of contractors, which, again, has implications for the Department
is a capacity to manage that process. And the third, which we
favor, is the use of a third party or partners, partners, again, who
would have a stake in the successful restructuring.

Mr. Shays. Can you just elaborate a little bit? When you say a
stake, what kind of a stake?

Mr. Retsinas. It seems to me that, again, to motivate behavior,
people ought to be rewarded if they do well and not rewarded if
they do poorly.

So, for example, right now, for the last 3 years, as we write new
FHA insurance in a number of States, we do it through a program
called risk sharing, which was authorized by the Congress 4 years
ago. In that particular program, we delegate to a State housing fi-
nance agency — there are a couple of local agencies, but generally
a State housing finance agency, the ability to endorse a new project
for insurance.

With that authority, however, they must share the risk. So if at
some future date that project fails, at some future date a claim
must be paid, at some future date there is a loss because the recov-
ered amount, is less than the outstanding insurance, then the way
this program works, we, the Federal Government, and the State
share the loss. That is what risk sharing is all about.

We think that is a model that works, and, again, we think it is
a model that appropriately motivates the right behavior.

I generally find when people have something at stake, they are
more likely to act in my interests than if they don't.

The third area that we want to speak to is the issue of FHA in-
surance. Again, as in the other areas, we believe there are three
options.

Option No. 1 is, under no circumstances provide any FHA insur-
ance; once you do the restructuring, just end the FHA insurance.

Option No. 2 is to automatically continue the FHA insurance.

Option No. 3 is, allow the new projects to apply for FHA insur-
ance, but under today's rules, not yesterday's rules.

We believe the first case — absolutely no FHA insurance — would
sometime deny financing for projects that because of their location
or situations, the private sector alone just will not get involved in.

The second option — automatically continue the FHA insurance —
we believe is just a continuation of the problem that got us into
trouble in the first place.

The third option is the one we prefer, which is using today's
rules, such as risk sharing; as an example, allow projects as they
become restructured, to apply for refinancing under the current
guidelines or rules of the FHA insurance program.

Let me just conclude by saying, in a sense, as big as the problem
is, it is relatively straightforward, as I suggested. We as a Govern-
ment, we as taxpayers, are artificially subsidizing properties, and
we are forced because of the financial arrangements to do so to
save even greater costs. We all agree that something must be done.



66

Over the past year, we and the Congress — again, this is to-
gether — we have put our foot in the water. As you indicated, with
the passage of the fiscal year 1996 appropriations bill in late April
of this year, we were given demonstration authority for a select
number of units with a select amount of money.

That authority, that demonstration program, is now underway.
The guidelines were published in the Federal Register the first
week in July. Our first loan committee meeting on transactions is
next week.

However, Mr. Chairman, again, I want to be — in respect for your
candor, also be honest with you. To really observe that demonstra-
tion, to really truly assess that demonstration, we are going to need
2 or 3 years, because we will not know whether this worked until
time passes.

We could certainly determine whether or not we restructured
projects but to determine whether we restructured in the right
way, you need time to pass for loans to mature. I do not believe
we can wait. I believe it is absolutely critical that we address this
issue. Even though the mountain is a very high one, we need to
begin scaling it.

Mr. Shays. Twenty-five percent will come due next year; correct?

Mr. Retsinas. About 230,000 units come due next year. Only
about one-third of those are above market.

Mr. Chairman, that concludes my statement. I would be obvi-
ously more than happy to answer any questions.

[The prepared statement of Mr. Retsinas follows:]



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STATEMENT BEFORE THE

HOUSE GOVERNMENT REFORM AND OVERSIGHT COMMITTEE

SUBCOMMITTEE ON
HUMAN RESOURCES AND INTERGOVERNMENTAL RELATIONS

BY

NICOLAS RETSINAS

ASSISTANT SECRETARY FOR HOUSING

FEDERAL HOUSING COMMISSIONER

WASHINGTON, DC
July 30, 1996



INTRODUCTION

Thank you Chairman Shays and Members of the Committee for this opportunity
to testify on the impending crisis facing the nation's stock of federally assisted,
privately owned housing - and the Administration's proposal for addressing the crisis
through portfolio reengineering. The crisis affects 8,500 properties - about 850,000
units that both receive Section 8 subsidy and have mortgages insured by the Federal
Housing Administration (FHA).

Mr. Chairman, it is important to note for the record that you, and this
Subcommittee, have played a significant role in identifying long-standing problems
with the muitifamily assisted housing programs. This Subcommittee held a series of
hearings in 1 994 on the cost, quality and effectiveness of the muitifamily housing
subsidized stock. Testimony from the General Accounting Office, HDD's Office of
Inspector General and others graphically demonstrated that the escalation of rents
and the deterioration of the housing units were contributing to a crisis situation. There
was no doubt that HUD policy makers and staff were faced with major operational and
programmatic challenges.

Looking back on those days I can say with all honesty that those hearings
provided a good deal of impetus for the actions that we took to improve the quality of
data, enforcement activities, and portfolio management. Chairman Shays, thank you
for those strong efforts and I would like to preface my remarks about the portfolio
reengineering concepts by explaining some of the improvements your hearings have
fostered.



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Improved Portfolio Management

Major improvements have been made in portfolio management and analysis.
This can be measured in both financial terms and operational terms. For example:

FHA will have a pilot data warehouse by this September that provides
better opportunities for field office staff to analyze their portfolios and to
better service the loans.

FHA for the first time in history conducted an internal loan loss reserve
analysis by risk ranking over 12,000 individual projects.

- The loan loss reserve itself has decreased substantially over the past
three years from $10.3 billion in 1993 to $8.4 in 1995.

- Thirteen training courses have been conducted for over 2,000 multifamily
housing staff on asset management activities.

Field managers were empowered to make decisions at the lowest
possible level and matrix organizations were formed to "work share" as a
means of overcoming staff shortages and imbalances.

Asset Sales

In order to aggressively reduce the large portfolio of Secrstar^'-held mortgages
(defaulted mortgages), FHA has established a core team of employees and
contractors that use creative and innovative business tools to carry out a highly
effective loan sales program. Examples include:

Multifamily notes have been sold through a program of mortgage sales.
From 1994 to 1996, HUD sold 927 loans with an unpaid principal balance
of $2.8 billion, thus reducing asset managers' dangerously high
workloads. Further, the loan sales generated over $2.1 billion in gross
proceeds to the taxpayers, $71 4 million higher than the value of the
loans had HUD continued to manage them as in the past.

Included in the mortgage sales program was a June 1 996 structured
finance transaction involving 1 58 loans with an unpaid principal balance
of $885 million. The projects represented by these loans included
approximately 6,400 units of subsidized housing. This sale resulted in
$645 million in proceeds to the taxpayer.



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Improved Tenant Involvement

More important than the financial and operational matters is the increased
attention being paid to investing in residents as customers, thereby increasing the
value of properties and communities. FHA has taken several initiatives to improve
tenant satisfaction. Some examples are:

A Neighborhood Networks initiative that encourages owners to invest in
computerized learning centers has resulted in some 40 projects
becoming operational and another 400 projects in various stages of
completion within seven months of the initiative's inception. Education
and job training are the focus of these centers.

- FHA has endorsed and sponsored the use of VISTA volunteers to work
with tenant organizations in bettering the living conditions at projects.

- HUD's FHA staff interact continually with tenant groups at local and
national levels as a means of ensuring that tenants have a voice in
housing programs.

Improved Enforcement Activities

Significant steps have been taken to upgrade the use of enforcement tools and
to develop new ones, including the following measures:

- FHA established a Special Workout and Assistance Team (SWAT) to
serve as both an enforcement arm and a training vehicle. The SWAT
team has been an active partner with owners in turning projects around
and a strong adversary to owners when appropriate in taking needed
sanctions.

Since its inception in 1 994, SWAT has screened over 880 projects, has
assigned over 400 of those for comprehensive review and action, and
has completed reviews on 256 projects. Of those 256 projects, owners
came into compliance on 1 63. Departmental sanctions were taken on 51
projects and 42 projects required no actions.

In addition to the SWAT activities, enforcement throughout the system
has been emphasized and increased. In 1994 and 1995 enforcement
actions at FHA were at a record high, especially in the areas of required
changes in management agents and in the use of foreclosure tools.



70



Legal services contracts were recently initiated to complement the
services provided by the short-staffed Office of General Counsel.
Contractors are currently working on sanction activities on 1 6 projects.

- During 1 995 and 1 996, the Administration submitted legislative proposals
to Congress to further strengthen enforcement. No action has been
taken to date on the proposed legislation. One of HDD's key proposals
was a request for legislative relief from the bankruptcy protections
afforded to multifamily project owners. The use of this protection has
been one of the major impediments to swift and effective enforcement
action.

Mr. Chairman, we have come a long way since this Subcommittee's hearings in
1 994. It goes without saying that much more needs to be done to arrest the
problems. But we are proud of our accomplishments and we are especially pleased
that three of the initiatives I mentioned above were recently recognized by Vice
President Gore's National Performance Review Hammer Awards - namely Asset
Sales, SWAT and Neighborhood Networks.

It is also important to note that, as HUD, under the leadership of Secretary
Cisneros, came to grips with these problems and began to analyze the conditions and
causes of the current situation, it became abundantly clear that major initiatives and
policy shifts were the only long-term solution. Hence, the move towards our current
proposals to reengineer the financing structure and, more importantly, treat housing
as a valuable resource for building better neighborhoods by investing in the people
that reside in the projects.

THE NEED FOR PORTFOLIO REENGINEERING

HUD has put forward a proposal to reduce Section 8 subsidized rents to
market while simultaneously reducing the FHA-insured debt to a level that can be
supported by market rents and would help pay for necessary repairs to these
buildings. I welcome your leadership and commitment to address this critical issue.

The vast majority of the residents of these properties are low-income, and a
substantial proportion are elderly. How we manage the transition of this portfolio
going fonward has critical long-term implications for millions of residents and hundreds
of communities.

The context is not bricks and mortar or expiring contracts or government rules
and regulations. The context is people and neighborhoods. I believe we have a
unique opportunity to reengineer this portfolio and the programs underlying it. We
have an opportunity to rebuild declining neighborhoods and inner cities through our
investment in a reengineered housing system.



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We also have the opportunity to see housing and its growing costs as a critical
piece of the "solution" rather than as a "problem." The rapid growth of our own
Neighborhood Networks initiative - where we encourage computer learning and job
centers in subsidized buildings - suggests to me without a doubt that the seeds of a
new and better approach are growing.

Some Progress but Fundamental Problems Remain

I can report to you that working together over the past 1 8 months, Congress
and the Administration were able to undertake important interim measures to begin to
address the Section 8 crisis.

- We acknowledged that the status quo and paying above market rents for
assisted housing is no longer sustainable.

- We gathered updated data about the Section 8 portfolio - including the
composition of the portfolio, the rent levels, and the condition of the
properties.

- We initiated a broad debate to address the problems - involving virtually
all of the constituencies that are affected by changes in the Section 8
assistance program.

We have begun to implement a Congressionally authorized
demonstration program to test a number of different approaches.

Despite our progress, however, we have still not solved the fundamental
problem. It is critical that we confront this problem now by passing legislation that will
help us preserve affordable housing resources over the long run. The longer we wait,
the more difficult it will be budgetarily and administratively. The basic question, which
was posed by Peter Passell in the New York Times on July 1 8, is whether Washington
(and the American taxpayer) "will end up paying a little now or a lot more later." Mr.
Chairman, I would ask that a copy of that article be included with my statement for the
record.

History of Over-Subsidization

To fully understand the need for portfolio reengineering, it is necessary to
understand how much of our multifamily inventory came to be over-subsidized.

From 1 965 to 1 983 the Federal government through HUD and the Internal
Revenue Code subsidized the development of privately-owned multifamily apartments
by providing low-interest loans; insuring mortgages made by private lenders;
furnishing project-based Section 8 subsidies to pay rents; and providing tax incentives



72



by allowing rapid depreciation on properties financed with non-recourse debt

This system of assistance produced substantial amounts of multifamiiy housing
but, in recent years, it has suffered serious and growing problems, chiefly due to
insulation of the properties from market forces. Thus HUD, at this point, is paying
rents far in excess of the market rents paid by unsubsidized tenants. Moreover, HUD
is paying these excess rents for about two-thirds of the reengineering portfolio.

Let me give you some examples from a General Accounting Office investigation
of this issue:

Here in Washington, DC, the GAO discovered that the Federal
government pays $734 a month in rent for a subsidized Section 8
apartment, when rent in a comparable unit in a neighboring,
unsubsidized building is $500.

~ In New York City, the government pays $1,138 a month for subsidized
apartments, while the monthly rent for units in neighboring unsubsidized
buildings is $600 or $750.

In Las Vegas, the same pattern is repeated: $820 a month for Section 8
subsidized units - and comparable market units renting at $380.

In Chicago, the government pays $849 a month for apartments in a
subsidized Section 8 building, while landlords in comparable
unsubsidized units charge $435 to $475 as market rents.

The other one-third of our portfolio of properties are under-subsidized and most
have fallen into distressed condition, with owners having no financial incentive to put
more funding into these projects. Tenants are effectively trapped. If they try to move,
they lose their federal rental assistance because the subsidies are tied to the building.

Budgetary Issues

Beginning in FY 1 997 - and for the next 7 years thereafter ~ Section 8
contracts will expire on 850,000 units of FHA-insured housing. The majority of Section
8 contracts on the 8,500 properties expire by 1 999. These expirations include a very
large wave in FY 1997 - 236,000. Earlier this year, as an interim measure. Congress
agreed to extend contracts expiring in 1 996 for one year at current rents.

Downward budgetary pressure on discretionary spending means that the
Federal government can no longer sustain the large and growing costs of renewing
over-subsidized Section 8 contracts at their current rent levels. The cost of renewing
Section 8 project-based assistance will increase from $950 million in fiscal year 1 997 to



73



almost $6 billion in fiscal year 2002. We do not anticipate Congressional funding for
HUD'S future-year budgets that would allow continued payment of Section 8 rents at
their current levels into the future or to bolster subsidies for troubled projects.

Given continued Congressional pressure to reduce HDD's budget, the
Administration believes that the prudent course is to use the market to set rents and
make a corresponding write-down of debt on these buildings in a managed, orderly
fashion.

Operational and Policy Issues

We must responsibly address the crisis caused by expinng Section 8 contracts.
The only way to responsibly address the impending crisis is to change the process by
which HUD supports these apartment buildings. In so doing, we must protect
residents, communities, legitimate interests of owners and taxpayers. What we are
looking for is a fair and equitable way to address a very complex problem.

While the Section 8 program is complicated, the choices confronting us are
stark and action is needed soon. We cannot afford to renew contracts that are above
market at their current levels. If we do not renew all of those contracts at their current
over-subsidized rents, or financially restructure these properties, most owners will
default on their FHA-insured mortgages. The result will be massive claims on the FHA
fund ~ possibly up to $2 billion in claims for the 1997 expirations alone. Furthermore,
many properties with below-market subsidies have significant capital backlogs. The
needs of these properties must be addressed as well.

But there is more than a financial cost to massive defaults. There is also a very
real human and community toll. Defaulting on a mortgage does not happen suddenly.
It is a process that can be stretched out over years as owners seek refuge in
bankruptcy court or use other means to delay the inevitable where they lose their
properties and must recognize as taxable income the debt as if it were the proceeds
of the sale.

As the owners default, they pull resources out of their apartment buildings.
They stop making repairs because they have no financial incentive to do so. We have
seen this pattern time and time again. The residents of these apartment buildings
suffer as the quality of their units deteriorate ~ sometimes to the point where HUD is
forced to take over the building. Meanwhile, the surrounding neighborhood feels the
impact of another apartment building that is being abandoned by its owner.

From a policy perspective, it is difficult to justify the continuation of over-market
rents. They began 20 years ago to induce the private sector to build in areas where
they would not otherwise have built. But should we continue to pay in excess of
market rents to induce the private sector to continue owning or operating these units?



74



From a budget perspective, over-market rents cost too much. In FY 1 997
alone, the federal government will spend an additional $1 50 million to keep these rents
above market, and this amount grows in the out years. This not only drains scarce
federal housing resources, it also weakens public support for affordable housing
programs across the board.

ADMINISTRATION'S PROPOSAL

We believe the solution to the problem of over-market rents is straightforward:

1 . Reduce over-market Section 8 rents to market levels and introduce the
discipline of competition in the operation of the properties.

2. At the same time, reduce the amount of the mortgage on the building to
a level that can be supported by market rents.

3. Provide appropriate solutions for the tax issues confronting the owners of
the property as a result of restructuring ~ that is, cancellation of debt
gives rise to taxable income in the amount of the debt forgiven.

Carrying out this process is not simple, but we believe that the best way to
serve the interests of everyone - the taxpayers, tenants and owners ~ is to use the
forces of the marketplace.

Analysis of the Portfolio

To help us understand what needs to be done and to answer questions about
the portfolio and the impact of restructuring, HUD engaged the E&Y Kenneth
Leventhal Real Estate Group to carry out an analysis of the FHA-insured, subsidized
portfolio. Here is what we learned from the EY study:

Size of Portfolio

There are 8,563 properties, 708,273 assisted units, 142,762 unassisted
units and $1 7.8 billion of mortgage insurance at risk in the reengineering
portfolio.

Problem is serious

~ 63 percent have rents greater than market rents
- 37 percent have rents less than market rents



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Physical condition of properties

- There are short term maintenance and capital needs across the entire
Section 8 insured portfolio averaging $6,400 per unit.

Portfolio reenqineering can solve the problem

Three-fourths of the portfolio works in market conditions after
restructuring.

1 3 percent of the properties require additional capital support to pay for
repairs.

- An additional 1 3 percent do not work in normal economic terms and
present a special challenge.

One size does not fit all

This portfolio has many needs and resolving the problems of this
portfolio cannot be accomplished by applying a single formula across
the board. It will require a variety of tools. We should not construct a
solution for all based on the needs of 1 3 percent of the portfolio.

Overarching Principles

The Administration's proposal is based on the following principles:

* Residents and neighborhoods must be protected.

* Portfolio reengineering must be undertaken in a way that recognizes the
diversity of the portfolio and owners.

* The interests of the taxpayers must be protected through proactive and
efficient implementation.

* There will be no abrogation of contracts.

* Any solution must recognize the limitations of HDD's current and future
staffing resources.

* For 1 997, we should focus on projects with rents above market while
continuing to develop a strategy to address other severe capital needs in
properties below market.



76

10

Costs Savings

The Administration estimates $0.9 billion in mandatory savings and $1 .8 billion
in discretionary Section 8 savings were estimated for the period 1 997-2002 under the
portfolio reengineering proposal. In discussions with Congressional Budget Office
staff, we understand that CBO may have reached a different conclusion about the
mandatory savings from portfolio reengineering. These differences appear to be
based upon different assumptions about recovery rates or, in other words, levels of
payments to reduce mortgages and the benefits of providing owners with an option to
restructure before contract expiration {known as proactivity).

We believe that the new data from the E&Y/Kenneth Leventhal analysis, which
was not completed when CBO prepared their scoring earlier this year, will lead to
different assumptions about recovery rates. We look forward to further discussions
with CBO on this matter.

We also have refined our analysis since the President's budget was submitted.
In addition, the Administration's proposal has also been refined between February and
now; therefore, our estimates will change, too. In developing the budget for fiscal year