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Testimony: 

Before the Subcommittee on Housing and Community Opportunity, Committee 
on Financial Services,: 
House of Representatives: 

United States Government Accountability Office: 

GAO: 

For Release on Delivery Expected at 10:00 a.m. EDT: 

Thursday, June 30, 2005: 

Federal Housing Administration: 

Managing Risks from a New Zero Down Payment Product: 

Statement of William B. Shear, Director, Financial Markets and 
Community Investment: 

GAO-05-857T: 

GAO Highlights: 

Highlights of GAO-05-857T, a testimony to the Subcommittee on Housing 
and Community Opportunity, Committee on Financial Services, House of 
Representatives: 

Why GAO Did This Study: 

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

What GAO Found: 

In recent years, many mortgage institutions have become increasingly 
active in supporting low and even no down payment mortgage products. In 
considering the risks of these new products, a substantial amount of 
research GAO reviewed indicates that loan-to-value (LTV) ratio and 
credit score are among the most important factors when estimating the 
risk level associated with individual mortgages. GAO’s analysis of the 
performance of low and no down payment mortgages supported by FHA and 
others corroborates key findings in the literature. Generally, 
mortgages with higher LTV ratios (smaller down payments) and lower 
credit scores are riskier than mortgages with lower LTV ratios and 
higher credit scores. 

Some practices of other mortgage institutions offer a framework that 
could help FHA manage the risks associated with introducing new 
products or making significant changes to existing products. Mortgage 
institutions sometimes require additional credit enhancements, such as 
higher insurance coverage, and stricter underwriting, such as credit 
score thresholds, when introducing a new low or no down payment 
product. FHA is authorized to require an additional credit enhancement, 
but does not currently use this authority. FHA has used stricter 
underwriting criteria, but told us it is unlikely they would use a 
credit score threshold for a new zero down payment product. Mortgage 
institutions may also impose limits on the volume of the new products 
they will permit and on who can sell and service these products. FHA 
officials question the circumstances in which they can limit volumes 
for their products and believe they do not have sufficient resources to 
manage a product with limited volumes, but the potential costs of 
making widely available a product with risk that is not well understood 
could exceed the cost of initially implementing such a product on a 
limited basis. 

Average Four-Year Default Rates for FHA Insured Loans Originated in 
1998, 1999, and 2000 (by LTV): 

[See Figure 1]

What GAO Recommends: 

GAO suggests that Congress consider limiting any new no down payment 
product it may authorize. GAO recommends that HUD, among other things, 
consider piloting a no down payment product and that HUD establish a 
framework for when and how to pilot this and other new or changed 
products. HUD told us that they face challenges in administering a 
pilot program. We believe that HUD needs to further consider piloting 
or limiting volume of new or changed products, including a zero down 
payment product. 

www.gao.gov/cgi-bin/getrpt?GAO-05-857T.

To view the full product, including the scope and methodology, click on 
the link above. For more information, contact William Shear at (202) 
512-8678 or shearw@gao.gov.

[End of figure]

Mr. Chairman and Members of the Subcommittee: 

I am pleased to be here today to provide the committee with information 
and perspectives as it considers legislation that would authorize the 
Secretary of Housing and Urban Development (HUD) to carry out a pilot 
program to insure zero down payment mortgages. The Federal Housing 
Administration (FHA) at HUD currently insures low down payment 
mortgages to homebuyers across the nation. FHA requires homebuyers to 
make a 3 percent contribution toward the purchase of the home, though 
some of this may come in the form of a gift from others. FHA also 
permits some closing costs to be financed. My testimony today is 
primarily based on a report we completed for this Subcommittee on 
managing risks associated with low and no down payment loans, which was 
issued in February, 2005.[Footnote 1] I will focus my discussion on the 
practices mortgage institutions use in designing and implementing low 
and no down payment products and how these practices could be 
instructive for the FHA in managing risks associated with a zero down 
payment product. A substantial body of research indicates that loans 
with lower down payments are generally riskier than those with higher 
down payments. 

To obtain information for our report, we interviewed officials from 
FHA; staff at selected conventional mortgage providers;[Footnote 2] 
private mortgage insurers; and two government-sponsored enterprises 
(GSE), Fannie Mae and Freddie Mac. We obtained information about the 
standards of low and no down payment mortgage products they support and 
the steps they take to design, implement, and monitor these products. 
However, we did not verify that these institutions, in fact, used these 
practices. We conducted this work from January through December 2004 in 
accordance with generally accepted government auditing standards. 

In summary, there are several risk-management practices mortgage 
institutions use in designing, implementing, and monitoring low and no 
down payment products, and we believe these practices could be 
instructive for FHA in managing risks associated with a zero down 
payment product. 

* Mortgage institutions can mitigate the risk of low and no down 
payment products by requiring additional credit enhancements such as 
higher mortgage insurance coverage. For example, Fannie Mae and Freddie 
Mac require higher mortgage insurance for loans with a loan-to-value 
ratio (LTV) of great than 95 percent.[Footnote 3] While FHA already 
will pay up to 100 percent of the losses from a foreclosure on a house, 
it does have the authority to share risk but does not currently use 
this authority. 

* Mortgage institutions sometimes implement stricter underwriting to 
manage the additional risks associated with a new mortgage product. For 
example, institutions can require a higher credit score or higher 
reserves from the borrower. FHA has made adjustments to its 
underwriting criteria on its existing products but FHA officials told 
us that FHA is unlikely to mandate a credit score threshold for a zero 
down payment product. 

* Mortgage institutions increase fees and charge higher premiums to 
compensate for the additional risks associated with a new mortgage 
product. For example, Fannie Mae officials stated that they would 
charge higher guarantee fees on low and no down payment loans if they 
were not able to require the higher insurance coverage. FHA is 
authorized to make, and has made, adjustments to its up-front and 
annual premiums on its existing products. The administration proposed 
higher premiums as part of its 2006 budget proposal for a zero-down 
payment product. 

* Mortgage institutions sometimes use pilots or limit the initial 
availability of new products to build experience or better understand 
the factors that contribute to risk for these products. For example, 
Freddie Mac limited the initial availability of its 100 LTV product. 
Some mortgage institutions also may limit the origination and servicing 
of the product to their better lenders and servicers. However, FHA 
officials told us they face challenges in piloting and limiting 
mortgage products to certain approved lenders or servicers. 

* According to officials of mortgage institutions, including FHA, they 
also often put in place more substantial monitoring and oversight 
mechanisms for their new products and then make changes based on what 
they learn. Some mortgage institutions, such as Fannie Mae, told us 
that they may conduct rigorous quality control sampling of new 
acquisitions, early payment defaults, and nonperforming loans. 
Depending on the scale of a new initiative, and its perceived risk, 
these quality control reviews could include a review of up to 100 
percent of the loans that are part of the new product. FHA officials 
told us they also more closely monitor loans underwritten under revised 
guidelines. In light of the risks that new lending products present and 
in recognition of established risk management practices, in our report, 
we suggested that Congress consider limiting the initial availability 
of any new single-family insurance product it may authorize, including 
a zero down payment product. We also suggested that Congress consider 
directing HUD to consider using various techniques for mitigating risks 
for a no down payment product, or products about which the risks are 
not well understood. We recommended that FHA consider using pilots for 
new products and for making significant changes to its existing 
products, regardless of any new products Congress may authorize. 
Additionally, we recommended that FHA explore various techniques for 
mitigating risks when implementing new products that have greater risk 
or for which risk is not well understood, such as a zero down payment 
product. 

However, during the course of our work, HUD officials told us that they 
face challenges in administering a pilot program and they question the 
circumstances in which they can limit the availability of a new 
product. We believe that HUD needs to further consider piloting or 
limiting volume of new or changed products, including a zero down 
payment product. There are several available techniques for limiting an 
initial product that could help to address HUD's concerns, including 
limiting the time period in which it is available. Further we believe 
that in some circumstances the potential costs of making widely 
available a product when the risks of that product are not well 
understood could exceed the cost of initially implementing such a 
product on a limited basis. To the extent HUD believes it does not have 
the authority for exercising the options we describe, we recommend it 
seek the authority from Congress. 

Background: 

Mortgage insurance, a commonly used credit enhancement, protects 
lenders against losses in the event of default, and FHA is a government 
mortgage insurer in a market that also includes private insurers. 
During fiscal years 2001 to 2003, FHA insured a total of about 3.7 
million mortgages with a total value of about $425 billion. FHA plays a 
particularly large role in certain market segments, including low- 
income and first-time homebuyers. In 2000, almost 90 percent of FHA- 
insured home purchase mortgages had an LTV higher than 95 percent. FHA 
insures most of its mortgages for single-family housing under its 
Mutual Mortgage Insurance (MMI) Fund. To cover lender's losses, FHA 
collects premiums from borrowers. These premiums, along with proceeds 
from the sale of foreclosed properties, pay for claims that FHA pays 
lenders as a result of foreclosures. 

In recent years, other members of the conventional mortgage market 
(such as private mortgage insurers, government-sponsored enterprises 
such as Fannie Mae and Freddie Mac, and large private lenders) have 
been increasingly active in supporting low and even no down payment 
mortgage products. For example, Fannie Mae and Freddie Mac's no down 
payment mortgage products were introduced in 2000; and many private 
mortgage insurers will now insure a mortgage up to 100 percent LTV. 
However, the characteristics and standards for low and no down payment 
products vary among mortgage institutions. Currently, homebuyers with 
FHA-insured loans need to make a 3 percent contribution toward the 
purchase of the property and may finance some of the closing costs 
associated with the loan. As a result, an FHA-insured loan could equal 
nearly 100 percent of the property's value or sales price. In recent 
years, a growing proportion of borrowers have received down payment 
assistance, which further helps them meet the hurdle of accumulating 
sufficient funds to purchase a home. Based on our preliminary analysis 
of FHA-insured loans that had LTVs above 95 percent, use of down 
payment assistance has grown to over half of such loans insured during 
the first seven months of 2005. 

When considering the risk of mortgages, a substantial amount of 
research GAO reviewed indicates that the LTV ratio and the borrower's 
credit score are among the most important factors when estimating the 
risk level associated with individual mortgages.[Footnote 4] We also 
analyzed the performance, expressed by the percent of borrowers 
defaulting within four years of mortgage origination, of low and no 
down payment mortgages supported by FHA and others.[Footnote 5] Our 
analysis supports the findings we found in the research literature. 
Generally, mortgages with higher LTV ratios (smaller down payments) and 
lower credit scores are riskier than mortgages with lower LTV ratios 
and higher credit scores. As can be seen in Figure 1, when focusing 
only on LTV for FHA loans, default rates increase as the LTV ranges 
increase. In theory, LTV ratios are important because of the direct 
relationship that exists between the amount of equity borrowers have in 
their homes and the risk of default. The higher the LTV ratio, the less 
cash borrowers will have invested in their homes and the more likely it 
is that they may default on mortgage obligations, especially during 
times of economic hardship (e.g., unemployment, divorce, home price 
depreciation). 

Figure 1: Average Four-Year Default Rates for FHA Insured Loans 
Originated in 1998, 1999, and 2000 (by LTV): 

[See PDF for image] --graphic text: 

Bar graph with three items.

LTV: High (>96%); 
Average default rate: 3.37%. 

LTV: Medium (87%-96%); 
Average default rate: 2.26%. 

LTV: Low (<83%); 
Average default rate: .90%. 

Source: FY 2003 Actuarial Review of the Mutual Mortgage Insurance Fund. 

[End of figure]

Risk assessment is a very important component of issuing and insuring 
mortgages, particularly when introducing a mortgage product that has 
the risk associated with a higher LTV. To help assess the risks 
associated with mortgages, the mortgage industry has moved toward 
greater use of mortgage scoring and automated underwriting 
systems.[Footnote 6] Mortgage scoring is a technology-based tool that 
relies on the statistical analysis of millions of previously originated 
mortgage loans to determine how key attributes such as the borrower's 
credit history, the property characteristics, and the terms of the 
mortgage note affect future loan performance. 

During the 1990s, private mortgage insurers, the GSEs, and larger 
financial institutions developed automated underwriting systems. 
Automated underwriting systems refer to the process of collecting and 
processing the data used in the underwriting process. These systems 
rely, in part, on individuals' credit scores or credit history, and 
they have played an integral role in the provision of low and no down 
payment mortgage products. These systems allow lenders to quickly 
assess the riskiness of mortgages by simultaneously considering 
multiple factors including the credit score and credit history of 
borrowers. FHA has developed and recently implemented a mortgage 
scoring tool, called the FHA TOTAL Scorecard, to be used in conjunction 
with existing automated underwriting systems. More than 60 percent of 
all mortgages--conventional and government-insured--were underwritten 
by an automated underwriting system, as of 2002, and this percentage 
continues to rise.[Footnote 7]

Several Practices Mortgage Institutions Use in Designing and 
Implementing Low and No Down Payment Products Could Be Instructive for 
FHA in Managing Risk of a No Down Payment Product: 

According to representatives of mortgage institutions we interviewed, 
they use a number of similar practices in designing and implementing 
new products. These practices can be especially important when 
designing and implementing new products with higher or less well 
understood risk, such as low and no down payment products. Some of 
these practices could be helpful to FHA in its design and 
implementation of a zero down payment product, as well as other new 
products. More specifically, mortgage institutions often establish 
additional requirements for new products such as additional credit 
enhancements or underwriting requirements. Although FHA has less 
flexibility in imposing additional credit enhancements it does have the 
authority to seek co-insurance, which it is not currently using. FHA 
makes adjustments to underwriting criteria and to its premiums, but 
told us that it is unlikely to use a credit score threshold for a new 
zero down payment product. Further, mortgage institutions also use 
different means to limit how widely they make available a new product, 
particularly during its early years. FHA does sometimes use practices 
for limiting a new product but usually does not pilot products on its 
own initiative. FHA officials with whom we spoke question the 
circumstances in which they can limit the availability of a program and 
told us they do not have the resources to manage programs with limited 
availability. Finally, according to officials of mortgage institutions, 
including FHA, they also often put in place more substantial monitoring 
and oversight mechanisms for their new products including lender 
oversight. In an earlier report, we made recommendations designed to 
improve HUD's oversight of FHA lenders.[Footnote 8]

Mortgage Institutions Require Additional Credit Enhancements: 

Some mortgage institutions require additional credit enhancements-- 
mechanisms for transferring risk from one party to another such as 
mortgage insurance--on low and no down payment products. Mortgage 
institutions such as Fannie Mae and Freddie Mac mitigate the risk of 
low and no down payment products by requiring additional credit 
enhancements such as higher mortgage insurance coverage. Fannie Mae and 
Freddie Mac believe that the higher-LTV loans represent a greater risk 
to them and they seek to partially mitigate this risk by requiring 
higher mortgage insurance coverage on these loans. For example, Fannie 
Mae and Freddie Mac require insurance coverage of 35 percent of the 
claim amount (on individual loans that foreclose) for loans that have 
an LTV of greater than 95 percent and require lower insurance coverage 
for loans with LTVs below 95 percent. 

Although FHA is required to provide up to 100 percent coverage of the 
loans it insures, FHA may engage in co-insurance of its single-family 
loans. Under co-insurance, FHA could require lenders to share in the 
risks of insuring mortgages by assuming some percentage of the losses 
on the loans that they originated (lenders would generally use private 
mortgage insurance for risk sharing). FHA has used co-insurance before, 
primarily in its multifamily programs, but does not currently use co- 
insurance at all.[Footnote 9] FHA officials told us they tried to put 
together a co-insurance agreement with Fannie Mae and Freddie Mac and, 
while they were able to come to agreement on the sharing of premiums, 
they could not reach agreement on the sharing of losses and it was 
never implemented. 

Mortgage Institutions May Require Stricter Underwriting for New Low and 
No Down Payment Products: 

Mortgage institutions also can mitigate risk through stricter 
underwriting. For example, mortgage institutions such as Fannie Mae and 
Freddie Mac sometimes introduce stricter underwriting standards as part 
of the development of new low and no down payment products (or products 
about which they do not fully understand the risks). Institutions can 
do this in a number of ways, including requiring a higher credit score 
threshold for certain products, or requiring greater borrower reserves 
or more documentation of income or assets from the borrower. Once the 
mortgage institution has learned enough about the risks that were 
previously not understood, it can change the underwriting requirements 
for these new products. FHA could also benefit from mitigating risk 
such as through stricter underwriting. Although FHA has to meet some 
statutory standards, it retains some flexibility in how it implements a 
newly authorized product or changes an existing product. The HUD 
Secretary has latitude within statutory limitations in changing 
underwriting requirements for new and existing products and has done 
this many times. 

The requirements in H.R. 3043 that prospective zero down payment loans 
go through FHA's TOTAL Scorecard and that borrowers receive prepurchase 
counseling are consistent with stricter underwriting. However, in 
addressing the final recommendations in our February report, FHA wrote 
that is unlikely to mandate a credit score threshold for a new zero 
down payment product because the new product is intended to serve 
borrowers who are underserved by the conventional market including 
those who lack credit scores. Also, FHA wrote that it is unlikely to 
mandate borrower reserve requirements since the purpose of a zero down 
payment product is to serve borrowers with little wealth or personal 
savings. 

Mortgage Institutions May Increase Fees or Charge Higher Premiums: 

Mortgage institutions can increase fees or charge higher premiums to 
help offset the potential costs of a program that is believed to have 
greater risk. For example, Fannie Mae officials stated that they would 
charge higher guarantee fees on low and no down payment loans if they 
were not able to require higher insurance coverage.[Footnote 10] FHA 
could set higher premiums in anticipation of higher claims from no down 
payment loans. Within statutory limits, the HUD Secretary has the 
authority to set up-front and annual premiums that are charged to 
borrowers who have FHA-insured loans. In fact, in the administration's 
2006 budget proposal for a zero down payment product, it included 
higher up front and annual premiums for these loans. 

Before Fully Implementing New Products, Some Mortgage Institutions May 
Limit Their Availability: 

Some mortgage institutions may limit in some way a new product before 
fully implementing the new product. For example, Fannie Mae and Freddie 
Mac sometimes use pilots, or limited offerings of new products, to 
build experience with a new product type or to learn about particular 
variables that can help them better understand the factors that 
contribute to risk for these products. Freddie Mac and Fannie Mae also 
sometimes set volume limits for the percentage of their business that 
could be low and no down payment lending. Fannie Mae and Freddie Mac 
officials provided numerous examples of products that they now offer as 
standard products but which began as part of underwriting experiments. 
These include the Fannie Mae Flexible 97® product, as well as the 
Freddie Mac 100 product. 

FHA has utilized pilots or demonstrations as well when making changes 
to its single-family mortgage insurance. Generally, HUD has done this 
in response to legislation that requires a pilot and not on its own 
initiative. For example, FHA's Home Equity Conversion Mortgage (HECM) 
insurance program started as a pilot. Congress initiated HECM in 1987; 
the program is designed to provide elderly homeowners a financial 
vehicle to tap the equity in their homes without selling or moving from 
their homes (sometimes called a "reverse mortgage"). Through statute, 
HECM started as a demonstration program that authorized FHA to insure 
2,500 reverse mortgages. Through subsequent legislation, FHA was 
authorized to insure an increasing number of these mortgages until 
Congress made the program permanent in 1998. Under the National Housing 
Act, the HECM program was required to undergo a series of evaluations 
and it has been evaluated four times since its inception. FHA officials 
told us that administering this demonstration for 2,500 loans was 
difficult because of the challenges of selecting a limited number of 
lenders and borrowers. FHA ultimately had to use a lottery to limit 
loans to lenders. 

H.R. 3043 also would mandate that FHA pilot the zero down payment 
program: it limits the annual number of zero down mortgages to 10 
percent of the aggregate number of loans insured during the previous 
fiscal year, and sets an aggregate limit of 50,000 loans. The 
appropriate size for a pilot program depends on several factors. For 
example, the precise number of loans needed to detect a difference in 
performance between standard loans and loans of a new product type 
depends in part on how great the differences are in loan performance. 
If delinquencies early in the life of a mortgage were about 10 percent 
for FHA's standard high LTV loans, and FHA wished to determine whether 
loans in the pilot had delinquency rates no more than 20 percent 
greater that the standard loans (delinquency no more than 12 percent), 
a sample size of about 1,000 loans would be sufficient to detect this 
difference with 95 percent confidence. If delinquency rates or FHA's 
desired degree of precision were different, a different sample size 
would be appropriate. 

FHA officials told us they have conducted pilot programs when Congress 
has authorized them, but they questioned the circumstances under which 
pilot programs are needed. FHA officials also said that they lacked 
sufficient resources to appropriately manage a pilot. 

Additionally, some mortgage institutions may also limit the initial 
implementation of a new product by limiting the origination and 
servicing of the product to their better lenders and servicers. 
Mortgage institutions may also limit servicing on the loans to 
servicers with particular product expertise, regardless of who 
originates the loans. Fannie Mae and Freddie Mac both reported that 
these were important steps in introducing a new product and noted that 
lenders tend to take a more conservative approach when first 
implementing a new product. FHA officials agreed that they could, under 
certain circumstances, envision piloting or limiting the ways in which 
a new or changed product would be available but pointed to the 
practical limitations in doing so. FHA approves the sellers and 
services that are authorized to support FHA's single-family product, 
but FHA officials told us they face challenges in offering any of their 
programs only in certain regions of the country or in limiting programs 
to certain approved lenders or servicers. FHA generally offers products 
on a national basis and, when they do not, specific regions of the 
county or lenders might question why they are not able to receive the 
same benefit (even on a demonstration or pilot basis). However, these 
officials did provide examples in which their products had been 
initially limited to particular regions of the country or to particular 
lenders, including the rollout of the HECMs and their TOTAL Scorecard. 

Mortgage Institutions Establish Enhanced Monitoring and Oversight for 
New Low and No Down Payment Products and Make Changes Based on What 
They Learn: 

Mortgage institutions, including FHA, may take several steps related to 
increased monitoring of new products and subsequently make changes 
based on what they learned. Fannie Mae and Freddie Mac officials 
described processes in which they monitor actual versus expected loan 
performance for new products, sometimes including enhanced monitoring 
of early loan performance. Some mortgage institutions, such as Fannie 
Mae, told us that they may conduct rigorous quality control sampling of 
new acquisitions, early payment defaults, and nonperforming loans. 
Depending on the scale of a new initiative, and its perceived risk, 
these quality control reviews could include a review of up to 100 
percent of the loans that are part of the new product. FHA officials 
told us they also monitor more closely loans underwritten under revised 
guidelines. Specifically, FHA officials told us that FHA routinely 
conducts a review of underwriting for approximately 6 to 7 percent of 
loans it insures. According to FHA officials, as part of the review, it 
may place greater emphasis on reviewing those aspects of the insurance 
product that are the subject of a recent change. 

Fannie Mae and Freddie Mac also reported that they conduct more regular 
reviews at mortgage servicer sites for new products. In some cases, 
Fannie Mae and Freddie Mac have staff who conduct on-site audits at the 
sellers and servicers to provide an extra layer of oversight. According 
to FHA officials, they have staff that conduct reviews of lenders that 
they have identified as representing higher risk to FHA programs. 
However, we recently reported that HUD's oversight of lenders could be 
improved and identified a number of recommendations for improving this 
oversight.[Footnote 11]

Conclusions: 

Loans with low or no down payments carry greater risk. Without any 
compensating measures such as offsetting credit enhancements and 
increased risk monitoring and oversight of lenders, introducing a new 
FHA no down payment product would expose FHA to greater credit risk. 
The administration's proposal for a zero down product included 
increased premiums to help compensate for an increase in the cost of 
the FHA program which would permit FHA to potentially offset additional 
costs stemming from a new product that entails greater risk or not well 
understood risk. The proposed bill also requires that borrowers receive 
prepurchase counseling. 

Although FHA appears to follow many key practices used by mortgage 
institutions in designing and implementing new products, several 
practices not currently or consistently followed by FHA stand out as 
appropriate means to manage the risks associated with introducing new 
products or significantly changing existing products. Moreover, these 
practices can be viewed as part of a formal framework used by some 
mortgage institutions for managing the risks associated with new or 
changed products. The framework includes techniques such as limiting 
the availability of a new product until it is better understood and 
establishing stricter underwriting standards--all of which would help 
FHA to manage risk associated with any new product it may introduce. 
For example, FHA could set volume limits or limit the initial number of 
participating lenders in the product. Further, changes in FHA's 
premiums, an important element of the administration's 2006 budget 
proposal for a zero down payment product would permit FHA to 
potentially offset additional costs stemming from a new product that 
entails greater risk or not well understood risk. 

However, FHA officials believe that the agency does not have sufficient 
resources to implement products with limited volumes, such as through a 
pilot program. Yet, when FHA makes new products widely available or 
makes significant changes to existing products with less-understood 
risks, these products or actions also can introduce significant risks. 
Products that would introduce significant risks can impose significant 
costs. We believe that FHA could mitigate these risks and potential 
costs by using techniques such as piloting. Moreover, FHA told us that 
it believes that pilot programs are not needed because the risks of 
every new year of loans are assessed annually as part of credit subsidy 
budgetary transactions and in its annual actuarial study, and it could 
terminate the program early in its life if it identified 
problems.[Footnote 12] However, because it may take a few years to 
determine the risks of a new loan product, early termination could 
still expose the government to significant financial risk without some 
type of limits on the number of loans insured. If FHA is unsure about 
its authority to conduct pilots or concerned about expectations of 
equitable distribution of its products, Congress can make clear that 
FHA has this authority by requiring a product to be implemented as part 
of a pilot, or by explicitly giving the HUD Secretary the authority to 
establish and implement pilots for new products. 

If Congress authorizes FHA to insure a no down payment product or any 
other new single-family insurance products, Congress may want to 
provide guidance and clear authority to FHA on this new product. 
Congress may want to consider a number of means to mitigate the 
additional risks that these loans may pose. Such means may include 
limiting the initial availability of such a new product, requiring 
higher premiums, requiring stricter underwriting standards, or 
requiring enhanced monitoring. Such risk mitigation techniques would 
serve to help protect the Mutual Mortgage Insurance Fund while allowing 
FHA the time to learn more about the performance of loans using this 
new product. Limits on the initial availability of the new product 
would be consistent with the approach Congress took in implementing the 
HECM program. The limits could also come in the form of an FHA 
requirement to limit the new product to better performing lenders and 
servicers as part of a demonstration program or to limit the time 
period during which the product is first offered. 

Mr. Chairman, this completes my prepared statement. I would be pleased 
to respond to any questions you or other members of the Committee may 
have at this time. 

GAO Contacts and Staff Acknowledgments: 

For more information regarding this testimony, please contact William 
B. Shear at (202) 512-8678 or shearw@gao.gov or Mathew Scirč at (202) 
512-6794 or sciremj@gao.gov. Contact points for our Offices of 
Congressional Relations and Public Affairs may be found on this last 
page of this testimony. Individuals making key contributions to this 
testimony also included Anne Cangi, Bert Japikse, Austin Kelly, Andy 
Pauline, Susan Etzel, and Barbara Roesmann. 

FOOTNOTES

[1] GAO, Mortgage Financing: Actions Needed to Help FHA Manage Risks 
from New Mortgage Loan Products, GAO-05-194 (Washington, D.C.: Feb. 11, 
2005). 

[2] Conventional mortgages do not carry government insurance or 
guarantees. 

[3] LTV is a ratio of the loan amount divided by the property sales 
price or appraised value of the house. 

[4] Credit scores are a single numerical score, based on an 
individual's credit history, which measures that individual's 
creditworthiness. 

[5] Mortgage defaults and foreclosures typically occur at the highest 
rates 4 to 7 years after the mortgages are issued. 

[6] The mortgage industry also uses credit scoring models for 
estimating the credit risk of individuals--these methodologies are 
based on information such as payment patterns. Statistical analyses 
identifying the characteristics of borrowers who were most likely to 
make loan payments have been used to create a weight or score 
associated with each of the characteristics. According to Fair, Isaac 
and Company sources, credit scores are often called "FICO scores" 
because most credit scores are produced from software developed by 
Fair, Isaac and Company. FICO scores generally range from 300 to 850 
with higher scores indicating better credit history. The lower the 
credit score, the more compensating factors lenders might require to 
approve a loan. These factors can include a higher down payment and 
greater borrower reserves. 

[7] Susan Wharton Gates, Vanessa Gail Perry, and Peter Zorn, "Automated 
Underwriting in Mortgage Lending: Good News for the Underserved," 
Housing Policy Debate, 13, no. 2, 2002. 

[8] GAO, Single-Family Housing: Progress Made, but Opportunities Exist 
to Improve HUD's Oversight of FHA Lenders, GAO-05-13 (Washington, D.C.: 
Nov. 12, 2004). 

[9] According to FHA officials, FHA discontinued the multifamily co- 
insurance program after experiencing significant losses. Since then, 
Congress provided FHA authority to enter into risk-sharing agreements 
with GSEs and housing finance agencies on certain multifamily 
insurance. 

[10] Fannie Mae and Freddie Mac charge fees for guaranteeing timely 
payment on mortgage backed securities they issue. The fees are based, 
in part, on the credit risk they face. 

[11] GAO-05-13. 

[12] The Federal Credit Reform Act of 1990 requires that federal 
government programs that make direct loans or loan guarantees 
(including insuring loans) account for the full cost of their programs 
on an annual budgetary basis. Specifically, federal agencies must 
develop subsidy estimates of the net cost of their programs that 
include estimates of the net costs and revenues over the projected 
lives of the loans made in each fiscal year. The Cranston Gonzales 
National Affordable Housing Act requires an independent actuarial 
analysis of the economic net worth and soundness of FHA's MMI Fund.