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

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.

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.