In a post that now looks prescient, I reported recently on the FHA’s Financial Troubles (“How will the FHA’s Financial Troubles Affect Reverse Mortgage Lending?“) and wondered aloud about the potential impact on the reverse mortgage industry (which wouldn’t be possible in its current form without the “largesse” of the FHA).
It’s no longer necessary to speculate, as the latest rumors are that the FHA is set to announce new limits on reverse mortgage lending after Thanksgiving. Specifically, the FHA will adjust downward the loan maximums that eligible reverse mortgage borrowers can obtain. This would be the second such “haircut” this year, the other being a 10% across-the-board reduction that went into effect on October 1.
Of course, it’s impossible to know whether this cut – which would presumably not take effect until January 1 – would be as deep. Loan maximums are calculated on a sliding scale that takes into account the age of the borrower and the interest rate on the loan. This quotients (found in this table) are then multiplied by the value of the one’s home to determine how much can be withdrawn upfront. In all likelihood, then, this round of cuts will affect younger borrowers more, since there is greater uncertainty attached to lending to them.
Given the severity of the FHA’s financial troubles, its goal is to minimize uncertainty going forward. HUD Secretary Shaun Donovan has all but promised Congress that under a worst-case-scenario, the FHA will still not require a bailout. Thus, it’s incumbent upon him and the FHA to make sure that there are no surprises going forward – that whatever happens in reality is no worse then their most extreme forecasts.
It’s impossible to offer concrete advice in the context of this development. Those contemplating reverse mortgages will surely feel some pressure to obtain one before the new loan maximums (if indeed a reduction takes place) go into effect. At the same time, obtaining a reverse mortgage is not a light decision. The upfront costs and steady erosion of home equity are serious downsides which must be weighed against receiving a one-way stream of “free” money from a reverse mortgage lender.
In fact, there is no inherent disadvantage of a reduced loan amount, since any part of your home that you don’t borrow against is naturally retained by you in the form of equity. It could even be argued that he FHA is doing borrowers a favor by forcing them to set aside a small chunk of home equity that they can tap into if need be. Industry lobbyists claim that lower loan maximums limit the pool of eligible borrowers, many of whom have pre-existing liens and very little equity in their homes. If you think you fall in this category of borrowers, you may have to hurry if you want to qualify for a reverse mortgage. For everyone else, I would advise against making a rash decision.
For those unlucky borrowers that took out reverse mortgages prior to the housing crisis, many have seen the equity in their homes collapse, to the point where some of their reverse mortgages are fully underwater. As a result, such borrowers are basically just squatting in their homes, continuing to pay property taxes and insurance, despite the fact that they own 0% of their homes.
While it’s unclear how widespread this phenomenon is, given the FHA’s recently announced financial troubles (the FHA insures the majority of reverse mortgages), one can safely surmise that a growing portion of reverse mortgages were characterized by negative equity when they were closed out. That also implies a growing quotient of borrowers that have left their homes after the expiry of their mortgages without receiving even a penny.
That’s not to say that this phenomenon is improper, or even unfair. After all, the terms of the reverse mortgage are such that the borrower’s equity is by definition, the value of the home minus the value of the reverse mortgage. If the value of the mortgage rises faster than the value of the home, then the borrower could quickly find himself without any equity left in the home. For long-term reverse mortgage borrowers – those that plan to remain in their homes until their passing – this shouldn’t be much of a problem, since the swings in real estate values will offset each other over a couple decades. For those that saw the quick cash offered by a reverse mortgage without fully understanding the terms,
this must be devastating.
In addition, as advocates of reverse mortgages have pointed out, the decline in equity would have affected the homeowner regardless of whether a reverse mortgage was in place. Critics argue that failure to pay property taxes and insurance could lead to foreclosure by the reverse mortgage lender, but to be fair, this would also be the outcome even in the absence of a reverse mortgage. The difference can be found in the high upfront costs and annual interest/insurance payments that quickly erode one’s equity under a reverse mortgage.
Going forward, it’s reasonable to expect that home prices will rise again at some point in the future. However, it’s not a given that prices will rise faster than rates, currently about 6% for a reverse mortgage. That being the case, in increasing portion of borrowers could find themselves with vastly depleted equity when it comes time to leave their homes. For that reason, it’s recommended that only borrowers with other reserves take out reverse mortgages. Even if you plan to remain in your home until the proverbial “last minute,” the possibility of unforeseen events (i.e. illness) should make you think twice.
In short, when you obtain a reverse mortgage, you should conservatively assume that when you ultimately move out of your house, you won’t have much equity left in it. If this proves to be the case, consider yourself prescient. If not, well, then you will reap a minor windfall from the sale of the home, which you can put towards other living arrangements.
The biggest up-front expense when taking out a reverse mortgage is typically the 2% FHA insurance premium. [If not, there is a possibility that you are being ripped off by your broker- but that’s another story]. Many mortgagers don’t realize that an annual insurance premium of .5% of the mortgage balance must be paid every year until the reverse mortgage must be repaid.
So what purpose is actually served by this insurance premium? I thought the whole concept behind a (reverse) mortgage is that the lender makes the loan with the tacit understanding that there is a risk of default. In the case of reverse mortgages, this turns out to not be the case. Basically, the reverse mortgage insurance protects the lender in the event of default. With a reverse mortgage, this would imply that the value of the home exceeded the balance of the mortgage when it came time to be repaid. Thanks to the insurance, it is the FHA (and potentially taxpayers, if you read my last post) that is on the hook for the difference. In this way, the broker that originated your mortgage bears zero risk. That’s something to think about when he’s pushing you fervently into obtaining one.
Brokers and industry insiders insist that reverse mortgage insurance is ultimately designed to protect you, the borrower. They will try to convince you that if not for the insurance, you could be on the hook for the difference, in the event of default. Theoretically, they are right. In practice, however, many states have laws that prevent lenders from seeking so-called deficiency judgements, which apply to cases of mortgage default involving borrowers that owe more than their homes are worth.
They will also argue that the insurance protects you in case of lender bankruptcy, in which case the title of the home could technically revert back to the bank, such that it would be sold to pay off creditors. Again, this is extremely unlikely in practice, primarily because the reverse mortgage contract guarantees you the right to remain in your home until death, if you desire to do so. In addition, lender bankruptcies are very different from bankruptcies of normal businesses, since the majority of lender bankruptcies end in a sale to a new lender, rather than a court-ordered sale of assets. Given also that reverse mortgages are increasingly being packaged and sold to investors, the possibility of lender/originator bankruptcy is becoming increasingly irrelevant.
In short, it seems self-evident that the insurance premium is designed to protect the lender first and foremost. If it was actually designed to protect homeowners, it would be seen as option, rather than mandatory. That’s not to say that it doesn’t serve a necessary function, but it’s still important to see if for what it is, and to make clear your understanding to your broker.
We have recently created a free visual guide for seniors who are looking to understand how reverse mortgages work.
Earlier this week, it was announced that the FHA’s insurance reserves have fallen below the benchmark 2% level of insurance commitments. In fact, it is now only .53%, and some analysts are suggesting that it could soon fall below zero, necessitating a government bailout.
It is not difficult to understand why the FHA’s reserves are falling. You can see from the excellent flowchart below (courtesy of the Wall Street Journal), that in the wake of the housing crisis, the FHA is involved in a growing portion of mortgage lending. In fact, FHA loans now represents nearly 25% of all new mortgages. Moreover, a high proportion of these loans are secured by very little equity- less than 5% in the majority of cases. As a result of the concurrent economic downturn, meanwhile, loans are souring at a faster rate, and the ratio of delinquent 2007 loans has surpassed the percentage of 2004 loans that are delinquent. “Nearly one in five loans it insured in 2007 falls into the category of ‘seriously delinquent,’ ” the agency admitted.
Shaun Donovan, Secretary of the Department of Housing and Urban Development (a Cabinet-level position) has insisted that the agency will remain solvent, and that in fact, its reserves could return the 2% level as soon as fiscal 2012. “In line with many analysts, the agency expects the housing market to turn down again over the next nine months and then to recover. Under this projection, foreclosures would be manageable and the reserves would quickly grow.” Nonetheless, he has delayed the release of the annual FHA audit so that more downside forecasts can be conducted, and included in the report.
Congress isn’t exactly buying this self-declared prognosis. “Rep. Scott Garrett (R., N.J.) introduced a bill last month that would raise minimum down payments to 5%, something that the agency opposes. ‘Others are beginning to see that this could be the next major bailout,’ he said.” Still, the agency is insisting both on its autonomy and its ability to survive this minor crisis unscathed.
It’s unclear how the reverse mortgage program will be affected. The FHA has already lowered the size of maximum allowable mortgages, as a percent of the value of the collateral housing. Shortly thereafter, it paradoxically raised the overall allowable mortgage to $625,000. According to the FHA, “This year, for the first time, we have added an actuarial study of the FHA reverse mortgage, or HECM, program, to the principal study of standard FHA single-family insurance programs supported by the Fund.” Since the report’s release has been delayed, we will have to wait to see whether the reverse mortgage program is in the same dire-financial straits as its conventional mortgage lending program.
Given that home prices have declined so precipitously and that reverse mortgage defaults are also rising, it seems likely that its reserves set aside for reverse mortgage lending are probably proportionately low. At the very least, lending standards will have to be tightened, and perhaps insurance premiums will have to be raised. Naturally, these costs will be passed on to the borrower. If you’re thinking about a reverse mortgage, then, this could be your last chance for a while to get in at good terms.
Over the last couple years, reverse mortgage lending has exploded, such that the product can no longer be considered a niche offering. Now, it looks as if the industry will get another boost, as Wall Street introduces the practice of securitization, which has long since been commonplace in conventional mortgage lending.
For those of you aren’t familiar with this concept, securitization involves the bundling of individual assets (mortgages in this case) into massive portfolios, so that they ca be sold to institutional investors. The idea is that by packaging many mortgages together, the risk declines, since a few defaults will presumably be offset by repayment by the majority of borrowers. By connecting capital markets (i.e. large investors) directly with mortgagers, it is believed that mortgage rates and terms are more attractive than they otherwise would be. (As an aside, it is also believed that securitzation played a large role in the fomenting of the housing bubble and the subsequent financial crisis).
With 110,000 reverse mortgages per year (and rising), Wall Street investment banks have discovered new potential for securitization. In fact, it is surprising that the practice wasn’t introduced earlier, since in some ways, reverse mortgages would seem to constitute the ideal candidate for securitization; due to mandatory FHA mortgage insurance, lenders already bear virtually zero risk in the reverse mortgages they originate. From an investor standpoint, meanwhile, the risk of default is also nil, since taxpayers (via the FHA) are ultimately on the hook for any mortgages that cannot be paid.
On the other hand, there are some inherent differences between reverse mortgages and conventional mortgages, which create a unique investment dynamic. Namely, the time horizon for repayment is typically much longer with a reverse mortgage, and in fact indefinite. Whereas a conventional mortgage borrower must repay the mortgage incrementally over a fixed time period (usually 15 or 30 years), it is impossible to predict when a reverse mortgage will be repaid since it usually only comes due when the borrower dies and/or the home is sold. In addition, whereas a conventional mortgage must be gradually repaid, a reverse mortgage is typically only repaid in full.
It would be difficult for investors, then, to judge how long the mortgage must be held before it will yield a profit. In some ways, then, it is akin to investing in an asset that doesn’t produce a stream of income payments, but only a lump-sum payout at the end of its life. Accordingly, it probably isn’t appropriate for the majority of investors.
How will this affect borrowers? Those with outstanding reverse mortgages won’t be affected in the slightest. For potential borrowers, it could lead to slightly lower interest rates, since a larger supply of capital will presumably drive down prices. Lending standards will probably also be relaxed, since lenders will have virtually zero incentive to ensure repayment. The FHA insurance premium guarantees that investors will ultimately be repaid, regardless of what happens to the value of one’s home (the main variable in a reverse mortgage) in the interim. Once again, it looks like taxpayers will get screwed, but everyone else will come out ahead.
In a new twist, lenders are utilizing reverse mortgages as a substitute – or in some cases, as a compliment to – modifying loans for borrowers having difficulty repaying their loans. The underlying logic is that for many borrowers, including those that have been fortunate enough to receive loan modifications, will still face difficulty repaying their mortgages.
Towards this end, lenders have generally taken one of two approaches. The first involves simply issuing a reverse mortgage for the remaining loan balance, such that the borrower doesn’t have to worry about making additional payments on a mortgage that he can’t afford. Sometimes, the balance of the loan is first reduced, such that the reverse mortgage qualifies for FHA reverse mortgage guidelines. This step is crucial for underwater mortgages, where the borrower’s equity is already negative. Under the second approach, the lender would simply issue a reverse mortgage to the borrower but pocket the proceeds itself. After the borrower passes away, the lender assumes control over the property. Typically, the borrower’s heirs can purchase it back by repaying the reverse mortgage.
Both of these approaches reflect the desperation of lenders, who are are increasingly faced with mortgages that are worth many times the value of the respective homes with which they are associated. Lenders evidently have concluded that selling the properties would involve considerable time and expense, and in many cases would bring in less than what the property was appraised before. Since reverse mortgage are based on appraised value – and not sale value – lenders are able to avoid recognizing the true decline in the property.
If you’re currently having trouble making mortgage payments, and are concerned that even loan modification wouldn’t be enough to forestall foreclosure, this strategy is worth broaching with your lender. Granted, it remains the exception and not the norm, but it doesn’t hurt to ask. In addition, borrowers under the age of 62 are not eligible for FHA-insured reverse mortgages, which could pose a problem from the lender’s standpoint, since a private reverse mortgage carries significant risks. Still, many lenders are eager to avoid foreclosure, because of the legal and financial burden it carries. Accordingly, they may be willing to work with borrowers to develop more creative solutions.
As a result of the gaping hole in its finances, the FHA is currently mulling a new reverse mortgage product: the Mini Home Equity Conversion Mortgage (Mini-HECM). The idea was put forward at a recent real estate conference in San Diego, and since then has been echoing around the blogosphere.
The product is still in the early stages of planning, so it’s unclear exactly how it would function. Basically, it is expected to serve as a more compact and economical version of the existing reverse mortgage product. For borrowers that want to receive cash now in one lump sump payment, the Mini-HECM would presumably allow them to withdraw a smaller portion, though at terms more favorable than existing loans offer. The catch could be that borrowers, then, wouldn’t have the option of withdrawing additional funds later.
In this way, the product would conceivably protect both borrowers and the FHA. Borrowers, while not having the luxury of converting the entire (projected) value of their home into equity, would still be able to withdraw a significant portion, though small enough to ensure that they would have remaining equity that they would receive at the time of sale (and repayment). One of the main criticisms of reverse mortgages is that it encourages borrowers to withdraw all of the equity in their homes, leaving them with little in case of emergency. With the Mini-ECM, borrowers would presumably be prevented from exceeding a certain equity threshold, thereby guaranteeing them an equity reserve that could be tapped in desperate circumstances.
The FHA would also be protected, since the likelihood of default would also decrease. Over the last few years, many reverse mortgages have been pushed underwater (i.e. loan size exceed home value) by the bursting of the housing bubble. This explosion in defaults, however, wasn’t anticipated by the FHA, which insures the majority of reverse mortgages, resulting in an $800 million home in the agency’s finances. It has responded by petitioning Congress for funds and lowering the maximum loan size for all reverse mortgage borrower. The Mini-HECM would provide a further layer of protection.
It seems the government (via HUD and the FHA) are finally getting serious about reverse mortgages. The industry is still something of a free-for-all, lacking comprehensive regulation. With this potential new addition the family of reverse mortgage products, the FHA will hopefully ensure that HECMs are provided in a way that primarily benefits the consumer (rather than the lenders), while also minimizing the exposure of taxpayers.