ranking Member: 
Subcommittee on Transportation, Treasury, and Housing and Urban 
Development, The Judiciary, District of Columbia, and Independent 
Agencies: 
Committee on Appropriations: 
House of Representatives: 

The Honorable Lincoln Chafee: 
United States Senate: 

The Honorable Patrick Kennedy: 
House of Representatives: 

The Honorable James Langevin: 
House of Representatives: 

[End of section] 

Appendix I: Objectives, Scope, and Methodology: 

Our objectives were to examine (1) the Department of Housing and Urban 
Development's (HUD) overall management of the program, including loan 
underwriting and monitoring; (2) the extent to which HUD's oversight of 
insured health care facilities is coordinated with the states' 
oversight of the quality of care provided by facilities; and (3) the 
financial implications of the program to the General Insurance/Special 
Risk Insurance (GI/SRI) Fund, including risk posed by program and 
market trends; and (4) how HUD estimates the annual credit subsidy for 
the program, including the factors and assumptions used. In addition, 
we examined HUD's action in response to a HUD Inspector General report 
that concluded that HUD's Office of Housing did not have adequate 
controls to effectively manage the Section 232 program; this 
information is summarized in appendix III. 

To examine HUD's overall management of the Section 232 program, we 
obtained and reviewed program manuals, guidance, and documentation, 
including the "MAP Guide," HUD's Section 232 "Mortgage Insurance for 
Residential Care Facilities Handbook," and HUD's "Multifamily Asset 
Management and Project Servicing Handbook," for loan processing 
procedures, underwriting policies and requirements, and oversight 
policies and requirements. We also interviewed HUD officials at HUD 
headquarters who are responsible for providing guidance and policies on 
loan underwriting and oversight and three private lenders that offered 
FHA-insured Section 232 loans. In addition, we conducted site visits to 
five HUD field offices (Atlanta, Georgia; Buffalo, New York; Chicago, 
Illinois; Los Angeles, California; and San Francisco, California) and 
conducted interviews with HUD officials, including the Hub or acting 
Hub director, appraisers, mortgage credit analysts, and project 
managers that are responsible for Section 232 loan applications, 
underwriting, and oversight, as well as other Federal Housing 
Administration (FHA) programs. We gathered relevant program 
documentation from each site visit. We also interviewed an official 
from one of HUD's Multifamily Property Disposition Centers during our 
site visit to Atlanta. To capture a variety of Section 232 loan 
activity, we selected five HUD field offices on the basis of (1) the 
volume of Section 232 loans the field office had processed during 
fiscal year 2004 up to September 2005; (2) the dollar amount of Section 
232 loans processed in the field office during fiscal year 2004 up to 
September 2005; (3) the timeliness of processing Section 232 loans 
during the last 2 years; (4) historical claim-rate data for the field 
office--that is, the rate at which Section 232 loans processed by the 
field office have gone to claim; (5) HUD's suggestions for field office 
site visits; and (6) geographical dispersion. 

To better understand how private lenders that do not participate in the 
Section 232 program manage risks, we interviewed five private lenders 
that offered non-FHA insured loans to residential health care 
facilities. We also interviewed representatives of three residential 
care facilities with FHA-insured Section 232 loans to better understand 
the borrowers perspective of the Section 232 program. 

To examine the extent to which HUD coordinated with states' oversight 
of quality of care provided by facilities, we reviewed FHA requirements 
for conducting management reviews and reviewing annual inspection 
reports. We also interviewed officials in FHA's Office of Multifamily 
Development and Office of Asset Management and field office officials 
about policies for coordination between FHA and state residential care 
oversight and rate setting agencies, as well as policies for review of 
annual inspection reports. In addition, we interviewed private lenders 
of FHA-insured and non-FHA insured residential care facilities to 
better understand common industry practices for coordination between 
lenders and state residential care oversight and rate setting agencies. 

To examine the financial risks that the program poses to the GI/SRI 
Fund, we interviewed and obtained documentation from HUD's Office of 
Evaluation and analyzed HUD data on program portfolio characteristics, 
including number of loans by cohort, current insurance in force, 
geographic and lender concentration of loans, and claims. We also 
analyzed HUD data used for their refinance credit subsidy regression 
model. Specifically: 

* To obtain the number of active and terminated loans and claim rate 
history, we analyzed data from extracts of HUD's F47 database, a 
multifamily database. We obtained extracts from HUD in May 2005, 
September 2005, and February 2006. Unless otherwise indicated, all 
analyses from the F47 data in the report utilized the May 2005 extract 
with subsequent updates from the other extracts and was current as of 
the end of fiscal year 2005. To assess the reliability of the F47 
database extract, we reviewed relevant documentation, interviewed 
agency officials who worked with the database, and conducted manual 
data testing, including comparison to published data. Because of the 
small number of loans endorsed in individual fiscal years, we conducted 
analyses of cohorts that were created by combining data from 5 to 6 
fiscal years. For claim rate analyses, we analyzed 5-and 10-year claim 
rates for the data based on the date of loan termination. 

* Our analyses found 13 loans for which facility type information was 
not able to be determined from the extract. FHA administrators were 
able to determine the facility type for all but one of these loans 
using the Development Application Processing (DAP) system. This one 
terminated loan was excluded from facility type endorsement and claim 
rate analysis and, therefore, had little impact on this report. We also 
determined final endorsement date information to be missing from 799 
records. Our analyses only used initial endorsement date information 
for which data was available for every record; therefore, there was no 
impact on this report. We also determined there were nine loans for 
which the facility type information was incorrect based on the 
endorsement date.[Footnote 37] FHA administrators checked in the DAP 
system and confirmed the correct facility type for these loans; 
therefore, there was no impact on the report. We determined the data to 
be sufficiently reliable for analysis of number of active and 
terminated loans, as well as claim rates. 

* To determine the proportion of the Section 232 Mortgage Insurance 
program's commitment authority to the larger GI/SRI Fund's commitment 
authority, we reviewed HUD's fiscal year 2006 budget. 

* To determine the proportion of the Section 232 Mortgage Insurance 
program's unpaid principal balance to the larger GI/SRI Fund unpaid 
principal balance, we obtained the GI/SRI Fund's unpaid principal 
balance as of December 31, 2005 from HUD's Office of Evaluation. We 
also analyzed data from HUD's Multifamily Data Web site, which is 
extracted from HUD's F47 database, to determine the unpaid principal 
balance of Nursing Home Mortgage Insurance program loans as of December 
31, 2005.[Footnote 38] 

* To determine the geographic concentration of loan properties in the 
program, we analyzed data current as of the end of fiscal year 2005 
from our extract of HUD's F47 database. Our analysis determined 
property state data was missing for 270 project numbers. FHA 
administrators informed us that loans endorsed more than 20 years ago, 
before electronic records were maintained, may have missing data that 
is unavailable. Our analyses of geographic concentration of loan 
properties utilized only one record with missing property state data; 
therefore, there was little impact on our findings. We determined the 
data to be sufficiently reliable for analysis of geographic loan 
concentration. 

* To determine the geographic concentration of loan dollars in the 
program we analyzed data current as of December 31, 2005, from HUD's 
Multifamily Housing Data Web site. 

* To determine prepayment history in the program, we analyzed data from 
our F47 extract, current as of the end of fiscal year 2005. We also 
analyzed 5-and 10-year prepayment rates for the data based on the date 
of loan termination. 

* To determine the appropriateness of using Section 207 refinance loans 
as proxy data in the Section 232 refinance loan credit subsidy estimate 
regression model, we analyzed data from several extracts from HUD's 
Office of Evaluation. The extracts contained the loan data used by HUD 
to calculate cumulative claim rates for Section 232 and 207 refinance 
loans for loans endorsed from fiscal year 1992 through fiscal year 
2005. The extracts did not include termination codes for all terminated 
loans. We determined termination code data for these loans from HUD 
data current as of December 31, 2005, from HUD's Multifamily Housing 
Data Web site. We also combined the extracts to include all loans in 
one larger extract. In addition, we performed manual data reliability 
assessments of these extracts and determined that three loans should 
not have been included in the extracts because they had section of the 
act codes that were not within the parameters of our analysis as 
defined by the notes included in HUD's extracts. These loans were not 
included in our analysis and, therefore, had no impact on our findings. 
We determined the data to be sufficiently reliable for analysis of the 
comparability of Section 207 refinance loans to Section 232 refinance 
loans. 

We conducted a literature review and interviewed numerous officials of 
lenders, residential care associations, and HUD to obtain information 
on risks due to health care market trends. We also searched for 
Inspectors General and agency reports through HUD Web sites. Finally, 
we conducted a search on our internal Web site to identify previous 
work on the Section 232 program. 

To determine how HUD estimates the annual credit subsidy rate for the 
program, we reviewed documentation of HUD's credit subsidy estimation 
procedures, reviewed the cash flow model for the program, and we 
interviewed program officials from HUD's Office of Evaluation and 
program auditors from the Office of Management and Budget (OMB). We 
also compared the assumptions used in HUD's cash flow model with 
relevant OMB guidance and reviewed economic literature on modeling 
defaults to identify factors that are important for estimation. 
Additionally, we analyzed data provided by HUD field offices on initial 
loan-to-value ratios and debt service coverage ratios (at the time of 
loan application). We obtained the credit subsidy rates from the 
Federal Credit Supplement of the United States Budget. 

To review the actions HUD has taken in response to the HUD Inspector 
General's 2002 report on the Section 232 program, we interviewed 
officials in HUD's Office of Inspector General. In addition, we 
reviewed the HUD Inspector General's 2002 report, as well as HUD's 
Management Plan Status Reports for Implementation of Recommendation 1A 
of audit 2002-KC-0002. We also interviewed HUD headquarters officials, 
as well as field office officials during our site visits. 

Our review did not include an evaluation of underwriting criteria or 
the need for the program. We conducted our work in Atlanta, Georgia; 
Buffalo, New York; Chicago, Illinois; Los Angeles, California; San 
Francisco, California, and Washington, D.C., between February 2005 and 
April 2006, in accordance with generally accepted government auditing 
standards. 

[End of section] 

Appendix II: Information on the Application Processing, Underwriting, 
and Oversight of Section 232 Loans: 

Application Processing and Underwriting for Section 232 Loans: 

The Department of Housing and Urban Development (HUD) currently 
processes a majority of the Section 232 loans using the Multifamily 
Accelerated Processing (MAP) program and processes some loans under 
Traditional Application Processing (TAP). Under MAP, the lender 
conducts the underwriting of the loan and submits a package directly to 
the Hub or program center for mortgage insurance. The Hub or program 
center reviews the lender's underwriting and makes a decision whether 
or not to provide mortgage insurance for the loan. New construction and 
substantial rehabilitation loans require a preapplication meeting where 
HUD reviews required documentation up front. Under TAP, HUD, not the 
lender, is primarily responsible for the underwriting of the loan and 
determines whether or not to accept the loan. 

FHA has numerous underwriting requirements for loans made under the 
Section 232 program. Some examples include: 

* Requiring documentation of a state-issued Certificate of Need (CON) 
for skilled nursing facilities and intermediate care facilities, and in 
states without a certificate of needs procedure, an alternative study 
of market needs and feasibility. 

* Requiring an appraisal of the facility (prepared by the lender under 
the MAP program) and a market study with comparable properties. 

* Reviewing current or prospective operators of the residential care 
facility and ensuring that they meet certain standards. For example, 
FHA has a requirement that operators of an assisted living facility 
have a proven track record of at least 3 years in developing, 
marketing, and operating either an assisted living facility or a board 
and care home.[Footnote 39] 

* For new construction facilities specifically, FHA requires a business 
plan along with an estimate of occupancy rates and prospective 
reimbursement rates with the percentage of population for patients 
whose costs are reimbursed through Medicare and Medicaid. 

* For existing facilities applying for a refinance loan, FHA requires 
the submission of vacancy and turnover rates and current provider 
agreements for Medicare and Medicaid, 3 years of balance sheet and 
operating statements, as well as the latest inspection report on the 
project's operation.[Footnote 40] 

* Requiring limits on loan-to-value and debt service coverage ratios, 
ratios identified by field office officials we interviewed as two of 
the more important financial ratios in the underwriting process. For 
example, for Section 232 loans, the loan-to-value ratio cannot exceed 
90 percent for new construction loans, and 85 percent loan-to-value for 
refinance loans.[Footnote 41] 

For loans processed under MAP, HUD field office officials are required 
to use MAP Guide checklists to ensure that lenders follow FHA's 
underwriting requirements. These checklists contained guidelines for 
reviewing lender submissions and overall parameters that an application 
must meet. For example, field office officials use an appraisal review 
checklist in the MAP Guide to ensure that the submitted market study 
complies with MAP requirements. For applications processed under TAP, 
field office officials stated that they use similar checklists to the 
ones included in the MAP Guide as the MAP Guide incorporates many of 
the Section 232 underwriting requirements. 

For MAP loans, HUD headquarters has a Lender Qualifications and 
Monitoring Division (LQMD) that conducts reviews of loans. LQMD is 
responsible for evaluating lender qualifications and lender 
performance. It reviews and ultimately approves lenders requesting MAP 
lender approval for loan underwriting. The division reviews a sample of 
lenders when a loan has defaulted or there is a need for additional 
lender oversight. While LQMD reviews are not specific to the Section 
232 program, they help to monitor lenders participating in the program 
and ultimately help to reduce the number of risky loans that enter the 
portfolio. 

Oversight and Monitoring of Section 232 Loans: 

FHA requires field office staff to conduct a number of reviews for 
oversight of Section 232 loans. For example, staff address 
noncompliance items that are identified by HUD's Financial Assessment 
Sub-System (FASS) for each facility. Noncompliance items can include 
items such as unauthorized distribution of project funds or 
unauthorized loans from project funds. Using information from the 
annual financial statement, FASS's computer model statistically 
calculates financial ratios, or indicators, for each facility, and 
applies acceptable ranges of performance, weights, and thresholds for 
each indicator. FASS then generates a score for each facility based on 
these indicators, and this financial score represents a single 
aggregate financial measure of the facility. However, a HUD draft 
contractor study found that FASS did not adequately account for the 
unique nature of nursing homes in the Section 232 portfolio and, 
therefore, was a poor predictor of a nursing home going to claim. Field 
office officials we interviewed also review physical inspections 
conducted by HUD's Real Estate Assessment Center (REAC), which is 
responsible for conducting physical assessments of all HUD-insured 
properties. Officials also ensure that the professional liability 
requirement for facilities is met and conduct file reviews to identify 
any activities that warrant additional oversight.[Footnote 42] 
Additionally, officials in each field office we visited stated that 
they are required to monitor projects in HUD's Real Estate Management 
System, the official source of data on HUD's multifamily housing 
portfolio that maintains data on properties and to conduct risk 
assessments on their properties at least once a year to identify those 
facilities that are designated as troubled or potentially troubled 
based on their physical inspection, financial condition, and other 
factors. 

Field offices also varied in the utilization of HUD's Online Property 
Integrated Information Suite (OPIIS), a centralized resource for HUD 
multifamily data and property analysis. According to officials at HUD 
headquarters, field office officials can use OPIIS to conduct a variety 
of portfolio analysis and view risk assessments on their properties to 
better assist them in overseeing their portfolios. For example, OPIIS 
contains an Integrated Risk Assessment score that combines financial, 
physical, loan payment status history, and other data into a score that 
can be used to identify at-risk properties and prioritize workloads. 
However, four of the five field offices that we visited did not 
frequently use OPIIS. Some of these offices used the system to develop 
risk rankings for their properties or in trying to obtain data about a 
property, but none of them regularly used the system for the monitoring 
of Section 232 loans. The one field office that utilized OPIIS more 
frequently did so because the system partly incorporates a loan risk 
and rankings system that the field office had previously developed for 
its own use. Officials in this field office stated that an issue with 
OPIIS is that it is not designed to capture important, specific 
financial information that is unique to some Section 232 loans, such as 
expenses on food or medication. 

[End of section] 

Appendix III: HUD Officials Addressed Some Issues Raised by the 
Agency's Inspector General in 2002, but Several Key Items Remain 
Unresolved: 

In a 2002 report, the Department of Housing and Urban Development's 
(HUD) Inspector General found that HUD's Office of Housing did not have 
adequate controls to effectively manage the Section 232 
program.[Footnote 43] Because of these weaknesses, the Inspector 
General found that HUD lacked assurance of the effective operation of 
Section 232 properties. The Inspector General noted that the Office of 
Housing had already taken steps to develop an action plan to address 
the weaknesses identified by a task force, but that time frames had not 
yet been established. The Inspector General recommended that the Office 
of Housing establish specific time frames for implementing the 
corrective actions for the 10 weaknesses identified by the task force 
and that it monitor the actions to ensure timely and effective 
completion. 

HUD officials developed a plan to correct the 10 control weaknesses 
identified by the Office of Housing, which included the current status 
of each action and specific target dates to complete the corrective 
actions. According to the Inspector General, HUD has taken action to 
address 2 of the 10 control weakness findings identified by the Office 
of Housing Task force and for which the Inspector General recommended 
that timelines for corrective actions be established. 

The eight unresolved control weaknesses identified by the Office of 
Housing task force are all contingent upon approval of the proposed 
revisions to the regulatory agreements. However, the proposed revisions 
have been awaiting approval since August 2, 2004. According to HUD 
officials, the delay is a result of numerous administrative issues, 
which include changes in FHA management and extended public comment 
periods. 

The addressed control weaknesses and respective corrective actions 
involved loan underwriting. The Inspector General agreed with the 
Office of Housing task force, which found that HUD's underwriting 
process for Section 232 properties needed to be strengthened and that 
HUD needed to complete market studies and background checks of 
applicants as part of the process. The Inspector General also agreed 
with the Office of Housing task force's finding of potential problems 
associated with the nonrecourse nature of HUD Section 232 loans. In 
particular, it found that HUD needed to strengthen the regulatory 
agreements and underwriting process for Section 232 loans if these 
mortgages were to remain nonrecourse and to avoid potential increase in 
the portfolio claim rate. HUD addressed these findings by adding 
requirements for operators, reviews of operators' financial statements, 
and professional liability insurance. Furthermore, applications for 
projects that are considered marginal are rejected. 

The eight remaining control weaknesses for which HUD has not fully 
completed its corrective actions are as follows: 

HUD lacks a handbook detailing monitoring requirements for nursing 
homes and assisted living facilities. The Inspector General found that 
HUD did not have a handbook specific to the Section 232 program 
monitoring requirements ensuring that all facilities follow the 
applicable regulatory agreements and state and federal requirements. In 
our site visits to five field offices, we found inconsistencies in the 
extent to which oversight procedures were followed, such as requiring 
operators to submit financial statements. HUD plans to include Section 
232 project monitoring requirements in the "Multifamily Asset 
Management and Project Servicing Handbook" once the proposed revisions 
to the applicable regulatory agreements have been approved. In 
addition, HUD headquarters officials told us that they plan to issue 
updated guidance on loan oversight for Section 232 properties while 
awaiting approval of the proposed revisions to the regulatory 
agreements. 

HUD's regulatory agreement does not include specific requirements for 
Section 232 properties. The Inspector General found that the regulatory 
agreement for owners lacked requirements for Section 232 properties, 
such as compliance with Medicare and Medicaid guidelines. The Inspector 
General also found inconsistencies between the requirements for 
facilities operated by the owners and those operated by a separate 
entity. The Inspector General recognized that these omissions created 
an inability for HUD to control the activities of operators and 
ultimately created risk to the General Insurance/Special Risk Insurance 
Fund. HUD's proposed revisions to the regulatory agreements have 
provisions that address these concerns; however, they are still 
awaiting approval. 

The Financial Assessment Subsystem (FASS) does not allow the owner and 
operator to submit annual financial statements electronically, denying 
HUD the ability to use the financial check and compliance feature in 
the system. The Inspector General found that the Real Estate Assessment 
Center's (REAC) FASS did not include all Section 232 properties. 
Furthermore, operators were not required to submit annual financial 
statements electronically through the system. HUD headquarters 
officials agreed that, while operators are unable to submit annual 
financial statements electronically, FASS has allowed electronic 
submissions from owners since the system's inception. However, the 
Inspector General found that because operator financial statements are 
not required to be submitted electronically, HUD is unable to utilize 
the financial and compliance checks performed within the system to 
identify and follow up on deficiencies. HUD plans to modify FASS to 
allow electronic submission of operator financial statements; however, 
implementation has been delayed by funding problems and approval of the 
proposed revision to the operator regulatory agreement. 

The Office of Housing needs to improve monitoring and legal tools to 
provide early indication of possible default. The Office of Housing 
task force identified a need for improved monitoring and legal tools to 
provide early indication of potential default. To better understand 
issues related to monitoring loans, HUD's Office of Evaluation 
completed several studies on Section 232 program performance.[Footnote 
44] As of April 2006, all of these studies remain in draft form. Also, 
to aid in monitoring, HUD has proposed revisions to the applicable 
regulatory agreements to require that owners and operators submit 
annual inspection reports and inform HUD of state or federal 
violations. These reports can be an early indicator of quality of care 
concerns and possible claim. However, the proposed revisions to the 
regulatory agreements have not been made final. 

The Office of Housing staff needs additional training on servicing 
nursing homes and assisted living facilities. The Inspector General 
identified that project managers did not have sufficient training on 
reviewing Section 232 properties and dealing with the issues unique to 
Section 232 properties. HUD's management plan states that, as of 
September 2004, REAC has conducted financial statement analysis for HUD 
hubs for the last 2 fiscal years. HUD has also proposed training 
specific to Section 232 program financial analysis upon approval of 
revisions to the applicable regulatory agreements and subject to the 
availability of funds. However, HUD headquarters officials stated that 
there were very limited funds available for training. 

Certain conditions lead to loss of Certificate of Need (CON) or 
license. The HUD Inspector General identified that, in some states, the 
CON and operating licenses may not transfer with the property. 
Consequently, an operator may hold these operational documents and take 
them with them upon termination of the lease. Without these documents, 
a facility is not viable as a residential care facility and its value 
is significantly diminished. This presents a large risk to HUD should 
the loan go to claim or should HUD have to acquire the property. HUD's 
proposed revisions to the applicable regulatory agreements address this 
concern by categorizing these operational documents as part of the 
mortgaged properties. 

Receivables need to be included in the relevant legal documents to 
strengthen HUD's control over assets of the property in case of 
regulatory agreement violations.[Footnote 45] The Inspector General 
established that the Section 232 security agreement language was too 
broad to ensure that all property assets are covered by the mortgage. 
To address this concern, HUD proposed revisions to the applicable 
regulatory agreements to include receivables in the personalty pledged 
as security for the mortgage. Additionally, HUD proposed added language 
in the owner regulatory agreement requiring the owner to execute a 
security agreement and financial statement upon all items of equipment 
and receivables. 

Field offices do not have consistent procedures for using different 
addendums for mortgages, regulatory agreements, and security 
agreements. The Office of Housing's task force found inconsistencies in 
the field offices' use of legal agreements between HUD and owners and 
operators, such as differing addendums to mortgages, regulatory 
agreements, and security agreements. We also found similar 
discrepancies during our five site visits. For example, only one office 
used addendums to HUD's legal agreements to prevent operators from 
keeping these operational documents once the lease terminates. HUD has 
proposed revisions to the regulatory agreements, and once they are 
approved and implemented all offices will use the same legal 
documentation. In the interim, HUD headquarters officials told us they 
plan to provide field offices with updated guidance on Section 232 loan 
oversight. 

[End of section] 

Appendix IV: HUD's Use of Proxy Data for Refinance Loans: 

As discussed earlier in this report, we question the Department of 
Housing and Urban Development's (HUD) use of Section 207 loans as a 
proxy for Section 232 loans in the claim regression that is part of 
HUD's credit subsidy estimates. This appendix provides greater detail 
on our analysis. 

HUD's Comparison Did Not Allow for Differences in the Age of Loans: 

Cumulative claim rates are generally compared for a set period of time 
and for loans from the same years of origination. However, HUD 
calculated the cumulative claim rates without making these adjustments, 
which confounds claim differences between programs with differences due 
solely to timing. HUD calculated the cumulative claim rates for each 
program by taking the total number of loans that went to claim during a 
14-year time period and dividing this by the total number of loans in 
that same time period. In this case, HUD was comparing a program that 
has been expanding over time, the Section 232 program, with a program 
that has had less loan volume in recent years, the Section 207 program. 
From 1992 to 1998, HUD insured 1,434 Section 207 loans. From 1999 to 
2005, HUD insured 870 Section 207 loans. As a result, HUD has been 
comparing the claim rate of loans that have had very little time in 
which to default (Section 232 loans had an average age of 4 years) with 
the claim rate of loans that have had substantial time in which to 
default (Section 207 loans had an average age of 7.5 years). A 
comparison between two programs' claim rates should allow for 
differences in the age of the loans. HUD officials also told us that 
they have not analyzed the comparability of these two loan types in 
terms of their prepayment rates. 

Substantial Differences Exist between Section 207 and Section 232 
Loans: 

To examine the comparability of the Section 207 and Section 232 loans, 
we compared the conditional claim and prepayment rates of the two types 
of loans. An analysis of conditional claim and prepayment rates 
compares claim and prepayment probabilities for loans of the same age, 
so that comparisons based on loans of widely varying ages are avoided. 

We found that the Section 207 loans generally had lower and, in some 
cases, significantly lower conditional claim rates than the Section 232 
loans. The differences were greater in the later years when loans more 
often go to claim. (see fig. 7). For example, the conditional claim 
rate for Section 207 loans in fiscal year 8 was .14 percent as compared 
with a conditional claim rate of 3.88 percent for Section 232 loans in 
fiscal year 8. 

Figure 7: Conditional Claim Rates Are Different for Section 232 and 
Section 207 Refinance Loans: 

[See PDF for image] 

Note: Through year 8, there are at least 200 loans in each category of 
loan for each conditional claim rate year. Beyond year 8, the loan 
numbers are small (particularly for Section 232 loans), and conclusions 
are less reliable. 

[End of figure] 

We found that Section 207 loans had generally higher, and sometimes 
significantly higher, conditional prepayment rates compared to Section 
232 loans. The differences were greater in the later years when loans 
more often are prepaid. (see fig. 8). For example, the conditional 
prepayment rate for Section 207 loans in fiscal year 8 was 21.72 
percent as compared to a conditional prepayment 11.25 percent for 
Section 232 loans in fiscal year 8 (making the conditional prepayment 
rate for the Section 207 loans 93 percent higher than the conditional 
prepayment rate for Section 232 loans). 

Figure 8: Conditional Prepayment Rates are Different for Section 232 
and Section 207 Refinance Loans: 

[See PDF for image] 

Note: Through year 8, there are at least 200 loans in each category of 
loan for each conditional prepayment rate year. Beyond year 8, the loan 
numbers are small (particularly for Section 232 loans), and conclusions 
are less reliable. 

[End of figure] 

Additionally, we examined and compared cumulative 5-year claim and 
prepayment rates. Section 207 loans had a 5-year cumulative claim rate 
of 3 percent, while for the Section 232 loans it was approximately 6.7 
percent. The 5-year cumulative prepayment rate for Section 207 loans 
was about 27 percent, while for Section 232 loans it was about 11 
percent. 

[End of section] 

Appendix V: Comments from the Department of Housing and Urban 
Development: 

U.S. Department Of Housing And Urban Development: 
Washington, DC 20410- 8000: 
Assistant Secretary For Housing-Federal Housing Commissioner: 

May 12 2006: 

Mr. David Wood: 
Director, Financial Markets and Community Investment: 
United States Government Accountability Office: 
Washington, DC 20548: 

Dear Mr. Wood: 

Thank you for the opportunity to respond to the draft report entitled 
Residential Care Facilities Mortgage Insurance Program: Opportunities 
to Improve Program and Risk Management (GAO-06-515). The Department 
plans to implement the GAO recommendations as follows: 

The Department has already separated the revision of the healthcare 
regulatory agreements and other closing documents from the rental 
housing revisions, so that specific focus can be placed on assuring the 
unique nature of health care operating structures and oversight will be 
adequately addressed in those revisions. 

June 30, 2006 - Conclude industry and stakeholder fact gathering that 
began in March 2006 to better define the role of the FHA 232 program in 
providing mortgage insurance for the critical healthcare market 
segment. 

September 30, 2006 - Prepare report addressing key ownership and 
operator structure and agreements including conventional mortgage 
practices for project oversight, available third party sources for 
project operations review, state and federal inspections, receivables 
financing, insurance practices and policies, and risk management 
approaches to enhance FHA participation in and oversight of insured 
healthcare mortgages. 

March 31, 2007 - Complete plan to implement findings and draft 
appropriate policy and handbook changes. Recommend organizational 
changes to assure adequate skills and staffing are dedicated to the 
healthcare programs. Complete the revisions of the regulatory 
agreements and closing documents. Prepare regulatory changes for 
clearance and publication in the Federal Register. Initiate staff 
training based upon proposed changes and implement program changes that 
do not require regulatory clearance. 

February 28, 2008 - Fully implement the revised healthcare program 
assuring that staff is adequately trained in the underwriting and 
servicing policies and adherence to those policies is consistent across 
all responsible areas. 

The Department believes that these actions will fully accomplish the 
recommendations made by Report GAO-06-515 related to program redesign, 
enhanced staff and organizational structure, and asset and risk 
management. However, for reasons already explained to the GAO, the 
Department does not agree with the GAO's recommendations for changes to 
the annual credit subsidy estimations. This disagreement is based upon 
the following: 

The GAO recommends that a property's loan-to-value and debt service 
coverage ratios at origination should be included in the econometric 
models used to estimate conditional claim rates for Section 232 loans. 
The data is unavailable for analysis and is unlikely to be 
statistically significant if they were available. GAO acknowledges that 
recent statistical studies have found no statistical relationship 
between ratios at origination and subsequent performance. 

The GAO contends that FHA's models suffer from a failure to capture 
prepayment penalties. Because FHA uses all of its historical experience 
to model conditional prepayment rates, it is capturing the effect of 
prepayment penalties on project owners' behavior. The GAO report goes 
on to state that FHA does not capture the effect of changes in market 
interest rates in its prepayment models. In fact, FHA does include both 
the mortgage interest rate and the 10-year Treasury bond rate in its 
models and has tested using the difference between the two as an 
explanatory variable. FHA uses the model specification with the 
greatest explanatory power. Each year FHA tests alternative 
specifications and will continue to test whether inclusion of the rate 
difference will improve its models. 

The report questioned the use of multifamily refinance loans as proxy 
data for residential care refinance loans, but did not recommend 
another source of historical data that could be used to generate 
performance estimates. Given the sparsity of available data, FHA does 
not believe that the differences noted in Appendix IV are great enough 
to justify concern that residential care facility loans are being 
improperly modeled. 

The GAO recommends taking into account the differences among types of 
residential care facilities in its modeling. FHA agrees to do so when 
sufficient historical data are available and if the data indicate that 
loan performance varies sufficiently by type of facility to warrant the 
creation of new risk categories. 

The Department acknowledges the unique nature of these healthcare loans 
and the resulting need for specialized underwriting and oversight. To 
that end, the Department has initiated a full review of the program and 
has found the added insight and recommendations provided by the GAO 
report to be very useful. These recommendations, along with those 
previously made by the Inspector General are being incorporated into 
the findings that will be the basis for program revisions. 

If you have any questions concerning this response, please contact 
Charles H. (Hank) Williams, Deputy Assistant Secretary for Multifamily 
Housing Programs at (202) 708-2495. 

Sincerely: 

Signed by: 

Brian Montgomery: 
Assistant Secretary for Housing-Federal Housing Commissioner: 

[End of section] 

Appendix VI: GAO Contact and Staff Acknowledgments: 

GAO Contact: 

David G. Wood (202) 512-8678: 

Staff Acknowledgments: 

In addition to the individual named above, Paul Schmidt, Assistant 
Director; Austin Kelly; Tarek Mahmassani; John McGrail; Andy Pauline; 
Carl Ramirez; Richard Vagnoni; Wendy Wierzbicki; and Amber Yancey- 
Carroll made key contributions to this report. 

(250238): 

FOOTNOTES 

[1] Based on data from the HUD's F47 multifamily database. 

[2] Pursuant to the Federal Credit Reform Act of 1990, HUD must 
annually estimate the credit subsidy cost for all of its loan guarantee 
programs. 

[3] Medicare is the federal health care program for the elderly and 
people with disabilities. In addition to other health services, 
Medicare covers up to 100 days of nursing home care following a 
hospital stay. Medicaid is the joint federal-state health care 
financing program for certain categories of low-income individuals, 
including elderly and disabled individuals. Medicaid also pays for long-
term care services, including nursing home care. 

[4] GAO, Nursing Homes: Quality of Care More Related to Staffing than 
Spending, GAO-02-431R (Washington, D.C.: June 13, 2002), 1. 

[5] GAO analysis of data from the U.S. Department of Health and Human 
Services, Centers for Medicare & Medicaid Services. 

[6] While we refer to these inspections as annual, every nursing home 
receiving Medicare or Medicaid payments must undergo a standard 
inspection survey not less than once every 15 months, and the statewide 
average interval for these surveys must not exceed 12 months. 

[7] We provided the results of the mandated study of the Hospital 
Mortgage Insurance program in GAO, Hospital Mortgage Insurance Program: 
Program and Risk Management Could be Enhanced, GAO-06-316 (Washington, 
D.C.: Feb. 28, 2006). 

[8] Underwriting refers to the process of determining the risk of 
particular loan applications. 

[9] We selected these locations on the basis of several factors for 
each office, including (1) the historical claim rates experienced among 
loans processed, (2) the volume and dollar amounts of loans, (3) 
insurance application processing times, and (4) discussions with HUD 
officials. Because we did not select the offices randomly, we do not 
know the extent to which they are representative of all HUD's field 
offices that process Section 232 program loans. 

[10] According to HUD's "Section 232 Mortgage Insurance for Residential 
Care Facilities Handbook," nursing homes are those facilities that 
provide accommodation for persons who are not acutely ill and not in 
need of hospital care but require skilled nursing care and related 
medical services. Intermediate care facilities provide for the 
accommodation of persons who require minimum, but continuous care, and 
do not require skilled nursing services. In this report, we use the 
term "nursing home" to include facilities providing skilled and/or 
intermediate care services. Assisted living facilities are facilities 
for residents who need assistance with activities of daily living. 
Board and care facilities provide room, board, and continuous 
protective oversight. 

[11] Based on 2003-2005 data in GAO, Nursing Homes: Despite Increased 
Oversight, Challenges Remain in Ensuring High-Quality Care and Resident 
Safety, GAO-06-117 (Washington, D.C.: Dec. 28, 2005), 60, and 2004 data 
in Robert Mollica and Heather Johnson-Lamarche, State Residential Care 
and Assisted Living Policy: 2004 (National Academy for State Health 
Policy, March 2005), 1-2. 

[12] 42 U.S.C. ß1396a(a). 

[13] Loan-to-value is a ratio of the amount of the loan as a percentage 
of the property's value or sales price. Debt service coverage ratio is 
the ratio of the property's annual net operating income to the annual 
debt service. 

[14] Officials in one field office explained that they had previously 
required operators to submit financial statements and were planning to 
resume following this requirement. 

[15] A Certificate of Need is a state regulatory process that requires 
residential health care facilities to receive state approval before 
offering certain new or expanded health care services. 

[16] According to headquarters officials, the Web site includes notices 
related to loan insurance applications processed under the Multifamily 
Accelerated Processing (MAP) system, which includes the majority of 
Section 232 loan applications. 

[17] See GAO-06-117, 4. 

[18] The GI/SRI Fund's commitment authority represents the maximum 
aggregate amount of loans that can be guaranteed under the programs in 
the fund. 

[19] In our analysis of Section 232 loan data, we grouped loans into 
cohorts (loans originated in a given fiscal year) of approximately 5 
fiscal years of loans. This was done to allow for a more meaningful 
analysis given the small number of Section 232 loans endorsed per 
fiscal year. We analyzed 5-and 10-year claim and prepayment rates 
because more claims and prepayments take place within 10 years of loan 
endorsement. 

[20] We are reporting 5-year claim rates rather than 10-year claim 
rates when comparing refinance loans because HUD insured its first 
refinance loans in 1992. As a result, there are limited data available 
for 10-year claim rates. 

[21] GAO, 21ST Century: Reexaming the Base of the Federal Government, 
GAO-05-325SP (Washington, D.C; Feb. 1, 2005), 33-35; GAO, Long-Term 
Care Financing: Growing Demand and Cost of Services Are Straining 
Federal and State Budgets, GAO-05-564T (Washington, D.C; Apr. 27, 
2005), 7; Fitch Ratings, 2005 Non-Profit Hospitals and Health Care 
Systems Forecast (New York, NY: Jan. 20, 2005), 8. 

[22] GAO-04-143, 3. 

[23] GAO, Aging Issues: Related GAO Products in Calendar Years 2001 and 
2002, GAO-04-275R (Washington, D.C.: Nov. 21, 2003), 1. 

[24] For purposes of tracking Section 232 loans in its databases, HUD 
groups together refinance and purchase loans. Similarly, it also groups 
together new construction and substantial rehabilitation loans. 

[25] Jesse M. Abraham and H. Scott Theobald, "A Simple Prepayment Model 
of Commercial Mortgages," Journal of Housing Economics, vol. 6 no. 1, 
(1997); Austin Kelly; V. Carlos Slawson, Jr., "Time-Varying Mortgage 
Prepayment Penalties," Journal of Real Estate Finance and Economics, 
vol. 23, no. 2, (2001); Qiang Fu, Michael LaCour-Little, and Kerry D. 
Vandell, "Commercial Mortgage Prepayments Under Heterogeneous 
Prepayment Penalty Structures," vol. 25, no. 3 (2003). 

[26] The regulations also state that prepayment restrictions and 
penalty charges must be acceptable to the FHA Commissioner. 

[27] We analyzed prepayment restrictions from the mortgage notes of 32 
projects with loan payments beginning in 2001 to 2005. 

[28] We analyzed debt service coverage ratios from the underwriting 
reports of 42 projects that applied for mortgage insurance between 
fiscal years 2000 and 2006. 

[29] Athanasios Episcopos, Andreas Pericli, and Jianxun Hu, "Commercial 
Mortgage Default: A Comparison of Logit with Radial Basis Function 
Networks," Journal of Real Estate Finance and Economics, vol. 17, no. 
2, (1998); and Wayne R. Archer, Peter J. Elmer, David M. Harrison, and 
David C. Ling, "Determinants of Multifamily Mortgage Default," Real 
Estate Economics, vol. 30, no. 3 (2002). 

[30] Brian A. Cochetti, Honeying Deng, Bin Gao, and Rui Yao, "The 
Termination of Commercial Mortgage Contracts Through Prepayment and 
Default: A Proportional Hazard Approach with Competing Risks," Real 
Estate Economics; vol. 30, no. 4 (2002); Kerry D. Vandell, Walter 
Barnes, David Hartzell, Dennis Kraft, and William Wendt, "Commercial 
Mortgage Defaults: Proportional Hazards Estimation Using Individual 
Loan Histories," Journal of the American Real Estate and Urban 
Economics Association, vol. 21, no. 4 (1993). 

[31] We analyzed loan-to-value ratios from the underwriting reports of 
42 projects that applied for mortgage insurance between fiscal years 
2000 and 2006. 

[32] Y. Deng, J. Quigley, and A. Sanders, "Commercial Mortgage 
Terminations: Evidence from CMBS," University of Southern California 
(2004); Athanasios Episcopos, Andreas Pericli, and Jianxun Hu, 
"Commercial Mortgage Default: A Comparison of Logit with Radial Basis 
Function Networks," Journal of Real Estate Finance and Economics vol. 
17, no. 2, (1998); and Office of Federal Housing Enterprise Oversight, 
"Risk-Based Capital Regulation: Second Notice of Proposed Rulemaking," 
Federal Register 64 (1999). 

[33] Wayne R. Archer, Peter J. Elmer, David M. Harrison, and David C. 
Ling, "Determinants of Multifamily Mortgage Default," Real Estate 
Economics, vol. 30, no. 3 (2002); B. Ambrose and A. Sanders, 
"Commercial Mortgage-Backed Securities: Prepayment and Default," 
Journal of Real Estate Finance and Economics, vol. 26, no. 2 and 3. 

[34] Scott Richard and Richard Roll, "Prepayments on Fixed-rate 
Mortgage-backed Securities," Journal of Portfolio Management, Spring 
1989. Additionally, we found other studies which include market rate 
and contract rate as a ratio in the modeling of mortgage terminations. 
These studies include B. Ambrose and A. Sanders, "Commercial Mortgage- 
Backed Securities: Prepayment and Default," Journal of Real Estate 
Finance and Economics, vol. 26, no. 2 and 3; and Qiang Fu, Michael 
LaCour-Little, and Kerry D. Vandell, "Commercial Mortgage Prepayments 
Under Heterogeneous Prepayment Penalty Structures," 25, 3 (2003). 

[35] One of HUD's regressions calculates the difference between 
contract rates and market rates. Considering the difference between the 
contract rate and the market rate is better than considering the rates 
separately, but is still not as strong an approximation as using a 
ratio. See Richard and Roll. 

[36] FASAB is responsible for promulgating accounting standards for the 
U.S. government, and these standards are recognized as generally 
accepted accounting principles for the federal government. FASAB 
developed standards for agencies regarding the basis for supporting 
cash flow assumptions for loan guarantee programs. 

[37] These nine loans were coded as assisted living facility loans in 
F47. However, these loans were endorsed prior to HUD insuring assisted 
living facilities in 1994. 

[38] Department of Housing and Urban Development, "Insured Multifamily 
Mortgages Database," Multifamily Data, 
http://www.hud.gov/offices/hsg/comp/rpts/mfh/mf_f47.cfm (downloaded 
Feb. 24, 2006). 

[39] U.S. Department of Housing and Urban Development, Notice H 97-01, 
4. 

[40] According to the MAP Guide, the latest state residential care 
facility agency's report on the project's operation is required. The 
MAP Guide provides mortgage insurance program descriptions, mortgagor 
and lender eligibility requirements, application requirements, HUD 
underwriting standards for all technical disciplines, construction 
administration requirements, and closing instructions. 

[41] When determining the maximum insurable mortgage, HUD also has 
requirements regarding the acquisition costs and net earnings. For 
nonprofit mortgagors, the loan-to-value cannot exceed 95 percent for 
new construction loans and 90 percent for refinance loans. 

[42] In April 2001, HUD issued Notice H01-03, titled "Review of Health 
Care Facility Portfolios and Changes to the Section 232 Programs." 
Section X of the notice established the requirement that HUD-insured 
health care facilities maintain professional liability insurance. 
Housing Notice 04-15 lists the requirements for professional liability 
insurance for owners and operators of health care facilities. 

[43] Department of Housing and Urban Development, Office of Inspector 
General, Nationwide Survey of HUD's Office of Housing Section 232 
Nursing Home Program, 2002-KC-0002 (Kansas City, Missouri, 2002). 

[44] These studies include: FHA, Review of HUD Disposition and Asset 
Management Practices (Draft), May 12, 2004; Proposed Benchmark Report 
Containing Per Unit Multifamily Expense and Revenue Data for 75 MSAs, 
(Draft), Aug. 2, 2004; Effect of Rising Insurance Costs on FHA-Insured 
Multifamily Mortgages (Draft), Mar. 16, 2004; and Analysis of FHA 
Endorsed Mortgages Presented for Claim in FY 2003 (Draft), May 14, 
2004. 

[45] Receivables are the value of services billed to third-party payors 
that have yet to be received. An example of receivables is the value of 
Medicare services billed to the federal government that have not yet 
been reimbursed. 

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