Bubbles In Reverse?
We’ve all heard enough talk of bubbles by this point to make any two year old happy, but weve seen some recent events that are worth discussing. In this inaugural ReverseIQ newsletter, well point out a product that defies conventional logic and an analysis relating to the flood of new competitors youre seeing in the market every day. Theyre both symptoms of industry outsiders optimistic assessments of near term growth prospects and weakness in other mortgage markets, but cause concern among dedicated reverse mortgage lenders seeing their volumes contract as industry growth has slowed.
NCSECU Product Priced For Perfection
You may have seen the recent press release from the North Carolina State Employees Credit Union (NCSECU) for their new simple interest, low fee reverse mortgage. As a borrower, its hard to find anything not to like about it if you can qualify: a low, simple and fixed interest rate; low upfront fees; no monthly service fees; and even higher payouts than HECM. As a lender, youll have a tough hill to climb in competing with this product by only offering a HECM. So how many of your potential clients are eligible for membership in SECU and more importantly, how viable is this product as a competitive threat to your business?
The first good news is that eligibility for NCSECU (and thereby their RM product) is essentially limited to state employees and their families. For anyone not doing business in North Carolina youre probably not affected at all, and even those in the state will likely see limited impact due to this membership eligibility limitation.
To the more fundamental point, our initial analysis of the product shows that it is inherently unsustainable, even with the lower cost structure and non-profit status typical of credit unions. The 62 year old borrower illustrated in the NCSECU product guide receives $670 per month on a $200,000 home. If the borrower finances the closing costs and lives out a 21 year life expectancy, he will have received $173,010 in total draws. Using those numbers, home prices must appreciate at a compound annual growth rate (not simple) of 1.7% per year just for NCSECU to earn a yield equivalent to its current CD rates on offer, assuming a 7% closing cost to sell the home.
While that home price appreciation figure is very reasonable, the credit union is assuming all the home price risk while capping their offsetting return uncomfortably close to their current CD yield. In our humble opinion, that seems to be cutting it extremely close given the other inherent risks in these loans. Essentially, the credit union is creating a very low ceiling on its net return while at the same time assuming substantial interest rate risk (fixed rate with tenure payments), home price risk and duration risk. This last item may not seem like a big issue at first glance, but the idea that a credit union is lending long term at fixed rates using short term deposits as collateral is exactly what got the S&L industry in trouble a few decades back.
Looking at the table above, imagine what would happen if interest rates rose 2.5% from the historically low current levels suddenly every single loan written at current rates is losing money in any home price appreciation environment. It is not unreasonable to think that this situation would prompt the one hidden risk to the borrower: the risk that a lender might not perform because they cannot fund their monthly payment obligation to the borrower. A HECM would be backstopped by the HUD guarantee, but the credit union product provides no such protection.
Its a great deal for borrowers who qualify (with one hidden risk), but at the expense of NCSECUs broader membership and anyone else that might invest in this product. Among potential investors, even the state pension fund has a fiduciary responsibility to manage assets for the benefit of its beneficiaries, and its extremely difficult to imagine this product meeting that test.
You may have already seen our reports showing that over 1,000 new originators entered the industry in the first six months of 2008 (86% growth) while volume grew just 5%. That combination of statistics is alarming and spells certain pressure for any originators looking to reverse as a growth engine.
What is less obvious, however, is that many of these new competitors are likely to be less of a threat than the numbers above indicate. While many will divert some incremental loan volume away from the larger, more established competitors in the marketplace today, many more will struggle to rise above the lowest volume thresholds.
The chart below illustrates the historical performance of new originators in the reverse mortgage business. The number indicates the percentage of companies at each average monthly volume level in Jan-Jun 2008, grouped by when they entered in each half year period for the last three years. As you can see, 22.6% of the new competitors in Jul-Dec 2007 did no business just six months later in Jan-Jun 2008 and trends toward almost 50% fallout rate as they approach 1-2 years seasoning.
Beyond the companies that exit the business entirely, a huge share of the companies never rise above the 2-5 loans per month average. While that level of business might satisfy some small business owners and their wholesale lenders, it is not sufficient to threaten the business and the case could be made that the increasing numbers of new entrants may experience higher fallout rates than prior years, given the slower pace of loan growth.
Indeed, an initial look at the fallout rates at six and twelve months for the new originator vintages above shows a distinct correlation between higher numbers of entering competitors and faster, higher fallout rates (defined as no business in a six month period):
So whats the moral of the story? Put simply, we all know that reverse is the hot story of the financial services industry, and indeed, the only real mortgage arena showing any strength. Weve seen huge increases in the number of competing originators and now unrealistic product pricing with the NCSECU product. While these both make life a lot harder in the short term, rest assured that neither of these phenomenon are sustainable.
While our industry progresses from a small niche into a larger business segment with more products, competitors and investors serving more customers than ever before, its part of the growing pains that well sometimes get out of alignment and experience tough times. Right now it looks as though were in a period where competition got ahead of the market, but smart, informed competitors will always stand the best chance to succeed in tough times.
Thanks for reading ReverseIQ, and enjoy your summer while it lasts!
The RMI Team