The Federal Housing Administration's cash reserves have shrunk to a level far below what is required by law, and the agency could need taxpayer funding if worst-case scenarios play out, according to an independent audit designed to measure the agency's financial soundness.

The audit examined the excess cash the agency must set aside to deal with unexpected losses in its flagship home-buying program, which has played a key role in supporting the housing market.

As of Sept. 30, those reserves had an estimated value of $3.6 billion, a sharp drop from the $12.9 billion available a year earlier, the audit found. The current total represents 0.53 percent of all outstanding single-family-home loans insured by the FHA, well below the 2 percent portion set by law. This is the first time reserves have fallen under that threshold since 1994.

A year ago, the agency's reserves equaled 3 percent of those loans.

The audit, performed by Integrated Financial Engineering of Rockville, attributes the dramatic drop in reserves to hefty losses on insured loans from 2005 through 2008, when home prices declined, the economy soured and unemployment soared beyond projections.

The FHA does not make loans; it insures the lenders it works with against default if loans go bad. The agency has long self-financed its operations by collecting the insurance premiums paid by borrowers.

The FHA's reserve levels are closely watched in Washington because they help gauge the agency's financial health. The FHA's default rate has climbed as its loan volume has exploded in recent years, and lawmakers are worried that taxpayers may have to kick in funds to cover the agency's losses.

The FHA can raise its insurance premiums or increase the size of down payments to boost reserves to the 2 percent threshold. Should reserves become completely exhausted, the government would be obligated to make good on any claims.

Such a scenario would be a first for the FHA, which has not used public funding for that purpose since its creation in 1934.

The auditors concluded that the FHA can remain self-sustaining under five of six possible economic scenarios, and possibly even rebuild its financial cushion in the near future. The findings were based on a series of stress tests that considered a mix of home prices, interest rates and the amount of money the agency can recover from foreclosures.

Under the audit's base scenario, the FHA can cover projected losses over 30 years and have $3.6 billion left in its reserves if home prices stabilize by the second half of 2010 and start rising about three years later. The agency's reserves could even bounce back to the required 2 percent level by the end of fiscal 2012, the audit said.

But under the audit's most pessimistic assumptions, the reserves would run dry in fiscal 2011, requiring a $1.6 billion cash infusion from the Treasury. This case assumes that home mortgage interest rates would plummet to about 2 percent and trigger a significant wave of refinancing. It also assumes that most of those borrowers would refinance out of FHA-backed loans, depriving the agency of insurance premiums. FHA officials said that scenario is unlikely.

The only other test that produced similar results was one that assumed depression conditions. That test, requested by the FHA, projects that reserves would be depleted by 2011 if unemployment reached 12.5 percent and housing prices declined by another 30 percent. This test was not included in the audit but was mentioned at a briefing with reporters Thursday.

During the briefing, Housing and Urban Development Secretary Shaun Donovan said the reserve fund has played the role for which it was intended by allowing the FHA to continue to support lenders at a time when they otherwise would have been forced to retrench.

But Donovan acknowledged that the current $3.6 billion reserve is too thin a margin for the agency's $685 billion portfolio. "It is absolutely critical going forward to build that cushion back up," he said.

For a portfolio that large, Thomas Lawler, an economist and housing consultant, said the current cushion "basically rounds to zero . . . They were supposed to have their reserve at the 2 percent level in order to be actuarially sound. If your base scenario wipes you out, you are not actuarially sound."

Donovan said newer loans are expected to have much more modest claims, and belong to more credit-worthy borrowers than the FHA has served in the past.

Donovan and FHA Commissioner David H. Stevens also pointed out that the $3.6 billion in the reserve fund represents only part of the money the agency maintains to cover losses on insured mortgages. The agency, on an ongoing basis, pays for losses directly out of a second fund. Money is shifted into that second fund from the capital reserve fund based on loss projections, but it can also be moved back if loans don't go bad.