In the first part of this series, we outlined “The Trouble with HECMs,” the result of extremely high Loan-to-Value (“LTV”) ratios permitted by the HECM program, which left FHA highly exposed to losses during the current deep slump in home prices. FHA projects that it will lose $798 million on $30 billion of HECM loans originated in FY 2010. According to our calculations, this implies annual home appreciation of about 3% per annum. The $798 million figure represents the net present value of FHA’s losses, even after charging the senior borrower a high upfront Mortgage Insurance Premium (“MIP”) of 2% on the HECM borrower’s home value, plus 0.50% per annum on the loan balance. This installment describes how we quantify and analyze HECM cash flows, and FHA’s risk profile under various scenarios. This will provide the basis for our third and final installment in which we propose a solution to end The Trouble with HECMs.
The HECM program was profitable for years, as historically high home price appreciation kept HECM “crossover” losses to a minimum. Recently, the housing bust has caused an alarming increase in HECM losses, and the program moved dramatically from profit to loss. New View Advisors believes that this trend is reversible, and that FHA’s troubles can be fixed with the right product design guided by a proper understanding of crossover risk. But first, how do we measure the magnitude of FHA’s (and therefore the taxpayer’s) risk? What drives these crossover losses?
To answer these questions, we first need to analyze the cash flow of an individual reverse mortgage. Compared to forward mortgage credit analysis, which necessarily deals with the borrower’s ability to make monthly payments, reverse mortgage cash flow analysis is more transparent. A reverse mortgage borrower cannot default by failing to make monthly payments: there are no monthly mortgage payments. Unlike forward mortgage credit analysis, which requires a model that predicts the likelihood that borrowers will continue to make monthly payments, reverse mortgages do not require a “black box” credit model. Given a set of assumptions about housing prices and prepayments (plus, for adjustable rate loans, the rate of credit line draws and interest rates), one can quantify the timing of reverse mortgage cash flows, and therefore the timing and magnitude of realized crossover losses.
A further advantage of reverse mortgages is that their prepayment and credit line draw rates are relatively stable. Prepayments are typically very low for the first 24 months, and then increase steadily. as the pool ages. Despite conventional thinking, credit line draws in the aggregate follow a predictable, steady pattern over time. Interest rates and home price appreciation (“HPA”) are much less predictable. For our analysis we will assume a relatively steep (400 basis point) rise in interest rates, and vary assumptions regarding home price appreciation, which both our cash flow model and historical data experience have shown is the most powerful driver of crossover risk.
Before we begin our analysis, we have to add one more assumption: the cost of property disposition. HECMs are non-recourse loans, so the cost of property disposition, a component of our home value assumption, must be taken into account. The expected cost of property disposition climbs steeply when the loan approaches the crossover point, as the borrower’s incentive to pay taxes and insurance, or the estate’s incentive to maintain and sell the property declines along with their home equity. We will assume, based on our experience with seasoned pools, that property disposition cost is equal to 10% of the property value. This is by no means a conservative assumption; the model must account for not only the usual fees but also the high costs that arise from negative equity property dispositions.
In other words, measuring crossover risk is not simply a matter of calculating the excess of the loan balance over the property value; the crossover event itself dramatically changes the equation. Once the crossover threshold is reached, loss severity increases dramatically. Among all types of mortgages, negative equity properties comprise nearly half of all loans in foreclosure; they are four times more likely to enter foreclosure than properties with positive equity. For this reason, significant increases in foreclosures can take place at the end of a reverse mortgage pool’s life, when instances of negative equity are higher.
Let’s apply our assumptions to a typical reverse mortgage loan: the 73-year-old who takes out a fully drawn fixed rate loan on her $250,000 house at a 6.5% interest rate (including the 0.50% MIP). She would receive a $172,750 loan that would accrete to $250,000 in approximately 68 months. At 3% HPA, the crossover point arrives a year and a half later, in month 86. In this example, assuming a Maturity Event before month 86, the FHA experiences no losses. As a practical matter though, many loans will be outstanding much longer than the average: these loans are the main population driving crossover loss.
Using this example, the same loan will reach the crossover point in 48, 56, and 68 months at 0%, 1%, and 2% home price appreciation, respectively. If home prices decline another 15% (over the course of a year), and then resume 3% appreciation, the crossover point will be reached in only 28 months. If the loan is paid off before the crossover point is reached, as in our 3% HPA example above, FHA makes a profit equal to the present value of all of the MIP it collects. Stated generally, FHA’s profit (or loss) equals the excess (or shortfall) of the present value of MIP minus crossover loss. FHA can experience crossover loss and still come out ahead, whether on an individual loan or a pool of loans. In fact, that describes the FHA’s experience until recently: suffering some crossover loss but managing a net profit.
Returning to our individual loan, however, we can now add a prepayment assumption to quantify FHA’s profit or loss. Based on prior experience, we would expect this loan to be outstanding for about 8 years. At our 0%, 1%, 2%, and -15%/+3% scenario, the total crossover loss is approximately $61,000, $43,000, $23,000, and $47,000, respectively, at the time of payoff. Taking the MIP into account, and translating future dollars into present value (using the expected rate as the discount rate), FHA loses approximately 15%, 9%, 1%, and 10% in each scenario. The 3% HPA scenario produces a 6% gain. Again, note that this single-loan/single-payoff analysis is different from analyzing a pool of loans, where payoffs occur over many periods and the vast bulk of losses occur from loans that mature after year 8.
To measure FHA’s exposure for the entire FY 2010 vintage of HECMs, we simply apply this analysis, loan by loan, to a theoretical $30 billion pool of HECMs for our cash flow model. This pool should be representative of the age, gender, product type, and fixed/adjustable distribution of the HECM market as a whole. Fortunately, much of that data is available from various data sources, and HECM pools are fairly consistent with respect to these subcategories. Of course, these can change over time; fixed rate loans are a much higher percentage of the market now, and the average borrower age has drifted younger in recent years as interest rates have decreased and baby boomers have begun to reach retirement age.
For the purposes of this analysis, we will assume a pool that has the typical borrower age and product type distribution and consists of 166,000 loans totaling $30 billion. We then distill these loans down into 39 representative sub-pools for each age cohort (62-100). We will also assume the expected interest rate is 6%, and that half of the loans are fixed and the other half adjustable, with a net margin of 2.75%.
For the adjustable rate loans, we will assume that the available credit line is three-fourths drawn, and that the servicing fee is $33 per loan. We will assume fixed rate loans are fully drawn at closing and that the servicing fee is $30 per loan. Finally, we assume that prepayments take place in every period, based on the rates and probabilities suggested by historical data for each age cohort.
By constructing our theoretical HECMs in a manner that properly represents typical HECM loan production, we have a pool that represents a year of HECM production. We can then run each scenario for each assumed loan in the entire pool, and aggregate the resulting cash flow to FHA: MIP collected versus realized crossover loss. For the purpose of calculating present value, we use the expected rate. Using this methodology, we produced the following results.
As we noted above, FHA projects a loss of 2.66%, or $798 million on a pool of $30 billion HECM loans. Our model confirms this estimate, using a 3% home price appreciation assumption, along with the other assumptions outlined above. (FHA will not release the home price scenario which underlies their projected $798 million shortfall. 3% is our estimate). Home price appreciation of at least 3.5% would be required for the program to break even.
Of course, these losses will be worse, much worse, under less optimistic scenarios. Our cash flow model suggests that if home prices increase at 2% per annum, losses increase to 8.5%, representing a loss of over $2.5 billion. Similarly, if home prices decline another 15% and then resume a 3% increase, FHA would lose $3.5 billion, or about 11.8% of a $30 billion HECM loan pool. If homes prices stay flat, losses for the FY 2010 increase to an astonishing 19.7% or nearly $6 billion. In any of those circumstances, FHA would have to continue to request a positive subsidy. Nor are these the worst possible outcomes: a spike in interest rates or another multi-year decline in home prices would make FHA’s losses even worse. The public and political support of HECM could erode in the face of such large losses, with dire consequences for the reverse mortgage industry.
To breakdown our 3% HPA scenario further, FHA collects about $1 billion in upfront MIP, an additional $2.8 billion in ongoing MIP, but suffers $12.4 billion in crossover losses over the life of this pool. Translating into present value, the upfront MIP is still $1 billion, the ongoing MIP is worth $1.624 billion in present value (discounted at 6%) and the crossover loss is worth $3.422 billion at the same discount rate. The bottom line: FHA loses $798 million.
This does not even begin to address the problem of previous years’ production. Any HECM loan originated in the years 2005 to 2007 is probably underwater, provided the borrower elected to borrow the maximum amount permitted and the property value was equal to or near the HUD lending limit (or Maximum Claim Amount).
Many of these loans were originated at a 70% to 80% LTV, meaning that after a 20 to 30% decline in the value of the underlying property, the loan balance now exceeds the property value. Thus, a large portion of outstanding HECMs of recent vintage will generate losses, with more and more loans crossing over into loss territory each year. Our 3% HPA scenario above changes from a 2.66% loss to a staggering 25% loss, if one assumes an immediate 30% reduction in home prices, followed by 3% annual appreciation. That translates into nearly $8 billion dollars of loss in present value terms, which exceeds the sum of all HECM MIP ever collected. These old vintages probably began with lower effective LTVs, but have had two to four years of draws, compound interest, and very slow prepayments, too. Meanwhile, the proprietary loans originated in those same years at much lower LTVs have experienced much smaller losses, less than $1 million as of May 2009 in total for the last three securitized pools, out of nearly $1.5 billion in loans originated!
Even if the continuing nightmare of home price declines were to reverse, it would be a pyrrhic victory for the industry. The one-sizes-fits-all nature of the HECM program, that forces high upfront fees on all borrowers regardless of their need, will continue to hang the “high cost” albatross around the neck of the reverse mortgage industry.
A prolonged housing slump, or even, as we have seen, a slow recovery can significantly increase FHA’s losses; FHA loses money even as its premiums are criticized for being too high. This is not a theoretical scenario: it is happening right now. The reverse mortgage industry cannot afford to be perceived as a high cost product to both the government and the senior borrower. A new approach to the program is needed, one that eliminates high upfront cost, provides sufficient funds to senior borrowers, and leaves sufficient home equity to mitigate FHA’s losses and restore the HECM program’s long-term viability. In The Trouble with HECMs: Part III, New View Advisors will provide that solution.