A U.S. government internal watchdog warned Friday that the Federal Housing Administration may not be able to cope with a surge in its business, citing the agency's largely manual lender approval process and problems with internal controls and risk management.

Department of Housing and Urban Development Assistant Inspector General James A. Heist told a U.S. House panel that the FHA had a "critical need" for more funding to upgrade computer systems, increase staffing levels and training and strengthen its oversight of lenders and appraisers.

"FHA may not be able to handle its expanded workload or new programs that require the agency to take on riskier loans then it historically had in its portfolio," Heist testified before the House Financial Services Committee.

The call for more funding was echoed by Phillip Murray, an FHA official and HUD's deputy assistant secretary for single family housing programs. In prepared remarks before the committee, Murray defended FHA's ability to oversee its lenders and catch fraud. However, he said FHA urgently needed funds to upgrade its computer systems.

After falling into near-irrelevancy during the sub-prime mortgage heyday of 2004-2006, the FHA has roared back. The agency insures mortgage lenders against default on FHA loans.

It has seen its loan volume roughly quadruple in the last year, yet its staffing levels have remained nearly flat. The situation has spawned concerns that the agency will become a victim of mortgage fraud. Some fear that it will be hit by a wave of defaults and require a taxpayer-funded bailout.

With the cratering housing market, the FHA's insurance fund took an estimated $8.7 billion hit in fiscal 2008, according to an actuarial review.

In October 2008, FHA market share, including both new mortgages and refinancings, jumped to 76% from 21% the year before, according to Heist. The agency's share of new mortgages had climbed to 23% from 6.4% over the same period.

Heist also warned that the spike in demand for FHA loans could have "collateral implications" for the mortgage-backed securities issued by the Government National Mortgage Association, known as Ginnie Mae. A wholly-owned U.S. government corporation, Ginnie Mae guarantees for investors the timely payment of principal and interest payment of securities backed by FHA and other loans guaranteed by the U.S. government.

With the explosion in FHA loan volume, Ginnie Mae has also seen its business boom. In October, Ginnie Mae's share of the mortgage-backed securities market swelled to 39%, surpassing both Fannie Mae (FNM) and Freddie Mac (FRE).

-By Jessica Holzer, Dow Jones Newswires; 202-862-9228; jessica.holzer@dowjones.com

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