Impact of FHA Loan Policy Changes on Financial Losses and Homebuyers

Published by the Government Accountability Office on 1990-07-10.

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

                     United St&es General         Accounting    Office


For Release           Impact      of     FHA Loan      Policy   Changes   on   Financial
on Delivery           Losses      and     Homebuyers
Expected    at
9:30   a.m.    EDT
July    10, 1990

                      Statement           of
                      John M.          Ols,  Jr.,  Director
                      Housing          and Community      Development     Issues

                      Before    the
                      Subcommittee     on Housing    and Community
                      Committee     on Banking,   Finance,and    Urban              Affairs
                      House of Representatives          .

GAO/T-RCED-90-95                                                                GAO Form 160   (12187)
Mr.   Chairman    and Members of the        Subcommittee:

      I am pleased to be here again to further             discuss    our analyses
of the impact that certain         proposed policy     changes to the Federal
Housing Administration's        (FHA) Mutual Mortgage Insurance           (MMI) Fund
will  have on the Fund's cash position.            This discussion      will  serve
to update the interim      results      and data of our ongoing work for
Congressman Gerald Kleczka,         which we presented       in testimonies
before this Subcommittee        on November 16, 1989,l         and the
Subcommittee    on Housing and Urban Affairs,          Senate Committee on
Banking,   Housing,   and Urban Affairs        on June 6, 1990.2       The results
of our work will     be included      in a report   to Congressman Kleczka.

        In addition     to highlighting       the major results       of our analyses,
I will    present    our views on the reforms proposed by the Secretary
of Housing and Urban Development               (HUD) to resolve     the MM1 Fund's
financial     problems     as well as on the actuarial          study conducted    by
Price Waterhouse,         which defined     these problems.        The proposed
reforms    are aimed at restoring         the Fund to actuarial         soundness by
increasing     its capital      reserves.

       As you know, Mr. Chairman,         the MM1 Fund supports    single
family   mortgages     insured    by FHA. It is FHA’s   largest    insurance
fund, with a cash balance at the end of fiscal            year 1988 of about
$6.2 billion.       This Fund is used to cover potential        losses from its
insurance-in-force,        currently   valued at about $271 billion.

      Briefly      stated,    Mr. Chairman,       the Congress and the nation          face
a dilemma:       Can FHA operate        a financially      sound single   family
mortgage     insurance     program at reasonable          costs and risks     and still
serve low- and moderate-income              homebuyers,     particularly    first-time
homebuyers,      without    substantially       increasing     burdens on them in

lImoacts    of   FHA Loan Policv      Chancres (GAO/T-RCED-90-17,           Nov.   16,
21mDacts of FHA Loan Policv           Changes    on Its     Cash Position      (GAO/T-
RCED-90-70, June 6, 1990).
achieving  that financial          soundness?       Because of the substantial
financial  and social         consequences     inherent     in any policy  changes to
the MM1 Fund's insurance           criteria,     the Congress should careEully
balance desires      to assist       homebuyers with its expectations           of the
housing market's       future     performance,      the federal   government's
potential  financial        risk   in assuming responsibility         for the
additional   amount of insurance-in-force               such changes can generate,
and the possible       need Eor assistance          by the U.S. Treasury      in the
Fund's survival.

       Mr. Chairman,   we support    the recent efforts          of Secretary     Kemp
and the Congress to restore       financial     health     to the MM1 Fund.        We
also compliment     the Secretary    for initiating        inquiries      into the
financial   status   of the Fund and, as the scope of the problem
became known, for considering        several    alternatives         to replenish   the
Fund's reserve.

       We believe    that the Price Waterhouse         study,    which defined    the
scope of the financial       problems facing       the MM1 Fund and the likely
outcomes of alternative       policy     changes on these problems,          is
credible     and accurately   portrays     the financial      problems facing     the
Fund.    We reached this conclusion          after  having met with
representatives      of Price Waterhouse        and discussed     their
methodology     in detail.    If we had conducted         a similar     analysis,  we
may have employed different          assumptions    or techniques,       which could
have affected     the numbers slightly;         however, we do not believe        the
basic message would have changed.

       The Secretary     only recently     announced various       proposals     for
reform,   and, subsequently,         the Senate passed legislation          that
adopted most of the Secretary's           proposals.      Although    we have not
fully   assessed these proposed policy          changes, we would like to
address several      issues regarding      the impact of these proposals             on
the Fund's financial        condition    and on potential       homebuyers.      These
issues   concern the following:
       --   the financial    benefits    that would accrue to the MMI
            Fund by adopting     a policy    change to increase FHA'S
            mortgage ceiling     on a regular     basis,

       --   the financial    impact on potential    homebuyers of FHA’s
            proposal   to eliminate   the financing   of most closing
            costs in mortgages,     and

       --   the application      of better       management   techniques      in
            reducing   losses.

        Before proceeding  with the details   of these issues, let me
briefly     summarize the major results   of our ongoing study of the
impact of FHA loan policy      changes on the MM1 Fund's cash position.


         The MM1 Fund is presently        incurring        losses for several
reasons--primarily        high default      and foreclosure          rates.      In our
testimony     before   the Subcommittee        on Housing and Urban Affairs,
Senate Committee on Banking,            Housing,      and Urban Affairs          on June 6,
1990, we pointed       out that our analysis            shows that the future          cash
position     of the Fund will      depend heavily          on two factors--policy
changes to the MM1 Fund's insurance               criteria      and the actual
economic conditions         that prevail     in the next decade.              After
considering      both of these factors,         we concluded         in that prior
testimony     that one proposed policy          change--increasing            the FHA
mortgage ceiling       on a regular      basis to account          for increases        in
house prices--      is necessary     to prevent       the deterioration          of the
Fund's cash balance         and to allow FHA to maintain               its current     share
of the housing market.           However, we also concluded               that there is a
need to proceed with caution            on how high to raise the mortgage
ceiling.      Several    factors   influenced      our cautionary           advice.
        Of the proposed policy            changes we analyzed,           raising    the
mortgage ceiling            to 95 percent       of a state's      median house price
would have the greatest             positive      effect    on the Fund's cash balance.
However, raising            the mortgage ceiling         will    also generate      the most
new business         for FHA, thereby         increasing      the government's
financial       risk    in the form of additional             insurance-in-force.          In
the June 6, 1990, testimony,               we illustrated         this relationship
through an economic scenario                in which we estimated           that raising      the
ceiling     to 95 percent        of a state's        median house price would
increase      the Fund's cash balance by $8.2 billion                    by 1998.      However,
at the same time, this policy                 change would more than triple             the
amount of insurance-in-force,                 to $886 billion.         The increased
financial      risks      that such a policy         change poses were further
intensified        by indications       from FHA that the Fund may not be
actuarially        sound if it continues           to operate       as it has in the past.

        Consequently,         we suggested    that if the Fund is not
actuarially        sound, 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 would be created.           Instead,     we suggested     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.


        Our words    of caution  took  on a more compelling      meaning when
Secretary    Kemp    testified  before the Subcommittee       on Housing and
Urban Affairs,       Senate Committee on Banking,       Housing,  and Urban .
Affairs    on June     6, 1990.  He pointed  out that the Fund, while
currently    financially       solvent,    has been steadily       eroding   from a net
worth in constant          1989 dollars    of $7.8 billion      in 1980 to $2.6
billion    in 1989 and eventually          will    have a negative     net worth
unless something         is done to replenish        the Fund's reserve on a
continuing     basis.       The Secretary      reached this conclusion       based on
the results     of the actuarial        study conducted     by Price      Waterhouse
for FHA.

        To restore      the Fund to actuarial            soundness,   the Secretary
proposed several          reforms     aimed at increasing         the Fund's capital
reserves--establishing             minimum capital        standards   for the Fund and
a premium structure           sufficient       to cover expected      and normal
operating       losses.      Specifically,       the reforms      are (1) setting      a
risk-related        premium structure,          with higher premiums for loans with
lower downpayments;            (2) ending the practice          of financing     most
closing      costs in mortgages;           (3) further     reforming   management
throughout        FHA, particularly         in the areas of property         disposition
and in accounting          systems to prevent          fraud in the future;        (4)
discontinuing        paying distributive           shares for future      business,      but
continuing        to pay them on past business;              and (5) holding     mortgage
limits     at present      levels.

         The proposed set of policy          changes announced by Secretary                 Kemp
provides      one way to minimize        financial      risks     and potentially
resolve     the MM1 Fund's financial           problems.        Subsequent       to the
Secretary's       announcement,      the Senate passed legislation                 (S. 566)
on' June 27, 1990, that adopted reforms                 in line with the Secretary's
proposals.        The proposed legislative           reforms      are (1) establishing
capital     requirements       for the Fund; (2) setting             a risk-related
premium structure,          with higher premiums for loans with lower
downpayments;        (3) limiting     the principal        obligation       for FHA loans
to no more than 98 percent            of the appraised          value of the property
or 97 percent        in the case of an appraised            value     in excess of
$50,000;      (4)  discontinuing      paying distributive            shares on past and
new business       until    the Fund is actuarially           sound: and (5)
conducting   an annual actuarial    study of the Fund.     Although  we
have not fully    assessed these proposals,     we support  these efforts,
particularly   the concept of risk-related      premiums, and the goals
these policy   changes are directed     at achieving.


       While we support       these efforts,    there are three issues
concerning    the impact of the proposed policy            changes on the Fund's
financial    condition    and on potential      homebuyers that I would like
to discuss:     the financial      benefits   of raising     the mortgage limit,
the impact on homebuyers from no longer             financing    most closing
costs,    and the application       of better   management to reduce losses.

Financial    Benefits   of Raising     FHA's
Mortgage    Ceilinq   on a Regular     Basis

        FHA's proposals       are based on holding      mortgage ceiling      limits
at the present         level   ($124,875),   while our analyses       and the
actuarial     study by Price Waterhouse          show that the MM1 Fund could
benefit    financially       by raising    mortgage ceiling    limits    on a regular

      In   regard to raising     the mortgage ceiling,      Secretary      Kemp has
stated   that,   "The Price Waterhouse      analysis   concludes    that,
contrary    to popular   impression,   raising     the loan limits     will   not
help the MM1 fund."       However, Price Waterhouse's        report    points    out
that under certain     conditions,    which are discussed       below, raising
FHA's mortgage ceiling       could benefit     the Fund.

       This observation     is similar    to the conclusions   we reached in
our   analyses    of the cash position      of the MM1 Fund.    Namely, while
increasing     the FHA mortgage ceiling       would increase  the
government's      financial   risk  in the form of additional     insurance-in-
force,    it would have a positive         effect    on FHA's cash balances.
Another way to look at this issue is to ask what would happen to
the Fund if the Congress would decide not to raise FHA's mortgage
ceiling     above the $101,250 limit         in effect      before 1990 and to
which it will     revert     after   September 30, 1990, barring           further
congressional     action.       Under this condition,          the Fund's cash
balance would fall        to an estimated      $3 billion        in 1998 from the
fiscal   year 1989 level of $6.2 billion,              even under favorable
economic conditions         and rapidly    appreciating       house prices.        The
Fund's 1998 cash balance would be less than $3 billion--and                        might
even disappear     altogether--      if the recent       trend of lower rates of
house price appreciation           would continue      through     the 1990s.

        The Price Waterhouse        study demonstrates         the value of raising
mortgage ceilings         by combining      such a policy     change with other
policy    changes.      The report     points   out that the Fund's equity
position     would be enhanced by increasing             the loan limit     to 95
percent     of a state's      median house price and, at the same time,
requiring      a lo-percent     downpayment on that part of the loan
exceeding      $101,250 and charging         a premium of 1.5 percent        of the
loan amount up front          and 0.5 percent      annually     on the remaining      loan
balance.       Price Waterhouse      estimates     that the result      would be an
increase     of $78 million       in the Fund's equity        above the amount of
equity    that would have been realized            by not raising      the ceiling.
While $75 million        of this amount would be needed to meet the
proposed capital        requirement      of 1.25 percent      on the new insurance
business     this policy      change would create,        the remaining     $3 million
could be used to help build            the capital     reserve    or, depending     on
how the program is restructured,              to cover losses on more risky
loans to first-time         homebuyers.

       Mr. Chairman, once reforms    are instituted     and FHA determines
that the Fund is actuarially     sound, raising     the loan ceiling    while
increasing   the amount of insurance-in-force       should improve the
financial   position of the MM1 Fund slightly       because such a change
would allow FHA to build equity          faster   than if the ceiling    is not
raised.     For these reasons,    among others,       we suggested   in our June
6, 1990, testimony      that the Congress consider        raising  the mortgage
ceiling   to 95 percent     of a state's     median house price    if the Fund
is actuarially     sound.

Impact on Homebuyers of Eliminatinq
the Financing of Most Closing    Costs

        The proposed policy     change to eliminate        the financing       in FHA
 insured   mortgages of most closing        costs and, instead,        require     that
 these costs be paid in cash at settlement            could help improve the
Fund's financial      soundness,   but    could also mean that a number of
potential    FHA homebuyers may be forced out of the market or have to
delay their     home purchases.      For example, when buying a $75,000
home, a FHA borrower       must currently      have a minimum downpayment of
about $3,363 in cash (assuming that closing             costs,     equal to about 3
percent    of the purchase price,        are financed    in the mortgage),         but
if,   as proposed by FHA, the buyer is required             to pay two-thirds          of
the closing     costs in cash, the total        amount of cash needed at
settlement    would increase     by $1,431-- an increase       of 43 percent          over
the current     minimum downpayment.        While this may not seem like a
lot to some people,      41 percent     of FHA's borrowers       in fiscal       year
1989, or about 215,000 homeowners, paid less than 5 percent                      down.
For many of these homebuyers,          the increased    amount of cash needed
could have kept them out of the housing market or delayed their

Better Management       to
Reduce the Fund's       Losses

       Mr. Chairman,      the losses being incurred    by the MM1 Fund do not
result    only from economic factors,       such as the rising     number of
defaults     in economically     stressed regions   and the sale of
foreclosed     properties    at less than the outstanding      mortgage values.
They also result     from poor program management and waste, fraud,       and
abuse.    The full   extent  of losses attributable     to these factors  is
not yet known.      However, as we pointed     out in our June testimony,    a
number of financial      management problems exist    that the top
management of HUD and FHA need to address to keep future           losses
under control,     no matter what changes are made to the ceiling
limits,   premium rates,    or closing  costs requirements.     HUD's
Inspector    General and GAO have been reporting      on these management
problems since the early      1980s.

       Secretary     Kemp has taken specific          steps to address management
problems and strengthen           FHA's financial      position,      which we detailed
in our previous       testimony     before this Subcommittee.             Since then
Secretary      Kemp has outlined       further    steps he plans to take to
address FHA management problems              in the areas of property
disposition,      underwriting      practices,     monitoring      of lenders,    and
reforms      to accounting     systems to prevent        fraud in the future.         Any
success achieved        by the Secretary       in reducing       FHA's losses through
better    management will       improve the financial          health of the MM1

        In conclusion,        Mr. Chairman,       while we face the dilemma of
placing     added burdens on potential             FHA homebuyers in order to help
restore     the Fund's financial           soundness,    the MM1 Fund has not yet
reached the point of requiring               assistance     from the U.S. Treasury.
Therefore,      there is still        time to take action        to reform the program
and reverse       the trend towards insolvency             before federal    financial
assistance      becomes necessary.           In deciding      on what reforms    are
appropriate       to achieve this goal,           the Congress should not only
carefully      balance desires        to assist      homebuyers with the federal
government's        potential    financial      risk and liability,       but it should
also base these reforms            on its expectations         of the housing market's
future    performance.
         This concludes our statement,   :Ir. Chairman. We will   be
pleased to respond to any questions    you or members of the
Subcommittee  may have.