Creditline Issues

Why Creditlines Are Decreasing

The reason why some HECM creditlines are decreasing is that HECM servicers are growing the loan’s servicing fee set aside (SFSA) at a different rate than the rate they are using to grow the principal limit (PL), and then subtracting the SFSA from the PL to obtain the remaining creditline amount. Specifically, they are growing the SFSA by the loan’s expected rate (plus 0.5%), but growing the PL by the loan’s current note rate (plus 0.5%), and then subtracting the SFSA from the PL to obtain the remaining creditline.

This “subtraction” method violates HUD regulation 206.25 (d) and HECM Loan Agreement section 2.6.1, both of which state that “The line of credit amount increases at the same rate as the total principal limit increases.” It also violates a requirement of section 2.7.3 of the HECM Loan Agreement, which explicitly says that the creditline will increase “independently at the same rate as the total Principal Limit increases” (emphasis added).

The pro forma tables below illustrate the incorrect “subtraction” method by which HECM servicers are deriving creditline growth. Instead of applying the same percentage increase to the loan’s PL, SFSA, and remaining creditline each month, they are increasing the principal limit by one rate (the current note rate on the loan), increasing the SFSA by what is generally a higher rate (the loan’s initial expected rate), and then subtracting the SFSA from the principal limit to derive the creditline.


Source of the Problem

Why are servicers growing their PLs and SFSAs by different rates? Prior to 4/24/97, servicers grew their PLs and SFSAs by the same rate, so when they subtracted a SFSA from a PL the result was a creditline that had grown by the same rate as the PL and SFSA. On 4/24/97, however, HUD Mortgagee Letter (ML) 97-15 changed the rate at which the HECM PL and its constituent parts (including the SFSA and the creditline) grow. On HECMs closed prior to the ML’s effective date, the PL, SFSA, and creditline all increased each month after closing by each loan’s fixed expected rate (plus 0.5%). On HECMs closed after the ML’s effective date, the PL, SFSA, and creditline were all required to grow each month after closing by each loan’s then-current variable rate, that is, the rate currently being charged on the loan balance each month (plus 0.5%).

But servicers did not follow this new directive. They did increase the total PL by the new rate, that is, by the variable current rate actually being charged on the loan balance each month. But they continued increasing the SFSA by each loan’s fixed expected rate. So when they subtracted this incorrectly calculated SFSA from the correctly calculated PL, the result was an incorrect creditline amount. And since the expected rate was generally larger than the current rate, the resulting SFSAs were too large, and the derived creditlines were therefore too small. In loans with relative small creditlines, increases in the “too large” generated actual reductions (that is, negative growth) in creditlines.
The servicers misinterpreted the 1997 ML for several reasons. First, they confused the calculation that determines the initial amount of the SFSA at closing with the calculation used to grow the creditline after closing.
· In the first calculation, the loan’s fixed expected rate is used to project a future value for the SFSA when the borrower would reach age 100. This figure is then discounted back to a present value, which equals the SFSA amount at closing.
· The second calculation then grows the SFSA each month after closing as the loan actually elapses using the actual variable rate being charged on the loan each month.
The misinterpretation led HECM servicers to calculate both the initial SFSA amount and all actual SFSA growth after closing by the same fixed expected rate. But the fixed expected rate mistakenly used to grow the SFSA each month after closing was generally greater than the current variable rate on the loan. So the SFSA calculated by the servicers each month was too large and – when this “too large” amount was subtracted from the loan’s principal limit – the resulting creditline amount was too small. For loans with very small creditlines, the remaining creditline could decrease from one month to the next even if the borrower made no creditline draws in that month.
The other reasons for the servicers’ misinterpretation were that the HECM program is complicated, very few people understood its workings in detail, and the 1997 ML could have been written more clearly and precisely. Most importantly, HUD’s own accounting contractor, Lockheed Martin, misinterpreted HUD’s 1997 ML in the same way as the servicers had. As a result, servicers reconciling their figures to Lockheed Martin’s received what they took to be official confirmation that they were making the calculations correctly.

Consequences

As a result of industry-wide use of the incorrect “subtraction” method, HECM servicers are using a de facto creditline growth formula that
· is so complicated that it cannot be reasonably explained to consumers;
· violates HUD regulations and the HECM Loan Agreement; and
· generally shortchanges borrowers on the amount of growth stated in the regulations and loan agreement.
HUD and HECM servicers have been aware of this problem since 2004. In 2005, the servicers proposed a draft HUD Mortgagee Letter (ML) to resolve the matter. Separately, HUD developed its own ML draft directing servicers to correct their HECM creditlines. Neither ML was ever issued, however, in part because HUD found that its own accounting contractor, Lockheed Martin, was using the same complicated formula as the servicers. In addition, the servicers were concerned about potential liability for insufficient creditline growth.
HECM servicers have made it clear that they will not correct the problem unless directed to do so by HUD. Recently, a private consultant determined for HUD that Lockheed Martin has all the data that would be needed to correct the problem from a systems standpoint. Still unresolved, however, is the matter of servicer liability for insufficient creditline growth. But since this problem remains unresolved,
A) HECM lenders cannot reasonably tell consumers the rate at which their creditlines will grow;
B) HECM servicing statements clearly show creditline growth that violates HUD regulations and the HECM loan agreement; and
C) the aggregate shortfall in creditline growth is most likely substantial and growing.
A) Growth Rate Disclosure
Basic tenets of full disclosure and transparency require that lenders tell loan applicants how their loan will work with specificity, but in an understandable manner. On the one hand, loan terms must not be so vague that the precise meaning is unclear. On the other, they must not be so complex that hardly anyone could understand them. For example, it would be insufficiently precise to tell consumers that “your interest rate will change” or that “your interest rate is generally likely to be somewhat similar to the 1-year Treasury rate.” On the other hand, it would be overwhelming to tell them that
your rate each month will be tied to the 1-year Treasury rate at that time, but will also depend on the 10-year Treasury rate at the time of your loan’s closing and each month hereafter, the amount of your loan’s original principal limit and servicing fee set aside, and the amount of your monthly servicing fee, although the precise formula for determining this rate is highly complex and may be very difficult or impossible for you to understand.
A very attractive feature of the HECM program is that the amount of creditline funds remaining available to a borrower grows larger at the end of every month, until all such remaining funds are drawn down by the borrower. Although this creditline growth feature does not mean that creditline funds are “earning interest,” the effect is similar, but unlike interest earnings, this growing availability of credit is not taxable.
Understandably, many consumers want to know the rate at which their unused creditline funds will grow. But the de facto formula being used by HECM servicers defies disclosure. It is so complicated that it roughly matches the description in italics above and, according to a knowledgeable industry source, precisely equals the following:
Monthly increase in creditline = (PrincipalLimitLastMonth* (1+(NoteRateThisMonth+OngoingAnnualMIP)/12)-SFSALastMonth*(1+(ExpectedRate+OngoingAnnualMIP)/12)-LoanBalanceLastMonth*(1+(NoteRateThisMonth+OngoingAnnualMIP)/12))/(PrincipalLimitLastMonth-SFSALastMonth-LoanBalanceLastMonth) – 1
B) Creditline Miscalculations
HUD never intended that the HECM creditline growth rate should be so bizarrely convoluted, and virtually impossible to disclose or explain. To the contrary, as noted in a never-issued corrective HUD Mortgage Letter (ML) draft in 2005, HUD intended for the creditline to grow each month at the same rate as the growth in each loan’s “principal limit” – which is also the rate at which each loan’s balance (amount owed) grows. This growth rate would enable lenders to tell consumers that “your creditline will grow by the same rate as the one being charged on your loan balance.” HUD regulations at 24 CFR 206.25 (d), 206.3, and section 2.6.1 and 2.7.3 of the HECM Loan Agreement support this intent.

As explained in the 2005 ML draft, however, HECM servicers since 1997 had not been growing their creditlines by the same rate as the growth in each loan’s principal limit, as required by the citations in the previous paragraph. Instead, the draft said, they had been indirectly deriving each month’s new creditline amount by

1) increasing each loan’s principal limit (PL) by the loan’s current rate;
2) increasing each loan’s servicing fee set aside (SFSA) account by the loan’s original “expected” rate; and then
3) subtracting the new SFSA and the loan balance from the new PL amount to obtain the new creditline amount.
(Converting this subtraction method into a precise formula for creditline growth results in the formula above.)
C) Insufficient Creditline Growth
Generally, the incorrect servicer calculations discussed above generate creditline growth that is less than the correct calculations would produce. This occurs because fixed HECM expected rates are generally greater than current variable HECM rates. So when the resulting “too large” SFSAs are subtracted from PLs, the resulting creditlines are too small.
From 1997 to 2004, the average HECM expected rate exceeded the average HECM current note rate by about 150 basis points. So it is highly likely that the aggregate creditline reduction for the approximately 100,000 HECMs insured by HUD during that time was substantial. From the beginning of 2005 until the end of 2008, about 325,000 additional HECMs were closed. It is likely, however, that the per-loan reduction during this time was less than in the 1997-2004 period because the average HECM expected rate exceeded the average HECM current rate by about 50 basis points during this period.
Although the aggregate reduction since 1997 is a matter of speculation, there is no doubt that HECM creditlines and principal limits are growing by different rates, which directly contravenes the HUD regulations and HECM loan agreement sections cited above. The evidence of this fact can be found in the monthly servicing statements of major HECM lenders. Actual statements sent to HECM borrowers clearly show that the loan’s principal limit is growing at a different rate than its creditline.