Part II: The Uncertain Present - Should Auld Principal Limits Be Forgot?

With so few HECMs paying off, we can only estimate FHA’s total risk profile and likely profit (or loss) outlook. Two recent attempts to quantify this risk have been made. First, in October 2009, IBM published a study entitled “An Actuarial Analysis of the FHA Home Equity Conversion Mortgage Loans in the Mutual Mortgage Insurance (”MMI”) Fund Fiscal Year 2009.” In November, FHA published its Annual Management Report (”AMR”) for Fiscal Year 2009, which includes financial results and forecasts for all of its major funds and mortgage loan programs, including HECM.

The IBM study was commissioned by HUD and conducted before FHA’s reduction in Principal Limits. The study projected future profits and losses for the HECM program, and concludes, among other things, that ” … our projections indicate that there are sufficient capital resources to meet the anticipated liabilities associated with the HECM portion of the MMI fund.” Armed with this conclusion, The AMR in turn concludes that the projected future profits of the HECM portion of the MMI fund help offset the erosion of that fund’s capital position.
This might lead one to conclude things are not so bad, so why did FHA have to reduce those Principal Limits? To answer, one must look beyond the HECM portion of the MMI fund, where the picture does not look so rosy. FHA’s main problem is the non-HECM portion of the MMI fund, and their non-MMI HECM portfolio is not looking so great either. When the entire scope of FHA’s risk is properly examined, the wisdom of the Principal Limit reduction becomes even clearer. We can therefore expect that the next round of FHA’s changes, anticipated in January 2010, will tighten lending standards across their entire program, forward and reverse.

Interesting But Moot
The IBM report is part of FHA’s FY 2009 overall Actuarial Review, but it deals with much more than what we normally think of as “actuarial” analysis. Although many reverse mortgage prepayments involve mortality, housing price risk looms much larger in importance, as the study points out in its summary of risk factors. Let’s analyze what this report did, and what it did not do.

The study considers eight theoretical years of HECM production and projects their cash flow, including Mortgage Insurance Premium (”MIP”) payments and crossover losses. Its base case Home Price Appreciation (HPA) scenario is as follows: three more down years with home prices declining 3.9%, 6.9%, and 1.1% in 2009, 2010, and 2011, respectively, followed by a pretty solid recovery, with HPA exceeding 4.5% in every year from 2015 through 2021. FY 2012 HECM production in this scenario therefore avoids the three down years, and instead experiences 11 uninterrupted years of robust home price increases. Even the previous three vintages, despite the near-term down years, experience average price increases of approximately 2.5%, 3%, and 4% over their lifetime.

On top of this, the study assumes relatively fast prepayments. For example, it assumes a prepayment rate of nearly 9% for the FY 2009 cohort in 2011, nearly twice the rate at which 2007 loans are paying in 2009. It mentions, but does not quantify, disposition cost, so we don’t know if it makes the proper assumption of at least 15% disposition costs for loans near or past the crossover point (i.e., when it matters). It’s not surprising that the study forecasts a $909 million positive net present value for the FY 2009 cohort. But we already knew that FHA made money at the old Principal Limits under optimistic HPA scenarios, especially with fast prepayments. Both FHA and our own analysis, discussed in previous New View Commentary, came to that conclusion. It bears mentioning that New View Advisors’ analysis also showed that losses grow exponentially the longer a housing slump lasts.

The IBM study presents some sensitivity analysis showing less optimistic scenarios, but their analysis has two major shortcomings: it does not vary the assumptions even close to the magnitude of change seen even in very recent experience, and it does not adequately explore the correlation between risk factors. For example, the “More Pessimistic Home Price Assumption” scenario changes the assumptions for only one year (FY 2010).

The study gives short shrift to correlations between risk factors, despite the present economic circumstances in which declining home price slowing prepayments, raising disposition costs, and causing higher credit line draws. These correlations magnify losses. This is especially true with the mobility effect, in which sluggish or declining home prices reduce the rate of prepayments, as the lower sales proceeds make moving less attractive or even impossible economically. This means more HECM loans accreting interest for a longer time, and more crossover losses. Any thorough risk analysis should reflect the increased loss frequency and severity caused by these correlations. Instead, the study states “all of the scenarios are estimated to result in a rising ratio of the economic value to insurance-in-force over the time frame of this study.” Well, sure they do! If one changes one variable at a time against a backdrop of steadily rising home values, it seems like FHA can’t lose. FHA’s own analysis, as reflected in the 2009 AMR, tells a different story.

Analyzing the FHA report
The FY 2009 AMR is a comprehensive summary of FHA’s financial position as of September 30 2009, the end of its fiscal year. The AMR is prepared in compliance with Federal Accounting Standard Advisory Board’s (FASAB) Statement of Federal Financial Accounting Standards (SFFAS). Many key elements of financial reporting that one might find in a private company’s financial statements have counterparts in the AMR. For example, “Subsidy Expense for Loan Guarantees by Program and Component” is akin to a supporting schedule for an income statement. “Loan Guarantee Liability” is similar to supporting detail for a balance sheet. We will focus on HECM data in the AMR, and see if we can answer: in FY 2009, was the HECM program profitable? Looking to the future, what is the risk profile of the HECM program? Does FHA have sufficient capital to weather the storm?

Analyzing the FHA reports is made difficult not only by the changing principal limits and the changing format of the report, but also the changing fund categories in which the HECM program is placed. Outstanding HECM loans from the inception of the program through the end of FY 2008 are still in the General Insurance (GI) fund. HECMs endorsed in FY 2009 and beyond are placed in the MMI. These different vintages have very different risk profiles, as we explained in our previous blog entry.

Complicating matters further, the nature of HECMs and the way in which FHA insures them makes losses hard to measure. The investor may assign a HECM loan to FHA when the HECM loan balance reaches 98% of the Maximum Claim Amount. That doesn’t necessarily mean FHA loses money on these loans, it means FHA owns the loan until it matures. When that happens (which could be years later) FHA may or may not be able to collect the full loan amount. However, given the residential housing market rout, FHA will probably experience crossover losses on many, if not most, of the HECMs it is now buying.

By the same token, the amount of MIP collected on each HECM is not the same as profits, or in government parlance, “negative subsidy.” The MIP is heavily frontloaded, with 2% charged on the Maximum Claim Amount, and 0.50% per annum on the loan balance. Therefore, each HECM has frontloaded revenue, and backloaded risk. Not surprisingly, as the HECM market has grown, FHA’s cash flow has been consistently positive. For example, in FY 2007, FHA collected nearly half a billion dollars in upfront MIP alone, in a year where endorsements exceeded 100,000 HECM loans for the first time. Assignments and Type I defaults tend to reflect loans originated six to twelve years before, which in this case corresponds to years when fewer than 8,000 HECMs were originated each year. So despite the positive cash flow in FY 2007, the outlook for these 2007 HECM loans is rather grim, given the decline in home prices, additional borrower draws and negative amortization of the last three years.

As a result, net cash flow in any given year doesn’t tell us much about the total risk profile of the program. The HECM numbers in the “Subsidy Expense for Loan Guarantees by Program and Component” for FY 2009, which show $1.043 billion in “Defaults” and $1.457 billion in “Fees and Other Collections,” relate more to cash flow than economic performance. They certainly don’t tell us that the HECM program made a $414 million profit. A true measure of profit looks beyond cash flow, and marks to market the gains and losses of the outstanding HECM portfolio. Only this approach can reflect the true value of FHA’s position. We estimate that the “Fees and Other Collections” include nearly $600 million in upfront MIP on loans that will create backloaded costs in the future, whereas the “Defaults” probably include a lot of 98% MCA assignments for loans originated in the past.

What is needed is an estimate of the present value of projected income and costs, so FHA accounts for this present value with the Loan Liability Guarantee (”LLG”). According to the AMR, LLG “is comprised of the present value of anticipated cash outflows, such as claim payments, premiums refunds, property expense for on-hand properties and sales expense for sold properties, less anticipated cash inflows such as premium receipts, proceeds from property sales and principal and interest on Secretary-held notes.”

The LLG rose alarmingly from $19.3 billion in FY 2008 to $33.9 billion in FY 2009, up 75%. HECM accounted for $4.4 billion of this increase, not an insignificant amount. Overall, HECM LLG nearly quadrupled, from $1.5 to $5.9 billion. This amount represents, in effect, the negative net present value of the HECM program, and exceeds the total amount of MIP ever collected. Most of this is concentrated in the GI fund, not the MMI fund. The AMR attributes says this “increase in liability is primarily due to the drop in house price appreciation projections … [which] results in lower recoveries from future HECM assigned assets which increase the liability.” True, but the reversal of fortune for the LLG surely also reflects the house price depreciation that began in 2007 and continued through FY 2009, as we explained at length in our previous blog entry.

So where does that leave the capital position of FHA? The headline from FHA’s annual reports was that the Capital Ratio for the MMI fell to 0.53%, down from 3.22% in FY 2008, well below the required 2% floor. In the “Actuarial Analysis Briefing” which accompanied the AMR, FHA shows the HECM portion of the MMI fund with a 3.17% capital ratio, and a positive Economic Net Worth of $909 million. Without HECM’s contribution, according to the briefing, the MMI Capital Ratio would have been 0.42%. But those numbers, comprised of $614 million of Net Insurance Income and $295 million “Present Value of Future Cash Flows on Outstanding Insurance,” are taken from IBM’s base case. Needless to say, we think that scenario is too optimistic. Using instead IBM’s “More Pessimistic” HPA scenario, (which is somewhat worse for housing prices but still pretty optimistic for other risk factors), the HECM capital ratio would be 0.68%, not much better than the rest of the fund. The FHA report acknowledges that, while having sufficient cash-on-hand for the time being, ” … the MMI Fund has only a small additional margin should economic conditions and guaranteed-loan performance be even worse than projected.”

In summary, the HECM program still generated positive cash flow in FY 2009, and may even do so again in FY 2010. Furthermore, FY 2009 production has a fighting chance to eke out a profit for FHA. As we explained in our previous blog entry, it benefits from lower appraised values and therefore lower MCAs. However, the HECM program is not subsidizing the rest of FHA. The dramatic increase in the HECM LLG makes that clear. As we have explained in detail throughout our blog, the very high principal limits (i.e. LTVs) that existed in the HECM program until September 30, 2009 left FHA exposed to significant losses in an economic downturn. This is now borne out in the FY 2009 AMR and, we expect, will become even clearer in subsequent reports. Therefore, given the uncertain state of the housing market, and its diminished capital position, FHA was justified in reducing the HECM principal limits. In our third and final installment, we will conclude this series with a discussion of what FHA should do next.

Part I: The Ghost of Principal Limits Past

Three months have passed since we published the last installment of our three-part “Trouble With HECMs” blog, enough time for the dust to settle on a number of fronts. First, FHA made a major change to its Home Equity Conversion Mortgage (HECM) reverse mortgage program, lowering by 10% the Loan-to-Value (LTV) ratios (or Principal Limits, in HECM parlance) for all HECMs originated after September 30, 2009. Second, FHA released its Annual Management Report, in which it made the alarming disclosure that the capital ratio for its main fund, Mutual Mortgage Insurance (MMI) fell to a scant 0.53%, below its required 2% floor. FHA maintains that the recent changes they have implemented will improve its financial position, such as the raising of credit standards and the exclusion of non-compliant lenders, among others. Finally, Ginnie Mae’s HMBS securitization program experienced rapid growth, and is now the mainstay of the reverse mortgage secondary market. All of these developments have wide-ranging implications for the reverse mortgage industry, causing significant changes in the volume, product, and pricing of new reverse mortgages.

This entry is the first part of another three-part blog sorting through these events. Part I will review the events of the recent past and discuss their implications for the risk profile of the HECM program in the current economic climate. Part II will delve into the present financial situation of the HECM program and FHA in general, as reflected in their recent Annual Management Report. Part III will present our recommendations for the future.

In a nutshell, our main recommendations were first, keep the old HECM but fix it, and second, implement “HECM II,” a low cost, lower LTV HECM product. We also proposed replacing the Servicing Fee Set Aside (”SFSA”) with a Tax and Insurance (T&I) Set Aside. The SFSA has proved more trouble than it’s worth, whereas HECM investors are increasingly concerned about T&I defaults. With the LTV reduction, FHA has implemented the first recommendation; FHA has also announced that they are studying the HECM II concept, or “HECM Mini,” as they call it. A less fortunate development is that it is becoming more clear that FHA will suffer significant losses from the 320,000 or so high-LTV HECMs originated during the peak years of residential property values. The first order of business, therefore, was to reduce the extremely high LTVs in the HECM program.

As of October 1st, the beginning of FHA’s Fiscal Year (FY) 2010, FHA lowered HECM LTVs across the board by 10%. Therefore, a HECM borrower who could previously take out an 80% LTV HECM can now borrow no more than 72% LTV, borrowers who would have qualified for a 60% LTV will now get 54%, and so on. This necessary and appropriate action will go a long way to reducing FHA’s, and therefore the taxpayer’s risk, for reasons we discussed at length in our previous blogs. Suffice to say that it addresses our previous concerns and should allow the program to break even at lower home price appreciation rates in the 2% to 3% per annum range.

FHA’s action capped a series of significant changes that permanently altered the shape of the reverse mortgage industry. To summarize the sequence of events: the Housing and Economic Recovery Act of 2008 (HERA) raised the loan limits for HECM Maximum Claim Amounts (MCA) to $417,000 and moved all new endorsements for the HECM program from FHA’s General Insurance (GI) Fund to the MMI Fund starting in FY 2009. In February 2009, the American Recovery and Reinvestment Act of 2009 (ARRA) raised the MCA again to $625,500, which spurred a record fiscal year of HECM origination, just barely in number of loans, but by about 20% in loan balances. FY 2010 began with the 10% LTV reduction. Of course, this all took place with the backdrop of extremely difficult economic conditions, including a continuing fall in home prices.

All these changes have effectively created three groups of HECM loans: pre-FY 2009 HECMs, originated at the old (higher) LTVs, but lower loan limits, and classified in the GI fund (let’s call this “Group 1″), the FY 2009 HECMs with the higher LTVs, higher loan limit and placed in the MMI fund (”Group 2″), and HECMs endorsed on or after October 1, 2009, with lower LTVs, higher loan limit and placed in the MMI fund (”Group 3″). These three categories have very different risk profiles. Group 1 clearly poses the most risk to FHA, with loans originated at higher LTVs on properties appraised during the peak of the residential housing boom. Group 2 benefits from the more modest appraisals this year, but still has the high LTVs. Group 3 is the safest for FHA: lower LTVs on lower property values. The lower MCAs and lower initial utilization rates of Group 1 do mitigate its risk, but this is almost certainly overwhelmed by the other risk factors, as we discuss below.

Group 1 comprises about 320,000 of the approximately 450,000 HECM loans outstanding. Group 2, the FY 2009 production, has approximately 125,000 units, and Group 3 is the future. Pre-2002 production was tiny to begin with (only about 50,000 HECMs were originated in that period), and very few are still outstanding.

Home prices have generally fallen to 2002 levels, about 30% below their peak in 2007. That means essentially none of the loans in Group 1 have benefitted from price appreciation; their loan balances have grown as their property values have fallen. A 5.5% HECM loan originated in 2002 with a 60% LTV that has the same value 8 years later, is now a 92% LTV loan. A 2007 5.5% HECM loan that began at a 60% LTV on a property that has declined 30% in value is now underwater, especially taking the cost of property disposition into account (more on that in Part II).

Loss Mitigation vs. Lost Mitigation
Defenders of the old regime sometimes insist that there are overlooked mitigating factors to FHA’s HECM risk. Chief among these are utilization or draw rates, and loans with excess equity (that is, loans with property values exceeding their Maximum Claim Amounts). However, as we shall see, this loss mitigation looks more like lost mitigation when examined in light of the housing bust, changes in the HECM product, and borrower behavior.

Many adjustable rate HECM borrowers do not initially borrow the full amount available, instead opting to draw the remaining amount, or Net Principal Limit, over time. For example, a borrower with a $200,000 house may elect to borrow $100,000 initially and leave $40,000 on a line of credit. The line of credit can then be drawn down any time in the future. In the meantime, the unused portion grows each year at the loan interest rate.

This loan is initially less risky to FHA, but borrowers do make their draws. According to HUD data, line of credit draws average an additional 15% of the Net Principal Limit in the first year and nearly as high in the remaining years, so that the average Net Principal Limit rapidly approaches zero, even with the growth feature. It’s no surprise then that most loans put back to HUD are fully drawn, or nearly so, with utilization rates exceeding 90% for ARMs, according to one study. Of course, fixed rate HECMs are fully drawn from day one.

Bear in mind that the borrower who does not take down a high percentage of proceeds at closing, and also does not make a lot of subsequent draws, has a rather high cost loan. Using our example, the 2% Initial MIP alone represents a 4% fee on the loan balance. FHA may not lose money on this loan, but it is a pyrrhic victory, at a high cost to the senior homeowner. Even if there were enough of these loans, it would mean that one group of borrowers is heavily subsidizing another group. This is not the intention of the HECM program, which seeks to equalize risks and benefits. It also illustrates the unfairness of charging the same upfront insurance fee to each and every borrower, despite their widely variable degrees of risk.

Before the HECM loan limits were raised, FHA capped the Maximum Claim Amounts at much lower levels, from $200,160 to $362,790 depending on geographic location. But unlike now, borrowers then had the option of taking out jumbo mortgages, both forward and reverse. The forward jumbos offered generally higher LTVs and the reverse jumbos offered much lower upfront costs, albeit with generally higher interest rates. Due to its much higher LTV, the HECM was able to compete against the jumbos in the $300,000 to $600,000 property value range, when the borrower felt the HECM’s higher proceeds and lower interest rate outweighed the higher upfront fees. Consequently, a number of HECMs had some excess equity at origination. Since their underlying value exceeded the HECM loan limit, their real LTV was lower than that of other HECMs with the same borrower age and expected rate. For example, according to the General Accounting Office, some 42% of HECMs originated in 2006 were originated with some excess equity.

However, that was before the crash in residential home values. Most of these excess equity loans were originated in California and other regions that were hit hardest by the crash in home prices. So how much, if any, of that excess equity remains?

Recent borrower behavior provides a clue. When HECM limits were raised to nearly double their old amount, some predicted a wave of reverse mortgage refinancing. For the jumbo loans, this came true. Many jumbo borrowers took advantage of the lower rates and higher LTVs that were suddenly available for homes in their price range. Jumbo prepayment rates climbed from an average of 9% CPR (that is, the per annum rate) in October 2008 through March 2009 to 19% in April through September 2009, thereby recovering back to their approximate historical averages. But for HECMs, the refinancing boom was a refinancing bust; lenders reported significantly fewer HECM refinancings than expected. If there were so many borrowers with excess equity, the industry should have seen a much higher number of originations in FY 2009. Instead, unit volume was only slightly higher than 2008. The most plausible explanation: the excess equity was modest to begin with and has since vanished. That HECM borrower in California who borrowed $250,000 in 2007 on a home appraised at $475,000 might now owe $300,000 (with draws and interest roll-up), with little if any equity remaining.

With the HECM loan limit now at $625,500, the vast majority of new loans will have a Maximum Claim Amount equal to their appraised property value. The mean average Maximum Claim Amount jumped from under $220,000 in FY 2008 to over $260,000 for loans originated in FY 2009. The same GAO analysis that shows the percentage of 2006 HECMs with Maximum Claim Amounts capped by the loan limit at 42% also shows that percentage dropping to 25% in FY 2008, and to only 18% for the first four months of FY 2009. Therefore, it seems the percentage of Group 1’s excess equity has all but vanished (for the minority of loans which had any), and for Groups 2 and 3 it will scarcely exist.

With each passing year, and after massive home price declines, the slow prepayments, higher draw rates, and the negative amortization built into reverse mortgages, it seems less and less likely that by the time these HECM loans mature they will have excess equity or undrawn credit lines to cushion the blow to FHA.
But very few of these loans have paid off or even been put back to FHA yet … which brings us to Part II.

In the third and final installation we propose a solution to end “The Trouble with HECMs.” In Parts I and II, we described the problems associated with the current high-cost, one-size-fits-all HECM reverse mortgage loan. Despite the high fees to the borrower (an Initial MIP equal to as much as 2% of the property value plus ongoing fees equal to 0.5% per annum on the loan balance), FHA is still losing money. The extremely high loan amounts, with Loan-to-Value ratios as high as 80% to 90% for older borrowers, are creating “crossover” losses as property values decline and loan balances increase. As a result, the HECM program faces a potential death spiral scenario, in which senior borrowers are faced with ever increasing costs to fund the subsidy required to continue its existence, an existence made more tenuous by the high costs to the borrower and the taxpayer.

A new approach is needed, one that lowers the senior borrower’s cost, lowers FHA’s risk, while still providing sufficient proceeds to the senior. Therefore, we propose HECM II: a HECM loan with no upfront MIP, no Servicing Fee Set-aside, a 75 basis point (0.75%) annual premium, and sensibly lower Loan-to-Value (LTV) Ratios. We do not propose eliminating the original HECM, but rather maintaining it, with some improvements, as an alternative for the neediest seniors.

HECM II should be implemented as follows:

Eliminate Upfront MIP: As noted above, FHA currently charges the senior borrower an upfront fee of up to 2% on the property value, meaning that the senior borrower pays as much as $12,510 before they pay for any lender fees or interest. This fee is charged to the 62-year-old and 99-year-old borrower alike. It is the largest expense borne by the HECM borrower, and it is the main reason HECMs are burdened with the “high-cost” label. Eliminate the initial MIP and this reputation will be eliminated with it. The remaining closing costs are the typical closing costs any mortgage borrower pays, plus the lender’s origination fee, which is capped by federal law at $6,000.

Replace Servicing Fee Set-Aside with Tax and Insurance Set-Aside: The Servicing Set-Aside
(”SFSA”), a concept unique to HECM, is the subject of some controversy. It basically quantifies the present value of the servicing fee, a flat monthly dollar amount that is added to the HECM loan balance each month. The SFSA is disclosed to the borrower as a reduction in the Principal Limit, which gives it the appearance of yet another initial cost. Suffice to say that many reverse mortgage lenders and borrowers find it to be a confusing and unnecessary concept. On the other hand, no set-aside or escrow provision is required for payments of property taxes and insurance (“T&I”). Servicing fees, which total less than $400 per year per loan, can easily be paid by the investor to the servicer, but T&I payments can run into thousands of dollars. If not paid, T&I delinquencies can ruin the value of a HECM loan by causing it to lose its first lien status and therefore its FHA insurance. The reverse mortgage industry is currently grappling with the issue of rising T&I delinquencies and losses.

In other words, FHA created the wrong set-aside. The HECM program was first introduced in the late 1980s, and most features have never been updated. FHA should use the clean slate of a new product design to replace the SFSA with a T&I set-aside. The T&I set-aside could take the form of a fixed dollar amount equal to six months of taxes and insurance payments. This amount would be deducted, or “set-aside” from the Principal Limit at origination. The servicer would then have the ability to cure T&I defaults by paying those expenses directly and adding the payment to the loan balance.

Raise Ongoing MIP to 0.75% per annum: The ongoing MIP should be increased from 50 basis points (0.5%) to 75 basis points per annum (0.75%). The ongoing fee of 75 basis points, which is charged on the loan balance, not the property value, would keep borrowers’ LTVs greater than 40%, and provide sufficient revenue to FHA to insulate it from further losses. With a purely monthly MIP, FHA’s risk is aligned with the borrower fees it collects, and the borrower pays for the risk she creates and the duration of the benefit she receives. This makes the HECM safer to the taxpayer, and fairer to the borrower. A 75 basis point fee keeps the LTVs not too high, and not too low, while still delivering to the senior borrower the traditional HECM benefits of no monthly payments, no preset maturity date, free counseling, and the flexibility of choosing (and changing) product types. That is a good value proposition.

Allow Put Back to HUD at 88% of Maximum Claim Amount: As we noted in Part II, a loan effectively reaches the crossover point when the loan balance approaches 90%, not 100% of the home value. This is because of property disposition costs, which rise precipitously as the homeowner’s equity approaches zero. Adjusting the put back to 88% puts FHA appropriately in control of the asset they are insuring, at the moment that losses may occur. The 88% put would also shorten the average life of the HECM loans and securities backed by HECM loans.

Keep the Old HECM, but fix it: FHA could maintain the old HECM as a needs-based product for borrowers where higher proceeds are critical. Lenders and counselors would be required to show the relative costs, total annual loan cost (“TALC”), and proceeds, side-by-side. The LTVs for this product would have to be lowered too, to make them revenue neutral under FHA and OMB’s revised lower expectations for home price appreciation. We may address this in a future blog, but for now, FHA should cap all “HECM I” LTVs at no more than 75%.

Implement HECM II With Lower LTVs: Lower MIP fees and lower expectations for home prices require lower Loan-to-Value (LTV) ratios. This is a big change for an industry weaned on high LTVs, but the reverse mortgage industry need not fear lower lending limits. For most borrowers, HECM II will provide better value. This will open up a whole new market for the industry, and provide a much-needed rejoinder to industry critics. Meanwhile, the neediest senior borrowers can still use the (reformed) standard HECM product. Moreover, since we posted Parts I and II of this blog, a consensus has been building in Congress and the reverse mortgage industry that a lower fee/lower LTV HECM should be implemented. The industry and its customers are ready for a change.

So how do we create this new product? How do we calculate these new LTVs (or Principal Limits)? Recall that in Part II we reviewed the mechanics of calculating the crossover loss for a single loan, and then applied that methodology to a pool of loans. To create the HECM II, we simply apply the same techniques, using the same inputs (3% home price appreciation, historical HECM prepayment rates, 10% cost of property disposition, etc.) and the new product guidelines we have outlined above (no initial MIP, 0.75% annual fee, swap servicing set-aside for T&I set-aside). We then solve for the break-even LTV of each unique pair of values for borrower age (62 – 100) and Expected Rate (5.5% to 15% in 12.5 basis point increments). The resulting matrix of 3,003 values is the HECM II Principal Limit table.

The Principal Limit table is the cornerstone of any reverse mortgage product: it sets forth the maximum LTV for each borrower. The table applies to both fixed and adjustable rate HECMs. For adjustable rate loans, the Expected Rate is equal to the ten-year equivalent of the base index (e.g. the 10 year LIBOR swap rate for LIBOR-based loans), plus the applicable rate margin. For fixed rate loans, the expected rate is the fixed rate itself. For our HECM II table, we assumed that the spread between the spot rate and 10 year equivalent is 400 basis points. We perform two iterations of our analysis, one for fixed rate loans and one for adjustable rate loans, and take the lower of the two results for each age/rate pair.

Our proposed HECM II Principal Limit table is attached. Under current market conditions, our HECM II provides for LTVs ranging from about 50% to 60%, and would average about 52% for the 73-year-old borrower. As we noted above, this is about 14%, or up to $87,500 less than the standard HECM, but also saves that same borrower $12,500 in initial MIP! Incidentally, this illustrates the high cost of over-leverage. LTVs which exceed the limit of prudent financial boundaries result in high costs to the borrower, to taxpayers, and to investors alike.

We leave for subsequent discussion the amount of T&I Set Aside: it could be an amount equal to six or twelve months of taxes and insurance payments, deducted from the Net Principal Limit and advanced by the lender if needed.

Therefore, the HECM II would benefit senior borrowers, lenders, and investors, as well as the taxpayer. Senior borrowers (and their counselors and families) would finally have a choice. They would pay substantially lower costs and leave more home equity to their heirs. Lenders would likely have more customers, as the many senior borrowers previously turned off by high costs would instead choose HECM II. Investors would have the comfort of knowing that they have a larger equity cushion protecting their loans, and that the T&I default issue is mitigated by the new set-aside.

Finally, HECM II would reduce the size and volatility of FHA’s risk and relieve a considerable drain on HUD’s budget. In sum, HECM II would provide a balance of risk and reward more suitable to the senior borrower’s needs and the taxpayer’s means in the current housing market. We urge Congress and FHA to implement the HECM II as soon as possible.