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Time to Normalize Mortgage Fees

fha

In the spring of 2015, the Federal Housing Administration (FHA) reduced its annual insurance premium. The move was controversial as the FHA was below its statutory capital ratio of 2.0 percent. However, the reduction in the MIP generated an increase in demand for the FHA purchase and refinance product which helped the FHA reached its 2.0 percent capital ratio. The FHA’s fees remain historically high and a reasonable analysis suggests that there is still room for the fees to decline.

Following the financial crisis and great recession, the FHA expanded from less than 5 percent of the market at its boom-time nadir to its post-recession peak of more than 50 percent. The FHA was an important source of credit during and after the recession, wadding into the market as the countercyclical source of credit while the private sector pulled back. The FHA’s books took sharp losses as a result and fees were subsequently increased to limited adverse selection, to shore up the FHA’s books, and to help stimulate the private sector.

reduced-annual

Between 2011 and 2014, market reforms like the ability to repay rule were implemented and the private mortgage insurance industry rebounded. To support consumer confidence and to continue the FHA’s financial recovery, the FHA’s annual mortgage insurance premium was reduced from 1.35 percent to 0.85 percent. Reducing a fee to improve its books appeared counter intuitive, but the then excessive fees were driving borrowers away from the FHA. Thus, by reducing its fee but retaining a healthy revenue margin, the FHA boosted loan volumes and total revenues.

In fiscal year 2015, the FHA breached its mandatory 2.0 percent capital ratio. However, the FHA’s forward book of business, which represents purchase and refinance mortgages, remains below this threshold. With continued profitability, the forward book of business too is expected to surpass the 2.0 percent mark and to keep progressing. With the 2.0 percent threshold in sight, it is reasonable to revisit the FHA’s pricing of its mortgage insurance. Overshooting a reasonable capital ratio may provide artificial solace, but it could also create negative externalities such as reducing borrowers’ capacity and a transfer of wealth from consumers to the government. Furthermore, reducing the rate of convergence on the capital ratio would be in line with other government insurance programs like the FDIC.[1]

What is the Right Fee?

Following the methodology of Goodman, Bai, and Zhu of the Urban Institute[2] (hereafter referred to as UI), the profitability of the FHA’s portfolio for 2015 to 2022 is estimated below.[3] This analysis differs from that of the UI as it incorporates the FHA’s forecast of its portfolio for the period of 2015 to 2022 as well as its estimate of normal (43.4 percent) and stress (60.1 percent) severities.[4] While these are lower than those incorporated by UI, they include losses accrued to the FHA as a result of the Seller Funded Down Payment Assistance Program. The delinquency rates and severities for this cohort were significantly higher than the rest of the FHA’s book[5] and this program has since been eliminated. Thus, the updated severities remain conservative.

credit-composition

The 2015 book[6] of business retains its strong credit profile, but the FHA projects an even stronger profile for 2015 through 2022.[7] As a result, the FHA’s revenue growth is expected to increase modestly bringing in annual revenues of $3.55 billion. The sustained profitability is a boon for the program, but should be scaled back to avoid overshooting the intended goal. Reducing profitability to 1.87 percent per the FHA’s target as outlined in its proposed supplement performance metric[8] could allow for a reduction of its annual fee of roughly 10 basis points, while still generating annual revenues of roughly $2.6 billion. Alternatively, a decline in the profitability to 1.0 percent, enough to cover 8 basis points of administrative fees and a small margin, could reduce the MIP by as much as 25 basis points, while netting nearly $1.4 billion in annual revenues.

Fund Still Reaches Capital Ratio

Reducing the FHA’s premium would reduce the economic value or the current value of its total future earning adjusted for inflation on each year’s book. However, under either scenario the FHA’s resources would continue to grow. A 10 basis point reduction in the MIP would yield revenue of roughly 1.4 percent net of administrative expenses. With a 1.4 percent ratio of the economic value to the endorsement volume, the capital ratio for the forward book of business would be met in 2017 instead of 2016 as under the baseline.[9] With a more aggressive 25 basis point reduction, the economic value of future books is reduced to 0.5 percent of endorsements and the forward book of business reaches the 2.0 capital ratio in 2022 (See appendix).

capital-ratio

The Consumer Benefits

A reduction in MIP would have real impacts for a borrower. A 10 basis point reduction would save a borrower with a $200,000 mortgage roughly $17 each month or $200 per year. The benefit grows with the size of fee reduction more than $50 per month or reaching $600 annually for a reduction of the annual insurance fee from 0.85 percent to 0.55 percent.

reduced-mortgage

Overlays Will End

Another important trend in recent years has been lender overlays. The Department of Justice sued several lenders under the False Claims Act arguing that loans originated did not comply with FHA’s underwriting requirements. Under the law lenders were subject to triple damages and as a result many in the lending community became risk averse and deployed overlays. Efforts are underway to remedy this situation. As lender confidence grows, the share of borrowers in the FHA program with lower credit scores will expand, but the FHA has likely incorporated this scenario into its estimates. The stronger borrowers attracted by lower fees will help to support a broad portfolio as overlays normalize and to achieve the FHA’s goal of access.

A Path to Normalization

The FHA stepped in to support the market as countercyclical lender of last resort. The agency’s fees rose to offset losses, to prevent adverse selection and to stimulate the private market. With market reforms in place and a robust private mortgage insurance market returned, its time reevaluate the FHA’s fees. The FHA’s book will reflect a different mix of borrowers over the next 8 years and with a broad credit base and reduced fees, it is well positioned to support its role in the market.

Appendix:

pricing-assumptions

actuarial-estimates

volume

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