Report 2010-123 Summary - February 2011
California Housing Finance Agency:
Most Indicators Point to Continued Solvency Despite Its Financial Difficulties Created, in Part, by Its Past Decisions
Our review of the California Housing Finance Agency (CalHFA) revealed the following:
- Losses of $146 million and $189 million in fiscal years 2008-09 and 2009-10, respectively, which were due, in part, to high delinquency rates on CalHFA's single-family loans and the costs associated with its high levels of variable-rate debt, raised questions about the solvency of CalHFA.
- Although it will continue to face significant risks, its major housing programs and the fund it uses to pay its operating expenses will likely remain solvent. However, the fund set up to provide insurance on its mortgages will become insolvent by summer 2011.
- Some of the biggest threats to CalHFA's solvency are the amount of variable-rate bond debt it holds—which as of June 30, 2010, constituted 61 percent of CalHFA's total bond debt—and the interest-rate swap agreements (interest-rate swaps) it entered into to mitigate the risks associated with variable-rate bonds.
- The decisions approved by the CalHFA board of directors (board) to use variable-rate bonds and interest-rate swaps were a result of CalHFA's decision to pursue ever-increasing loan volume goals.
- To increase loan volume, CalHFA introduced new 35- and 40-year loans, which provided for lower monthly payments and allowed borrowers to more easily qualify for loans. However, the delinquency rates for these borrowers proved to be twice as high as those with conventional 30-year loans.
- The decisions to implement what turned out to be risky loan products were never brought before the board for a vote because such decisions are delegated to staff.
RESULTS IN BRIEF
The California Housing Finance Agency (CalHFA) is a state agency responsible for financing affordable housing. Using proceeds from the sale of bonds, CalHFA funds loans for single-family and multifamily housing for low- and moderate-income Californians. CalHFA is entirely self-supporting, and the State is not liable for the financial obligations of CalHFA deriving from bonds that it has issued or loans that it has insured.
Although profitable for many years, CalHFA suffered losses of $146 million and $189 million in fiscal years 2008-09 and 2009-10, respectively. The underlying conditions that contributed to these losses—high delinquency rates on CalHFA's single-family loans and the risks and costs associated with its high levels of variable-rate debt1—resulted in lower credit ratings for CalHFA, which, taken together with its losses, raised questions about its future solvency.
To examine whether CalHFA is likely to remain solvent, we hired Caine Mitter & Associates Incorporated, a consultant firm with recognized expertise in housing finance agency issues (our consultant) and had it perform an analysis of CalHFA's financial position. Our consultant found that, although CalHFA will continue to face significant risks, its major housing programs and the fund it uses to pay its operating expenses should remain solvent under most foreseeable circumstances. However, by CalHFA's own calculations, the fund set up to provide insurance on its mortgages will become insolvent by summer 2011. Despite this and other financial stresses, our consultant's analysis shows that CalHFA's largest housing program—its Home Mortgage Revenue Bonds program—will likely remain solvent. Similarly, although the California Housing Finance Fund—the fund CalHFA uses to pay its operating expenses—faces risks, principally from its interest-rate swap agreements (interest-rate swaps),2 our consultant concluded that it should remain solvent under most likely circumstances.
One of the biggest threats to CalHFA's solvency is the amount of variable-rate bond debt it holds, which as of June 30, 2010, constituted $4.5 billion, or 61 percent of CalHFA's total bond debt (excluding certain bonds issued in fiscal years 2008-09 and 2009-10). CalHFA started using variable-rate debt extensively in 2000 because the costs of this type of debt were less than the costs of the fixed-rate debt it had traditionally used to fund loans to borrowers. These lower costs allowed CalHFA to offer loans to lenders and borrowers at attractive interest rates, thus enabling it to increase its loan volume. To mitigate the risks associated with variable-rate bonds, primarily that interest rates would go up, CalHFA entered into interest-rate swaps with counterparties. However, interest-rate swaps entail risks of their own, including risks associated with terminating or replacing such agreements, which cost CalHFA $39 million in fiscal year 2009-10 alone. The decisions to use variable-rate bonds and interest-rate swaps are a result of CalHFA's decision to pursue ever-increasing goals for its loan volume. CalHFA's board of directors (CalHFA board) was aware of and approved of these strategies and goals.
CalHFA is overseen by a 14-member board, each of whom is appointed by the governor, Legislature, or as specified by statute. State law also requires that the governor's appointees to the CalHFA board include members with certain types of experience. Annually, the board approves CalHFA's business plan and provides CalHFA with resolutions authorizing its staff to operate and manage the agency's bond and loan programs (annual delegations). The statutes establishing the composition of the CalHFA board do not appear to call for the kind of sophisticated financial expertise that would have been valuable in determining whether CalHFA should launch into variable-rate bond debt and interest-rate swaps to the degree that it did. Furthermore, the annual delegations appear to have been overly permissive. For example, they continued to authorize CalHFA staff to enter into interest-rate swaps when this was not a planned business strategy, and they also authorized interest-rate swaps for many years before the CalHFA board was briefed on the risks associated with these instruments. CalHFA modified the wording of these annual delegations in January 2011 after we brought this issue to its attention.
Another threat to CalHFA's solvency is the high delinquency rate on its mortgage loans.3 Historically, CalHFA offered a standard 30-year fixed-rate mortgage, but in 2005 and 2006, to compete with alternative loan products being offered by the lending industry, CalHFA introduced two new primary mortgage loans: a 35-year loan in which the borrower made interest-only payments for the first five years, and a 40-year loan with fixed monthly payments. Because the 35- and 40-year loans required lower monthly payments than the 30-year product, and because underwriters assessed borrowers' qualifications based on those lower monthly payments, borrowers could more easily qualify for the 35- and 40-year loans than for the 30-year loans. Consequently, these two new loan products were popular with borrowers and, as of August 2010, they constituted approximately 40 percent of CalHFA's outstanding loan balances. However, over the past two years CalHFA has experienced increased delinquencies in mortgage payments from its borrowers, especially among borrowers with the 35- and 40-year loans. In fact, the delinquency rates for borrowers with these CalHFA products are presently twice as high as for borrowers who obtained 30-year conventional loans during the same time period.
Although the CalHFA board had some involvement in and knowledge of the 35- and 40-year home loan products, the decision to implement what turned out to be risky loan products was never brought before the board for a vote because CalHFA's board delegates these decisions to staff. If a new home loan strategy appears in CalHFA's annual update to its business plan, the board will ostensibly approve this change as part of its overall approval of the plan. However, because the annual delegations were so broad, CalHFA staff could launch a new loan product without presenting this strategy change to the CalHFA board for approval. In fact, the implementation of the 35-year home loan product occurred only two months before this new strategy would have appeared in the annual business plan that the board reviews and approves. Although a board with more financial expertise that was more engaged in questioning CalHFA staff about new initiatives may not have changed the decisions that CalHFA ultimately made, its recent financial difficulties created in part by these decisions provides an opportunity to examine the statutory makeup of the board and how the board provides oversight.
To ensure that CalHFA's business plans and strategies are thoroughly vetted by an experienced and knowledgeable board, the Legislature should consider amending the statute that specifies the composition of CalHFA's board to include appointees with knowledge of housing finance agencies, single-family mortgage lending, bonds and related financial instruments, interest-rate swaps, and risk management.
To provide better oversight of CalHFA, its board should issue a policy stating that it must approve any new debt-issuance strategy or mortgage product prior to its implementation, either directly or by inclusion in CalHFA's annual business plan.
Within its annual resolutions delegating authority to CalHFA staff, the CalHFA board should include language restricting staff's actions regarding debt strategies and mortgage products to those specified in the annual delegations themselves, the approved business plans, or subsequent board resolutions.
CalHFA agrees with our recommendations, has begun implementing them, and plans to work with its board to complete implementation.
1 Generally, CalHFA's variable-rate debt is in the form of bonds with interest rates that periodically reset based on market conditions.
2 An interest-rate swap is a contractual agreement between two parties, known as counterparties, who agree to exchange cash flows over a certain period. These swaps may be used by issuers of variable-rate debt to create a synthetic fixed rate for such debt, thereby reducing the risk should interest rates rise.
3 The delinquency rate is the percentage of loans for which payments are past due.