The Federal Housing Administration’s (“FHA”) Fiscal Year 2024 reports confirm the financial strength of the Home Equity Conversion Mortgage (“HECM”) program. These reports, which include the FHA Annual Management Report (“AMR”), the Annual Report to Congress Regarding the Financial Status of the FHA Mutual Mortgage Insurance Fund (“MMI Report”), and the FHA HECM Actuarial Review (“Actuarial Report”), show the program with an astonishing 24.5%(!) capital ratio, over twelve times the required 2%. Even more astonishing, FHA’s HECM claim loss is negative, in other words, FHA is making a profit on their HECM claims. Is this an insurance fund or a hedge fund?
Only a few years ago, the 2016, 2017, 2018 and 2019 editions of these reports showed a HECM program deeply in the red. Many forward mortgage industry leaders were calling for the HECM program’s banishment to a separate MMI fund; a Wall Street Journal editorial called for its abolishment. We argued at the time that the FHA estimates were too pessimistic, and that in time the combined effect of FHA’s reforms and positive home price appreciation would put the program back in the black. As early as 2017, we wrote of the data showing the positive effects of FHA’s reforms, such as lower default rates from improved financial assessment. Also, four rounds of lower Principal Limit Factors (“PLFs,” allowable loan-to-value ratios) gave significantly more home equity cushion to the HECM program, reducing FHA’s HECM loan loss frequency and severity. (Before FHA’s reforms, more than a few years ago in 2009, we initiated this blog with the opinion that the program’s PLFs and default rates were too high.)
Perhaps most astonishing is the FHA’s statement that the program’s claim loss is negative. According to the MMI Report (p 82) “… FY 2024 was unusual because the combination of the upward trend in HPA, which results in increases in underlying collateral, along with an unusually large number of assignments created a shift where the NPV of losses was reduced so significantly that it produced an annual gain.” The accompanying figure (Exhibit IV-11) shows a positive Net Present Value of $4.59 billion for claims as of the end of FY 2024, versus an NPV claim loss of $0.83 billion at the end of FY 2023. Claim Type I and Supplemental Claim losses in past years were significantly worse (See Exhibit III-30 p 121).
The MMI Report does not fully elaborate on this claim about their claims as much as we would like. However, it does say that higher interest rates, more assignments, and higher home price appreciation contribute to this unusual phenomenon. This implies FHA is making money on the assignments, or Claim Type II, in which they purchase active HECMs from the investor at par when the HECM loan reaches 98% of its Maximum Claim Amount (“MCA”), i.e. the underlying property value at the time of origination (subject to a cap). Several years elapse between loan origination and the 98% MCA assignment, meaning that FHA benefits from any home price appreciation during those years.
FHA’s portfolio of assigned HECMs is known as the “Secretary’s Notes” portfolio. We estimate that this portfolio now totals about $40 billion in unpaid balance, with an average gross interest rate (including MIP) of about 7.5%. We found no reference in the reports to the portfolio’s current size. All these loans are active when assigned, in other words, none of these loans are in default at the time of assignment. Inevitably, some of these loans do go into default and have “crossover” loss, wherein the loan balance exceeds the property value at the time of loan liquidation, but many never default, and they pay off without any realized losses.
The decline in the loss reserve has many causes, which we have discussed in other blog entries:
Factors Driving Financial Improvement
• Financial Assessment (“FA”): FA measures, implemented in 2015, have proven effective. Older, riskier loans are diminishing as a share of the portfolio. Only about 15% of the current HECM portfolio consists of pre-FA loans. We have discussed this at length in other blog entries.
• Servicing Enhancements: Much of the improved performance of the Secretary’s Notes happened after a new subservicer was appointed. The importance of special servicing, that is, handling of defaults and foreclosures, cannot be overstated. Loss severity before and after this change merits further detailed analysis.
• Home Price Appreciation (“HPA”): Rising property values have reduced the frequency and severity of crossover losses, providing a significant buffer for the MMI Fund.
• Lower Principal Limit Factors (“PLF”): Four successive PLF reductions have reduced the frequency and severity of crossover losses, providing a significant home equity buffer for the MMI Fund.
• Corrected Forecasting Errors: Past reports, particularly in 2018 and 2019, underestimated long-term financial health. The 2024 FHA Annual Management Report (e.g., p. 44) seems to acknowledge these inaccuracies, with current data reflecting a more realistic and positive trajectory.
FHA earns a handsome excess spread equal to the gross interest rate on the Secretary’s Notes, minus FHA’s funding rate, minus any losses. In other words, like a hedge fund, the Secretary’s Notes portfolio is a leveraged fund that buys assets at a favorable price (par) and earns a healthy excess spread. Also like a hedge fund, it succeeds when it manages its assets properly, hires a good servicer, and benefits from favorable economic conditions.
The present value of the gain equals this excess spread multiplied by the duration of the portfolio, minus expected losses. A back-of-the-envelope check does seem to work: $40 billion multiplied by 7.5% Gross Interest Rate minus a 4.5% funding rate, multiplied by a duration of 5 years, minus a loss reserve of about 3.5% (or $1.41 billion) equals approximately $4.59 billion. That is just our calculation. It would be very illuminating if FHA published the actual components of the $4.59 billion gain, breaking down Type I versus Type II losses, as well as the net effect of Claim I losses and gains on future Claim II assignments.
Claim I Losses and Supplemental Claims totaled approximately $300 million in FY 2024, or about 0.5% of the Insurance-in-Force (“IIF”) for HECMs in the MMI Fund. Coincidentally or not, this annual Claim loss rate is equal to the ongoing annual Mortgage Insurance Premium. Also, coincidentally or not, the upfront MIP is 2% of the MCA, and the required Capital Ratio is 2% of the Insurance-in-Force.
Despite the good news, HECM originations remain weak because, and this is worth emphasizing, the upfront MIP reduces HECM volume significantly. HECM borrowers must pay a 2% upfront MIP on the MCA, which can exceed $20,000. This staggering upfront fee is a non-starter for many potential borrowers.
IIF fell for the second year in a row, as more loans liquidate than the total of originations, additional amounts lent, and interest roll-up. In fiscal year 2024, the FHA endorsed 26,501 new HECM loans, totaling just under $4 billion in loan balance. At this rate, the number of outstanding HECMs will continue to fall. We estimate that at current rates of production the MMI fund will fall to about half its current size (287,000 loans outstanding totaling approximately $65 billion) in ten to twelve years.
So why not change the upfront MIP to reflect this? Keep the ongoing MIP at 0.50% per annum and reduce the upfront MIP to 1% of the MCA, or 2% of the Initial Principal Limit. That way, each loan immediately makes the capital requirement without charging an exorbitant upfront MIP that gets worse (as a percentage of the loan balance) as interest rates and MCA rise. With this trajectory of rising rates and rising MCA, HECM program volume will continue to suffer, perhaps fatally.
The FHA’s reporting on the HECM program can be further improved through additional data transparency, for example, providing loss severity for all HECMs, particularly for the Secretary’s Notes. A table summarizing key metrics, including payoff counts, beginning balances, and ending balances, loss frequency and severity, would highlight the impact of program changes, and servicing changes, on financial outcomes.
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