The Home Equity Conversion Mortgage Program: Issues in HECM Finance and What the Future May Hold

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The Home Equity Conversion Mortgage Program
Issues in HECM Finance and What the Future May
Hold

• Presented by Ed Szymanoski and Colin Cushman
• US Department of Housing and Urban Development
• December 2008

The views expressed are those of the authors, and
not necessarily those of the U.S. Department of
Housing and Urban Development.
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Topics To Discuss

• HUDs Financial Management
• Whats At Stake
• Managing Risk
• Loan Level
• Portfolio Level
• Effect of Falling House Prices
• Financing HECM in the Private Sector
• Primary Market
• LIBOR vs. CMT
• Secondary Market
• Non-agency securities
• Ginnie Mae securities
• What the Future May Hold
• Rising Demand
• Trends in Supply
• New Directions
• Websites for Reference

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HUDs Financial Management of HECM

• HUD does not lend money HECM insures private
  lenders against losses
• Encourages lenders to offer reverse loans
• Offers highly competitive limits on cash advances
• Protects borrowers from lender failure to advance
  funds
• Almost invoked after lender disruptions due to
  Hurricane Katrina
• Increased importance in current banking crisis
• Risk levels managed by limits on loan advances to
  borrowers
• Cost of insurance paid by premiums assessed on
  all borrowers

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Whats At Stake?

• HECM is supposed to be self supporting
• Unlike a private lender/insurer FHA does not have
  to earn profits to pay shareholders for use of
  their capital
• Thus, HECM can offer borrowers better lending
  terms than most private lenders
• However, HECM insurance puts taxpayers at risk
• Long term viability of HECM depends on how well
  HUD manages the financial risks

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Conventional (not government insured) reverse
mortgage lenders in the US often offer smaller
loan amounts to reduce risks. They find it hard
to compete with government insured HECM except in
the jumbo market for homes valued above FHA
loan limit of 417,000. Note conventional
market has become inactive due to current
financial crisis.
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Managing Risk Loan LevelConcept of Principal
Limit

• Principal Limit Factor Times Adjusted Property
  Value (Maximum Claim Amount) Sets Each HECM
  Loans Principal Limit
• Factor is Like a Maximum Loan-to-Value Ratio
• Contains Imbedded Actuarial Assumptions
• Loan Termination Rates (mortality and move-out)
• House Price Appreciation (mean and variance)
• Factor Varies by Interest Rate and Borrower Age
• Principal Limit Factors were Designed to
  Break-Even
• Principal Limit Controls the Amounts and Timing
  of Cash Advances on a HECM
• Net Present Value of All Cash Advances Must Not
  Exceed the Principal Limit
• Once Borrower Reaches Principal Limit, No More
  Cash Advances

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HECM Insurance Model

• Set Actuarial Assumptions
• House Price Growth
• Mortality/Moveout
• Expected Interest Rates

• Set Premium Structure
• 2 Max. Claim Upfront
• 0.5 Annually on Balance

Solve For Factors Such That Expected Revenues
Expected Losses
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HECM Principal Limit Factorsfor Selected Ages
and Interest Rates
Factor decreases with interest rate
Factor increases with age
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Managing Risk Portfolio Level

• HECM Demonstration Period (1989 - 1998)
• Originally limited to a small pilot or
  demonstration program
• Mandated reports to US Congress included
  actuarial reviews
• Permanent HUD Program (1998 present)
• Subject to same portfolio risk management
  requirements as HUDs other credit guaranty
  programs pursuant to
• Chief Financial Officers Act
• Credit Reform Act
• Other laws and guidance
• Annual estimates of remaining liability for
  existing portfolio reported in HUDs audited
  financial statements
• Annual estimates of credit subsidy rate for
  future cohorts reported in federal budget

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Financial Management Reporting and Budget Process
Remaining Liability (Existing Loans Only)
Actual Activity
Remaining Liability for Financial Reporting
Year 30
Year 0
Year t
(last year of actual data)
(Re-estimate of total net liability is actual
activity plus estimated remaining liability)
Credit Subsidy Rate (Future Loans Only)
Credit Subsidy Rate for Next Years Budget
Year 30
Year 0
HECM Requires Analysis Beyond Year 30
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Credit Reform Act of 1990

• Subsidy cost for federal loan programs (direct
  loans and guarantees) must be fully budgeted in
  the year in which the loan is made
• Eliminates prior practice of yearly cash
  budgeting which often deferred long term loan
  costs to future budget years
• Subsidy cost is net present value (NPV) of cash
  flows to and from the government (except
  administrative expenses) associated with the loan
  or guarantee over the full term of the loan
• Positive subsidy requires Congressional
  appropriation prior to loan commitment
• Negative subsidy represents receipts to
  government
• Administrative costs are budgeted separately on a
  cash basis

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HECM Has Consistently Operated with Negative
Credit Subsidy

• Negative subsidy means NPV of expected revenues
  exceeds NPV of expected costs
• HECM subsidy rate projected for FY2008 is
  negative 1.68
• How to reconcile with break-even pricing model
• Current Economic Forecast Different
• Actual Program Experience Different from
  Assumptions
• HUD operates other credit guaranty programs with
  negative subsidy rates
• Prevent rate from going positive due to small
  economic shifts
• Maintains stability of programs features

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Effect Of Falling House Prices
Expected Price Declines in 2008-2009 Compared
With HUDs Long Run Assumption (4 per YR)
Forecast by Global Insight
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HECM Solvency is Tied More Closely to Long Run
Prices than Traditional Home Purchase Mortgages

• Home purchase mortgages terminate (default) at
  much greater rates when short term house prices
  fall
• HECM borrowers have no incentive to terminate
  when prices fall and may weather the storm
  until prices recover
• HUD is currently analyzing the effect of recent
  house price declines on HECM
• HUDs losses will increase as re-estimates are
  made under credit reform re-estimates are paid
  for out of standing appropriation from Congress
• Older cohorts will maintain negative total net
  liability (net surplus of cash inflow to the
  government)
• Recent loan cohorts may now have positive total
  liability (net cash outflow).
• Future cohorts, beginning with 2010 vintage, are
  likely to remain sound (keep negative subsidy)

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Primary Mortgage Market Update

• Primary market includes all activities that
  relate to originating HECM loans
• Main participants are FHA-approved mortgagees
  (banks, mortgage companies, and loan
  correspondents) who have originated at least one
  HECM loan during the year
• Correspondent originators only take applications
  the underwriting and funding of loan comes from
  a sponsor who meets more stringent FHA
  requirements
• For the 12-months ending 5/31/2008, there were
  4,060 mortgagees who originated at least one HECM
  loan 401 sponsors and 3,659 correspondents
• This is up from 2,296 (309 sponsors and 1,987
  correspondents) for the 12-months ending 5/31/2007

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Consolidation in the Primary Market

• Major reverse mortgage lenders being purchased by
  big banks and insurance companies
• Bank of America bought Seattle Mortgage
• Genworth Financial (insurance conglomerate)
  bought Liberty Reverse Mortgage
• Metlife bought Everbank (formerly BNY Mortgage)
• Is this a result of credit crunch or a longer
  term trend?
• Big banks may see opportunity
• Insurance companies accustomed to actuarially
  based cash flows
• How will the reverse mortgage industry emerge
  from the current crisis?

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What is the Secondary Market?

• The secondary mortgage market is simply a
  financial market in which existing mortgage loans
  are bought and sold.
• Often the sale of existing mortgages involves
  securities or bonds collateralized by the value
  of a pool or group of mortgage loans.
• Participants in the secondary market are mortgage
  lenders, commercial banks, investment banks,
  pension funds, and agencies such as Fannie Mae,
  Freddie Mac, or Ginnie Mae.

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Secondary Market for HECM Is Evolving

• Lenders prefer not to hold HECM loans on balance
  sheet
• Depository lenders difficult to manage capital
  requirements while holding illiquid assets
• Non-depository lenders (mortgage banks) only
  structured to warehouse mortgages
• Until 2006 HECM loans were sold to a single
  investor Fannie Mae (a government sponsored
  enterprise)
• Fannie Mae has ability to hold HECM in portfolio
• Fannie Mae participation was a critical factor in
  success of HECM
• However, single investor is not a competitive
  market

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Secondary Market for Reverse Mortgages Will

• Broaden lender distribution channels (more
  lenders to originate loans)
• Expand investor base
• Reverse mortgage cash flows have desirable
  investment features
• Yields comparable to forward mortgages
• Predictable cash flows (less sensitive to
  interest rate and house price changes than
  forward mortgages)
• Provide unique portfolio hedging opportunities
• Banks can hold securities in portfolio more
  easily than illiquid whole loans
• Expect different types of institutional investors
  as well
• Insurance Companies
• Pension funds
• International Investors
• Help realize full market potential
• Become a mainstream loan product
• Product innovation
• Reduced borrowing costs

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Secondary Market Developments

• Challenges to Securitizing A Reverse Mortgage
  Compared to Traditional Forward Mortgage
• Two-way flows of cash
• Cash inflows only upon loan termination
  difficult to structure current pay bonds
• Despite challenges, first US reverse mortgage
  structured security issued in 1999 (using
  conventional loans)
• First HECM-backed security issued in 2006
• In 2007 Ginnie Mae announced its HECM MBS program
  
• In 2007 HUD permits HECM adjustable interest
  rates to be indexed to LIBOR (in addition to US
  Treasury) to increase investor demand

Note Ginnie Mae is the Government National
Mortgage Association an agency within HUD
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LIBOR-Indexed HECM Will Enhance the Secondary
Market

• LIBOR is acronym for London Inter-Bank Offered
  Rate
• An international interest rate index determined
  on the basis of the world economy
• Increasingly used for ARM loans in the United
  States
• More closely matches the cost of funds for global
  investors
• Very popular for secondary mortgage market
  investors makes LIBOR-indexed mortgage backed
  securities more liquid (easier to sell)
• Greater liquidity means lenders can offer lower
  margins to borrowers
• While the LIBOR rate may often be slightly higher
  than a comparable maturity Treasury rate, the
  better margins available for LIBOR-indexed loans
  often make these loans a better deal for
  consumers.
• Although LIBOR may diverge from Treasury rates
  from time to time, the two indices have
  historically tracked each other closely over
  time.
• There is no guarantee that the consumer will be
  better off with a LIBOR-indexed loan, but such a
  loan need not be considered exotic or unusually
  risky on the basis of being indexed to a rate set
  outside the U.S.

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Adjustable Rate HECMs Old Policy

• Since HECM began in 1989, adjustable rates had to
  be pegged to Constant Maturity Treasury (CMT)
  rates
• CMT refers to weekly average yields of all
  Treasury notes and bills having a given remaining
  time to maturity (e.g., 1-Month, 1-Year, or
  10-Years)
• The CMT rates are published weekly by Federal
  Reserve Board
• Whenever the rate is to be adjusted after
  closing, it is to be set at the value of the
  index in effect as of a specified look-back
  period (30-days) plus lenders margin (subject to
  annual and life of loan rate caps as appropriate)
• Annually adjusting HECM had to use 1-YR CMT as
  the rate index
• Monthly adjusting HECM also had to use the 1-YR
  CMT (but with lower margin because less interest
  rate risk for lender)
• All HECM ARMs had to use 10-YR CMT plus margin
  for the expected rate
• NOTE Fixed Rate HECM have always been
  permitted and are not indexed to anything.
  Expected rate for a fixed rate HECM is the fixed
  note rate.

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HECM ARMs New Policy Adds LIBOR

• Mortgagee Letter 2007-13 added LIBOR as an
  acceptable index, but permitted lenders to
  continue using CMT
• Once chosen, the index cannot change
• Annually adjusting HECM now may use either
• 1-YR LIBOR
• 1-YR CMT
• Monthly adjusting HECM now may use
• 1-MO LIBOR
• 1-YR CMT
• 1-MO CMT (this was also added by ML-2007-13)
• Expected Rate is now
• 10-YR CMT plus margin for all CMT-indexed HECM
• 10-YR LIBOR Swap Rate (dollar denominated) plus
  margin for all LIBOR-indexed HECM

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LIBOR SWAP Rates

• Unlike US Treasury Bonds, LIBOR rates are not
  available for maturities greater than 1-Yr. The
  10-Yr LIBOR swap rate is used as the equivalent
  of the 10-Yr Constant Maturity Treasury rate for
  calculation of the expected rate on a HECM.
• An interest rate swap is a financial contract
  used by institutional investors to reduce
  interest rate risks. For example, a fixed
  payment stream is exchanged for a floating
  (adjustable rate) payment stream for a
  predetermined time period.
• In a swap, there are two parties to the contract.
  In the type of swap noted above, one party
  prefers to receive floating rate, while the other
  prefers to receive a fixed rate.
• The floating side of the swap contract is usually
  set at the LIBOR rate for the relevant currency
  (typically the 3- or 6-month LIBOR for dollar
  denominated swaps) and time period (in this case
  10- years).
• Once the floating side terms are specified, the
  swap rate is determined competitively in the
  financial markets. It simply represents the
  fixed interest rate that investors would be
  willing to exchange for the specified floating
  rate for the duration of the contract.
• LIBOR swap rates reflect the financial markets
  expectations about future floating rates thus
  the swap rate is ideal for setting the expected
  rate with LIBOR-indexed HECM.
• LIBOR swap rates are published daily by the
  International Swaps and Derivatives Association
  (ISDA) and are reported by various financial news
  services and on the US Treasury website.

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How the Secondary Market Securitizes HECM
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Unlike a single HECM loan, cash flows on a pool
of loans turn positive quickly (although there
will be variability if loan payoffs dont occur
as expected.)
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Secondary Market Issues Termination Speeds
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Secondary Market Issues HECM Rate Types
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Funding Account consists of cash or liquid
securities that ensure sufficient cash is
available to pay interest on bonds as well as
advance payments to borrowers. Bond rating
agencies will determine funding account size to
achieve desired bond rating. Preferred legal
vehicle for this type of security is a REMIC.
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Privately Issued HECM Securities

• In August 2006, the Mortgage Equity Conversion
  Asset Corporation issued the first ever HECM
  security using the following collateral as assets
  
• HECM adjustable rate loans with an aggregate
  balance of 135.5 million
• Plus an 85.5 million funding account comprised
  of cash and securities.
• Altogether during 2006 and 2007 there have been
  about 2.7 billion in private reverse mortgage
  securities issued, of which about 2.2 billion
  involved HECM collateral, and the rest
  conventional reverse loans.
• Due to mortgage market turmoil, no private HECM
  securities were issued in 2008

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Ginnie Mae Continues to Fund HECM During the
Credit Crunch
Securities Issued Between November 2007 and June
2008

• Goldman Sachs (Pool 891088)
• 117 million
• Type Collateral US Treasury (CMT) -indexed
  Adjustable Rate HECMs
• Lehman Brothers (Pool 811588)
• 220 million
• Type Collateral CMT-indexed Adjustable Rate
  HECMs
• Financial Freedom (Pool 686712)
• 102 million
• Type Collateral Fixed Rate HECMs
• Lehman Brothers (Pool 690041)
• 32 million
• Type Collateral Fixed Rate HECMs
• Financial Freedom (Pool 686713)
• 75 million
• Type Collateral Fixed Rate HECMs
• Expected Soon First Ginnie Mae HECM MBS Indexed
  to LIBOR

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What the Future May Hold Rising Demand

• According to the 2005 American Housing Survey
• 17.8 million US homeowners headed by person age
  65
• 14.8 million are potential HECM borrowers
• 12.1 million had no mortgage debt
• 2.7 million had mortgage less than 40 of home
  value
• Between 2005 and 2015 Joint Center for Housing
  Studies of Harvard University projects
• Owner households ages 62 to 69 will increase by
  53
• These are the first of the large post-WWII baby
  boom generation

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US Population By Age Group 2000 and Projected
for 2025
Large Growth Projected in HECM Eligible Age Groups
HECM Minimum Age
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What the Future Holds Trends in Supply

• Housing and Economic Recovery Act of 2008
  established a higher, national loan limit
  (ceiling on maximum claim) for HECM
• 417,000 nationwide limit equals the conforming
  loan limit for Fannie Mae and Freddie Mac
• This limit is indexed to nationwide house price
  growth, but will not decline if house prices
  decline
• Gives HECM access to more of the former jumbo
  market
• HUD estimates a 20 increase in volume in 2009
  related to the new limit
• Will the jumbo market return after the current
  financial turmoil subsides?
• HECM market share had fallen to about 85 to 90
  of the reverse mortgage market in 2006 (before
  the turmoil)
• Return of conventional jumbo market highly
  dependent on a source of secondary market
  financing

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New Directions for the Reverse Mortgage Industry

• Since 2006, we have seen several new variations
  in reverse mortgage financing
• Fixed Rate HECM (closed end credit) but are
  fixed rates too costly for the consumers?
• LIBOR-indexed HECM
• Zero closing cost conventional RM
• HECM for home purchase (implemented by HUD in
  November 2008)
• Possible innovations for the near future
• HECM with lower upfront costs (through premium
  pricing in secondary market)
• HECM upfront premium reduction had been under
  consideration but is not likely to happen in 2009
  as housing prices remain soft

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New Directions Continued

• Weathering the Credit Crunch
• Keeping HECM sound given falling house prices
• Dealing with potential lender financial
  insolvency
• What is needed to effect a return of the
  non-agency secondary market?
• How will Fannie Mae and Freddie Mac emerge after
  conservatorship?
• Expect to see greater link between reverse
  mortgage products and the provision of long term
  health care in the home
• Exploding costs of Medicaid as baby boomers age
• Use of reverse mortgages can provide better
  quality care in the home
• Better coordination between reverse mortgage
  providers and local aging networks
• New products designed to help lower wealth
  homeowners afford in-home care

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Websites for Reference

• HECM Lender List http//www.hud.gov/ll/code/llslc
  rit.cfm
• Reverse Mortgage Calculator (AARP)
  http//www.rmaarp.com/
• HECM Housing Counselors http//www.hud.gov/office
  s/hsg/sfh/hecm/hecmlist.cfm/
• HECM Processing Handbook http//www.hud.gov
  /offices/adm/hudclips/handbooks/hsgh/4235.1/index.
  cfm
• HECM Mortgagee Letters (processing updates)
  http//www.hud.gov/offices/hsg/sfh/hecm/hecmml.cf
  m
• HUD Articles and Research Related to HECM (go to
  link and type HECM into Find Results with Exact
  Phrase) http//www.huduser.org/search/search_sit
  e_adv.asp