Archive for the ‘HECM LTVs’ Category

The New Trouble With HECM

Wednesday, November 21st, 2012

The FHA released its FY 2012 HECM Actuarial Study and MMI Fund Report on November 16. The report reflects many changes to their economic and modeling assumptions, resulting in significantly higher projected losses for the HECM program. This is a dramatic turnaround from just a year ago. We criticized last year’s FHA actuarial study for being “too rosy.” This year, we might echo William Blake in saying “Rose thou art sick.” Last year, our criticism centered principally on their assumptions on prepayment rates, home prices, and Tax and Insurance (T&I) defaults. At the same time, we saw reason for optimism because of the many changes (lower PLFs, higher MIP, HECM Saver, etc.) that the FHA has adopted. As a result, we predicted that the overall HECM picture, particularly for the Mutual Mortgage Insurance Fund (MMI), would gradually improve each year as old loans paid off and were replaced by new HECMs with lower Loan-to-Value (LTV) ratios, higher MIPs, and less underlying home price erosion.

The new assumptions in FHA’s FY 2012 model include slower prepayments, smaller home price increases, and higher default frequencies and severities, all of which result in a significantly higher estimate of expected losses. The Actuarial Study predicts that the FHA will lose $7.6 billion, a figure that represents the present value of the net inflows and outflows from currently outstanding HECMs in the MMI. HECMs originated prior to FY 2009 are insured by the General Insurance Fund (GI) and therefore are not included in this analysis. After giving $4.8 billion credit to previously built-up capital and income (mostly from initial and ongoing MIP), the MMI fund has an economic value of negative $2.8 billion. As a result, says the FHA, they will change the program again, including a third round of PLF reductions. As much as we criticized their assumptions last year, we have to ask: have they gone too far?

To understand the answer to that question, we should first understand the dimensions of the MMI fund. About 300,000 HECM loans remain of the approximately 320,000 originated since the beginning of FY 2009. These are the HECM loans that comprise the reverse mortgage portion of the MMI fund. The FY 2009 vintage is the largest of the four vintages in the MMI and is also worst performing: home prices have declined about 11% since October 2008, when that Fiscal Year began. Moreover, the FY 2009 HECMs were originated under a higher Principal Limit Factor (PLF) table, so these loans have significantly higher LTVs than later vintages. FHA receives only 0.50% annual mortgage insurance premium (MIP) for these loans. Over 100,000 FY 2009 loans remain outstanding. The FY 2010 vintage has significantly lower PLFs, but also has the lower 0.50% MIP. This vintage has suffered only a 5% average home price decline since October 30, 2009. The last two vintages, FYs 2011 and 2012, have lower PLFs, a much higher annual MIP (1.25%), and have suffered comparatively little, if any, home price deterioration.

From this and other FHA reports we estimate that these 300,000 loans have approximately $48.5 billion in outstanding principal balance and $77 billion in Maximum Claim Amount. That implies that FHA will collect about $375 million in MIP next year from the loans and less with each subsequent year as loans pay off. We estimate the present value of the ongoing MIP for these loans at about $1.6 billion. Squaring this with the Actuarial Report’s estimate of the net present value of the MMI Fund HECM cash flow at -$7.6 billion implies that the Report estimates the present value of future losses at over $9 billion. This is a staggering number, representing nearly 20% of the current loan balance. The FHA expresses this number in its financial statements as the Liabilities for Loan Loss Guarantees (LLG), defined as “the net present value of anticipated cash outflows and cash inflows.” Our opinion: this estimate seems way too high. Even in a market with flat home prices (no increase or decrease for the life of the loan portfolio), we would not expect a newer vintage of HECMs to cause FHA to suffer losses exceeding the present value of 12% of the current balance. A flat market is hardly the base case, which usually allows for home price appreciation that should lower expected losses.

The actuarial report is not the final word; the FY 2012 Financial Statement Audit shows a $5.5 Billion MMI LLG, which probably reflects the favorable home price increases of the third quarter of 2012 and other adjustments. Still, this implies an average 15% loss level, which we think overstates the risk of the HECMs in the MMI fund.

Risk Factors
The cash flow model needed to analyze the MMI Fund is necessarily complex. It must have good loan level data input, sound statistical methods, and reflect a comprehensive knowledge of reverse mortgage cash flow with all its idiosyncrasies. It is impossible to evaluate any model conclusively without examining it first hand, but the actuarial report provides a lengthy description of its methodology. Although this description is long on statistical methodology and short on cash flow methodology, it does provide some insight into how it reached its conclusions.

The really big differences came from changes in the model’s methodology for measuring loss from defaults. These include tax and insurance defaults and also the losses resulting from loans that end up in foreclosure. These loans have very high loss severities because of the legal, maintenance, and disposition costs that arise during the lengthy process of foreclosure. According to the report, changes from the updated valuation model account for $2.4 billion in additional losses, nearly equal to the overall negative value of the fund. This includes slower payoff assumptions.

We warned last year that the Actuarial Analysis loan payoff speed estimates were too high. The 2011 Analysis suggested an annual prepayment rate of 6%, even for new vintages. The new report shows 4-5% prepayment rates in the near term (page A-12), still a bit higher than what we are observing, but more realistic than last year’s forecast. We are told 54,591 HECMs were originated in FY 2012. In its latest statistical release, HUD states that 595,342 HECM loans remained outstanding at the end of the year; the corresponding number in last year’s report was 560,843. That implies that about 20,000 loans paid off, a prepayment rate of approximately 3.5%. One can easily do this math going back through previous years’ FHA Annual Management Reports to find that HECM prepayment rates have been falling steadily for almost seven years. Still, the report’s payoff speed adjustment is a step in the right direction.

The report gives a detailed description of the regression model used to estimate T&I loss frequency, but not so much detail on its impact on loss severity. The report does not break out how much of the $2.4 billion loss is due to T&I defaults vs. slower payoffs or any other factor. The report describes its HECM Cash Flow Analysis methodology in Appendix C, where it states (on page C-3) that “the HECM forecasting model assumes that the assignment occurs when the projected UPB reaches 98 percent of the MCA threshold.” But this is not necessarily correct: assignment cannot take place if the loan is in default. In that case, the investor (which could be an HMBS issuer) must hold on to the loan. This is an important feature that can have a major impact on loss severity. If the cash flow model assumes automatic assignment regardless of default status it is overestimating the T&I advances and losses suffered by FHA.

In any case, the lifetime T&I default rates predicted by the model, as shown on page D-8, would give us some comfort if they made any sense, but they don’t. Page D-7 describes Exhibit D-6 (which is on page D-8, confused already?) as “… T&I default probabilities were forecasted for all active loans at the end of June 30, 2012. The resultant cumulative lifetime T&I default rates by historical fiscal years of endorsement for the active loans appear in the Exhibit D-6 below.” (By “Active” loans it appears that they mean any loan still outstanding, not to be confused with the Loan Status Category “Active” used by servicers to describe a loan that is still outstanding but not in default.) But the T&I default numbers look lower than the T&I default rates already achieved. Is this an estimate of additional defaults only? If so, what is the impact of loans already in T&I default? Most importantly, if 3 of the 4 vintages of the MMI will not exceed 1% in Lifetime T&I default rates, then how can this add significantly to the loss estimate?

The second largest factor in the model was the Updated Loan Conveyance Projection. The report points out an alarming swing in conveyance rates at termination, that is, the rate at which properties are conveyed to FHA upon loan termination, as opposed to owners or estates engaging in direct sales. Whereas last year 30% of all terminations resulted in property conveyance (e.g. foreclosure, deed-in-lieu) and 70% were paid off by the estate, in FY ’12 the proportions switched to 70%/30% conveyance and normal payoff, respectively. This adds nearly $2 billion to the loss estimate. This is a huge change; the report cites declining home prices, which are clearly the main driver, but such a large and abrupt change might have other immediate causes, such as a change in tactics by a large HECM investor.

In FHA’s Annual Report to Congress for the FY 2012 Financial Status of the MMI Fund (p 29), FHA notes that:

“ … Research indicates that this was directly tied to falling home prices. Owners and estate executors faced with mortgage balances greater than property value at the time of borrower exit from the home are less willing to engage in marketing and sale of the property than are those with positive equity in the home. In such cases, there is no financial benefit from managing the property sale and so those responsible for the home are more likely to convey the property to HUD for sale. … Property management and marketing costs associated with the disposition of homes conveyed to HUD typically cost approximately 12 percent of property value and thus increase the severity of loss for FHA.”

So far so good; this is an accurate description of this risk factor and consistent with our own research. When a loan passes the crossover point, at which time the loan balance exceeds the net property value, default frequency and severity rise sharply. The FHA continues:

“ .. The actuarial projections now include consideration of how conveyance rates vary with changes in house prices when estimating the economic value of the HECM portfolio. The actuarial projections now include consideration of
how conveyance rates vary with changes in house prices when estimating the economic value of the HECM portfolio.”

This is conceptually sound, but the key question is: how do you predict loss frequency and severity accurately? Most of these conveyances are from loans in the GI Fund that were originated in 2005 to 2008. Many of these loans are deeply underwater, which is why they have such sharply high frequency and severity of loss. They cannot be relied upon as a historical benchmark for the MMI loans; these distressed GI loans will have much higher frequency and severity of losses compared to the MMI loans. Conveyance rates vary indirectly from changes in home prices; what really matters is do these changes in home prices result in crossover and negative equity, and if so, by how much?

The experience of the GI Fund loans is applicable to only the most severe scenarios, which should be considered given recent history, but should by no means serve as average benchmarks for frequency and severity of loss. The report admits that “The lack of long-run performance data potentially limits the robustness of the models’ predictive capacity for later policy years.” That is precisely why the numbers should be used carefully; we have very little data on foreclosure frequency and severity for the MMI loans, as comparatively few have paid off and fewer still of these payoffs were underwater. The best option is to provide alternatives to conveyance: we will discuss this topic further in our next blog.

Also, the question we posed above for T&I default is relevant here too: does the model properly measure the cases in which FHA does NOT bear the brunt of the loss due to conveyance? For payoffs that take place before FHA assignment, the investor can bear the brunt of the loss, especially if it results in an Appraisal-Based Claim, where the investor ends up with an REO property for more than six months. Referring again to page C-3 of the report, the “historical severity rate” is used to calculate Type I (pre-assignment) claims and seems to imply that all loans that hit 98% MCA are put to FHA. As we explained above, historical severity is probably too high and defaulted loans cannot be assigned to FHA.

The third largest factor was the Updated Economic Forecast for home prices. This portion of the model is also appropriately more conservative; this resulted in a downward adjustment to the MMI fund value of $462 million.

The fourth largest factor was the introduction of Monte Carlo Stochastic Home Price Appreciation (HPA) and interest rate simulation. This is a very technical topic, but conceptually it is a valid approach and one intended to avoid an overreliance on a base case. Instead, it calculates several future scenarios, based on assumed probabilities and volatilities of underlying variables, and takes the weighted average of the results. This can result in a more robust model, but bear in mind that it discards one set of base assumptions in favor of another, namely the assumed volatilities and probabilities. The model’s accuracy is therefore limited by the availability of robust historical data. For example, according to the report, home price data before 1980 is not considered reliable (page F-4). Is the volatile boom and bust experience since 1980 typical?

In any case, the Monte Carlo methodology raises expected losses by $412 million. This is not surprising, due to the phenomena known as Jensen’s inequality, explained by the report on page F-1:

“ … when HPA goes negative, default losses increase at an increasing rate as HPA falls, but when HPA goes positive and keeps increasing, default losses can only go as low as zero and premium income does not increase. This is what we observed for HECMs.”

In fact, it is also true for proprietary reverse mortgages and forward mortgages. Our objection is more philosophical than quantitative. Among other advantages, the Monte Carlo method is intended to capture the “Black Swan” risk, the doomsday scenarios that could cause losses as high as $28.3 billion (page iv). According to the report, this worst-case scenario is one of 100 equally likely outcomes. This implies that this one doomsday scenario accounts for $283 million of expected loss. A repeat of the 2006-2009 crisis (or worse) would surely cause very high losses of the magnitude that doomed the private mortgage insurers. But if FHA is pricing its risk like a private insurer does (or should), it risks straying from its mission. This is especially true if the coming product changes are too severe and price out some of the senior homeowners who need help. Something to think about: what is government mortgage insurance for?

A few other conclusions that appeared in the report seem puzzling:

The Principal Limit discussion (page 2) says the expected mortgage interest rate floor is 3.0%. In fact, the PLF tables might show 3%, but the effective floor is 5%. The PLFs do not increase for expected rates lower than 5%. We will explain the significance of this in our next installment.

The report seems to say that the value of the FY 2012 book of business is negative $385 million (page 14). How can that be when the nearly identical FY 2013 vintage is positive?

In the actuarial model, all loans are assumed to pay off after 35 years (page 42). For a pool of nearly 300,000 loans, FHA will certainly end up with several 97 year-old borrowers who took out a HECM at age 62. Our decades-long observations from the proprietary reverse mortgage market confirm this. The loss severities for these loans can be quite high, but the present value impact today is much lower.

The model appears to project annual, not monthly, cash flows. If this is the case, it may overstate losses as the crossover amounts are determined in arrears (at period end). All else equal, this will increase estimated crossover amounts and therefore lower economic value overall.

Implications of the Model Results
FHA’s own numbers show a steady improvement over the next several fiscal years. As we explained last year, with each passing year more of the bad old loans pay off, and the remaining portfolio contains proportionately more of the profitable (to FHA) loans.

The FHA concludes that the MMI deficit means they must further change the product. The report does state fairly clearly that:

1. The fixed rate HECM Standard will be “merged” into the fixed rate HECM Saver;
2. FHA intends to reduce the amount of the initial draw; it’s not clear if this language refers to capping fixed rate proceeds which the report stated is a “longer term” objective, or is another change not well articulated in this report;
3. PLFs will be lowered “across the board” for all products;
4. Some form of economic incentive will be implemented to motivate estates to dispose of properties on their own. No hint was provided as to what or how that might work, but it is intended to provide some flexibility that will reduce loss severity;
5. Proceeds on fixed rate loans will be limited to the amount necessary to pay off “mandatory obligations,” i.e. mortgage liens, closing costs, delinquent tax, and insurance premiums. The report references immediately limiting the amount borrowers will be allowed to draw at origination but gives no specific program detail; and
6. Financial assessment and some form of T&I set-aside continue to be on the docket for introduction in the future.

The FHA must abide by the rules set by Congress, so they must bring the MMI back into balance. But remember, the MMI consists of 4 vintages of HECM that are really 3 different standard products: high PLF/Low MIP (FY ’09), Medium PLF/Low MIP (FY ’10), and Lower PLF/High MIP (FY ’11 and ’12). The last two vintages also include the HECM Saver. If the MMI consisted of only the last two vintages, we would not be having this discussion. Instead, the FHA is forced into a situation where the product must become even more conservative to subsidize the other two vintages (especially ’09).

This leads to another problem: further PLF cuts may be counterproductive as they will drive down origination volumes and actually hinder the MMI’s recovery. The report acknowledges this with respect to the forward program, for example, higher MIPs charged for longer periods will result in faster prepayments by credit worthy borrowers, leaving a remaining pool of lower quality.

Conclusion
The report seems to agree with us that the fund will improve over time. At the same time, it predicts a level of loss that seems too severe. FHA must operate under the budget rules that force it to act now and close the gap sooner, which paradoxically means changing a product that, in its current form, is probably not contributing to the problem.

We do not suggest that a perfectly modeled MMI fund would give us cause for complacency: the program should be reformed further. For example, the T&I Chickens have come home to roost; we advocated a T&I set aside or escrow over 3 years ago. The inaction on this issue has been costly.

Our next blog will discuss what FHA should do next, with an emphasis on using tools in the current program’s features and less on the root-canal of across-the-board PLF cuts.

One last word: far from being the disproportionate cause of FHA’s problems, it is the forward mortgage program that has disproportionately higher delinquencies, defaults, realized losses, and leverage. HECM has, if any, borne a disproportionate share of the reforms. We searched the FHA reports in vain for any discussion of lowering forward mortgage LTVs. No amount of adjustment to MIP and FICO requirements will fix the problems caused by overleverage. Unlike the current forward mortgage FHA program, the existing HECM loans being originated today are not making the situation worse.

FHA’s Underwater Problem – Is the Worst Over?

Monday, January 30th, 2012

FHA recently released another updated Home Equity Conversion Mortgage (“HECM”) loan level data file, this time showing all FHA-insured reverse mortgages originated through November 2011. Once again, prepayment rates declined to new lows: the annual prepayment rate for seasoned HECMs is about 4.7%, compared to the historical average of 6.8%. We have adjusted our HECM “Prepayment By Borrower Age” table accordingly.

Beginning with the prior release (January 2011), FHA added new fields to their data set. This new data enables us to get a sharper picture of the economic state of the HECM program. These include data showing the amount borrowed for each loan, and the year it was drawn. As we explained last April, a good approximation of each loan balance can be calculated by rolling forward the draws, plus estimated accrued interest, MIP, and servicing fees.

Using this same methodology, and applying the data from the most recent FHA dataset, we rolled forward the approximately 580,000 HECM loans currently outstanding. We estimate the total outstanding balance of all HECM loans to be approximately $87.6 billion as of November 2011. This estimate is consistent with FHA’s most recent FY 2011 report.

The dataset also contains the estimated property value at origination for each loan, as well as the mortgaged property’s location: Metropolitan Statistical Area (MSA), State, Zip Code, etc. Once again, for about 92% of the loans in the file, we were able to link these data fields to publicly available data showing historical price levels by MSA, and thereby estimate each loan’s current underlying property value. For the remaining 8%, we used state level home price data. Comparing these property values to the rolled balances, we can estimate the current state of the HECM program with respect to crossover losses.

Our analysis shows the following: approximately 108,000 HECM loans (or 19% of outstanding) are underwater by a total of $4.3 billion, an increase of nearly $1 billion over 10 months. However, those numbers simply compare loan balance to property value; a more accurate measure haircuts the property value to reflect the cost of property disposition. As a practical matter, only the net property value (home price minus the property disposition cost), is available to pay off the HECM loan. Unfortunately, property disposition costs grow significantly as the mortgage balance approaches the crossover point; a haircut of 10% or even 15% is not unreasonable. If the loan is in default or foreclosure, the cost can be much higher. Applying a 10% haircut to property values raises the number of HECMs effectively “crossed over” to 160,000 loans (28% of outstanding), underwater by $6.4 billion, and a 15% haircut to 196,000 loans (34% of outstanding) underwater by $7.9 billion.

Not surprisingly, HECM loans originated from 2005 through 2008 comprise substantially all of these underwater loans. In the 10% haircut scenario, they account for about 88% of the underwater loans. The 2006 and 2007 vintages alone account for nearly 60% of the problem loans.

Because of the 2005-2008 vintages, these numbers will get worse before they get better. The underwater numbers are simply a snapshot as of November 2011, in other words, how much FHA could lose if all the loans paid off at that cutoff date. But these loans are paying off slowly, and will take several years to pay off completely. During those years, accreting loan balances and borrower advances, especially if combined with slow prepayments and a struggling housing market, will make the problem worse. This fact is reflected in FHA’s estimate of a Loan Loss Liability of $10.013 billion (for HECMs originated through FY 2011) in their most recent Annual Management Report. (FHA made upward revisions to their loss estimates for HECMs originated through FY 2008, from their $8.7 billion estimate at the end of FY 2010, $4.8 billion estimate at the end of FY 2009 and $1.5 billion the year before.) We also estimate, based on the FHA dataset, that FHA has already experienced anywhere from $700 million to $1 billion in realized losses from underwater HECMs that have paid off.

Last April we put the HECM program’s net economic value since inception at -$7.3 billion. With declining home prices, (down about 3% in the 12 months ended November 2011), slow prepayments, and accreting loan balances, one might expect FHA’s HECM bottom line to get much worse. But with several months of new loan production of improved HECM products, the overall outlook for FHA’s HECM insurance portfolio avoided further deterioration. With each new loan, FHA is collecting MIP at a higher rate on loans with lower Loan-to-Value ratios. As we noted in our previous blog, FHA reduced its estimate of future losses on its HECM portfolio. Combining FHA’s estimates of what will happen with our estimates of what has happened, the program’s net economic value since inception now stands at about -$5.4 billion. We think FHA’s current projections are a bit optimistic, but even using their old numbers, the program’s economic value held steady.

The details of the HECM program’s bottom line: probably a little over $5.3 billion in MIP collected to date (in present value terms), minus at least $0.7 billion in realized losses, minus the $7.9 billion in projected negative net present value (“NPV”), which includes nearly all of the $4.3 – $7.9 billion baked-in crossover loss we estimate, minus another $2.1 billion in projected losses for HECMs originated in FY 2009 – 2011. In sum, about $5.4 billion negative NPV for the program since its inception, with the vast majority of the damage coming from the 2005 – 2008 HECM loan cohorts. Even if FHA’s assumptions are too rosy by $2 billion, the program is still holding the bottom line in unfavorable economic conditions.

$5.3 Billion   MIP collected
-$0.7 Billion   Realized losses
-$7.9 Billion   1990-2008 originations: projected net loss
-$2.1 Billion   2009-2011 originations: projected net loss
-$5.4 Billion   HECM program Net Present Value 1990-2011

In our last blog on this topic, we note that unlike the forward mortgage industry, the reverse mortgage industry has already undergone the painful process of reform, including reducing loan-to-value ratios (principal limits) and weaning itself off Fannie Mae. Barring another housing catastrophe, the worst may be over. If so, the current position of the HECM will improve each year, as FHA’s HECM risk profile reflects an increasing percentage of the new, more conservative standard HECM loans and HECM Savers.

FHA Fiscal Year 2011 Annual Reports – Still Too Rosy

Friday, November 18th, 2011

HUD released its FY 2011 annual reports on November 15, 2011, including the HUD Mutual Mortgage Insurance (MMI) report, the FHA Annual Management Report (AMR), and the HECM MMI Actuarial Analysis. Upon review, our conclusion is that HUD is still significantly understating the expected future losses in the HECM book of business. Others have concluded the same about the forward loan book: The Wall Street Journal Editorial page took HUD to task on this point Thursday, November 17, 2011, and Wharton Professor Joseph Gyourko published a study for the American Enterprise Institute’s for Public Policy Research asking “Is FHA the next housing bailout?”

There are three central points addressed in this post:
1. Aggregate changes to the FHA’s overall HECM exposure;
2. Comments on the FHA’s prepayment conclusions; and
3. FHA’s Home Price Appreciation (HPA) assumptions, T&I defaults, and their impact on future losses.

Overall HECM Exposure

It is important to note the FY 2011 HECM Actuarial Analysis covers only the MMI Fund, not the GI Fund, where most of the HECM program’s exposure rests. While the Economic Value of the loans in the MMI Fund may be positive, it represents just 37% of HECMs, all of which were originated in 2009-2011, after the recent real estate bubble deflated. The brunt of the analysis should have focused on the GI fund. Instead, the economics of the GI fund is mentioned briefly deep in the notes to the FHA financial statements in the AMR.

We reported in our April posting that the Net Present Value of the entire HECM program was -$7.3 billion as of 9/30/10. Our calculation took FHA’s FY 2010 projected loss of $11.365 billion and offset it with historical receipts ($4.5 billion), and estimated realized losses ($400 million). The bulk of this $11.365 billion estimate comes from projecting future losses on existing books of business, primarily those loans originated in years 2005-2008, which account for 47% of all HECMs ever originated. This group of HECMs was originated at the height of the home appreciation bubble, and as a result, the overall program is particularly sensitive to prepayment assumptions and HPA forecasts, especially in the later years.

For FY 2011, The GI Fund reported Liabilities for Loan Guaranties (LLG) of $7.864 billion dollars, down $828 million from last fiscal year’s $8.692 billion projection. The LLG is defined as the net present value of anticipated cash outflows and cash inflows. The MMI fund, which has insured HECMs since FY 2009, reported an LLG of $2.149 billion, down $524 million from FY 2010’s $2.673 billion projection. Therefore, FHA’s overall projected exposure to future HECM losses is reduced by $1.352 billion to $10.013 billion.

How is this projection calculated? The two principal drivers for future performance in the HECM book of business are 1) future HPA assumptions; and 2) prepayment assumptions. Because reverse mortgage exposure to loss is back-ended, the magnitude of loss is particularly sensitive to expected home prices in the distant future. Future losses are also sensitive to prepayment speeds because the more slowly the loans pay off, the longer they are outstanding and subject to future home price appreciation/depreciation.

Prepayment Analysis

The Actuarial Analysis “HECM Termination Rates” Exhibit A3.1 (page A-10) suggests an annual prepayment rate of 6% even for new vintages. (The section on prepayments in the Actuarial Analysis is confusing and hard to follow.) Amid the blizzard of statistical formulae, we cannot find anything that resembles recent actual experience. In the AMR for example, we are told 73,093 HECMs were originated in FY 2011. Later in the report, it states that 560,843 HECM loans remained outstanding at the end of the year; the corresponding number in last year’s report was 510,144. That implies that 22,394 loans paid off, a prepayment rate of approximately 4.4%. One can easily do this math going back through previous years’ FHA AMRs to find that HECM prepayment rates have been falling steadily for almost six years. For the largest cohorts, the bubble-year vintages, prepayment rates are currently closer to 2%. See New View Advisors’ Prepayment Index tab here.

New View Advisors’ modeling of prepayment activity also incorporates mortality, mobility, and refinance, but in this environment, the latter two factors equal nearly zero. Actuarial life expectancy tables have been used since 1999 with extreme accuracy. They are a highly predictive indicator of prepayments, and much easier to comprehend. The tables we use are Annuitant mortality tables, not those of the population as a whole; this is essential for capturing the adverse selection of seniors who choose long-term financial products. The FHA Actuarial Review report states “base-case mortality rates were based on the 1999-2001 U.S. Decennial Life Exhibit, published by the Center for Disease Control and Prevention in 2004.” These tables appear to be for the population as a whole, and for major subgroups, but do not address annuitants. This may have introduced a serious sampling error into the Actuarial Review’s prepayment forecast.

Mortality is the dominant driver of Maturity Events, and depressed home prices slow down the rate at which matured HECMs are liquidated (i.e. loan paid off and/or property sold), putting still more downward pressure on prepayment rates. FHA’s faster prepayment assumptions are painting too rosy a picture of future expected loss.

Home Price Appreciation (Depreciation)

As for the impact on future HPA, each of the five scenarios portrayed in the Actuarial Review fails to contemplate the effect of a prolonged real estate slump or the effect of volatility on future losses. As mentioned above, because reverse mortgages suffer realized losses at the end of their life, short-term swings in home prices do not have nearly the deleterious effect on loss that long-term economic trends do. Exhibit B2.1 in Appendix B of the Actuarial Review clearly depicts the five different HPA scenarios used to test sensitivity. Every scenario has HPA returning to between 3% and 5% annual growth by 2015, with a relatively smooth curve that ignores the volatility of the housing market.

Home prices rose at an unprecedented 6% annual growth from HECM’s inception in 1989 until 2007, and HPA was 3-4% from 1945 until the bubble in 2007, but this doesn’t predict future home values. Assuming this period as the norm conveniently forgets that it is bracketed by the Great Depression and the Great Housing Bust. One could argue the recent 30% drop in HPA is the reversion to the mean, and that a relatively quick return to 5%, then 3.4% (Page 6 of the Actuarial Review) annual growth is not a plausible “Base Case.” What would happen if HPA spiked and fell again? That would also be devastating, as a new book of business would be originated at another temporary peak in the real estate market. While no one has a crystal ball, at a minimum, the FHA should be showing the effect of volatility and a prolonged flat or negative HPA in some of its sensitivity scenarios.

If we can’t predict the future, we at least can examine the past. Home prices fell over the last year, at about 5% on average during FY 2010. If prepayments were slower than expected and home prices fell, how can FHA justify an LLG decline of nearly $1.4 billion?

Default

The Actuarial Review Appendix D forecasts a T&I default rate of 2.2%. Once again, this bears no semblance to recent reported experience. At the annual NRMLA conference in Boston last month, the FHA themselves reported T&I defaults in its portfolio were running north of 8% and growing, nearly four times this assumption. Where did 2.2% come from? It is neither descriptive of historical experience nor plausible as a forecast. Unfortunately, the severity of loss for defaulted loans was not disclosed, so it is not possible to understand the impact of default on realized losses for these books of business.

Conclusion

FHA’s $10 billion expected loss from its HECM book is likely low, based on overly optimistic HPA, loss, and prepayment assumptions. How far off is anyone’s guess, but sensitivity analysis is supposed to show worst case, base case, and best case execution, and these reports have failed to do so. Nonetheless, we emphasize that FHA has taken many of the proper steps necessary to reform the HECM program. The reverse mortgage industry has reduced the amount it lends, weaned itself off Fannie Mae, and introduced financial assessment to minimize loss.
Considering HECM is less than 1% of the overall mortgage market, the FHA needs to take a sober look at the forward side of its business. The astonishingly high Loan-to-Value ratios of FHA’s forward mortgage programs are a good place to start.

HECMs: Are We Still In Trouble?

Monday, January 11th, 2010

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.

HECMs: Are We Still In Trouble?

Saturday, December 19th, 2009

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.

The Trouble with HECMs: Part III

Friday, August 7th, 2009

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.

The Trouble with HECMs: Part II

Tuesday, July 21st, 2009

In the first part of this series, we outlined “The Trouble with HECMs,” the result of extremely high Loan-to-Value (“LTV”) ratios permitted by the HECM program, which left FHA highly exposed to losses during the current deep slump in home prices. FHA projects that it will lose $798 million on $30 billion of HECM loans originated in FY 2010. According to our calculations, this implies annual home appreciation of about 3% per annum. The $798 million figure represents the net present value of FHA’s losses, even after charging the senior borrower a high upfront Mortgage Insurance Premium (“MIP”) of 2% on the HECM borrower’s home value, plus 0.50% per annum on the loan balance. This installment describes how we quantify and analyze HECM cash flows, and FHA’s risk profile under various scenarios. This will provide the basis for our third and final installment in which we propose a solution to end The Trouble with HECMs.

The HECM program was profitable for years, as historically high home price appreciation kept HECM “crossover” losses to a minimum. Recently, the housing bust has caused an alarming increase in HECM losses, and the program moved dramatically from profit to loss. New View Advisors believes that this trend is reversible, and that FHA’s troubles can be fixed with the right product design guided by a proper understanding of crossover risk. But first, how do we measure the magnitude of FHA’s (and therefore the taxpayer’s) risk? What drives these crossover losses?

To answer these questions, we first need to analyze the cash flow of an individual reverse mortgage. Compared to forward mortgage credit analysis, which necessarily deals with the borrower’s ability to make monthly payments, reverse mortgage cash flow analysis is more transparent. A reverse mortgage borrower cannot default by failing to make monthly payments: there are no monthly mortgage payments. Unlike forward mortgage credit analysis, which requires a model that predicts the likelihood that borrowers will continue to make monthly payments, reverse mortgages do not require a “black box” credit model. Given a set of assumptions about housing prices and prepayments (plus, for adjustable rate loans, the rate of credit line draws and interest rates), one can quantify the timing of reverse mortgage cash flows, and therefore the timing and magnitude of realized crossover losses.

A further advantage of reverse mortgages is that their prepayment and credit line draw rates are relatively stable. Prepayments are typically very low for the first 24 months, and then increase steadily. as the pool ages. Despite conventional thinking, credit line draws in the aggregate follow a predictable, steady pattern over time. Interest rates and home price appreciation (“HPA”) are much less predictable. For our analysis we will assume a relatively steep (400 basis point) rise in interest rates, and vary assumptions regarding home price appreciation, which both our cash flow model and historical data experience have shown is the most powerful driver of crossover risk.

Before we begin our analysis, we have to add one more assumption: the cost of property disposition. HECMs are non-recourse loans, so the cost of property disposition, a component of our home value assumption, must be taken into account. The expected cost of property disposition climbs steeply when the loan approaches the crossover point, as the borrower’s incentive to pay taxes and insurance, or the estate’s incentive to maintain and sell the property declines along with their home equity. We will assume, based on our experience with seasoned pools, that property disposition cost is equal to 10% of the property value. This is by no means a conservative assumption; the model must account for not only the usual fees but also the high costs that arise from negative equity property dispositions.

In other words, measuring crossover risk is not simply a matter of calculating the excess of the loan balance over the property value; the crossover event itself dramatically changes the equation. Once the crossover threshold is reached, loss severity increases dramatically. Among all types of mortgages, negative equity properties comprise nearly half of all loans in foreclosure; they are four times more likely to enter foreclosure than properties with positive equity. For this reason, significant increases in foreclosures can take place at the end of a reverse mortgage pool’s life, when instances of negative equity are higher.

Let’s apply our assumptions to a typical reverse mortgage loan: the 73-year-old who takes out a fully drawn fixed rate loan on her $250,000 house at a 6.5% interest rate (including the 0.50% MIP). She would receive a $172,750 loan that would accrete to $250,000 in approximately 68 months. At 3% HPA, the crossover point arrives a year and a half later, in month 86. In this example, assuming a Maturity Event before month 86, the FHA experiences no losses. As a practical matter though, many loans will be outstanding much longer than the average: these loans are the main population driving crossover loss.

Using this example, the same loan will reach the crossover point in 48, 56, and 68 months at 0%, 1%, and 2% home price appreciation, respectively. If home prices decline another 15% (over the course of a year), and then resume 3% appreciation, the crossover point will be reached in only 28 months. If the loan is paid off before the crossover point is reached, as in our 3% HPA example above, FHA makes a profit equal to the present value of all of the MIP it collects. Stated generally, FHA’s profit (or loss) equals the excess (or shortfall) of the present value of MIP minus crossover loss. FHA can experience crossover loss and still come out ahead, whether on an individual loan or a pool of loans. In fact, that describes the FHA’s experience until recently: suffering some crossover loss but managing a net profit.

Returning to our individual loan, however, we can now add a prepayment assumption to quantify FHA’s profit or loss. Based on prior experience, we would expect this loan to be outstanding for about 8 years. At our 0%, 1%, 2%, and -15%/+3% scenario, the total crossover loss is approximately $61,000, $43,000, $23,000, and $47,000, respectively, at the time of payoff. Taking the MIP into account, and translating future dollars into present value (using the expected rate as the discount rate), FHA loses approximately 15%, 9%, 1%, and 10% in each scenario. The 3% HPA scenario produces a 6% gain. Again, note that this single-loan/single-payoff analysis is different from analyzing a pool of loans, where payoffs occur over many periods and the vast bulk of losses occur from loans that mature after year 8.

To measure FHA’s exposure for the entire FY 2010 vintage of HECMs, we simply apply this analysis, loan by loan, to a theoretical $30 billion pool of HECMs for our cash flow model. This pool should be representative of the age, gender, product type, and fixed/adjustable distribution of the HECM market as a whole. Fortunately, much of that data is available from various data sources, and HECM pools are fairly consistent with respect to these subcategories. Of course, these can change over time; fixed rate loans are a much higher percentage of the market now, and the average borrower age has drifted younger in recent years as interest rates have decreased and baby boomers have begun to reach retirement age.

For the purposes of this analysis, we will assume a pool that has the typical borrower age and product type distribution and consists of 166,000 loans totaling $30 billion. We then distill these loans down into 39 representative sub-pools for each age cohort (62-100). We will also assume the expected interest rate is 6%, and that half of the loans are fixed and the other half adjustable, with a net margin of 2.75%.

For the adjustable rate loans, we will assume that the available credit line is three-fourths drawn, and that the servicing fee is $33 per loan. We will assume fixed rate loans are fully drawn at closing and that the servicing fee is $30 per loan. Finally, we assume that prepayments take place in every period, based on the rates and probabilities suggested by historical data for each age cohort.

By constructing our theoretical HECMs in a manner that properly represents typical HECM loan production, we have a pool that represents a year of HECM production. We can then run each scenario for each assumed loan in the entire pool, and aggregate the resulting cash flow to FHA: MIP collected versus realized crossover loss. For the purpose of calculating present value, we use the expected rate. Using this methodology, we produced the following results.

As we noted above, FHA projects a loss of 2.66%, or $798 million on a pool of $30 billion HECM loans. Our model confirms this estimate, using a 3% home price appreciation assumption, along with the other assumptions outlined above. (FHA will not release the home price scenario which underlies their projected $798 million shortfall. 3% is our estimate). Home price appreciation of at least 3.5% would be required for the program to break even.

Of course, these losses will be worse, much worse, under less optimistic scenarios. Our cash flow model suggests that if home prices increase at 2% per annum, losses increase to 8.5%, representing a loss of over $2.5 billion. Similarly, if home prices decline another 15% and then resume a 3% increase, FHA would lose $3.5 billion, or about 11.8% of a $30 billion HECM loan pool. If homes prices stay flat, losses for the FY 2010 increase to an astonishing 19.7% or nearly $6 billion. In any of those circumstances, FHA would have to continue to request a positive subsidy. Nor are these the worst possible outcomes: a spike in interest rates or another multi-year decline in home prices would make FHA’s losses even worse. The public and political support of HECM could erode in the face of such large losses, with dire consequences for the reverse mortgage industry.

To breakdown our 3% HPA scenario further, FHA collects about $1 billion in upfront MIP, an additional $2.8 billion in ongoing MIP, but suffers $12.4 billion in crossover losses over the life of this pool. Translating into present value, the upfront MIP is still $1 billion, the ongoing MIP is worth $1.624 billion in present value (discounted at 6%) and the crossover loss is worth $3.422 billion at the same discount rate. The bottom line: FHA loses $798 million.

This does not even begin to address the problem of previous years’ production. Any HECM loan originated in the years 2005 to 2007 is probably underwater, provided the borrower elected to borrow the maximum amount permitted and the property value was equal to or near the HUD lending limit (or Maximum Claim Amount).

Many of these loans were originated at a 70% to 80% LTV, meaning that after a 20 to 30% decline in the value of the underlying property, the loan balance now exceeds the property value. Thus, a large portion of outstanding HECMs of recent vintage will generate losses, with more and more loans crossing over into loss territory each year. Our 3% HPA scenario above changes from a 2.66% loss to a staggering 25% loss, if one assumes an immediate 30% reduction in home prices, followed by 3% annual appreciation. That translates into nearly $8 billion dollars of loss in present value terms, which exceeds the sum of all HECM MIP ever collected. These old vintages probably began with lower effective LTVs, but have had two to four years of draws, compound interest, and very slow prepayments, too. Meanwhile, the proprietary loans originated in those same years at much lower LTVs have experienced much smaller losses, less than $1 million as of May 2009 in total for the last three securitized pools, out of nearly $1.5 billion in loans originated!

Even if the continuing nightmare of home price declines were to reverse, it would be a pyrrhic victory for the industry. The one-sizes-fits-all nature of the HECM program, that forces high upfront fees on all borrowers regardless of their need, will continue to hang the “high cost” albatross around the neck of the reverse mortgage industry.

A prolonged housing slump, or even, as we have seen, a slow recovery can significantly increase FHA’s losses; FHA loses money even as its premiums are criticized for being too high. This is not a theoretical scenario: it is happening right now. The reverse mortgage industry cannot afford to be perceived as a high cost product to both the government and the senior borrower. A new approach to the program is needed, one that eliminates high upfront cost, provides sufficient funds to senior borrowers, and leaves sufficient home equity to mitigate FHA’s losses and restore the HECM program’s long-term viability. In The Trouble with HECMs: Part III, New View Advisors will provide that solution.

The Trouble with HECMs: FHA’s Bumpy Road to Grandma’s House

Monday, June 15th, 2009

The reverse mortgage industry prides itself as the lenders of the Good Mortgage: the mortgage that not only provides essential retirement funds but also the mortgage that comes to the rescue, preventing foreclosures by paying off old “forward mortgages,” delinquent property taxes and unpaid insurance bills. A growth sector in an otherwise ailing mortgage industry, reverse mortgages reward investors with lower prepayment risk and superior performance in securitized form.

Until recently, the reverse mortgage held another distinction: the mortgage that actually makes money for the federal government, a “negative subsidy” of positive cash flow that enabled the expansion of the Federal Housing Administration’s Home Equity Conversion Mortgage (“HECM”) reverse mortgage program during a time of otherwise considerable financial difficulty. However, FHA’s recent announcement that the HECM program is expected to lose over $800 million in FY 2010 has exposed a weakness in this relatively small but rapidly growing sector. (With the recent demise of virtually all proprietary or “jumbo” reverse mortgage lending programs, HECMs comprise the vast majority of reverse mortgage loans originated in the U.S.) The Trouble with HECM is that the program encourages senior homeowners to borrow a very high percentage of their home value, which not only increases FHA’s losses, but also unnecessarily drives up costs to borrowers, lenders and investors. The lack of a more efficient, low-cost alternative has also discouraged many senior borrowers who might otherwise benefit from a HECM loan, but are discouraged by the size of the upfront fees. This three-part discussion seeks to outline the dimensions of the Trouble with HECM and concludes that the problem is fixable, if the FHA acts quickly enough.

FHA insures the investor against “Crossover Loss,” that is, the risk that the negatively amortizing HECM increases to the point where it “crosses over” the value of the home securing the reverse mortgage. FHA insures the HECM investor against crossover loss by purchasing the loan (at par plus accrued interest) from the investor when the HECM loan balance causes the HECM to reach a 98% loan-to-value ratio (“LTV”). The value used as the denominator in this formulation is called the Maximum Claim Amount (“MCA”), equal to the lesser of the property value or the FHA lending limit at the time the loan is originated. When the investor exercises this put, FHA effectively steps into the shoes of the investor and bears the crossover risk. When the loan finally does pay off, FHA’s losses are equal to the excess of the loan balance over the net property value.

In return, the HECM loan investor pays FHA a Mortgage Insurance Premium (“MIP”) equal to a whopping 2% of the Maximum Claim Amount at the time of loan origination plus 0.50% per annum, based on the unpaid principal balance of the HECM. In other words, a borrower whose home value is equal to or exceeds the FHA maximum of $625,500 is charged a $12,510 upfront MIP at closing, in addition to any other fees. These amounts are added to the loan balances, so the borrower ultimately bears these costs.

From the HECM program’s inception in 1990 until this year, these substantial premiums, combined with rising home prices, consistently resulted in ever-increasing positive cash flow to FHA. In its first decade, the program grew slowly from 157 loans in its first year to a mere 6,600 loans in 2000, but then grew rapidly, with a record of over 112,000 loans originated in FY 2008. Year after year, FHA reaped the additional benefit of collecting an ever-growing amount of upfront MIP from the new loans while the older vintages, with the help of ever-increasing home prices, largely avoided crossover loss. But beginning in 2008, that trend reversed abruptly: The HECM program’s profit (or negative subsidy) declined to $462 million in FY 2008, down from $697 million in FY 2007.

FHA projects that HECM originations will exceed $30 billion in FY 2010. They further project, using the Office of Management and Budget’s base case assumptions on home price appreciation, a positive subsidy (similar to a loss reserve) of nearly $800 million — in other words, a negative swing of $1.5 billion in a program with approximately $50 billion in outstanding loans. $800 million is nearly equal to the entire amount of all upfront premiums collected in the history of the HECM program from inception to 2006, and nearly one fourth of all of the premiums, monthly and upfront, ever collected. This $800 million does not include losses on HECM loans outstanding from previous years of HECM origination. This reversal of fortune follows a year, FY 2009, where FHA will collect nearly $1 billion of upfront MIP, due to another year of record new lending volume (over 150,000 loans projected) and much higher balance loans. (The latter is the result of the very large increase in FHA’s HECM lending limit mandated by the Housing and Economic Recovery Act of 2008 and the Economic Stimulus Package of 2009). The total dollar volume of new HECMs could exceed $20 billion in FY 2009. But despite these record premiums, FHA’s results are far different from the banner years of the past.

Declining home prices have played a part in these losses, just as they have wreaked havoc on every mortgage sector. But there is another culprit: the astonishingly high LTVs of HECM loans. Each HECM’s LTV is determined by borrower age and interest rate. The older the borrower, or the lower the interest rate, the higher the LTV. With interest rates hovering at or near FHA’s minimum value for interest rates (5.56%), a 72 year-old HECM borrower can receive as much as 71% of the value of their home, in an upfront lump sum if they wish. An 80 year-old qualifies for a 78% LTV loan and a 90 year-old 86%. This is for a loan with no monthly payments, with negative amortization from day one! Not every HECM borrower elects to borrow the maximum amount in one initial lump sum, but many do so, and are doing so in increasing numbers.

The HECM program began at the dawn of a great bull market in residential real estate. From the year of the program’s inception to 2006, home prices rose at an average of about 6% per year, outpacing the historical average of 4%. With such rapid home appreciation, it’s easy to see why the HECM program was so profitable. Even beginning at an 80% LTV, a loan accreting at 6% per year will take about 12 years to reach the crossover point if the underlying property is appreciating at 4% per year. The same loan will take 19 years to reach crossover starting at 70% LTV, 27 years starting at 60% LTV, and so on.

However, reverse that trend and the numbers change dramatically: without home price appreciation, the 80%, 70%, and 60% LTV loans reach the crossover point in about 4, 7, and 8 years, respectively, well under the expected average life of HECM loans. Bear in mind that we are not even considering property disposition costs, which both hastens the arrival and magnifies the severity of the crossover loss.

Needless to say, if home prices decline at the double-digit rates of the past two years, the homeowner’s equity is wiped out very quickly, and FHA is deep in crossover loss territory. If history were a smooth curve, the HECM program would have continued its smooth sailing. But history is a bumpy road.

A more conventional view of risk, and the approach employed in the design of private-label reverse mortgage, takes into account not only the worst-case scenario for a particular variable (like home prices), but also the correlation between risk factors. For example, the current housing crisis involves not only dramatic declines in home prices, but also lower prepayment rates, resulting from lower mobility and reduced ability to refinance. In a downturn, these correlations magnify losses: the crossover point is closer and fewer loans pay off before that loss threshold is reached. Standard & Poor’s requires, among other criteria, that a AAA-rated reverse mortgage bond be able to withstand a decline in home prices of approximately 30% over 3 years, prepayment rates of about half of the usual rate and sharply higher interest rates. This necessitated the much lower LTVs for the jumbo products. As a consequence, the five outstanding private label reverse mortgage securitizations have thus far weathered the housing storm, and continue to pay back bondholders.

With the rapid decline in home prices, FHA’s reversal of fortune is not surprising, but it also has a lot to do with where the HECM starts out. The majority of the fully-drawn HECMs originated in the peak valuation years of 2005 to 2007 is probably underwater, with 20% – 35% home price declines combined with two to three years of negative amortization removing any excess home equity. For those vintages, the only HECMs loans with significant home equity remaining are those whose home value was substantially higher than the Maximum Claim Amount (recall that FHA limits were much lower then), or where the borrower elected to borrow much less than the maximum LTV. Even then, with the combination of borrower draws and negative amortization increasing the loan balance, and home price declines decreasing the value, this equity cushion is disappearing in a hurry.

Of course, the loan balances for these loans already past the crossover point will continue to increase through negative amortization, draws, and servicing fees; all this subsequent increase piles on more losses. With so many loans from past vintages already underwater, FHA is effectively losing much if not most of the accrual from past vintages, the vast bulk of which were originated during the peak years of home prices. Estimating these losses is tricky, because it is not a simple cash flow equation. The HECM program probably still has positive cash flow due to the collection of the upfront MIP in a rapidly growing market, as we noted above. However, the 2% upfront MIP is meant to cover losses over the life of the HECM loan. Consequently, it should not be fully credited upon collection, but instead amortized over the life of each loan.

FHA’s loss estimate for 2010 seems reasonable. Assuming that $30 billion of HECMs are originated, the FHA estimate implies a 2.66% net loss, in present value terms ($798 million = $30 billion times 2.66%) . Using New View Advisors’ HECM cash flow model, and assuming a typical distribution of borrower ages, prepayment speeds, and loan-to-value ratios for HECM loans, and a home appreciation rate of about 2.9% per annum, the FY 2010 vintage would suffer about $19 billion in losses over its entire life. However, these losses would not be significant for about 6 years. Using a 6% discount rate that approximates an average HECM interest rate, the present value of these losses is about $4 billion. Offsetting those losses are over $1 billion in upfront MIP and the ongoing MIP, totaling about $5.5 billion over time and about $2 billion in present value terms.

Using these numbers, one arrives at FHA’s estimated $800 million loss:

$4,000 million (Crossover losses)
– 2,000 million (Monthly MIP)
– 1,200 million (Initial MIP)
____________
$   800 million

This approach is very “back of the envelope,” but is an altogether plausible picture of where FHA stands today. In a subsequent blog, we will dive into these numbers further.
As for the future, HECMs originated after 2008 are based on much lower appraisals, but the effective initial LTV is much higher than previous years, because of the higher loan limit. A return to the home price appreciation of five years ago seems unlikely; home prices could fall even further.

What does not seem possible is a return to surplus in FY 2011. Every factor determining crossover loss is going in the wrong direction: home prices, prepayment rates, interest rates, monthly draws, LTVs, initial draws, and cost of disposition, which is driven significantly higher by foreclosures, and tax and insurance (T&I) defaults. Unless something changes in the housing market or the HECM program, the problem will get worse before it gets better. More loans will pass the crossover point and underwater loans will sink deeper underwater. Also, what if interest rates go up? What if home prices decline further? These could result in even higher losses.

Recall that the root of this problem is the amount lent to the borrower in the first place. This “Principal Limit,” or Loan-to-Value ratio means that even with flat home prices, the crossover point can be reached in short order. Therein lies the problem and solution to this dilemma. In Part II, we will attempt to quantify the problem more specifically for this year and subsequent years, and project the magnitude of the problem under various assumptions and scenarios. In Part III, our final installment, we will propose a new HECM choice for senior homeowners, a “HECM II” that substantially reduces FHA’s risk, and removes the high cost stigma unfairly attached to reverse mortgages. With proper product innovation, the HECM program can achieve long-term viability and serve the interests of senior homeowners in a more efficient and sustainable way.