Mortgage Financing: Opportunities to Enhance Management and Oversight of FHA's Financial Condition

The Department of Housing and Urban Development's (HUD) Federal Housing Administration (FHA) has helped millions of families purchase homes through its single-family mortgage insurance programs. In recent years, FHA has experienced a dramatic increase in its market role due to the contraction of other mortgage market segments. FHA insures almost all of its single-family mortgages under its Mutual Mortgage Insurance Fund (Fund), which is reviewed from both an actuarial and budgetary perspective each year. On the basis of an independent actuarial review, FHA reported in November 2009 that the Fund was not meeting statutory capital reserve requirements as of the end of fiscal year 2009, as measured by the Fund's estimated capital ratio (i.e., economic value divided by the unamortized insurance-in-force). Additionally, although the Fund historically has produced budgetary receipts for the federal government, a weakening in the performance of FHA-insured loans has heightened the possibility that FHA will require additional funds to help cover its costs on insurance issued to date. In light of FHA's changing market role and financial condition, Congress asked us to examine (1) how estimates of the Fund's capital ratio have changed since 2001, the primary factors contributing to recent changes, and the budgetary implications of changes in the Fund's financial performance; (2) how FHA and its actuarial review contractor evaluate the financial condition of the Fund, including the Fund's performance under different economic scenarios; (3) the steps FHA has taken to improve the financial condition of the Fund, and how it has interpreted statutory requirements pertaining to the Fund; and (4) the performance of FHA's mortgage portfolio from 2005 through 2009, and the extent to which key characteristics of FHA-insured mortgages have changed in recent years.

We found the following: (1) After increasing earlier in the decade, the Fund's capital ratio dropped sharply in 2008 and fell below the statutory minimum in 2009, when a combination of economic and market developments created conditions that simultaneously reduced the Fund's economic value (numerator of the ratio) and increased the insurance-in-force (denominator of the ratio). According to annual actuarial reviews of the Fund, from 2001 through 2006, the capital ratio rose from 3.8 percent to 6.8 percent, but fell to 3.0 percent by the end of 2008 and to 0.5 percent by the end of 2009. Major factors contributing to the declines in 2008 and 2009 included the following: (1) More pessimistic forecasts of economic conditions--house prices, in particular--which increased the number of predicted insurance claims and losses associated with those claims, thereby reducing the Fund's economic value. (2) The contraction of other segments of the mortgage market and legislated increases in the loan amounts eligible for FHA insurance, which resulted in higher demand for FHA-insured mortgages and increased FHA's insurance-in-force. At the same time, the Fund's condition from a budgetary perspective also has worsened. In recent years, the Fund's capital reserve account has covered large upward reestimates of FHA's credit subsidy costs (through transfers to the financing account). As a result, balances in the capital reserve account have fallen dramatically. At the end of 2007, the balance stood at $22.0 billion, but it is estimated to drop to $3.5 billion by the end of 2010. If the reserve account were to be depleted--a scenario that an FHA budget official told us was a possibility within the next few years--FHA would need to draw on permanent and indefinite budget authority to cover additional increases in estimated credit subsidy costs. (2) FHA and its actuarial review contractor have enhanced their methods for assessing the Fund's financial condition but still are addressing other methodological issues that could affect the reliability of estimates of the Fund's capital ratio. However, FHA, its financial statement auditor, and mortgage market and budget analysts have identified a number of potential issues with the current review methodology. FHA officials told us that they were planning to require the actuarial review contractor to use a stochastic simulation model for the 2011 actuarial review. These officials said that the model would be used to examine the implications of extreme economic scenarios on the Fund but that decision about whether to use the model to estimate the Fund's capital ratio had not been made. (3) To help improve the financial condition of the Fund, FHA has raised premiums and made or proposed policy and underwriting changes, but certain legislative requirements concerning FHA's administration of the Fund provide limited direction and have required interpretation by FHA. In the absence of more explicit directions, the priority that FHA should place on restoring the capital ratio versus its operational goals may be unclear, and Congress may not be receiving all of the information that it would find useful to monitor the Fund's financial condition. (4) Data on the performance and characteristics of FHA-insured mortgages illustrate the challenges and uncertainties facing the Fund as well as improvement in certain risk factors. As in other segments of the mortgage market, the performance of FHA-insured mortgages deteriorated as the economy weakened and home prices fell in 2008 and 2009. FHA is closely monitoring the early performance of the 2009 loan cohort, which will have a major influence on the Fund's financial condition because of its large size (35 percent of the amortized insurance-in-force as of May 31, 2010). The 2009 cohort was projected to perform better than the 2006 cohort in the long run. However, it is unclear from the early performance of the 2009 cohort whether this projection will hold.