Before the mortgage-sparked national and global financial tsunami of 2008 which swept it and others into the rubbish of financial history, Lehman Brothers’ prowess in mortgage securitization (and all things mortgages) was the envy of Wall Street.
For reverse mortgages, in the days when Fannie Mae was the sole buyer of whole HECM loans in the secondary market, Lehman supplied capital to launch the proprietary jumbo reverse mortgage market. It did not stop there.
It dug deeper into reverse country with a number of strategic moves: the acquisition and consolidation of portfolio companies, such as Financial Freedom, Unity Mortgage, and others into a dominant Financial Freedom; the buying of whole jumbo loans from a pioneer reverse jumbo lender that was leaving the business; and the deployment of critical capital market expertise to support a young and struggling proprietary market.
Using the jumbo reverse loans it bought from Transamerica HomeFirst as underlying collateral, Lehman engineered the first securitization of reverse mortgages in U.S. financial history in 1999. Four similar securitizations followed between 2000 and 2007.
Among its army of structured finance talents was Joe Kelly, now a partner at New View Advisors, a Wall Street boutique specializing in reverse mortgages. A chief architect of the historic 1999 securitization, Kelly (and New View Advisors) anticipated, and advocated for, some of the critical changes that have repositioned the HECM program for success in a leaner post-2008 world of reverse mortgage lending: HUD has slashed credit limit across the board by about 18 percent, hiked monthly insurance premiums by 150 percent, introduced a lower-cost and lower-credit-limit product (HECM Saver), and renamed the existing product as HECM Standard, among other changes.
A Wharton MBA and tireless industry speaker, Joe Kelly’s work in structured finance was nominated for the Total Securitization’s North American RMBS Deal of the Year in 2007.
Kelly has described Ginnie Mae’s HECM Mortgage-Backed Security (HMBS) as the “holy grail” of fixed-income securities. We caught up recently to explore the “holy grail” idea as well as other vital issues in reverse-land. The following is a transcript of our conversation:
Atare E. Agbamu: What is the fixed-income market and what are fixed-income securities?
Joe Kelly: Any security that pays a fixed rate on a debt instrument or a predetermined margin over an adjustable rate index. We are basically talking about bonds. Fixed-income includes municipal bonds, treasury bonds, corporate bonds, and mortgage-backed bonds.
AEA: And mortgage-backed bonds are where HMBSes are located, right?
AEA: And that is probably the newest of the fixed-income asset class, right?
JK: Yes. I would say it is one of the most important developments in the U.S. fixed-income markets in the past couple of years.
AEA: Why do you say that?
JK: The HMBS market has rapidly grown to the point where you now have several billion dollars of outstanding HMBS. Besides saving the HECM program and the reverse mortgage market, there are unique aspects to its performance.
AEA: What’s unique about its performance?
JK: It is a mortgage-backed bond that has a decent spread; but more importantly, it has much less pre-payment risk than other mortgage bonds.
AEA: Why is that the case?
JK: The refinancing incentives and the refinancing ability of the borrower are significantly less compared to a forward mortgage loan. A forward mortgage loan usually pays off over time, so the equity builds up as the balance of the loan goes down and, maybe even the property value goes up. So there is more equity there for the borrower to take out. Whereas with a reverse mortgage, the loan balance goes up and the equity goes down, so there is less and less money to take out. That speaks to the ability. As far as the incentive, for a forward mortgage, if you refinance your loan, you can often reduce your monthly payment. With a reverse mortgage, you don’t have a monthly payment, so the incentive is considerably less.
Consequently, if you look at the prepayment data, you can see that the forward mortgage prepayments are generally higher and more volatile. It is interest rate- and property market- driven. By contrast, the reverse mortgage prepayment rates, especially HECM, are more range-bound. Not that they don’t change, but there is less variability in HECM prepayment rates.
AEA: What else is unique about HECM?
JK: Its performance is also actuarially based. Its maturity is not certain; it’s an event. And the event is more predictable if you have a pool of loans, versus one loan. If you have a pool of loans, you can predict prepayments within reasonable range if you know the borrowers’ ages and therefore what the range of actuarial events would be.
Another unique thing about the HMBS is that the underlying HECM has that put back to HUD when the loan balance reaches 98 percent of the Maximum Claim Amount (MCA).
For a fixed-rate loan, you know exactly when that is going to be. So, that protects the investor from what we would call “extension risk.” Extension risk is the risk that you own the security longer than you thought. That could be, for instance, if interest rates go up and the forward mortgage that you invested in does not refinance, so your investment extends – it goes on and on and on earning what is now a low yield.
That’s not the case with a HECM. You know when it reaches 98 percent of MCA, and if the HECM loan is not in default, you can put that loan back to HUD. That’s another unique feature. The unique features are its actuarial nature, its prepayment stability, and its extension risk protection. The FHA insurance is valuable to investors. By itself, the FHA insurance doesn’t make HMBS unique, but a combination of actuarial nature, prepayment stability, and extension-risk protection is pretty unique. Also, the way the market is now, there is a bit of excess spread on HMBS versus your average new-origination Ginnie Mae.
AEA: When you say “excess spread,” you mean extra profit for the investor, right?
JK: Not necessarily. It depends on what price the investor pays. What I mean is that the interest rate on newly originated HECM has tended to be above the interest rate on most newly originated forward mortgages. That may change in the coming year, however.
AEA: OK, how important is the fixed-income market to investors, and to consumers of credit?
JK: It is vitally important. The economy couldn’t exist the way it is without a very robust fixed-income market. That’s mostly how we finance housing, the government, and private corporations in this country. The amount of debt that is raised, sold, and traded greatly exceeds comparable amounts in the equity markets. If you construct a household balance sheet, or a corporate or FHA balance sheet, you’ll see most of it is fixed-income instruments of one kind or another.
AEA: You have described the HMBS as the “holy grail” of fixed-income securities. With your pedigree on Wall Street as a pioneer in reverse mortgage securitization, that is a very bullish statement. Why are HMBSes the “holy grail” of fixed-income securities?
JK: There is no other fixed-income security that has all those aspects that I mentioned – actuarially based performance; relatively stable and low prepayment speed; put back to HUD when loan balance reaches 98 percent of MCA; extension-risk protection;, and a healthy spread (especially in this environment).
For example, there are fixed-income instruments which have prepayment protection, but the yield is much lower. There are fixed-income instruments that have extension protection, but not necessarily prepayment protection. You are protected from your bonds paying off longer, but not necessarily quicker. There are bonds that have high yield, but they don’t have FHA insurance, and so on and so on. I don’t know of a security that has all those things that the HMBS has. You add all that together, it is a very valuable security.
AEA: Is there a comparative security anywhere in the world’s capital markets?
JK: Well, there are other countries that have reverse mortgages. Those markets are relatively small, as they are here. In Canada, they have the CHIP program, though I am not familiar with its details. There have also been non-HMBS reverse mortgage securities issued in the U.S. That market is very small and doesn’t have FHA insurance or the automatic 98 percent put, but it has excess spread and it has a relatively stable prepayment.
AEA: How deep is this awareness (HMBS as the “holy grail” of fixed-income) among fixed-income investors?
JK: There are more investors getting into this market all the time. Every month we have about $800 million of these securities being issued. Since prepayments are so low that’s about how much the overall supply is growing. So every month you might have a handful of investors investing in these securities, as well as existing investors adding to their portfolio, adding to their stake in the whole program. The word is definitely out. You saw improving execution in this market steadily, beginning around May 2009. As the word spread, the demand for HMBS securities rose. It was reflected in the price of those securities. As it turned out, this happened just in the nick of time for the reverse mortgage industry because Fannie Mae was pulling back.
AEA: What are some of the implications, both positive and negative, of this awareness for the primary HECM market?
JK: It is positive because you’ve got great execution and that creates a virtuous circle versus the vicious circle we used to have. You have execution, you make money; then you have more investors and more information available to the investors, such as prepayment data. This sets the table for demand and supply for the next round of issuance, which generates more profits, more interest, more investors, etc. That is a virtuous circle.
Previously, it was more of a vicious circle. We had one investor [Fannie Mae] and information was limited. There were a lot of problems too in the old days where we had the CMT Index for HECM but not LIBOR, and no fixed-rate product either. So that was a vicious circle, where we had small profits, small volume, and there wasn’t much interest from new investors. It was very slow going with the exception of the boom-let in 2006 and 2007. Before, sellers relied on Fannie Mae as a whole loan buyer. There wasn’t a good securitization program for HECM. Now, there is a great securitization program.
On the negatives, not everyone can be an HMBS issuer because there are lots of things an HMBS issuer has to do: They have to fund all the additional amounts and then finance that somehow, they have to bear the brunt of any defaults, and so on. Those are intrinsic risks to HECM, not HMBS per se. It is just that with the HMBS program, you can’t do what you can do with a lot of mortgage loans, for which the seller can say: “Here are all the loans. We will sell them into the trust as if we were selling whole loans.” The seller then no longer retains any risk other than those created by its representations and warranties to the trust. The bondholders are bearing all the risks.
In the case of HMBS, you can sell the HMBS, but you still are going to have residual risks you have to deal with one way or another.
AEA: So, you have to be well capitalized to get into the game, right?
JK: The HMBS issuer bears liquidity risk in two ways. First, it must fund future advances, such as borrower draws and MIP payments. Second, the HMBS issuer must provide the interim funding to purchase each HECM loan from the HMBS trust at the 98 percent trigger. It can then put these back to FHA, but still must reserve sufficient capital to perform this "middleman" duty on an ongoing basis. The issuer also bears default risk, for example, from tax and insurance defaults. A defaulted loan cannot be put back to FHA. Of course, HMBS issuers should have capital markets expertise and infrastructure, and that requires capital as well.
AEA: There is another potentially troubling aspect I want you to address: Could this heightened awareness and interest perversely incentivize the primary HECM market to produce loans at any cost to feed Ginnie Mae’s HMBS machine?
JK: Well, New View Advisors has always stressed the distinction between the performance of reverse mortgages and the rest of the mortgage sector. A securitization or any type of financing is only as good as the underlying collateral. And for all those reasons we talked about, including all the other safeguards of the HECM program, like the counseling and so on, there are lots of safeguards that exist in reverse mortgages that are superior to other sectors.
The other thing is some of those mortgage securities, like the CDOs and so on, weren’t structured as well and as conservatively as the reverse mortgage transactions were. With the reverse mortgage transactions, the rating agencies – now we are not talking about HECM anymore but about jumbo reverse mortgages – had very strict criteria, resulting in those deals having a lot of subordination.
Getting back to HECM, we are talking about Ginnie Maes and those are agency securities because it has the “full faith and credit” of the U.S. government. Investors feel much more secure. It is a whole different animal if we are talking about CDOs and subprime deals.
AEA: Investors are secured. For example, over the last 12 months, we’ve seen increases of fully drawn fixed-rate HECMs. Some, including myself, have expressed concern that in a couple of years, these borrowers could run out of funds and may be unable to pay their taxes and insurance, let alone maintenance, resulting in defaults. Of course, investors may not be affected because they may have exercised their put to HUD at 98 percent of MCA. But these defaults could damage the insurance fund and HUD’s ability to support HECM origination and the primary market. What do you say to this fixed-rate trend?
JK: In the summer of 2009, we published a pretty extensive blog about what we think should be done, and a lot of it was done. For the 2006-2008 vintage, we also warned that HUD could lose as much as $8 billion. And sure enough, FHA reported in its latest Annual Management Report that it expects to lose about $8 billion for those vintages.
So, you’re right. FHA is at risk from crossover loss, tax and insurance defaults, and other types of defaults. That’s an issue, but FHA has dealt with it. They’ve lowered the principal limit, they created HECM Saver, and they raised the mortgage insurance premium (MIP). The remaining item on the agenda is to address the tax and insurance issue (T&I). There is no surefire solution, but I think you can significantly mitigate that risk if you create a tax and insurance set-aside in lieu of the servicing fee set-aside.
But that comes at a cost too. By bringing down the principal limit, especially now that people have less home equity, there are fewer homeowners who can qualify. That doesn’t mean you shouldn’t do it, but it means that you must carefully weigh cost and benefit.
Over time, with each new cohort of loans being originated, the HECM program has a better chance to get back in the black. FHA has done all the right things. Once they address the T&I issue, I think all the major fixes are in place.
AEA: So you propose setting up a T&I set-aside as a way to solve the T&I issue. Are there other ways?
JK: You can have an escrow instead, and there is always the brute force method, which is to reduce principal limit even more. But I think the preferable way is just have a T&I set-aside, and say, “Look, we are going to set aside four, five, six, or nine months of tax and insurance money, and if you default on your taxes or insurance, the investor has the right to draw on that set-aside and add that amount to your loan balance.”
But that would necessitate a reduction in the initial proceeds the borrower receives. The servicing set-aside used to reduce what they receive by about 2 or 3 percent. If the tax and insurance set-aside was like 2 or 3 percent, it would be a wash, except it is not a wash because right now, for a lot of loans, the servicer is not charging a servicing fee. Nonetheless, it would be a good idea to have a T&I set-aside that creates a margin of error to mitigate these losses.
A more flexible but also more complex method would be, instead of having the same T&I set-aside for everyone, vary the amount of the T&I set-aside based on the credit score of the borrower.
AEA: Why credit score? At that age and for this product, credit scores do not mean much. Why?
JK: Credit score or other methods of credit underwriting can still give you significant information regarding the borrower’s ability to pay their bills, including taxes and insurance. The most credit-worthy borrower might not need a tax and insurance set-aside. But for some borrowers with poor credit, we may find that the necessary T&I set-aside is prohibitively high.
There is no easy solution, but there should be something so that the frequency and the severity of T&I losses are small enough so that issuers and investors can deal with them.
AEA: Actually, investors are not in HMBS …
JK: You’re right. I mean someone who is an HMBS issuer and holds that risk. They are, in effect, an investor in that excess spread [HECM cash flow minus HMBS cash flow, they get everything in between] and in the advances they make, the sub-servicing fees they have to pay, and the losses that they bear. And the losses they bear on the T&I side are big issues in the industry today.
AEA: In light of Mortgagee Letter 2011-01, how adequate is FHA's response to the Tax and Insurance default issue?
JK: ML 2011-01 formulates a curative response to the T&I default issue; I'm talking about preventive measures when the HECM loan is originated.
AEA:What are the implications of the new Ginnie Mae capital requirements for HMBS issuers?
JK: It was appropriate for Ginnie Mae to raise the HMBS issuer capital requirements, given all the risks we have been discussing
AEA: Ginnie Mae is the only game in town for HMBS. Ginnie Mae is also a government entity. With Fannie Mae and Freddie Mac, the unthinkable has happened: They failed. What could happen to Ginnie Mae and, potentially, disrupt the reverse mortgage market?
JK: If it does, we’ll have problems beyond reverse mortgage. There is a difference between GSEs (Fannie and Freddie) that had shareholders and Ginnie Mae, which is a government agency. Fannie and Freddie owned a lot of securities and a lot of loans, but Ginnie Mae doesn’t do that. As long as Ginnie Mae and FHA stick to the insurance business and get it right, then they are OK. Ginnie Mae has a much different risk profile compared to Fannie and Freddie.
AEA: What of the political risks?
JK: If you have very large losses in an FHA program, they will either shut it down or they will change it. In the case of HECM, they didn’t shut it down; they took very constructive steps that enhanced the program’s long-term viability. The political risk is always going to be there.
AEA: Choice is always important. Right now, Ginnie Mae is the only option. At some point, which entity on Wall Street do you see playing the role Lehman Brothers played in proprietary jumbo reverse mortgage-backed securities?
JK: There isn’t right now. That’s not unique to reverse mortgages. There’s not a real non-agency market, except for a few deals being done here and there. A lot of things will have to happen for that market to be revived.
AEA: What are those things?
JK: The implications of Dodd-Frank and the other new regulations will have to be sorted out. There is Reg. AB. The new regime of Reg. AB will have to be sorted out. The lending limit being so high hinders development of a non-agency market for forward and reverse. Even if you did have all of those problems solved, a government-backed market is always going to have better execution. With the lending limit at $625,500, there is not a big market left for [proprietary] reverse mortgages.
AEA: Is there any evidence that these hurdles will be cleared in the next 24 months?
JK: No. I will believe it when I see it. If, for example, the lending limit were lowered, then, necessity being the mother of invention, you might see some deals being done. There might be some baby steps in the next 24 months. That lays the groundwork for the market returning in earnest, and that is good, but we’ll see.
AEA: I am willing to speculate that might happen. The new Republican-controlled House might say, “Hey, we are too exposed in this reverse mortgage sector; we should cut the lending limit to the Fannie Mae limit to encourage ‘free markets’ and create jobs.” What do you think?
JK: If you really couldn’t securitize any loan (forward or reverse) above the $417,000, then, as I said, necessity being the mother of invention, there will be much more of an impetus to solve those hurdles, and you might see something get done.
AEA: Lehman went down with a lot of mortgage expertise in every area in the capital markets. Of the survivors, is there any entity that could quickly reassemble those skills and play the Lehman role for the jumbo market?
JK: Sure. I don’t think there is a shortage of experience out there. I think it is there, including New View Advisors, of course.
AEA: Do you have any closing thoughts?
JK: In some ways reverse mortgage lending has always been a lucky industry, whose problems get solved just in the nick of time. So, let’s hope the lucky streak continues.
AEA: Thanks, Joe.
Atare Agbamu is author of Think Reverse and more than 140 articles on reverse mortgages. Since 2002, he writes the nationally distributed column “Forward on Reverse,” the first regular column on reverse mortgages in America’s mortgage media.
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