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

1. 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.

2. Topics To Discuss • HUD’s Financial Management • What’s 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

3. HUD’s 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

4. What’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 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

6. 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.

8. Managing Risk – Loan LevelConcept of Principal Limit • Principal Limit Factor Times Adjusted Property Value (Maximum Claim Amount) Sets Each HECM Loan’s 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

9. HECM Insurance Model Set Premium Structure • 2% Max. Claim Upfront • 0.5% Annually on Balance Set Actuarial Assumptions • House Price Growth • Mortality/Moveout • Expected Interest Rates Solve For Factors Such That Expected Revenues = Expected Losses

10. Age of Borrower at Loan Origination Interest 65 75 85 Rate * 7.0% 0.489 0.609 0.738 8.5% 0.369 0.503 0.660 10.0% 0.280 0.416 0.589 * Expected Rate ( e.g., 10-Year Treasury Rate + Lender's Margin) HECM Principal Limit Factorsfor Selected Ages and Interest Rates Factor decreases with interest rate Factor increases with age

12. 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 HUD’s 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 HUD’s audited financial statements • Annual estimates of credit subsidy rate for future cohorts reported in federal budget

13. 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 Year’s Budget Year 30 * Year 0 * HECM Requires Analysis Beyond Year 30

14. 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

15. 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 program’s features

16. Effect Of Falling House Prices Expected Price Declines in 2008-2009 Compared With HUD’s Long Run Assumption (4% per YR) Forecast by Global Insight

17. 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 • HUD’s 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)

18. 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

19. 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?

20. 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.

21. 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

22. 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

23. 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

24. 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.

25. 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 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 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.

26. 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

27. 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.

31. How the Secondary Market Securitizes HECM

32. Unlike a single HECM loan, cash flows on a pool of loans turn positive quickly (although there will be variability if loan payoffs don’t occur as expected.)

33. Secondary Market Issues: Termination Speeds

34. Secondary Market Issues: HECM Rate Types

35. 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.

36. 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

38. 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

39. 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

40. US Population By Age Group 2000 and Projected for 2025 Large Growth Projected in HECM Eligible Age Groups HECM Minimum Age

41. 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

42. 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

43. 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

44. Websites for Reference • HECM Lender List: http://www.hud.gov/ll/code/llslcrit.cfm • Reverse Mortgage Calculator (AARP) http://www.rmaarp.com/ • HECM Housing Counselors: http://www.hud.gov/offices/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.cfm • 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_site_adv.asp