Editor’s note: This is the first of a three-part series.
The recent actuarial review of the financial status of FHA’s home equity conversion mortgage (HECM) insurance fund revealing a deficit of $2.8 billion has generated considerable attention in Congress and elsewhere.
Some commentators have suggested that the deficit was a reason for curtailing the program. This article is directed to the question of what the reaction to the actuarial report ought to be, and to the broader question of what needs to be fixed in the HECM program.
The actuarial report
Basing policy changes on the actuarial report would be a terrible mistake. This is not because the report is poorly done. On the contrary, it is very well done, and one of its strengths is the documentation of the very large margin of error in that negative $2.8 billion figure. Consider:
- Estimates of fund value depend on forecasts of property values and interest rates as far as 38 years into the future. These forecasts change every year.
- The estimate of fund value one year earlier was a positive $2.1 billion. Among other things, the $4.9 billion swing resulted from less optimistic forecasts of property values and interest rates, as expected, and also from a change in the model used to calculate value. The model change itself resulted in a value drop of $2.4 billion. The new model is better, which is not the same thing as saying that it is right.
- One of the useful features of the new model is that it shows probability bounds for different fund values. It indicates, for example, that there is a 25 percent probability that the true fund value is a positive $592 million or higher.
- The model forecasts a gradual shrinking of the deficit in future years because the new business added will be increasingly profitable.
In my view, many changes are needed in the HECM program, but not because the actuarial report shows a deficit this year. An appropriate response to that report is, "Interesting. Let’s keep an eye on it."
What needs fixing
The critical problem of the HECM is that it attracts too many borrowers with short time horizons and poor payment habits, looking for as much cash in hand as possible, who impose heavy costs on FHA’s insurance reserve fund. And it is not attracting enough borrowers who need steady financial help to stay in their homes during their retirement years, or who will have intermittent needs over extended periods. The HECM program was designed to serve the second group, which also imposes much lower costs on the reserve fund than the first group.
FHA’s initial response
In a letter on Dec. 18, 2012, to U.S. Sen. Bob Corker (R-Tenn.), responding to the senator’s inquiry about the adequacy of FHA’s HECM reserve fund, FHA Commissioner Carol Galante indicated that FHA planned to eliminate the standard fixed-rate option, under which borrowers withdraw the maximum possible cash upfront.
This is the option used by seniors looking for the maximum cash they can draw. The fixed rate is appealing, and under the rules seniors who select it must use all their borrowing power at the outset.
The standard fixed-rate option can be criticized for providing an incentive to exhaust all borrowing power at the beginning, attracting those who are most shortsighted, and encouraging others to become shortsighted.
This is inconsistent with the major objective of the HECM program, which is to help seniors stay in their homes by providing funding during their retirement years — not concentrated at the outset of retirement. Allowing seniors to withdraw it all upfront leaves nothing to withdraw later on when needs may be greater.
Losses to FHA on fixed-rate cash-out loans are much higher than those on HECMs that fund over time. Equity depletion is greater in the early years, which can discourage maintenance and encourage property tax defaults.
In its most recent annual report to Congress, HUD noted that "HECM loans with such high upfront draws are twice as likely to have a tax-and-insurance default as are loans with initial draws of 60 percent, and four times as high as those with initial draws of 40 percent of the maximum allowed."
It is clear from the tone of the Galante letter that HUD/FHA is looking into the question of other changes that may be needed in the HECM program to protect FHA’s insurance reserve. The second article in this series will be directed to the same question.