Establish a Home Loan Program for Teacher Retirement System Members

The Legislature should authorize the Teacher Retirement System to establish a member home loan program.


Background
A member home loan program is a program in which a sponsoring fund, such as the Teacher Retirement System (TRS), provides home loans at competitive interest rates to its members. The sponsoring fund contracts with a program manager, or master servicer, to administer the program. The loans are made to members by participating mortgage lenders. The mortgage lenders originate, process, close and sell the member loans to the program manager. The program manager packages the loans, works with a guarantor to convert the loans to AAA-rated mortgage securities and then sells the securities to the sponsori ng fund as a fixed income investment.

In the course of reviewing member home loan programs, TPR found that these programs provide several benefits to the sponsoring fund, its members and the state economy.

One benefit is that member home loan program s provide safe investments to sponsoring pension funds. The loans have attractive investment yields and excellent credit quality, since they are fully backed by the credit of the Federal National Mortgage Association (FNMA), Federal Home Loan Mortgage Corp oration (FHLMC) or the Government National Mortgage Association (GNMA). As shown in Table 1, the average annual total return between 1983-1991 for FNMA securities (Fannie Maes) was higher than the average total return for GNMA securities (Ginnie Maes) and other long-term AAA-rated government and corporate fixed income securities. 1 AAA-rated mortgage-backed securities provide for the timely payment of principal and interest regardless of the performance of the underlying mortgage loans. Thus, the risk of foreclosure losses to the sponsoring fund is eliminated.

Another benefit is that loan programs of this kind give pension funds a rare opportunity to provide an additional benefit to its customers active and retired members by offering various types of home mortgages, lower up-front fees (which save borrowers an average of $200-300 per loan), competitive interest rates and the convenience of working with qualified lenders.

Member-home-loan programs also promote the state economy by directly investing funds back into the state. Put simply, the interest paid on member home mortgages becomes the investment income to the pension fund. And finally, allowing multiple lenders to pa rticipate on a statewide basis promotes diversity and maximum exposure of the program.

Member Home Loan Programs
The California Public Employees Retirement System (PERS) offers a home loan program to active members and annuitants of PERS, the Legislators Retirement System, and the Judges Retirement System. 2

The program is multi-lender, meaning that PERS members can obtain home loans from any of 60 lenders participating in the program. These lenders have 571 branches in 182 cities throughout the State of California. The program requires lenders to provide a gu aranteed interest rate lock-in, reduced loan origination fees and limited costs for appraisals, credit reports, title policies, mortgage insurance, loan processing and other services.

A program manager, based on a formula established by PERS, sets interest rates for the program each day as the market changes. Conventional, fixed-rate mortgages with 10-30 year terms and adjustable rate mortgages are available for both refinances and purc hases of owner-occupied single-family residences. All properties must be located in the State of California.

Table 1 - Comparison of Annual Total Return
(Percentages)

FHLMC FNMA
(30 year (30 year Long-term Long-term Long-term
original issue) original issue) GNMA AAA Corporate A Corporate Government

1978 4.03 NA 2.16 (0.41) 0.22 (1.11)
1979 0.02 NA 0.16 (3.62) (4.03) (0.87)
1980 0.33 NA 0.75 (2.96) (2.33) (2.96)
1981 (2.35) NA 0.47 (1.64) 0.70 0.48
1982 46.04 NA 42.40 43.02 43.54 42.08
1983 11.64 15.26 9.47 4.95 9.23 2.23
1984 17.27 16.86 15.19 16.71 17.60 14.80
1985 25.93 24.25 25.23 29.95 27.52 31.54
1986 16.17 14.86 12.52 20.13 18.43 24.08
1987 4.12 4.47 4.32 (0.41) 1.70 (2.67)
1988 8.77 8.70 8.80 9.40 9.93 9.24
1989 15.19 15.20 15.69 15.34 15.23 19.03
1990 10.85 10.86 10.58 7.07 6.74 6.29
1991 15.47 15.69 16.04 19.37 21.67 18.68
Average Annual
Returns 78- 91 12.39 NA 11.70 11.21 11.87 11.49
Average Annual
Returns 83- 91 13.93 14.02 13.09 13.61 14.23 13.69

* Returns for all securities are reported on a month-end to month-end basis and are market value weighted inclusive of accrued interest.
Source: Lehman Brothers Fixed Income Research - Bond Market Annual 1991


The interest-rate-lock feature allows a PERS member to lock in the interest rate of the loan on the date of application. If the PERS rate is lower on the day the loan is approved, the member can lock in the lower rate. If rates are lower on the date the legal documents are drawn for closing, the member s rate is reduced again. If the PERS rate increases on either date, the member is guaranteed the lower interest rate locked in on the original date of application.

PERS has set a maximum allowable loan origination fee at 1.25 percent of the loan amount that may be charged to the member. Some lenders may choose to offer lower fees than the program allows to be more competitive. The minimum loan amount is $25,000, and the maximum loan amount for the program is $350,000. The average PERS loan is $129,000. PERS has approximately 800,000 members and has made nearly 17,000 loans totaling more than $2 billion in p rincipal amount to its members since the inception of the multi-lender program in December 1989. 3

Other Programs
The California State Teachers Retirement System (STRS) also offers a home loan program to employed and retired members. 4 The STRS program has one lender, a large banking institution with branches throughout the state. STRS purchases both whole loans and mortgage-backed securities from the member home loan program. Investments in whole loans differ from mortgage-backed secur ities because whole loans represent direct investments in individual loans. Thus, whole loans are riskier because the fund has the risk of foreclosure losses. The program is designed for loans on the members primary residence. STRS has approximately 465,000 members and has made 16,000 loans totaling $1.9 billion since the inception of the program in 1986.

The County of Los Angeles is implementing a member home loan program for their county employees. The program is also a single-lender program. Based on research, no other s tate pension funds (except for California) provide home loan programs to their members. 5


Recommendation
The Legislature should authorize the Teacher Retirement System (TRS) to establish a member home loan program for its active members and annuitants.

The TRS member-home-loan program should offer to its members conventional, FHA and VA mortgages with 10-30 year terms, competitive interest rates, and mandate that reduced fees be charged by lenders. TRS should consider offering a guaranteed interest rat e lock-in feature as part of the program. TRS should contract with an outside manager to administer the program.

To ensure geographical representation of lenders throughout the state, multiple lenders should be allowed to participate in the program, as long as they meet approval guidelines established by TRS. Mortgage brokers would have the option of working through a qualified lender.

Interest rates on the loans should be competitive with the market so that TRS s fiduciary responsibility to invest prud ently would not be violated. The general counsel of TRS would need to review Section 72(p) of the Internal Revenue Service (IRS) Code to establish that a member loan made through the program would not be considered a distribution from the plan. TRS may nee d to request an IRS ruling so that the tax exempt status of TRS retirement distributions is not jeopardized. The State of California has been successful in implementing these programs without losing their tax exempt status. 6

TRS should be the first fund t o implement a member home loan program in the state due to the size of the membership base and its familiarity of ownership in mortgage-backed securities. The Employees Retirement System (ERS) should have no problem designing a similar program for state em ployees if the Legislature specifically authorizes a program.

The Loan Process
The recommended program would involve TRS and its members, qualified lenders, a program manager and a guarantor as shown in Figure 1.

The program would be marketed to TRS members and retirees through mortgage bankers, realtors and lenders throughout the state. Members would obtain home loans from qualified lenders, similar to the process of obtaining a loan without the program. Under the program, the only difference from the member s perspective is that fees paid to obtain the loan would be reduced and the interest paid on their mortgage would become investment income to TRS, rather than to another investor.

TRS would establish rules and regulations for the program and set the policy for the daily interest rate pricing formula for the loans. TRS would purchase AAA-rated securities from the program manager. The TRS investment office would review all printed advertising prepared by the lenders to market the program to members. Additionally, the TRS investment office would coordinate the settlements of the securities with the program manager.

Lenders would be responsible for the application, processing, credit qualification, loan closing and loan servicing for the member. Loan servicing is the collection of monthly loan payments and maintenance of escrow accounts to provide for the timely payment of real estate taxes and insurance on the property. However, lenders would have the option of selling their servicing rights to the p rogram manager or another participating member.

The program manager would: (1) provide daily interest rate quotes to participating lenders; (2) perform the lock-in function of the member s interest rate, if TRS decides to offer this feature; (3) track mo rtgage securities so that TRS can monitor its investment position; (4) report program statistics to TRS; (5) review loan files to ensure that lenders follow program guidelines and that members receive the proper interest rate; (6) purchase closed loans fro m participating mortgage lenders; (7) package loans and work through a guarantor to convert the loans to AAA-rated securities and (8) sell the securities to TRS.

The packaged loans would be guaranteed by FNMA, GNMA or FHLMC, unless TRS decides to guarant ee loans with private insurers to obtain a AAA-rated security. The guarantor would convert packaged loans into AAA-rated mortgage-backed securities, which would eliminate the risk of foreclosure losses to TRS. The loans must conform to the guarantor s guidelines before they can be converted into mortgage-backed securities.


Implications
Under the program, members would benefit from reduced fees, TRS would receive a safe investment with an attractive yield and the state economy would benefit from the loan activity generated by the program.

Opponents of the recommendation may argue that member home loan programs are subsidized by the sponsoring fund. However, this is not the case. Member home loan programs differ from subsidized home loan programs, such as the Texas Department of Housing and Community Affairs tax-exempt bond program, because they do not have below market interest rates, income ceilings and sales price limitations for borrowers. Member home loan programs do not require the sale of tax-exe mpt bonds to provide a source of financing home loans. Thus, the program would not be a general obligation of the state. Unlike bond programs, member home loan programs would permit the refinancing of existing mortgages and would not require that the borro wer be a first-time home buyer.

The recommendation would not have a significant impact on the TRS investment portfolio, since TRS already invests in mortgaged-backed securities. As shown in Table 2, U.S. Government Agency residential mortgages represented 7.31 percent of the book value of the total TRS investment portfolio as of August 31, 1991. 7 Additionally, mortgage-backed securities have attractive long-term returns (See Table 1). According to the 1991 TRS annual financial report, the system considers itself to be a long-term investor, so that long-term returns, or appreciation, are given relatively more emphasis than short-term returns, or cash flow. 8


Fiscal Impact
The administrative costs of the program would be paid by the borrower through the interest rate charged on the loan. Thus, the loan program would not result in any additional costs to TRS. The TRS investment office would need to designate a current staff person to act as program liaison with the program manager.

The investment yield to TRS on the securities purchased would be measured on a net of fees basis. This means that the servicing fee retained by the lender, the servicing fee to compensate the program manager, or master servicer, and the guarantee fee to credit enhance the se curities would be subtracted from the gross yield on the mortgage to determine the investment yield TRS would receive on the securities. This is normal and customary in the mortgage securities industry. 9

Table 2 - TRS Investments as of August 31, 1991

Book Value

Agency Mortgages-Residential
GNMA-30 year $ 1,230,159,176
GNMA II-30 year 54,257,240
FHLMC-30 year 111,404,949
FHLMC-15 year 528,497
FHLMC-Multi Family Plan B 10,676,529
FNMA-30 year 322,735,500
Total, Agency Mortgages-Residential $ 1,729,761,891

Total TRS Portfolio $23,650,685,274

Percent of Total TRS Portfolio 7.31%


Source: TRS 1991 Investment Report (Supplement)



According to th e Texas A&M Real Estate Center, more than 200,000 single-family homes are sold in Texas each year. One out of every five home sales are for newly-constructed homes, with the remaining sales for existing homes. The average price of new homes sold during 199 1 was $120,000-$130,000, and the average price for existing homes sold was $92,700. 10

As of August 1992, TRS had 506,486 active members and 129,124 annuitants. 11 Based on California s experience a good assumption it is assumed that 1 percent of the TRS membership will obtain a mortgage under the program with an average loan amount of $80,000. Assuming a 2 percent growth rate in TRS membership, the fiscal impact of the recommendation is estimated as follows:

Number Dollar Assumed Gain/(Loss) Gain/(Loss)
Fiscal of Amount Membership to the General to the Change in
Year Loans of Loans Penetration Revenue Fund 001 TRS Fund FTEs

1994 1,589 $127,120,000 0.25% $0 $0 0
1995 3,242 259,360,000 0.50 0 0 0
1996 6,613 529,040,000 1.00 0 0 0
1997 6,745 539,600,000 1.00 0 0 0
1998 6,880 550,400,000 1.00 0 0 0

Endnotes
1 Interview with Dennis L. Verhaegen, Managing Director, First Southwest Company, Austin, Texas, October 8, 1992.
2 California Public Employees Retirement System, The California PERS Home Loan Program, March 1992. (Pamphlet).
3 Interview with Henny Lasley and Gary Kell, Lomas Mortgage USA, Austin, Texas, October 8, 1992.
4 Telephone interview with Henny Lasley, Vice President, Lomas Mortgage USA, Dallas, Texas, November 30, 1992.
5 Telephone interview with Gary Kell, Lomas Mortgage USA, Sacramento, California, December 18, 1992.
6 Telephone interview with Henny Lasley, November 30, 1992.
7 Teacher Retirement System of Texas, Investment Report, A Supplement to the Component Unit Financial Report For the Fiscal Year Ended August 31, 1991 (Austin, Texas), pp. 2, 133.
8 Teacher Retirement System of Texas, Component Unit Financial Report For the Fiscal Year Ended August 31, 1991 (Austin, Texas), p. 27.
9 Telephone interview with Henny Lasley, November 30, 1992.
10 Telephone Interview with Ted Jones, Texas A&M Real Estate Center, College Station, Texas, December 21, 1992.
11 Teacher Retirement System of Texas, Membership Analysis, August 31, 1992.