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1The Home Equity Conversion Mortgage Program: Issues in HECM Finance and What the Future May Hold Presented by Ed Szymanoski and Colin CushmanUS Department of Housing and Urban DevelopmentDecember 2008The views expressed are those of the authors, and not necessarily those of the U.S. Department of Housing and Urban Development.
2Topics To Discuss HUD’s Financial Management What’s At StakeManaging RiskLoan LevelPortfolio LevelEffect of Falling House PricesFinancing HECM in the Private SectorPrimary MarketLIBOR vs. CMTSecondary MarketNon-agency securitiesGinnie Mae securitiesWhat the Future May HoldRising DemandTrends in SupplyNew DirectionsWebsites for Reference
3HUD’s Financial Management of HECM HUD does not lend money: HECM insures private lenders against lossesEncourages lenders to offer reverse loansOffers highly competitive limits on cash advancesProtects borrowers from lender failure to advance fundsAlmost invoked after lender disruptions due to Hurricane KatrinaIncreased importance in current banking crisisRisk levels managed by limits on loan advances to borrowersCost of insurance paid by premiums assessed on all borrowers
4What’s 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 capitalThus, HECM can offer borrowers better lending terms than most private lendersHowever, HECM insurance puts taxpayers at riskLong term viability of HECM depends on how well HUD manages the financial risks
6Conventional (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.
8Managing Risk – Loan Level Concept of Principal Limit Principal Limit Factor Times Adjusted Property Value (Maximum Claim Amount) Sets Each HECM Loan’s Principal LimitFactor is Like a Maximum Loan-to-Value RatioContains Imbedded Actuarial AssumptionsLoan Termination Rates (mortality and move-out)House Price Appreciation (mean and variance)Factor Varies by Interest Rate and Borrower AgePrincipal Limit Factors were Designed to Break-EvenPrincipal Limit Controls the Amounts and Timing of Cash Advances on a HECMNet Present Value of All Cash Advances Must Not Exceed the Principal LimitOnce Borrower Reaches Principal Limit, No More Cash Advances
9HECM Insurance Model Set Premium Structure Set Actuarial Assumptions House Price GrowthMortality/MoveoutExpected Interest RatesSet Premium Structure2% Max. Claim Upfront0.5% Annually on BalanceSolve For Factors Such ThatExpected Revenues = Expected Losses
10HECM Principal Limit Factors for Selected Ages and Interest Rates 6575857.0%0.4890.6090.7388.5%0.3690.5030.66010.0%0.2800.4160.589* Expected Rate ( e.g., 10-Year Treasury Rate + Lender's Margin)InterestRate *Age of Borrower at Loan OriginationFactor decreaseswith interest rateFactor increases with age
12Managing Risk – Portfolio Level HECM Demonstration Period ( )Originally limited to a small pilot or demonstration programMandated reports to US Congress included actuarial reviewsPermanent HUD Program (1998 – present)Subject to same portfolio risk management requirements as HUD’s other credit guaranty programs pursuant toChief Financial Officers ActCredit Reform ActOther laws and guidanceAnnual estimates of remaining liability for existing portfolio reported in HUD’s audited financial statementsAnnual estimates of credit subsidy rate for future cohorts reported in federal budget
13Financial Management Reporting and Budget Process Remaining Liability (Existing Loans Only)Actual ActivityRemaining Liability for Financial ReportingYear 30 *Year 0Year 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 Year’s BudgetYear 30 *Year 0* HECM Requires Analysis Beyond Year 30
14Credit Reform Act of 1990Subsidy cost for federal loan programs (direct loans and guarantees) must be fully budgeted in the year in which the loan is madeEliminates prior practice of yearly cash budgeting which often deferred long term loan costs to future budget yearsSubsidy 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 loanPositive subsidy requires Congressional appropriation prior to loan commitmentNegative subsidy represents receipts to governmentAdministrative costs are budgeted separately on a cash basis
15HECM Has Consistently Operated with “Negative” Credit Subsidy Negative subsidy means NPV of expected revenues exceeds NPV of expected costsHECM subsidy rate projected for FY2008 is negative 1.68How to reconcile with break-even pricing model:Current Economic Forecast DifferentActual Program Experience Different from AssumptionsHUD operates other credit guaranty programs with negative subsidy ratesPrevent rate from going positive due to small economic shiftsMaintains stability of program’s features
16Effect Of Falling House Prices Expected Price Declines in Compared With HUD’s Long Run Assumption (4% per YR)Forecast by Global Insight
17HECM 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 fallHECM borrowers have no incentive to terminate when prices fall and may “weather the storm” until prices recoverHUD is currently analyzing the effect of recent house price declines on HECMHUD’s losses will increase as re-estimates are made – under credit reform re-estimates are paid for out of standing appropriation from CongressOlder 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)
18Primary Mortgage Market Update Primary market includes all activities that relate to originating HECM loansMain participants are FHA-approved mortgagees (banks, mortgage companies, and loan correspondents) who have originated at least one HECM loan during the yearCorrespondent originators only take applications: the underwriting and funding of loan comes from a sponsor who meets more stringent FHA requirementsFor the 12-months ending 5/31/2008, there were 4,060 mortgagees who originated at least one HECM loan: 401 sponsors and 3,659 correspondentsThis is up from 2,296 (309 sponsors and 1,987 correspondents) for the 12-months ending 5/31/2007
19Consolidation in the Primary Market Major reverse mortgage lenders being purchased by big banks and insurance companiesBank of America bought Seattle MortgageGenworth Financial (insurance conglomerate) bought Liberty Reverse MortgageMetlife bought Everbank (formerly BNY Mortgage)Is this a result of credit crunch or a longer term trend?Big banks may see opportunityInsurance companies accustomed to actuarially based cash flowsHow will the reverse mortgage industry emerge from the current crisis?
20What 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.
21Secondary Market for HECM Is Evolving Lenders prefer not to hold HECM loans on balance sheetDepository lenders: difficult to manage capital requirements while holding illiquid assetsNon-depository lenders (mortgage banks): only structured to warehouse mortgagesUntil 2006 HECM loans were sold to a single investor: Fannie Mae (a government sponsored enterprise)Fannie Mae has ability to hold HECM in portfolioFannie Mae participation was a critical factor in success of HECMHowever, single investor is not a competitive market
22Secondary Market for Reverse Mortgages Will: Broaden lender distribution channels (more lenders to originate loans)Expand investor baseReverse mortgage cash flows have desirable investment featuresYields comparable to forward mortgagesPredictable cash flows (less sensitive to interest rate and house price changes than forward mortgages)Provide unique portfolio hedging opportunitiesBanks can hold securities in portfolio more easily than illiquid whole loansExpect different types of institutional investors as wellInsurance CompaniesPension fundsInternational InvestorsHelp realize full market potentialBecome a mainstream loan productProduct innovationReduced borrowing costs
23Secondary Market Developments Challenges to Securitizing A Reverse Mortgage Compared to Traditional “Forward” MortgageTwo-way flows of cashCash inflows only upon loan termination – difficult to structure current pay bondsDespite challenges, first US reverse mortgage structured security issued in 1999 (using conventional loans)First HECM-backed security issued in 2006In 2007 Ginnie Mae announced its HECM MBS programIn 2007 HUD permits HECM adjustable interest rates to be indexed to LIBOR (in addition to US Treasury) to increase investor demandNote: Ginnie Mae is the Government National Mortgage Association – an agency within HUD
24LIBOR-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 economyIncreasingly used for ARM loans in the United StatesMore closely matches the cost of funds for global investorsVery 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 borrowersWhile 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.
25Adjustable Rate HECMs – Old Policy Since HECM began in 1989, adjustable rates had to be pegged to Constant Maturity Treasury (CMT) ratesCMT 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 BoardWhenever 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 lender’s margin (subject to annual and life of loan rate caps as appropriate)Annually adjusting HECM had to use 1-YR CMT as the rate indexMonthly 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 rateNOTE: 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.
26HECM ARMs – New Policy Adds LIBOR Mortgagee Letter added LIBOR as an acceptable index, but permitted lenders to continue using CMTOnce chosen, the index cannot changeAnnually adjusting HECM now may use either1-YR LIBOR1-YR CMTMonthly adjusting HECM now may use1-MO LIBOR1-MO CMT (this was also added by ML )Expected Rate is now:10-YR CMT plus margin for all CMT-indexed HECM10-YR LIBOR Swap Rate (dollar denominated) plus margin for all LIBOR-indexed HECM
27LIBOR SWAP RatesUnlike 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.
35Funding 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.
36Privately Issued HECM Securities In August 2006, the Mortgage Equity Conversion Asset Corporation issued the first ever HECM security using the following collateral as assetsHECM adjustable rate loans with an aggregate balance of $135.5 millionPlus 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 $2.2 billion involved HECM collateral, and the rest conventional reverse loans.Due to mortgage market turmoil, no private HECM securities were issued in 2008
38Ginnie Mae Continues to Fund HECM During the Credit Crunch Securities Issued Between November 2007 and June 2008Goldman Sachs (Pool #891088)$ 117 millionType Collateral: US Treasury (CMT) -indexed Adjustable Rate HECMsLehman Brothers (Pool #811588)$220 millionType Collateral: CMT-indexed Adjustable Rate HECMsFinancial Freedom (Pool #686712)$102 millionType Collateral: Fixed Rate HECMsLehman Brothers (Pool #690041)$32 millionFinancial Freedom (Pool #686713)$75 millionExpected Soon: First Ginnie Mae HECM MBS Indexed to LIBOR
39What the Future May Hold – Rising Demand According to the 2005 American Housing Survey17.8 million US homeowners headed by person age 65+14.8 million are potential HECM borrowers12.1 million had no mortgage debt2.7 million had mortgage less than 40% of home valueBetween 2005 and 2015 Joint Center for Housing Studies of Harvard University projectsOwner households ages 62 to 69 will increase by 53%These are the first of the large post-WWII “baby boom” generation
40US Population By Age Group 2000 and Projected for 2025 Large Growth Projected in HECM Eligible Age GroupsHECM Minimum Age
41What 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 MacThis limit is indexed to nationwide house price growth, but will not decline if house prices declineGives HECM access to more of the former jumbo marketHUD estimates a 20% increase in volume in 2009 related to the new limitWill 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
42New Directions for the Reverse Mortgage Industry Since 2006, we have seen several new variations in reverse mortgage financingFixed Rate HECM (closed end credit) – but are fixed rates too costly for the consumers?LIBOR-indexed HECMZero closing cost conventional RMHECM for home purchase (implemented by HUD in November 2008)Possible innovations for the near futureHECM 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
43New Directions Continued Weathering the Credit CrunchKeeping HECM sound given falling house pricesDealing with potential lender financial insolvencyWhat 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 homeExploding costs of Medicaid as baby boomers ageUse of reverse mortgages can provide better quality care in the homeBetter coordination between reverse mortgage providers and local aging networksNew products designed to help lower wealth homeowners afford in-home care
44Websites for Reference HECM Lender List:Reverse Mortgage Calculator (AARP)HECM Housing Counselors:HECM Processing Handbook:HECM Mortgagee Letters (processing updates):HUD Articles and Research Related to HECM (go to link and type “HECM” into Find Results with Exact Phrase) :