tion.

Mr. Hale. What this is, it provides information on the unpaid
principal balances of mortgages.

Mr. Shays. I understand what that does, right. But what I want-
ed to ask next is that the unpaid ā€” I just want to have you be clear
with me and for me to clearly understand: The HUD held, was that
insured but then HUD picked up?

Mr. Hale. It was defaulted and assigned to HUD; yes, sir.

Mr. Shays. So we are looking at a total of either insured or
HUD-held of 967,000 units. The unpaid principal on that is $17.8
bilhon and $2 bilHon, $2 billion HUD held, for $19.8.

What is the value of these units? In other words, I have no sense
of whether this is 50 percent of their value or 25 percent of their
value, or what.

Mr. Hale. The value of the properties, that is something that the
Ernst & Young study doesn't directly assess. Maybe they have in-
formation that could be used to try to come up with the value of
the properties, but it is not in any of the reports.

Mr. Shays. This is something that I just would like to have a
sense of somehow. Then what I would like to know is, I would like
to know in terms of Ernst & Young's assessment of the condition
of these properties, they were basically saying they needed to
spend, what, $9 billion to bring them up?

Mr. Hale. The long- and short-term capital needs of the prop-
erties was over $9 billion. Then I think it gets down to $8.3 billion
when you take into account the reserves available at the property.

Mr. Shays. What was the common assessment before this? Was
this a reduction or increase?

Mr. Hale. There hasn't been much of any study previously that
tried to go look at this from the same perspective. What this study
was trying to do was look and say what really needs to be done at
these properties for them to be able to compete without project-
based subsidies in the commercial real estate market.

Mr. Shays. In other words, if HUD wants to make sure we have
little old facilities, long-term, there would have to be an investment
of $9 billion? Is that what they are saying?

Mr. Hale. No, not exactly. Again, what they are saying is what
these properties would need if you were to pull the subsidies away,
which is a bit different from saying, if we were going to keep these
as insured project-based subsidies, what do we need to do to fix
them up.

Mr. Shays. I don't know why the standard would need to be dif-
ferent. We are pajdng rent. We are wanting to make sure that the
people who live there, the residents, have a good facility. So why
would it be any different logically?



58

Mr. Hale. That is a good question you are asking. One of the as-
sumptions that they used ā€” if I can try to talk to you, and it would
be good for you to ask them as well ā€” they would assume, if you
have a refrigerator and it reaches the end of its useful life at 10
years, you would go in and replace the refrigerator, even if the re-
frigerator was still operating.

Normally, in the existing HUD-subsidized properties, I don't
think you are going to see that happen. As long as the refrigerator
is functioning, you would probably keep that in there. That would
tend to drive down the estimates to some degree. To what degree,
it is difficult to say.

Mr. Shays. Do either of my colleagues have any more questions?

Let me just understand if the significance of their deciding that
there was basically $8 billion ā€” I will say $9 billion minus the re-
serves ā€” if that is a significant number in the dialog ā€” it seems to
me it is very significant ā€” I would like you to tell me why it is sig-
nificant.

Mr. Hale. It is very significant because if you look at that as the
amount of money that would actually need to go into the properties
for them to be able to operate without project-based assistance,
what it says is, as you are restructuring these mortgages, in addi-
tion to just writing down the mortgage so the property can operate
at the reduced rents, if you are lowering market rents, we are also
going to have to make a considerable investment in dealing with
the physical needs of these properties.

So that is something in addition to just writing down the mort-
gage to deal with the lower rents.

Mr. Shays. Would the developers want that number to be higher
or lower?

Mr. Hale. I think the developers would want that number ā€” they
would want a thorough assessment of what the capital needs of the
properties were.

Mr. Shays. They would want it lower, wouldn't they? Wouldn't
they?

Mr. Hale. I would think the developers would want it to be high
enough to make sure the physical needs of the property are met.

Mr. Shays. This is what I am wrestling with. One, if it is a take-
over by HUD, HUD would want to say my gosh, these properties ā€”
it is a take ā€” I am going to get into this with HUD.

But my sense is that this is a much bigger debate than I am
grasping right now, that this is a very key factor here. I am just
not quite able to articulate it, because, really, you devalue the
property. In one sense, you say this property is not worth anything,
if you say it has to be fixed up. In another sense, if you say it is
going to be fixed up and it will be HUD's responsibility to get the
rent to do it ā€” I see heads go up. Thank you for that affirmation.

Mr. Hale. If I can say one other thing on that point, the point
is a very valuable one, because I think it points to the importance,
when you are doing the restructuring on these properties, that you
do this very carefully and you have people that not only know what
they are doing but are looking out for the Government's interest so
we are not paying more for rehabilitation costs for the properties
and not paying more for operating expenses at these properties
than needs to be done. We need to keep those costs down as much



59

as possible, so the properties can survive but we don't waste money
in the process.

Mr. Shays. The problem is we have to undo some past mistakes.
That may be very costly.

Ms. Fishkin, do you have anything you want to say, observing
the dialog here?

Ms. Fishkin. I guess just in terms of talking about the physical
condition of the properties and those estimates, that those are very
integral into the predictions of what is going to happen in re-engi-
neering ā€” those which will be able to perform without debt restruc-
turing, and, when they have their debt restructured, what that
amount is, and that it is important, it is going to be very impor-
tant, to have good assessments made on these properties.

Mr. Shays. That is a helpful comment.

Yes.

Ms. England-Joseph. If I can say one more thing about whether
developers or owners would like to see that number higher or
lower. It largely, in my opinion, would depend on who is paying for
the rehabilitation and how that rehabilitation is being paid for.
They would probably want it higher if they knew it would be a di-
rect grant from the Federal Government, if they were interested in
additional cash. They might like it lower if, in fact, it was going
to be a part of the way in which the rents were determined and
if they felt in any way the long-term rents would not be guaranteed
by the Federal Government in some way.

Mr. Shays. They would want it lower if they had to pay it. That
is really the issue ā€” if they had to pay it.

Well, this has been very helpful to me. I feel like I have been in
a true confessional here. Thank you very much.

Our second panel is Mr. Nicolas Retsinas, the Assistant Sec-
retary, Federal Housing Commissioner, Department of Housing
and Urban Development; and also Susan Gaffney ā€” here it says
"The Honorable Susan Gaffney;" I guess you are both honorable ā€”
inspector general. Department of Housing and Urban Development.

[Witnesses: Ms. Gaffney and Messrs. Retsinas, Derecola, and
Gittelson, sworn. 1

Mr. Shays. If other individuals come up, would you identify your-
selves for the record?

Ms. DUNLAP. My name is Helen Dunlap.

Mr. Gittelson. Alan Gittelson.

Mr. Shays. Mr. Secretary, it is nice to have you here. I will hear
from you first.

Mr. Retsinas. Thank you, Mr. Chairman.

Mr. Shays. This is an important hearing for me. I appreciate
your both being here.



60

STATEMENTS OF NICOLAS RETSINAS, ASSISTANT SECRETARY
FOR HOUSING, FEDERAL HOUSING COMMISSIONER, DE-
PARTMENT OF HOUSING AND URBAN DEVELOPMENT; AND
SUSAN GAFFNEY, INSPECTOR GENERAL, DEPARTMENT OF
HOUSING AND URBAN DEVELOPMENT, ACCOMPANIED BY
DAVID DERECOLA, AUDITOR, OFFICE OF INSPECTOR GEN-
ERAL, ALAN GITTELSON, AND HELEN DUNLAP

Mr. Retsinas. Thank you, Mr. Chairman, and thank you very,
very much for holding this hearing. I must confess at the out-
set

Mr. Shays. You are going to confess to?

Mr. Retsinas. I said at the outset; I said not throughout. At the
outset, Mr. Chairman, let me say I thought your ā€” I was very im-
pressed with the opening statement. I may quibble at a margin or
two, but I thought that was as clear a statement of the difficulty
in the mountain we need to climb.

As a matter of fact, I thought the particular analogy that you
used throughout of the tidal flood or the tidal wave that is ap-
proaching was particularly apt, because I must concede, since the
last time I appeared before this committee a couple of years ago,
I do have this notion sometimes of constantly sticking my finger in
the dike trying to stop the dam and the water coming over. But
that is not possible; it really isn't. So I do again thank you, very
much, for holding this hearing.

With your indulgence, I would take you up on your offer of mak-
ing this as much as a problem solving, issue illumination discus-
sion as possible. So I would like to submit my full testimony for
the record but really walk with you, or jog with you, through some
of the key issues, and perhaps in so doing, I will try to reflect on
some of the questions from your earlier panel.

When I first met with this committee a couple of years ago, we
had another video, and that video, as I recollect, talked about some
of the very, very dastardly, inexcusable conditions in assisted hous-
ing. Since that time, we have done a lot to deal with those condi-
tions. We now have, where we didn't have 2 years ago, good infor-
mation, not good enough, but good information, which is the study
we have been talking about today.

We are now using modem technology information on a host of ac-
tivities and projects. We at that time were talking about an audit
that indicated that, of the total $40-plus billion of insurance in
force under our multifamily programs, when we started this ven-
ture 3 years ago, the loan loss reserve that auditors require us to
set aside was $11.9 billion, 27 percent of that total insurance.

Over the last 3 years, we have chipped away at that. In the re-
cent audit, the loan loss reserve is now down to $8.4 billion ā€” still
too much. It is still a tremendous exposure, not so much to HUD,
not so much to the Congress, but to the American taxpayer that
we are all tr3dng to work for.

We have also made a dent, I believe, in the inventory of prop-
erties and problems that we came upon. Over the last 2 years, we
have sold almost 1,000 multifamily notes that had previously been
delinquent and in default. Not only have we garnered proceeds,
but, more significantly, as I recollect, the estimated net proceeds to
the taxpayer ā€” that is net above and beyond book value ā€” is around



61

$600 million, which I think is also illuminating of the value that
can be captured if the Government had less of a role sometimes as
opposed to more of a role. I think there is a message in all of that.

Over the course of the last year, we have been involved with
partners in different ways of doing business. While it may be useful
and illuminating for us to look back and talk about how we got to
where we got ā€” and I will talk about that in a moment or two ā€” it
is probably more useful to understand, we don't do things that way
an3anore, which is good.

That doesn't, however, allow us therefore to walk away and deny
the problems that have accumulated over time. Indeed, while it is
easy in hindsight to say, "What could they possibly have had in
mind? How could they possibly have provided 40-year mortgages
with only a 20-year subsidy commitment?" one would think, "How
would they do that? What did they possibly have in mind when
they developed the financing system that provided all the incen-
tives to produce and very, very few incentives to manage?"

It is easy to look back. But as some of us recall those days of the
seventies or eighties, or our forefathers recall those days, in the
seventies and eighties we were dealing with a situation where
there was an appropriate and understandable eagerness to develop
housing for people in need, and the commitment at the time that
we ought to do all that we can to produce this housing, to produce
it when the market would not produce it, and to produce it in a
way that would maintain affordability over time. So that is what
we did.

Anyway, let's talk a bit about where we are today and where we
might go. As I said before, when this housing was produced, there
were essentially three forms of assistance that were provided. Un-
fortunately, as the underwriting, as the assessment of that assist-
ance, took place over time, they weren't always linked and looked
to as a whole.

One element of assistance was subsidies. There were guaranteed
subsidy contracts. The subsidy levels were set at an amount nec-
essary to secure and underwrite a mortgage. That mortgage was
then insured by the Federal Government.

We often had a situation where the mortgage, unlike conven-
tional mortgages at the time, often was equal to the total develop-
ment costs. In conventional financing, as you know, developers
were required to put in a substantial equity involvement, particu-
larly in these kinds of commercial ventures. But for purposes of
this HUD program, it was not uncommon to have all the develop-
ment costs secured by this mortgage. On top of the subsidies, on
top of the insurance, there were very generous tax incentives.

The only correction, if I could, Mr. Chairman, in terms of your
earlier comment, is, you just got the wrong name of the tax pro-
gram. You are absolutely right, these were tax incentives. These,
however, were before the low-income housing tax credit; these were
in the days of pre-tax reform. There was accelerated depreciation
and a whole host of other incentives.

Ironically and regrettably, those incentives provided motivation
to increase the costs and increase the mortgage, because the tax re-
turn, the tax yield, was a function of the eligible basis. The higher
the basis, the more that could be depreciated. So it was in



62

everybody's incentive, except the taxpayers, over time, to increase
the costs in the beginning.

As my colleague from GAO indicated, I imply no malice
aforethought of those who are participating. As you yourself point-
ed out, those were the rules. That is what the rules were. People
played by the rules. They developed these developments over time.
But now the clock has moved, and now we are at a different stage.

Let's talk a little bit about where we are precisely today. As the
data indicates, we now have a situation where approximately
850,000 units in approximately 8,500 projects. They face a situa-
tion where they are both insured by the Federal Housing Adminis-
tration and also receive rental subsidies.

That, in logical terms, is not necessarily bad, except for the dis-
connects. The disconnects are really of two types: No. 1, there is
a disconnect in the terms of the two contracts.

If indeed, when these developments were originally financed, if
we had allocated sufficient funds for subsidy contracts that were
exactly coincidental with the mortgage terms, then the situation
that we now come upon, which is the subsidy contracts are expiring
but the insurance goes on, would not pose a financial risk to the
taxpayer. There would be other costs in terms of impact on resi-
dents and where they live, which we will talk more about, but you
would not have the financial impact in terms of the insurance fund,
because we now have a situation where the subsidy contracts ex-
pire, and yet the Federal Government over time is often put in a
position that, if we do not renew those subsidy contracts, then we
pay an insurance claim.

In other words, we have to pay more so we do not pay even more.
I wish I had a clearer way of saying it, but that is essentially what
it is.

The second issue is, in part because of the way these develop-
ments were capitalized at the outset, as our data indicates, about
two-thirds of the subsidy contracts are over market.

Again, to put it in simple terms, the Government is paying more
for a housing unit than anyone else is paying. That is what "over
market" means.

Now, over the next 4 or 5 years, these contracts begin to expire.
I appreciate the reference to our efforts over the last 2 years to
bring this matter to everyone's attention. I appreciate that. I wish,
certainly looking back over these last 2 years, that we had been
more persuasive. I do believe that at least today there is a common
agreement on the point you concluded on, which is, the one thing
we know for sure is, the status quo is not sustainable.

In an era where there is a common and organized focus on deficit
reduction and balancing the budget, the kinds of subsidies that
would be necessary to sustain the status quo, very few people ā€”
there are a few, but very few people believe that is possible.

The difficulty, however, is what to do about it. Again, as I would
again confess once again, for the second time, our proposal has not
carried the day in terms of how to go about this change.

I think there is agreement that change is necessary. We believe
there are certain principles, however, that are worth noting in any
proposal, because the one alternative that we find absolutely unac-
ceptable and unsustainable is the status quo.



63

Principle No. 1 is that we ought to ensure that we take on this
task of, and I don't want to use jargon, but restructuring the finan-
cial terms of these developments in a way that would be sustain-
able on a proactive basis. That is to say, if we wait for defaults,
if we wait for contracts to expire and for subsidies to cease, there
will be an inevitable disinvestment in the properties. The real los-
ers will be the residents and the neighborhoods in which these
properties are located.

So principle No. 1 is, we ought to do this; unlike other problems
the Government gets involved in, do it on a proactive basis as op-
posed to a reactive basis.

Principle No. 2 is, we ought to concede that in the future, going
forward, if we want to motivate behavior by the private sector ā€”
and, as an aside, I agree with you, there is a different play on this
with nonprofit/for profit, but if we want to motivate behavior by the
private sector, let us, to the extent we can, use the market as a
motivator; let us not continue to fight the market.

We clearly understand that the old way of regulation, the old
way of intensive staff overview and oversight, is also not sustain-
able. While we may say here, as I did 2 years ago, that we don't
have enough staff or enough capable staff to oversee these projects,
let me say to you, Mr. Chairman, 2 years later, we have less today.

There is an inevitable downsizing of the Government which has
very little to do with this particular issue, but it is a reality of the
political environment we are all in, and we understand that reality.

The third principle, which relates to the second principle, is, as
we proceed on this restructuring, I would be misleading you if I
said that today or tomorrow or the day after tomorrow that we at
the Department have the capacity to individually restructure 8,500
different projects. We need assistance, but we need, I think, a spe-
cial kind of assistance, not assistance of contractors, though clearly
we use contractors and we will keep using contractors, but we need
the assistance of partners. Referring to my second principle, I
would suggest in selecting those partners, that the best way to mo-
tivate those partners is to ensure that they have a stake in the out-
come of the restructuring. We believe they are excellent candidates
for that.

Mr. Shays. I am missing the third one. There is a principle, you
can't wait for defaults. You have to let the marketplace be the
motivator. Now you get into detail. What is the principle behind
the detail?

Mr. Retsinas. The principle is that HUD does not have the ca-
pacity, and the principle is that a partnering approach is the only
way to move this agenda forward.

We believe there are good candidates for partnering. We believe
the work of the State housing finance agencies can shed some light
on this. We have partnered with them in a variety of programs
over the past couple of years. We would not limit it to them, but
we would look to public sector organizations to the extent we can.

And the fourth principle and last principle, before I conclude
with some operational points that I would strongly urge, and it
may seem obvious, but I have been here too long not to say the ob-
vious sometimes: We do not believe, notwithstanding the immense
proportion of the budget crisis, that we ought to abrogate existing



64

contracts. That is, existing contracts, while they may be oversub-
sidized, ought to go on.

I add parenthetically by the way, we have no statutory authority
to reduce contracts that are above market.

Let me close, if I could, and I apologize for sort of walking
through it, but I want to give you a sense of both the frustration
and the eagerness I have for this challenge. Let me talk about the
three or four issues that provoke the most debate in our proposals
and not sit here and advocate a particular approach, but let me tell
you what some of the pros and cons are of a couple of the issues.

Issue No. 1: If you were to restructure, what ought the rent to
be? What is the right rent to pay?

Our proposal argues strongly that the right rent to pay is the
market rent, that we ought to pay what the marketplace pays.
That is the best way to reduce the unnecessary exposure and cost
to the Federal Government.

We have had many criticisms about that proposal, because peo-
ple argue, well, how do you know what the market is? In some
places the notion of market doesn't make much sense, because you
don't have comparables. There are alternatives.

One alternative is to just say, just by fiat, well, this is what the
rent will be; set a formula.

We have reservations about that approach because a formula, al-
most by definition, sometimes will be too high and sometimes will
be too low. Indeed, it will not, again, put that focus on the market
that we think is appropriate.

There are others suggesting that the rent ought to be what they
call budget-based. That is whatever a project needs. And, again, we
question, one, our capacity to administer a true individual budget-
based approach and, second, whether in fact that it moves away
from what we think is an appropriate understanding of tenants
and residents as customers, not as victims of this effort.

Mr. Shays. I want to have you go through those two real quickly
with me again. You say you would set the rent based on what, the
first one?

Mr. Retsinas. We would prefer the rent be set on the basis of
what the market is.

Mr. Shays. And the second was based on what we have the abil-
ity to pay?

Mr. Retsinas. The second approach that some have suggested is
just to set a formula. For example, one approach is, well, the rent
should be a certain percentage of fair market rent; a rent ought to
be at a certain number. Just by formula, by fiat, set a particular
number.

The third approach is what is called budget-based. That is, the
rent ought to be whatever the project needs it to be.

The difficulty with the third approach is, if one of your conditions
is to not have defaults, then you would have to set the rent at a
high enough level, albeit inflated, so that the existing debt service
payments can be made.

So we think those are basically the three alternatives on rent
setting.

Mr. Shays. OK



65

Mr. Retsinas. No. 2, which I have alluded to before, is the use
of third parties. I will not go over it in detail except to say you have
what I think are three basic options:

First, HUD doing it; and I have already questioned our capacity
to do so, as others have, including yourself. The second is the use