And early prepayments are exactly what triggered the collapse of the subprime mortgage market in the late 1990s. A multitude of subprime RMBS portfolios were weakened when creditworthy borrowers refinanced at faster-than-expected rates beginning in 1998. Back in the 1990s, people had this quaint notion that an originator should have skin in the game. Many now-defunct subprime originators, like ContiFinancial and Southern Pacific Funding, acquired the equity tranches of deals securitizing the mortgages they originated. And with faster-than-expected prepayments, the NPVs of their bond holdings plummeted in value, which wiped out their capital, prompting banks to cut their credit lines and, viola, they went out of business rapidly.
This is really basic and really important: Rapid prepayment impacts the risk of principal recovery for private label deals in a way it does not for mortgage securities sold by Fannie Mae and Freddie Mac. Forget about any implicit or explicit government support, we're talking about structure in structured finance deals. Private label RMBS are non-recourse, whereas the government sponsored enterprises guarantee their deals. Anyone who equates the credit risk diversification of private label deals with that of GSE securitizations is simply too ignorant or dishonest to be taken seriously.
Historically, the biggest trigger for rapid prepayments is falling interest rates. This is bad news for private label deals, but not for buy-and-hold lenders, which can easily replace early prepayments with new or refinanced loans. Similarly, if an investor in one GSE securitization sees the mortgage pool declining more rapidly than expected, he knows that the corporate guarantor is still generating new business, which enhances its ability to honor that guarantee. And since the GSEs extend credit during all stages of the real estate cycle, an individual investor is less concerned about credit losses from a mortgage pool that was booked at the wrong time.
The FHA, which insures mortgages, is like a balance sheet lender; it books new insurance policies on new mortgages when other loans prepay faster than expected. But the annual NPV of FHA's portfolio, calculated by an outside consultant, Integrated Financial Engineering, Inc., assumes that FHA will never book a new insurance policy ever. Prepaid mortgages represent a permanent shortfall in cash flows. This fiction may be useful for analyzing the extant portfolio, but, again, the volatility in the different annual numbers is mostly traceable to revised assumptions and methodologies. And no one would confuse that valuation with GAAP accounting, which is based on the idea that you don't book income or losses until the period when they actually occur.
The consultant calculated the annual NPV based on forecasts by Moody's Analytics as of July 2012. The revised assumptions of lower interest rates, triggering faster prepayments, lowered the NPV by $8 billion. The revised assumptions of reduced home price appreciation lowered the NPV by another $10.5 billion.
As the consultant wrote, "We project that there is approximately a 5 percent chance that the Fund's capital resources could turn negative during the next 7 years." Such concerns were addressed in the FHA Emergency Fiscal Solvency Act of 2012.
Ed Pinto and His Cherry Picked Factoids
The same day that the actuarial study was released, Pinto rushed out his crackpot analysis to frame the media narrative. He said the FHA was masking its financial problems, because the latest interest rate forecasts, which were lower than those in July 2012, meant that the company was $31 billion in the hole. If you have no idea what he's referring to, his words sound confusing, but not ridiculous.
Today the FHA released its FY 2012 actuarial study and as documented by FHA Watch, the FHA's financial condition continues to deteriorate. This report should be cause for significant concern for Congress and taxpayers. As expected, the report shows that the FHA main single-family insurance program has a negative economic value of negative $13.5 billion. Even under generous accounting rules that no other financial entity gets to use, it is insolvent.To make matters worse, this report is already obsolete and outlines a conservative estimate of the true losses incurred by the FHA. The projection of negative $13.5 billion is based on Moody's July 2012 forecast projecting 10 Year Treasuries in CY Q3:12 to be over about 2.2% and climbing to 4.59% by 2014. Today the 10-year is at 1.57%. Under that same forecast, mortgage rates are projected to double to 6.58% by CY Q3:14.
The base case scenario ignores the Fed's September QE 3 announcement. FHA has once again ignored intervening events that dramatically change the base case findings in their annual report. If the current low interest rate scenario were substituted, the FHAs FY 2012 is a negative $31 billion. Yet, FHA chose cherry pick a piece of "good news"--the study projects that FHA will generate $11 billion in new economic value in FY 2013 and seize on it as evidence the 2012 deficit will be largely wiped out and all will be fine. This ignores the of the real negative $31 billion hole in 2012. No matter how bad things get today, FHA continually paints a rosy picture. The SEC would be all over a public company that played by FHA's rules.
"Yet FHA chose to cherry pick..."? Hey Ed, projecting much?
Let's get to the big stuff first. Pinto says that the "economic value" of the " FHA main single-family insurance program," is not negative $13.5 billion, but negative $31 billion, based on an interest rate outlook that was even lower than that forecast in July.
Pinto conflates a static portfolio at a point in time with FHA's " single-family insurance program" which operates as a business. He says that FHA is dishonest in its presentation because the NPV, would change if it were based on updated projections from Moody's Analytics, which show that interest rates are expected to be lower than previously forecast.
Again, under the methodology used by Integrated Financial Engineering, lower interest rates translate into faster prepayments, thereby reducing future income which is assumed to be lost forever. It's sort of like assuming that every wage earner in his 30s who changes jobs or is temporarily laid off will never get another payroll check for the rest of his life.
Historically, about 60% of those loans that prepay because of lower rates end up refinancing with FHA.
And since interest rates have risen over the past few months, the outside consultant will need to reverse that year-old assumption that hammered the NPV. So, we can expect, at minimum, an $8 billion increase in the net amount.
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