A Whole New "HECM" WORLD

Saturday, 28 February 2009 16:00

Articles - Legal Updates

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As reverse mortgage industry participants already know, 2009 has brought greater pricing volatility as the secondary market has contracted and responded to dramatic changes in world financial markets.  The good news is that the industry’s traditional investor, Fannie Mae, continues to support the cornerstone product of the industry, the Federal Housing Administration insured Home Equity Conversion Mortgage (“HECM”).  However, unlike days of yore, and prior to the short-lived surge of secondary market investors, when Fannie Mae was the sole industry investor and investor pricing rarely changed, lenders and originators must now cope with Fannie Mae’s “live” daily pricing.  Effective November 3, 2008, Fannie Mae eliminated 60-day forward negotiated (or “static”) pricing for HECM loans in favor of automated (or “live”) pricing.  Under the “live pricing” process, lenders obtain a price for a HECM loan for the current business day, with commitment periods ranging from as few as two to as many as 90 days.  In addition, lenders and originators must cope with the availability of new HECM products, including multiple fixed interest rate HECMs and adjustable interest rate HECMs offering different margins.  From a macro perspective, these developments reflect the maturation of market forces that ultimately drive innovation and offer seniors more options that better suit their needs.  From a micro perspective, they pose challenges to our industry members that create operational hurdles and reputational risk for the reverse mortgage industry as a whole.  



With that broad view in mind, this article will focus on one of the legal and regulatory issues raised by our new, more “volatile,” pricing landscape.  Namely, the operation and disclosure of the so-called HECM principal limit lock.  



HECM Principal Limit Lock
HUD initially announced the operation of a principal limit lock for HECM loans on September 24, 2003, in Mortgagee Letter 2003-16.  In a nutshell, operation of the principal limit lock, as announced by HUD, simply sets the expected interest rate used to determine the principal limit (or the initial loan amount) on a HECM loan.   As explained in Mortgagee Letter 2003-16, the so-called principal limit “lock” is intended, during a rising interest rate environment, to protect the borrower from erosion in the principal limit between application and closing of the loan.  Although this is clearly a praiseworthy goal, in a volatile secondary market, where prices can change daily and, in fact, are changing at a pace not previously experienced in the industry, it is important that lenders and originators manage the risks associated with the operation of the principal limit lock and provide appropriate disclosures to the consumer.  



Principal Limit 101
To fully understand these issues, it is helpful to take a step back and review the basics on how the principal limit lock works.  There are three components under the HECM program that are used in an algorithm to determine the initial principal limit.  As pointed out above, the expected interest rate is one of those components, the others are (i) the age of the youngest borrower and (ii) the appraised property value, or FHA limit, whichever is lower (known as the “maximum claim amount”).  To clarify, the “expected rate” is not the contract interest rate that lenders use to calculate finance charges that accrue during the term of the loan (although, as discussed below, on a fixed interest rate HECM the expected rate and the contract rate must be the same).  Instead, it should be thought of conceptually as a projection of what the average interest rate will be over the life of the loan.  



For adjustable rate HECM loans, the expected interest rate is equal to an index plus a margin.  The index used to calculate the expected interest rate is based on a longer term Treasury or LIBOR based rate, while the contract interest rate is based on a shorter term Treasury or LIBOR based rate.  For example, as directed by HUD in Mortgagee Letter 2007-13, lenders offering adjustable rate HECMs utilizing a 1-year or a 1-Month CMT index to calculate the contract interest rate must use the 10-year CMT index as the corresponding index for calculating the expected interest rate.  Lenders offering adjustable rate HECMs utilizing a 1-year or a 1-Month LIBOR index to calculate the contract interest rate must use the 10-year LIBOR swap index as the corresponding index for calculating the expected interest rate.  Finally, if a HECM is offered as a fixed interest rate, HUD has mandated in Mortgagee Letter 2008-08 that the expected rate must be the same as the fixed contract interest rate.



Because these three components factored together generate the principal limit, it is clear that a change in any one of the three will impact the principal limit at closing.  As you might suspect, there is a directional relationship between each of these factors and the resulting principal limit.  As the age of the borrower goes down, generally the principal limit will also decrease since the borrower’s life expectancy is longer and negative amortization accruing under the loan is expected to be greater.  As the value of the property increases, generally the principal limit will increase since the value of the collateral that ultimately must retire the loan is greater (subject to the FHA limit).  Finally, as the expected interest rate goes up, the principal limit will generally decrease since the amount of negative amortization anticipated over the life of the loan is projected to be higher.  



Given the foregoing, and putting aside changes in the underlying index or even any change in the offered margin or fixed interest rate, if the appraised value of the property is less than projected by the borrower in his/her application (which is not an uncommon occurrence during a period of declining real estate values), the principal limit available to the borrower at closing will be less than projected at application.  Additionally, although the age of the borrower should be readily ascertainable, if the youngest borrower celebrates a birthday between application and closing, the principal limit at closing will be different than was initially projected at application.  Each of these instances highlight the fallacy of using the term principal limit “lock” when describing the process of setting the borrower’s expected interest rate, since the projected principal limit provided to the applicant is never truly “locked.”  Accordingly, the principal limit “lock” can be more accurately described as principal limit “protection” that lenders offer to HECM borrowers by setting the expected interest rate at the time of application. 



As set forth in Mortgagee Letters 2006-22 and 2007-13, HUD provided further clarification and extended operation of the setting of the expected interest rate.  HUD explained that the expected interest rate set at application may extend for up to 120 days from the FHA loan case number assignment, rather than 60 days as originally provided in Mortgagee Letter 2003-16.  In addition, seniors are afforded a “float-down” feature.   This simply means that if the expected interest rate at closing is lower than the expected interest rate at application, the senior will generally be provided the lower expected interest and correspondingly an increased principal limit.  HUD stated in Mortgagee Letter 2006-22 that lenders may not charge a fee for the principal limit lock nor the float-down feature.  Finally, HUD reiterated in Mortgagee Letter 2008-08 that while lenders may extend operation of the principal limit lock on fixed-rate HECMs, offering a true lock of the contract rate and corresponding expected interest rate, they may not charge the consumer a fee for this feature.    



Although there is currently no requirement under the HECM regulations, HUD’s HECM Handbook or any Mortgagee Letter requiring a disclosure in any particular form, or at all, as a matter of industry practice, most originators and lenders provide a disclosure to the applicant describing how the expected interest rate is set (or “locked”) in determining the initial principal limit of their HECM loan.  Whether or not such a disclosure is provided to the consumer, the setting of the expected interest rate must be consistent with Mortgagee Letters 2003-16, 2006-22 and 2007-13, and therefore the 120-day expected interest rate protection and “float down” features apply whether or not an initial principal limit “lock” disclosure is provided.  



Principal Limit & Interest Rate Volatility
Now that we understand the mechanics behind the calculation of a principal limit in the HECM world and how it is initially established, let’s turn now to how setting of the expected interest rate used to determine the initial principal limit in a volatile interest rate environment might cause confusion for consumers and potentially expose originators and lenders to legal and regulatory risk.  



As originators and lenders are aware, current volatility in the reverse mortgage secondary market has made continuing availability of any particular HECM adjustable rate margin, or fixed interest rate, over a period of 120 days problematic.   During this interval, unless a lender receives a purchase commitment from its investor, there is a chance that the investor may not even be willing to purchase a HECM with the same margin or fixed interest rate as the lender disclosed to the consumer, or if willing to do so, may only be willing to do so at a reduced price.  For this reason, if a lender provides a principal limit disclosure, it is important that the consumer understand that the so-called principal limit “lock” is not a commitment to make a reverse mortgage at any particular fixed interest rate, adjustable rate margin or at all.  In addition, if used, the principal limit disclosure should clarify that the expected interest rate used to set the initial principal limit is protected for 120-days solely in connection with the particular adjustable rate margin or fixed interest rate HECM product for which the consumer applied.  If that particular fixed interest rate or adjustable rate margin product is no longer available, or if the consumer elects to change to a different HECM product notwithstanding the continuing availability of the product initially applied for, the lender’s disclosure should clearly inform the consumer that the disclosed expected interest rate, and projected principal limit, will no longer apply.  Without clear disclosures, seniors might understandably be confused when their originator or lender advises them that they cannot obtain the initial principal limit they expected.



This raises the question of what lenders should be doing in these circumstances.  Focusing on a scenario in which the senior changes his or her loan program selection, as discussed above, and assuming no commitment has been made by the lender to the consumer to make a HECM with a particular fixed interest rate, adjustable rate margin, or initial principal limit, the expected rate and initial principal limit provided to the consumer in connection with this change (occurring within the 120-day period from the initial application) is governed by Mortgagee Letter 2007-13.  There, HUD provides the industry with very specific guidance stating:



“If the borrower chooses or is offered an index and/or margin different from that chosen or offered at application, the Expected Interest Rate used to calculate the Principal Limit shall be the new margin chosen or offered, plus the index as applicable, as of the application date or the date of closing, whichever is lower.”



This, among other things, means that if the index used at loan application is based on the Treasury rate, and the borrower later changes to a LIBOR index based loan, the lender must use the applicable LIBOR index to calculate the expected interest rate and set the initial principal limit.  If the index at loan application is based on the LIBOR rate and the borrower later changes to a Treasury index based loan, the lender must use the applicable Treasury Index to calculate the expected interest rate and set the initial principal limit.



In addition, in cases involving a product change, originators and lenders should consider providing the consumer a new principal limit disclosure (if such a disclosure was provided initially), re-disclosing the projected initial principal limit for the new product and the remaining period of expected interest rate protection (calculated based on the original application date).  In such instances, lenders also should consider providing an updated TALC disclosure, a new HECM comparison worksheet and a new amortization disclosure.  



NRMLA Best Practice
In recognition of the impact a volatile interest rate environment may have on operation of the so-called principal limit lock, the National Reverse Mortgage Lenders Association (NRMLA), through its Compliance Committee, published on February 5, 2009, an industry Best Practice entitled HECM Principal Limit Lock and Disclosure.  That document acknowledges the complexity and the risk of managing any principal limit lock commitment made to a senior.  The NRMLA Best Practice further emphasizes the need for sound disclosures, and provides model language for use in either a HECM Principal Limit Lock Disclosure, or other disclosures.  In addition, NRMLA strongly recommends that its members consult with their counsel on appropriate and required disclosure policy and documentation of their HECM product offerings and hedging strategies.  The NRMLA Best Practice Compliance Committee memo is published in the password protected NRMLA Members-only section of NRMLA’s website, at www.nrmlaonline.org, and NRMLA Members are urged to review it in its entirety for the additional guidance it provides to NRMLA Members in this challenging area, including its suggested model disclosure language.



As we’ve seen, interest rate volatility can add a little turbulence to the magic carpet ride, but employing a few safeguards as we’ve discussed, starting with good disclosures and re-disclosures when changes occur, can keep you firmly in your seat as you navigate the wonders of a whole new “HECM” world.  



Due to the generality of this article, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advised based on particular situations.



By Joel Schiffman and Fed Kamensky, of the law firm of Weiner Brodsky Sidman Kider, P.C.  The law firm serves as General Counsel to the National Reverse Mortgage Lenders Association and advisor to reverse mortgage lenders and industry participants throughout the nation.  The firm has offices in Washington, D.C., Newport Beach and Dallas.  Additional information can be found at www.wbsk.com or by telephone at 202.628.2000.  Messrs. Schiffman and Kamensky can be reached at This e-mail address is being protected from spambots. You need JavaScript enabled to view it and This e-mail address is being protected from spambots. You need JavaScript enabled to view it .