Forward Mortgage Does Not Subsidize Reverse Mortgage

This blog began in 2009 with an entry entitled “The Trouble with HECM.” What was the Trouble we predicted? Is FHA’s Home Equity Conversion Mortgage (“HECM”) reverse mortgage program in for more trouble? The reader of FHA’s recent report, the “Federal Housing Administration’s Annual Report to Congress Regarding the Financial Status of the FHA Mutual Mortgage Insurance Fund,” would probably think so. The report depicts FHA’s HECM Reverse Mortgage Portfolio and Forward Mortgage Portfolio, respectively, as the Goofus and Gallant of mortgage loans. In no fewer than three instances does the report describe the Gallant Forward Mortgage Portfolio as “subsidizing” the “volatile” Goofus Reverse Mortgage Portfolio. Gallant Forward Mortgage is an earnest young first-time homebuyer, whereas Goofus Reverse Mortgage is a grumpy old man with anger issues.

In this blog entry, we address these questions by discussing the FHA report, especially as it relates to HECM. We will conclude with three major points:

(1) The HECM program’s outlook has improved significantly, and may be on the verge of returning to surplus;
(2) FHA’s forward mortgage program’s delinquencies have risen sharply at a time when HECM defaults remain low; and
(3) Therefore, FHA’s forward mortgage portfolio cannot be said to subsidize its HECM reverse mortgage portfolio. FHA should improve its disclosure to show where its risk really is, prospectively and historically, for both HECM and forward mortgage.

We wrote our first blog entry around the time when the HECM program began to show a small deficit. Prior to that, it was fashionable to say that the HECM program subsidized the FHA’s forward program. The HECM program had a negative subsidy of $462 million in FY 2008, down from $697 million in FY 2007, but still profitable to FHA. Forward mortgages, on the other hand, were in the midst of their worst crisis since the Great Depression.

In 2009, the first large cohorts of HECM loans had not yet been stress-tested, as HECM volume before the crisis years of 2007-2009 were relatively small. But as the HECM program grew, the weakness in the program’s design was revealed. In 2009, we predicted the HECM portfolio was headed for a big loss, due to very high loan-to-value ratios (“LTVs,” also referred to as “Principal Limit Factors,” or “PLFs”). Back then, it was possible for an 80 year-old HECM borrower to borrow 78% of their home value, without any financial assessment or limitation on the initial draw amount. It was only a matter of time until many of these loans were underwater.

Our “Trouble with HECM” blog predicted FHA’s small HECM deficit would grow and could be potentially very large. Sure enough, in FHA’s FY 2012 MMI Report, the surplus of a few years earlier had been replaced by a deficit, an Economic Net Worth of negative $2.8 billion (Financial Status of the FHA Mutual Mortgage Insurance Fund, p. 35). The trouble had come.

Since then, FHA improved the design of the HECM program. PLFs were lowered, the initial draw amount was restricted, and Financial Assessment (“FA”) was enacted. The 80-year-old who could receive a 78% LTV HECM in 2009 could then borrow no more than 64%, even less depending on interest rates. As we have analyzed in previous blogs, the implementation of Financial Assessment also materially reduced the number of HECM borrowers unable to keep current tax and insurance payments. Today, default rates for FA-era HECMs are a fraction of the default rates for pre-FA era HECMs.

These FHA reforms have two major implications. First, there is a good and bad portion of FHA’s HECM book, the high-LTV, pre-FA loans, and the low-LTV, FA loans. Second, with each passing day, the old riskier HECMs pay off, good new less-risky HECMs are added, and the portfolio percentage comprised of FA loans grows larger. According to this year’s FHA report (p. 110), about half the loans in the HECM portfolio were originated before FY 2015. At a certain point in the not-too-distant future, FHA’s HECM book will consist almost entirely of FA-era loans.

So are HECMs out of trouble yet? That brings us to this year’s FHA MMI report.

Types of Loss: Type I and II; Realized versus Projected

At FY-end 2020, FHA insures HECM loans totaling $62.638 billion: this amount is known as the Insurance-in-Force (or “IIF,” p. 118). During FY 2020, FHA paid $6.22 billion in HECM claims, down from $9.55 billion in FY 2019 (p. 47).

HECMs claims are divided into two types: Type I and Type II. In FY 2020, Type I Claims totaled about $500 million; the remaining $5.7 billion were Type II Claims. To the reader untutored in the idiosyncrasies of the HECM program, the magnitude of the Type II Claims seems gigantic: at nearly $6 billion, they approach almost one-tenth of the IIF and nearly a year’s worth of HECM production. However, Type I Claims represent realized losses to FHA, whereas Type II Claims do not.

Type I Claims

Type I Category Claims “represents the dollar volume of claims generated when the borrower no longer occupies the home, and the property is sold at a loss, with the mortgage never being assigned to the Secretary of HUD” (p. 47). These claims are realized losses for FHA, which insures investors against these crossover losses. For FY 2020, Type I Claims equaled about 0.75% of the total outstanding balance of HECMs insured by FHA (p. 47 and p. 111). Stated otherwise, these are realized losses incurred by HMBS issuers and HECM investors and reimbursed by FHA during the fiscal year.

The rate of Type I Claim losses each fiscal year has fallen steadily since FY 2015 (p. 47 and Table B-25 on p. 111). Barring significant economic problems, this trend will almost certainly continue as the HECM program portfolio quality improves, as pre-FA loans pay off, and FA loans are added.

Type II Claims and the Secretary’s Notes

Type II Claims are very different. The Type II Claim is a sale, or “assignment,” of an Active HECM loan from an investor to HUD when the balance of that loan reaches 98% of its Maximum Claim Amount, or “MCA.” The MCA is a dollar amount, determined at the time of the HECM loan’s origination, equal to the lesser of the property value and the HECM lending limit. By “Active,” the HECM borrower is alive, and the loan is not in default for any reason. As the report puts it, “The Type II Claim represents the dollar volume of claims resulting from the assignment of the mortgage to the Secretary of HUD when the mortgage reaches 98 percent of MCA” (p. 47).

Therefore, the Type II Claim amount does not represent a realized loss; it is a loan sale in which the investor assigns a HECM loan to HUD. HUD pays a price of 100%, or par. Again, HUD will not purchase any HECM loan that is matured or in default. Investors therefore benefit from a put option that shields them from losses and shortens the otherwise very long duration of HECM loans. HUD then holds the loan in its “Secretary’s Notes” portfolio until that loan pays off. Through this Claim Type II mechanism, HUD has become a very big investor in highly seasoned HECM loans. The Secretary’s Notes portfolio now holds nearly 150,000 HECM loans (FHA presentation to NRMLA p. 24), totaling an estimated $30 billion in unpaid balance.

Due to the terms of the Type II Claim assignment, these loans are positively selected with respect to credit, but negatively selected with respect to LTV. At the time of assignment, HUD may be buying a loan that is underwater (a loan with an LTV exceeding 100%), however, for most HECM loans this is probably not the case, as the underlying properties have benefitted from several years of home price appreciation.

It is worth noting these loans have interest rates well above the treasury funding rate, and the borrower’s mortgage insurance premium (“MIP”) rate continues to accrue on top of the interest rate. Whether HUD can collect that interest accrual, or even the loan balance it paid for, depends on the LTV. For loans in the Secretary’s Notes portfolio that are not underwater at the time of loan payoff, HUD can collect the full loan amount and make a decent profit. For loans that are underwater at the time of loan liquidation, HUD suffers a realized crossover loss equal to the excess of the loan balance over the property value, plus any related expense.

The latest FHA report does not disclose much data on the Secretary’s Note portfolio itself; plus, this disclosure has varied from year to year. However, reading between the lines of the report, it is clear that the majority of expected future HECM MMI fund losses are concentrated in the Secretary’s Notes portfolio.

If the Type I Claim Net Present Value (“NPV”) loss is 0.75% per year (i.e. Type I Claims per year/IIF), and continues to decline, we estimate that the total Type I Claim-related loss is approximately 2% of IIF in present value, given the duration of the non-assigned portfolio. Using FHA’s own estimate of the total “Net Present Value of loss” of 10% of IIF (p. 118), less the estimated Type I Claim-related NPV of loss of 2% of IIF, a total Type II-related NPV loss equal to 8% of IIF is projected. Said otherwise, a total NPV loss of $5 billion is projected for the entire Secretary’s Notes portfolio, not just for FY 2020.

This $5 billion loss is 15% – 20% of the total Secretary’s Notes portfolio. Such a high loss severity is possible with a combination of adverse factors, such as high LTVs, expenses, inflated appraisals, and servicing issues. The FHA report does not provide empirical data showing the portfolio’s recent performance, such as loss severities of recent loan liquidations. If it did, we suspect that it would show that HECM’s troubles were largely caused by high-LTV pre-FA loans, a problem that is melting away as those loans pay off.

FHA should show more detailed performance data for the Secretary’s Notes, by fiscal year, showing dollar amounts and units outstanding, interest accrued, payoffs, realized losses from those payoffs, payoffs without loss, etc. The FHA report should also show realized losses by all product types, both forward and reverse. Only then can the reader make proper comparisons.

It is clear that for HUD’s HECM program, the greater portion of its risk resides in the high LTV loans in the Secretary’s Notes portfolio. Nearly all of these loans are from the pre-FA era. The oldest FA loan is barely five years old; very few have been assigned to HUD. Under the current trend of falling number of assignments, and rising number of payoffs, the Secretary’s Notes portfolio will probably peak sometime in 2022 with 170,000 – 180,000 loans. As this portfolio shrinks, so will HUD’s losses.

Models of Volatility

In the section “MMI Fund Capital Ratio Sensitivity to Modeling Assumptions“ (p. 67), the report discusses the rapidly rising delinquencies in the forward mortgage portfolio, and relates this to the COVID crisis and forbearance provisions allowed by the CARES Act. It discusses some stress-case scenario sensitivity analysis for both forward mortgages and HECMs. So far, the recent economic stress has manifested itself in the forward mortgage program, not the HECM program, where default rates remain low.

The FHA report claims that forward mortgage subsidizes reverse mortgage based on the estimated present values of future losses, but it’s worth noting two anomalies in these estimates (Table C-7 and C-8, p. 118). First, FHA’s estimate for its forward portfolio losses was little changed from last year, despite the COVID crisis and the massive increase in delinquencies. How is this possible?

Second, FHA’s estimate of future HECM losses has declined significantly in each of the past two years. FHA’s estimate of HECM NPV losses topping $21 billion in FY 2018 was reduced to an estimate of $13 billion last year and now $6.3 billion (p. 118). The decline each year is approximately equal to one year of HECM production. An accompanying report, “Fiscal Year 2020 Independent Actuarial Review of the Mutual Mortgage Insurance Fund” (the “Actuarial Report”), shows a similar decline, including a $2.4 billion increase in NPV due to “Impact of Assumption Change” and an $8.3 billion increase due to “Impact of model change.”

No change in economic conditions, program design, or portfolio composition, however favorable, should cause changes of that magnitude. This begs the question, which is really more volatile, the HECM program, the forward mortgage program, or the modeling assumptions?

Conclusion: The Essence of Subsidy

The FHA FY 2020 MMI Fund report states that projected reverse mortgage losses are falling, forward delinquencies are rising rapidly, and HECM is responsible for the entire $6 billion improvement in the fund’s loss reserve. Yet, it concludes that its forward mortgage program subsidizes its HECM reverse mortgage program. FHA bases this claim on prospective losses, but this will likely be proved wrong if current trends continue. Examining FHA’s own report, it appears that prospective losses are a rapidly moving target, changing significantly year to year due to changes in economic conditions, portfolio composition, and modeling assumptions.

We think Forward Mortgage does not subsidize Reverse Mortgage now any more than Reverse Mortgage subsidized Forward Mortgage in 2009. A true subsidy would mean outsized realized HECM losses, and a compelling case that this will continue. This is not demonstrated in the report. In fact, given current trends, a reversal of fortune is possible, in which the HECM program returns to surplus and forward mortgage enters a deficit.

Any loan portfolio can be stratified into a superior performing portion and an inferior performing portion, with the former “subsidizing” the latter. Within the reverse mortgage portfolio, we could say reverse mortgages owned by investors and issuers subsidize the Secretary’s Notes, or that post-Financial Assessment loans subsidizes Pre-Financial Assessment loans. The question is: which characteristic is the most meaningful? Historically, the Loan-to-Value Ratio has proven to be the most important characteristic. Low-LTV loans subsidize high-LTV loans, for both Reverse Mortgage and Forward Mortgage.

Under current trends, the HECM program should be making money for taxpayers by the end of FY 2021. In fact, assuming the Actuarial Report’s lower loss estimate, the HECM program is already in the black (Actuarial Report (Revised), p. 12). By the end of FY 2022, about 70% of the HECM Insurance-In-Force will consist of post-FA HECM loans. The cash flow and Economic Net Worth of the HECM program could then be strongly positive.

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