Federal Housing Administration: Capital Requirements and Stress Testing Practices Need Strengthening

FHA insures private lenders against losses from defaults on single-family mortgages. According to independent actuarial reviews, in fiscal years 2009–2014, FHA's MMI Fund (which insures $1.2 trillion in single-family traditional and reverse mortgages) did not meet its statutory 2 percent capital requirement. Also, a budgetary review determined that the fund required $1.69 billion in supplemental funds in fiscal year 2013.

GAO was asked to examine issues concerning the MMI Fund's capital requirement and actuarial reviews. This report examines the types of information provided by assessments of the fund's financial condition, FHA's capital requirement and stress testing practices, and trade-offs associated with including reverse mortgages in the fund's capital assessment.

GAO analyzed actuarial and budgetary assessments of the MMI Fund. GAO reviewed financial institution and regulatory capital and stress testing principles to develop an evaluative framework and applied it to FHA. GAO also interviewed federal and mortgage industry officials.

The Federal Housing Administration's (FHA) budgetary reviews of the Mutual Mortgage Insurance Fund (MMI Fund) assess whether it needs more budget authority to cover expected future costs, and independent actuarial reviews provide complementary information on the fund's finances. FHA uses the actuarial reviews to assess whether the MMI Fund's capital ratio (economic value divided by insurance obligations) meets the 2 percent requirement and how fund components would perform under alternative economic scenarios. While the actuarial assessment does not directly determine the need for additional budget authority, it evaluates the fund's ability to absorb unexpected losses and may prompt changes in FHA policies and insurance premiums.

Capital requirements and stress testing practices—tools for managing financial risks—for the MMI Fund are not consistent with all elements of a framework GAO developed to help assess these tools in the context of FHA's single-family mortgage insurance programs. In accordance with the framework, FHA's capital assessments and stress tests are transparent and incorporate a number of relevant risk factors. However, areas of inconsistency include the following:

Scenario-based requirement . The statutory capital requirement is intended to help ensure the fund can absorb unexpected losses but is not based on a specified risk threshold, such as an adverse economic scenario the fund would be expected to withstand without requiring supplemental funds.

Accountability mechanisms . The capital requirement also does not include accountability mechanisms, such as a set of steps FHA would have to take if the capital ratio again fell below the 2 percent minimum.

Fund-wide stress tests . FHA has conducted separate stress tests—projections of financial condition under adverse scenarios—of its forward (traditional) and reverse mortgage (loans against home equity available to seniors) portfolios, but has not performed tests on a fund-wide basis.

Stress test objectives . FHA has not defined specific objectives for its stress tests such as determining the amount of additional capital, if any, that would be needed to withstand conditions similar to the last housing crisis.

Strengthening FHA's capital requirement and stress testing practices could help ensure that the MMI Fund is able to withstand economic downturns and that stress test results are as relevant and useful as possible for risk management.

Including reverse mortgages in the fund's capital assessment has advantages and disadvantages. Unlike for stress tests, FHA jointly assesses forward and reverse mortgages to calculate a combined capital ratio. Subjecting the reverse mortgage portfolio to capital assessment has made its financial condition more transparent. But, the portfolio's sensitivity to changes in economic assumptions makes the combined ratio more unpredictable. Alternative approaches also pose trade-offs. For example, a separate reverse mortgage capital requirement may help ensure the financial transparency of both portfolios, but requiring FHA to hold more capital to account for the volatility of the reverse mortgage portfolio could compel FHA to raise insurance premiums or lower borrowing limits.

Congress should consider specifying the economic conditions the MMI Fund would be expected to withstand without supplemental funds, and FHA should conduct stress tests on a fund-wide basis and specify the objectives of its stress tests. GAO also continues to maintain that Congress should incorporate accountability mechanisms into FHA's capital requirement (as stated in GAO-13-722 ). FHA agreed with GAO's recommendations.

The Department of Housing and Urban Development’s (HUD) Federal  Housing Administration (FHA) administers single-family forward and  reverse mortgage programs that insure private lenders against losses on  mortgages that finance home purchases, refinance existing mortgages,  and convert home equity into cash advances. These programs have  helped millions of households achieve homeownership or benefit from  home equity while living in their homes. FHA insures almost all of its  single-family mortgages under its Mutual Mortgage Insurance Fund (MMI  Fund). As of the end of fiscal year 2016, the fund’s insurance-in-force  (total insured mortgage balances outstanding) was about $1.2 trillion.

The MMI Fund is statutorily required to maintain at least a 2 percent  capital ratio, defined as the economic net worth (economic value) of the  fund divided by the amortized insurance-in-force. The fund’s economic  value depends on actual and estimated cash inflows (for example  insurance premiums collected from borrowers) and outflows (for example,  claim payments to lenders on defaulted loans). Therefore, FHA must  manage the fund such that, on average, the inflows exceed the outflows  by enough to maintain the required capital reserve. However, in fiscal  year 2009, in the midst of the 2007–2011 housing crisis, the MMI Fund’s  capital ratio fell below 2 percent and did not meet the statutory  requirement again until fiscal year 2015, according to independent  actuarial reviews. Additionally, at the end of fiscal year 2013, the MMI  Fund required supplemental funds—about $1.7 billion—for the first time in  its history to help ensure that it had sufficient resources to cover expected  net future costs on outstanding insurance. These developments highlight  a key challenge FHA and Congress face in balancing the fund’s financial  self-sufficiency with FHA’s role in facilitating mortgage credit to  underserved borrowers and stabilizing the housing market during  economic downturns.

In light of the MMI Fund’s recent fiscal challenges, you asked us to  examine issues pertaining to the MMI Fund’s actuarial reviews, capital  requirement, and stress tests. This report examines (1) the types of  information actuarial reviews and other assessments provide about the  MMI Fund’s financial condition, including its ability to remain self- sufficient; (2) the extent to which the capital requirement and stress  testing practices for the MMI Fund are consistent with principles and  practices underlying those of other financial institutions; and (3) key  advantages and disadvantages of including both forward and reverse  mortgages in the MMI Fund’s capital assessment.

To examine the types of information actuarial reviews and other  assessments provide about the MMI Fund’s financial condition, including  its ability to remain self-sufficient, we reviewed actuarial reports of the  fund prepared by an FHA contractor and related FHA reports to  Congress. Additionally, we reviewed FHA budget documents and audited  financial statements containing assessments of the fund, as well as FHA  documents and our prior reports describing the mechanisms used to  provide supplemental resources to the fund, if necessary.

To assess the extent to which capital requirements and stress testing  practices for the MMI Fund are consistent with principles underlying  requirements for other institutions, we developed and applied two  evaluative frameworks. We developed draft frameworks by reviewing  documents on the requirements and practices of financial regulators and  institutions, and by identifying key common elements that could apply to  the MMI Fund, assuming the fund would continue to operate under  federal accounting standards and budgeting requirements. In addition to  FHA, we shared the draft frameworks with the Federal Housing Finance  Agency (FHFA), the National Association of Insurance Commissioners,  and the American Academy of Actuaries and interviewed officials from  these organizations to obtain their input on the frameworks. We chose  these organizations based on their expertise in financial assessments of  housing finance and mortgage insurance institutions. To provide  additional perspective on stress tests of the MMI Fund, we compared the  two most stressful economic scenarios from the fiscal year 2016 actuarial  review of FHA’s forward mortgage portfolio with the severely adverse  scenario used by the Board of Governors of the Federal Reserve System  (Federal Reserve) in its 2016 supervisory stress tests of large banking  organizations.

To identify key advantages and disadvantages of jointly considering  forward and reverse mortgages in the MMI Fund’s capital assessment,  we reviewed actuarial results for both mortgage portfolios for fiscal years  2009–2016 and recent FHA reports to Congress discussing this issue.  Using information from the actuarial reviews, we analyzed the  implications of including the reverse mortgage portfolio in the joint capital  assessment and of holding the reverse mortgage portfolio to a separate  capital requirement. We also interviewed FHA officials and five mortgage  industry associations and stakeholders (selected based on their  knowledge of FHA and reverse mortgages) to obtain their views on the  joint capital assessment and possible alternative approaches. Appendix I  describes our objectives, scope, and methodology in greater detail.

We conducted this performance audit from August 2016 to November  2017 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.

FHA’s single-family mortgage insurance programs insure private lenders  against losses from borrower defaults on mortgages that meet FHA  criteria for properties with one to four housing units. FHA insures a  variety of mortgage types, including loans for initial home purchases,  construction and rehabilitation, and refinancing. In fiscal year 2016, FHA  insured roughly 1.3 million single-family mortgages with total initial  balances of approximately $260 billion. Partly because of its low 3.5  percent minimum down-payment requirement, FHA has played a  particularly large role among groups with lower average levels of  accumulated wealth, including minority, lower-income, and first-time  home buyers. For example, in fiscal year 2016, roughly 82 percent of  FHA-insured home purchase loans went to first-time home buyers and  more than 33 percent went to minority home buyers.

FHA also generally is thought to promote stability in the housing market  by helping to ensure the availability of mortgage credit in areas that may  be underserved by the private sector or that are experiencing economic  downturns. Consistent with this view, the volume of FHA-insured forward  mortgages peaked in fiscal year 2009, toward the end of the 2007–2009  recession and in the midst of the 2007–2011 housing crisis. In terms of  loan originations, the share of the single-family home purchase mortgage  market insured by FHA reached nearly 30 percent in fiscal year 2009,  while in more recent years it has been about 20 percent.

The MMI Fund includes almost all of FHA’s single-family mortgage  insurance programs, the largest of which is the 203(b) program. The  Housing and Economic Recovery Act of 2008 (HERA) moved a number  of other programs that were previously under the General and Special  Risk Insurance Fund to the MMI Fund. These included programs for  insuring mortgages on condominium units, mortgages that simultaneously  finance home purchase and rehabilitation costs, and reverse  mortgages.

A reverse mortgage is a type of loan against the borrower’s home equity.  With a reverse mortgage, borrowers do not need to repay the loan as  long as they meet certain conditions. These conditions, among others,  require the borrower to live in the home, pay property taxes and  homeowners’ insurance, maintain the property, and retain the title in his  or her name. Unlike forward mortgages, where the borrower makes  monthly payments to the lender, increasing equity and decreasing the  loan balance over time, reverse mortgages typically are “rising debt,  falling equity” loans. For reverse mortgages, the loan balance increases  and the home equity decreases over time. As the borrower receives  payments from the lender, the lender adds the principal and interest to  the loan balance, reducing the homeowner’s equity. FHA insures reverse  mortgages under its Home Equity Conversion Mortgage (HECM)  program, which serves eligible borrowers aged 62 or older. Congress  established the HECM program in 1988 as a way to alleviate economic  hardship caused by the increasing costs of health care, housing, and  subsistence needs at a time in life when income is reduced, while  protecting reverse mortgage lenders and borrowers from financial  losses.

The MMI Fund is supported by insurance premiums paid by borrowers.  For forward mortgages, FHA has the authority to establish and collect a  single up-front premium (in an amount not to exceed 3.0 percent of the  amount of the original insured principal of the mortgage) and annual  premiums of up to 1.5 percent of the remaining insured principal balance,  or 1.55 percent for borrowers with down payments of less than 5.0  percent. As of September 2017, FHA charged a 1.75 percent up-front  premium and either a 0.80 percent or 0.85 percent annual premium,  depending on the size of the down payment. As of the same date, FHA  charged HECM borrowers an initial premium of either 0.50 percent or 2.5  percent, depending on how they draw down available funds, and an  annual premium equal to 1.25 percent of the outstanding HECM  balance.

Each year, the MMI Fund is subject to three different financial  assessments:  Independent actuarial review. The National Housing Act requires an  annual independent actuarial review of the MMI Fund’s financial  position. FHA uses the results of the actuarial review to determine  whether the MMI Fund is meeting the act’s requirement that it maintain a  capital ratio of at least 2 percent. Each year, an independent actuarial  contractor conducts two separate actuarial reviews—one for forward  mortgages and one for HECMs—to estimate the economic value of the  two portfolios. In a separate annual report to Congress, FHA combines  the findings of the forward mortgage and HECM actuarial reviews to  determine the capital ratio for the MMI Fund as a whole. As previously  noted, the capital ratio is the fund’s economic value divided by the  insurance-in-force.

Budgetary review. FHA estimates and reestimates the net lifetime  costs—known as credit subsidy costs—of the mortgages it insures as part  of the MMI Fund’s annual budgetary review. Under the Federal Credit  Reform Act of 1990 (FCRA), FHA and other federal agencies must  estimate the credit subsidy costs of their direct loan or loan guarantee  programs in their annual budgets. Credit subsidy costs represent the  present value of estimated cash flows to the government minus the  present value of estimated cash flows from the government over the life  of the loan, excluding administrative costs. For a mortgage insurance  program, cash inflows consist primarily of insurance premiums charged to  borrowers and proceeds from sales of foreclosed properties, and cash  outflows consist mostly of insurance claim payments to lenders. Annually,  agencies estimate credit subsidy costs for new loan cohorts—the loans  agencies commit to guarantee in a given fiscal year. When estimated  cash inflows exceed expected cash outflows, a cohort is said to have a  negative credit subsidy cost, meaning that the cohort is estimated to  generate income. When the opposite is true, the cohort is said to have a  positive credit subsidy cost.

Generally, agencies also are required to produce annual updates of their  subsidy estimates—known as reestimates—for each loan cohort on the  basis of information on actual performance and estimated changes in  future loan performance. Each additional year provides more historical  data on loan performance that may influence estimates of the amount and  timing of future claims. Additionally, economic assumptions (such as  house prices and interest rates) also can change from year to year, which  would affect estimates of future loan performance. In recognition of the  difficulty in making credit subsidy estimates that mirror actual loan  performance, FCRA provides permanent and indefinite budget authority  for reestimates that reflect increased credit subsidy costs (upward  reestimates). While FHA has had a number of upward reestimates, the  only year in which the MMI Fund has needed to draw on permanent and  indefinite budget authority was fiscal year 2013, when it received $1.69  billion. All other upward reestimates were covered by funds held in the  MMI Fund’s capital reserve account.

Financial accounting review. The preparation of FHA’s financial  statements also provides a review of the MMI Fund. FHA is required to  prepare financial statements in accordance with generally accepted  accounting principles for the federal government (federal GAAP). The  financial statements provide information on the overall financial position of  the MMI Fund, including its assets, liabilities, and actual cash flows during  the year. In addition, federal GAAP requires FHA to calculate a liability for  loan guarantees, which represents the estimated net present value of  expected future cash flows for outstanding insurance.

In general, capital exists to absorb unexpected losses and allow a  financial institution to continue operations during economic downturns.  The MMI Fund plays a key role during such periods by helping to  maintain the flow of mortgage credit to areas that may be underserved by  the private sector. As previously noted, the MMI Fund is statutorily  required to maintain at least a 2 percent capital ratio. It also is the only  federal credit program with a capital requirement. Because the MMI  Fund can draw on permanent and indefinite budget authority, if  necessary, it has greater ability to weather adverse economic conditions  than a private entity. However, the capital requirement is intended to help  ensure that the fund remains self-sufficient by creating a reserve for  unexpected losses. The size of the MMI Fund’s capital reserve can be  expected to fluctuate depending on economic conditions and other  factors. For example, the reserve may tend to grow when the economy is  strong (limiting borrower defaults and FHA insurance losses), and may  tend to shrink when the economy is weak (increasing borrower defaults  and FHA insurance losses).

Stress tests are a risk management tool used by banks and other  financial institutions. The International Actuarial Association defines  stress testing as a projection of the financial condition of an institution  under a specific set of adverse conditions. While there is no requirement  that FHA stress test the MMI Fund, actuarial reviews of the MMI Fund  have included analyses of the MMI Fund’s economic value and  insurance-in-force under alternative scenarios, including adverse  scenarios. As discussed later in this report, the alternative scenarios  include selected economic paths used in estimating the economic value  of the MMI Fund’s forward mortgage and HECM portfolios, as well as  baseline and economic slump paths produced by Moody’s Analytics.  FHA considers these analyses to be a form of stress testing.

Budgetary and Actuarial Assessments of the Fund Serve Different but Complementary Functions

Supplemental Funding Is Determined by Budgetary Assessments, and Actuarial Reviews Provide Complementary Information

FHA assessments performed as part of the MMI Fund’s annual budgetary  review—specifically, the credit subsidy estimates and reestimates  discussed previously—determine the fund’s financing account and capital  reserve account balances. The financing account is designed to hold  sufficient funds to cover anticipated net future costs on outstanding  insurance. The capital reserve account holds additional funds that could  be used to cover unexpected losses (for example, due to higher-than- anticipated mortgage defaults). If the capital reserve account had  insufficient funds to cover an upward credit subsidy reestimate (that is, an  increase in expected lifetime costs), FHA would draw on permanent and  indefinite budget authority. As previously noted, this has occurred one  time (fiscal year 2013) since the implementation of FCRA. Drawing on  permanent and indefinite budget authority means that the MMI Fund is  not self-sufficient under FCRA requirements. However, it does not  indicate that the fund is unable to pay insurance claims in the near-term  without supplemental funding, because the fund’s financing account holds  balances to cover the anticipated net future costs on claims expected in  the near-term and over the long-term for the existing insurance portfolio.

In contrast, the actuarial reviews do not directly determine the need for  additional budget authority; rather, they are used to assess whether the  MMI Fund is in compliance with the requirement to maintain at least a 2  percent capital ratio. Additionally, the reviews are statutorily required to  be conducted by an independent actuary rather than by FHA. As  previously noted, the actuarial reviews estimate the economic value of the  forward mortgage and HECM portfolios separately, and FHA combines  these estimates to calculate the capital ratio (that is, the economic value  divided by the insurance-in-force) for the MMI Fund as a whole. The  economic value of each portfolio consists of existing net capital resources  (assets less liabilities) plus the net present value of anticipated future  cash inflows and outflows on outstanding insurance.

To determine existing net capital resources, FHA’s actuarial contractor  uses information on the assets and liabilities of the financing and capital  reserve accounts previously discussed. Beginning with the fiscal year  2012 actuarial review and continuing through the fiscal year 2016 review  (the most recently completed one), FHA’s actuarial contractor has  estimated the net present value of cash flows using Monte Carlo  simulation—a methodology that involves running simulations of multiple  economic paths. Specifically, for the forward mortgage and HECM  portfolios separately, the contractor generated 100 economic paths,  centered around Moody’s Analytics’ baseline economic scenario, and  computed a net present value of future cash flows for each of these  paths. The contractor added the average of these 100 numbers to the  existing net capital resources to produce the economic value used to  assess compliance with the MMI Fund’s 2 percent capital requirement.  Table 1 shows the fiscal year 2016 economic value, insurance-in-force,  and capital ratio for the forward mortgage and HECM portfolios, as well  as for the MMI Fund as a whole.

Under the independent actuarial reviews, an economic value of zero— and therefore a capital ratio of zero—for the MMI Fund as a whole  indicates that estimated resources are enough to cover anticipated net  future costs and no more. Specifically, if the capital ratio is zero, the MMI  Fund’s existing net capital resources (for example, cash and Treasury  investments) and the net present value of future cash inflows (for  example, premium revenue and proceeds from sales of foreclosed  homes) are estimated to be equal to the net present value of future cash  outflows (for example, insurance claim payments and costs to maintain  foreclosed properties). Therefore, in concept, a positive economic value is  similar to a positive balance in the capital reserve account under the  budget process—that is, it projects the availability of funds above what is  needed to cover expected net future costs on outstanding insurance.

However, the independent actuarial reviews have used different  estimation models and economic assumptions from those used in FHA’s  budgetary assessment to estimate the present value of future cash flows;  therefore, the actuarial and budgetary reviews have not produced  identical capital estimates. (See app. II for more information on the  related components of the budgetary and actuarial reviews.) A capital  ratio below 2 percent, or even below zero, does not directly determine the  need for permanent and indefinite budget authority. However, it indicates  that according to the models and assumptions of the actuarial reviews,  the MMI Fund’s ability to absorb unexpected losses may be limited and  that premium and policy changes designed to bolster the fund’s capital  position may be needed.

Actuarial Reviews Also Include Stress Tests of the MMI Fund and Other Insights

In addition to the capital assessment, the actuarial reviews also have  projected the MMI Fund’s performance under alternative economic  scenarios, including stress scenarios. For example, the fiscal year 2016  actuarial reviews estimated the economic value and insurance-in-force of  the MMI Fund under eight alternative scenarios, including both strong  economic conditions and economic downturns. Specifically, the fiscal  year 2016 reviews estimated the 10th best and worst, 25th best and  worst, and worst economic values produced by the Monte Carlo  simulation, along with the economic values resulting from Moody’s  Analytics’ baseline and protracted slump scenarios. In addition, the  fiscal year 2016 reviews included a low-interest-rate scenario, which  assumes that low interest rates persist for 2 years, before resuming on  the path of the Moody’s Analytics’ baseline scenario. The reviews also  include information on the house price index values, interest rates, and  unemployment rates from the economic paths that produced these  alternative economic values.

The actuarial reviews have analyzed the economic value under  alternative scenarios separately for the forward mortgage and HECM  portfolios. The estimated economic values for the forward mortgage and  HECM portfolios can be combined to arrive at fund-wide capital ratios for  the average of the 100 economic values produced by the simulation— Monte Carlo average—and all of the Moody’s Analytics’ scenarios (see  table 2). However, the 10th best and worst, 25th best and worst, and  worst economic values produced by the Monte Carlo simulations cannot  be combined. This limitation is due to the fact that the economic scenario  that led to the 10th best forward mortgage economic value, for example,  may be different from the scenario that led to the 10th best HECM  economic value.

In contrast, the budgetary reviews do not include analysis of future loan  performance under alternative economic scenarios. The budgetary  reviews are required to use the President’s economic assumptions, which  the Office of Management and Budget provides to agencies for budget  formulation.

In addition to the actuarial reviews prepared by FHA’s contractor, FHA  compiles statutorily required annual reports for Congress based on the  results of the actuarial analysis. These reports include the calculation of  the MMI Fund’s overall capital ratio and some additional analyses of the  MMI Fund’s financial condition. Statutory requirements for the content of  the reports to Congress are broad, and each year, FHA determines the  types of information it believes will be most useful to Congress. FHA  officials said they consider what they reported in the previous year,  events from the past year, and feedback from readers to determine what would be most useful to include. For example, in its fiscal year 2015  report to Congress, FHA discussed the amount of additional capital that  would have been needed for the forward mortgage portfolio to achieve a  2 percent capital ratio and withstand losses in the event of an economic  downturn similar to the last economic crisis.

Financial Statements and Quarterly Reports Provide Additional Perspectives on the MMI Fund’s Financial Condition

FHA’s financial statements present the MMI Fund from a financial  accounting perspective and are prepared according to federal GAAP. The  financial statements are composed of year-end balance sheets, the  related statements of net cost and changes in net position, and the  combined statements of budgetary resources. As with the budgetary and  actuarial reviews, FHA’s annual management reports, which include the  financial statements, also include information on the MMI Fund’s capital  resources and a net present value calculation of cash flows from  outstanding insurance. Information used in preparing the financial  statements—specifically, the MMI Fund’s assets and liabilities (excluding  the liability for loan guarantees)—is used in the budgetary review to  inform the amount needed in the financing account and is used by the  actuarial review to determine the existing capital resources component of  the economic value calculation. Like the budgetary reviews, the financial  statement reviews do not include analysis of future loan performance  under alternative economic scenarios.

Another source of information on the MMI Fund’s financial status is  quarterly reports FHA issues to Congress, as required by HERA. The  quarterly reports can help provide early insight into whether there are  potential deviations from the prior year’s projections before the next  annual budgetary and actuarial reviews are completed. Among other  topics, the reports must include information on any significant changes  between actual and projected claim and prepayment activity, and  projected versus actual loss rates. However, while the quarterly reports  update certain measures of the MMI Fund’s performance and financial  condition, they are not intended to provide a full actuarial or budgetary  analysis.

The MMI Fund’s Capital Requirement Lacks Accountability Mechanisms, and Stress Tests Are Not Fund-Wide

The MMI Fund’s capital requirement and stress tests are consistent with  some principles and practices promulgated or used by financial  institutions and regulators, but are not consistent with others. To assess  the MMI Fund’s consistency with these principles and practices, we  developed a framework of important considerations in designing capital  requirements and another for designing stress tests. Our frameworks  include underlying principles or key features of the requirements and  practices of institutions we reviewed—such as transparency and  accountability—that could also be applied to the MMI Fund. See appendix  I for further details on our methodology.

The Capital Requirement Is Not Based on a Specified Risk Threshold and Lacks Accountability Mechanisms

The MMI Fund’s capital requirement is consistent with our framework  element on transparency and partially consistent with two other  elements—that the requirement include both risk-based and fixed  components and that the requirement be designed to cover unexpected  losses and be based on specified risk thresholds. However, the MMI  Fund’s capital requirement is not consistent with the element on including  accountability mechanisms. We were unable to determine whether the  requirement is consistent with the element on balancing financial  soundness with the entity’s role and mission because such an  assessment would require more information about the severity of the  economic conditions the capital requirement was designed to withstand  without supplemental funding. Table 3 summarizes our assessments.

The MMI Fund’s capital requirement is consistent with the framework  element of being transparent so that external parties can understand the  financial risks facing the entity. FHA’s actuarial reports and  accompanying report to Congress provide specific information about the  MMI Fund’s capital requirement and capital assessment results. For  example, the actuarial reports describe how the capital ratio is calculated,  the models and data sources used to calculate the net present value of  future cash flows, key economic assumptions used in calculating the MMI  Fund’s economic value, and estimated economic values of the forward  mortgage and HECM portfolios. Additionally, FHA’s reports to Congress  include calculations of the Fund-wide capital ratio based on these values,  as well as analyses of factors affecting the past performance of the  forward mortgage and HECM portfolios and factors that could affect their  future performance. The actuarial reviews and reports to Congress are  publicly available on HUD’s website.

The MMI Fund’s capital requirement is partially consistent with the  framework element of having both a risk-based and a fixed component.  For capital requirements with this feature, whichever component requires  the greater level of capital is the binding minimum requirement. Among  other things, a risk-based component helps to ensure that the entity holds  more capital as the asset quality of its portfolio (credit quality, specifically,  in the case of a mortgage portfolio) decreases. A fixed component is  insensitive to asset quality; it therefore is not subject to the potential for  estimation errors of risk-based assessments and serves as a backstop to  the risk-based component.

While the MMI Fund’s capital requirement is statutorily set at 2 percent, it  is risk-based because the calculation of the capital ratio’s numerator  (economic value) accounts for loan and borrower quality. As loan and  borrower characteristics, such as loan-to-value ratios and borrower credit  scores, get riskier, the models used to estimate the MMI Fund’s economic value predict higher insurance claims and higher net losses on claims  (due to increased foreclosures and decreased returns on sales of  foreclosed properties). This, in turn, reduces the MMI Fund’s estimated  economic value and makes it more difficult for the fund to meet the 2  percent capital requirement. The MMI Fund’s capital requirement also has  attributes similar to a fixed component in that the fund’s economic value  must be at least 2 percent of the insurance-in-force, regardless of the  credit quality of the insurance portfolio. However, the requirement does  not have a separate fixed component that backstops the risk-based  component (that is, becomes binding when it is the more stringent of the  two).

Developing and implementing a separate fixed component to the MMI  Fund’s capital requirement would pose challenges. For example, a  requirement that was insensitive to portfolio credit quality would not align  with the FCRA requirements and accounting principles that FHA must  follow. These requirements and principles emphasize the consideration of  risk factors in estimating potential financial losses. Additionally,  substantial additional analysis would be required to determine the  structure of a separate fixed component, the level at which it should be  set, under what conditions it might become binding, and how it might  affect FHA’s ability to fulfill its mission. As a result, it is unclear whether  developing a separate fixed component to the MMI Fund’s capital  requirement would be beneficial.

Unexpected Losses and Specified Risk Thresholds

The MMI Fund’s capital requirement is partially consistent with the  framework element of being able to cover unexpected losses and being  based on a specified risk threshold, such as an adverse economic  scenario that the entity would be expected to withstand. The MMI Fund’s  capital requirement is designed to cover some unexpected losses. As  previously noted, the MMI Fund’s capital ratio is calculated by dividing the  economic value of the fund by the amortized insurance-in-force. The  economic value is determined by adding existing capital resources to the  net present value of future cash flows on outstanding insurance. An  economic value of zero (and therefore a capital ratio of zero) indicates  that based on the actuarial calculations, the sum of the MMI Fund’s  existing capital resources and the present value of expected cash inflows  (for example, premium income) is exactly the amount needed to cover the  present value of expected cash outflows (for example, claim payments).  Therefore, a 2 percent capital requirement serves the purpose of covering  some losses above expected amounts. However, the requirement was  not designed to absorb losses associated with a specified economic  scenario, so the extent of loss protection it provides is unclear.

In a February 2001 report, we concluded that neither the statute that  created the 2 percent capital requirement nor FHA had established  criteria to determine how severe of a stress the MMI Fund should be able  to withstand. Accordingly, we recommended that Congress or FHA  specify the economic conditions that the MMI Fund would be expected to  withstand. In March 2002, a legislative proposal was introduced in the  House of Representatives that would have required a capital ratio  sufficient to withstand a broad range of adverse economic circumstances,  but it was not enacted. Neither Congress nor FHA has subsequently  specified the economic conditions the MMI Fund should be able to  withstand or corresponding minimum capital ratios. FHA officials said they  did not consider it their role to define those economic conditions and  would comply with any requirement Congress established. Because the  MMI Fund’s capital requirement is not based on a specified risk threshold,  it may not provide an adequate financial cushion under economic  scenarios in which Congress may anticipate that the fund would be self- sufficient.

The MMI Fund’s capital requirement is not consistent with the framework  element of having accountability mechanisms such as additional reporting  requirements, remediation plans, and operational restrictions that are  triggered if capital requirements are not met. Failure to comply with the  MMI Fund’s capital requirement does not trigger a defined process or set  of steps to be taken by FHA. In a September 2010 report, we stated that  Congress should consider establishing a minimum time frame for  restoring the capital ratio to 2 percent should the ratio fall below that  level. A legislative proposal was introduced in Congress in December  2011 that, among other things, would have required FHA to return the  MMI Fund’s capital ratio to the statutorily required level within 2 years, but  it was not enacted. In addition, in a September 2013 report, we stated  that Congress should consider requiring FHA to submit a capital  restoration plan and regular updates on plan implementation whenever  the capital ratio falls below 2 percent. Congress has not yet acted on  this suggestion, but doing so could help ensure prompt action by FHA  and focus Congress’s monitoring efforts should this situation arise in the  future.

Balancing Financial Soundness and Mission

We could not assess the consistency of the MMI Fund’s capital  requirement with the framework element of balancing financial soundness  with the entity’s role and mission. Such an assessment would require  more information about the severity of the economic conditions the capital  requirement was designed to withstand without supplemental funding. As  previously discussed, the statute that created the requirement did not  specify those conditions. As a result, it is unclear whether FHA’s  difficulties in maintaining the financial soundness of the MMI Fund while  carrying out its public mission during and after the 2007–2011 housing  crisis indicate that the 2 percent capital requirement is insufficient.

Any reconsideration of the capital requirement would involve policy  decisions that would need to be made through congressional  deliberations. These decisions center on the relative weight FHA should  place on its financial and mission goals and requirements. On the one  hand, FHA has a statutory operational goal to minimize mortgage default  risk to the MMI Fund and a statutory requirement to maintain a capital  ratio of at least 2 percent. A minimum capital requirement that is too low  may result in FHA taking on too much risk and having an insufficient  capital buffer to withstand an economic downturn without requiring  supplemental funding. On the other hand, FHA also has a statutory  operational goal to provide mortgage insurance to traditionally  underserved borrowers—such as low-income, minority, and first-time  home buyers—and historically has played a role in stabilizing housing  markets during economic downturns. Setting a minimum capital  requirement that is too high may limit FHA’s ability to serve the borrowers  for which it was intended or play its market-stabilizing role, because it  might require FHA to charge insurance premiums that many borrowers  cannot afford or impose underwriting standards they cannot meet. The  tension between the financial and mission aspects of FHA’s goals and  requirements poses trade-offs that must be weighed by policymakers in  setting the MMI Fund’s capital requirement.

FHA Has Not Conducted Fund-Wide Stress Tests or Specified the Objectives of Its Tests

Stress testing practices for the MMI Fund are consistent with two of the  five elements in our stress testing framework—that stress testing  methods and results be transparent and stress testing scenarios capture  relevant risks. The stress testing practices are inconsistent with two other  elements—that the scope of testing includes entity-wide assessments  and that the specific objectives of the tests be defined. We were unable to  determine the consistency of MMI Fund stress testing practices with the  framework element that methods and scenarios be consistent with the  objectives of the tests because FHA has not defined specific objectives.  Table 4 summarizes our assessments.

Stress tests of the MMI Fund are consistent with the framework element  of transparency. Specifically, stress testing methods, scenarios, and  results should be specific and available for review. Actuarial reports on  the MMI Fund provide detailed information on the methodology and  results of fund stress tests. For example, the actuarial reports describe  the stress testing method of estimating economic values for the forward  mortgage and HECM portfolios using hypothetical scenarios based on  projected unemployment, house price appreciation, and interest rates.  The reports also describe sources for these projections, including  scenarios developed by Moody’s Analytics and generated by the actuarial  contractor through Monte Carlo simulation. In addition, for each variable,  the reports present graphics showing their projected paths under each  scenario over the stress period. Furthermore, for each scenario, the  reports provide quantitative results and an accompanying narrative  discussion highlighting key drivers of the results. The reports are publicly  available on HUD’s website.

Stress tests of the MMI Fund are consistent with the framework element  of capturing risks that are relevant to the entity. The stress scenarios  used in the actuarial reviews have incorporated risks the MMI Fund faces  by considering changes in economic conditions that would negatively  affect the fund’s cash flows and, by extension, the fund’s economic value.  More specifically, they include declines in house prices and rises in  unemployment, which can be expected to increase borrower defaults on  FHA-insured mortgages and increase the number and severity of  insurance claims FHA pays to lenders. In addition, the scenarios include  declines in interest rates, which can be expected to increase the number  of FHA-insured mortgages that are paid off before maturity—for example,  as borrowers refinance out of their FHA-insured mortgages into  conventional mortgages (those without government insurance or  guarantees)—thus reducing the amount of insurance premiums FHA  collects. To examine these risks, the stress scenarios in recent FHA  actuarial reviews have included substantial declines in a Federal Housing  Finance Agency national house price index, increases in unemployment  rates, and decreases in interest rates for 30-year home mortgages.

To provide additional perspective on the severity, duration, and timing of  scenarios used to stress test the MMI Fund, appendix III compares  selected MMI Fund stress scenarios to the severely adverse scenario  used by the Federal Reserve in conducting annual supervisory stress  tests of large banking organizations.

Stress tests of the MMI Fund are not consistent with the framework  element of including entity-wide assessments to provide a complete  picture of risk. Since fiscal year 2009, when the HECM portfolio was first  included in the MMI Fund, stress tests of the MMI Fund have analyzed  the forward mortgage and HECM portfolios separately, but not on a fund- wide basis. This practice partly reflects the way in which capital  assessments of the MMI Fund are performed—through separate  assessments of the forward mortgage and HECM portfolios. Additionally,  an FHA official said the agency has been reluctant to report combined  ratios for stress scenarios because the results could be misinterpreted  (for example, result in too much or too little confidence in the fund’s ability  to withstand stress) if the scenarios are not viewed in the proper historical  context. However, without the combined analysis, it is unclear what the  capital position of the MMI Fund as a whole would be under stressful  conditions. As a result, FHA and Congress may lack information that  could be useful in assessing risks to the MMI Fund, including  circumstances that could cause the fund’s capital ratio to fall below the  statutory minimum.

Stress testing of the MMI Fund is not consistent with the framework  element of defining the specific objectives of the tests. According to  guidance from federal banking regulators, large banking organizations  should indicate the specific purpose and focus of stress tests within a  framework that allows for consistent, repeatable exercises. Additionally,  this guidance and stress testing principles and practices from two  international financial organizations provide examples of stress testing  objectives such as informing assessment of vulnerabilities, contingency  planning, identifying and monitoring risk concentrations, and determining  the level of risk the entity is willing to accept (risk appetite).

The MMI Fund actuarial reviews have included the broad statement that  the stress tests performed as part of the reviews provide insights into the  sensitivity of the MMI Fund’s economic value under different economic  conditions. In addition, FHA has included some information from the  stress tests in recent annual reports to Congress to highlight different  points. However, FHA has not articulated specific objectives for the stress  tests, in part because a key use of the actuarial reviews is to help  determine the MMI Fund’s compliance with the capital requirement under  a baseline economic scenario (which, in recent actuarial reviews, has  been the Monte Carlo average). Accordingly, the types of information  FHA has reported to Congress have varied from year to year. For  example, in recent years, FHA’s reporting on stress test results has  ranged from no information (fiscal year 2016), to how much additional  capital the forward mortgage portfolio would need to withstand losses  comparable to the last economic crisis (fiscal year 2015), to the  probability that the economic value of the HECM portfolio would fall below  zero under deteriorating economic conditions (fiscal year 2013). Without  specific objectives for its stress testing, FHA has limited assurance that its  stress tests are targeted to risk-management needs and that its reporting  to Congress provides consistent information on the MMI Fund’s ability to  withstand adverse conditions.

Methods and Scenarios Consistent with Objectives

Because FHA has not defined specific objectives for MMI Fund stress  tests, we could not assess whether existing tests were consistent with the  framework element of using stress testing methods and scenarios that  are consistent with stated objectives. Entities should use stress testing  methods—such as conventional stress testing (which looks at the effect  of specified hypothetical or historical stress scenarios) or reverse stress  testing (which assumes a negative outcome and identifies scenarios that  would lead to that outcome)—that yield information responsive to the  objectives of the stress tests.

Actuarial reviews of the MMI Fund have used conventional stress testing  and a range of stress scenarios developed by Moody’s Analytics and  generated by Monte Carlo simulation. But, depending on how FHA  defines the specific objectives of the MMI Fund’s stress tests, other stress  testing methods or scenarios might provide useful information for risk  management. For example, if the objective of the stress testing was to  identify the conditions that might cause the MMI Fund’s capital ratio to fall  below 2 percent or require supplemental funding, reverse stress testing  would be an appropriate method. If the objective was to assess the MMI  Fund’s ability to withstand conditions similar to those of the Great  Depression or the 2007–2011 housing crisis, developing historical stress  scenarios would be appropriate. Additionally, if the objective was to  assess the effect of changes to a particular variable or input (as opposed  to a broader economic scenario), sensitivity stress tests would be  appropriate.

Joint Capital Assessment Has Advantages and Disadvantages

Advantages of Including Reverse Mortgages in the Fund’s Capital Requirement Include Greater Transparency

Beginning with the 2009 loan cohort, HERA placed new HECMs (FHA- insured reverse mortgages) in the MMI Fund, while previous HECMs  remained in the General and Special Risk Insurance Fund. When the  post-2008 HECM portfolio became part of the MMI Fund, it also was  included in the MMI Fund’s capital ratio assessment and became subject  to annual actuarial review requirements. These changes have had some  advantages. First, subjecting HECMs to the annual actuarial review  requirements has improved the transparency of the program’s financial  condition. For example, the actuarial reviews have included estimates of  the HECM portfolio’s economic value and performance under alternative  economic conditions, which were not available prior to 2009.

Second, jointly considering the forward mortgage and HECM portfolios in  the MMI Fund’s capital assessment mitigates the potential difficulty of  independently holding the HECM portfolio to a specified capital ratio. The  economic value of the HECM portfolio is more sensitive to changes in  economic conditions and inputs to the models than the forward mortgage  portfolio. As a result, the capital ratio for the HECM portfolio is more  volatile, and requiring HECMs to independently meet a capital ratio would  be difficult. Specifically, it could be difficult to manage HECM insurance  premiums, loan limits, and other program requirements to ensure that a  capital requirement is consistently met. Estimates of HECM capital ratios  under alternative economic scenarios from the fiscal year 2016 actuarial  review illustrate the sensitivity of this portfolio’s economic value—and  therefore its capital ratio—to changes in economic conditions (see fig.1).  While the capital ratio for forward mortgages ranged from negative 3.3  percent to positive 4.17 percent under all of the economic scenarios, the  corresponding range for HECMs was negative 38.74 percent to positive  3.07 percent.

Under the current approach of jointly considering the HECM and forward  mortgage portfolios in the capital assessment, both portfolios in  combination are subject to the capital requirement, but the volatility of the  HECM portfolio’s economic value is mitigated by the relative stability of  the forward mortgage portfolio. More specifically, because the forward  mortgage portfolio is substantially larger than the HECM portfolio (with the  HECM portfolio accounting for roughly 10 percent of the MMI Fund’s  insurance-in-force in fiscal year 2016), the combined capital ratio more  closely follows the generally less volatile capital ratio for forward  mortgages (see fig. 2). As a result, the combined capital ratio is less  uncertain than the HECM capital ratio, and managing the HECM portfolio  within that combined framework is more feasible than managing it to a  separate capital requirement.

Finally, another possible advantage of the joint assessment is some  degree of risk diversification. The cash inflows and outflows of the forward  mortgage and HECM portfolios do not necessarily rise and fall in tandem  in response to changes in macroeconomic conditions. For example, all  other things being equal, rising mortgage interest rates tend to increase  the economic value of the forward mortgage portfolio but tend to  decrease the economic value of the HECM portfolio. Because the cash  flows of the two portfolios are not fully correlated, the amount of capital  needed for the two portfolios in combination may be less than the sum of  the amount of capital needed for each portfolio separately.

Disadvantages of Including HECMs in the MMI Fund Include More Uncertainty about the MMI Fund’s Financial Condition

Joint assessment of the forward mortgage and HECM portfolios in  determining compliance with the capital requirement also has some  disadvantages. First, including HECMs in the MMI Fund can result in  more uncertainty about the Fund’s expected performance. As previously  discussed, the economic value of HECMs is more volatile and sensitive to  economic conditions than the economic value of forward mortgages. As a  result, estimates of the MMI Fund’s economic value and capital ratio and  its potential performance under alternative economic scenarios are less  predictable and more difficult to interpret with the inclusion of HECMs.

Although the combined capital ratio generally tracks with the forward  mortgage capital ratio, the inclusion of HECMs in the assessment can  affect the combined capital ratio. For example, in fiscal year 2015, a high  HECM capital ratio (6.44 percent) pulled the combined capital ratio above  2 percent (2.07 percent), even though the forward mortgage capital ratio  was below 2 percent (1.63 percent). In this case, the inclusion of the  HECM portfolio in the capital ratio resulted in the MMI Fund meeting the 2  percent capital requirement for the first time in 6 years. In its fiscal year  2014 report to Congress, FHA concluded that the HECM portfolio was  over 10 times more volatile than the forward mortgage portfolio, noting  that small changes to the HECM program can affect the overall value of  the MMI Fund. Further, in its fiscal year 2015 report to Congress, FHA  noted that because the HECM portfolio is projected to continue growing at  a faster rate than the forward portfolio, year-to-year HECM volatility is  likely to contribute more uncertainty to future actuarial valuations of the  MMI Fund. In recent years, HECMs have accounted for an increasing percentage of the MMI Fund’s insurance-in-force, rising from 4.01 percent  in fiscal year 2009 to 9.42 percent in fiscal year 2016.

Second, relying on a combined capital ratio to assess the MMI Fund’s  compliance with the capital requirement could mask the financial  condition of the individual portfolios. Information on the performance of  each portfolio is available in separate actuarial reports, but differences  between the financial health of the two portfolios may be overlooked  because compliance with the 2 percent capital requirement is determined  by the combined capital ratio. For example, in fiscal year 2013, the  combined capital ratio was below 2 percent (negative 0.11 percent), while  the HECM capital ratio was 7.50 percent. In contrast, in fiscal year 2016,  the combined ratio was above 2 percent (2.32 percent), while the HECM  capital ratio was below 2 percent (negative 6.90 percent). In those years,  the substantial difference between the financial condition of the HECM  portfolio and the overall MMI Fund would not have been evident from the  combined capital ratio.

Even in years when the capital ratios of both the forward mortgage and  HECM portfolios are above or below the 2 percent level, the combined  capital ratio may still hide important differences between the two. For  example, in fiscal year 2014, the capital ratios for both the forward  mortgage and HECM portfolios were below 2 percent. However, the  forward mortgage capital ratio was positive (0.56 percent), while the  HECM capital ratio was negative (-1.20 percent). This difference may be  important to policymakers because a positive capital ratio indicates that  the portfolio has some capital cushion to absorb unexpected losses, even  if it is small. In contrast, a negative ratio suggests the portfolio may not  have sufficient capital to independently cover all expected net losses on  outstanding insurance, and may essentially be financially supported by  the other portfolio in the MMI Fund.

Finally, in certain circumstances, the joint capital assessment could  create pressure to raise insurance premiums or tighten underwriting  standards in one program to compensate for the weaker financial  performance of another program. For example, if the forward mortgage  capital ratio were above 2 percent, but the HECM capital ratio pulled the  combined ratio below 2 percent, raising insurance premium rates for  forward mortgages could be the quickest way to regain a 2 percent capital  ratio. In this example, a portion of the premiums paid by the forward  mortgage borrower would essentially support the HECM program. While  this situation would benefit HECM borrowers (because their insurance  premiums would not increase), it would potentially create a burden for  forward mortgage borrowers and could reduce the number of prospective  borrowers who are able to afford FHA mortgage insurance. However, as  of September 2017, FHA officials said that the agency had not increased  forward mortgage premiums to support the HECM program or vice versa.

Alternative Approaches to Managing the HECM Program and Assessing the Capital Requirement Pose Trade-offs

Alternatives to the MMI Fund’s joint capital assessment could address  some of the disadvantages of this approach but would also involve  potential trade-offs between mission, financial soundness, and  transparency goals. Policy decisions about these trade-offs could have  significant implications for the management of FHA’s programs and for  potential FHA borrowers.

If Congress wishes to place additional emphasis on the financial self- sufficiency of the HECM program, it may be appropriate to hold the  HECM portfolio to a capital requirement separate from that of forward  mortgages. Under this option, future HECMs could either remain in the  MMI Fund or be placed under a different insurance fund. The capital  requirement could be set at the same congressionally defined level as the  one for forward mortgages, or it could be tailored to the risks and volatility  of the HECM portfolio. A separate HECM capital requirement would help  ensure that the forward mortgage portfolio is not supporting the HECM  portfolio, or vice versa. Decisions about premiums and other program  requirements could be based solely on each portfolio’s financial condition  and would not be influenced by a need to keep a combined capital ratio  sufficiently high.

In addition, a separate HECM capital requirement would help ensure that  for future loan cohorts, the financial conditions of the individual portfolios  are not masked by a combined capital ratio. However, if the HECM  portfolio was required to independently meet a minimum capital ratio, the  volatility of the portfolio’s economic value could make it difficult for FHA to  consistently meet the requirement without targeting a capital level  substantially above the minimum requirement. Doing so may require FHA  to raise insurance premiums or place greater restrictions on the amount  seniors can borrow, which would limit the program’s ability to serve its  goal of alleviating economic hardship.

In comparison, if Congress wishes to place greater emphasis on  maximizing the benefits of the HECM program for seniors, another option  may be to exempt the HECM portfolio from a capital requirement. Under  this option, future HECMs would not be part of the MMI Fund and would  not be subject to the MMI Fund’s capital requirement. As with a separate  HECM capital requirement, this option would help ensure that the  financial condition of future loan cohorts in the forward mortgage portfolio  is not masked by a combined capital ratio. But, the financial condition of  the HECM portfolio would not be as transparent, unless FHA continued to  conduct HECM actuarial assessments. In addition, FHA could set  premiums and program limits without consideration for building a capital  buffer, which might decrease the likelihood that the HECM program would  operate on at least a break-even basis over the long run. Some industry  participants we spoke with did not think that HECMs should be exempted  from a capital requirement, noting that the increased transparency and  accountability of HECMs were important. However, even without a capital  requirement, FHA could choose to continue conducting actuarial  assessments of the HECM program for continued transparency.

The programs FHA administers under its MMI Fund play an important role  in the mortgage market by expanding homeownership opportunities and  helping stabilize housing markets during economic downturns. However,  the MMI Fund’s financial challenges in the wake of the 2007–2011  housing crisis illustrate the fund’s vulnerability to severely adverse  economic conditions and underscore the importance of capital  requirements and stress testing practices for this $1.2 trillion mortgage  insurance portfolio. Opportunities exist to strengthen these requirements  and practices by making them more consistent with those used by  financial institutions and regulators, as reflected in our two evaluative  frameworks.

As we concluded in our September 2013 report, and consistent with the  capital requirements framework in this report, including accountability  mechanisms in FHA’s capital requirement could enhance management  and oversight of the MMI Fund. Therefore, as we suggested in our 2013  report, we maintain that Congress should consider requiring FHA to  submit a capital restoration plan and regular updates on plan  implementation whenever the fund’s capital ratio falls below the required  level. In our current review, we identified three additional areas where  the capital requirement and stress testing practices for the MMI Fund  could be strengthened in accordance with our frameworks. Specifically,  the statutory 2 percent capital requirement does not specify the economic  conditions the fund would be expected to withstand. As a result, it may  not provide an adequate financial cushion under scenarios in which  Congress may anticipate that the fund would be self-sufficient. In addition,  FHA has not analyzed or reported stress test results on a fund-wide  basis, making it unclear what the capital position of the fund as a whole  would be under stressful conditions. Finally, FHA has not defined the  specific objectives of the fund’s stress tests and therefore has limited  assurance that its stress testing methods and scenarios are targeted to  risk-management needs.

Congress should consider amending the National Housing Act to specify  the economic conditions the MMI Fund would be expected to withstand  without substantial risk of drawing on permanent and indefinite budget  authority, and require FHA to specify and comply with a capital ratio  consistent with these conditions. In specifying the economic conditions,  Congress should take into account FHA’s statutory operational goals and  role in supporting the mortgage market during periods of economic stress.  (Matter for Consideration 1)

We are making the following two recommendations to FHA:  The Commissioner of FHA should combine stress test results for the  forward mortgage and HECM portfolios, where possible, and report  estimated MMI Fund-wide capital ratios for the stress scenarios  examined. (Recommendation 1)

The Commissioner of FHA should develop specific objectives for stress  tests of the MMI Fund and apply stress testing methods and scenarios  consistent with those objectives. (Recommendation 2)

We provided a draft of this report to HUD, the Federal Reserve, and  FHFA for their review and comment. The Federal Reserve and FHFA had  no comments. In its comments, reproduced in appendix IV, HUD agreed  with our recommendations. HUD said that FHA’s forthcoming annual  actuarial reports and report to Congress on the MMI Fund would include  stress test results for forward mortgages and HECMs, but HUD did not  state whether the reports would address our recommendations. By  analyzing and reporting stress test results on a fund-wide basis and  defining the specific objectives of its stress tests, FHA would better  understand the capital position of the MMI Fund as a whole under  stressful conditions and have greater assurance that its stress testing  methods and scenarios are targeted to risk-management needs.

HUD also said it was important to recognize the trade-offs between FHA’s  mission and insurance policy holders when considering financial  soundness. HUD said it appreciated our report’s statement that minimum  capital requirements that are too high may limit FHA’s ability to serve its  mission and market role and recommended that we make this statement  more prominent. While our report does contain that statement, it also  states that a minimum capital requirement that is too low may result in  FHA taking on too much risk and having an insufficient capital buffer to  withstand an economic downturn without requiring supplemental funding.  Accordingly, we added language to the introduction of the report noting  the challenge FHA and Congress face in balancing the fund’s financial  self-sufficiency with FHA’s role in facilitating mortgage credit to  underserved borrowers and stabilizing the housing market during  economic downturns.

As agreed with your offices, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies to the appropriate  congressional committees, the Secretary of Housing and Urban  Development, the Chair of the Board of Governors of the Federal  Reserve System, the Director of the Federal Housing Finance Agency,  and other interested parties. In addition, the report will be available at no  charge on the GAO website at http://www.gao.gov.

If you or your staff have any questions about this report, please contact  me at (202) 512-8678 or garciadiazd@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on  the last page of this report. GAO staff who made key contributions to this  report are listed in appendix V.

Appendix I: Objectives, Scope, and Methodology

Our objectives were to examine (1) the types of information actuarial  reviews and other assessments provide about the Mutual Mortgage  Insurance Fund’s (MMI Fund) financial condition, including its ability to  remain self-sufficient; (2) the extent to which the capital requirement and  stress testing practices for the MMI Fund are consistent with principles  and practices underlying those of other financial institutions; and (3) key  advantages and disadvantages of including both forward and Home  Equity Conversion Mortgages (HECM) in the MMI Fund’s capital  assessment.

Information Provided by Reviews of the MMI Fund

To examine the types of information actuarial reviews and other  assessments provide about the MMI Fund’s financial condition, including  its ability to remain self-sufficient, we reviewed actuarial reports of the  fund prepared by a Federal Housing Administration (FHA) contractor and  related FHA reports to Congress. We focused on reports for fiscal year  2009 (the first year HECMs were part of the MMI Fund) through fiscal  year 2016 (the most recently completed report). Additionally, we reviewed  FHA budget and financial documents containing assessments of the fund.  Specifically, we reviewed the Department of Housing and Urban  Development (HUD) appendix from the President’s budgets for fiscal year  2011 through fiscal year 2018 (the most recent available) and FHA’s  audited financial statements for fiscal year 2011 through fiscal year 2016  (the most recent available). We also reviewed FHA documents and prior  GAO reports describing the mechanisms used to provide supplemental  resources to the fund, if necessary.

We determined the extent to which the actuarial, budgetary, and financial  accounting reviews contained information pertinent to assessing the MMI  Fund’s financial condition, such as the amount of funds needed and  available to cover expected net future costs on outstanding insurance, the  amount of funds available to cover unexpected losses, and the projected  performance of the MMI Fund under alternative economic scenarios. We  compared the types of information available in the actuarial reviews with  the types of information in the budgetary and financial accounting reviews  of the fund, as well as in FHA’s quarterly reports to Congress, focusing on  information that could help inform whether the MMI Fund is likely to  remain self-sufficient. Additionally, we interviewed FHA headquarters  officials about the content and interpretation of the various reviews of the  fund.

To illustrate the similarities and differences between the MMI Fund’s  actuarial and budgetary reviews, we summarized information about the  two reviews, including their purposes and the sources of their  requirements (see app. II). In addition, we reviewed recent actuarial  reports and HUD budget appendixes and spoke with FHA officials to  understand their similarities and differences. We developed a hypothetical  illustration of how certain components of the budgetary review are used in  the actuarial review.

To assess the extent to which the MMI Fund’s capital requirement and  FHA’s stress testing approach are consistent with principles underlying  such requirements for other financial institutions, we developed two  evaluative frameworks and assessed requirements and practices for the  MMI Fund against them. For the capital requirements framework, we  reviewed publicly available documents on requirements and capital  assessment practices from financial regulators and institutions, including  the Bank for International Settlements, Fannie Mae and Freddie Mac  (specifically, their capital requirements for private mortgage insurers), the  Federal Deposit Insurance Corporation, and the Federal Housing Finance  Agency (FHFA). For the stress testing framework, we reviewed articles on  principles and practices from financial regulators and institutions,  including the Bank for International Settlements, the Board of Governors  of the Federal Reserve System (Federal Reserve), and the International  Monetary Fund. We included in our frameworks key common elements in  designing capital requirements and stress tests that could apply to the  MMI Fund, assuming the fund would continue to operate under federal  accounting standards and budgeting requirements.

In addition to FHA, we shared the draft frameworks with FHFA, the  National Association of Insurance Commissioners, and the American  Academy of Actuaries and interviewed officials from these organizations  to obtain their input on the frameworks. We chose these organizations  based on their expertise in financial assessments of housing finance and  mortgage insurance institutions. We then reviewed publicly available  reports and documents, including relevant statutory provisions and FHA’s  annual actuarial reviews and reports to Congress, to assess whether the  requirements and practices of the MMI Fund were consistent with our  framework elements.

To provide additional perspective on stress tests of the MMI Fund, we  compared variables in selected economic scenarios from the fiscal year  2016 actuarial review of FHA’s forward mortgage portfolio with  corresponding variables in one of the scenarios used by the Federal  Reserve in its 2016 supervisory stress tests of large banking  organizations (see app. III). Specifically, we graphed the projected paths  of the house price index, 30-year fixed mortgage rate, and unemployment  rate for the two most stressful MMI Fund scenarios—the Monte Carlo  simulation path producing the lowest economic value for forward  mortgages and the Moody’s Analytics’ protracted slump scenario—and  the Federal Reserve’s severely adverse scenario. We chose to highlight  the worst simulation path and the Moody’s Analytics protracted slump  scenarios because they are generally the two most severe scenarios  used in stress tests of the MMI Fund. The Federal Reserve’s severely  adverse scenario was the most analogous to the two MMI Fund scenarios  and has been referenced in Fannie Mae’s and Freddie Mac’s financial  requirements for private mortgage insurers. We analyzed the similarities  and differences in the severity, duration, and timing of the three variables  discussed above. To assess the reliability of FHA’s data on its stress  scenarios, we compared the data we received from the agency with  published information in FHA’s actuarial reviews. We determined the data  were sufficiently reliable for the purposes of illustrating similarities and  differences with the Federal Reserve’s severely adverse scenario.

Consideration of Forward Mortgages and HECMs in Capital Assessment

To identify key advantages and disadvantages of including both forward  mortgages and HECMs in the MMI Fund’s capital assessment, we  reviewed actuarial results for both portfolios from fiscal year 2009 through  fiscal year 2016. Using information from the actuarial reviews, we  calculated and compared the separate and combined capital ratios for  forward mortgages and HECMs to determine the effect of including the  reverse mortgage portfolio in the MMI Fund capital calculation, as well as  the potential effects of holding the HECM portfolio to a separate capital  requirement. We also reviewed discussions in FHA’s annual reports to  Congress describing the effect of including the forward mortgage and  HECM portfolios in the same fund. In addition, we interviewed FHA  officials and other industry participants and stakeholders, including the  National Reverse Mortgage Lenders Association, Mortgage Bankers  Association, U.S. Mortgage Insurers, American Bankers Association, and  the American Association of Retired Persons, about the advantages and  disadvantages of jointly considering both portfolios in assessing the MMI  Fund’s capital ratio as well as of alternative approaches.

We conducted this performance audit from August 2016 to November  2017 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.

Appendix II: Mutual Mortgage Insurance Fund Budgetary and Actuarial Reviews

The budgetary and actuarial reviews of the Mutual Mortgage Insurance  Fund (MMI Fund) serve different purposes, stem from different  requirements, and are conducted by different entities. See table 5 for a  summary of these two reviews of the fund.

However, the two reviews share some concepts and numbers. For  example, the actuarial analysis of the MMI Fund’s economic value  includes an existing capital resources component, which can be  calculated from information on assets and liabilities presented in the  budgetary review. In addition, both reviews include a calculation of the  present value of future cash flows on outstanding insurance, though the  two reviews use different models and economic assumptions to perform  these calculations. Both reviews also provide estimates of the amount of resources the MMI Fund has, in excess of what is needed to cover  estimated credit subsidy costs (that is, the net present value of expected  future cash flows on outstanding insurance). Figure 3 provides a  simplified, hypothetical illustration of the relationship between the MMI  Fund’s budgetary and actuarial reviews.

Appendix III: Comparison of Economic Scenarios Used in Mutual Mortgage Insurance Fund and Federal Reserve Supervisory Stress Tests

We compared selected economic scenarios used in stress tests of the  Federal Housing Administration’s (FHA) Mutual Mortgage Insurance Fund  (MMI Fund) with the severely adverse scenario developed by the Board  of Governors of the Federal Reserve System (Federal Reserve) for its  supervisory stress tests of large banking institutions. (Under the direction  of the Federal Housing Finance Agency, the housing enterprises Fannie  Mae and Freddie Mac incorporated the Federal Reserve scenario into  financial criteria that private mortgage insurance companies must meet to  be an approved insurer of mortgages acquired by the housing  enterprises.) Our analysis focused on scenarios used in the fiscal year  2016 actuarial review of the MMI Fund’s forward mortgage portfolio (the  most recently completed review) and the Federal Reserve’s 2016  supervisory stress tests, because these scenarios all used projections of  economic variables beginning in calendar year 2016. We examined  similarities and differences in the severity, duration, and timing of these  scenarios’ projections of three variables most pertinent to the MMI Fund’s  economic value: single-family home prices, 30-year fixed mortgage  interest rates, and unemployment rates. These comparisons should be  treated as illustrative because the MMI Fund and Federal Reserve stress  tests have different intended uses and time horizons. For example, the  Federal Reserve stress scenarios last 3 years and one quarter, whereas  the MMI Fund scenarios last nearly 12 years. In addition, because both  the MMI Fund and Federal Reserve stress scenarios change from year to  year, the similarities and differences we discuss are not representative of  those that might be observed for other time periods.

The following analysis compares the projected quarterly paths of the  three variables under two economic scenarios used in stress tests of  FHA’s forward mortgage portfolio—the Monte Carlo simulation path  producing the lowest economic value for forward mortgages (MMI Fund  worst simulation path) and the modified Moody’s Analytics protracted  slump scenario (MMI Fund protracted slump)—with the projected paths of  the variables under the Federal Reserve’s severely adverse scenario.  We chose to highlight these MMI Fund stress scenarios because they  generally have been the two most adverse scenarios considered in the  actuarial reviews and are therefore the most analogous to the Federal  Reserve’s severely adverse scenario. The projections for the MMI Fund  scenarios and the Federal Reserve scenario start 6 months apart (third  quarter and first quarter of calendar year 2016, respectively). We treated  the starting quarter of each scenario as the first quarter of the  comparative analysis.

As shown in figure 4, the MMI Fund and Federal Reserve scenarios differ  in terms of the severity, duration, and timing of projected changes in  house prices (as measured by house price indexes). All other things  being equal, falling house prices negatively affect the MMI Fund because  they increase the number of mortgage foreclosures and the severity of  insurance losses on those foreclosures. The MMI Fund protracted slump  and Federal Reserve severely adverse scenarios assume similar sharp  declines in house prices during the first 2 years—about negative 20  percent and negative 23 percent, respectively. However, under the MMI  Fund protracted slump scenario, house prices begin to recover in the third  year and rise steadily thereafter, ending 15 percent higher than they were  at the start of the scenario. In contrast, under the Federal Reserve  scenario, house prices decline about an additional 2 percentage points,  then recover slightly before the scenario ends in the fourth year.

The MMI Fund worst simulation path features a substantially different  house price path than the other two scenarios. It shows a small initial  increase in house prices over the first 2 years, before projecting an  extended 6-year decline, resulting in a peak-to-trough drop of about 18  percent. Thereafter, house prices recover somewhat, but end up about 10  percent below their level at the start of the scenario.

The projected path of 30-year fixed mortgage interest rates also differs  among the three stress scenarios. Changes in mortgage interest rates  can have varying effects on the MMI Fund. On the one hand, lower  interest rates can negatively affect the fund by incentivizing borrowers to  prepay their mortgages (for example, through refinancing), which reduces  the fund’s income from insurance premiums. On the other hand, if  coupled with conditions that increase foreclosure risk (such as low house  price growth), higher interest rates can negatively affect the fund by  reducing prepayments, resulting in more mortgages remaining in the fund  that could lead to foreclosures and insurance claims.

As shown in figure 5, the three scenarios exhibit differences in the  severity and timing of interest rate changes and the overall volatility of the  interest rate path. The mortgage interest rate under the Federal  Reserve’s severely adverse scenario increases by about 1 percentage  point over the first year, then essentially levels off through the end of the  scenario in the fourth year. In contrast, the MMI Fund protracted slump  scenario projects an initial 1.5 percentage point decline in the interest rate  over about the first 2 years, followed by an extended increase that leaves  the interest rate almost 2 percentage points higher at the end of the 12- year scenario than it was at the start. The MMI Fund worst simulation  path features the most dramatic interest rate changes of the three  scenarios. It begins with a sharp increase of more than 3.5 percentage  points over about the first 2 years, then assumes several up and down  spikes over about the next 10 years, before ending with an interest rate  about 3 percentage points higher than it was at the start of the scenario.

As shown in figure 6, all three scenarios feature a steep increase and  subsequent decline in the unemployment rate, but the timing and duration  of the changes differ. All other things being equal, increases in the  unemployment rate adversely affect the MMI Fund because of the  negative effect that job loss has on a borrower’s ability to make monthly  mortgage payments and avoid foreclosure. The unemployment rate under  the Federal Reserve severely adverse scenario and the MMI Fund  protracted slump scenario follows similar paths. Both start with nearly  identical increases of about 4 percentage points within the first 2 years,  followed by declines of roughly 1 percentage point over the subsequent  six quarters, at which juncture the Federal Reserve scenario ends. In the  longer MMI Fund protracted slump scenario, the unemployment rate  continues to fall gradually through the 12th year, ending about 1  percentage point lower than it was at the beginning of the scenario. In  contrast, the MMI Fund worst simulation path features a more gradual  and less even increase in the unemployment rate—about a 3.25  percentage point rise over about the first 5 years. The unemployment rate  then slides below the starting level by year 10, before rebounding past the  starting level by the end of the scenario.

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

Appendix V: GAO Contact and Staff Acknowledgments

In addition to the contact named above, Steven Westley (Assistant  Director), Winnie Tsen (Analyst in Charge), Stephen Brown, Marcia  Carlsen, William Chatlos, Robert Dacey, Emei Li, John McGrail, Angela  Pun, Jennifer Schwartz, Jena Sinkfield, and Frank Todisco made key  contributions to this report.