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entitled 'Mortgage Financing: FHA's $7 Billion Reestimate Reflects 
Higher Claims and Changing Loan Performance Estimates' which was 
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Report to the Chairman, Subcommittee on Housing and Community 
Opportunity, Committee on Financial Services, House of Representatives: 

September 2005: 

Mortgage Financing: 

FHA's $7 Billion Reestimate Reflects Higher Claims and Changing Loan 
Performance Estimates: 

[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-05-875]: 

GAO Highlights: 

Highlights of GAO-05-875, a report to the Chairman, Subcommittee on 
Housing and Community Opportunity, Committee on Financial Services, 
House of Representatives: 

Why GAO Did This Study: 

The U.S. Department of Housing and Urban Development (HUD), through its 
Federal Housing Administration (FHA), provides insurance for private 
lenders against losses on home mortgages. FHA’s largest insurance 
program is the Mutual Mortgage Insurance Fund (Fund), which currently 
is self-financed and operates at a profit. FHA submitted a “reestimate” 
of $7 billion for the credit subsidy and interest for the Fund as of 
the end of fiscal year 2003, reflecting a reduction in estimated 
profits. Given this substantial reestimate, you asked GAO, among other 
things, to determine what factors contributed to the $7 billion 
reestimate and the underlying loan performance variables influencing 
these factors and to assess how the loan performance variables 
underlying the reestimate could impact future estimates of new loans. 

What GAO Found: 

The $7 billion reestimate was due primarily to an increase in estimated 
and actual claims over what FHA previously estimated. For example, 
actual claim activity in fiscal year 2003 exceeded estimated claim 
activity for 2003—by twice as much in some cases—for the majority of 
loan cohorts. Prepayments also played a role in the reestimate as they 
were higher than previous estimates. In fact, actual prepayment 
activity during 2003 exceeded estimated prepayment activity for all 
cohorts. Because of the additional claims it paid, upfront premiums it 
refunded, and the annual premiums it lost, FHA’s net cash outflows for 
the year increased, contributing to the $7 billion adjustment of the 
Fund’s credit subsidy. 

Several recent events may help explain this increase, including changes 
to underwriting guidelines, competition from the private sector, and an 
increase in the use of down payment assistance. FHA has taken some 
steps to tighten underwriting guidelines and better estimate loan 
performance, though it is not clear that these steps are sufficient to 
reverse recent increases in actual and estimated claims and prepayments 
or help FHA to more reliably predict future claim and prepayment 
activity. Increases in claim and prepayment activity are likely to 
continue to add risk to FHA’s portfolio. 

Actual Versus Estimated Claim and Prepayment Rates for FY 2003: 

[See PDF for image] 

[End of figure] 

What GAO Recommends: 

To more reliably estimate program costs, the Secretary of HUD should 
direct the FHA Commissioner to study and report the impact of variables 
that have been found in other studies to influence credit risk. When 
changing the definitions of key variables, FHA also should report the 
impact such changes would have had on the forecasting ability of its 
loan performance models. In written comments, HUD generally agreed with 
GAO’s overall findings. 

www.gao.gov/cgi-bin/getrpt?GAO-05-875. 

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

[End of section] 

Contents: 

Letter: 

Results in Brief: 

Background: 

The $7 Billion Reestimate Is Significant for Its Size and Direction: 

The $7 Billion Reestimate Primarily Reflects Higher-Than-Estimated 
Claims: 

The Loan Performance Variables Underlying the $7 Billion Reestimate 
Will Likely Affect Future Credit Subsidy Estimates, but Are Being 
Addressed: 

The Loan Performance Variables Underlying the Reestimate Could Affect 
Estimates of the Fund's Long-Term Viability: 

Conclusions: 

Recommendations for Executive Action: 

Agency Comments and Our Evaluation: 

Appendixes: 

Appendix I: Scope and Methodology: 

Appendix II: Data for Figures Used in This Report: 

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

Appendix IV: GAO Contact and Staff Acknowledgments: 

Tables: 

Table 1: Annual Credit Subsidy Reestimates For the MMI Fund, Fiscal 
Years 2000-2004 (Figure 3): 

Table 2: Amount of the 2003 Reestimate Attributed to the 2001-2003 
Cohorts, as a Percentage of the Original Loan Amount, For Single-Family 
Loan Guarantee Programs (Figure 4): 

Table 3: Original Estimated Credit Subsidy Rates and Most Recent 
Reestimated Rates for the FHA and VA Loan Guarantee Programs, 1992-2004 
Cohorts (Figure 5): 

Table 4: Primary Factors Contributing to the Fiscal Year 2003 MMI 
Credit Subsidy Reestimate (Figure 6): 

Table 5: Change in Future Cash Flow Estimates for the Fund from Fiscal 
Year 2002 to Fiscal Year 2003 (Figure 7): 

Table 6: Variables Contributing to the $3.9 Billion Change in Estimated 
Cash Flows (Figure 8): 

Table 7: Increase in Estimated Net Cash Outflows from Removing the Loss 
Mitigation Adjustment Factor, 1992-2003 Cohorts (Figure 9): 

Table 8: Actual Versus Estimated Conditional Claim Rates for Fiscal 
Year 2003, 1993-2003 Cohorts (Figure 10): 

Table 9: Actual Versus Estimated Conditional Prepayment Rates for 
Fiscal Year 2003, 1993-2003 Cohorts (Figure 10): 

Table 10: Amount of FHA Prepayments During Fiscal Years 2000-2004 
(Figure 11): 

Table 11: Capital Ratio Versus Economic Value of the MMI Fund, Fiscal 
Years 2000-2004 (Figure 12): 

Table 12: Amortized Insurance-In-Force, Fiscal Years 2000-2004 (Figure 
13): 

Table 13: Minimum Required Capital Ratio Versus Actual Capital Ratio 
(Figure 14): 

Figures: 

Figure 1: Calculation of Credit Subsidy for the Fund: 

Figure 2: Relationship between Actuarial Review and Reestimate: 

Figure 3: Annual Credit Subsidy Reestimates for the MMI Fund, Fiscal 
Years 2000-2004: 

Figure 4: Amount of the 2003 Reestimate Attributed to the 2001-2003 
Cohorts, as a Percentage of the Original Loan Amount, for Single-Family 
Loan Guarantee Programs: 

Figure 5: Original Estimated Credit Subsidy Rates and Most Recent 
Reestimated Rates for the FHA and VA Loan Guarantee Programs, 1992-2004 
Cohorts: 

Figure 6: Primary Factors Contributing to the Fiscal Year 2003 MMI 
Credit Subsidy Reestimate: 

Figure 7: Change in Future Cash Flow Estimates for the Fund from Fiscal 
Year 2002 to Fiscal Year 2003: 

Figure 8: Variables Contributing to the $3.9 Billion Change in 
Estimated Cash Flows: 

Figure 9: Increase in Estimated Cash Outflows from Removing the Loss 
Mitigation Adjustment Factor, 1992-2003 Cohorts: 

Figure 10: Actual Versus Estimated Conditional Claim and Prepayment 
Rates for Fiscal Year 2003, 1993-2003 Cohorts: 

Figure 11: Amount of FHA Prepayments during Fiscal Years 2000-2004: 

Figure 12: Capital Ratio Versus Economic Value of the MMI Fund, Fiscal 
Years 2000-2004: 

Figure 13: Amortized Insurance-In-Force, Fiscal Years 2000-2004: 

Figure 14: Minimum Required Capital Ratio Versus Actual Capital Ratio: 

Abbreviations: 

FCRA: Federal Credit Reform Act: 

FHA: Federal Housing Administration: 

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

OMB: U.S. Office of Management and Budget: 

USDA: U.S. Department of Agriculture: 

VA: U.S. Department of Veterans Affairs: 

Letter September 2, 2005: 

The Honorable Bob Ney: 
Chairman: 
Subcommittee on Housing and Community Opportunity: 
Committee on Financial Services: 
House of Representatives: 

Dear Mr. Chairman: 

The Department of Housing and Urban Development (HUD), through its 
Federal Housing Administration (FHA), provides insurance for single- 
family home mortgage loans made by private lenders. During fiscal year 
2004, FHA insured 892,591 mortgages, representing $107.7 billion in 
single-family mortgage insurance. The insurance program is supported by 
the Mutual Mortgage Insurance Fund (Fund), which is financed through 
insurance premiums that FHA charges its borrowers.[Footnote 1] FHA's 
mortgage insurance program is currently a negative subsidy program, 
meaning that the Fund is self-financed and operates at a profit. 

In 2001 we reported that the Fund had an economic value, or net worth, 
of about $15.8 billion (as of the end of fiscal year 1999) and a 
capital ratio of 3.20 percent of the unamortized insurance-in- 
force,[Footnote 2] or the initial amount of the mortgages.[Footnote 3] 
We noted that the minimum required capital ratio of 2 percent, set by 
Congress in 1990, appeared sufficient to withstand moderately severe 
economic downturns that could lead to worse-than-expected loan 
performance. In 2002, we reported that while loans made during the 
1990s were performing much better than loans made in the 1980s, 
performance was somewhat weaker for loans originated during the latter 
1990s than for those originated earlier in the decade.[Footnote 4] Our 
analysis suggested that changes in FHA's underwriting procedures and in 
the conventional mortgage market may have increased the overall 
riskiness of FHA's portfolio, potentially affecting the Fund's economic 
value and its ability to withstand future economic downturns. 
Therefore, we cautioned against concluding that the Fund could 
withstand specified economic scenarios. In October 2004, FHA estimated 
that the Fund had an economic value of about $22 billion and a capital 
ratio of 5.5 percent. However, because of the uncertainty of these 
measures and recent declines in loan performance, we continue to 
believe that caution is warranted. 

In recent years, FHA has adjusted its budget estimates to reflect that, 
while not requiring subsidy, the performance of FHA-insured loans and 
the resulting cash flows were not as strong as previously estimated. 
Higher estimated costs caused the program to be less profitable than 
previously estimated. Specifically, as of the end of fiscal year 2003, 
FHA submitted a "reestimate" of $7 billion for the Fund. Given this 
substantial reestimate of program cash flows, you asked us to (1) 
assess the significance of the $7 billion reestimate, (2) determine 
what factors contributed to the $7 billion reestimate and the 
underlying loan performance variables influencing these factors, (3) 
assess how the loan performance variables underlying the reestimate 
could impact future estimates of new loans, and (4) assess what the 
reestimate and the underlying loan performance variables mean for the 
long-term viability of the Fund. 

To respond to these objectives, we interviewed officials at FHA and 
staff from the Office of Management and Budget (OMB). We collected and 
analyzed budget data on FHA and comparable loan guarantee programs at 
the Department of Veterans Affairs (VA), and Department of Agriculture 
(USDA) to determine the significance of FHA's $7 billion credit subsidy 
reestimate for the Fund. We interviewed FHA officials and FHA 
contractors and collected and analyzed their written information and 
data to determine the main factors contributing to the reestimate, the 
underlying loan performance variables influencing these factors, and 
the likelihood these variables could impact future estimates. We also 
analyzed FHA and other data on new loan products and home mortgage 
industry trends to assess what the reestimate and underlying loan 
performance variables mean for the long-term viability of the Fund. 
Details about our scope and methodology appear at the end of this 
letter. 

We conducted our work from November 2004 through July 2005 in 
Washington, D.C., in accordance with generally accepted government 
auditing standards. 

Results in Brief: 

The $7 billion credit subsidy reestimate for the Fund was more than 
twice the size of FHA's other recent reestimates and represented a 
greater proportion of the Fund's recent cohorts[Footnote 5] than was 
the case for the 2003 reestimates for comparable loan guarantee 
programs. While the $7 billion reestimate is unusually large, the 
upward direction of FHA's recent reestimates in general is of concern 
because of the increase in estimated cash outflows they represent. 
Also, FHA's current credit subsidy estimates are, with one exception, 
higher than the original estimates for all post-1991 cohorts. 

Three major factors contributed to the $7 billion reestimate: a change 
in the estimated future cash flows of its loans insured through 2003, 
the difference between estimated and actual cash flows occurring during 
fiscal year 2003, and an interest adjustment. The primary loan 
performance variable underlying these factors is unexpectedly high 
claims. For example, in 2003 FHA estimated that most cohorts would 
experience more claim activity over the course of their 30-year terms 
than it estimated in 2002, increasing estimated cash outflows by $2.5 
billion. Higher-than-estimated prepayments as well as changing 
assumptions about the impact that FHA's loss mitigation efforts could 
have on claims are also important variables. For example, the revisions 
to loss mitigation assumptions increased estimated cash outflows by 
$1.7 billion. 

The change in expected claims underlying the $7 billion reestimate will 
likely affect credit subsidy estimates for future loan cohorts, but the 
effect of prepayments is less certain. Several recent policy changes 
and trends may help explain the increase in claims, including changes 
to underwriting guidelines, competition from the private sector, and an 
increase in the use of down payment assistance. It appears that these 
policy changes and trends will continue to impact claims, and thus they 
will likely continue to add risk to FHA's portfolio. Prepayment rates 
increased significantly prior to the 2003 reestimate, but it is less 
likely that the same conditions that caused the surge in prepayments 
early in the decade will be repeated. The revisions to loss mitigation 
assumptions will also affect future estimates of subsidy by no longer 
artificially reducing claims, though the significance may decline. FHA 
does not intend to use the same assumption again given its greater 
historical experience with loss mitigation. 

Because the loan performance variables underlying the $7 billion 
reestimate will likely persist to varying degrees, they are also likely 
to affect estimates of the Fund's long-term viability. The capital 
ratio, a measure of the Fund's long-term viability, has increased in 
recent years. However, if the Fund's economic value declines or is 
restated at a lower level than previously estimated, because of higher 
claims, and if the insurance-in-force remains steady, because of 
declining prepayments, then the capital ratio will decline. Whether the 
currently estimated 5.5 percent capital ratio or a lower capital ratio 
is sufficient depends on the scenarios the Fund is expected to survive 
while maintaining the minimum 2 percent reserve. Neither Congress nor 
HUD has established criteria to determine how severe a stress the Fund 
should be able to withstand. 

To more reliably estimate program costs, we recommend that the 
Secretary of HUD direct the FHA Commissioner to study and report the 
impact on the forecasting ability of its loan performance models of 
variables that have been found in other studies to influence credit 
risk, such as payment-to-income ratios, credit scores, and the presence 
of down payment assistance. We also recommend that when changing the 
definitions of key variables, FHA should report the impact of such 
changes on the forecasting ability of its loan performance models. 

Background: 

FHA was established in 1934 under the National Housing Act (P.L. 73- 
479) to broaden homeownership, shore up and protect lending 
institutions, and stimulate employment in the building industry by 
providing mortgage insurance for loans made by private lenders. 
Generally, borrowers are required to purchase single-family mortgage 
insurance when the value of the mortgage is large relative to the price 
of the house. Together, FHA, VA, USDA, and private mortgage insurers 
provide virtually all of this insurance. FHA provides insurance for 
mortgages that finance the purchase of properties with one to four 
housing units, often by low-income, minority, and first-time 
homebuyers. 

The economic value of the Fund that supports FHA's guarantees depends 
on the relative size of cash outflows and inflows over time. Cash flows 
out of the Fund from payments associated with claims on defaulted loans 
and refunds of up-front premiums on prepaid mortgages.[Footnote 6] To 
cover these outflows, FHA receives cash inflows from up-front and 
annual insurance premiums from borrowers and net proceeds from 
recoveries on defaulted loans. If the Fund were to be exhausted, the 
U.S. Treasury would have to cover lenders' claims directly. 

The Fund remained relatively healthy from its inception until the 1980s 
when claims and losses were substantial, primarily because of high 
foreclosure rates in regions experiencing economic stress. These losses 
prompted reforms that were enacted as part of the Omnibus Budget 
Reconciliation Act of 1990 (P.L. 101-508). The reforms were designed to 
place the Fund on an actuarially sound basis and required, among other 
things, that it maintain a capital ratio of 2 percent of the insurance- 
in-force and that an independent contractor conduct an annual actuarial 
review of the Fund to analyze its economic value. 

The Federal Credit Reform Act of 1990 (FCRA), enacted as part of the 
Omnibus Budget Reconciliation Act of 1990, reformed budgeting methods 
for federal credit programs, including FHA's mortgage insurance 
program. As a result of FCRA, OMB requires federal credit agencies to 
report the actual and estimated lifetime cost to the government of 
their programs in their annual budgets. Similarly, federal accounting 
standards require agencies to recognize the estimated lifetime costs of 
their programs in their financial statements. To determine the expected 
cost of credit programs, agencies predict or estimate the future 
performance of the programs on a cohort basis. This cost, known as the 
subsidy cost, is the net present value[Footnote 7] of estimated 
payments the government makes less estimated amounts it receives over 
the life of the loan or loan guarantee, excluding administrative costs. 
For the Fund, the overall subsidy is currently a negative cost, meaning 
that the present value of cash inflows exceeds cash outflows. Outflows 
include claims paid on foreclosed properties, refunds of up-front 
insurance premiums, and foreclosed property holding costs, while 
inflows include insurance premiums and proceeds from the sale of 
foreclosed properties, over the life of the loan guarantees (fig. 1). 

Figure 1: Calculation of Credit Subsidy for the Fund: 

[See PDF for image] 

[End of figure] 

FCRA established a special budgetary accounting system to record the 
budget information necessary to implement credit reform. For loans and 
loan guarantees made during or after fiscal year 1992--the effective 
date of credit reform--federal agencies use program and financing 
accounts to handle credit transactions.[Footnote 8] The program account 
is included in budget totals, receives separate appropriations for the 
administrative and subsidy costs of a credit program, and records the 
budget authority and outlays for these costs. The program account is 
used to pay the associated subsidy cost to the financing account when a 
direct or guaranteed loan is disbursed. The financing account, which is 
nonbudgetary,[Footnote 9] is used to collect the subsidy cost from the 
program account, borrow from Treasury to provide financing for loan 
disbursements, and record the lifetime cash flows associated with 
direct loans or loan guarantees. In 2002, a new capital reserve account 
was established for the Mutual Mortgage Insurance Fund to maintain 
reserves for the post-1991 cohorts. In 2003 this new account started 
earning interest on Treasury investments, collecting negative subsidy 
and downward reestimates from the financing account, and paying upward 
reestimates. 

Agencies are required to reestimate subsidy costs annually to reflect 
actual loan performance and expected changes in estimates of future 
loan performance. Annual estimates of a program's expected lifetime 
subsidy change from year to year. Beyond changes in estimation 
methodology, each additional year provides more historical data on loan 
performance that may influence estimates of the amount and timing of 
future claims and prepayments. Economic assumptions also change from 
one year to the next, including assumptions on interest rates, 
unemployment, and home prices. Assumptions about the impact of policy 
changes also can affect estimates of subsidy costs--for example, by 
changing how loans are serviced or the treatment of foreclosed 
properties, which potentially influences the timing and amount of 
losses. 

In accordance with the Omnibus Budget Reconciliation Act of 1990, FHA 
contracts with private firms to prepare an annual actuarial 
review.[Footnote 10] Figure 2 illustrates the relationship between the 
actuarial review and the credit subsidy reestimate. For the review, the 
contractors develop econometric loan performance models to estimate 
future claim and prepayment activity for the loans FHA insures. The 
contractors also develop a cash flow model through which they run the 
output of the loan performance models. The actuarial cash flow model 
calculates the net present value of future cash flows in and out of the 
Fund to estimate its economic net worth and capital ratio. FHA also 
uses the actuarial claim and prepayment data with its credit subsidy 
cash flow model to estimate the net present value of future cash flows 
for the budget and the ending balance of the liability for loan 
guarantees in the financial statements. At the end of the fiscal year, 
FHA uses a "balances approach" to compare the resources in the 
financing account to the liability for loan guarantees.[Footnote 11] 
The difference is the credit subsidy reestimate. 

Figure 2: Relationship between Actuarial Review and Reestimate: 

[See PDF for image] 

[End of figure] 

In November 1996, FHA implemented a new loss mitigation program that 
included a range of options to help homeowners who have defaulted on 
their mortgage to either retain their homes or enable FHA to dispose of 
them in ways that reduced the costs of foreclosure. The loss mitigation 
program has five options: (1) special forbearance, or a repayment 
agreement between the lender and borrower to reinstate a loan; (2) loan 
modification, which provides borrowers with a permanent reduction in 
mortgage payment; (3) partial claim, which enables a borrower to get an 
interest-free loan from HUD to bring their mortgage payments up to 
date; (4) pre-foreclosure sale, which provides borrowers with a 
transition to more affordable housing; and (5) deed-in-lieu of 
foreclosure, an alternative to foreclosure whereby a borrower 
voluntarily deeds the property to HUD and is released from all mortgage 
obligations. 

The $7 Billion Reestimate Is Significant for Its Size and Direction: 

The $7 billion credit subsidy reestimate for the Fund was more than 
twice the size of other recent FHA reestimates and represented a 
greater proportion of the Fund's recent cohorts than other 2003 
reestimates for comparable loan guarantee programs. Both this unusually 
large reestimate and the upward direction of FHA's recent reestimates 
are matters for concern. Overall, though the Fund still operates at a 
profit, FHA's current reestimated credit subsidy rates are higher than 
FHA originally estimated for all but one of the 1992 through 2004 
cohorts. In comparison, current reestimated subsidy rates for VA's loan 
guarantee program are lower than VA originally estimated for all but 
one of the 1992 through 2004 cohorts. 

The Reestimate Is Large Compared with Other Recent Reestimates and 
Programs: 

The $7 billion reestimate FHA reported in its 2003 financial statements 
was by far the largest reestimate FHA has made in recent years. As 
figure 3 illustrates, it was more than twice the size of any other 
reestimate from 2000 through 2004, indicating that FHA's actual and 
estimated cash flows have changed substantially. 

Figure 3: Annual Credit Subsidy Reestimates for the MMI Fund, Fiscal 
Years 2000-2004: 

[See PDF for image] 

[End of figure] 

An alternative way of measuring the magnitude of the reestimate is by 
comparing it with reestimates for comparable loan guarantee programs. 
FHA's 2003 reestimate was also unusually large compared with 
reestimates for the same year for VA's and USDA's single-family loan 
guarantee programs.[Footnote 12] FHA reestimates the credit subsidy 
separately for each cohort of loans that it insures, totaling the 
separate reestimates into one overall reestimate for the fiscal year. 
Loans that FHA insured in 2001 through 2003 accounted for $4.5 billion, 
or 64 percent, of the total $7 billion reestimate. The $4.5 billion of 
the reestimate attributed to these three cohorts of loans equaled 1.22 
percent of their combined total endorsements.[Footnote 13] As figure 4 
illustrates, this percentage is more than double that of comparable 
loan guarantee programs at VA and USDA. 

Figure 4: Amount of the 2003 Reestimate Attributed to the 2001-2003 
Cohorts, as a Percentage of the Original Loan Amount, for Single-Family 
Loan Guarantee Programs: 

[See PDF for image] 

[End of figure] 

FHA's Current Reestimated Subsidy Rates Are Less Favorable Than Its 
Original Estimates: 

FHA has estimated negative credit subsidies for the Fund since 1992, 
when credit reform became effective. However, with one exception, 
current reestimated subsidy rates for FHA's loan guarantees are less 
favorable than originally estimated. Meanwhile, across the country home 
prices have been growing faster and more uniformly since 2000 than they 
grew during the 1990s and most of the 1980s. This indicates that very 
few borrowers would have seen their home values decline to the point at 
which their homes were worth less than their mortgage balances, putting 
them at a greater risk of foreclosure and causing subsidy rates to 
worsen. In keeping with the trend of increasing home prices, current 
reestimated rates for VA's program are more favorable than originally 
estimated. As shown in figure 5, the original and current subsidy cost 
estimates for FHA's 1992 through 2004 cohorts were negative, meaning 
FHA estimated total cash inflows to be greater than outflows over the 
life of each cohort. FHA's most recent reestimates indicate that all 
but the 1992 cohort will be less profitable than originally estimated, 
though FHA is not estimating that these cohorts will have overall 
negative cash flows. In comparison, the original subsidy estimates for 
VA's 1992 through 2004 cohorts did indicate negative cash flows, 
meaning VA estimated that the present value of total cash outflows 
would exceed inflows over the life of each cohort. With the exception 
of one cohort, VA's reestimated subsidy costs are all lower than 
originally estimated, indicating that VA currently estimates that its 
cohorts will perform better than originally expected. However, VA 
estimates that several cohorts will continue to have overall negative 
cash flows. 

Figure 5: Original Estimated Credit Subsidy Rates and Most Recent 
Reestimated Rates for the FHA and VA Loan Guarantee Programs, 1992-2004 
Cohorts: 

[See PDF for image] 

[End of figure] 

The $7 Billion Reestimate Primarily Reflects Higher-Than-Estimated 
Claims: 

The $7 billion reestimate represents the changes in FHA's estimates of 
future loan performance and the change in cash flows stemming from the 
difference between estimated and actual loan performance during fiscal 
year 2003. These changes primarily reflect the impact of higher-than- 
estimated claims, but also reflect the impact of higher-than-estimated 
prepayments and a technical change in FHA's calculation of claims. The 
reestimate also represents an interest adjustment (fig. 6). 

Figure 6: Primary Factors Contributing to the Fiscal Year 2003 MMI 
Credit Subsidy Reestimate: 

[See PDF for image] 

[End of figure] 

Three Main Factors Contributed to the Reestimate: 

The largest contributing factor--55 percent--was the $3.9 billion 
difference between FHA's fiscal year 2003 estimates of the net present 
value of future cash flows and the estimates it made one year earlier. 
As previously discussed, FHA estimates the value of expected future 
cash flows each year by calculating the present value of anticipated 
cash outflows, such as claim payments and premium refunds, and 
subtracting inflows, such as insurance premiums and proceeds from the 
sale of foreclosed properties. In 2002, FHA estimated that the net 
present value of future cash flows for the 1992 through 2002 cohorts 
was a positive $1.9 billion, meaning that FHA expected cash inflows to 
exceed cash outflows on a net present value basis. In 2003, FHA 
estimated that the net present value of future cash flows for the 1992 
through 2003 cohorts was negative $2 billion, meaning that FHA expected 
future cash outflows to exceed future cash inflows.[Footnote 14] As 
figure 7 illustrates, the difference between the two estimates is $3.9 
billion. 

Figure 7: Change in Future Cash Flow Estimates for the Fund from Fiscal 
Year 2002 to Fiscal Year 2003: 

[See PDF for image] 

[End of figure] 

The second factor contributing to the $7 billion reestimate--30 
percent--was the $2.1 billion difference between estimated and actual 
cash flows occurring during fiscal year 2003. This amount indicates 
that FHA had $2.1 billion less in cash inflows during 2003 than it had 
estimated it would have a year earlier. The final factor contributing 
to the reestimate (15 percent) was the $1.1 billion of interest on the 
reestimate. OMB guidance requires agencies to calculate an interest 
adjustment on the reestimate.[Footnote 15] In FHA's case, the interest 
adjustment increased the total reestimate by $1.1 billion. 

A Change in Estimated Claims Was the Primary Loan Performance Variable 
Behind the $3.9 Billion Change in Estimated Future Cash Flows: 

Approximately $2.7 billion (70 percent) of the $3.9 billion net change 
in FHA's estimate of future cash flows stems from changes in FHA's 
estimates of claims and, to a lesser extent, prepayments (fig. 8). That 
is, FHA changed its estimate of future loan performance based on its 
observation of actual loan performance during 2003 and revised economic 
assumptions. In 2003 FHA estimated that, except for the 1993 and 1994 
loan cohorts, all cohorts would experience more claim activity over the 
course of their 30-year terms--and thus increase FHA's outflows--than 
estimated in 2002. The cash flows associated with these claims 
increased estimated cash outflows by $2.5 billion, accounting for 92 
percent of the $2.7 billion. Increases in the expected level of 
prepayments also affected FHA's estimate of future cash flows. FHA 
estimated in 2003 that about half of the cohorts would experience more 
prepayment activity than it had estimated in 2002. Because of the 
increase in estimated prepayments, FHA expected to collect less premium 
income and to pay out premium refunds more often, reducing estimated 
cash inflows by about $200 million and accounting for 8 percent of the 
$2.7 billion. 

Figure 8: Variables Contributing to the $3.9 Billion Change in 
Estimated Cash Flows: 

[See PDF for image] 

[End of figure] 

Another major variable that contributed to the $3.9 billion change in 
estimated future cash flows was a technical change in FHA's calculation 
of claims that increased the reestimate by $1.7 billion. Specifically, 
for estimates prepared during fiscal years 2001 and 2002, FHA used a 
cash flow assumption--a loss mitigation adjustment factor--to reduce 
the claim rates predicted by the actuarial review and used in the 
subsidy cash flow model. FHA had been using this factor in the belief 
that the historical data used to estimate claim rates did not include 
enough years under the loss mitigation program to adequately reflect 
the impact of this program--that is, an expected decline in claims. 
However, FHA officials stated that in fiscal year 2003 FHA removed the 
factor because the historical loan performance data, which by then 
included more years of experience with the loss mitigation program, 
sufficiently reflected the program's impact. In addition, FHA noted 
that its actuarial review was underestimating claims, making it 
counterproductive to use a loss mitigation adjustment factor that 
further reduced the actuarial claim predictions. Removing the loss 
mitigation adjustment factor from the 2003 subsidy cash flow model 
increased the reestimate by a total of $1.7 billion, with the greatest 
increase related to loans made in the most recent years (fig. 9). 

Figure 9: Increase in Estimated Cash Outflows from Removing the Loss 
Mitigation Adjustment Factor, 1992-2003 Cohorts: 

[See PDF for image] 

[End of figure] 

The above increases in estimated cash outflows are offset by the 
estimated additional cash inflows from new loans that FHA insured in 
2003. Specifically, FHA estimated that for loans originating during 
2003, future inflows would exceed future outflows by $1 billion. 
Several other factors had much smaller positive or negative impacts on 
future cash flows. The net impact of these other factors contributed 
$500 million to the reestimate. 

Higher-Than-Estimated Claims and Prepayments Contributed to the $2.1 
Billion Difference between Estimated and Actual Cash Flows Occurring 
during 2003: 

The remaining part of the $7 billion--$2.1 billion--represents the 
difference between estimated and actual cash flows occurring during 
fiscal year 2003. Certain elements of the difference relate to the 1992 
through 2002 cohorts, including $330 million in underestimated claims 
and recoveries on claims and $1 billion in overestimated net fees 
(insurance premium receipts less premium refunds). The remaining $700 
million relates to cash flow differences associated with the 2003 
cohort. 

Our analysis of loan performance data found that claims and prepayments 
occurring during 2003 exceeded FHA's estimates. As figure 10 
illustrates, actual claim activity in fiscal year 2003 exceeded 
estimated claim activity for 2003--by twice as much in some cases--for 
the majority of loan cohorts. For example, FHA estimated that about 1.6 
percent of all the loans it insured in 2000 that were in the portfolio 
at the beginning of 2003 would result in a claim during 2003. However, 
4 percent of such loans actually ended in a claim in 2003. Actual 
prepayment activity exceeded estimated prepayment activity for all loan 
cohorts. For example, FHA estimated that 14 percent of all the loans it 
insured in 2001 that were still in the portfolio at the beginning of 
2003 would prepay during 2003. However, more than 40 percent of such 
loans actually prepaid during 2003. Because of the additional claims it 
paid, up-front premiums it refunded, and the annual premiums it lost, 
FHA's cash inflows for the year declined and resulted in a $2.1 billion 
upward adjustment of the Fund's credit subsidy. 

Figure 10: Actual Versus Estimated Conditional Claim and Prepayment 
Rates for Fiscal Year 2003, 1993-2003 Cohorts: 

[See PDF for image] 

Note: The 2003 estimate data are from the 2002 actuarial review. The 
2003 actual data are from the 2004 actuarial review. 

[End of figure] 

The Loan Performance Variables Underlying the $7 Billion Reestimate 
Will Likely Affect Future Credit Subsidy Estimates, but Are Being 
Addressed: 

The events behind the change in expected claims underlying the $7 
billion reestimate will likely continue to affect future credit subsidy 
estimates, though prepayments may have a smaller effect. The one-time 
modeling change caused by removing the loss mitigation adjustment 
factor should also continue to have an effect on future estimates, 
though its significance may decline. 

Higher Claims Will Likely Continue, but FHA Is Taking Steps to Improve 
Its Estimates: 

As we have seen, the $7 billion reestimate was largely due to higher- 
than-estimated claims. Several recent events may help explain this 
increase, including changes to underwriting guidelines, competition 
from the private sector, and an increase in the use of down payment 
assistance. FHA has taken some steps to tighten underwriting and to 
better estimate claims, but it is not clear that these steps will be 
sufficient to reverse recent increases in claims or significantly 
improve future estimates of claims. 

According to FHA, revised underwriting guidelines issued in 1995 
represented significant changes that would enhance home-buying 
opportunities for a substantial number of borrowers. These changes made 
it easier for borrowers to qualify for loans and for higher loan 
amounts. In previous work, we noted that these underwriting changes may 
partly explain the higher claim rates of the late 1990s.[Footnote 16] 
FHA officials told us that since making these changes, FHA's share of 
first-time homebuyers has increased by more than 30 percent, and its 
share of minority homebuyers has increased by 40 percent. FHA officials 
noted that these borrowers are more susceptible to changes in economic 
conditions and, thus, may be more likely to default on their mortgages. 
The officials also noted that, while this change in the composition of 
their borrowers had resulted in a one-time increase in claims, claims 
have leveled off and should remain steady at the new level. 

To evaluate the impact of the underwriting changes, FHA introduced a 
simple variable into its annual actuarial models that captures whether 
or not a loan was made after fiscal year 1995. This variable is 
intended to capture the one-time impact of the 1995 underwriting 
changes, not to capture any adverse trends that might result from 
changes that accrue over time, such as increasing competition from the 
private sector or the growing prevalence of down payment assistance. If 
there are adverse trends, as opposed to only one-time changes, the 
model will not fully capture them and, therefore, will likely 
underestimate future claims. For example, if loans with down payment 
assistance have higher claims and if this category of loans grows over 
time, then the claim model will consistently underestimate claims and 
the model's error will worsen with time. 

In 2002, we reported that the performance of loans insured during the 
late 1990s was weaker than the performance of loans originated earlier 
in the decade. We noted then that increased competition and changes in 
the conventional mortgage market could result in FHA's insuring 
relatively more loans that carried greater risk. These issues continue 
to be significant. In recent years, private mortgage insurers and 
conventional mortgage lenders have increasingly offered products that 
compete with FHA for homebuyers who are borrowing more than 95 percent 
of the value of their home. In addition, automated underwriting systems 
and credit-scoring analytic software are believed to be able to more 
effectively distinguish low-risk loans for expedited processing. If, by 
selectively offering these low down payment loans to better risk 
borrowers, conventional mortgage lenders and private mortgage insurers 
were able to attract lower-risk borrowers that would have traditionally 
sought FHA-insured loans, recent FHA-insured loans with down payments 
of less than 5 percent may be more risky on average than they have been 
historically. 

A growing trend that has raised some concerns and may increase claims 
is the use of seller-funded down payment assistance for mortgages 
insured by FHA. FHA requires borrowers to make a 3 percent contribution 
toward the purchase of the property, but that contribution can come 
indirectly through borrowers' relatives or nonprofit organizations. 
Although FHA does not permit down payment funds to come directly or 
indirectly from sellers, it does permit nonprofits that receive 
contributions from sellers to provide down payment assistance to 
homebuyers. Many conventional mortgage products also permit down 
payment funds to come from sources other than the borrower; however, 
the terms of these mortgage products generally stipulate that such 
funds cannot come either directly or indirectly from an interested or 
seller-related party. A HUD Office of the Inspector General evaluation 
of FHA-insured loans found that loans with down payment assistance from 
seller-funded nonprofits had a greater risk of default and that the 
percentage of FHA-insured loans with down payment assistance from 
seller-funded nonprofits was growing at an increasing rate. As of July 
2005, FHA had not revised its policies regarding acceptable sources of 
down payment assistance or imposed additional underwriting requirements 
on borrowers who obtained down payment assistance from seller-funded 
nonprofits. At your request, we are currently conducting a study on 
down payment assistance and evaluating the performance of these loans. 

A program assessment jointly prepared by OMB and FHA and included with 
the 2006 President's Budget noted that FHA's loan performance model is 
neither accurate nor reliable because it consistently under predicts 
claims. For the 2004 actuarial review, FHA worked with a new contractor 
to redesign and respecify its loan performance models. FHA continues to 
work on improving its new models so that it can more accurately and 
reliably predict claims and prepayments. Several factors distinguish 
the new models from those used previously. First, the new models use 
quarterly data, while the previous models used annual data. In 
addition, the new models explicitly address the time lag in claims and 
the implications of the time lag for prepayments,[Footnote 17] and 
allow for a closer correspondence between the actual and predicted time 
pattern of claim and prepayment rates. These changes may improve the 
models' ability to predict the number and timing of claims and 
prepayments. Nonetheless, for the 2004 actuarial review FHA had to 
adjust model estimates of claims that will occur in fiscal years 2004 
through 2006 for all loan cohorts. By the third quarter of fiscal year 
2004, while FHA was preparing the 2004 actuarial review, FHA realized 
that actual claims for the year were outpacing the amount of estimated 
claims based on data from the first half of 2004 and earlier. FHA and 
its contractors assumed this difference was caused by a temporary 
deviation and adjusted the model's projected claim rates to match the 
recorded claim counts. Specifically, FHA applied a claim rate 
multiplier to increase estimated claim rates by 50 percent for all 
cohorts for fiscal years 2004 and 2005 and by 25 percent for fiscal 
year 2006. Because FHA was responding to what it believed to be a 
temporary deviation, it did not apply the multiplier to any years after 
2006. 

The new models also eliminated some explanatory variables, such as 
unemployment rates and payment-to-income ratios, and altered the 
definitions of other key variables. For example, the previous models 
assumed that borrowers who passed up profitable refinancing 
opportunities would experience permanently higher claim rates-- 
sometimes referred to as burnout--while the new models assume that 
higher claim rates are a temporary phenomenon that will last only 2 
years. In addition, neither model incorporates certain variables that 
have been found to be important in assessing credit risk, such as 
credit scores and the source of down payments. FHA officials are 
researching these variables currently. FHA officials told us they will 
not be including credit scores for the 2005 actuarial review, though 
they are considering ways to account for credit scores in the 2006 
actuarial model. For the 2005 model, FHA made adjustments for the 
source of down payments by adjusting the loan-to-value ratio for seller-
funded down payment assistance. On balance, it is not clear that these 
changes to the actuarial models will permit FHA to more reliably 
estimate claim (or prepayment) activity. In fact, the $7 billion 
reestimate was followed a year later with an upward reestimate of $2.3 
billion for fiscal year 2004. 

Prepayments Had a Smaller Impact on the $7 Billion Reestimate and Their 
Impact on Future Credit Subsidy Estimates Is Uncertain: 

While claims may have been the largest driver behind the reestimate, 
prepayments also had an impact. As we discussed above, FHA experienced 
a significant increase in prepayment activity from 2001 through 2004. 
As figure 11 illustrates, between 2000 and 2001, the dollar amount of 
prepayments more than doubled, rising from $37 billion to $82 billion. 
Prepayments reached a total of $190 billion in 2003 and decreased 
slightly to $123 billion in 2004. 

Figure 11: Amount of FHA Prepayments during Fiscal Years 2000-2004: 

[See PDF for image] 

[End of figure] 

FHA experienced surges of prepayment activity in the mid-1980s and 
early 1990s. All three of these time periods coincided with periods of 
declining interest rates, though the rates of prepayment are highest in 
2003, when mortgage interest rates reached a 30-year low. As of July 
2005, mortgage interest rates had declined even further from their 2004 
level, though by a much smaller amount compared with the 2002-2003 
decline. Because it is difficult to project future interest rates, it 
is difficult to project their impact on future prepayment activity. As 
we noted previously, house prices have risen faster in the first part 
of the decade than they did in the 1990s or most of the 1980s. Rapid 
appreciation in housing prices permits borrowers to refinance using 
conventional loans, however, it is uncertain that the upward trend in 
appreciation will continue. 

One-time Removal of Loss Mitigation Factor Should Continue to Affect 
Future Estimates: 

The removal of the loss mitigation adjustment factor also had a notable 
impact, affecting the cash flow model's calculation of claims and thus 
contributing $1.7 billion to the reestimate. FHA does not intend to use 
this adjustment again given its greater historical experience with loss 
mitigation. That is, FHA expects that the historical data on which loan 
performance estimates are based will include and reflect more years of 
experience with the loss mitigation program. However, this change in 
the assumptions used in estimating loan performance will affect the 
estimated subsidy costs of new cohorts because estimates of future 
cohorts will not include the loss mitigation adjustment factor, though 
the significance of no longer making this adjustment may decline over 
time. That is, as FHA estimates of loan performance include more 
historical experience with loss mitigation, any positive effect loss 
mitigation may have would be reflected in the loan performance 
variables. 

Recent Policy Changes May Affect Claims and Prepayments: 

In recent years, FHA has introduced several policy changes that may 
affect claim activity. Since 2000, FHA has loosened some underwriting 
procedures to encourage homeownership. For example, FHA increased the 
amount of the mortgage payment it will permit relative to borrower 
income. Specifically, in April 2005, FHA increased its maximum payment- 
to-income ratio from 29 percent to 31 percent and its debt-to-income 
ratio from 41 percent to 43 percent.[Footnote 18] By increasing these 
qualifying ratios, FHA could offer mortgage insurance to borrowers who 
would not have otherwise been approved for a loan. However, borrowers 
who devote more of their income to their mortgage payments could have 
trouble meeting their payments if they encounter financial trouble. FHA 
made these changes in response to recent federal tax cuts, which 
increased potential borrowers' buying power. Therefore, FHA noted, the 
changes should broaden eligibility without increasing the risk of 
default. 

FHA has also taken steps to tighten some underwriting guidelines. For 
example, in 2000 it changed its policies on gift transfers and the 
types of assets that may be considered for cash reserves. FHA now 
requires more documentation for gift transfers to ensure that the funds 
are applied toward the borrower's down payment and come from sources 
with no interest in the sale of the property. However, in a recent 
review of FHA's new mortgage loan products, we found that FHA does 
permit nonprofits that receive contributions from sellers to provide 
down payment assistance to borrowers.[Footnote 19] FHA also now 
requires lenders to ensure that borrowers' assets, such as retirement 
accounts, can be easily converted into cash before applying them toward 
cash reserves. This policy change requires that lenders account for any 
applicable taxes or withdrawal penalties that borrowers may incur when 
converting their assets to cash, potentially reducing the amount of 
cash available to these borrowers. In early 2004 FHA introduced the 
Technology Open to Approved Lenders Mortgage Scorecard. This tool is 
used in conjunction with automated underwriting systems to evaluate the 
credit risk of borrowers who apply for FHA insured loans. The 
introduction of the new mortgage scorecard may help FHA and lenders 
more efficiently and effectively identify and evaluate credit risk and, 
therefore, may help reduce claims. 

FHA has taken measures to enhance the effectiveness of its loss 
mitigation program. In 2002, FHA modified some of its loss mitigation 
options to give lenders more flexibility to assist borrowers who are 
unable to make their monthly payments, help avoid or reduce the time 
and expense of the foreclosure process, and enable borrowers to obtain 
credit again in the future. FHA believes that the introduction of loss 
mitigation and changes made since the program's implementation should 
reduce losses it incurs when borrowers default on their loans. FHA also 
introduced the Accelerated Claim Disposition demonstration program in 
2002 (referred to as the "601" program) to streamline the claim and 
property disposition processes with the goal of reducing losses to the 
Fund. 

FHA has also made some recent policy changes that may affect prepayment 
activity. For example, FHA changed its up-front mortgage insurance 
premium rules for mortgages endorsed after December 2004. In the past, 
FHA refunded a percentage of the up-front premium to borrowers when 
they prepaid their loans, typically by refinancing or selling their 
homes. Borrowers were entitled to this refund even when they refinanced 
outside of FHA. For new loans guaranteed after December 2004, FHA will 
no longer refund a percentage of the up-front premium to borrowers who 
refinance their mortgages outside of FHA. FHA also shortened the refund 
schedule of the up-front premium from 5 to 3 years. These changes could 
encourage borrowers to refinance their mortgage with another FHA- 
insured loan, while reducing the amount of refunds that FHA pays to 
borrowers who refinance or sell their homes. However, these changes may 
also discourage some borrowers from choosing to finance their home 
purchases with an FHA-insured mortgage. FHA predicts that the changes 
to its up-front premium rules will increase cash flows by about $168 
million annually. 

The Loan Performance Variables Underlying the Reestimate Could Affect 
Estimates of the Fund's Long-Term Viability: 

The effect of recent trends on the loan performance variables 
underlying the $7 billion reestimate will likely persist to varying 
degrees and therefore affect estimates of the Fund's long-term 
viability. The capital ratio, a measure of the Fund's long-term 
viability, has increased in recent years. However, should the economic 
value decline or be restated as lower than previously estimated (due to 
higher-than-estimated claims), and should the insurance-in-force remain 
steady (due to declining prepayments), then the capital ratio will 
decline. Whether the currently estimated 5.5 percent capital ratio or a 
lower capital ratio is sufficient to meet federal requirements depends 
on what conditions the Fund is expected to survive while maintaining 
the minimum 2 percent reserve. Neither the Congress nor HUD has 
established criteria to determine how severe of a stress the Fund 
should be able to withstand. 

The Fund is required to maintain a minimum capital ratio (a measure of 
its long-term viability) of 2 percent of the insurance-in-force. As 
figure 12 illustrates, the Fund's capital ratio has been well above 3 
percent and rising since fiscal year 2000. The economic value of the 
Fund--the sum of existing capital plus the net present value of 
expected future cash flows from existing cohorts--has also been rising 
for a number of years, though it declined in fiscal year 2004. However, 
the Fund's insurance-in-force declined 20 percent between 2002 and 2004 
in response to increased claim and prepayment activity during those 
years and a decline in new loan originations. As the capital ratio is 
the Fund's economic value divided by its insurance-in-force, the 
capital ratio only increased because the decrease in the insurance-in- 
force was proportionately larger than the decrease in the economic 
value of the Fund. 

Figure 12: Capital Ratio Versus Economic Value of the MMI Fund, Fiscal 
Years 2000-2004: 

[See PDF for image] 

[End of figure] 

If the economic value declines or is restated at a lower level than 
previously estimated and if the insurance-in-force does not decline 
(for example, due to substantial prepayments), then the capital ratio 
will decline. As we noted, the events that help explain the increase in 
claims underlying the $7 billion reestimate--such as changes in 
underwriting guidelines, competition from the private sector, and an 
increase in the use of down payment assistance--do not appear to be one-
time events and likely will continue to add risk to FHA's portfolio. 
For example, the borrowers FHA has attracted since introducing its 1995 
underwriting changes are more susceptible to economic downturns and, 
therefore, more likely to default on their mortgages. Further, despite 
HUD's Office of the Inspector General finding that loans with down 
payment assistance from seller-funded nonprofits have a greater risk of 
default, the percentage of FHA- insured loans with down payment 
assistance from seller-funded nonprofits is growing at an increasing 
rate. 

FHA has introduced several policy changes that may help reduce claim 
activity, such as requiring lenders to ensure that borrowers' assets 
can be easily converted into cash before applying them toward cash 
reserves and introducing the TOTAL Mortgage Scorecard to evaluate the 
credit risk of borrowers who apply for FHA-insured loans. Despite these 
changes, it seems likely that FHA's higher level of claims will 
continue. Higher claim rates imply a lower estimated economic value of 
the Fund. 

While prepayment rates increased significantly in the early part of the 
decade, it is less likely that the same conditions that caused the 
surge in prepayments will be repeated, reducing the impact that 
prepayments may have on reducing the insurance-in-force. As we noted 
above, the three surges of prepayment activity that FHA experienced 
coincided with periods of declining interest rates. The rates of 
prepayment were highest in 2003, when mortgage interest rates reached a 
30-year low. As figure 13 illustrates, the Fund's amortized insurance- 
in-force also declined in fiscal years 2003 and 2004 as prepaying 
borrowers left the portfolio. Mortgage interest rates have been even 
lower in the spring and early summer of 2005. Even if prepayments slow, 
should claim activity continue to be higher and FHA be unable to 
compete for new borrowers, the Fund's insurance-in-force may shrink. 
But if the net effect is that the size of the portfolio stabilizes or 
declines only slightly, higher claim activity could result in a lower 
capital ratio. 

Figure 13: Amortized Insurance-In-Force, Fiscal Years 2000-2004: 

[See PDF for image] 

[End of figure] 

The long-term viability of the Fund depends on both the impact that the 
underlying change in loan performance may have on the capital ratio and 
the conditions or scenarios under which Congress expects the Fund to 
maintain its 2 percent minimum reserve. A lower capital ratio would 
mean that the Fund is less able to withstand adverse economic 
conditions. As figure 14 illustrates, the Fund's capital ratio has been 
well above the 2 percent minimum and rising since fiscal year 2000. But 
whether the currently estimated 5.5 percent capital ratio or a lower 
capital ratio is sufficient depends on what conditions the Fund is 
expected to survive while maintaining the minimum 2 percent reserve. 

Figure 14: Minimum Required Capital Ratio Versus Actual Capital Ratio: 

[See PDF for image] 

[End of figure] 

Because economic downturns put downward pressure on house prices and 
incomes, they can stress FHA's ability to meet its obligations. Thus, 
it is reasonable that measures of the financial soundness of the Fund 
would be based on tests of the Fund's ability to withstand recent 
recessions or regional economic downturns. The 2004 actuarial review 
examines four stress scenarios, none of which are particularly severe. 
Three of the 4 stress tests examine one source of stress at a time, 
while one examines two stresses simultaneously. A severe stress test 
would examine the possibility of multiple stresses occurring 
simultaneously, such as a decrease in house prices coupled with a 
decrease in recoveries on the sale of foreclosed homes and an increase 
in the dispersion of house price changes across multiple regions. 
Neither Congress nor HUD has established criteria to determine how 
severe a stress the Fund should be able to withstand. While the Fund 
continues to maintain a capital ratio above the required minimum, we 
have recommended in the past that HUD develop criteria that specify the 
economic conditions the Fund should be able to withstand and the 
capital ratios currently consistent with those criteria. We also 
recommended that the annual actuarial analysis give more attention to 
tests of the Fund's ability to withstand appropriate stresses. Finally, 
we recommended that HUD develop better tools for assessing the impact 
that policy changes may have on the volume and riskiness of the loans 
that FHA insures.[Footnote 20] 

Conclusions: 

There are two important ways that FHA can manage risks to the Fund and 
its ability to withstand economic downturns. First, FHA needs to be 
able to reliably estimate program costs. To do so, FHA needs to 
understand the factors that influence loan performance and, considering 
this information, accurately estimate future claims and prepayments and 
the resulting cash flows. Without better estimates of loan performance, 
FHA cannot reasonably estimate the economic net worth of the Fund or 
its capital ratio. Second, even if FHA can better estimate program 
costs, it still needs to know what conditions the Fund is expected to 
endure while maintaining the minimum 2 percent capital reserve. 

Recommendations for Executive Action: 

To more reliably estimate program costs, the Secretary of HUD should 
direct the FHA Commissioner to study and report in the annual actuarial 
review the impact of variables that have been found in other studies to 
influence credit risk, such as payment-to-income ratios, credit scores, 
and the presence of down payment assistance, on the forecasting ability 
of the loan performance models used in FHA's actuarial reviews of the 
Fund. FHA also should report in its annual actuarial review the impact 
of any changes it makes to key variables, such as the burnout variable, 
on the forecasting ability of the loan performance models. 

Agency Comments and Our Evaluation: 

We provided HUD, VA, and OMB with a draft of this report for their 
review and comment. We received written comments from HUD, which are 
reprinted in appendix III. We also received technical comments from 
HUD, which have been incorporated where appropriate. VA and OMB did not 
have comments on the draft. 

HUD stated that it agrees with GAO's overall finding that higher than 
projected claims were a significant variable underlying the $7 billion 
reestimate, and that its 1995 underwriting changes help explain the 
increase in claims. HUD also agreed with our description of the steps 
it has taken to better estimate claims in its recent actuarial reviews. 

HUD raised a concern that our first recommendation would require FHA to 
direct its actuarial contractor to include certain variables in its 
loan performance models, and that this would compromise the requirement 
for an independent actuarial study of the Fund. In response, we 
recommend instead that FHA study and report in the annual actuarial 
review the impact of such variables on the forecasting ability of the 
loan performance models. HUD further noted that its contractor is 
actively considering the specific variables that we had recommended FHA 
include in its annual actuarial review. 

In response to our second recommendation that FHA report in its 
actuarial review the impact of any changes it makes to key variables on 
the forecasting ability of its loan performance models, HUD noted that 
the actuarial reviews and appendices contain full documentation of the 
models and justifications for the selection of the included variables 
and their definitions. However, we found, for example, that the 2004 
actuarial review did not fully document or justify the change in the 
definition of the burnout variable. Specifically, the 2004 actuarial 
review contained only a short statement regarding this change, with no 
accompanying analysis of its impact on the forecasting ability of FHA's 
loan performance models. We therefore continue to recommend that the 
annual actuarial review include analyses of the impact of changes made 
to key variables on the forecasting ability of the loan performance 
models. 

As agreed with your office, unless you publicly announce the contents 
of this report earlier, we plan no further distribution until 30 days 
from the report date. At that time, we will send copies of this report 
to interested Members of Congress and congressional committees. We will 
also send copies to the Secretary of Housing and Urban Development and 
Director of the Office of Management and Budget and make copies 
available to others upon request. In addition, this 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, please 
contact me at (202) 512-8678 or shearw@gao.gov. Contact points for our 
offices of Congressional Relations and Public Affairs may be found on 
the last page of this report. GAO staff who made key contributions to 
this report are listed in appendix IV. 

Sincerely yours, 

Signed by: 

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

[End of section] 

Appendixes: 

Appendix I: Scope and Methodology: 

To assess the significance of the $7 billion reestimate, we interviewed 
officials at the Department of Housing and Urban Development's (HUD) 
Federal Housing Administration (FHA) and Office of the Inspector 
General (OIG) and staff from the Office of Management and Budget (OMB). 
We reviewed the fiscal year 2000-2004 audited financial statements for 
FHA to compare the size and direction of MMI reestimates over time. We 
analyzed data from the fiscal year 2005-2006 Federal Credit Supplements 
to compare the size and direction of reestimates, by cohort, among 
comparable loan guarantee programs at FHA, the Department of Veterans 
Affairs, and Department of Agriculture. 

To determine what factors contributed to the $7 billion reestimate and 
the underlying loan performance variables influencing these factors, we 
collected and analyzed supporting documentation for the reestimate, 
including analyses prepared by FHA and work papers prepared by FHA's 
financial statement auditor. We collected and analyzed the fiscal year 
2000-2004 actuarial reviews of the MMI Fund and related loan 
performance data to examine trends in loan performance and consider the 
impact that model changes may have had on estimated subsidy costs. We 
collected and analyzed fiscal year 2002-2003 credit subsidy cash flow 
models used to calculate the reestimates for those years, to consider 
the impact of loan performance on cash flows. We supplemented this 
analysis by interviewing the 2003 financial statement auditors, OMB 
staff, officials in the OIG, FHA staff, FHA contractors that assist in 
the preparation of the reestimate, and the 2004 actuarial review 
contractors for background information to verify our findings on the 
factors and underlying loan performance variables. 

To assess the control procedures governing the loan performance data we 
collected, we reviewed the findings of our previous studies in which we 
assessed the reliability of data for FHA-insured loans that came from 
the same source as the data used in this report. While the data in 
these previous reports covered a limited number of loan cohorts, the 
control activities we reviewed apply to all cohorts. In 2004 we 
assessed the reliability of a random sample of FHA-insured loans from 
the 1996-1999 cohorts, comparing seven elements of the paper loan file 
to the electronic file to determine if they matched, and found no 
material errors. We also reviewed several years' worth of FHA financial 
statement audits and found no known or suspected problems with the 
relevant FHA information systems. From these steps, we concluded these 
data were sufficiently reliable for our analyses.[Footnote 21] In 2005 
we obtained loan performance data on FHA-insured loans from the 1992, 
1994, and 1996 cohorts. To verify this data, we met with FHA staff 
involved in generating the sample data set and discussed data quality 
procedures with appropriate FHA staff. FHA officials indicated that 
their data systems contain data entry checks and that data submitted by 
lenders were reviewed by FHA. As part of its annual financial statement 
audit, FHA's data system was audited by external auditors, and no major 
issues concerning data quality were raised. Based on these discussions, 
we determined that the FHA data were sufficiently reliable for our 
analyses.[Footnote 22] 

To assess how the loan performance variables underlying the reestimate 
could impact future estimates of new loans, we interviewed FHA 
officials and the contractors for the 2004 actuarial review regarding 
the causes of the loan performance variables and their impact on future 
estimates. We also discussed recent and planned changes to the loan 
performance models that may affect FHA's future estimates. We reviewed 
recent policy changes that may impact loan performance variables by 
analyzing relevant policy changes discussed in recent actuarial reviews 
and mortgagee letters issued by FHA through the HUD Web site. 

To assess what the reestimate and its underlying loan performance 
variables mean for the long-term viability of the Fund, we analyzed FHA 
and other data on new loan products and home mortgage industry trends. 
We reviewed prior GAO reports describing changes in the home mortgage 
market and FHA loan performance and used professional judgment to opine 
on whether earlier concerns for the viability of the Fund persist. 

[End of section] 

Appendix II: Data for Figures Used in This Report: 

Table 1: Annual Credit Subsidy Reestimates For the MMI Fund, Fiscal 
Years 2000-2004 (Figure 3): 

Dollars in millions: 

Fiscal year: 2000; 
Credit subsidy reestimate: $3,350. 

Fiscal year: 2001; 
Credit subsidy reestimate: -$1,687. 

Fiscal year: 2002; 
Credit subsidy reestimate: $1,526. 

Fiscal year: 2003; 
Credit subsidy reestimate: $7,029. 

Fiscal year: 2004; 
Credit subsidy reestimate: $2,340. 

Source: GAO analysis of FHA data. 

[End of table] 

Table 2: Amount of the 2003 Reestimate Attributed to the 2001-2003 
Cohorts, as a Percentage of the Original Loan Amount, For Single-Family 
Loan Guarantee Programs (Figure 4): 

Agencies: FHA; 
Current reestimate as a percentage of total disbursements: 1.22%. 

Agencies: VA; 
Current reestimate as a percentage of total disbursements: 0.46%. 

Agencies: USDA; 
Current reestimate as a percentage of total disbursements: 0.50%. 

Source: GAO analysis of Federal Credit Supplements, fiscal years 2005 
and 2006. 

[End of table] 

Table 3: Original Estimated Credit Subsidy Rates and Most Recent 
Reestimated Rates for the FHA and VA Loan Guarantee Programs, 1992-2004 
Cohorts (Figure 5): 

Cohort: FHA: 

Cohort: 1992; 
Original subsidy rate (MMI): -2.60%; 
Fiscal year 2005 reestimate rate (MMI): -3.03%. 

Cohort: 1993; 
Original subsidy rate (MMI): -2.70%; 
Fiscal year 2005 reestimate rate (MMI): -2.55%. 

Cohort: 1994; 
Original subsidy rate (MMI): -2.79%; 
Fiscal year 2005 reestimate rate (MMI): -1.58%. 

Cohort: 1995; 
Original subsidy rate (MMI): -1.95%; 
Fiscal year 2005 reestimate rate (MMI): -0.44%. 

Cohort: 1996; 
Original subsidy rate (MMI): -2.77%; 
Fiscal year 2005 reestimate rate (MMI): -0.85%. 

Cohort: 1997; 
Original subsidy rate (MMI): -2.88%; 
Fiscal year 2005 reestimate rate (MMI): -1.10%. 

Cohort: 1998; 
Original subsidy rate (MMI): -2.99%; 
Fiscal year 2005 reestimate rate (MMI): -1.74%. 

Cohort: 1999; 
Original subsidy rate (MMI): -2.62%; 
Fiscal year 2005 reestimate rate (MMI): -1.95%. 

Cohort: 2000; 
Original subsidy rate (MMI): -1.99%; 
Fiscal year 2005 reestimate rate (MMI): -0.55%. 

Cohort: 2001; 
Original subsidy rate (MMI): -2.15%; 
Fiscal year 2005 reestimate rate (MMI): -0.94%. 

Cohort: 2002; 
Original subsidy rate (MMI): -2.07%; 
Fiscal year 2005 reestimate rate (MMI): -1.07%. 

Cohort: 2003; 
Original subsidy rate (MMI): -2.53%; 
Fiscal year 2005 reestimate rate (MMI): -1.53%. 

Cohort: 2004; 
Original subsidy rate (MMI): -2.47%; 
Fiscal year 2005 reestimate rate (MMI): -1.61%. 

Cohort: 2005; 
Original subsidy rate (MMI): -1.82%. 

Cohort: 2006; 
Original subsidy rate (MMI): -1.70%. 

Cohort: VA: 

Cohort: 1992; 
Original subsidy rate (MMI): 2.19%; 
Fiscal year 2005 reestimate rate (MMI): 1.72%. 

Cohort: 1993; 
Original subsidy rate (MMI): 2.33%; 
Fiscal year 2005 reestimate rate (MMI): 0.31%. 

Cohort: 1994; 
Original subsidy rate (MMI): 1.36%; 
Fiscal year 2005 reestimate rate (MMI): -0.02%. 

Cohort: 1995; 
Original subsidy rate (MMI): 1.18%; 
Fiscal year 2005 reestimate rate (MMI): -0.13%. 

Cohort: 1996; 
Original subsidy rate (MMI): 1.56%; 
Fiscal year 2005 reestimate rate (MMI): 0%. 

Cohort: 1997; 
Original subsidy rate (MMI): 0.74%; 
Fiscal year 2005 reestimate rate (MMI): -0.25%. 

Cohort: 1998; 
Original subsidy rate (MMI): 0.49%; 
Fiscal year 2005 reestimate rate (MMI): 0.01%. 

Cohort: 1999; 
Original subsidy rate (MMI): 0.45%; 
Fiscal year 2005 reestimate rate (MMI): 0.01%. 

Cohort: 2000; 
Original subsidy rate (MMI): 0.68%; 
Fiscal year 2005 reestimate rate (MMI): -0.25%. 

Cohort: 2001; 
Original subsidy rate (MMI): 0.29%; 
Fiscal year 2005 reestimate rate (MMI): 0.35%. 

Cohort: 2002; 
Original subsidy rate (MMI): 0.39%; 
Fiscal year 2005 reestimate rate (MMI): 0.27%. 

Cohort: 2003; 
Original subsidy rate (MMI): 0.81%; 
Fiscal year 2005 reestimate rate (MMI): 0.44%. 

Cohort: 2004; 
Original subsidy rate (MMI): 0.50%; 
Fiscal year 2005 reestimate rate (MMI): -0.07%. 

Cohort: 2005; 
Original subsidy rate (MMI): -0.32%. 

Cohort: 2006; 
Original subsidy rate (MMI): -0.32%. 

Source: GAO analysis of Federal Credit Supplements, fiscal years 2005 
and 2006. 

[End of table] 

Table 4: Primary Factors Contributing to the Fiscal Year 2003 MMI 
Credit Subsidy Reestimate (Figure 6): 

Dollars in billions. 

Difference between estimated and actual cash flows for FY 2003: $2.1; 
Change in estimated future cashflows: $3.9; 
Interest on adjustment: $1.1. 

Source: GAO analysis of FHA data. 

[End of table] 

Table 5: Change in Future Cash Flow Estimates for the Fund from Fiscal 
Year 2002 to Fiscal Year 2003 (Figure 7): 

Dollars in millions. 

Fiscal year: 2002; 
Amount: $1,864. 

Fiscal year: 2003; 
Amount: -$2,008. 

Source: GAO analysis of FHA financial statements, fiscal years 2002- 
Fiscal year: 2003. 

[End of table] 

Table 6: Variables Contributing to the $3.9 Billion Change in Estimated 
Cash Flows (Figure 8): 

Dollars in billions. 

Loans originating in 2003: $1.0; 
Other: -$0.5; 
Removal of loss mitigation adjustment: -$1.7; 
Change in conditional claim and prepayment rates: -$2.7. 

Source: GAO analysis of FHA data. 

[End of table] 

Table 7: Increase in Estimated Net Cash Outflows from Removing the Loss 
Mitigation Adjustment Factor, 1992-2003 Cohorts (Figure 9): 

Dollars in thousands. 

Fiscal year: 1992; 
Impact: $10,979. 

Fiscal year: 1993; 
Impact: $24,126. 

Fiscal year: 1994; 
Impact: $32,926. 

Fiscal year: 1995; 
Impact: $21,632. 

Fiscal year: 1996; 
Impact: $40,131. 

Fiscal year: 1997; 
Impact: $52,666. 

Fiscal year: 1998; 
Impact: $108,630. 

Fiscal year: 1999; 
Impact: $151,683. 

Fiscal year: 2000; 
Impact: $142,118. 

Fiscal year: 2001; 
Impact: $349,441. 

Fiscal year: 2002; 
Impact: $451,067. 

Fiscal year: 2003; 
Impact: $339,110. 

Source: GAO analysis of FHA data. 

[End of table] 

Table 8: Actual Versus Estimated Conditional Claim Rates for Fiscal 
Year 2003, 1993-2003 Cohorts (Figure 10): 

Cohort: 1993; 
Estimated claims: 0.60%; 
Actual claims: 0.48%. 

Cohort: 1994; 
Estimated claims: 0.58%; 
Actual claims: 0.53%. 

Cohort: 1995; 
Estimated claims: 0.96%; 
Actual claims: 1.71%. 

Cohort: 1996; 
Estimated claims: 0.93%; 
Actual claims: 1.69%. 

Cohort: 1997; 
Estimated claims: 1.08%; 
Actual claims: 2.29%. 

Cohort: 1998; 
Estimated claims: 0.95%; 
Actual claims: 1.75%. 

Cohort: 1999; 
Estimated claims: 0.92%; 
Actual claims: 1.93%. 

Cohort: 2000; 
Estimated claims: 1.58%; 
Actual claims: 4.03%. 

Cohort: 2001; 
Estimated claims: 0.87%; 
Actual claims: 1.96%. 

Cohort: 2002; 
Estimated claims: 0.32%; 
Actual claims: 0.50%. 

Cohort: 2003; 
Estimated claims: 0.01%; 
Actual claims: 0.01%. 

Source: GAO analysis of FHA data. 

[End of table] 

Table 9: Actual Versus Estimated Conditional Prepayment Rates for 
Fiscal Year 2003, 1993-2003 Cohorts (Figure 10): 

Cohort: 1993; 
Estimated prepayments: 17.10%; 
Actual prepayments: 34.33%. 

Cohort: 1994; 
Estimated prepayments: 16.32%; 
Actual prepayments: 32.13%. 

Cohort: 1995; 
Estimated prepayments: 17.33%; 
Actual prepayments: 29.91%. 

Cohort: 1996; 
Estimated prepayments: 17.58%; 
Actual prepayments: 32.45%. 

Cohort: 1997; 
Estimated prepayments: 18.20%; 
Actual prepayments: 31.33%. 

Cohort: 1998; 
Estimated prepayments: 17.36%; 
Actual prepayments: 36.54%. 

Cohort: 1999; 
Estimated prepayments: 16.58%; 
Actual prepayments: 35.80%. 

Cohort: 2000; 
Estimated prepayments: 22.73%; 
Actual prepayments: 34.67%. 

Cohort: 2001; 
Estimated prepayments: 14.37%; 
Actual prepayments: 41.63%. 

Cohort: 2002; 
Estimated prepayments: 7.78%; 
Actual prepayments: 33.81%. 

Cohort: 2003; 
Estimated prepayments: 1.12%; 
Actual prepayments: 7.00%. 

Source: GAO analysis of FHA data. 

[End of table] 

Table 10: Amount of FHA Prepayments During Fiscal Years 2000-2004 
(Figure 11): 

Dollars in millions. 

Fiscal year: 2000; 
Prepayment: $37,576. 

Fiscal year: 2001; 
Prepayment: $82,260. 

Fiscal year: 2002; 
Prepayment: $121,154. 

Fiscal year: 2003; 
Prepayment: $190,370. 

Fiscal year: 2004; 
Prepayment: $123,029. 

Source: GAO analysis of FHA data. 

[End of table] 

Table 11: Capital Ratio Versus Economic Value of the MMI Fund, Fiscal 
Years 2000-2004 (Figure 12): 

Dollars in millions. 

Fiscal year: 2000; 
Economic value: $16,962; 
Capital ratio: 3.51%. 

Fiscal year: 2001; 
Economic value: $18,510; 
Capital ratio: 3.75%. 

Fiscal year: 2002; 
Economic value: $22,636; 
Capital ratio: 4.52%. 

Fiscal year: 2003; 
Economic value: $22,736; 
Capital ratio: 5.21%. 

Fiscal year: 2004; 
Economic value: $21,977; 
Capital ratio: 5.53%. 

Source: GAO analysis of FHA data. 

[End of table] 

Table 12: Amortized Insurance-In-Force, Fiscal Years 2000-2004 (Figure 
13): 

Dollars in millions. 

Fiscal year: 2000; 
Amortized insurance in force: $449,867. 

Fiscal year: 2001; 
Amortized insurance in force: $459,305. 

Fiscal year: 2002; 
Amortized insurance in force: $466,598. 

Fiscal year: 2003; 
Amortized insurance in force: $406,619. 

Fiscal year: 2004; 
Amortized insurance in force: $372,373. 

Source: GAO analysis of FHA data. 

[End of table] 

Table 13: Minimum Required Capital Ratio Versus Actual Capital Ratio 
(Figure 14): 

Fiscal year: 2000; 
Capital ratio: 3.51%; 
Required minimum capital ratio: 0.02%. 

Fiscal year: 2001; 
Capital ratio: 3.75%; 
Required minimum capital ratio: 0.02%. 

Fiscal year: 2002; 
Capital ratio: 4.52%; 
Required minimum capital ratio: 0.02%. 

Fiscal year: 2003; 
Capital ratio: 5.21%; 
Required minimum capital ratio: 0.02%. 

Fiscal year: 2004; 
Capital ratio: 5.53%; 
Required minimum capital ratio: 0.02%. 

Source: GAO analysis of FHA data. 

[End of table] 

[End of section] 

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

U.S. DEPARTMENT OF HOUSING AND URBAN DEVELOPMENT: 
WASHINGTON, D.C. 20410-8000: 

OFFICE OF THE ASSISTANT SECRETARY FOR HOUSING-FEDERAL HOUSING 
COMMISSIONER: 

AUG 15 2005: 

Mr. William B. Shear: 
Director:
Financial Markets and Community Investments: 
United Sates Government Accountability Office: 
Washington, D. C. 20548: 

Dear Mr. Shear: 

The Department of Housing and Urban Development (HUD) appreciates the 
opportunity to address the Government Accountability Office (GAO) draft 
report entitled "FHA's $7 Billion Reestimate Reflects Higher Claims and 
Higher Loan Performance Estimates" (GAO-05-875). 

The Department agrees with GAO's overall finding that higher than 
projected claims were a significant factor that resulted in a $7 
billion credit subsidy re-estimate for the Mutual Mortgage Insurance 
Fund in FY 2003. FHA became aware that models developed by its 
independent actuarial review contractor were under-predicting claims 
for post-1995 books of business in early 2003. In FY 1995, FHA had 
implemented underwriting changes intended to expand the proportion of 
its insured borrowers who were first-time and minority homebuyers. 
These changes were successful, and FHA's share of first-time homebuyers 
increased from 60 percent to 80 percent and its share of minority 
homebuyers increased from 20 to 35 percent. Changing the composition of 
FHA borrowers, however, also reduced the effectiveness of FHA's 
existing models for predicting claims. In 2003, FHA worked with the 
contractor to include a simple indicator variable to capture the impact 
of these underwriting changes. The inclusion of this new variable in 
the FY 2003 actuarial review appropriately increased the predicted 
future claims on all post-1995 books of business and was the principal 
reason for the $7 billion re-estimate. 

For the FY 2004 actuarial review, FHA selected a new contractor that 
was tasked with developing new models that would more accurately 
predict claims in the short-as well as the long-run. The contractor 
made a number of technical improvements to the econometric methodology 
used to model FHA conditional claim and prepayment rates. These changes 
resulted in more credible predictions of ultimate claim and prepayment 
rates, but still under-predicted claims for the most immediate 
termination years. This limitation was corrected in the FY 2004 
actuarial review with the contractor's decision to use a one-time claim 
adjustment factor. For FY 2005, FHA has continued to work with the 
contractor to further refine the specifications of the conditional 
claim and prepayment models. 

In its report, GAO recommends "the Secretary of HUD should direct the 
FHA Commissioner to include in FHA's loan performance models additional 
variables that have been found in other studies to influence credit 
risk, such as payment-to-income ratios, credit scores, and the presence 
of down payment assistance." While HUD can ask the independent 
contractor to consider certain variables, it cannot direct the 
contractor to do so, since that would violate the statutory requirement 
for an independent actuarial study of the MMI Fund. Selection of 
variables for FHA's conditional claim and prepayment models is 
determined by economic theory and by statistical tests that measure the 
accuracy of the models' predictions. Mandating the inclusion of 
variables could actually weaken rather than strengthen the models' 
predictiveness. 

With regard to its specific recommendations to consider inclusion of 
credit scores, to acknowledge the presence of down payment assistance, 
and to reconsider the specification of the burnout factor, FHA informed 
GAO that FHA's actuarial contractor has these actions under active 
consideration. With regard to its general recommendation, "whenever 
making changes to the definitions of key variables FHA should determine 
whether and to what extent revisions of these definitions may have 
improved the forecasting ability of the loan performance models used in 
FHA's actuarial reviews of the Fund," FHA refers GAO to the actuarial 
review itself and its appendices that contain full documentation of the 
models and justifications for the selection of the included variables 
and their definitions. 

Thank you for the opportunity to review the GAO report. FHA and its 
contractor are motivated by the desire to implement state-of-the-art 
models that meet the highest standards of technical performance. FHA 
believes that recent modeling improvements have reduced the likelihood 
of future sizable MMIF credit subsidy re-estimates. 

Sincerely, 

Signed by: 

Brian D. Montgomery: 

Assistant Secretary for Housing-Federal Housing Commissioner: 

[End of section] 

Appendix IV: GAO Contact and Staff Acknowledgments: 

GAO Contact: 

William B. Shear (202) 512-8678: 

Staff Acknowledgments: 

In addition to the above, Mathew Scirè, Assistant Director, Anne Cangi, 
Marcia Carlsen, Emily Chalmers, Austin Kelly, Mamesho Macaulay, Marc 
Molino, and Katherine Trimble made key contributions to this report. 

(250223): 

FOOTNOTES 

[1] FHA also provides mortgage insurance for certain single-family 
programs, such as condominiums and home equity conversion mortgages, 
through its General and Special Risk Insurance Fund. The single-family 
mortgage insurance programs supported by the General and Special Risk 
Insurance Fund represented about 13 percent of all single-family 
mortgages that FHA insured in 2004. The remaining 87 percent were 
insured through the Mutual Mortgage Insurance Fund. 

[2] The Omnibus Budget Reconciliation Act of 1990 defined the capital 
ratio as the ratio of the Fund's capital, or economic net worth 
(economic value), to its unamortized insurance-in-force. However, the 
act defined unamortized insurance-in-force as the remaining obligation 
on outstanding mortgages--a definition generally understood to apply to 
amortized insurance-in-force. HUD has calculated the capital ratio 
using unamortized insurance-in-force as it is generally understood-- 
which is the initial amount of mortgages. 

[3] See Mortgage Financing: FHA's Fund Has Grown, but Options for 
Drawing on the Fund Have Uncertain Outcomes, GAO-01-460 (Washington, 
D.C.: Feb. 28, 2001). 

[4] See Mortgage Financing: Changes in the Performance of FHA-Insured 
Loans, GAO-02-773 (Washington, D.C.: July 10, 2002). 

[5] A cohort includes those direct loans or loan guarantees of a 
program for which a subsidy appropriation is provided in a given year 
even if the loans are not disbursed until subsequent years. 

[6] FHA refunds a portion of the up-front premium based on the time 
elapsed since the loan was originated and when a borrower prepays or 
refinances their loan. 

[7] Present value is the worth of the future stream of cash inflows and 
outflows, as if they had occurred immediately. In calculating present 
value, prevailing interest rates provide the basis for converting 
future amounts into their "money now" equivalents. Net present value is 
the present value of estimated future cash inflows minus the present 
value of estimated future cash outflows. 

[8] Liquidating accounts were established to handle credit transactions 
on a cash basis for pre-credit reform loans and loan guarantees. 

[9] Nonbudgetary accounts may appear in the budget document for 
informational purposes but are not included in the budget totals for 
budget authority or budget outlays. 

[10] From 1989 to 1998, Price Waterhouse (PricewaterhouseCoopers as of 
1998) performed the actuarial review; from 1999 to 2003, Deloitte & 
Touche performed the review; in 2004, Technical Analysis Center, Inc., 
was awarded the contract. 

[11] Current OMB guidance allows agencies to use either the 
"traditional approach" or the "balances approach" to reestimate costs. 
The traditional approach uses both actual past and estimated future 
cash flows to calculate a revised expected cost. Then the amount of the 
reestimate is based on the change in the expected cost. HUD uses the 
balances approach, which compares the net resources (cash, other 
assets, and liabilities) in the financing account to the total 
estimated future cash flows. Both approaches yield simular results. 
Figure 2 illustrates the balances approach. 

[12] Because the age composition of these programs' portfolios may 
differ, we selected only the three most recent cohorts for our 
analysis. These three cohorts represented the majority of FHA's loan 
portfolio in 2003. 

[13] Figure 4 is based on data from the fiscal year 2006 Federal Credit 
Supplements, which reports $369 billion in Fund loans endorsed 
(guaranteed) to date for the fiscal year 2001-2003 cohorts. According 
to the Federal Credit Supplement, 100 percent of Fund loan guarantees 
are endorsed in the first year. 

[14] Lifetime cash flow estimates continued to be positive, primarily 
because of positive cash flows occurring earlier in the life of the 
cohort. 

[15] Circular No. A-11, Part 5: Federal Credit Programs, Office of 
Management and Budget, June 2002. 

[16] See Mortgage Financing: Changes in the Performance of FHA-Insured 
Loans, GAO-02-773 (Washington, D.C.: July 10, 2002). 

[17] A loan may be seriously delinquent for several quarters before 
that delinquency is resolved. Because it is difficult for a borrower 
with a delinquent loan to obtain a new loan in order to refinance, 
several quarters may pass during which time a loan has a high 
probability of resulting in a claim, because it is delinquent, and has 
a low probability of resulting in a prepayment, because the borrower 
cannot refinance using conventional channels. 

[18] The payment-to-income ratio, also referred to as the housing- 
expense-to-income ratio, examines a borrower's expected monthly housing 
expenses as a percentage of the borrower's monthly income. The debt-to- 
income ratio looks at a borrower's expected monthly housing expenses 
plus long-term debt as a percentage of the borrower's monthly income. 
FHA limits the monthly mortgage payment to no more than 31 percent of 
monthly gross income (before taxes) and limits the mortgage payment 
combined with other debts to no more than 43 percent of income. 

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

[20] See Mortgage Financing: FHA's Fund Has Grown, but Options for 
Drawing on the Fund Have Uncertain Outcomes, GAO-01-460 (Washington, 
D.C.: Feb. 28, 2001). 

[21] See Home Inspections: Many Buyers Benefit from Inspections, but 
Mandating Their Use Is Questionable, GAO-04-462 (Washington, D.C.: 
April 30, 2004). 

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

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