HECMs: Are We Still In Trouble?

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.