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 committee meeting was called in the wake of news reports alleging lax oversight by the agency of mortgage lenders. "We need to know what is behind these allegations, whether they are accurate," Financial Services Committee Chairman Barney Frank, D-Mass., said in his opening remarks.

The allegations were firmly refuted in testimony from Phillip Murray, an FHA official and HUD's deputy assistant secretary for single family housing programs, who defended the agency's ability to oversee its lenders and catch fraud.

"These stories misrepresent a well-respected federal program that has provided untold benefits to millions of Americans," Murray said.

However, Murray agreed that FHA urgently needed more funds. "We have real needs to upgrade our technology, hire more staff, purchase more fraud detection tools," he said.

After falling into near-irrelevancy during the subprime lending heyday of 2004-2006, the FHA has roared back. A Depression-era agency, the FHA was created to help low-income and first-time home buyers by insuring mortgage lenders against default on FHA loans.

Today, with the subprime collapse and the subsequent across-the-board tightening in credit, it is a vital cog in the U.S. mortgage market.

A hike in the size of mortgages the agency can insure has vastly expanded the pool of borrowers eligible for FHA loans. Economic stimulus legislation last year raised the limit to nearly $730,000 from about $362,000. As of Jan. 1, the limit was permanently lifted to $625,500.

The agency 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. Still, its capital ratio remains above the 2% minimum required by law at around 3%. The fund still has nearly $13 billion in capital to absorb losses.

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.

Frank said that he would introduce draft legislation Friday that would increase the FHA's role in helping borrowers avoid foreclosure. Last year, Frank spearheaded the creation of a program, Hope for Homeowners, to help as many as 400,000 strapped borrowers refinance into FHA loans. So far, the program has attracted few participants due to constraints on borrowers and lenders.

Frank said he would make fixes to the program in legislation setting out conditions for the release of the remaining $350 billion in financial rescue funds. He asked Murray to provide the committee with information on how much money the FHA needs to staff up. "We want to make you more of a player," he said.

Heist 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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