UPDATE 1-FHA strong enough to play key role in down mkt-HUD

(Adds more comment from Donovan)

WASHINGTON Feb 23 (Reuters) - The Federal Housing Administration has taken sufficient steps to shore up its balance sheet to play a key role in funding home purchases where the private mortgage market has fallen short, Housing and Urban Development Secretary Shaun Donovan said on Tuesday.

"FHA has taken the kinds of steps necessary to make sure that it will remain strong and healthy enough to continue to fulfill its mission of serving the underserved and playing a vital counter-cyclical role in the housing market," Donovan pledged in prepared testimony on the agency's budget to lawmakers on Capitol Hill.

Asked about the strength of the FHA at the hearing, Donovan stressed that FHA did not try to compete with sub-prime lenders who were making loans with poor or no underwriting standards during the height of the housing bubble.

"Even though I have concerns about FHA's condition and we have to watch what is happening very carefully, the share of business that we did in the worst years of the crisis was very, very small" and that translates into a stronger balance sheet today, Donovan told lawmakers.

The Obama administration's top housing official said he expects FHA's share of the home first purchase market would fall from the current 50 percent to about 20 percent as private lending returns to the residential mortgage market.

Just a few years ago, FHA's share of the market for new purchases was in the low single digits because FHA requires full documentation and only offers conservative terms on mortgages, Donovan said. (Reporting by Corbett B. Daly; Editing by James Dalgleish)