Buyers for newer homes returned to the single-family home market in 2012, resulting in better than expected operating results for most of the homebuilders we rate. Sales volumes and average selling price exceeded our initial expectations, and we currently expect that the homebuilders we rate will deliver on average 20% more homes in 2012 compared with 2011. Most new homebuilders have also posted healthy increases in average selling prices, outpacing overall market trends, as buyers gravitated toward competitively positioned new home communities and the supply of existing homes for sale has remained very low.
Despite our expectation that favorable housing demand and supply fundamentals will continue to support strong revenue and EBITDA growth in 2013, our outlook on the homebuilding sector remains stable. Improved fundamentals reduce downside risk in our view, particularly for the lowest rated companies, but we expect upside rating momentum will likely be more muted as homebuilders draw down their sizable cash balances (a primary support to liquidity over the past few years), and raise additional debt capital for future land and inventory investment in anticipation of higher sales volumes. The effect of this additional debt issuance will likely slow the leverage improvements necessary for more positive rating actions over the next 12 months.
We also remain concerned that the impact of a potential recession in the U.S. would be more significant for homebuilders than many other sectors, since a drop in consumer confidence would likely derail buyers’ appetite for large discretionary purchases such as single-family homes. In addition, decisions on numerous regulatory and policy initiatives that would have an impact on housing are slated for the first half of 2013, many of which could significantly affect the availability and cost of mortgage financing.
MORTGAGE INSURANCE COMPANIES ARE STILL SADDLED WITH LEGACY PORTFOLIOS
The mortgage insurance sector continued to experience losses stemming from their legacy portfolios in 2012, leading to reserve adjustments and higher expected losses from delinquency to claim. Despite the reserve adjustments mortgage insurers have taken, reserve adequacy remains a significant risk, particularly given the capital impairment of many of the mortgage insurers remaining. We expect losses to continue through 2013 into 2014, although new notices of default should continue to trend downward barring a setback in the economy or housing markets.
Regulatory risk also remains heightened. Many of the mortgage insurers are operating under capital waivers from state insurance regulators allowing them to continue writing new business. Despite the ongoing depletion of capital, however, there appears to be little appetite on the part of either the state insurance regulators or the GSEs to discontinue allowing new business writings or accept the mortgage insurance paper from a counterparty perspective. Indeed, moves by Freddie Mac toward settling a dispute with Mortgage Guaranty Insurance Corporation (MGIC), acceptance of a voluntary runoff plan with higher claim payments for Republic Mortgage Insurance Co. by the North Carolina Department of Insurance, and permitted practices that the Wisconsin Office of the Commissioner of Insurance has allowed appear to be indicative of a shift toward greater accommodation.
We expect the very high credit quality of new insurance being written, combined with improvement in the housing markets and economy, to result in this business being profitable and capital accretive. Nevertheless, significant risks to the economic recovery remain. Should a recession occur in 2013, the declining trend of new notices of default could reverse and claim frequency could increase to an extent that could force several mortgage insurers into regulatory supervision and voluntary run-off.
FANNIE AND FREDDIE CONTINUE TO SUPPORT SECONDARY MARKET LIQUIDITY
Fannie Mae and Freddie Mac remain vital cogs in U.S. mortgage finance. The two combined to guarantee roughly 70% of new mortgages in the U.S. through the first nine months of 2012 and are effectively providing market liquidity at a time when private capital remains scarce. They continue to receive the financial support of the U.S. Treasury, and the Federal Reserve has committed to buying $40 billion of their mortgage-backed securities each month until economic conditions improve, meaning rates should stay low. Their financial results have improved because new loan loss provisions have declined, in line with their falling delinquencies, but potential losses within their single-family guarantee portfolios remain substantial. We believe the September 2012 amendments to their investment agreements with the U.S. Treasury ensure that sufficient financial support for these entities remains in place for the foreseeable future, which means they will be able to continue to support the U.S. housing recovery in 2013.
SINGLE-FAMILY PROGRAMS IN THE PUBLIC HOUSING INDUSTRY ARE SEEKING ALTERNATIVES
For more than a decade, U.S. public finance issuers have faced increasing competition from commercial lenders for the first-time low- to moderate-income homebuyers they traditionally serve. Competitive mortgage products and persistent low interest rates have caused many U.S. housing finance agencies (HFAs) to use variable-rate debt, coupled with hedges and other structures, to enable them to actively issue bonds while maintaining competitively low rates. Because HFAs’ mission is to provide affordable housing options for low- to moderate-income families, some of these issuers have searched for alternatives to mortgage revenue bonds for financing loans and have used these methods more increasingly in 2012.
We found that these issuers are using a variety of mortgage product options to fund their programs. These options include mortgage-backed securities (MBS) to the “to be announced” (TBA) market, the forward trade of Ginnie Mae issued MBS that guarantee HFA originated mortgages with delivery of the MBS to the market investor prior to the established trade settlement date, and direct purchase loan participation pool sales to financial institutions. In addition, HFAs are originating home mortgages under their guidelines, insured by the federal government under the Federal Housing Administration (FHA), and selling them directly to financial institutions. They are also originating whole loan HFA program guidelines and selling directly to GSEs (Fannie Mae or Freddie Mac) for cash.
The investors in the HFAs’ alternative funding products vary. Fannie Mae and Freddie Mac purchase whole loans directly from the HFAs through various programs that include recourse to the HFA during the earlier part of the loan’s term. Market activity suggests that insurance companies, individual investors, and some institutional investors (through brokers) are purchasing MBS through the TBA market. We expect this shift in mortgage funding among HFA issuers to prevail in 2013 and over the long term. While direct sales of loans to the GSEs remain a viable alternative for the HFAs, the agencies’ receivership status may impair their long-term capacity to purchase whole loans. As the U.S. public housing sector continues to evolve, HFAs’ ability to identify and use alternative sources for mortgage funding, while also recognizing and mitigating the risks of these alternative options, will be critical to their credit strength and, ultimately, to their sustainability over time.