The first article in this series (see First Article) indicated that major changes were needed in the HECM program to a) reduce its appeal to those with short time horizons looking for the largest possible immediate “cash-out”, who impose the largest costs on FHA; and b) to increase its reach to seniors who need steady financial help to stay in their homes during their retirement years. The one concrete proposal directed to this objective, stated in a letter FHA Commissioner Galante wrote to US Senator Bob Corker, is to eliminate the fixed-rate standard HECM. This is the option most used by seniors looking for the maximum cash they can draw.
Eliminating the Fixed-Rate Standard HECM
However, eliminating the fixed-rate standard HECM would not eliminate the ability of seniors to use all of their HECM borrowing power to draw cash. They could continue to do this with the fixed-rate saver, which is identical except that the maximum cash withdrawal on the saver is somewhat smaller while the upfront mortgage insurance premium is largely eliminated.
Viewed strictly as a way to reduce FHA deficits, elimination of the fixed-rate standard while leaving the fixed-rate saver, makes no sense. If the first is a loser for FHA, so is the second. While the saver loans are smaller and therefore expected losses are smaller, the insurance premiums on the saver are correspondingly smaller. The only financial benefit to FHA would occur from seniors who, because the fixed-rate standard is no longer available, elect to drop out altogether.
I would not expect many dropouts because the options remaining are far more attractive than anything else available to financially strapped seniors. Borrowers looking for the maximum cash draw can switch not only into the fixed-rate saver, but also into the adjustable rate standard, which would allow them to draw more than on the fixed-rate saver. I doubt that the risk of rising interest rates would offset the attraction of larger cash draws.
If every borrower looking for the maximum cash draw who is shut out of the standard fixed-rate HECM swings to either the saver fixed-rate HECM, or to the standard adjustable-rate HECM, the expected impact on FHA’s net income would be zero. Indeed, it could be even worse if --as seems very likely -- cash-out adjustable rate HECMs pose a greater risk of loss to FHA than cash-out fixed-rate HECMs.
HUD/FHA are certainly aware of this. It is clear from the tone of the Galante letter that the agency is looking into other changes in the HECM program that may be needed to protect FHA’s insurance reserve. Since we don’t know what these other changes are, I will take the opportunity to indicate what I believe they ought to be.
Reducing Adverse Selection
The way to strengthen FHA’s finances is to eliminate adverse selection. HECM borrowers are not a cross-section of senior homeowners, rather a disproportionate number are bad risks who won’t properly maintain their properties and will default on their property taxes.
Eliminating adverse selection means discouraging those who are the greatest risks, and encouraging those who are the smallest risks. The risk imposed on FHA by HECM borrowers is highly correlated with the time horizon of the borrower. The greatest risk is posed by those with short horizons who are looking to draw the largest amount of cash allowed. The best way to get rid of them is to limit cash withdrawals in the early years – under all HECM programs.
One possibility would be to limit cash withdrawals to 20% of what would now be the maximum cash withdrawal, in each of the first 3 years. This might be subject to specified exceptions based on the uses of the funds drawn. One such exception could be seniors who use a HECM to purchase a house, based on the premise that home buyers constitute a relatively low risk group. Another possible exception would be the use of a HECM to pay off the balance on a standard mortgage.
FHA has the data to determine whether or not these and perhaps other groups have sufficiently low default rates on property taxes and insurance that they deserve to be exempt from limits on the size of cash draws.
The restriction of cash withdrawals would be much more palatable if it were combined with a provision to allow combinations of fixed-rate and adjustable rate programs. It makes good sense to allow seniors to select a fixed rate on the cash they draw, and an adjustable rate on what they will draw in the future.
Reducing adverse selection is actually the easy part of the challenge facing HUD/FHA. The greater challenge is increasing favorable selection by encouraging seniors with long time horizons to participate in the HECM program. It is important not only for making the program self-supporting, but also as a way of redeeming the purpose of the program, which is to help senior homeowners finance their retirement. This is the subject of next week’s article.