In the third and final installation we propose a solution to end “The Trouble with HECMs.” In Parts I and II, we described the problems associated with the current high-cost, one-size-fits-all HECM reverse mortgage loan. Despite the high fees to the borrower (an Initial MIP equal to as much as 2% of the property value plus ongoing fees equal to 0.5% per annum on the loan balance), FHA is still losing money. The extremely high loan amounts, with Loan-to-Value ratios as high as 80% to 90% for older borrowers, are creating “crossover” losses as property values decline and loan balances increase. As a result, the HECM program faces a potential death spiral scenario, in which senior borrowers are faced with ever increasing costs to fund the subsidy required to continue its existence, an existence made more tenuous by the high costs to the borrower and the taxpayer.
A new approach is needed, one that lowers the senior borrower’s cost, lowers FHA’s risk, while still providing sufficient proceeds to the senior. Therefore, we propose HECM II: a HECM loan with no upfront MIP, no Servicing Fee Set-aside, a 75 basis point (0.75%) annual premium, and sensibly lower Loan-to-Value (LTV) Ratios. We do not propose eliminating the original HECM, but rather maintaining it, with some improvements, as an alternative for the neediest seniors.
HECM II should be implemented as follows:
Eliminate Upfront MIP: As noted above, FHA currently charges the senior borrower an upfront fee of up to 2% on the property value, meaning that the senior borrower pays as much as $12,510 before they pay for any lender fees or interest. This fee is charged to the 62-year-old and 99-year-old borrower alike. It is the largest expense borne by the HECM borrower, and it is the main reason HECMs are burdened with the “high-cost” label. Eliminate the initial MIP and this reputation will be eliminated with it. The remaining closing costs are the typical closing costs any mortgage borrower pays, plus the lender’s origination fee, which is capped by federal law at $6,000.
Replace Servicing Fee Set-Aside with Tax and Insurance Set-Aside: The Servicing Set-Aside
(“SFSA”), a concept unique to HECM, is the subject of some controversy. It basically quantifies the present value of the servicing fee, a flat monthly dollar amount that is added to the HECM loan balance each month. The SFSA is disclosed to the borrower as a reduction in the Principal Limit, which gives it the appearance of yet another initial cost. Suffice to say that many reverse mortgage lenders and borrowers find it to be a confusing and unnecessary concept. On the other hand, no set-aside or escrow provision is required for payments of property taxes and insurance (“T&I”). Servicing fees, which total less than $400 per year per loan, can easily be paid by the investor to the servicer, but T&I payments can run into thousands of dollars. If not paid, T&I delinquencies can ruin the value of a HECM loan by causing it to lose its first lien status and therefore its FHA insurance. The reverse mortgage industry is currently grappling with the issue of rising T&I delinquencies and losses.
In other words, FHA created the wrong set-aside. The HECM program was first introduced in the late 1980s, and most features have never been updated. FHA should use the clean slate of a new product design to replace the SFSA with a T&I set-aside. The T&I set-aside could take the form of a fixed dollar amount equal to six months of taxes and insurance payments. This amount would be deducted, or “set-aside” from the Principal Limit at origination. The servicer would then have the ability to cure T&I defaults by paying those expenses directly and adding the payment to the loan balance.
Raise Ongoing MIP to 0.75% per annum: The ongoing MIP should be increased from 50 basis points (0.5%) to 75 basis points per annum (0.75%). The ongoing fee of 75 basis points, which is charged on the loan balance, not the property value, would keep borrowers’ LTVs greater than 40%, and provide sufficient revenue to FHA to insulate it from further losses. With a purely monthly MIP, FHA’s risk is aligned with the borrower fees it collects, and the borrower pays for the risk she creates and the duration of the benefit she receives. This makes the HECM safer to the taxpayer, and fairer to the borrower. A 75 basis point fee keeps the LTVs not too high, and not too low, while still delivering to the senior borrower the traditional HECM benefits of no monthly payments, no preset maturity date, free counseling, and the flexibility of choosing (and changing) product types. That is a good value proposition.
Allow Put Back to HUD at 88% of Maximum Claim Amount: As we noted in Part II, a loan effectively reaches the crossover point when the loan balance approaches 90%, not 100% of the home value. This is because of property disposition costs, which rise precipitously as the homeowner’s equity approaches zero. Adjusting the put back to 88% puts FHA appropriately in control of the asset they are insuring, at the moment that losses may occur. The 88% put would also shorten the average life of the HECM loans and securities backed by HECM loans.
Keep the Old HECM, but fix it: FHA could maintain the old HECM as a needs-based product for borrowers where higher proceeds are critical. Lenders and counselors would be required to show the relative costs, total annual loan cost (“TALC”), and proceeds, side-by-side. The LTVs for this product would have to be lowered too, to make them revenue neutral under FHA and OMB’s revised lower expectations for home price appreciation. We may address this in a future blog, but for now, FHA should cap all “HECM I” LTVs at no more than 75%.
Implement HECM II With Lower LTVs: Lower MIP fees and lower expectations for home prices require lower Loan-to-Value (LTV) ratios. This is a big change for an industry weaned on high LTVs, but the reverse mortgage industry need not fear lower lending limits. For most borrowers, HECM II will provide better value. This will open up a whole new market for the industry, and provide a much-needed rejoinder to industry critics. Meanwhile, the neediest senior borrowers can still use the (reformed) standard HECM product. Moreover, since we posted Parts I and II of this blog, a consensus has been building in Congress and the reverse mortgage industry that a lower fee/lower LTV HECM should be implemented. The industry and its customers are ready for a change.
So how do we create this new product? How do we calculate these new LTVs (or Principal Limits)? Recall that in Part II we reviewed the mechanics of calculating the crossover loss for a single loan, and then applied that methodology to a pool of loans. To create the HECM II, we simply apply the same techniques, using the same inputs (3% home price appreciation, historical HECM prepayment rates, 10% cost of property disposition, etc.) and the new product guidelines we have outlined above (no initial MIP, 0.75% annual fee, swap servicing set-aside for T&I set-aside). We then solve for the break-even LTV of each unique pair of values for borrower age (62 – 100) and Expected Rate (5.5% to 15% in 12.5 basis point increments). The resulting matrix of 3,003 values is the HECM II Principal Limit table.
The Principal Limit table is the cornerstone of any reverse mortgage product: it sets forth the maximum LTV for each borrower. The table applies to both fixed and adjustable rate HECMs. For adjustable rate loans, the Expected Rate is equal to the ten-year equivalent of the base index (e.g. the 10 year LIBOR swap rate for LIBOR-based loans), plus the applicable rate margin. For fixed rate loans, the expected rate is the fixed rate itself. For our HECM II table, we assumed that the spread between the spot rate and 10 year equivalent is 400 basis points. We perform two iterations of our analysis, one for fixed rate loans and one for adjustable rate loans, and take the lower of the two results for each age/rate pair.
Our proposed HECM II Principal Limit table is attached. Under current market conditions, our HECM II provides for LTVs ranging from about 50% to 60%, and would average about 52% for the 73-year-old borrower. As we noted above, this is about 14%, or up to $87,500 less than the standard HECM, but also saves that same borrower $12,500 in initial MIP! Incidentally, this illustrates the high cost of over-leverage. LTVs which exceed the limit of prudent financial boundaries result in high costs to the borrower, to taxpayers, and to investors alike.
We leave for subsequent discussion the amount of T&I Set Aside: it could be an amount equal to six or twelve months of taxes and insurance payments, deducted from the Net Principal Limit and advanced by the lender if needed.
Therefore, the HECM II would benefit senior borrowers, lenders, and investors, as well as the taxpayer. Senior borrowers (and their counselors and families) would finally have a choice. They would pay substantially lower costs and leave more home equity to their heirs. Lenders would likely have more customers, as the many senior borrowers previously turned off by high costs would instead choose HECM II. Investors would have the comfort of knowing that they have a larger equity cushion protecting their loans, and that the T&I default issue is mitigated by the new set-aside.
Finally, HECM II would reduce the size and volatility of FHA’s risk and relieve a considerable drain on HUD’s budget. In sum, HECM II would provide a balance of risk and reward more suitable to the senior borrower’s needs and the taxpayer’s means in the current housing market. We urge Congress and FHA to implement the HECM II as soon as possible.