News of a “windfall” in the Federal Housing Administration’s (FHA) Mutual Mortgage Insurance (MMI) fund this year generated excitement, while disappointing results last year generated concern. The truth is, however, that the largest part of the MMI—FHA’s traditional forward loan portfolio—is in somewhat better shape this year than last, but the capital ratio is still below the required 2 percent. This reality is masked by the misleading way that FHA calculates its financial status.
FHA currently insures 4.8 million mortgages, including nearly one-fourth of all mortgages over the past six months. Each fall, FHA releases an actuarial assessment of its MMI fund—the fund used to pay its mortgage guarantee obligations. Since 2009, FHA has calculated this value by lumping together its traditional loans and its small reverse mortgage business, or Home Equity Conversion Mortgages (HECM). By combining two very different programs, the administration’s assessment masks the programs’ individual performance, potentially encouraging policy changes—like increasing or decreasing fees—that may not actually be justified. FHA should separately assess the financial solvency of its forward and reverse mortgage businesses beginning in 2016 for four reasons:
The HECM business is a small percent of FHA insurance. The HECM program represents only about 9 percent of total FHA lending: current insurance in force for the forward book of business is $1,046 billion, and only $105 billion for the entire HECM book of business. But the value of FHA’s reverse mortgage business jumped significantly from a deficit of $1.17 billion to a surplus of $6.78 billion from 2014 to 2015. Despite its small size, this high volatility makes FHA’s much larger and more stable portfolio appear more volatile than it really is.
The HECM business is highly volatile and unpredictable. FHA’s HECM program allows homeowners who are over 62 years old and have equity in their home to tap into that equity by borrowing from an FHA-approved lender. As with a traditional mortgage, FHA does not make the loan but it insures the loan so if the borrowers defaults, FHA pays the lender, using money from the MMI. Unlike a traditional mortgage, the balance of a reverse mortgage grows over time because the borrower does not make monthly payments. The loan is typically repaid to the lender when the homeowner (or their estate) sells the property. Because an HECM borrower takes out a long-term loan secured by their home generally at a fixed interest rate, as rates rise, the value of that loan falls and vice versa. Accordingly, the value of the HECM program is much more closely linked to interest rate changes than the value of the majority of FHA’s business. If we assume that half the HECM business is at a fixed rate and that each 1 percent rise or fall in rates causes a 12 percent fall or rise in the value of the loan, that would explain most of the drop in the value of the fund last year and much of the rise in the value of the HECM book of business this year.
Figure 1 shows the capital ratios on the HECM business, the forward business and the total over time, demonstrating how the variability of the HECM business increases the variability of the total. The HECM business is also highly unpredictable. Figure 2 shows the difference between the fund value in each year, versus its projection a year earlier. As can be seen for 2013, 2014 and 2015, the projections for the tiny HECM fund have been far less reliable than those for the forward fund which is 10 times larger.
HECM’s volatility is mostly immune to policy changes. Given the close tie between interest rates and HECM swings, the accounting effect of policy changes in the HECM program are dwarfed by changes in interest rates. Yet, when FHA reports that the MMI value exceeds or fails to meet expectations, a call for new policies is inevitable. Public policy would be better served if we had a more accurate picture of the status of both programs and could then tailor policy changes for each. For example: the capital ratio of the forward book of business is 1.63 percent for fiscal year 2015 as compared with 0.56 percent for fiscal year 2014, an improvement but well under the 2 percent mandatory minimum. This suggests that there should be no premium cut this year, despite the calls for it.
Interest rates are unlikely to change significantly over the next year. This is a good year to remove the HECMs from the MMI fund because interest rates in November 2015 are largely unchanged from November 2014. The November 2015 interest rates will determine the discount rate used to calculate the 2016 MMI fund’s net worth. Thus, next year’s interest rate impact will be very small. However, in future years, as rates rise, the HECM book of business could cast a pall over the MMI fund.
It’s time to stop publishing a distorted picture of the value of the MMI fund. We should separately assess the forward and reverse mortgage businesses when determining FHA’s financial status. The coming year is the right time to make this change.