Reverse Mortgage Interest Rate Caps Spell Trouble for Secondary Market

The Federal Housing Administration last week proposed several new rules for the Home Equity Conversion Mortgage (HECM) program, including interest rate caps on adjustable-rate reverse mortgages. But while FHA asserts these new changes will benefit HECM borrowers, industry members say this proposal could adversely impact the secondary market.

FHA’s set of proposed rules largely aim to create borrower protections and reduce risk to the Mutual Mortgage Insurance Fund. Perhaps one of the most significant proposals is the agency’s plans to cap lifetime interest rate increases on all HECM adjustable rate mortgages (ARMs) to 5%, as well as reduce the cap on annual interest rate increases on HECM ARMs from 2% to 1%.

The intention of the new annual and life-of-loan rate adjustment caps, as FHA puts it, is to provide greater interest rate protection to borrowers and more closely align annual caps with those of forward FHA mortgages.

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“The proposed rate adjustment caps can benefit some borrowers through lower rates of interest accruals resulting in higher residual equity in the property,” states the Department of Housing and Urban Development (HUD) in an economic analysis on the impact of FHA’s proposed rules for the HECM program.

Higher residual equity, HUD adds, can also reduce the “crossover risk” on the loan—the time in the future when the loan balance grows to exceed the property value.

“Offsetting these benefits to borrowers and to FHA is the effect of transferring some interest rate risk from borrowers to mortgagees on the margins mortgagees charge to all HECM borrowers,” HUD states. “That is, all borrowers will share the increased cost of the additional interest rate protection that some borrowers (specifically those whose loans are seasoned during a rising interest rate environment) will receive.”

HUD admits that if the rate caps have an impact, it will reduce the mortgagee’s margin between the interest income and the cost of funds, lowering the mortgagee’s net income on the loan. As a result, HUD speculates that mortgagees will likely respond to this risk of reduced earnings by raising either the initial interest rate on the loan or other loan charges.

Secondary market players argue the impact of this proposal will spell higher margins for adjustable rate HECMs as the product will then become less inviting to investors.

Ginnie Mae has been the primary vehicle for funding HECM loans since it created the HECM mortgage-backed securities (HMBS) program in 2007. The agency can also serve as collateral for Real Estate Mortgage Investment Conduits (REMICs) backed by HMBS, known as H-REMICs, which further broadens the potential capital investor markets.

However, the 1% periodic cap proposal for adjustable rate HECMs is a “non-starter” for the HMBS and H-REMIC investor base, said Darren Stumberger, executive vice president at Live Well Financial.

“The theoretical cost to uncap the HECM loan back to where it is today is several points, and the unrealistic best-case scenario would be that Investors pursue derivatives to do just that and this change causes origination coupons to skyrocket, saddling the consumer with much higher interests costs (making the loan more costly),” Stumberger told RMD in an email.

The realistic base case expectation is that this change eliminates the buyer base and the sector becomes extinct, Stumberger added.

“Conservative domestic bank buyers of HECM floaters are not in the business of buying bespoke derivatives to hedge cap risk on fairly plain vanilla Ginnie Mae floating rate paper,” he said. “Without floater buyers, there is no demand to support the sector.”

In FY 2015, approximately adjustable-rate HECMs accounted for approximately 84% of total endorsements, while fixed-rate loans comprised the remaining 16%, according to data from the Department of Housing and Urban Development. Of this proportion of adjustable-rate loans, 45% were monthly ARMs and 39.2% were annual ARMs.

While it is difficult to estimate the value of the interest rate risk that transferred from the borrower to the mortgagee under this shift in product utilization, an informal estimate based on information from Ginnie Mae analysts suggests a range of 20-25 basis points in higher yield demanded by HMBS issuers.

“This may not necessarily translate into a full 20-25 basis point increase in HECM ARM margins to the extent the yields on HMBS depend on many factors, but it serves as a benchmark for estimating the impact of the proposed rule,” HUD states.

Written by Jason Oliva

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  • This article is a little over my head in the particulars, but the bottom line seems pretty clear. I hope FHA has an open mind during the comment period and can acknowledge the ‘law of unintended consequences’ as it applies to their proposed rules.

    • REVGUYJIM,

      From the above, it is my conclusion that HUD intends to harm the whole in order to bring down the costs for the few. It excuses the decision by bringing it under the umbrella of bolstering up the MMI Fund. Of course the resulting higher margins will ultimately drive down originations. While that may be OK with executive management at HUD (specifically Secretary Castro), it is difficult for those who make their living selling HECMs and most future borrowers.

    • On the money Jim!
      “Secondary market players argue the impact of this proposal will spell higher margins for adjustable rate HECMs as the product will then become less inviting to investors”

      Lowering the Cap will not benefit the client if they are paying higher margins. More equity will be depleted from the get go with the higher margins!
      (unintended consequence)

      See the statement below which was made by HUD official Karin Hill at the NRMLA east convention just last month.

      We certainly look forward to the HECM program continuing to settle down,” Hill said. “Based on the perception of the program and the marketing in the industry, we feel that will increase our volume going forward.”

      • treverse,

        “This just goes to show” that the executive managers at HUD “fail to communicate.”

  • “The proposed rate adjustment caps can benefit some borrowers through lower rates of interest accruals resulting in higher residual equity in the property,” states the Department of Housing and Urban Development (HUD) in an economic analysis on the impact of FHA’s proposed rules for the HECM program. Adding that higher residual equity can also reduce “crossover risk”- Crossover is indicative of the loan balance growing larger than the property value.

    While I tend to agree that the rate cap reduction could help some borrowers, The circumstances of that occurrence is very unlikely given the history of the HECM average expected interest rate. If you reference HUDs own HECM case study : arguably since 1990 the average expected rate span over 25 years has not gone north of 4.7%. The same period in the LIBOR , the most common of benchmark of interest rate indexes has shown insignificant changes given the annual caps we currently embrace. Forward predictions through 2025 indicate growth will most likely progress to 2.875- peaking at 3.125 in 2023. So my question is, how many borrowers will actually benefit from the interest rate cap of 5% over the life of the loan? It’s a given that a 1% annual cap will mitigate the risk of unforeseen rate increases.

    The proposed changes will:
    •reduce the borrowers available funds

    •increase the initial interest rate due to the mortgagee proposed income decreasing

    •increase the cost of the funds due to other loan charges such as origination fee’s.

    •Secondary market players argue the impact of this proposal will spell higher margins for adjustable rate HECMs and the product will then become less attractive to investors.
    •HUD will further mitigate the risk of any possible cross over lessening it’s potential skin in the game. This is a very attractive proposition for HUD and will further secure the program.

  • “Higher residual equity, HUD adds, can also reduce the “crossover risk” on the loan—the time in the future when the loan balance grows to exceed the property value.”

    If HUD is concerned about this, then maybe HUD should open the door to a HECM Streamline that would not require an appraisal, income verification, etc. so long as the new margin is equal to or less than the current margin. This could apply to Annual to Annual or Monthly to Annual. Any Net Principal Limit or Set-Asides could be transferred to the new HECM. No additional proceeds or increase in PL would be allowed with a HECM Streamline.For fixed rates, a reduction in the accrual rate of 0.25% should suffice. Also, no closing costs could be added to the new HECM.

    Just as FHA allowed all forward streamlines for case numbers with the 0.55% MIP to keep their current rate, FHA should allow those with the 0.5% MIP to keep their current MIP rate so they can take advantage. The only issue with these is there are oftentimes margins below 2.0%. Since there currently is not a margin available below 2.0%, HUD/FHA should consider if these HECM’s can streamline with a margin increase between 0.5% and 1.0% so they can also get the benefit to convert a Monthly to an Annual. These HECM’s most likely have rate caps above 13% so HUD should consider if it is worth insuring the higher initial interest rate in order to reduce the crossover risk in the future with a lower lifetime cap.

    Not only would this benefit the borrower with the lower cap, but would help HUD reduce the risk they are seeking. Even those HECM’s currently with no available NPL or Set-Asides should be able to benefit as the current HECM is already insured so there should not be an additional risk factor with doing a HECM Streamline.

    If HUD wants to compare the HECM to forward FHA, then HUD should at least consider a HECM Streamline, as the FHA Streamline and VA IRRRL have been a mainstream product to borrowers and help reduce the risk of HUD/FHA MMI while at the same time collecting UFMIP or a VA FF.

    How much additional reserve in the MMI Fund would there be if there was a HECM Streamline where tens of thousands of HECM’s would be able to Streamline? Would this not help HUD/FHA accomplish their goal of reducing risk while at the same time potentially collecting BILLIONS, if not hundred of millions in revenue from the UFMIP?

  • The following is fascinating: “’Offsetting these benefits to borrowers and to FHA is the effect of transferring some interest rate risk from borrowers to mortgagees on the margins mortgagees charge to all HECM borrowers,’ HUD states. ‘That is, all borrowers will share the increased cost of the additional interest rate protection that some borrowers (specifically those whose loans are seasoned during a rising interest rate environment) will receive.’”

    So HUD expects all borrowers will see overall higher average effective interest rates as a result of lowering interest rate caps. That is an amazing admission. While spreading the cost is ideal for the MMI Fund and the borrowers would be impacted by the higher interest rate caps, it is not for the borrowers who are affected. Of course that is the concept of insurance but NOT of interest rates. So it seems HUD is applying insurance principals to what it knows lender reactions must be to the proposed reductions to specific interest rate caps. Truly this is a principal of liberal leaders like Senators Warren, McCaskill, and Sanders along with Secretaries Castro and Clinton, i.e., take from those who can afford it and give it to those who will need help even before it is needed.

  • This can have a serious impact in the trading of trailing GNMA’s, especially in rising market conditions. These caps, as they may be attractive to the borrower and the origination market could put a stop in trading some pools that started out with low UPB’s. These pools could consist of low margin product and low initial rates, which may be fine for the initial trade!

    The problem lies in trading future pools, consisting of those same loans. Remember, pools that start out with low UPB’s, low margins and low initial rates trade again at some point in time as additional draws are taken against the line of credit or when tenure payments build up.

    With the proposed caps, based on those low initial rates (Especially ARM’s) in a high interest rate environment, could make that pool, untradeable! What do you think that would do for the marketability of the HECM, today and tomorrow!

    Like REVGUYJIM stated, lets hope FHA is open minded during the comment period on this subject, however, I am sure they will and we will see a major shift from this proposal!

    John A. Smaldone
    http://www.hanover-financial.com

    • John,

      Are you talking about tails? Interest rate caps are never favored by investors in debt securities except in a falling interest rate environment. They want interest rates to be able float upward but not downward.

      On the other hand, if the float is restricted, then like any “flawed” debt, the day may come when tails might have to be sold at a discount. That is somewhat analogous to having a line of credit on a fixed rate HECM in a rising interest rate environment. In the latter case, the borrower benefits by obtaining funds at below market rates and the lender loses by having to sell draws at a discount. HUD does NOT reimburse such losses.

      So we agree if you are talking about tails. On the other hand, subsequent sales of HMBs after initial issuance will generally not impact the lender but will generally negatively impact the seller of the instrument.

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