FHLBInsider

By James Eibel, consulting manager, assistant vice president

"They call him `broker’ because
after you deal with him, you are."

— Anonymous

Historically, bankers have regarded long-term fixed rate mortgages as forbidden fruit. Risk management concerns led many to sell high credit quality mortgage loans into the secondary market. Recently, many financial institutions have been reevaluating their long-held positions on fixed rate mortgages. As a result, many have been adding fixed rate mortgages to their portfolios to increase earnings without necessarily taking on more risk.

Lenders are discovering the investment value of the long-term fixed rate mortgage loans they originate. This is evidenced by the 28.8% reduction in mortgage loan sales to Freddie Mac and Fannie Mae during the first half of 1997 (Inside Mortgage Finance, p.4). Historically, both agencies have relied on their fixed rate mortgage

portfolios and lower capital standards to consistently produce ROEs far above the majority of their clients.

Given the high profitability levels achieved by Freddie Mac and Fannie Mae, it seems obvious that fixed rate mortgage portfolios can produce consistent and attractive returns. Rather than sell these potentially valuable assets, it makes sense for financial institutions to consider their contribution as a portfolio asset.

Prior to constructing a fixed rate mortgage portfolio, bankers must consider the risk/return goals for their institution. As with all investment vehicles, there is a strong positive relationship between risk and return for loan products. In competitive markets, higher yielding loans reflect a higher degree of perceived riskiness. The best loans will ultimately find the best rates. While loans are priced based on their specific risk characteristics, the decision of whether or not to add fixed rate mortgages to a portfolio needs to be made based on the financial institution’s overall risk position. Three basic areas that must be considered are credit risk, interest rate risk and liquidity risk.

Credit risk

Bad loans not only are a threat to earnings, they are the single biggest risk to a financial institution’s solvency. In general, mortgages have little credit risk due to the high priority that home owners place on making timely payments. The low credit risk of mortgages is evidenced by the 1995 loss experiences for Fannie Mae and Freddie Mac of only 5 and 10 basis points, respectively. These loss rates contrast with the average guarantee fees charged for loan sales of 22 and 24 basis points, respectively (Inside Mortgage Finance, p.3).

The low credit risk of mortgages is a primary reason for their lower yields relative to higher credit risk loans, such as commercial and consumer loans. From the regulatory risk-based perspective, mortgages only require half as much capital as consumer and commercial loans. This lower capital requirement enables institutions with a high concentration of mortgages to safely use a higher degree of leverage than those with large commercial and consumer loan portfolios. Use of greater leverage should enable lower yielding mortgage portfolios to produce ROEs consistent with comparable risk consumer and commercial portfolios.

Interest rate risk

Interest rate risk management is the primary area of concern with long-term fixed rate mortgage portfolios. The stable ROEs achieved by both Freddie Mac and Fannie Mae are proof that fixed rate mortgage interest rate risk can be effectively managed. Members of the FHLBI have access to the same risk management tools used by the agencies to manage their interest rate risk.

Some financial institutions, such as heavy commercial and ARM lenders, have the natural capacity to hold long-term fixed rate mortgages. These institutions’ net interest margins tend to increase when interest rates rise, and decrease when interest rates fall due to their relatively short-term asset composition. This interest rate sensitivity is exactly the opposite of a fixed rate mortgage. Thus, the addition of a fixed rate mortgage portfolio can actually reduce overall interest rate risk as well as generate additional earnings for asset sensitive institutions.

The majority of financial institutions do not possess the capacity to add large amounts of fixed rate mortgages without increasing their interest rate risk position. Usually, fixed rate mortgage portfolios need to be balanced either by adding long-term liabilities or synthetically lengthening the current liability structure with derivatives. The FHLBI can assist members in developing and executing strategies to hedge the interest rate risk of fixed rate mortgage portfolios.

Liquidity risk

Financial institutions have both internal and external sources of liquidity. Internal liquidity primarily consists of assets, such as securities, which can be quickly sold at or near market value to raise cash. External liquidity consists of unutilized borrowing capacity, such as FHLBI borrowings, repo lines, and brokered CDs.

In the past, financial institutions and regulators have focused primarily on internal liquidity measures. Thus, replacing low yielding treasuries with higher yielding mortgage loans would necessarily depress liquidity by a like amount. The obvious problem with this approach is that it totally ignores the transaction’s impact on external liquidity.

Mortgages are pledgable assets at the FHLBI. Under the FHLBI’s specific collateral agreement, up to 80% of a mortgage’s market value can be borrowed. Replacing $1 of securities with mortgages would decrease internal liquidity by $1, but increase external liquidity by $.80. Thus, every dollar of securities swapped for mortgages decreases total liquidity by only $.20. For most institutions, the increase in portfolio yield due to the trade would more than compensate for the small decrease in overall liquidity.

Conclusion

The fact that more and more lenders are discovering (or rediscovering) the investment value of long-term fixed rate mortgage loans is not surprising. While they have long been stigmatized by negative press, fixed rate mortgages represent a unique asset class that can add value to a financial institution’s overall portfolio. Rather than automatically selling these loans, it is prudent to consider whether greater shareholder value can be created by retaining at least some of them. After all, if Freddie Mac and Fannie Mae can consistently achieve ROEs in excess of 20% by purchasing and portfolioing long-term fixed rate loans, it would appear that a great opportunity is foregone by the sale.

Source: Inside Mortgage Finance, July 5, 1997, pp. 3-6.

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.

Copyright 1997, Federal Home Loan Bank of Indianapolis.