July 28, 2010  
Reverse MBS  
A Look at a Burgeoning Agency  
MBS Asset Class  
Ronald E. Thompson, Jr.  
Managing Director, Global  
Head of ABS/MBS Strategy  
+44 (0)20 7997 2163  
Reverse mortgage loans have been around in guaranteed form for over twenty years,  
with agencies providing endorsements since that time and, more recently, Ginnie Mae  
wrapping securitized pools. Reverse mortgages are offered to older borrowers as a  
way to access equity in their homes, but instead of paying principal and interest on a  
regular basis, reverse mortgage loans negatively amortize and typically repay when  
the borrower dies or permanently leaves the property.  
In 1987, FHA began offering insured Home Equity Conversion Mortgages (HECMs),  
with the first loan granted in 1989. In 2007, Ginnie Mae was authorized to begin  
offering pass-throughs backed by HECMs. Under this program, security holders  
receive principal and interest payments when the borrower dies, or permanently  
leaves the property or when the loan reaches 98% of the maximum claim amount  
(effectively the lower of appraised house value at origination and the maximum  
amount HUD will insure in a particular location). This last feature helps to provide  
more cash flow stability and more predictability of the life of the security.  
As a result, we believe that Ginnie Mae HECM-backed securities (HMBS) may offer  
investors outsized returns vis-à-vis agency securities with less prepayment/extension  
risk than found in comparable securities.  
The predominant securitization vehicle for reverse mortgages has been the HMBS  
program. From 2006 to 2008, private-label CMOs backed by HECMs were issued by a  
number of Wall Street firms as well as a few backed by proprietary/jumbo reverse  
mortgages that were backed by uninsured reverse mortgages and issued from 1999  
to 2007 by Lehman Brothers. The total issuance of these private-label securities is  
relatively small compared with issuances under the Ginnie Mae HMBS program.  
Today, HMBS represents a $15.5 billion market in outstandings according to our  
calculations. Though still a very small segment when compared with other agency  
securities, the sector represents one of the fastest-growing in the mortgage market – a  
growth that we believe should continue given demographic trends.  
One feature in HMBS is unique, in that the underlying HECM loans include a put back  
to FHA once the loan reaches 98% of the maximum claim value (an amount that is the  
lesser of the appraised value of the borrower's home and in the maximum amount that  
FHA will insure in the borrower's area), if the loan has not already reached a maturity  
event (i.e., borrower dies or exits from the property).  
As such, reverse mortgage-backed securities offer investors agency securities that  
have less interest rate sensitivity than traditional agency mortgage-backed securities.  
Under certain circumstances, HMBS may actually shorten with a rise in interest rates,  
especially those backed by floating-rate loans given the FHA put.  
The bulk of this paper will focus on HMBSs and how they function.  
Please See Important Disclaimer on the Last Page of This Document  
What are Reverse Mortgages?  
Reverse mortgages are generally offered to older borrowers as a way to access built-  
up equity in a borrower's own residential property. Instead of monthly payments made  
to pay off the loan, the loans negatively amortize and typically repay when the  
borrower dies or permanently leaves the property.  
Reverse mortgages have risen in popularity as retirees face financial pressures or  
seek to unlock equity in the home for cash in the US. This mortgage product has been  
around since 1989 in a FHA-guaranteed form, but loan originations have grown in the  
last several years with economic uncertainty and increased product acceptance (see  
Figure 1). Reverse mortgages are also well-known outside the US and have been  
generally sold with residual house price risk or risk tails that are privately insured.  
Figure 1. Reverse Mortgage Loan Origination by Year, 1990-2010YTD  
130  
115  
120  
110  
100  
90  
80  
70  
60  
50  
40  
30  
20  
10  
0
112  
108  
76  
55*  
43  
38  
18  
13  
8
8
8
7
5
4
4
3
2
1
0.4  
0.2  
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010  
HUD Federal Fiscal Year (Oct. 1 to Sep. 30)  
*Year to date through 31 May 2010. Source: HUD and Knight.  
Since the first HECM loan made in 1989, HUD has endorsed more than 600,000  
reverse mortgages. The HECM program finally became a permanent program with the  
HUD Appropriation Act of 1998. The combination of growing product awareness,  
longer life expectancy, and economic pressures from longer retired life has boosted  
the number of loans originated.  
Monthly insured loan production has been growing stronger each year, but fiscal year  
2010 (which began in October) showed initial slower monthly endorsement volume.  
However, production has begun to accelerate recently, according to recent HUD data.  
The Federal Housing Administration Modernization Act within the Housing and  
Economic Recovery Act of 2008 (HERA) shifted the HECM program out of the  
General Insurance Fund into the Mutual Mortgage Insurance Fund effective in fiscal  
year 2009. Under the FHA Modernization Act of 2008, limits were raised to $417,000  
and a temporary stimulus was provided with higher limits in "high-cost" areas.1  
1 The Act set the FHA loan limit for an area to the lesser of (1) 115% of the median price of a 1-family  
residence, as determined by HUD, or (2) 150% of the Freddie Mac conforming loan limit, except that the  
limit for an area may not be less than 65% of the Freddie Mac conforming loan limit.  
2
Under the American Recovery and Reinvestment Act of 2009 (ARRA), HECM loan  
limits were raised to a maximum of $625,500 (150% of the conforming limit) in late  
February 2009, but each area is subject to its own limits that are capped at 150% of  
the conforming limit applicable in each area.  
Figure 2. Borrower and Loan Requirements for FHA-Insured Reverse  
Mortgages (HECMs)  
Borrower Requirements  
Mortgage Amount Basis  
Be 62 years of age or older  
Age of the youngest borrower  
Current interest rate  
Own the property outright or have a small  
mortgage balance  
Occupy the property as principal residence  
Lesser of appraised value or the HECM FHA  
mortgage limit  
Not be delinquent on any federal debt  
Participate in a consumer information session  
given by an approved HECM counselor  
Source: FHA.  
Under the program, a homeowner must be 62 years of age or older to be eligible, own  
a home outright or have a low or zero existing mortgage balance (that must be paid off  
with the HECM), but these reverse mortgages also may be used for home purchases.  
Prior to finalizing the reverse mortgage, the borrower must have received reverse  
mortgage counseling by a HUD-approved service, to help ensure that the borrowers  
fully understand the implications of the mortgage.  
Unlike traditional mortgages or home equity loans where borrowers must qualify  
based on income and other outstanding debt and must make monthly mortgage  
payments, borrowers need only be qualified based on the age of the borrower, interest  
rates and the appraised value of the property. No payments are required prior to  
house sale. Loans are non-recourse and generally have no impact on, or from, Social  
Security or health care programs.2 These key differences make the product attractive  
for retirees with little current income as loans negatively amortize. The typical reverse  
mortgage requires no monthly payments but is due when the borrower dies or the  
house is no longer the borrower's principal residence for more than 12 months.  
Figure 3. Types of Distributions  
Payment Plan:  
Structure:  
Tenure  
equal monthly payments as long as at least one borrower lives and  
continues to occupy the property as a principal residence.  
equal monthly payments for a fixed period of months.  
Term  
Line of Credit  
unscheduled payments or in installments, at times and in an amount of  
the borrower’s choosing until the line of credit is exhausted.  
combination of line of credit plus scheduled monthly payments for as  
long as the borrower remains in the residence.  
Modified Tenure  
Lump Sum  
full advance of loan.  
Source: HUD  
HUD has established certain parameters by which borrowers may qualify for reverse  
mortgages, including principal amounts that are dictated by age of the youngest  
borrower, the appraised value of the home and the interest rate applied, dictated by  
Principal Limit Factors, or PLFs. However, borrowers may use the proceeds for a  
2 Certain types of reverse mortgages may impact the borrowers’ ability to access Medicaid,  
Supplemental Security Income or other programs.  
3
variety of purposes, including home improvement, paying off existing bills or debt, or  
other living expenses.  
PLFs were established by HUD to provide a conservative borrowing limit consistent  
with life expectancy, voluntary move-out, or refinancing expectations. These factors  
were determined by evaluating types of terminations, plus an examination of home  
price appreciation and projections of loan balances, based on interest rates and  
borrower cash drawdown patterns.  
In October 2009, PLFs were reduced by 10% of their previous factor, cutting potential  
funds available to borrowers to withdraw and likely reducing refinancing risk.  
Figure 4. Principal Limit Factors for Various Borrower Ages at Different  
Interest Rates  
Source: HUD.  
The maximum claim amount is the lesser of the appraised value of the mortgaged  
home and the HUD limit applicable in each geographic area. The principal limit factor  
applicable to any borrower is dependent upon the youngest borrower's age and initial  
effective loan rate. The amount available to the borrower would be reduced further by  
servicing fee, upfront mortgage insurance premium, origination fees, other financed  
costs, and any lien costs. Depending upon when the participation is securitized and  
how much of the loan already was advanced to the borrower, would determine the  
amount of the net participation in the loan.  
If we use an example of a $500,000 appraised home value and a $625,500 HUD limit,  
the maximum claim amount would be $500,000. Under the guidelines from HUD, a  
62-year old would be able to borrow up to $281,500, or 56.3% principal limit factor  
times the maximum claim amount, including capitalized costs and fees. HECM loans  
are capped at $625,500 at the very top level, but private, jumbo mortgages are  
available through certain lenders. According to Reverse Mortgage Guides, there is  
only one jumbo program open at this time, but loan limits as a percentage of home  
values are significantly lower than under the HECM program.  
The PLFs show some interesting patterns when studied (see Figure 4). First, there is  
a floor that begins at a 5.5% interest rate. Second, the slope of the PLFs increases  
over a given age at a more rapid rate than that for lower rates. The existence of the  
4
floor however provides less incentive for refinancing, especially given a slowly  
recovering or soft housing market as well as the reduction in PLFs that occurred last  
September. This issue will be discussed further in the later section on prepayment  
dynamics. Third, the PLFs are gender blind, meaning that male and female borrowers  
receive the same PLF, despite differences in average life expectancies.  
Figure 5. HECM Loans by Payment  
Option, as of May 2010  
Mod.  
Tenure  
Mod.  
Term  
Term  
Tenure  
As of this writing, no further PLF changes have been announced, despite discussion  
around the time of the early negotiations of the Appropriations Bill that PLFs may have  
to be decreased without further subsidy of the HECM program. User groups feared  
that a further reduction in PLFs would lead to less interest in HECMs. Other proposals  
circulated that suggested borrowers could be divided into needs-based categories and  
have loan terms dependent upon into which needs-based category borrowers might  
fall. In July, the House Appropriations Committee passed a bill that included $150  
million in HECM subsidy, less than the $250 million requested by the President  
Barack Obama Administration, and a similar amount was approved by the Senate  
Committee. If finally approved, we believe that PLFs likely would not have to be  
reduced in the near term.  
Line of  
Credit  
Source: Ginnie Mae.  
Under the terms of HECM program, borrowers may withdraw cash in various forms,  
including lines of credit, lump sum drawdown, or monthly annuities. These differences  
in withdrawal affects the HMBS structuring and cash flow trends, but most borrowers  
tend to use much of the available credit at the outset of the loan.  
A recent study showed that most borrowers tend to draw the majority of the principal  
within the first month.3 Generally, younger borrowers tended to draw larger amounts  
than older ones, in part because of lower amounts available under appraised values  
that are a result of longer life expectancies for those borrowers.  
Figure 6. First Month Borrower Cash Draw as a Percentage of Initial  
Principal Limit  
Initial Principal Limit  
Age Group  
62 – 70  
70 – 80  
80+  
Number of Loans  
39,698  
0-40%  
16%  
40-80%  
25%  
80-100%  
58%  
33,074  
24%  
25%  
51%  
13,757  
32%  
23%  
45%  
22%  
25%  
54%  
Total  
86,529  
Source: IBM Global Business Services/HUD, and Knight calculations.  
Borrowers may use reverse mortgages to purchase homes or to refinance purchase  
mortgages but the closing for the purchase mortgage and refinancing with their  
reverse mortgage must occur simultaneously.  
HECM costs include several different components, apart from interest. Origination  
fees to compensate the lender for processing can range up to $2,500, if the home is  
valued at less than $125,000. For homes valued at more than $125,000, the fee is  
generally 2% of the first $200,000, plus 1% of the amount over $200,000, with a cap  
at $6,000. Similar to other mortgages, closing fees are also payable, including  
appraisals, title search and insurance, surveys, inspections, recording fees, mortgage  
taxes, credit checks and other fees. Mortgage insurance premiums (MIP) are charged  
up front at closing out at the rate of 2% of the lesser of the home's value or the FHA  
3 See IBM Global Business Services Prepared for U.S. Department of Housing and Urban Development,  
An Actuarial Analysis of FHA Home Equity Conversion Mortgage Loans in the Mutual Mortgage  
Insurance Fund Fiscal Year 2009, IBM Global Business Services, October 2009.  
5
HECM limit for the particular geographic area. In addition, a monthly MIP is assessed  
that equals 0.5% of the mortgage balance.4 Lastly, a servicing fee is assessed  
monthly at $30 per month for fixed rate and $35 for adjustable rate mortgages, though  
there is a recent trend by lenders to eliminate these fees for competitive reasons.  
Figure 7. Pct. of HECM Loans by  
Age at Origination, as of May 2010  
25%  
20%  
15%  
10%  
5%  
HECM loan origination traditionally had been targeted toward the mid-70s year old  
age group, or more recently, loans have been increasingly targeted to younger  
borrowers. This shift has resulted in changes within the complexion of the age  
blending in HMBS as well (see Figure 7).  
Servicing Issues  
0%  
Under the terms of the loans, homes must be kept in good repair and the servicer  
must verify the condition of the mortgaged property. If needed, servicers must ensure  
that repairs are completed before funds are disbursed to the borrower. The servicer  
may deem the loan note due and payable for failing to complete repairs, but it must  
first seek, and receive, HUD approval.  
Age  
Source: Ginnie Mae.  
Each year, the servicer must obtain a written certification from the borrower that the  
property is still the borrower's principal residence. In the event that the borrower no  
longer occupies the property, the servicer may request a deed in lieu of foreclosure,  
but, in any event, it must obtain HUD approval before calling the loan note due and  
payable for an occupancy violation.  
Borrowers are also obligated to pay taxes and insurance. Borrowers may elect to pay  
taxes and insurance on their own or allow the servicer to pay on his or her behalf. In  
the event that the servicer pays the taxes and insurance, either a portion of the  
monthly payments is withheld to advance against taxes and insurance or a portion of  
the line of credit is set aside for those advances. In most cases, borrowers have to  
pay their own taxes and insurance, but this method may create problems with real  
property tax deferrals and tax lien transfers. Therefore, servicers are required to  
ensure that payments are made regularly and completely.  
A Look at the Securitized Market  
Until the introduction of Ginnie Mae-guaranteed HMBS in 2007, Fannie Mae was the  
principal investor in HECMs, purchasing them as whole loans and providing liquidity to  
approximately 90% of the loan origination. Since its start in 2007, the Ginnie Mae  
HMBS program has grown significantly, and market reports suggest Fannie Mae's  
share fell dramatically.  
In the late 1990s, Lehman issued several private reverse mortgage-backed securities,  
and in 2007 and 2008, several other private issuers placed HMBS in the market.  
Ginnie Mae-backed HMBS issuance has grown over the last several years, but the  
bulk of the growth has really come in the last year. While $12.8 billion of HMBS issues  
over the last twelve months represents less than 5% of GNMA II issuance and a  
miniscule portion of total agency MBS, the rate of growth has been strong and has  
begun to attract considerable investor interest. The pace of transactions has grown  
too, and since January, an average of 40 deals has come to market monthly.  
Under Ginnie Mae's current rules, pools are limited to single issuer; therefore, the  
average deal sizes are relatively small ($44 million), ranging from just over $1 million  
4 There has been some recent discussion at HUD to examine reducing the initial insurance fees but  
raising monthly payments. Reductions in initial fees could reduce some frictional costs of refinance.  
6
to $518 million. Under the program, participations in loans are securitized. In fact,  
multiple participations in the same loan may be sold across different deals, especially  
when the borrower takes a floating rate loan or a line of credit, and further increases in  
loan balances create the need for additional lender funding.  
Figure 8. Ginnie Mae HMBS Issuance: April 08–May 10  
$1.8  
$1.6  
$1.4  
$1.2  
$1.0  
$0.8  
$0.6  
$0.4  
$0.2  
$0.0  
60  
50  
40  
30  
20  
10  
0
Fixed Rate  
Monthly, LIBOR Indexed  
Monthly, CMT Indexed  
Annual, CMT Indexed  
Number of Pools (Rt Scale)  
Apr 08 Jul 08 Oct 08 Jan 09 Apr 09 Jul 09 Oct 09 Jan 10 Apr 10  
Source: Bloomberg LLP and Knight.  
The bulk of issuance has been fixed-rate product but monthly LIBOR adjustable-rate  
mortgage pools have also grown in popularity. Monthly-adjusted CMT floating-rate  
mortgage pool issuance has become sporadic, while very little of annually-adjusted  
CMT floating-rate mortgage pools have been issued. As of the end of June, we have  
observed that $15.5 billion was outstanding, up from a standing start in April 2008.  
One product that has not yet seen traction in securitized pools is a monthly adjustable  
rate, LIBOR-indexed mortgage with a 2%/5% cap structure. If rates become more  
volatile, more loans will likely be originated in this type of product and therefore  
securitized, though fixed-rate origination has been on the increase.  
Most HECM loans fall into three types of interest rate forms: fixed-rate, CMT-indexed  
and LIBOR-indexed adjustable rates. Prior to 2007, the market was dominated by  
CMT-indexed rates that were adjustable monthly or annually.  
Following the HERA authorization in 2008, LIBOR and fixed-rate options were added.  
LIBOR-based rates may be offered in several forms (based on one-month or one-year  
LIBOR); however, most were and are originated with fixed interest rates. Until mid-  
2006, CMT-based rates were offered with a 150bp margin, and then early- to mid-  
2007, loan margin dropped to a 100bp margin. In late 2007, the market growth  
accelerated when HUD introduced the fixed-rate and LIBOR-based rates programs.  
Under the Ginnie Mae terms, fixed-rate loans may only be offered in closed-end form  
and must be fully drawn at closing. Floating-rate products are generally offered in the  
form of a line of credit, but may be offered in lump-sum or annuity form.  
For the future, several important changes are contemplated. Today, Ginnie Mae II  
securities are only available in single issuer/servicer formats. Discussions around  
multiple issuer formats are being considered. As an interim solution, re-REMICs,  
7
known as H-REMICs, have been introduced, combining several securities to gain the  
benefit of more diversified pools and thus attracting more investor interest.  
Figure 9. Simplified HMBS Securitization Process  
Source: Knight.  
As the HECM loan market expands, the HMBS market is expected to also grow  
alongside. Further advances in prepayment analytics will likely attract more investors  
who are seeking additional yield on government-backed MBS. Underlying loan  
information in securities has been fairly robust, providing a wealth of variables to study  
against a new housing dynamic. New investors need to grow comfortable with the  
differences in payment speed versus traditional mortgages, but these differences  
often are rewarded with better characteristics in the form of convexity.  
8
How the Structures Work  
HECM HMBS structures are relatively straightforward. Deals are constructed as pass-  
through securities – principal is passed through to investors as principal, and interest  
is passed as interest. Reverse mortgages do not pay interest or principal until a  
maturity event, so principal windows on HMBS may not begin immediately.  
To accommodate multiple drawings on HECMs, loans are securitized via participation.  
Only the funded portion of reverse mortgage is securitized at a given time via  
participation. However, there may be many participations representing multiple draws  
from one reverse mortgage, but at this time, each participation can only correspond to  
one HMBS.  
Participations consist of advances made to borrowers, monthly insurance premium  
paid to FHA, servicing fees and accrued interest. Interest on the loans is accrued daily  
and is added to the remaining principal balance at month end. No interest or principal  
payments are due on the mortgage until a maturity event occurs or the loan is  
refinanced.5  
Key Terms and Definitions  
There are several key terms that are important when evaluating reverse mortgages  
and the pools that are backed by them.  
Maturity Event – A reverse mortgage becomes due and payable under certain  
circumstances:  
One of the borrowers (if originated to joint occupants) dies and the property  
no longer is the principal residence of at least one of the surviving  
borrowers;  
The property no longer stays the principal residence of any surviving  
borrowers  
If all of the property title is sold and no other borrower retains title  
A borrower does not physically occupy the property for a period longer than  
12 consecutive months  
Obligations under the security instrument are not performed, i.e.,  
o
o
A borrower fails to pay taxes and insurance  
A borrower fails to maintain the property up to a minimum  
maintenance level  
Gross Principal Limit – The maximum funds that a borrower may draw at origination.  
This amount is determined by three factors: the age of the youngest borrower; the  
expected average mortgage interest rate; and the maximum amount the FHA will pay  
under its insurance. This limit increases monthly and represents the maximum loan  
amount the borrower may receive.  
Net Principal Limit – The Gross Principal Limit less all payments made to or on  
behalf of the borrower, including Mortgage Insurance Premium (“MIP”) payments,  
origination fees/closing costs, servicing fee set asides, repairs, etc.  
5 In the case of a loan purchase event as result of the loan reaching 98% of the maximum claim amount  
(defined here as FHA Put Option), the borrower is not affected by – or even notified of – the event.  
9
Maximum Claim Amount – The maximum amount of mortgage insurance that the  
FHA will provide, derived from the lesser of the appraised value of the mortgaged  
property and the maximum mortgage amount that HUD will insure in that area.  
FHA Put Option – When the outstanding amount of a HECM equals 98% of the  
Maximum Claim Amount, or if a draw on a line of credit on a HECM loan will equal or  
exceed 98%, the loan can be assigned to HUD via the FHA in return for a payment  
not greater than the maximum claim amount. This option may be exercised only if a  
maturity event has not occurred.  
Crossover – Point at which the loan balance equals the appraised home value. Under  
HECM guarantees, the agency will buy out loans once they reach 98% of the  
Maximum Claim Amount if a maturity event has not occurred.  
There are two types of purchase events for reverse mortgage securitizations: a  
mandatory purchase event and an optional purchase event.  
In a mandatory purchase event, the issuer is required to purchase all Ginnie Mae  
participations related to HECM loans when the principal balance of the mortgage is  
equal to or greater than 98% of the maximum claim amount.  
Under an optional event, the issuer may purchase a pooled participation if:  
1) any mortgagor's additional funded advance would result in the principal  
balance exceeding 98% of the Maximum Claim Amount threshold;  
2) any mortgagor's loan remains due payable at the end of the reporting  
month, either through death of any remaining mortgagor and no other  
mortgagor retains the property as his or her principal residence, or a  
mortgagor conveys title in the mortgaged property and no other mortgagor  
retains title;  
3) the mortgaged property ceases to be the principal residence of any  
mortgagor (other than for death) and the property is no longer a principal  
residence of any surviving borrower;  
4) the borrower does not occupy mortgage property for a period longer than  
12 consecutive months (due to physical or mental illness) and the mortgage  
property is no longer the residence of at least one other borrower;  
5) the borrower fails to perform on any of his or her obligations (such as  
payment of taxes or Insurance premiums due) as described in the loan  
terms and conditions.  
FHA is required to purchase all participations at par (which includes all capitalized  
interest and any fees or payments due).  
Lenders may perform servicing or sell servicing rights to third parties. Large banks  
participating in the market generally service their own loans, but others have turned to  
specialist servicers to manage loans and ensure that borrowers meet all of their  
obligations due under the terms of the mortgages.  
10  
Characteristics of Reverse Mortgage HMBS  
Ginnie Mae reverse mortgage-backed securities offer investors interesting value: an  
intermediate maturity profile with excess yield versus similar credit and with  
considerably less negative convexity than other mortgage-backed securities. The  
number of transactions is quickly ramping up, and more dealers are making two-way  
markets.  
Figure 10. Outstanding Ginnie Mae  
HMBS by Coupon and Type, as of  
May 2010  
Mo Adj,  
CMT  
$1.8B  
The most prolific product in the reverse mortgage sector has been that from Ginnie  
Mae, commonly known as HMBS. For FHA-backed loans – the ones used in Ginnie  
Mae HMBS – the youngest borrower must be at least 62 years of age.  
A Adj,  
CMT  
$2.7MM  
Fixed  
Rate  
$8.8B  
HECMs were generally limited to fixed-rate, closed-end loans that were fully drawn at  
loan origination but more recently have expanded with floating rate securities due to  
changes in borrower demand (see Figure 10).  
Mo Adj,  
LIBOR  
$3.2B  
Most loans (and the securities that are backed by them) have a long potential final  
maturity, but the Ginnie Mae program has features on the underlying loans that tend  
to shorten security lives. As noted earlier, loans are structured with a negative  
amortization schedule, with loan balances capitalizing interest over time. This product  
comes with specific features that make it attractive to investors, including both fixed  
and floating rate coupon formats. Following the borrower's death or his/her long-term  
exit from the property, loans become due and payable.  
Source: Bloomberg and Knight.  
Figure 11. Investment Characteristics of HMBS  
Commentary  
Spreads  
+115-120bp to swaps  
Weighted Average Life 5-7 years (principal window of approximately 2-7 years)  
Risk  
GNMA for house price risk; prepayments  
Limited, but growing  
Liquidity  
Convexity  
Subject to prepayments, but adjustable rate loans can be positively  
convex as a result of the FHA put at 98% of maximum claim value  
Prepayments  
Subject to factors including those based on age and health of  
underlying borrower, interest rates on loans, and house price  
appreciation.  
Source: Knight.  
Under the program, servicers of loans are required to put guaranteed loans back to  
FHA once they accrete to 98% of maximum claim value – the lower of the appraised  
value at origination and the maximum loan amount in the given area provided that  
there has not been a maturity event on the loan. Given the expected longevity of the  
average 62-year-old (approximately 20.5 years), these put requirements likely provide  
a significant source of prepayments and create a more easily predictable maturity and  
cash flow profile.  
Using an average interest rate of 5.5% and 56.3% loan-to-value (the maximum  
amount a 62-year old might expect with interest rates below 5.5%), the interest and  
fees should cause the loan value to accrete to 98% within 9.3 years (11 years less  
than the average life expectancy). Therefore, loans are likely to be put to FHA and  
redeemed, prior to the lifetime expectancy. For the 73-year old, the available amount  
is higher at 64.4%, but using the same rate, the mortgages accrete to 98% at around  
7 years, or 51% of an average 73-year-old's remaining life expectancy.  
11  
Therefore, CPR vectors based on mortality or mobility for reverse mortgage pools  
have more impact on those transactions backed by loans that do not carry the FHA  
put. Certainly, factors such as ethnicity, gender and age have impact when evaluating  
pools, but also accretion of interest to the maximum claim value can be a major  
consideration when analyzing HMBS backed by loans with the FHA put option.  
Historical analysis helps in evaluating some of the securities; however, since most of  
the bonds have been in existence only since 2008 with a different product mix than  
historically, little history is available to guide valuations of these cash flow influences.  
While certainly not impervious to refinancing risk, loans underlying HMBS are  
increasingly difficult to refinance under the HECM program, despite the fact that a  
number of lenders have come out with programs offering no servicing or origination or  
other fees and charges. Refinancing risk recently has been lessened by several  
factors, including house price declines but more directly a decrease in principal limit  
factors used to determine maximum advanceable proceeds. Other frictional factors  
such as MIP premiums likely reduce refinancing appetite, though changes in these  
fees may influence future prepayments. Also, most borrowers do not actively manage  
loans on a monthly basis similar to forward mortgages, as terms are set at origination  
and there are no monthly payments and loans are due and payable for mortality or  
mobility reasons.  
Given the relative resilience against refinancing risk, we believe that these securities  
offer an attractive alternative for investors looking for excess yields on agency MBS. In  
the extreme without Ginnie Mae guarantees, reverse mortgage HMBS may offer a  
hedge for investors with longevity risk.  
Prepayment Dynamics  
Several factors can cause the average life of a reverse mortgage-backed security to  
change from expectations: a) an acceleration or deceleration in mortality; b)  
acceleration or deceleration in mobility of borrowers; c) a change in refinancing  
opportunities as a function of costs or interest rates; and d) shifts in interest rates for  
securities backed by adjustable-rate mortgages.  
The first and second factors may be broken down into several sub-analyses, by  
examining health patterns, gender distribution, and availability of alternative care.  
Figure 12. Influence of FHA Loan  
Assignments on HECM Loan  
Survival Rates, All Borrowers 62  
and Older  
Too, the failure to meet obligations has an impact on prepayments, as once a breach  
is detected a foreclosure process may begin, subject to HUD approval. Once the  
foreclosure process is complete, the property may be sold. The timeline behind this  
factor tends to be longer than for mortality or mobility.  
100%  
80%  
60%  
40%  
20%  
0%  
Excluding  
Assignments  
The third factor, change in refinancing opportunities, is muted by the lack of available  
options, plus the negative amortization of mortgages generally outpaces the LTV  
differential for different age cohorts. However, some frictional costs are being reduced  
or contemplated to be reduced.  
Including  
Assignments  
The fourth factor, changes in interest rates and their effect on floating-rate loans, has  
perhaps the biggest impact on prepayments due to the FHA put option on floating-rate  
HMBS. A significant rise in interest rates would cause loans to negatively amortize at  
a faster pace, more quickly approaching the 98% mandatory put to the FHA via Ginnie  
Mae and making securities more positively convex rather than negatively convex as in  
most other mortgage-backed securities.  
Assignment  
Effect  
1
3
5
7
9
11 13 15  
Policy Year  
Source: HUD Study and Knight.  
12  
In 2009, there were several significant changes to the product that shape prepayment  
dynamics related to refinancing risk. First, PLFs were reduced by 10%, offering  
borrowers less available funds to withdraw. Second, certain loan originators  
introduced zero-cost servicing and origination fees. Despite the elimination of these  
fees, the new PLFs reduced the propensity of borrowers to refinance by lowering the  
available limit, especially as loans negatively amortized in a softer house price market  
environment. While the PLFs are not expected to change in the near term, these two  
factors probably wash against each other but the bias is likely a net reduction in  
refinancing risk. As discussed earlier, a reduction in initial MIP may impact borrower  
behaviour.  
The other factors have more impact on prepayments than refinancing risk, and the  
FHA put option offers one of the more predictable of the factors.  
With the reduced PLFs impacting the refinancing ability of the borrower and more  
HECMs subject to adjustable rates that would accelerate a potential FHA put option at  
98% of the maximum claim amount, loans underlying the deals are likely positively  
convex, or certainly less negatively convex than traditional mortgages.  
A HUD study in 2007 of 235,000 HECMs, issued between 1989 and 2006, clearly  
demonstrated the influence of assignments on prepayments over time.6 Using  
differences in loan survival rates between pools including and excluding assignment  
as a proxy, we determined that assignments could shorten the average life of a typical  
pool by as much as 1.3 years, whereas the average life of a HECM loan pool was  
likely approximately 5 years, given mortality, mobility and assignment. However,  
gender, age and single versus couple status had significant influence over the likely  
average life of a pool. This “assignment effect” was most pronounced for single female  
borrowers, who benefit from higher longevity than even for loans to couples.  
Over the lifetime of the HMBS, the proportion of termination by assignment to FHA  
grew, according to the study. In the early years, death and mobility accounted for a  
substantial proportion of loan terminations, but negative amortization did not reach an  
assignment termination until year eight.  
Figure 13. Differences in Loan Paydowns by Year 8 Attributable to  
Assignment  
Single  
Female  
Single  
Male  
Age at Origination  
64-66  
All  
0.1%  
3.9%  
Couples  
0.0%  
0.1%  
4.0%  
0.0%  
4.5%  
74-76  
3.5%  
84-86  
7.0%  
3.9%  
8.0%  
3.3%  
6.5%  
4.3%  
7.6%  
3.7%  
All Borrowers 62 and Older  
Based on data from HUD's HECM Study in 2007. Source: HUD, Knight calculations.  
By year eight after origination, loan assignments form a greater proportion of  
payments. Virtually all the younger borrowers saw little difference among total  
terminations and those attributable to mobility or mortality, suggesting that the  
predominant reason for termination lies in mortality or mobility rather than  
compounding of interest. Intriguingly there were significant differences in older  
6 See Edward J. Szymanoski, James C. Enriquez, and Theresa R. DiVenti, “Home Equity Conversion  
Mortgage Terminations: Information to Enhance the Developing Secondary Market”, Cityscape: A  
Journal of Policy Development and Research, HUD, 2007.  
13  
borrowers, more so than the typical 74-76-year-old borrowers, and in some cases  
over twice the difference.  
The potential benefit of assignment becomes more visible by year ten, though still less  
apparent in younger borrowers. During the period of the study, borrowers were subject  
to higher principal limit factors than exist today, suggesting that ceteris paribus  
maximum claim values should take longer to reach thereby triggering an assignment.  
By year twelve, the difference between termination for assignment and mortality or  
mobility is maximized as loans paydown well below a loan factor of 10%. By this point,  
younger borrowers have begun to catch up to the broader group in all categories. By  
year fourteen and fifteen, the differences begin to level out, but by then most HECM  
loan pools would have been extinguished or nearly extinguished.  
Figure 14. Differences in Loan Paydowns by Year 12 Attributable to  
Assignments  
Age at Origination  
64-66  
All  
6.5%  
Couples Single FemaleSingle  
Male  
5.4%  
8.2%  
8.7%  
5.1%  
74-76  
12.2%  
13.9%  
12.3%  
84-86  
4.2%  
9.2%  
7.2%  
11.6%  
3.2%  
8.6%  
4.7%  
6.3%  
All Borrowers 62 and Older  
Based on data from HUD's HECM Study in 2007. Source: HUD, Knight calculations.  
In analyzing several of the sub-factors contributing to termination, several interesting  
conclusions may be drawn. First, loans taken out by couples generally experienced  
the highest amount of terminations due to assignments. Part of the difference is likely  
related to the fact that a survivor may stay on in the house, therefore mobility and  
mortality rates for couples should be lower than for single borrowers. Second, younger  
borrower HECM loans seemed to have longer average lives than older borrowers, not  
unsurprisingly. However, the difference between loan paydown for assignment versus  
mortality or mobility did not become apparent until much later in the loan life than that  
for older borrowers. This finding could be due to self-selection of loans, which may  
appeal to younger borrowers in poorer health than for older borrowers, and was  
particularly acute for single male borrowers in that age category.  
Demographic Trend Impact  
Longevity has been steadily increasing since the post-war period, with big strides  
made in the late 1970s and 1980s (see Figure 15). More recently, this trend has been  
slowing, especially among women, but it remains a significant change over time.  
The race gap has been narrowing as well, though substantial differences still remain.  
The gap likely will continue to narrow.  
14  
Figure 15. Estimated Life Expectancy at Birth in Years by Sex and Race,  
1929-2005  
85  
White Female  
Black Female  
White Male  
80  
75  
70  
65  
60  
55  
50  
45  
Black Male  
1930  
1945  
1960  
1975  
1990  
2005  
NB: Beginning 1970 excludes death of nonresidents of the United States. Life expectancies for 2000-2005 were  
calculated using a revised methodology and may differ from those previously published. In 1972, deaths based on  
a 50% sample. In 1962 and 1963, data excludes residents of New Jersey.  
Source: US Census  
Improvements in healthcare and more healthy, active lifestyles have led to longer  
lives. With this improvement in longevity, the need for post-retirement, alternative  
sources of funds has grown, lifting the demand for reverse mortgages.  
This increased longevity will have an impact on prepayment analysis as when  
borrowers live longer lives or are more able to stay in their own homes, the  
prepayment driver of assignment becomes even more valuable in assessing the  
cashflow signatures of HMBS.  
Women clearly outlast men as the population ages (see Figure 16). The factor will  
influence prepayments due to mortality. As noted elsewhere, most borrowers in  
reverse mortgages are women, meaning that the likelihood of prepayments due to  
mortality is even further lessened.  
Figure 16. 2010 Projection of Population by Age and Sex, by Age 60+ Years  
Cohorts, as of 2008  
Males  
90%  
80%  
70%  
60%  
50%  
40%  
30%  
20%  
10%  
0%  
20  
18  
16  
14  
12  
10  
8
Females  
Population (Rt Scale, MM)  
6
4
2
0
60 to 64 65 to 69 70 to 74 75 to 79 80 to 84 85 to 89 90 to 94 95 to 99 100+  
Source: US Census  
15  
Figure 17. Probability of Dying Between Ages x to x+1 Total US Population,  
as of 2005  
35%  
30%  
25%  
20%  
15%  
10%  
5%  
0%  
Source: US Census, Knight.  
Important Disclaimer Regarding Strategy Letter  
IMPORTANT INFORMATION CONCERNING CREDIT TRADING DESK COMMENTARY AND STRATEGY Trading desk  
material is NOT a research report under U.S. law and is NOT a product of a research department (fixed income or  
otherwise) of Knight Libertas LLC or any of its affiliates (collectively, “Knight”) and is not a research report or a research  
recommendation for purposes of FSA rules as it does not constitute substantial research. Analysis and materials are being  
provided you for informational purposes only without regard to your particular circumstances, and any decision to purchase  
or sell a security is made by you independently without reliance on us. No information contained herein should be construed  
as a solicitation or an offer to buy or sell any security or product. Investors interested in GNMA HMBS securities should read  
the prospectus prior to investing. Any analysis or material that is produced by a trading desk has been prepared by a  
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Conflicts Disclosures  
The person distributing this material may have already provided any strategy or idea to the Knight’s trading desk or  
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