FHLBInsider

By James Eibel, consulting manager, assistant vice president

As an investment alternative, fixed rate mortgage loans seem to get no respect. They have negligible credit risk and manageable interest rate risk. For well-capitalized institutions, the risk/reward characteristics of fixed rate mortgages are superior to those of securities. Nevertheless, many institutions choose to sell these assets rather than deal with the interest rate risk that the mortgages may add to their balance sheet. To sell loans in favor of booking lower yielding securities is to incur significant opportunity cost.

Fixed rate mortgages have prepayment risk. This is the risk that the average life of a mortgage will extend or contract due to changes in prepayment speeds. The graph illustrates the estimated impact of prepayments on 15 year fixed rate mortgages given a 3% interest rate increase and decrease.

While current market rate mortgages have an expected average lifeof about five and a half years, the actual life varies widely with interest rate changes. When rates fall, refinancing activity climbs, and portfolio lives shorten dramatically. For instance, if rates fall 3%, the average 15 year mortgage’s life could shrink to less than three years. However, if interest rates rise by 3% and refinancing activity slows, the average life is likely to extend only slightly beyond six years.

It is important to note that mortgage lives contract much faster under falling rates than they extend for comparable interest rate increases. In other words, the risk of mortgage life contraction is greater than the risk of extension. This has significant implications for funding mortgage investments.

Advances with embedded options can be used to manage prepayment risk. Option-based strategies essentially involve purchasing prepayment "insurance" up front in the form of prepayable advances. Many institutions balk at the cost of using options to fund mortgages. Instead, they use standard amortizing advance funding. Typically, the amortizing advances are structured either to match the mortgage portfolio’s average life or to be somewhat shorter. The graph on the next page illustrates the risk/return trade-off for both match and short funding strategies over a three year holding period.

Match Strategies

Many institutions attempt to "match fund" their mortgage portfolios. This strategy involves structuring amortizing advance funding to match the anticipated average life of the portfolio. In the case of market rate 15 year mortgages, this would entail using an amortizing advance with an average life of approximately five and one half years.

Interest rate neutral strategies attempt to balance the effects of mortgage life contraction and extension. The graph illustrates that match funding is not an interest rate risk neutral strategy. Match funding has a bias towards mitigating the impact of rising rates, but is vulnerable to falling rates and contraction risk. When rates increase and prepayments slow, match funding protects the portfolio’s value. The mortgages will not extend too far beyond the five and a half year average life of the advance funding. However, if rates decrease, unanticipated prepayments undermine the strategy’s matching structure. With a 3% interest rate drop, the average life of the portfolio may shrink to less than three years, but the funding will carry its original rate and duration. The resulting asset/liability mismatch causes the portfolio’s total return to fall.

When viewed in isolation, match funding fails to balance the relative magnitude of contraction and extension risks. However, the strategy may be useful in decreasing overall interest rate risk for liability sensitive (aka negatively gapped) institutions.

Short Funding Strategies

If match funding has a bias toward extension risk protection, it is logical to conclude that some degree of short funding must be used to achieve a more neutral strategy. The obvious question is, how much? Based on the risk/return analysis above, a four year average advancelife strikes a balance between contraction and extension risk over a 3% interest rate shock scenario. This modest one and a half year mismatch increases the spread under a flat rate scenario and is relatively balanced under both rising and falling rates.

The short funding strategy effectively trades off some of the extension risk protection in order to gain some contraction risk protection. The shorter funding helps manage prepayments if rates fall, but does not leave the portfolio excessively vulnerable to rising rates.

Conclusion

When funding mortgage portfolios, it is important to recognize that fast prepayment speeds are a much greater risk than slow prepayments. For this reason, interest rate risk neutral funding strategies will tend to have shorter average lives than the mortgage portfolios that they fund.

This article has been presented for educational purposes only.  The FHLBI is not a financial or investment advisor.   It is solely the reader's responsibility to evaluate the risk and merits of any funding strategy or business proposal.