Quantitative Research September 13 Your Global Investment Authority Analytics Analyzing MBS Backed by HECM Reverse Mortgages The reverse mortgage market is dominated by the HECM (Home Equity Conversion Mortgage) program, where the Federal Housing Administration (FHA) provides a guarantee against default. The program has been in existence for years, with Fannie Mae traditionally purchasing most of the production for their portfolio. In 7 Ginnie Mae started the Home Equity Conversion Mortgage-Backed Security (HMBS) program for HECM loans. This program eventually replaced the Fannie purchases and nowadays absorbs almost all the HECM originations. Stefano Risa Executive Vice President Global Head of Mortgage Analytics The HECM program has almost $1b mortgages outstanding, while HMBS securitizations have surpassed $b. Even as the HECM program suffered a slowdown during the financial crisis, production seems to have stabilized since 1 at about $7mm per month. Production has also changed from the floating rate loans that were prevalent before 9, to mostly fixed rate loans. FIGURE 1: HECM AND HMBS LOANS Loan origination and MBS issuance $(billion) 1 1 8 1 1 HECM loans originated Fiscal year (October September) HMBS issued Source: HUD (HECM data through September 1), Ginnie Mae (HMBS data through March 13), PIMCO Note: The first year of reported issuance for HECM is 199, but there is very limited origination initially. All data is reported for HUD fiscal years (October through September). The 13 HMBS data covers seven months, not annualized.
What is a reverse mortgage? A reverse mortgage is a product targeted to older homeowners. No payments are due on the mortgage until the borrower ceases to have the house as his or her primary residence (typically due to the death of the borrower or a sale of the house). The interest that accrues in the meantime is added to the balance of the mortgage. This is very similar to a HELOC (home equity line of credit), except that the lender here takes the longevity risk. Note that even if no payment is due on the mortgage, the borrowers still has to maintain the house and keep current on the tax and insurance payments; because of this, borrowers can and do default even in a reverse mortgage. The initial loan-to-value (LTV) on a reverse mortgage is capped at typically % 7% (depending on the age of the borrower and the mortgage rate), to allow room for the balance to grow with the unpaid interest. Given the target population, reverse mortgages are often structured as a line of credit, allowing the borrower to tap the line as needed. 1 In some cases, the line of credit is disbursed in monthly payments to the borrower, resembling an annuity. In other cases, the reverse mortgage can actually be used to purchase a home, where the borrower puts a large down payment, but owes no subsequent payment on the mortgage. Finally, reverse mortgages can possibly be refinanced for better terms or larger amounts if home prices increase. The HECM program and HMBS The FHA supports the reverse mortgage market through the HECM loan program. HECM is by far the largest reverse mortgage program. In return for a mortgage insurance premium (MIP) FHA guarantees the HECM credit. Loans have to be underwritten to FHA guidelines, mainly requiring that the borrower(s) must be at least years old and occupy the property as primary residence. FHA further establishes the maximum amount that can be borrowed as a function of the age of the borrower and the rate on the mortgage. 3 The program has been very successful (Figure 1), and has almost $1b of active loans. In 7, Ginnie Mae launched the HMBS program, aimed at increasing liquidity of the HECM loan program by creating a standard securitization channel. In doing so, Ginnie Mae had to face the peculiar challenges posed by the reverse mortgage product. The main features are as follows: HMBS are accrual securities. Similarly to the underlying loans, at the end of every month, the interest they accrue is added to the principal of the HMBS. HMBS are a pool of Participations in HECM loans. Several HECM loans are structured as a line of credit, allowing the borrower to tap their line over time. A participation in a HECM loan is a pro-rata share of the loan that is securitized in a HMBS. If the borrower draws additional funds the participation balance does not change, it simply becomes a smaller pro-rata share of the loan. If the borrower pays off a portion of the HECM, the payment is applied pro-rata to all participations regardless of when their funds were drawn. In addition to the HECM prepayments and terminations, HMBS participations have a mandatory re-purchase clause. The lender has to buy back all the participations of a HECM loan when the loan s LTV reaches 98%. Finally, CMOs created out of HMBS are referred to as HREMIC securities. 1 The Consumer Finance Protection Board (CFPB) has been criticizing the industry as an increasing numbers of seniors take the full amount of the mortgage upfront (7% in 11 vs. 3% in 3), partly defeating the retirement income purpose of the product. Their 3 page report provides a lot of information and statistics on the product: http://files.consumerfinance.gov/a/assets/documents/1_cfpb_reverse_mortgage_report.pdf. Lenders are guaranteed that they will be repaid in full when the home is sold, regardless of the loan balance or home value at repayment. The loans are non-recourse, so borrowers or their estates are not liable for loan balances that exceed the value of the home at repayment. MIP is 1 bps annually, with bps upfront for the standard program (see below) and 1 bps upfront for the saver program. 3 Borrowers can choose a saver program with a lower upfront cost and a standard program with a higher borrowed amount. LTV is actually masured relative to the maximum claim amount. This is established at the origination of the loan as the lowest of (a) the appraised value, (b) the (recent) sale price of the house, or (c) the FHA s mortgage limit. SEPTEMBER 13 QUANTITATIVE RESEARCH
Evolution of the market The HECM loan market was traditionally an ARM market, with Fannie Mae purchasing about 9% of the production until early 9. Fannie abruptly scaled back its presence in 9, down to 1% of new production in early 1. At that point, most of the HECM loan production got diverted to the HMBS market. The product mix also changed quite abruptly. While the virtual totality of the HECM loans pre-9 were ARMs, starting with the second half of 9 close to 7% of the new loans are fixed-rate. This is likely because fixed-rate HECM loans require borrowers to take the full amount upfront instead of using the loan as a line of credit, which makes the HMBS securitization easier. While the HMBS market size ballooned from a little over $1b in early 9 to over $b now, the overall HECM loan origination dropped in 1, with the slide continuing to date and an increasing number of large originators leaving the market (Wells Fargo and Bank of America left in 11). HECM performance HUD publishes loan level HECM performance on approximately an annual base, with the latest published data being up to November 11. While the data series is long, it unfortunately covers only a small period after the changes made in 1. Below we initially discuss performance for the whole HECM program, and eventually focus on the changes with the more recent products. Mortality Reverse mortgages being a retirement product for seniors, their prepayments are primarily driven by borrower mortality. Typical mortality rates by age are shown in Figure. About % of the HECM loans are in the name of one female borrower, % in the name of one male borrower, and the remaining % are given to couples. Since the conditions for the mortgage to be due are for the last borrower ceasing to have the property as primary residence, mortgages to couples have longer average FIGURE : MORTALITY RATES AND LOAN PREPAYMENTS BY AGE Expected mortality rates 3 3 1 1 3 3 1 1 Actual prepayments 7 8 9 1 7 8 9 1 Male Female Couple (both at closing) Borrower age Source: HECM data as of September 1, CDC mortality table for 8, PIMCO Note: Actual prepayments (right) are for loans 1-18 month seasoned. We use mortality rates published by the CDC. Most recent data is for 8. For couples, we compute mortality refers for the second person assuming the female is older. Note that in general mortality rates have been improving over the years, with some pause in 7 8. QUANTITATIVE RESEARCH SEPTEMBER 13 3
FIGURE 3: SEASONING CURVES FOR VARIOUS HPA RATES 1 % HPA 1 -% HPA 1 1 1 8 1 3 8 7 8 9 18 1 8 1 3 8 7 8 9 18 Loan age (months) CPR Projected mortality Source: HECM data as of September 1, CDC mortality table for 8, Corelogic, PIMCO Note: Conditional prepayment rate (CPR) is the annualized rate at which borrowers prepay. Annualized state HPA since origination. tenures. For couples the age differential and the age at which the mortgage was taken are also very relevant. Besides mortality, there are two main drivers of HECM prepayments: home price appreciation (HPA) and loan age. Loan age Similarly to regular mortgages, borrowers are less likely to prepay the mortgage soon after they have taken it (Figure 3). In the case of a reverse mortgage, this means that the prepayments in the first year after the mortgage was taken are even lower than the typical mortality rate for that borrower age. Home price appreciation As in many other mortgage products, HECM prepayments have also been much higher in periods of high home price appreciation and have substantially declined now (Figure ). This is clearly been driven by home prices. FIGURE : PREPAYMENTS ON HECM LOANS 1 18 MONTHS SEASONED 18 1 1 1 1 8 199 1997 1999 1 3 7 9 11 CPR Projected mortality Source: HECM data as of September 1, CDC mortality table for 8, PIMCO The larger the age differential the more the mortality will resemble that of the youngest borrower. The older the age at which the mortgage was taken the lower the mortality. Note that FHA does not lower the initial LTV limit on mortgages given to couples. Sadly, some couples do not realize this and only one party is listed as borrower on the mortgage, so that the other may be forced to pay back the mortgage if the borrower leaves the house. SEPTEMBER 13 QUANTITATIVE RESEARCH
As we show in Figure, though, once we control for home price appreciation, prepayments have not declined in past few years. Loans with high HPA still have double digit prepayments. A related question is how HPA affects prepayments. Looking at annualized HPA (as we do above) means that cumulative HPA differences grow with age. In practice (Figure ), the effect of annualized HPA does not change much by loan age. This could be due to a reduced propensity to cash out for older borrowers. FIGURE : PREPAYMENTS BY HPA OVER TIME (LEFT) AND FOR 9 11 COMBINED (RIGHT) Prepayments over time Prepayments vs. mortality for 9 11 1 1 1 1 1 3 7 9 11 HPA % HPA % HPA 1% -1-1 - 1 1 Annualized HPA since origination (%) CPR Projected mortality Source: HECM data as of September 1, CDC mortality table for 8, Corelogic, PIMCO Note: HPA in both charts is annualized state HPA since origination. Loans 1 18 month seasoned. FIGURE : PREPAYMENTS BY HPA FOR DIFFERENT LOAN AGE RANGES 1 33 Months seasoned Months seasoned 1 1 1 1-1 -1-1 1-1 -1-1 1 CPR Projected mortality Annualized HPA since origination (%) Source: HECM data as of September 1, CDC mortality table for 8, Corelogic, PIMCO. QUANTITATIVE RESEARCH SEPTEMBER 13
FIGURE 7: PREPAYMENTS AND PROJECTED MORTALITY FOR 9 AND 1 VINTAGES, % HPA 9 Vintage 7 3 1 7 3 1 1 Vintage -1 1 18 3 1 18 3 Loan age (months) CPR (fixed) Projected mortality (fixed) CPR (ARM) Projected mortality (ARM) Source: HECM data as of September 1, CDC mortality table for 8, PIMCO Recent vintages and fixed-rate loans While the main drivers of performance seem reasonably clear and consistent over time from the above charts, we know that the HECM program went through a sizeable shift in 9 with fixed-rate mortgages becoming the main product and HMBS becoming the main exit strategy. The obvious question is how different the post-9 cohorts are, but this is actually hard to answer with the available data. The preliminary evidence we have (Figure 7) points to the new fixed-rate product being slightly slower than the ARMs. Most if not all of that is justified by demographics, though. The fixed-rate product borrowers have a lower projected mortality, having a lower share of older people. In general (Figure 8) prepayments are higher for loans where the borrower draws more of the credit line in the first year. The fixed-rate product is not a line of credit and will likely tend to attract the high draw borrowers. Correspondingly, the median first year draw for ARMs has collapsed since 9 from around 8% down to the mid 3s. We would therefore argue that the small difference we observe for fixed vs. ARM borrowers over the past few years is likely due to the ARM product attracting a tail of slightly faster borrowers, more than by the fixed rate borrowers being slower what historically ARMs were. FIGURE 8: SEASONING CURVES BY INITIAL DRAW AMOUNT, % HPA 1 1 1 8 1 3 8 7 8 9 18 1 Loan age (months) % % % 8% % % 8% 1% Source: HECM data as of September 1, CDC mortality table for 8, Corelogic, PIMCO SEPTEMBER 13 QUANTITATIVE RESEARCH
Pricing At PIMCO we have been investing in both HMBS and HREMIC bonds. While fixed-rate HMBSs constitute most of the market, we traditionally mostly invest in floating rate HMBS and HREMIC. Floating rate HMBSs and HREMICs have minimal credit and very little interest rate risk, but can provide an attractive pickup over swaps. This is because of their accrual nature and of their limited liquidity. Fixed-rate HMBS are the majority of the market. Even if the optionality seems small (borrowers prepayments do not depend on rates, though the amount that can be borrowed does), those bonds do have interest rate risk, which is amplified by the accrual nature of the bonds. Since they trade at substantial premiums, they also have a sizeable prepayment risk. Given the discussion above, they are negatively impacted by an increase in HPA. We use the results of the previous section to put together a simple loan level HECM model, with the following features: Baseline projection is based on mortality, accounting for the number of borrowers and their gender and age This is then multiplied by a loan age seasoning curve, so that it takes 18 months for the baseline loan prepayments to reach the average mortality On top of that we add an HPA effect adding up to 1 CPR (i.e., assume 1% more borrowers pre-pay every year) in a high HPA environment We apply this approach to a few sample securities. The cashflows for two of these securities are shown in Figure 9. Depending on seasoning, the cashflows are for the first months purely driven by the prepayment assumption. Subsequently prepayments are also driven by the mandatory 98 LTV buyouts. FIGURE 9: HMBS AND HREMIC CASHFLOW PROJECTIONS UNDER DIFFERENT SCENARIOS Sample HREMIC 1 1 Sample HMBS 8 8 Cashflow (%) 1 13 37 9 1 73 8 97 19 CPR 1 CPR Loan level Months forward 1 13 37 9 1 73 8 97 19 Source: PIMCO, as of March 13 Note: Annualized cashflows as a percentage of original balance. Loan level assumptions explained in the text. Hypothetical example for illustrative purposes only. QUANTITATIVE RESEARCH SEPTEMBER 13 7
Spreads at the system prices are in Figure 1. The results from the simple loan model projections are between those at and 1 CPR. The resulting spreads are 7 bps. This is similar to the floaters, giving little compensation for the additional complexity of the prepayment/housing risk. FIGURE 1: SAMPLE HMBS AND HREMIC SPREADS UNDER DIFFERENT SCENARIOS 1 1 1 E-spread (bps) 8 - CPR CPR 1 CPR 1 CPR Loan level GNR 11-H BA GNMA II HECM single family GNMA II HECM single family GNMA II HECM single family Source: PIMCO, as of March 13 Note: Loan level assumptions explained in the text. E-spreads are spreads to the eurodollar curve. Hypothetical example for illustrative purposes only. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk. 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