oversight

Impact of FHA Loan Policy Changes on Its Cash Position

Published by the Government Accountability Office on 1990-06-06.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

      United States GeEral   Accounting   Office
      Testimony
GAO
 Mr.        Chairman                 and Members                      of        the      Subcommittee:


            I    am pleased                      to     appear              here         today           to     discuss           the     results             of
our      analyses                   of     the         impact          of        three            proposed             policy           changes          on the
cash        position                 of     the         Federal            Housing                 Administration's                        (FHA) Mutual
Mortgage    Insurance                              (MMI)             Fund.     This                discussion       will                 serve  to
update   the interim                              results              and            data        that         we presented               in       November
1989        before            the          Subcommittee                         on Housing                and         Community           Development,
House   Committee    on Banking,  Finance   and Urban Affairs.1                                                                               Our work,
which   was performed    at the request   of Congressman     Gerald Kleczka,
focused   on the impact,     over the next 10 years,     on the Fund's    cash
balance           from              (1)      increasing                     the        FHA mortgage                    ceiling           limits,            (2)
reducing             downpaycent                            requirements,                     and        (3)      allowing              FHA tc         insure
adjustable                   rate          mortgages                   (APJ‘I) With                higher             interest           rate         caps.            To
analyze           the          financial                     impacts              on the           MM1 Fund,              we developed                   a model
for      performing                       economic              estimations                       of     the      Fund's          cash         flow      over          a
lo-year           period                  covering              fiscal                years         1989        through           1998.


                Before              presenting                  the         results               of     our      work,          however,             I would
like      to stress that   our                                  analysis  focused    on the cash position                                                       of
the      Fund and is therefore                                     not an assessment    of the actuarial
soundness               of          the      Fund.              The         difference                   is     that       a 'cash        analysis
focuses           on the                  revenue              and         expenses               of     the      Fund      on an annual                    basis
rather           than         on the                  Fund's          ability.               to     support            potential               losses           over
the      entire              life          of         the      insured                mcrtqaqes.


            An actuarial                         analysis,                  on the            other            hand,      would          focus         on
whether           the          Fund         has             enough          reserves                to        cover      future          losses          from
insurance               currently                      in      force            and      nest insurance                   written.            The
important               distinction                          here          is     that        the        cash         balance           alone  cannot
indicate             the            Fund's             actuarial                  soundness.                    The      volume          of     loans
insured           and          anticipated                      future                losses           must       also      be considered                     to
determine               if       pclicy  changes   (such as raising    the mortgage                                                                   ceiling
that   result                  in higher    cash balances,  but higher     potential


l"'Impact            of        FHA Loan                     Policy          Chanqes"                   (GAO/T-RCED-90-17,                       Nov.        16,
1989).
liability,                      are       preferable                from       an actuarial                      standpoint.                             In      this
regard,              the         President's                     fiscal        year        1991           budget             states                that          the
Fund          is     not         actuarially                     sound       and        changes,               such         as         increasing                      the
FHA premium,                       will            be needed.                FHA has             contracted                      for         an independent
actuarial                   study            to      determine             what         reforms            are        needed                 to     make the
Fund          actuarially                        sound.


     Having  said all                                     that,   let's   take a look                                at     what             our         model
shows are the possible                                       impacts    of each policy                                alternative                              on the
Fund's              cash         position.


SUmARY


                   The      overall                cash      position             of     the         MM1 Fund                during                the          1990s
and          the      effect                of     the      various          policy            options               will          depend                heavily                  on
actual              econcmir                 conditions               durinr;           the      next          decade.                  If         house           prices
appreciate                  at a rate   of 5 to 9 percent    per year,                                                            and overall
economic                 conditicns   remain   generally  favorable,                                                            the Fund's                      cash
balance              will             likely             be adequate              to     cover            anticipated                        losses              during
the          next        10 years.                     However,             the     Fund will                  not perform    nearly                                    as
well          if      the        recent              trend   of           lower      rates    of               house appreciation
continues                   through                the      1990s.            For       example,               if         the      rate            of          house
price              appreciation                      is     less      than        4 percent,                   the          Fund        will              likely             not
be able               to        survive              without          U.S.        Treasury                assistance                    even              if     overall
economic    conditions        remain   generally   favorable.      Of the                                                                               prcposals
we analyzed,       increasing      the mortgage    ceiling    would have                                                                                the
greatest    effect      on the Fund's      cash balance.


              Besides                 the         overall          cash       position               of    the            Fund         and         the          effect
of      the         various                 policy          options,      of            equal         importance                       is         the          question
of      the         Fund's              actuarial                soundness.                   Increasing                   the mortgage      ceiling
will          have          a positive                    effect          on cash             balances:                   however,   it will       also
increase                 the          government's                   financial                risk        in        the         form         of         additional
insurance-in-fcrce.                                       This       raises            serious            concerns,                    particularly                          if
the          Fund          is     not        actuarially                  sound.
          We analyzed                       the       cash         position                 of     the      Fund under four   different
economic               scenarios.                     In      three          scenarios,                    we assumed economic
conditions                   were          generally                favorable,                    while       applying              various                rates
of     annual              house           price           appreciation                     to     each       scenario--7                   to        9
percent,               5 to          7 percent,                   and       2 to         4 percent.                   In     the         fourth
scenario,                  economic                conditions                    in   the         1990s       were          assumed             to
approximate                   those              experienced                     in   the         1980s.


           Assuming                  generally                   favorable               economic             conditions,                      that        house
prices           increase                  at      about          7 to       9 percent                   annually,               and      that            the
mortgage   ceiling      is allowed                                      to increase      with                       the annual  increase                                  in
house prices       - assumptions                                       which  constitute                           our base case - the
Fund's           cash          balance              will          grow           from1 $6.2              billion            at     the         beginning                  of
19E9 to an estimated                                  $8.8 billicn      in 1998 (see                                   exhibit                 I).         At       the
same time, however,                                 the Fund's     insurance-in-force                                      will                more        than
double           from            $271       billion               in      1989        to         $685      billion           by the              end       of
1998.            If        our       other          base          case           assumptions                 remain          unchanged                    but
house           prices             are          assumed           to      increase                at      rates       of      5 to        7 percent                   per
year,           as some experts                            are      now predicting,                          the      Fund's             cash         balance
will       remain              positive               but         will       decline               to      an estimated                   $3.9            billion
by the           end         of      1998.


           If         economic                  conditions                instead                approximate                those         experienced
during           the         1980s              (which           included             a period               early          in     the         decade            of
high       interest                  rates          and high                unesployment                     rates)           and        the      mortgage
ceiling               is     still              allowed           to      increase                with       the      annual             rate         of        house
price           appreciation,                       the Fund's cash balance    will   also                                                remain
positive               but         will          decline  to an estimated   $3.8 billion                                                    by the               end
of      1998.


           Under             economic               scenarios                having               generally                favorable                 economic
conditions                   but          lower       house              price        appreciation                    rates,             the         Fund        would
likely           insure              fewer          loans           and          lower           loan      amounts.                It     would            thus
receive               less         income           from          premiums.          As a result,                        its  cash                    balance
would           decline--in                      some cases                 becoming   negative                        by the end                     of fiscal
year       1998.                  For        example,                   at     an annual                      2-4         percent                   house           price
appreciation                        rate,               the      Fund          will            be unable                   to          maintain                    a positive
cash       balance                  without                   Treasury                assistance                     if      no             policy            change              is
made or               if      any           of     the         proposals                   we reviewed                       are                adopted,             even          if
economic                   conditions                    remain               generally                   favorable.


           If         the         Congress                    decides               not         to     raise              FHA's mortgage   ceiling
above           the         $101,250                    loan         limit,               the         Fund's              cash balance   would     fall
to an estimated     $3 billion in                                                     1998 even under   favorable    economic
conditions.     This would occur                                                      because  FHA's share    of the mortgage
market,               under             a constant                      loan          limit,              decreases                         as house                prices
appreciate                    above               the         FHA maximum                       limit.               The          decreased                        market
share,           in         turn,            would             add           less         premium              income                      to     the        Fund      to         cover
future           potential                        claims.                Without                     increases                   in         the        maximum
allowable                   loan            limit,             both           the         Fund's              cash         balance                      and        home
purchase                   options                for         homebuyers                   iii11          decrease.


           Of the                 three            proposals                    GAO analyzed,                             increasing                         the      mortgage
ceiling               to         95 percent                    of       a state's                     median              house                 price         would          have
the       greatest                     effect            on the               Fund's                 balance              and would                         also      assist            in
generating                       the        most         new business                           when          compared                      with            GAO's       estimated
base       case.                  The            reduced             downpayment                         and ARM proposal                                    are      estimated
to     have           a relatively                            small           effect                 on the          Fund's                     cash         position.


           Under                 generally                    favorable                   economic                  conditions                          and        annual
house           price             appreciation                          rates             of         7 to      9 percent,                             the      95-percent
mortgage                   ceiling                proposal,                   we estimated,                          will                  result            in     a cash
balance               of         $14.4            billion.                      This            would          be an increase                                  in     the         Fund's
cash       balance                     of        $8.2         billion               by the               end        of      1998,                 and        is     $5.7
billion               higher                than         the         balance               we estimated                               if        the         mortgage
ceiling               rises             only            at     the           annual             rate          of     house                  price            appreciation.
Because               of         the        substantial                       increase                   in    the          FHA mortgage                            ceiling,
however,                   the         amount             of        insurance-in-force                                    will              more            than      triple            to
$886       billicn                     b,y 1998.                 Under              the         other          economic                         scenarios,                  the


                                                                                           4
effects            of     raising                    the     mortgage                      ceiling               to      95-percent                 of      a state's
median            house            price             are         generally                  similar.


          What           does            this         te         1 us?               It     tells           us that                 while          increases              in
the     FHA's            mortgage                    ceiling              to      account                  for         house         price           increases               are
necessary                to        prevent                 the        deterioration                          of        the      Fund's             balance             and     to
allow    FHA to maintain    its                                         current    share of the housing    market,
there    is a need to proceed                                            with   caution  on how hiuh to raise      the
mortqaqe    ceilinq.     If the                                         Fund is not actuarially     sound,   we believe
the     Congress                   should             not         raise              the      mortgage                   ceiling             to      the         95
percent            level             because                this          action              may subject                       the         federal
government                 to        enormous                    costs           over         the          life          of     the      new insurance
that      will           be created.      We believe     that                                                a decision                 to raise  the
mortgage                ceiling,    under  these   conditions,                                                  should                 be made in
conjunction                    with         a decision                         on how to                   resolve              the      problem                 of
actuarial                soundness                     so that                 the         potential                   financial                  risks          assumed
by the            federal                government                      in      the         long          run         are      adequately
considered.                        If,      on the                other              hand,           the          Fund         is     actuarially                     sound,
we believe                 the Congress   should    consider    raising                                                               the mortgage
ceiling    to              95 percent   of a state's      median house                                                                price because                     doing
so will            have            a positive                     effect                  on the           Fund's              cash         position              and will
al low        homebuyers                        in    high             priced              states            to        participate                   more         act ively
in     the        FHA program.


             In    the         statement                    which              follows,               I provide                     a more           detailed
discussion                    of     our         assumptions,                             methodology,                        and     results.                   In
addition,                I will                 comment                briefly               on the               role         of     FHA in              the     national
mortgage                market             and         summarize                     the      comments                   we received                      from
academia,                government,                        and         housing               industry                   representatives                          on
FHA's         role.                We expect                     to      issue             a report                   containing                  a more
complete                discussion                     of        the      policy              changes'                   financial                 impacts             and
related            FHA management                                issues              during           the             summer.
BACKGROUND


          FHA was               established                   in     1934         under             authority                       granted              to the
President               by the          National                Housing               Act          (P.L.            73-479).                   In        1948, FHA
became          a wholly              owned            government                 corporation         subject   to the
Government                   Corporation                Control              Act,           as amended.     FHA and its
functions               were         transferred                    to the            Department                         of     Housing  and Urban
Development                    (HUD)        in     1965.              After           the transfer,                             FHA's staff  and
facilities                 were       merged            with         those            of     other              housing                 activities.


          The          basic         purpose             of        FHA programs                     is        to         encourage                  improvement
in     housing               standards             and         conditions,                   provide                     an adequate                     nome
financing               system           through              mortgage                insurance,                         and        exert           a
stabilizing                    influence               on the          mortgage                   market.                      To carry                 out         this
purpose,               the      Secretary                of        HUD administers                            FHA through                         four         separate
Funds         for       its       various              mortgage              insurance                    programs--the                            Mutual
Mortgage               Insurance                 (MMI)         Fund,         the          Cooperative                          Management                     Housing
Insurance                (CMHI)          Fund,           the        General                Insurance                     (GI)        Fund,              and         the
Special             Risk        Insurance                (SRI)            Fund.             Our       work               dealt          only            with         the
MM1 Fund,               which         basically                    insures            single-family                              homes.


GAO'S         ANALYSIS               OF MM1 FUND POSITIOJ


             The MM1 Fund                   is     FHA's            largest                fund       with               $271        billion                  of
insurance-in-force                               as of         September                   30,      1989.                     As a result                     of      a full
financial               audit,           we determined                       that           the       MM1 Fund                      had       a loss                of
$1.4         billion            in     fiscal            year         1988.               This           loss            caused             the
government's                    equity            in     this         Fund           to     fall          to        $1.8            billion              at         the    end
of     the       fiscal           year.            The         MM1 Fund               provides                  basic               single-family
mortgage               insurance  and                    is intended    to be self-sustaining                                                            through
charging               the homebuyer                     a premium   o f 3.8 percent      of the                                                   mortgage
amount.                Let's         look         at     why        the      MM1 Fund                    is        losing            money.


       The $1.4 billion                              loss in               the        MM1 Fund                     for         fiscal             year             1988    is
mainly    attributable                            to a $1.2                billion                 increase                    in     its         loss

                                                                                 0
reserves.                   These          reserves                are     necessary                  to      account            for          losses         on
foreclosed                  loans       that          will           eventually                 lead          to      claims.


           Two major                 factors             contribute                  to        the     MM1 Fund's                     increase              in
loss   reserves.      First,                             the         record          high            single-family                     mortgage
insurance     endorsements                               in        1986       and         1987        are          entering            the       period                in
which          historical                  evidence                suggests           that            high          claim        rates           could
occur.               Thus,    foreclosures                           may      remain            at      a high             level.              Like many
private              mortgage      insurers,                         the     NM1 Fund                 generally                 experiences                      its
highest              rate       of    claims             in        the     second              and         third         year         after        the
insurance               is      written.                 The         claim         rate         usually               decreases                gradually
after          the      third         year          and        levels          off         after            the       tenth           year       IIf     the
policy.               Given          the      significant                     level            of     insurance                 written            by- the
MM1 Fund              in     15E6          and      1987            ($44.5         and         $82.6          billion,                respectively),
foreclosures                    are likely                   to      continue              at        a relatively                     high       level,                at
least    in the                 near term.


           The        other          factor           contributing                        to    the          increase             in      loss         reserves
in      the     IVDKI Fund            is      the        persistently                      high            default            and       foreclosure
rates          in     economically                    stressed                regions,                particularly                     the       Rocky
Mountain              and       Southwest                regions.                  While             the      percentage                  of     total             MM1
insurance-in-force                            written                 in   these           regions                 has     remained
relatively                  stable,           claim               rates,       and thus                    losses,            have       been
substantial                  in      these          stressed               regions.


FHA POLICY                  OFTIONS


              Our     analysis              focused                 on the         cash         position                 of     the       Fund         at        the
end       of        each     fiscal           year,        during the period    1989                                       to 1998.    It                   shows
that          the     cash        pcsition               of the Fund is influenced                                           by FHA loan
insurance               policies              and        economic              conditions.


              To conduct              this          analysis,           we developed   econometric    models
based          on an analysis                       of       historical     trends   in FHA mortgages
originated                  during          fiscal             years          1579         through                 1988.         These

                                                                               7
econometric                models               identify               the         relationships                     between              claim         and
nonclaim            terminations                     and        a variety                    of     explanatory                   variables,
including                loan-to-value                     ratios,                 loan       amounts,               the         rate      of house
price           appreciation,                     and      other             economic               variables.                     The     results  from
these       models            were          then         combined                  with        a cash-flow                  model          to     provide
projections                  of     the         cash       position                   of     the      Fund         over          fiscal          years         1989
through            1998.


          Our       analysis                of     claim             rates            developed               from         FHA's          data      base         is
consistent                with        prior             studies              and        conventional                  economic               reasoning.
For      example,


           --      Claim           rates          tend      to         pea):           in    the      second          and         third          year      after
                   loan       crigination                      and then                 decline             in     subsequent                years.


          --       Claim           rates          are      higher               for         loans          with      higher            loan-to-value
                   ratios.


           --      Claim           rates          are      lower             for        higher             valued          mortgages               (within
                   the       19EC FHA loan                      lim<t              of       $101,250).


           --      Claim           rates          decline              as a homeowner's                            equity            increases
                   through            repayment                 of        the          mortgage             balance              and      through          home
                   price           appreciation.


          We projected                      the         cash         positlon                of      the      Fund         for      several             polic)
options.                 These        included                 the        following:                  a base          case           in    which         the
mortgage            ceiling                is     raised             in      accordance                    with      house          price          increases
to      enable           FHA to           maintain               its         market               share;          a more          substantial
increase             in      the      mortgage                 ceilin,g:                   a reduction               in     downpayment
requirements;                      and      allowing                 FHA to             guarantee                 ARMS with               higher         caps
on the           annual            and      lifetime                 interest                rate          increases.


          To make             these             projections,                       we used            forecasted                  values           of
economic            var iables                  developed                 blV Data                Resources,               Incorporated                   (DRI ;

                                                                                   3
in     the        fall           of      1989.           DRI provided                     forecasts                   of        unemployment                        rates,
interest         rates,    housing      prices,                                and loan volumes    and values.                                                        The
DRI      "trend"      economic     forecast                                  we used predicts   that  the economy
will         perform                reasonably                 well         over         the      next   10 years--mortgage                                          rates
average            from 9.4 to                         10.3 percent:                     the      unemployment      rate   does                                     not
exceed            5.5 percent:                         and housing                 prices,          except                  for         fiscal            year           1989
which         showed                  an annual            increase                of     about          4 percent,                      increase    at                   7
to     9 percent                    annually             over         the       1989-1998                period.2                       The forecast
values            that           were          used      are      shown            in     exhibit              III.


Base         Case          Analvsis


             In      our         base          case      analysis,                 we used              the      loan             ceiling               cf
$101,250                 for          1989       and     changed             this         limit      each year                          according                   to    an
index         of         housing  prices      so that,     using                                   DRI's trend                          economic
forecast,                 it reaches     slightly      more than                                        $206,000                   in     1998.               The        base
case thereby                          assumes           that      FHA's            market          share              is        not       eroded              because
of     properties                      increasing                in    price             so that              they          can         no longer
qualify              for         FHA insurance.                        The         base         case          further                 assumes                that        the
proportion                     of      ARMS will               remain           at       its      current                  level          in      the         FHA
portfolio                  and         that        current            downpayment                  requirements                           will          remain
unchanged.                       Under           authority             granted                 by Congress,                        HUD raised                   the
maximum              loan             limit       to     $124,875               for       the      period                  January               12,         1990,        to
September                  30,         1990.            Barring             further             congressional                           action,               the
loan         limit             will           revert       to     $101, 250 at                    the         end          of      that          period.
Because              of        the       higher           loan        limit's              introduction                         late        in         the      our
review            period               and       its     possible               short           duration,                   we have               used          the
$101,250                 limit            in     our     base         case         calculations                       throughout                       this
statement.




2 DRI's   most recent        projections      show housing      prices    for the
1989-98   period     increasing        at about   6 percent     annually.     According
to the National        Association       of Realtors,      median house prices        rose
7.4 percent      annually      over the 21-year       period    from 1968-86,     although
they rose by only         4.6 percent      per year from 1979-88.

                                                                                     9
           Under         this   base               case scenario  and using   DRI's    trend    economic
forecast,               we projected                  the MM1 Fund will  have positive       cash flows
in 8 of           the        10 forecast                       years.               These              results               are        displayed                    in
exhibit           I.         The       projections                      show         the            cash            position              of     the          Fund
increasing                by     the        end      of         1998 to an estimated    $8.8 billion.                                                             Under
these        economic                conditions,                  the volume  of insurance-in-force                                                                  for         FHA
is     estimated               to      increase                 from          $271             billion                in     fiscal             year          1989             to
$685       billion             in      fiscal            year           1998.                  Thus,            the         Fund        in      1998          will             have
greater           potential                 exposure                  to      loss.

           This         base         case       scenario                    can         be compared                         to     an analysis                       of
the       Fund's          projected                cash           balance                 if          the       Congress                decides               not          to
raise        FHA's           mortgage              ceiling                  above              the          $101,250               loan         limir.                This
projection                showed            that          if      the         ceiling                  remained                   at    $101,250,                    the
Fund's          cash         balance            would,                based             on our                projections,                      fall          to          $3
billion           by      1998.             This         projection                       again               uses          DRI's            trend        economic
forecast.                 This         decrease                 would             occur               because               a constant                  mortgage
ceiling           would             over      time             reduce             the          volume               of      newly-insured                       FHA
loans        in        housing             markets              where             home prices                         are         increasing.                        This
would        cause           a drop           in        premium               revenues                      while           claims             continue                   to        be
paid.           As a result,                      the          Fund's             cash           balance                   would        begin            to     decline
by      1995.


Raisins           FHA Loan                 Ceilinq              to
95 Percent                of        State       Median                House             Price


           In     our        analysis              of          the         effect              of      increasing                      the      mortgage
ceiling,               we allow             the         ceiling               to         increase                   in      the        first           year          to         95
percent           of      each         state's                 median             house               price           and         thereafter                  increase
each       year         at      the        same rate                  at      which              house              prices             appreciate.
Setting           a higher                 ceiling               in        this         manner                expands              FHA's         business                       in
very       high         price          states,                 such         as California                             and         Connecticut                      (see
exhibit            IV).             FHA would                  be able              to         write            substantially                          more
insurance               in      these         states,                 although                   it         still           would            be limited
within          certain              metropolitan                       areas.                   By increasing                           FHA's          volume                  of

                                                                                    10
business,              this          change          would           increase              FHA's           premium                income             and       cash
position.


           The        increased            ceiling                 would         provide   higher   cash balances      for
the       Fund        for two           reasons.                   First,          the Fund would    receive   greater
premium          income              because           it         would        insure    more mortgages.     On the
other        hand,          accompanying                     the         higher          premium                income            would            be a
greater  volume    of                       insurance-in-force,                                meaning               that         the         Fund        would
have higher   future                          liabilities.                         Second,            our        analysis                of        the        loans
insured          by FHA showed                       that          the        foreclosure               and loss   rates  would                                      be
slightly              lower   for higher                       valued   loans.                        According  to FHA's
experience               over the last                        10 years,    larger                         loans         tend            to        show
slightly              lower          foreclosure                   rates           and     experience                   lower            per_entaqe
losses         when           they      are         foreclosed.


            Using        DRI's          trend          economic                forecast,               we projected                           that        end-
of-year          cash          balances              would           grow          from        $6.2         billion               in         1988        to    $14.4
billion          by      1998,          an increase                      of    SE.2        billion.                    This        compares                   with        a
projected              1998          cash         balance            of       $8.8        billion               in     our        base            case,
indicating               that         with          this          policy           change           the         1998        cash         balance
would        be expected                  to        be $5.7              billion           higher               than         in    the            base        case.3
At    the       same time,                  the      amount              of    insurance-in-force                                 would            reach
$886        billion            by      fiscal          year          1598          under        this            proposal.                     While
raising          the          loan      ceiling               would           lead        to    a large                growth                in    FHA
business              and      cash       balances,                  lower           claim          rates            and      losses               would
result,          given           the        generally                favcrable                 economic                conditions                    and
sizeable              increases                in    house           prices           projected                  under            the         DRI trend
forecast.                   (See       exhibit              I.)


            However,             several              factors              that       might           reduce            the        positive                   impact
of    this       policy              change          on the              Fund        include              the        following:




3The        numbers            presented               here          do not           necessarily                      add        due         to     rounding.
(See        exhibit            I).

                                                                               11
        --        Analysis             of     FHA's           data         base            indicates               that         higher           value
                  loans      within                present           FHA limits                      have         lower         claim        rates,
                  partly          because              these         loans             have          had higher    downpayments
                  associated                 with       them.              However,                  as the ceiling     amount of
                  the      loan        would           be raised                 in        high       cost         areas,             many new
                  borrowers              either          might             not         desire              or     might         not      be able            to
                  make      correspondingly                          higher                downpayments.                        Therefore,               to
                  the      extent            this       happens,                 the         potential                 risk        associated               with
                  these          loans        would           increase.


        --        When higher                 value           loans         are            foreclosed,                    dollar         losses          might
                  be higher                 than       they         are     on lower                  value            loans.            Some private
                  mortgage             insurers               contend                 that          claim         rates         rise        with        loan
                  size.           High-value                  mortgages                    would           also        result          in      higher
                  dollar          losses,              should             a foreclosure                          occur.


        As part             of      our        study,          we obtained                          the         sometimes             conflicting
views        of     officials                knowledgeable                       about              housing            issues,           representing
government                agencies,                academia,               and mortgage                          industry             organizations.
Examples            of     the      commer,ts             received                    in     support              of      raising           the     limit
to   a percentage                   of       the       median             hoJse            price           follow:


        --        Raising           the        limit          is     the         only         way to              deal        with       the       housing
                  affordability                     problem,              because              it         would        increase
                  homeownership                     opportunities                          while           reducing             claim          rates          and
                  losses.


        --        Raising           the        limit          would          increase                     FHA's        volume          and        market
                  share          and        improve           the         geographical                      distribution                    of     FHA
                  loans,          better             insulating                  it        from           sectional             risks.


        --        Raising           the        limit          would          have            only          a minimal               impact          on
                  private           mortgage              insurers.




                                                                            12
          On the          other             hand,       examples                  of    comments          from         those           opposed             to
the     increase               in     the     loan         ceiling                differ:

          --     Losses on high  loan-to-value                                            loans   will            be compounded                      for
                 FHA and risks  will   be more                                         geographically               concentrated                       in
                 places              like     California                    and        some eastern               states.

          --     As builders                  use        the      FHA ceiling                   as their           benchmark,                      house
                 prices              will      increase.


          --     The      market             share         of     private               insurers          will         be reduced
                 substantially.


          --     Linking               FHA limits                to        area        median      house          prices          will             (1)
                 significantly           increase    FHA's                                  market   and risk                exposure
                 without       benefittinq        moderate-                                  or low-income                  households                    and
                  (2)      inevitably                   make      FHA insurance                    more          available               to
                 households                  in     areas         with            higher        real       incomes              than          in    areas
                 with          lower         real         incomes.


Revised          Downpayment                   Requirement


          FHA currently                      requires             a downpayment                    of      3 percent              on the
first          $25,000              and     5 percent                 on the           amount      above          $25,000              unless             the
appraised               value          of    the        home          is    $50,000           or   less,          in      which          case            the
required           downpayment                     is     3 percent.                    We evaluated                the         proposal                 that
FHA reduce               its         downpayment                 requirements                   by requiring                    3 percent                 down
for     amounts            at        or     below         $50,000             and        5 percent          down          for      amounts                over
$50,000.


          For      example,                 under         this         proposal,              a $100,000               mortgage                would
require          a minimum                  downpayment                    equaling           4 percent--3                  percent                on the
first          $50,000              and     5 percent                 on the           second      $50,000.                 If    this
alternative                is        adopted            and      the        mortgage            ceiling           is      still       increased
annually           according                 to     the         annual            increase         in      house          prices,              under
                                                                             3-l
DRI's        trend           economic               forecast,              the        Fund            balance           would             increase                by
$1.7       billion            from       the           end      of    1568           to     1998--a                 reduction               of $0.9
billion            in   the      1998           cash          balance               from        the       base         case.               (See exhibit
I.1

Adiustable              Rate         Mortqaqes

           The       FHA currently                         insures         ARMS having                         a l-percent                 annual             cap
and       a 5-percent                lifetime                 cap.         The ARM most                         frequently                     offered            by
private            lenders           has        a 2-percent                    annual              cap         and     a 6-percent
lifetime             cap.        Under              current           policy               FHA cannot                  insure             the         preferred
instrument.                   Therefore,                    very      little               of      its       portfolio                is        in     ARMS.
The third   policy     change                               we considered                       in       our        analysis              was         to     allow
FHA to insure      "two-six"                                AFGls but            to        limit          them         to    30 percent                      of    the
FHA portfolio.


           Under        DRI's          trend             economic              forecast,                  adoption              of        this         policy
would       have        very         little              effect          on the             cash          balances              of        the         Fund,
increasing              it     by less                than          $200       million                compared              with          the         base        case
by the        end       of     the       forecast                  period.     This occurs      for                                two reasons.
First,        we have            assumed                 that        ARMS will    not represent                                    new business
but       simply        transfers                   of      fixed        mortgages                    into          ARMS.          To the              extent
that       ARMS represent                       new business,                        the        Fund         will       receive                 additional
premium            income--but                  experience                 corresponding                            growth           in        loan
exposure.               Second,               the        forecast              of     economic                  conditions                     includes            no
significant                  increases                in      interest               rates.               ARMS, unlike     fixed-rate
mortgages,              increase                the         risk      of       foreclosure                  during   periods      of
rising        interest               rates            and       reduce           risks             during            periods              of     declining
rates.           With         forecasts                  of     stable           rates,               losses          associated                      with        ARI"I
business             would       not          differ            substantially                         from          those       of        fixed-rate
loans.
IMPACT UNDER LESS OPTIMISTIC
ECONOMIC FORECASTS


          DRI's          trend             economic              forecast          reflects              generally               favorable
economic            conditions                    and      housing          price         appreciation                     rates        that
exceed        the        inflation                 rate--factors                   that         are      very         favorable              to     the
cash      position              of         the     Fund.


          To test              the         sensitivity               of     our        results           to     DRI's          forecast,                we
considered               alternative                    economic            scenarios.                   For     two          alternative
economic            scenarios,                    we assumed              lower          rates         of      house          price
appreciation                   while             keeping          DRI's      other             forecast          values              ur,changed.
We used         a medium                   housing          price         appreciation                   scenario              in      which        house
prices         rise       at         2 percent              per      year         less         than      DRI's         fall           1989
forecast.                This         produces              price         increases               in     the     range           of      5 to       7
percent         annually,                   which          are      consistent                 with      short-term                   forecasts
produced            by    the         National              Association                  of     Realtors              and      DRI's         more
recent         lo-year               forecast.               We alsc              constructed                  a low          housing          price
appreciation              scenario                    in    which house prices                           rise         at      5 percent             per
year less             than forecast                        by DRI last  fall.                   At             this        level,  the
housing         price           appreciation                      rate      would         be less              than        the overall                  rate
of     inflation.                    A widely            publicized       academic  study has suggested
that        long-term                housing            price    increases     may be at a level  below                                                 the
inflation             rate.


          We also              considered                  a third          scenario              that         assumed           that        the
country         would           experience                  a repeat              of     the      economic             conditions                  of     the
1980s.        During                 the      early          198Os,      interest    rates   rose to 15 percent
and      unemployment                      levels          reached       10 percent.       House price
appreciation                   stayed             below          3 percent     per year until     1986.


          Under          the         base         policy          case      (loan         ceiling              increases               along        with
housing         prices,               while          ARMS and             downpayment                  requirements                    remain
unchanged),               the         Fund         would          fare      substantially                      worse          with
alternative               economic                 scenarios              than         under          DRI's      trend           economic

                                                                            15
forecast.                 Under          the       low            housing              price         appreciation               scenario,  the
Fund's        cash         balance               would             be depleted                     by       1996.          Under the other
two      alternative                    economic                  scenarios,                 the         Fund       balance          would             shrink
to    less         than         $4 billion.                        Medium              house         price          appreciation                  would
result        in     a $4.9              billion                  reduction                 in     the       1998 cash balance
relative            to     the          trend          economics                  case;            the       1980s economic    conditions
scenario            would          result              in         a $5.0          billion                reduction            relative                 to     that
same base.

           The      effects              of      the         alternative                     policy           options           under            the
alternative                economic                scenarios                  are           generally              similar            to     their
effects            under          the      trend             economic                  forecast.                  As shown            in     exhibit                I,
under        the         1980s          economic                  conditions                   scenario,                increasing               the         loan
ceiling            would         produce               a larger               1998             cash         balance          than         would         be
obtained            under          the         base          case        with           these            economic            conditions,
although            the         difference                   is      fairly             small.               At     house       price
appreciation                    rates          ranging               from         2 to            4 percent              a year,           the         Fund
would        have         an estimated                       $2.9          billion                deficit           by     1998       compared                to         an
estimated                $5.0      billion               deficit                 for        the       base        case.         That         same policy
change,    in contrast,                           would   increase    the                                Fund's     projected     balance                                to
$14.4 billion     under                          DRI's  trend    economic                                 condition,        compared    to                          a
projected                $8. 8 billion                      for      the      base             case.


           Under          all      economic                  scenarios,                     revising              the      downpayment
requirement                would              lower          the      Fund's                balance             relative            to     the         base
case,        while          the         increased                  use      of         ARMS shows                 results           nearly             equal             to
the       base      case          for      all         economic               conditions.


VIEWS ON WHAT FHA'S                              ROLE IN
THE HOUSING MARKET SHOULD BE


      From the time of the Great                                                  Depression                    through         the        196Os,             FHA
was the nation's   primary insurer                                                     of      mortgage             credit          for      the
purchase            of      single-family                          homes.               With          the       subsequent                growth             of     the
private            mortgage              insurance                   industry,                    policy          makers        began            to         ask

                                                                                 1c
what      role         FHA's      programs                    should           play         in      the      housing            market         and how
its      responsibilities                           should           differ           from          those         of     private         mortgage
insurers              (PNIs).


          In     response              to      conditions                     in    the        housing            market         and     the
economy          in     general,               major           changes              in      FHA's           single-family                insurance
program          since          the         1970s         included


          --     removing              FHA's           ceiling                interest              rate,


          --     increasing                   the      maximum            mortgage                  amount,


          --     encouraging                   the        direct          endorsement                       of    FHA-insured                loans      by
                 private              lenders,


          --     collecting                   the      full          premiun              at       loan      closing            and    allowing
                 the      premium              to      be added                to     the          mortgage             amount        and      financed
                 over       the        life          of       the      mortgage,


          --     liberalizing                       underwriting                    standards                to        enable      more        people
                 to     participate                    in      FHA's           program,


          --     liberalizing                       loan-to-value                        ratios,            and


          --     allowing              the          use       of     adjustable                    rate      mortgages.


       The        extent   to which FHA duplicates     private                                                  sector    activity                      was
considered           by the 1982 President's     Commission                                                   on Housing.        The
Commission              recommended                    that          FHA should                    increasingly        complement,
rather          than      compete              with,           the       private               market.             In the Commission's
view,          FHA should              maintain                its       historic                  role      in    assisting low- and
moderate-income                       families                to     achieve              homeownership,                    while        allowing
the      private          insurance                  companies                 to     take          all      home        loans        that      they
can      and will           insure.
       As part           of        our         work,        we solicited                 views               on the           impact         of     the
proposed          changes            from         knowledgeabie     representatives                                       of government
agencies,          academia,                   and industry     organizations.                                         Examples  of the
favorable          views           expressed                to      us    follow:


       --    FHA should                    perform            the        same fundamental                          role        in     the         1990s
             that        it        has         performed             throughout                 its        history--to                    provide
             homeownership         opportunities        for low- and moderate-income
             families.       With higher         home prices,    it will be essential
             to help   first-time,          lower    income families.    But, providing
             this        help            should         be done               without          a government                      subsidy.


       --    There            is      little           evidence               that      PMIs          will         provide            insurance
             to     those             families              who can            afford           a downpayment                        of     only      5
             percent               or      less        to     purchase               a home.                 Therefore,               the         need
             continues                   for        FHA to          assist           these        families.                    To do so,              FHA
             must        be able                 to    maintain               its     participation                       in     healthier
             markets.                    Without            the      pcsitive            effects                  of     cross
             subsidization,                           FHA would               be unable               to      provide            assistance               tc
             riskier               households.


       On the          other             hand,         we also            heard         from          those            with      serious
misgivings          about            the         proposed            changes.                For        example,               we were             told
that


       --    Raising               the         loan     limit            tc     95 percent                   of    the        area        median
             house            price            would        significantly                    increase                  FHA's         market         and
             risk        exposure                   without          proportionate                      benefits               to     moderate-
             or     low-income                      households.


       --    It     is        time         for        FHA to         refocus            on its               mission           of     serving
             people            most            in     need.   The best way to do this  is to target
             FHA's            assistance                based on income because  income is direct11
             related               to      the        house         one       can     afford.
           Although                  the      answers           to     policy                questions         on FHA's                  future         role
are     not           easy,          we believe                that     the            bases       exist       for        formulating
policies                   that      take       into      account                the         potential         impacts               on the
financial                   viability            of      the      MM1 Fund.


FHA'S         MANAGEMENT PROBLEMS


           In         November               1989      we testified                     that       a number              of      financial
management                    problems           exist          that         HUD and              FHA top          management                  need       to
address               if      future          losses           are     to        be kept           under          control            no matter
what changes                       are       made to the ceiling      limits,                                downpayment
requirements,                       or       adjustable  rate   mortgages.                                   GAO and HUD's
Inspector                   General           have       been         reporting                 on these           management                  problems
since           the         early           1980s.        Among these                        problems        were         the        need         for       (1)
more       effective                    monitoring               of    existing                 underwriting                   standards                and
procedures,                       (2)      improved            inter%1                 controls,            (3)      more           diligent
fol low-up                   of     audit       findings,              and            (4)      a HUD Chief               Financ          ial      Officer
and     FHA Controller.


           The             new management                 at         HUD under                 Secretary           Kemp has               taken
specific                   steps        to    address            and        to    strengthen                FHA's             financial
position.                     These          include


           --         establishing                    a Chief          Financial                  Officer          for         HUD and            a
                      controller                within           FHA,


           --         stepping               up monitoring                   and            enforcement            activities,


           --         performing                an independent                         actuarial            analysis                of    the         MMI and
                      GI Funds,


           --         publishing                annual           audited               financial            statements,


           --         improving               the      efficiency                 and          effectiveness                   of    HUD audit
                      resoluticn                and      follow:-uy'              process,

                                                                                 12
           --       establishing                   a task  force    to ensure     full                                                 compliance                   with
                    the     Federal              Managers'    Financial    Integrity                                                    Act,   and


           --       reviewing             lender                requirements                          to      ensure           that                only
                    responsible                  and       soundly                   capitalized                      firms             participate                          in
                    FHA programs.

          We are            currently                  reviewing                     HUD's            progress               in          implementing
these           management               initiatives                          and plan                to      issue          a report                      later             this
year.




              In    conclusion,                  Mr.       Chairman,                      if         overall              economic                   conditions
remain             general1        y favorable                         and house                     prices           appreciate                         at      a rate                of
5 to          9 percent            annually,                    the           Fund's            cash          balance                  will          remain
positive              under        our       base          case               and      will           be higher                   if          the        mortgage
ceiling             is     raised.               However,                     the      additional                     insurance-in-force                                          that
this       pclicy           change           will          generate                    may expose                     the         federal                  government
to     potentially                 greater                financial                    risks.                 If      the      Fund                 is     not
actuarially                  sound,          these              risks               may subject                     the       federal                    government
to     enormous             costs           over        the            life          cf        the         new insurance                            that         will             be
created,              unless          the        problem                 of         actuarial                 soundness                       is      addressed.


              Lower        house         price          appreciation                            rates              like      those                  we are
experiencing                  today          will          have               a negative                    impact            on the                  Fund         if        the>
continue.                  For     example,                if          during             the         1990s           the      annual                    rate           is        less
than          4 percent,              the        Fund           will           likely                not      be able                  to      survive                  without
U.S.          Treasury           assistance                     even           if      economic                    conditions                       remain
generally                 favorable.


              On the        basis           of      our         analysis,                      we believe                   that              while           increases
in      the        FHA's      mortgage                 ceiling                 tc      account                for         house               price           increases
are      necessary               to      prevent                the           deterioration                         of      the             Fund's            balance

                                                                                    20
and      to     allow             FHA to            maintain                its         current              share           of      the      housing
market,              there           is      a need            to     proceed  with caution                                    on how hish                   to
raise          the        mortsaoe                 ceilins.              If the Fund is not                                    actuarially                   sound,
we believe                 the           Congress              should             not      raise             the        mortgage              ceiling              to
the      95 percent                       level       because               this         action              may subject                    the      federal
government                 to enormous                     costs   over                  the          life    of the                 new insurance
that   will               be created.                      We believe                    that            a decision                  to raise   the
mortgage              ceiling,                    under        these             conditions,                   should              be made           in
conjunction                   with           a decision                    on how to                  resolve            the         problem            of
actuarial                 soundness                  so that               the      potential                  financial                   risks        assumed
by the           federal                  government                 in     the         long          run      are       adequately
considered.                        If,       on the            other             hand,          the         Fund        is        actuarially                 sound,
we believe                   the          Congress             should             consider                  raising               the      mortgage
ceiling              to      95 percent                   of        a state's              median              house              price       because              doing
so will   have a positive   effect                                                 on the             Fund's   cash position                                 and will
allow   homebuyers  in high priced                                                  states             to participate      more                              actively
in      the      FHA program.                         These               issues         will          be addressed                        further            in        our
upcoming               report.


              This        concludes                  my statement,                       Mr.          Chairman.                 We will  be pleased
to      respond              to      any          questions                you      or     members                 of        the Subcommittee   may
have.




                                                                                    21
                                                                 SII~IWI-~              of I’olicy       Oplions       hy Economic           Scenario

                                                                        I<ntl of I+%cal Year Cash Ilalancc                          ($Million)


IWiry     Swnnrio                                                1vxv           IVVfl           1991         IVVZ         lW.3         lW4         tws         1996       1997




19R(k Fxnnom          in
Pljh Maintninz          IVRR Marker      Shnrr                   S5.SR6         S?.<T           s6,osx       $7,070       SR.oQS       SA.06       S7.2vl      S7,lRl     S6.527
FHA     lnc~aws        Loan rcil!nR                              SS.MW          %h.l52          67.07H       68.41X       SV.hW       %lO.?fiV     611.729     S8.727     67.999
FliA    Rcdluccs      Dounpnymcnc          Rcqmrcmrnr            65,5Xfl        sq.u4           Sh.07 I      S7,003       S7.999       sx.3r I     S6.917      S6,7R6     5.975
FHA     l’rwic!c<     2/h AKMx                                   $5,WV          J5,Ydl          S6.009       s6.Xoo       S7.4 17      Sl.~SS      56.126      S6.079     ss.s60



Medium       House Rirr         Apprrriation
FIIA    Mammnc          19XX Markrt      Shnrc                   S5.5Rfi        x5.779          55.179       S4.719       SS.324       SS.27S      S4.775       S4,3R2    WlS9
WA      Incruws        Loan   C’ciling                           SS.N)R         WI.49 I         $6,573       vi.714       S7.RS9       W.277       SU.134       SR.123     SX.321
RIA     Rrducc~ Downpnvmcnt                Rcquirrmcnt           $5,.7X6        55,769          S5.0X.S      S4.671       fS,140       S‘l,QW      s4.356       S3.RO7     53.406
WI/\    l’rov~drs     2/h ARhlr                                  SS.SX’J        55,7H5          $5.1~1’)     S44,X24      $5,253       55,177      S4.740       s4,.416    M,256


ha      Itauw       Price Appreciation
%IA     Mamtam          I’JXX hlarkcr    Show                    TS,~Xfi        $5,74X          $2,705       53.674       $3.479       52.376        MS6       ($1,510)   (f3230)
i3iA Incruccc     Loan CcilmX                                    Ss,fax         b6.440          $6.032       SS.489       S5.76R       S4.956      S3.13H       $1.179
RIA Rrti~Jcr~ Downpaymrnt                  Rcqtrlrcmcnt          S5,5Xh         55,737          S4.649       SL54R        S3.279       %2.(K3       (‘6100)    ($2,19X)   (S44.062)
T-‘11A F’mvitlcs ‘L/O ARM\                                       SS.SXV         SS,7Sl          S4,747       S3.71 I      $3.194       y,,‘.IL          $191   (%1,49X)   ($1.1


NIUC,    I.ml d I.I‘;c;II     Yc~:lr IWS     c .1x1111:1l~m~cII:IC nppr[l*tm:ltc.lv      $0 ? hllltrrn
                             FXHTRTT
                                   TT




          c              C


       (sJelloa   UO!l1!8)
UO!l!SOd WeA Jea;r, J” PW 8667
                                                   Summary       of Economic         Variables



Fcoeonir   Vwiabkn                    1989        I990        1991           1992       I993     I994    1995     1996




                                       9.M         9.44        PM        10.26         IO.02      9.14    9.66     9.61
                                       597        $104                   $121          $130      $141    5153     Slfh
                                       5 23        5.M         5.40       s.22           !I.39    5 17    5.28     5.17
                                       574         w           $85        $9 I           sY9     sm      5117     5127


                                       9.88       1092        12.95          15.12      15.38    12 85   12.49    11.74
                                       $97        Slcn        $117           $125       $128     SIW     $139     $145
                                       5.23        sm          7 16           7 78       9 87     9.33    7.4 I    7 20
                                       374         $81         $89            $95        597     SW2     SIM      SllO


                                       9.88        9.44        9.66          10.26      IOSL?     9.74    9.66     9.61
                                       597        $103        $107           $113       $120     $128    $137     SlUl
                                       5.23        5.50        5.40           5.22       5.39     5.37    5.28     5.17
                                       574         578         $82            SH6        SW       $98    SUM      $111


                                       9.88        9.44        9.66          IO.26      IO.02     9.74    9.66     9.61
                                       $97        $100        SlOl           s104       Slrn     Slll    $115     $119
                                       5.23        J.50        5.40           5.22       5.39     5.37    5.28     5.17
Ave. Nnmmal I mm Vhc                   $74         376         577            579        $82      $84     $88      WI

NC&: Rurs UC exprcwcd in pcrccnts. Prices ud vrluo arc eaprrssed in SCUIO.
                                        Median                Home Prices



 Al:lh~~l:l                  $K!.YX)        Kentucky               $59,700      North Dakota
 Al;ukn                     $100. loo       I,oui\innna            $8 1,200     Ohio
 hri7cm                     FIno,7(XJ       hlainc                 $98,300      Oklahoma
 Arkan\;ts                   67 1.200     * hlmland               $111,600      Oreg0ll

*Califomin                  % Ih2.7UO     * hlass;ichusctt~       $lS9,WO       Pennsylvania
 COlOGldO                    $89,800        Michipn                $78,800     *Rhode       Island
*Connecticut                6171,1(x)       Minnesota              595.800       South Carolina
 DdZlWCllY                   fA3,SW         Mississippi            $71,000       South Dakota
*District     of Columbia   $133,000        Missouri               $74,600       Tennessee
 Florida                     $90,900        Mont‘ana               $73,900      Texas
 Georgia                     $92,800        Nebraska               $65,500       Utah
*Hawaii                     $170,700        Nevada                 $92,900       Vermont
 Idaho                       $79,800      * New Hampshire         s I 34,500   * Virginia
 Illinois                    $91 ,RW      * New Jersey            $lSS,lW        Washington
  Indiana                    $59,200        New Mexico             $70,300       West Virgina
  Iowa                       $63,200      * New York              $149,200       Wisconsin
  KnnsnT                     $7 1,100       North C:m~lin:t        $X6,WO        Wyoming