Agency MBS Strategy | 24 September 2010  
HECM PLF changes unlikely to  
trigger prepayments  
HUD announced changes to the Home Equity Conversion Mortgage (HECM)  
program, as well as a new HECM Saver program.  
Sandipan Deb  
+1 212 412 2099  
HUD reduced the principal limit factors (PLFs) for new HECM loans on September  
21. This will result in a lower initial principal limit than for a borrower taking out a  
new loan at the same WAC as before.  
Nicholas Strand  
+1 (212) 412 2057  
Somewhat unexpectedly, HUD reduced the floor WAC for calculating PLFs to 5% from  
5.5%. This has the effect of effectively increasing PLFs for most borrowers if they take  
out a new loan at sub-5.5% WACs. This creates some incentive to refinance.  
HUD also announced the HECM Saver program, which reduces the upfront  
mortgage insurance premium (MIP) in return for a lower PLF.  
Finally, HUD increased the running MIP to 125bp from 50bp.  
Despite the potential for higher prepayments from older vintages due to the  
increase in PLFs in the lower WAC range, we believe the concerns may be  
overblown, given the past performance of HECM loans, refinancing costs and  
negative amortization of loans.  
HUD decreases, and increases, PLFs at the same time  
We covered the calculation of the initial principal limit (IPL) in Reverse mortgages and  
HMBS, March 18, 2010. IPL is the maximum loan amount that can potentially be taken  
out by a borrower at the start of a HECM loan. The IPL is calculated from the maximum  
claim amount (MCA), which is the lower of the current value of the home or the  
prevailing FHA loan limit. Conceptually, the IPL is the PV of the MCA over the expected  
lifetime of the borrower, discounted at the WAC offered on the loan. In reality, other  
adjustments are added to that theoretical framework.  
To calculate the IPL on a HECM loan, HUD provides a table of PLFs. Using the table, it is  
possible to look up the PLF for a borrower of a certain age with a loan of a given WAC.  
Once the PLF is found, the IPL can be calculated as follows:  
Sensitivity of the PLF to WAC and age of borrower  
As we mentioned above, the PLF table is a function of the loan WAC and the age of the  
youngest borrower. Figure 1 shows the relationship between the variables for the PLF  
table that was in force till the latest announcement. Note that the PLF increases with an  
increase in borrower age. As the life expectancy of a borrower goes down, MCA is  
discounted over a shorter time period and hence the IPL goes up.  
Barclays Capital | HECM PLF changes unlikely to trigger prepayments  
Figure 1 also shows that PLFs increase with decreasing WACs. This is also intuitive because a  
lower WAC means that the discounting factor is lower, which results in a higher value.  
However, note that the PLF remains flat once WAC falls below 5.5%. This was an intentional  
design feature that was put in to ensure a certain safety margin on negatively amortizing loans.  
Figure 1: PLF sensitivity to borrower age and loan WAC  
Calculation WAC  
Source: HUD, Barclays Capital  
HUD reduces PLFs  
For all WACs of 5.5% and above, HUD reduced the PLFs in the September 21 announcement.  
The agency gave plenty of notice and provided the rationale for this move. Due to rapid  
deterioration in the housing environment, as well as falling recoveries on liquidated loans, HUD  
has long indicated that this program has been losing money. In the absence of appropriation  
requests being met, HUD had warned of a reduction of up to 21% in PLFs.  
The actual reduction is much lower than that. Figure 2 shows the reduction for a 5.5%-  
WAC loan. The reduction in PLFs will mean a lower IPL for borrowers.  
Obtaining a higher balance is the main driver of prepayments in the reverse mortgage  
space. A lower WAC in itself does not affect the borrower unless it comes with a higher  
balance. The simple reason for that is that the borrower is making no monthly payments.  
Hence, a lower WAC is of limited utility unless it provides a higher balance.  
Thus, the lower PLFs for these WACs can be expected to dampen prepayments.  
Unexpected reduction in WAC floor for determining PLFs  
In an unexpected move, HUD also lowered the WAC floor for calculating the PLF to 5% from  
5.5%. Given HUD’s comments on looking to reduce the exposure in this space due to prior  
losses, this move is surprising. For WACs below 5.5%, this move effectively increases the PLF  
for many borrowers, despite the overall reduction in PLFs. Given that there is a lot of  
origination potential in this area, the true effect of these changes is likely to be an increase in  
overall PLFs.  
In Figures 3 and we show the new PLFs versus the old PLFs across borrower age for 5%  
WAC. In addition, we show the average cost savings under the new PLFs (aggregate, not  
adjusted for upfront MIP and origination fees) for a borrower with a home valued at $200k.  
24 September 2010  
Barclays Capital | HECM PLF changes unlikely to trigger prepayments  
Figure 2: Old and new PLFs by age for 5.5% WAC  
Figure 3: Old vs new PLF by age for 5% WAC  
Additional limit ($k)  
Extra limit  
Borrower age  
Borrower age  
Source: HUD, Barclays Capital  
Source: HUD, Barclays Capital  
We note that a 62-year old-borrower with a 5%-WAC loan can now potentially take out  
$10k more that before.  
Effect of new PLFs on prepayments  
The new PLFs effectively increased the balance that borrowers can take out, given that most  
of the origination is likely to shift to lower WACs. This has the potential to increase  
prepayments in existing cohorts. However, we believe fears of a “prepayment rally” are  
overblown and discuss a few factors below that indicate to us that the effect may be much  
more muted.  
In analyzing the prepayment risk, we first divided the universe of existing HECM loans into  
seasoned and recent-vintage loans, with seasoned being defined as pre-October 2009  
loans. We discuss the risks to each separately.  
Minimal risk for pre-October 2009 loans  
For seasoned loans, we believe there are many factors that make refinancing an  
uneconomic proposition. Therefore the likelihood of a prepayment rally due to this week’s  
HUD announcement is low for these loans.  
The factors have not really increased for older-vintage loans  
In September 2009, HUD reduced the PLFs for all HECM loans originated from October  
2009 onwards by 10%. These changes to the PLFs come on top of adjustments made last  
year. In mid 2009, a 62-year-old borrower with a 5.5% WAC would have received a PLF of  
62.5%. If that borrower were to seek to refinance now, they would be looking at a PLF of  
62% at a 5% WAC (Figure 4). Thus, there has been no effective increase in PLFs for  
seasoned loans that were originated close to the earlier floor WAC.  
Seasoned loans have negatively amortized  
A loan taken out by a 62-year-old borrower on a house worth $200,000 with a 62.4% PLF  
at 5.5% in 2008 would have grown to more than $146,000 today. This includes  
amortization due to WAC, MIP and servicing fee. That borrower, now 64 years old, can get a  
PLF of only 62.9% at a 5% WAC today (Figure 4). Adding in some minimal originations  
costs, and assuming that the value of the home has remain unchanged, we find that the  
24 September 2010  
Barclays Capital | HECM PLF changes unlikely to trigger prepayments  
Figure 4: Different PLF Tables  
Figure 5: HECM geographical distribution  
Share of National Init Principal Limit  
Borrower Age  
Prevailing WAC  
Home Value  
Initial Principal Limit  
62 years  
Borrower Age  
Prevailing WAC  
Home Value  
64 years  
Initial Principal Limit  
Outstanding balance  
Origination fees  
Net Savings  
Endorsement Year  
Source: HUD, Barclays Capital  
Source: HUD, Barclays Capital  
borrower may have to pay out almost $23,000 to get the new loan. Thus, the negative  
amortization of seasoned loans overcomes the pace at which the PLF increases as a  
function of age, even for the lowest WACs. And the higher the WAC of the original loan, the  
faster the pace of amortization.  
As a result, it would be difficult for a borrower with a seasoned loan to fund a higher initial  
balance today.  
Effect of falling home prices  
Reverse mortgage have a strong presence in Florida and California (Figure 5). There has  
been a significant correction in home prices in these states. Thus, at reappraisal, the value of  
a home is most likely to be lower than it was in all years from 2003 to 2008. This will  
overcome any benefit that one might seek to get from the marginal increase in PLFs (if any).  
This is another economic disincentive to refinancing.  
Historical data argue against a significant prepay rally for recent origination  
The main risk of refinancing mostly comes from the most recent 2010 origination. Most of  
those loans were originated at a WAC of about 5.5% and will receive a slightly higher PLF  
now. However, we believe historical experience with newly originated loans, the costs  
involved in refinancing, and anti-churning disclosures will dampen potential prepayments  
for these loans.  
HECM loans have show little prepayment sensitivity  
We looked at HECM originations back to 2000 and found that borrowers were very slow to  
react to potential economic benefits in the form of higher balances – if they reacted at all. In  
Figure 8, we use loan level HECM data to analyze the prepayment response of HECM loans  
endorsed between 2002 and 2006 to different levels of cost savings.  
Given data limitations, we have made certain assumptions. Instead of using a dollar  
incentive, we use the difference between the rate at which the HECM was originated and  
the current rate represents the cost saving. As long as the rate is above the WAC floor for  
PLFs, this is a fair assumption. Additionally, we did not incorporate the negative  
amortization of the loans when looking at the rate incentive. This makes or analysis more  
conservative, since the effective incentive would be lower than was we are showing here.  
24 September 2010  
Barclays Capital | HECM PLF changes unlikely to trigger prepayments  
Note that almost all of these loans are floating rate ones. For floating rate HECMs, the 10yr  
rate plus a margin is used to determine the PLF.  
Figure 6 shows the prepayment response of HECM borrowers to different levels of rate  
incentive. It is clear from the data that there is almost no response to such economic  
incentive. These borrowers seem to be fairly prepayment insensitive.  
There are a few other issues that we did not consider in this analysis that make our  
argument on lack of prepayment sensitivity even stronger. Most of these loans were lines of  
credit that were not fully drawn out, unlike the present day fully drawn loans. Thus they  
would have had a clearer possibility of getting a bigger balance despite some negative  
amortization. In addition to the direct balance incentive due to lower rates, this was also a  
period when home prices were increasing significantly. Nonetheless, prepay rates remained  
very stable.  
We believe older borrowers do not react much to small potential increases in balances. They  
may not be aware of the benefit or they may be unwilling to take the extra effort. This  
would lead to the sort of prepayment experience that we see in the data.  
No doubt, there is much more publicity about reverse mortgage deals these days. There is  
also an army of mortgage brokers who are looking for extra business, given that the activity  
in the regular forward mortgage market has been scaled down significantly. However, we  
find no conclusive evidence of this being the case – prepayment rates on reverse mortgages  
have remained stable over time. Hence, in the base case, we expect little reaction from  
borrowers, unless the incentive is significant. As we will discuss in the following sections,  
the incentives are not too large either.  
Figure 6: HECM prepays by rate incentive 2002-2005 vintage  
1-12 WALA  
13-24 WALA  
25-36 WALA  
37-48 WALA  
Refi Incentive (Origination Rate - Current Rate)  
Note: Data shown for California loans only. Source: HUD, Barclays Capital  
Cost to refinance remain high  
Refinancing includes many costs. First, there are significant origination fees. Although it can  
be tempting for originators to overlook these, HUD’s strict enforcement of anti-churning  
laws leaves little room to game the system by cutting the fees too far.  
HUD also has an upfront insurance premium, which has been reduced for refinancing. It is  
now 2% of the increase in the MCA, which is not likely to increase in most cases. In  
addition, significant paperwork must be filled out, including anti-churning disclosure  
24 September 2010  
Barclays Capital | HECM PLF changes unlikely to trigger prepayments  
material. In some cases, borrowers may need to certify that the increase in principal is more  
than five-times the cost of the refinancing. All of these factors tend to raise the breakeven  
economic incentive at which significant prepayments will occur.  
At the same time, the effective cost of the loan has increased due to the 75bp increase in  
running MIP. This will lead to much faster accrual on the loan leading to higher effective  
borrower indebtedness.  
Though we do not think there is strong case for higher prepayments given the historical  
evidence, it is clear that the borrowers at the lower end of the HECM age scale will see some  
economic incentives. Also, if any borrowers are to prepay, it will most likely be a brief and quick  
affair, with remaining borrowers continuing to exhibit prepay behavior as seen in the past.  
Possible impact of other HECM announcements  
In addition to the changes in PLFs, HUD also made other announcements related to HECM.  
New HECM Saver product  
This product targets borrowers who do not want to make significant upfront payments. To  
help them, HUD set the upfront MIP to 1bp for the HECM Saver. In exchange of that, the PLF  
has been reduced compared with the standard HECM product. This product is likely to  
appeal to borrowers who intend to stay in the product for a short time before paying it off  
or moving to another product, or simply borrowers who like a lower debt burden.  
Higher running MIP across all products  
This adjustment has been in the making for a long time. HUD sees a potential risk that it has  
mispriced its affordability products and has sought to increase the monthly insurance  
premium across its entire portfolio. This increase follows the recent approval that HUD  
received from Congress. The increase is significant – from 50bp initially to 125bp now.  
Although this change does not play a role in the upfront PLF, it will increase the accrual rate  
for the loans, which should result in faster buyouts because loans will hit 98 LTV sooner.  
24 September 2010  
Analyst Certification(s)  
We, Sandipan Deb and Nicholas Strand, hereby certify (1) that the views expressed in this research report accurately reflect our personal views about any  
or all of the subject securities or issuers referred to in this research report and (2) no part of our compensation was, is or will be directly or indirectly related  
to the specific recommendations or views expressed in this research report.  
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