All of us feel strongly about the need for a strong, viable FHA, in fact, less than a year ago, the Department appeared before this subcommittee and also its Senate counterpart to discuss the results of a comprehensive analysis of the Mutual Mortgage Insurance Fund that was conducted at Secretary Kemp's direction by the accounting firm of Price Waterhouse. That report presented the first true picture of the actuarial soundness of the MMI Fund. That is important to keep in mind, because we had snapshots of cash transaction, but none of those really gave a picture of the financial health of the Fund. Indeed, the Fund had not been able to be audited since sometime at the end of the Carter administration when the GAO conducted its last audit.

Another attempt in 1981 was abandoned as I recall, and a scheduled audit for 1984 could not even be carried out. So this report by Price Waterhouse does in fact contain the first true picture of the actuarial soundness of the Mutual Mortgage Insurance Fund. And while the report showed that the MMI Fund was solvent, it revealed that the Fund was not actuarially sound and that it faced a serious threat of insolvency in the future. Price Waterhouse observed that the Fund's net worth had been declining for a decade at an alarming rate, and that the FHA would soon have a negative net worth unless strong corrective actions were taken.

In response to the Price Waterhouse study, the administration recommended a program of FHA reform based on four fundamental principles: achieving and maintaining adequate capital levels; requiring that insurance premiums be risk-related, with higher premiums for lower downpayments; requiring that FHA borrowers have a real equity interest in their homes; and continuing the focus of FHA on meeting the mortgage credit needs of low and moderate income borrowers.

On behalf of Secretary Kemp, I want to thank you, Mr. Chairman, and the other members of this subcommittee who contributed to the successful enactment of an FHA reform package that meets these four fundamental requirements for actuarial soundness. It wasn't easy, and preserving the Fund required some very tough decisions.

Mr. Chairman, since the FHA reforms were signed into law late last year, the Department has been in the process of drafting implementing regulations that are consistent with the intent of Congress and our understanding of the underlying agreements reached during the House-Senate conference last year.

At your request, my testimony today will provide the subcommittee a current performance report for the MMI Fund, and a status report on 1990 FHA reform implementation. The most recent data on the condition of the Fund indicates that the reforms enacted last year were both prudent and responsible, and that lesser actions would have failed to achieve actuarial soundness as prescribed by Price Waterhouse and embodied in the administration proposal.

As part of his effort to reform and improve the financial management of HUD, Secretary Kemp almost 2 years ago informed this subcommittee that the Department would publish annually, through an independent accounting firm, audited financial statements for FHA. Price Waterhouse has now completed its audit of

the 1989 financial results of the FHA. This audit reflected a net loss for FHA as a whole for the year of $3.9 billion, as compared to an overall $4.2 billion loss in fiscal year 1988. Specifically, the MMI Fund sustained a $617 million loss for 1989 compared to a $1.4 billion loss in fiscal year 1988. Although these figures reflect a slower rate of losses, stabilization of FHAS financial position has by no means been achieved.

As of September 30, 1989, FHAS overall liabilities were $18.9 billion, compared to assets of $12.3 billion, resulting in an overall deficiency of $6.6 billion. The equity of the MMI Fund is a positive $1.02 billion, down from $1.8 billion the previous year. The report of the accountants paints a pessimistic picture of the current state of the MMI Fund:

"The FHAS Mutual Mortgage Insurance, MMI, Fund's equity of $1 billion in relation to the risk inherent in its insurance-in-force of $251.5 billion is currently not sufficient to protect against adverse economic conditions. We are thus unable to conclude that MMI is being operated in accord with 'sound actuarial and accounting practice, which by law, it is required to do...the MMI Fund does not yet meet the capital requirements mandated by the National Affordable Housing Act, and the effect an economic downturn could have on the MMI Fund's financial position and the results of operations, which could be material is unknown."

Although it is apparent from the Price Waterhouse audit that the financial status of the Fund needs improvement, some observers have used FHAS Cash Reports as a basis for contending that the Fund is on sound footing. This is a miserable mistake, akin to someone who deposits his pay check in his checking account and writes his checks right up to the amount of that check then mails those checks to pay the bills and immediately goes over to one of those automatic teller machines and sticks his card in and says look at this, I paid all my bills and yet I still have my original balance. It is a terrible mistake to misread those forms, but that is what some critics are doing. While the MMI Fund sustained an over $600 million loss in 1989, there was an excess in receipts over cash disbursements of $7 million in the same period. So we lost $600 million, but it appears through the mirrors and the smoke that there was $7 million more. Mr. Chairman, the problem is that these cash reports present only a static and one-dimensional picture of the Fund's activity; they do not provide the basis for longterm fiscal management. Looking only at the current cash position fails to account for significant real and contingent liabilities the Fund has incurred-liabilities that will not be paid out until some date in the future. Just as in my example, Generally Accepted Accounting Principles, GAAP, require that these accrued liabilities be considered when analyzing the financial condition of the Fund. Claims incurred against the Fund will in some cases not be paid for up to a year after delinquency, further depleting the MMI Fund and impairing the Fund's position. Proper accounting and analysis required by GAAP leads us to the more prudent conclusion that implementation of the additional premium and the other reforms enacted last year is required to achieve MMI recovery. Even with these reforms, the recovery will not likely be achieved until the mid-1990's.

Mr. Chairman, even if one were to take some small comfort in the positive cash-flow statements, it would not constitute grounds for backtracking on the important reforms that were enacted in cooperation between Congress and the administration last year. The reforms we proposed last year were intended to address not shortterm trends, but long-standing problems that go to the heart of the stability and actuarial soundness of the Fund. The reforms were based on a realistic assessment of what was required, over the long term, to strengthen FHA and make it better able to serve first time home buyers.

In order to protect the Fund against future losses resulting from periods of unpredictable economic fluctuations and unanticipated program losses, the National Affordable Housing Act mandated that the MMI Fund attain a capital ratio of not less than 1.25 percent within 24 months after the date of enactment-at the end of fiscal year 1992. The 1990 reforms were, of course, designed to allow the Fund to meet this deadline, building the needed capital to ensure the Fund's solvency. We are nowhere near that capital level today, and we will not meet it without those reforms. In short, Mr. Chairman, although the statute provides HUD significant flexibility to vary premiums and other program requirements to adjust to economic conditions that are either more adverse or more favorable than those currently forecast, we will not consider such steps until the Fund achieves, at the very minimum, the capital standard mandated in the law.

FHA is the largest mortgage insurance operation in the country with over $350 billion in potential liability. Reducing the likelihood of mortgage defaults is essential to build needed capital, thereby stemming the outflow of claims payments.

Through its analysis of claims payments, Price Waterhouse found that homeowners with little home equity were much more likely to default on their mortgages. This is consistent with every serious analysis of mortgage defaults-conventional or FHA. À high initial loan-to-value mortgage is more likely to default. The 1990 FHA reforms provide for home buyers to contribute more upfront cash. The statute limits an FHA-insured mortgage to a principal obligation of no more than 98.75 percent of the appraised value of the property, or 97.75 percent in the case of a mortgage with an appraised value in excess of $50,000.

Historically, the Department permitted mortgagors to finance 100 percent of closing costs in the insured mortgage. The Price Waterhouse analysis of the agreement reached last year by House and Senate conferees on the National Affordable Housing Act assumed that no more than 57.25 percent of closing costs would be financed as part of an insured mortgage, thereby reducing the likelihood of an excessive mortgage balance in comparison to the actual home value. Consistent with HUD's understanding of the conference action, as conveyed previously in letters from Secretary Kemp to Chairman Gonzalez and Congressman Wylie, the Department is in the process of issuing regulations to limit to 57 percent the financing of "allowable costs". This interim rule has been transmitted to Congress for prepublication review. The 57 percent limit will be applicable to all allowable closing costs, regardless of who pays them, including the seller, or any other third party.

Without the 57 percent cap, the Department cannot be assured of reaching the goals set for actuarial soundness of the Fund.

On January 10, 1991, FHA issued Mortgagee Letter 91-1 which implemented the 1990 FHA reform provisions, with the exception of the restriction on the amount of closing costs that can be financed and the restructuring of the Mortgage Insurance Premium, MIP. These two regulations have been cleared by the Department. I have already alluded to the equity rule, which is designed to reduce the risks to the MMI Fund by increasing homeowner's equity and reducing the default rate. The MIP Rule, which provides for a structure of mortgage insurance premiums based on risk, is currently with Congress for review. After completion of congressional review, this interim rule will be published in the Federal Register. This rule provides for the monthly collection of the riskbased portion of the insurance premium. HUD is currently modifying its processing systems in preparation for the commencement of this new collection procedure expected in August 1991.

Mr. Chairman, both the equity rule and the MIP rule have been developed to be consistent with the analysis conducted by Price Waterhouse last year, with the scenarios that Congress considered during its deliberations, and with the solutions the conference committee adopted last fall.

With the implementation of these two essential provisions, and the continuation of internal reform efforts, I am confident that HUD will be well on its way towards stabilizing the FHA Fund and establishing a cushion of capital needed to ensure that FHA never becomes a burden on the American taxpayer.

Mr. Chairman, President Bush's and Secretary Kemp's single most important goal for HUD is to expand homeownership opportunities for low- and moderate- income American families. HUD estimates that the increased cash requirements will mean that 20,000 borrowers will delay closing a home purchase each year. These families will not be "shut out" of homeownership opportunities but will defer their purchase of a home until they can save the amount needed to make a home purchase.

The task of balancing the need for prudent fiscal reform with the responsibility of carrying out our housing mission is often difficult to achieve but, I can assure you, we remain dedicated to both our mandate of ensuring that the MMI Fund is operated in a sound, fiscally prudent manner, and our goal of expanding homeownership opportunities for low and moderate income American families. But, Mr. Chairman, we recognize that we do home buying families no favor if we allow them to assume an obligation on which they are likely to default.

The National Affordable Housing Act will facilitate our efforts to restore the actuarial soundness of the FHA Fund through the implementation of provisions such as the restriction on closing costs and the provision for risk-based premiums, among others, designed to build financial stability into FHAS programs and activities.

The Price Waterhouse actuarial analysis completed last year also made it clear that poor management and lax monitoring were two major causes for the losses suffered by FHA in the 1980's. Therefore, in addition to the FHA reforms contained in the National Affordable Housing Act, the Department has begun to implement

various FHA reforms provided under the HUD Reform Act of 1989, as well as other management efforts to improve internal controls and enhance operations. These management reforms, while not alone sufficient to restore FHA to actuarial soundness, will, in combination with the 1990 reforms, begin to reverse the steady erosion of FHAS capital base that had been occurring in recent years. Implementation of the 1990 FHA reforms contained in the National Affordable Housing Act will permit us to build the needed capital to ensure the Fund's solvency during periods of unpredictable economic fluctuations and unanticipated program losses.

Last year, Secretary Kemp stated that "we will not rest until FHA is made sound and solid and able to serve the American public for the 1990's." We stand firm behind this commitment. We appreciate the support we received from Congress last year, and look forward to working with the members of this subcommittee on future initiatives designed to ensure that FHA continues to meet its historic mission to provide affordable homeownership opportunities for low and moderate income American families.

Thank you, Mr. Chairman. I will be pleased to answer any of your questions, as will Dr. Weicher and Mr. Hill.

Chairman GONZALEZ. Well, thank you.

[The prepared statement of Alfred A. DelliBovi can be found in the appendix.]

Chairman GONZALEZ. As we were opening the hearing, Mr. Hill presented me with this Price Waterhouse FHA report, from 1989, and he said it is fresh off the press. But I notice that it is dated December 20, 1990. How come we got it now and not soon thereafter? I mean how fresh off the press can that be?

Mr. DELLIBOVI. Mr. Chairman, first of all let me say, this is the first FHA report that has been issued in anyone's memory. Though it was required to be prepared by March 1st, it contains a number of documents which were not completed by that deadline. While some parts were prepared earlier, the entire report was not prepared and did not come off the presses until this week.

I will let Mr. Hill comment specifically on the Price Waterhouse letter, which was prepared December 20. But let me point out, this is the FHAS annual report. The first one in recent memory. We regret that it is the 1989 report. But please do not hold us responsible for the fact that when Secretary Kemp and I and Mr. Hill and John Weicher got to HUD, things, as you well know, were not exactly hunky-dory. This Department had not been run in such a way-and frankly, I am pleased that we could get a report out in 2 years, considering they had never gotten one out before.

Art may want to comment specifically on the fact that the Price Waterhouse letter is dated December, and that is one item in the report.

Mr. HILL. That is right, Mr. Deputy Secretary.

The delay was due to the fact, Mr. Chairman, that as a part of the reform, we were required to have our chief financial officer in place. We didn't get him on board until the first of the year.

The Secretary is required to sign off and authenticate that this truly reflects the annual position of the FHA Fund itself and related activities. The chief financial officer did not come on board until the beginning of 1991, and and needed time to review the audit. We