Archive for the ‘HECM Program’ Category

HMBS Issuance Hits 5-Year Low

Monday, March 17th, 2014

HMBS issuers created just $493.6 million in new HMBS pools during February 2014, the smallest monthly HMBS issuance since May 2009. 76 pools were issued, 44 original issuances and 32 tail pools. By comparison, HMBS issuance totaled $710 million in January 2014, $695 million in February 2013, and averaged nearly $800 million per month during 2013. Original HMBS issuances are the pools created when a pool of FHA-insured Home Equity Conversion Mortgages (“HECMs”) is securitized for the first time. Tail HMBS issuances are HMBS pools created from the Uncertificated Portions of HECMs that have already had their original HMBS issuance.

HMBS pools can be formed using seasoned collateral, but the healthy premiums of HMBS drive the vast majority of new HECM production quickly into HMBS. Since January 2013, at least 75% of every month’s HMBS issuance has consisted of participations from HECM loans aged 3 months or less. As such, HMBS issuance is a good barometer for recent HECM production.

February 2014 represents the first month in which original HMBS issuances almost entirely reflect HECMs originated in Fiscal Year 2014. Beginning with FY2014, HECM principal limits were cut once again, and FHA imposed new restrictions on the initial draw allowed for certain borrowers. The resulting lower HECM production inevitably reduces HMBS production.

Seasonality, secondary market conditions, and day count also affect monthly issuance totals. Day count differences account for nearly all the $16 million decline in tail issuance from January to February. However, with a still robust secondary market, and with other previous February issuances at least 40% higher, seasonality is not a factor. In fact, February 2010 was the third highest HMBS issuance month ever, with over $1.4 billion in new pools.

Overall Ginnie Mae issuance is down significantly too, with $21 billion issued in February 2014, compared to an average of $38 billion per month in FY2013. (These figures include both forward and reverse, Ginnie Mae I and Ginnie Mae II securities.) The $76 billion issued in the first quarter of FY 2014 is the lowest quarterly total since the 3rd quarter of FY2008. This reflects the decline in mortgage originations generally, especially refinancing.

New View Advisors compiled this data from publicly available Ginnie Mae data as well as private sources.

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Open Letter to the WSJ Editors

Monday, December 31st, 2012

December 15, 2012

To the Editor,

Re: “Mortgages in Reverse” editorial of December 15-16, 2012

Your editorial suggesting that FHA-insured reverse mortgages (called the Home Equity Conversion Mortgage or “HECM”) should be eliminated is akin to throwing out the baby with the bath water. The conditions that once allowed for a thriving private reverse mortgage market no longer exist. Given the state of the moribund, overregulated private market, mortgage liquidity remains firmly entrenched with government agencies like the FHA.

The government created the problem of over-leverage in the housing sector and, like it or not, will have to help de-lever it. FHA has already twice reduced the loan-to-value ratios of HECMs, raised mortgage insurance premiums, and introduced low-cost alternatives. Furthermore, the independent actuarial estimates you cite, which have been all over the map from one year to the next, include many older, higher risk loans. The HECM as currently structured does not add nearly the same level of risk. It remains to be seen if these FHA initiatives will produce the desired effect. But the elimination of an entire industry, which you advocate, would be disastrous for lenders and customers alike.

If neither the government nor the private sector can be trusted to manage reverse mortgage risk, where does that leave the senior homeowner who wants to age in place but cannot afford a conventional mortgage loan? They want to pay for life’s necessities without having to leave their home. They do not want to “blow through their life savings before they die” as you so derisively put it. The fact is that the HECM is often the best financial tool to help these seniors.

Sincerely,

Joseph J. Kelly
Michael K. McCully
New View Advisors LLC

http://newviewadvisors.com

New York, NY

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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.

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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.

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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.

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FHA’s Underwater Problem – And Its Way Back to the Surface

Monday, April 25th, 2011

FHA recently released an updated loan level data file showing all HECMs originated through January 2011. Not surprisingly, prepayment rates have declined. We have adjusted our HECM “Prepayment By Borrower Age” table accordingly.

The real news is that FHA included some new data fields in the January 2011 data set that were not released previously. 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. For example, for a loan that has been outstanding four years, the FHA file shows the amounts drawn in year 1 (mostly the initial draw at closing), year 2, year 3, and year 4. That’s not the same as simply showing the cutoff balance for each loan as of January 2011, but we can get a good approximation by rolling forward each of those draws, plus estimated accrued interest, MIP, and servicing fees.

We rolled the draw balances forward, using historical data for adjustable rate base indices as applicable. About 540,000 HECM loans are currently outstanding. Of these, about 510,000 were outstanding at the end of FY 2010. We estimate the total outstanding balance of all HECM loans to be approximately $76 billion as of January 2011. This estimate, derived from the most recent FHA dataset, is consistent with FHA’s most recent FY 2010 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. 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 93,000 HECM loans (or 17.1% of outstanding) are underwater by a total of $3.3 billion. 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 135,000 loans (24.9% of outstanding), underwater by $4.9 billion, and a 15% haircut to 166,000 loans (30.6% of outstanding) underwater $6.1 billion.

These amounts are small in absolute numbers compared to forward mortgage, but similar in percentage terms: for example, the analytics firm CoreLogic estimates that 23.1% of all outstanding forward mortgages were underwater as of yearend 2010.

Not surprisingly, HECM loans originated from 2005 through 2008 comprise substantially all of these underwater loans. In the 10% haircut scenario, they account for 91% of the underwater loans. The 2006 and 2007 vintages are the worst offenders: each accounts for about 30% of the problem loans.

These numbers will get worse before they get better. The underwater numbers above represent how much FHA might lose if the loans paid off immediately. Most likely, they will pay off slowly over the next several years. 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 $8.692 billion (for HECMs originated through FY 2008) in their most recent Annual Management Report. This is consistent with the $8 billion crossover loss New View Advisors predicted in July 2009. (FHA has continually made upward revisions to their loss estimates for HECMs originated through FY 2008, from their $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 about $400 million in realized losses from underwater HECMs that have paid off.

The HECM program’s bottom line: probably a little over $4.5 billion in MIP collected to date (in present value terms), minus about $0.4 billion in realized losses, minus the $8.7 billion in projected negative net present value (“NPV”), which includes nearly all of the $4.9 – $6.1 billion baked-in crossover loss we estimate, minus another $2.7 billion in projected losses for HECMs originated in FY 2009 and FY 2010. In sum, about $7.3 billion negative NPV for the program since its inception, with the vast majority of the damage coming from the 2005 – 2008 HECM loan cohorts.

$4.5 billion   MIP collected
-$0.4 billion   Realized losses
-$8.7 billion   1990-2008 originations: projected net loss
-$2.7 billion   2009-2010 originations: projected net loss
-$7.3 billion   HECM program NPV 1990-2010

If there is good news in all this, it is that 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. In contrast, the forward mortgage industry has kicked those cans down the road. FHA loans are still available for as little as 3% down. Fannie Mae and Freddie Mac account for over 60% of the forward market, with FHA taking the lion’s share of the remainder. But for the reformed HECM program, FHA and the taxpayer are better protected, with Principal Limits much lower and monthly MIP rates much higher than before. FHA’s FY 2012 budget predicts a modest surplus from newly originated HECM loans; this is a plausible estimate reflecting a more conservative HECM program.

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