Reverse Mortgages and Subprimes - Are there Parallels?

Reverse Mortgages and Subprimes - Are there Parallels?,

As the reverse mortgage industry expands and constantly introduces new (and confusing) products, some people are beginning to wonder whether reverse mortgages are destined to become the next subprime mess.

The same type of financial engineering and securitization that repackaged regular mortgages (once held by local banks) into exotic investment securities sold around the world is now fueling reverse mortgage growth. The financial alchemy worked extremely well with traditional mortgages. Investors exhibited an almost unquenchable thirst for these “safe” mortgage-backed securities (MBS). Yet it’s now clear that credit agencies, regulators and investors themselves did not always understand the investments or the underlying risks.

At the other end of the process, mortgage professionals, sensing the thirst of MBS investors, continually came up with new and exotic mortgage products catering to the needs of just about anyone with dreams of owning their own home. No-doc loans, negative amortization, 2/28s, teaser rates, and a host of other “innovations” were introduced and marketed aggressively. It’s hard not to draw parallels with the current rash of new reverse mortgage product innovations.

But there are many important structural differences when it comes to reverse mortgages and many good reasons to believe that the reverse mortgage market will not go the way of the subprime market:

1. A Much Different Clientèle - Unlike subprime mortgage borrowers (or any traditional mortgage borrower for that matter), reverse mortgage borrowers own their homes outright (or nearly so) at the time they take out the mortgage. There’s no risk of owners walking away from properties they have little equity stake in.

2. Innovation Aimed at Higher-End Homeowners - Subprime loan “innovations” (and lax underwriting) made homeowners out of many lower income people who could barely afford the price tag even at teaser rates. Innovations in the reverse mortgage arena, on the other hand, appear mostly aimed at seniors with homes valued over $400,000. Indeed, the original HECM reverse mortgage program was more targeted toward the economically disadvantaged senior homeowner and has worked quite well for nearly twenty years. HECM FHA insurance premiums have proven more than adequate to cover loan losses.

3. Non-Recourse Loans - No matter what happens to home values, the reverse mortgage borrower is secure in the knowledge that the amount owed will never exceed the market value of the home at the time the loan terminates. Strangely, a reverse mortgage that goes “underwater” (loan balance grows to exceed home value) in some sense is a “win” for the homeowner because it means: a) the homeowner lived longer than the lender expected or, b) the homeowner locked in a reverse mortgage commitment on a home that subsequently declined in value.

4. More Options - People intent on buying a home have only the option of getting a mortgage. In many cases, people stretch too far to qualify and wind up in foreclosure. Seniors considering a reverse mortgage, on the other hand, are looking for additional retirement income (not homeownership) and have other options available to them. They can sell and downsize, borrow via a home equity loan, seek part-time employment, sell other assets, etc. The point is, the reverse mortgage decision is likely to be considered as one of many possibilities and, hopefully, entered into more cautiously than some traditional mortgages have been.

5. Investor Demand - As alluded to above, eager investors snatched-up traditional mortgage-backed securities without fully understanding the underlying risks. This demand helped fuel expansion of mortgage lending to borrowers with questionable ability to repay. The same phenomenon has not reached the reverse mortgage arena - at least not yet. Securitization of reverse mortgages is just beginning and is still but a small niche undiscovered by many investors. It remains to be seen what kind of safeguards are put in place as the reverse market matures. Presumably, credit rating agencies, investors, and regulators will apply some of the things learned to help keep reverse mortgage securitization from experiencing the problems of subprime mortgage backed securities.

6. Less Risk - Reverse mortgages are more predictable and less risky for investors in several ways. For one, borrower employment, income and repayment ability are not factors. The borrower owns the home and the home is the source of loan repayment. Second, although reverse mortgages do not have set repayment dates, repayment streams are very predictable. The reverse mortgage repayment stream is determined by a) homeowner death or, b) mobility (sell the home and move). While there is some risk of prepayment due to rising home values or falling interest rates, the prepayment risk is less than it is with traditional mortgages.

Only time will tell how successful the maturation of the reverse mortgage market is. But although there are some interesting similarities between the current subprime mess and recent reverse mortgage industry developments, there is also plenty of good reasons to be optimistic that reverse mortgages won’t become Mortgage Mess: Act II.

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Written by News & Feeds on April 10th, 2008 with comments disabled.
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