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.
“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