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.
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?
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.
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.