Annual Sector Outlook for State Housing Finance Agencies Remains Negative for 2011

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1 FEBRUARY 22, 2011 U.S. PUBLIC FINANCE INDUSTRY OUTLOOK Annual Sector Outlook for State Housing Finance Agencies Remains Negative for 2011 Table of Contents: SUMMARY OPINION 1 HFAS WILL CONTINUE TO FACE CHALLENGING ENVIRONMENT THROUGH NEGATIVE OPERATING ENVIRONMENT COULD LEAD TO NEAR-TERM AND LONG-TERM CREDIT PRESSURES 3 MANY HFAS SHOULD MAINTAIN STABLE FINANCIAL PERFORMANCE DESPITE THE CHALLENGING ENVIRONMENT 8 SOME DOWNGRADES AND OUTLOOK CHANGES EXPECTED 9 CHANGES IN KEY FACTORS COULD CAUSE ADDITIONAL DOWNGRADES 10 Analyst Contacts: NEW YORK Rachael R. McDonald Assistant Vice President-Analyst Rachael.McDonald@moodys.com Florence Zeman Senior Vice President Florence.Zeman@moodys.com Naomi Richman Managing Director-Public Finance Naomi.Richman@moodys.com Moody s outlook for the state housing finance agency (HFA) sector is negative. This outlook expresses our expectations for the fundamental credit conditions in the sector over the next 12 to 18 months and does not speak to either expectations for rating changes or to individual rating changes during this timeframe. Summary Opinion Moody s outlook for the state HFA sector remains negative for the 3rd straight year. In the next 12 to 18 months, the HFAs will continue to be challenged by persistent weakness in the U.S. single family real estate market, unemployment, scarcity of liquidity, counterparty credit deterioration, and low interest rates. This will be the case particularly for HFAs with single family programs facing the negative factors listed below. Some of these challenges could lead to near-term liquidity and cash flow hits over the next 12 months, while others could lead to longer-term asset deterioration over the next five years. Challenges that may impact liquidity and cash flows in the near term include: a) Liquidity risks related to variable rate debt, resulting in roll-over risk, higher liquidity fees, and pressures related to swap contracts. b) Further deterioration of counterparty credit quality, which could weaken current and future payment streams from nonperforming mortgages and invested assets. Further counterparty deterioration could also lead us to increase the stresses that we incorporate into our loan loss and cash flow projections for the HFA and HFA program.

2 Challenges that may impact cash flow and loan losses over a longer time horizon include: a) High delinquency and foreclosure rates combined with weak loan types and/or high exposure to private mortgage insurance (PMI) rather than governmental insurance, increasing the potential for loan losses, particularly in states that have had high property value declines. b) Continued low reinvestment rates for funds not held at guaranteed rates, leading to the potential for profitability declines. c) Lower demand for HFA loans due to either competition from the conventional mortgage market or a lack of demand for mortgage loans. While the stressful operating conditions have already resulted in profitability declines for some HFAs and their single family programs, most HFAs have remained financially stable and some have even seen positive growth in their balance sheets since This financial strength results from several factors, including the overcollateralization of HFAs and their programs, the willingness and ability to infuse cash into single family programs from the HFA general fund, and federal government support in the form of the New Issue Bond Program (NIBP), the Temporary Credit and Liquidity Program (TCLP) and the Hardest Hit Fund (HHF). The negative outlook on state HFAs is consistent with our negative outlooks on all of the primary sectors in U.S. public finance, including state and local governments, healthcare and higher education. Rating activity in 2010 provided further evidence that the municipal market faces the greatest credit pressure since the Great Depression. Rating downgrades have outpaced upgrades for eight consecutive quarters, with all major municipal sectors continuing to face credit pressures related to deterioration of revenue streams, growing expenditure demands, and already weakened balance sheets. HFAs Will Continue to Face Challenging Environment Through 2011 We expect that the adverse economic and real estate conditions that challenged HFAs between 2008 and 2010 will continue in 2011, with limited improvements. These conditions, such as the persistent weakness in the U.S. real estate market, unemployment, counterparty credit deterioration, scarcity of liquidity, and a prolonged period of low interest rates are not projected to abate, and many HFAs will continue to feel pressure particularly those with single family programs that have high levels of PMI, high percentages of interest-only loans, high levels of variable rate debt, exposure to weakened counterparties, and/or a high dependence on investment income. Figure 1 below shows the potential for credit deterioration for single family programs, which, in general, are the primary programs under stress for HFAs. While many HFA programs have some credit factors that fall within the medium or high end of the spectrum, those HFAs with mostly high factors will feel the most stress. 2 FEBRUARY 22, 2011 INDUSTRY OUTLOOK: ANNUAL SECTOR OUTLOOK FOR STATE HOUSING FINANCE AGENCIES REMAINS NEGATIVE FOR 2011

3 FIGURE 1 Potential For Credit Deterioration for Single Family Programs Low High Debt Structure All fixed rate debt VRDOs less than 25% bonds outstanding VRDO over 25% bonds outstanding Loan Portfolio MBS or government insurance; 30-year, fixed-rate loans Mix of government insurance and PMI; 30-year, fixed-rate loans Majority PMI and/or exposure to interest only loans Counterparty Exposure US government Diversified portfolio of highlyrated counterparties Counterparty concentration or counterparties with low ratings Financials Asset to debt ratio well above benchmark for rating level Asset to debt ratio above benchmark for rating level or at benchmark for rating level with availability of external resources Asset to debt ratio at or near benchmark for rating level with no availability of external resources For each of the factors listed in the chart above, we have developed stress case scenarios, such as loan loss or cash flow scenarios, for each rating level to ensure that the HFA programs have enough current and projected financial strength to sustain pressures from the operating environment. These stress case scenarios are an important part of the rating process. For more information on how we evaluate ratings in the context of the operating environment, please see the Moody s special comment entitled, Roadmap 2010: State Housing Finance Agencies published in July Challenges related to any of the factors above could lead to a rating migration in the next 12 to 18 months. The impact on the rating would depend on the nature, severity, and duration of the stress. For example, liquidity events, changes in the delinquency rates of a loan portfolio, and counterparty downgrades could all lead to a near-term rating migration or outlook change, but the level of migration depends on the severity of the stress and the level of financial cushion available to the HFA or program. Negative Operating Environment Could Lead to Near-Term and Long-Term Credit Pressures HFAs face challenges that could have near-term and long-term impacts on their financial positions, including their asset, liability and income performance. HFAs with high levels of exposure to lowrated counterparties or high levels of variable rate debt could face potential liquidity challenges, which would impact their available cash and investments and erode profitability in the near term. Programs with high foreclosure rates and in weakened real estate markets face deterioration of their asset base due to loan losses over a longer time horizon. However, high levels of delinquencies, loan modifications, and/or low investment returns in the near term could also lead deterioration of the income statement in the current fiscal year and beyond. 3 FEBRUARY 22, 2011 INDUSTRY OUTLOOK: ANNUAL SECTOR OUTLOOK FOR STATE HOUSING FINANCE AGENCIES REMAINS NEGATIVE FOR 2011

4 Below we summarize the primary challenges that HFAs will continue to face in Liquidity Risks Related to Variable Rate Debt Could Have Near-Term Impact on Cash Flows Management of variable rate demand obligations (VRDOs) continues to be a challenge for those HFAs that issued them. The disruption in the variable rate market has been a primary cause of increased expenses for HFAs with substantial amounts of variable rate debt. These expenses can largely be attributed to higher basis expenses for the variable rate debt, credit deterioration of several liquidity providers that resulted in failed remarketings and a higher bank rate for those bonds, and increased liquidity fees. In the next 12 to 18 months, we anticipate that one of the biggest challenges for HFAs with variable rate debt, in addition to the cash flow, liquidity and swap-related risks that they have faced in the past, 1 will be renewing or replacing their standby bond purchase agreements (SBPAs). SBPAs are contracts that require liquidity banks to provide funds to purchase VRDOs that have been tendered and cannot be remarketed. To date, most HFAs have been successful in renewing or replacing SBPAs. However, HFAs seeking to renew or replace expiring facilities over the next few years are likely to face an increasing challenging market. Challenges include:» High level of SBPA rollovers, including TCLP rollovers» Fewer SBPA providers» Increased costs for new facilities» More stringent conditions, such as shorter terms, higher bank interest rates and/or shorter termout periods If an HFA is unable to renew or replace the SBPA before its expiration, the bonds will become bank bonds increasing the interest rate on the bonds and subjecting the bonds to a term-out period, often over a period of three to five years. This combination of increased interest cost and accelerated principal repayment would likely cause material stress on an HFA s cash flows, particularly because the HFA s principal assets are fixed-coupon mortgages with 30-year amortization. Some HFAs are attempting to refinance their VRDOs with fixed rate bonds, thus eliminating the need for external liquidity. However, HFAs ability to fix out the bonds is constrained by the interest rate swaps that were used to hedge interest rate risk for the majority of the VRDOs. Unless the HFA can use the swap for other purposes (such as hedging other unhedged variable rate debt), the HFA must either terminate the swap, and potentially face a termination payment, or continue making payments on a swap that no longer provides any economic benefit. Deterioration of Counterparty Quality Poses Near-Term Asset and Profitability Risks Counterparty performance is an important factor to HFA performance as HFAs are relying on current or potential future payments for their financial stability. Credit deterioration of an HFAs counterparties increases the risk that these counterparties will not perform as expected. For example, non-performance of a guaranteed investment contract (GIC) provider could result in a debt service payment shortfall on the bonds due to a loss of interest earnings or, in the case of a bankruptcy, in the issuer s inability to access the funds in the GIC. Non-performance of a PMI provider could lead to a loss of insurance claim moneys, resulting in significantly higher loan losses for the program. Non- 1 Moody s Investors Service Annual Sector Outlook for State Housing Finance Agencies Remains Negative for 2010, February FEBRUARY 22, 2011 INDUSTRY OUTLOOK: ANNUAL SECTOR OUTLOOK FOR STATE HOUSING FINANCE AGENCIES REMAINS NEGATIVE FOR 2011

5 performance of an SBPA or swap provider could lead to liquidity shortfalls as described in the section above. While counterparty exposure remains a risk for HFAs, many of the PMIs and financial institutions that serve as counterparties were downgraded in 2008 and 2009 and these downgrades have already been incorporated into the HFAs ratings. For example, as a result of the downgrades of many of the counterparties we have already assumed reduced levels of support or no support from the counterparty depending on the rating level or nature of the counterparty. To the extent that an HFA continues to have significant exposure to highly-rated counterparties, counterparty risk will remain an important part of our review of the HFA s credit profile. In early 2011, we have seen downgrades of the long-term and short-term ratings of several investment-grade counterparties, and also have seen additional counterparties placed on Watchlist for downgrade. These actions have resulted in the ratings of several HFAs with large exposures to these counterparties being placed on Watchlist for downgrade. High Delinquency and Foreclosure Rates Continue and Could Result in Long-Term Financial Strain High unemployment rates and declines in home prices continue to plague homeowners and to contribute to high delinquency and foreclosure rates for many HFA single family whole loan programs. Based on the forecasts from our Macroeconomic Board, we expect sluggish job growth and a backlog of foreclosures to lead to home prices continuing to decline until the third quarter of this year. 2 Declining and low home prices increase the potential for losses for HFA programs. We also anticipate that the unemployment rate, which is a major driver of HFA single family delinquencies, will dip only slightly to 9.4% from a yearly average of 9.7% in Figures 2 and 3 below show current and projected data related to median home prices and unemployment. FIGURE 2 Median Existing Single Family Home Prices Actual Forecast Source: Moody s Economy.com 2 Moody s Investors Service U.S. Private-label RMBS: 2011 Outlook and 2010 Review, January FEBRUARY 22, 2011 INDUSTRY OUTLOOK: ANNUAL SECTOR OUTLOOK FOR STATE HOUSING FINANCE AGENCIES REMAINS NEGATIVE FOR 2011

6 FIGURE 3 Moody s-rated State HFA 90+ Delinquency and Foreclosure Rates vs. Unemployment Rates 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% 90+ Delinquecy Unemployment Source: Moody s Economy.com and Moody s second quarter 2010 HFA survey As a result of these macroeconomic factors, we expect delinquency and foreclosure rates to remain high over the near term. Moody s-rated single family whole-loan programs experienced a slight rise in foreclosure rates and a slight decline in delinquency rates in the first half of 2010, but remain high, as shown in Figure 4 below. While the sector on average experienced a slight decline in delinquency rates in the first half of 2010, 13 of the 35 programs surveyed experienced a rise in total delinquencies and foreclosures during this time. FIGURE 4 HFA Delinquency and Foreclosure Rates, December 31, 2005-June 20, 2010* Delinquency Type* Foreclosure 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% 12/31/ /31/ /31/ /31/ /31/2009 6/30/2010*** *2007 figures do not include foreclosures for New Hampshire HFA; figures include Michigan State HFA s Single Family Mortgage Revenue Bonds and Utah HC s Single Family Mortgage Revenue Bonds (2007 Indenture); figures include SONYMA s Mortgage Revenue Bonds indenture. Unlike delinquency rates, foreclosure rates continued to rise through the middle of Many HFAs have been seeing a buildup of loans occur in the 90+ day delinquency category during the course of the economic crisis as they try to modify or cure delinquent loans. However, as the crisis continues, HFAs are finding that some loans are incurable and they are moving them into foreclosure so that the loan principal and interest can be recovered. We expect that the increase in foreclosure rates is the result of this process and that it will continue through FEBRUARY 22, 2011 INDUSTRY OUTLOOK: ANNUAL SECTOR OUTLOOK FOR STATE HOUSING FINANCE AGENCIES REMAINS NEGATIVE FOR 2011

7 The delinquency and foreclosure rates that HFAs are experiencing are well below the default rates that we use for our stress case loan loss calculations. However, in cases in which an HFA is experiencing unusually high levels of delinquency or foreclosure rates, we may adjust upward the assumed default rates in our loss calculations for the HFAs which could increase our stress case loan losses and put pressure on HFA ratings. It is possible that we may see some downgrades or negative outlooks in 2011 as a result of this phenomenon if the program s asset to debt ratio is not robust enough to absorb the increased stress case losses. Although increases in foreclosure rates could lead to an increase in realized losses over the long term for HFA programs, the potential losses are significantly reduced by the payment of claims by PMI counterparties, many of which have ratings below investment grade. To account for these low ratings, we assume in our stress case loan loss projections for Aa-rated HFA whole loan programs that PMI companies with below investment-grade ratings are unable to pay any claims and that PMI companies with investment-grade ratings below A1 only pay a portion of their claims. Therefore, these losses are already incorporated into our ratings for the HFA programs. However, high 90+ delinquency rates and loan modifications could place both near and long-term strain on an HFA s income statement as the HFA has less loan revenue coming into the program than expected over time. Hardest Hit Fund Could Help 19 HFAs Combat Rising Delinquencies and Foreclosures In support of the mortgage market, the federal government has pledged $7.6 billion dollars to the Hardest Hit Fund, a fund that 19 HFAs can utilize to develop housing-related programs to help families in their states. These programs include mortgage modifications, principal reductions, and unemployment programs. Depending on the number of the HFA s borrowers who benefit from the HHF and also the type of support that the borrowers receive, HFA single family loan portfolios may be positively impacted by the application of the HHF funds. Low Reinvestment Rates Continue to Impact Profitability Another market factor that will continue to impact HFAs in 2011 is the low interest rate environment. Short-term interest rates have been at record lows for much of the past three years, as shown in Figure 5 below. As a result, HFAs have received less investment income and have experienced greater negative arbitrage for their bond programs. In fiscal year 2010, we saw a number of HFAs experience a decline in profitability and a few HFAs experience shortfalls. We expect that this trend will continue in FEBRUARY 22, 2011 INDUSTRY OUTLOOK: ANNUAL SECTOR OUTLOOK FOR STATE HOUSING FINANCE AGENCIES REMAINS NEGATIVE FOR 2011

8 FIGURE 5 State HFA Profitability Mirrors Investment Rates Average Federal Funds (left axis) Average 1 Month LIBOR (left axis) State HFA Profitability (right axis) Interest Rates 8% 7% 6% 5% 4% 3% 2% 1% 16% 14% 12% 10% 8% 6% 4% 2% Profitability 0% % Level of Demand for HFA Loans Can Impact Financials Many HFAs have faced challenges originating loans under their programs due to the low conventional rates and the general slowdown of single family home sales. In October 2009, the US Department of Treasury launched the New Issue Bond Program (NIBP) to address this issue. The program offers the HFAs the opportunity to issue bonds through the end of 2011 at below-market rates in order to increase their loan originations. While we expect HFAs to use the NIBP program in 2011, loan originations may become a renewed challenge once the NIBP bond allocations have been fully utilized. If the HFAs that participated in the NIBP are able to access the bond market and make profitable, full-spread mortgage loans, we anticipate that their overall financial position will begin to improve. Furthermore, the majority of these loans are expected to be high credit quality loans that are federally insured or securitized into MBS. If the NIBP issuance occurred under a new trust indenture, only the financial health of this trust indenture and the overall health of the issuer will be impacted. However, if the NIBP issuance occurred under the HFA s older, existing trust indenture, then this indenture should be enriched by the influx of these new, profitable loans. Those HFAs that fail to issue bonds and originate loans over a long time period may suffer from an operational perspective. For example, without growth in the program, the staff that administers these programs may become costly to maintain. This, in turn, could impact program profitability. Many HFAs Should Maintain Stable Financial Performance Despite the Challenging Environment While the operating environment for the state HFAs remains negative, we expect that the financial performance of many HFA and HFA programs will remain strong. HFA fund balances continue to grow and asset to debt ratios remain stable, as shown in Figure 6 below. This stability results from the reduction in bond issuance and the subsequent decline in bonds outstanding that has occurred in the last few years. 8 FEBRUARY 22, 2011 INDUSTRY OUTLOOK: ANNUAL SECTOR OUTLOOK FOR STATE HOUSING FINANCE AGENCIES REMAINS NEGATIVE FOR 2011

9 FIGURE 6 HFA PADR Remains Stable at 1.20x For some single family programs, the asset position was further bolstered by infusions of cash or loans from the authority s general fund or other trust indentures. In fiscal year , we saw a number of HFAs experience a decline in profitability and a few HFAs experience shortfalls, as shown in Figure 7 below. We expect that this trend will continue in 2011 due to lower investment income, higher costs related to variable rate debt, and higher delinquency rates, as discussed in the sections above. However, profitability could receive a boost if asset balances continue to grow over time and produce additional revenues. FIGURE 7 HFA Median Profitability has Declined to a Median of 8.3% 16% 14% 12% 10% 8% 6% 4% 2% 0% Some Downgrades and Outlook Changes Expected While we expect the majority of HFAs and HFA programs to maintain their ratings, we anticipate that some downgrades or outlook changes will occur. The programs that will face rating pressure are those that are most vulnerable to the stress in the operating environment, including those that have single family programs with high levels of PMI, high delinquency rates, high percentages of interest only 9 FEBRUARY 22, 2011 INDUSTRY OUTLOOK: ANNUAL SECTOR OUTLOOK FOR STATE HOUSING FINANCE AGENCIES REMAINS NEGATIVE FOR 2011

10 loans, high levels of variable rate debt, exposure to weakened counterparties and/or a high dependence on investment income. The impact on the rating depends on the nature, severity, and duration of the stress facing the program as well as the financial resources available to offset the stresses. Changes in Key Factors Could Cause Additional Downgrades Our analysis of HFA single family programs incorporates a review of the programs ability to absorb stresses applicable to their rating levels. Most HFAs and single family programs continue to outperform our stress case loan loss and/or cash flow tests due to their high levels of overcollateralization, and we project that they will continue to do so as long as the factors listed below remain. To the extent that these factors change, the sector may experience more downgrades or outlook changes than we otherwise would predict.» PMI companies continue to pay insurance claims: Despite the fact that most PMI companies have ratings below investment grade, PMIs continue to pay claims that have kept HFA losses to a very low and manageable level. If any of the PMIs were to stop paying claims, we could see a significant impact on the cash flows of the HFAs. However, we have already assumed reduced levels of support or no support from the PMI companies in our loan loss calculations for the HFA programs and these losses are already incorporated into our ratings.» Foreclosure rates remain well below our probability of default assumptions: As mentioned previously, foreclosure rates for HFAs remain well below the stress case default rates that we assume in our loan loss calculations. However, in cases where an HFA is experiencing unusually high levels of stress on their loan portfolio, we may adjust upward the assumed default rates which could impact ratings if overcollateralization is not enough to absorb the stress case losses.» HFA VRDOs are successfully remarketed and HFAs continue to extend or replace liquidity agreements: Since the beginning of 2009, very few of the HFAs liquidity bank counterparties have had trouble remarketing HFAs VRDOs. Therefore, HFAs have not experienced the costs associated with bank bonds that we incorporate into our stress case cash flow scenarios. As long as HFAs are able to extend or replace liquidity facilities, bank bonds will not be an imminent risk for HFAs.» Counterparties maintain their ratings: Many of the PMIs and financial institutions that serve as HFA counterparties were downgraded in 2008 and 2009 and these downgrades have already been incorporated into the HFA s ratings. However, to the extent that and HFA is still exposed to a highly rated counterparties, any downgrade of these counterparties could impact HFA ratings. In the few cases in which the stress case scenarios have shown that a program s financials cannot absorb the stress, most HFA management teams have chosen to use other financial resources at their disposal, such as money from their general fund or excess funds from other trust indentures, to infuse cash into the program to support the rating. Furthermore, in the past few years, the federal government has chosen to support HFAs by implementing several large initiatives, including the NIBP, TCLP and HHF. Cash and services provided through these programs have also provided support to the ratings. To the extent that an HFA or HFA program s current asset position or future cash flows are not strong enough absorb our projected stresses, an outlook change or rating change may be warranted. 10 FEBRUARY 22, 2011 INDUSTRY OUTLOOK: ANNUAL SECTOR OUTLOOK FOR STATE HOUSING FINANCE AGENCIES REMAINS NEGATIVE FOR 2011

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