Market implications of the reduction in FHA mortgage insurance premium

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In early January President Obama announced a 50 basis point reduction in the mortgage insurance premium (MIP) charged on FHA loans.

Currently the Federal Housing Authority (FHA) charges a one-time upfront mortgage insurance premium (MIP) of 175 bps and 135 bps per annum for the life of the loan. Beginning January 2015 FHA will start charging 85 bps ongoing. The upfront MIP amount and the life of loan feature on the annual MIP remain unchanged. While the statement from the White House emphasized the desire to help first time homebuyers enter the market, the lower premium will also apply to refinancings.

FHA loans (along with VA loans and USDA rural housing loans) make up Government National Mortgage Association (GNMA, also known as ‘Ginnie Mae’) securities. As a result of the reduction in the MIP, prepayment speeds will increase on FHA loans as well as on the GNMA securities they back. The FHA rate now is 3.75%. Prior to the announcement a borrower would pay 5.1% (3.75% rate plus 135 bps MIP). Now the all-in rate will decline to 4.6%. By comparison, a recently issued GNMA 3.5% pool may have a gross coupon of 4.0% and MIP of 135, paying an effective 5.35%. Now this pool of loans is in the money for refinancing by 75 bps. This change will hit newer production 3.5s and 4.0s the hardest. More seasoned bonds may also prepay more quickly but the refinancing incentive is more nuanced. In many cases, older bonds generally have an MIP that is even lower than the new, reduced MIP announced by the President.

As a result of the announced reduction in the MIP for FHA loans, the market is anticipating an increase in GNMA prepayment speeds and has correspondingly re-priced the GNMA sector. Generic GNMA TBA pass-throughs have cheapened versus comparable Fannie Mae and Freddie Mac issues and versus the curve. Benchmark GNMA inverse Interest-only (IO) securities are also quoted lower. The new change in insurance premiums will take a few months to implement. If rates stay where they are we would expect to see faster prepayment speeds show up in the March report.

We see this as a one-time re-pricing of the GNMA sector. The FHA’s Mutual Mortgage Insurance (MMI) fund remains sharply undercapitalized versus the Congressional statutory requirement. The timing of the announcement is therefore somewhat controversial. The U.S. Department of Housing and Urban Development (HUD) will need to outline a plan to address MMI’s undercapitalization given that they will be charging less for insurance going forward. Furthermore, many higher credit quality borrowers have shifted out of the FHA program and over to conventional programs, which diminishes the overall credit quality of the remaining FHA insured borrower pool. Given undercapitalization of the MMI fund and declining credit profile of the borrower pool, we think it is very unlikely that any additional cuts in insurance premiums will be forthcoming.

Fischer Francis Trees & Watts (FFTW), a wholly owned subsidiary of BNP Paribas, is a global investment company providing active, fixed-income capabilities across global, US and emerging markets to institutional investors.
Michael Naughton

Portfolio Manager, Structured Securities

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