FHLBInsider

By James Eibel, consulting manager, assistant vice president

"Behold the turtle. He only makes progress
when he sticks his neck out."

— James Bryant Conant,
American chemist and educator

The previous issue of the Insider made a general case for holding fixed rate mortgage loans based on their impact on an institution's overall risk position. In short, fixed rate mortgages have little credit risk, little impact on liquidity risk (since the FHLB will accept them as collateral for borrowings), and a manageable impact on interest rate risk.

Fixed rate mortgages are a unique asset class that can add value to an institution's overall portfolio. Rather than automatically selling these loans after origination, it is wise to consider whether shareholder value can be enhanced by some degree of retention. Consider the economics of a typical transaction.

Holding vs. Selling

Based on the market conditions of early November 1997, assume a financial institution could originate 15 year fixed rate mortgages, retain 0.25% for servicing, and sell the loans at approximately a 0.50% premium. Rather than sell the loans, a FHLB member could have match funded the loans (on a duration basis) at approximately a 1.00% spread over a seven year amortizing advance. Assuming a 1.00% loan loss provision and a 40% tax rate, the projected impact of $5 million of fixed rate loans on reported net income is pictured below:

The relative payoffs for holding vs. selling fixed rate mortgages are very different. During the first year, selling produces a greater impact on earnings than holding the mortgages. This is primarily a result of one-time impact of the loan sale premium and the accounting impact of the loan loss provision. In subsequent years, the net income produced by holding dwarfs that of selling. The combination of spread income and the reversal of the loan loss provision results in far higher reported earnings than the relatively minor contribution of servicing income.

All cashflows are not created equal. Cashflows with different levels of risk should be discounted at different rates. Loan sale premiums are near-term and subject to less uncertainty than either servicing or spread income, which are future and are more sensitive to interest rate risk. For this reason, both servicing and spread income need to be discounted at higher rates than loan sale premiums. Also, the impact of credit risk needs to be considered. Given that charge-offs for Indiana and Michigan institutions have recently averaged about 0.05%, the expected impact of mortgage credit losses would be negligible.

Net charge-off ratios 1992-96

After all risks are accounted for and projected cashflows are conservatively discounted to present value, holding mortgages will always produce a higher expected return than selling. How can this be true?

Theoretically, if mortgage loans were being sold in an efficient market, there should be little economic difference between the risk-adjusted expected returns for holding or selling loans. Equal power and access to information would result in the buyer and the seller negotiating a neutral price for both parties. Given this, why are the returns for holding mortgages superior to selling them?

The simple answer is that midwestern financial institutions are selling mortgages for less than their intrinsic investment value. When loans are sold to either Fannie Mae or Freddie Mac, among other things, the sale price is reduced by a credit risk premium charged by the agency. This guarantee fee is not subject to negotiation. In the case of Fannie Mae, the fee has recently hovered around 0.22%. Since this fee alone is more than four times the charge-off experience for Indiana and Michigan institutions, loan sales are occurring, by definition, at prices below their true intrinsic value. Thus, the risk-adjusted returns for holding mortgages must exceed the expected returns for selling mortgages.

The Impact of Constraints

If the expected returns for holding mortgages are superior, are there any reasons to sell mortgages? The answer, of course, is yes. Financial institutions are subject to various operational constraints. These constraints set the boundaries within which the game of banking can be played.

Regulatory constraints such as liquidity and capital requirements can impact the hold verses sell decision. For example, an institution could be approaching the risk-based capital minimum. This institution must ration the remaining capital resource. In order to maximize shareholder value, the capital would be allocated only to the most attractive investment alternatives.

In the case of holding or selling mortgages, the institution must consider whether additional mortgages would displace other more attractive investments. The favorable 50% risk-weighting would enable an institution to book two-times as many mortgages as either consumer or commercial loans. Thus, a 1% spread on mortgages would produce the same incremental ROE as a 2% spread on commercial and consumer loans. However, selling the loans would free up capital for other uses while still allowing the institution to book a sale premium (hopefully) and servicing income. Management must identify the point at which the capital resource is better used supporting a mortgage selling program rather than additional portfolio assets. This, of course, leads to the subject of investment and capital policies.

For most financial institutions, regulatory constraints are a practical non-issue for the hold verse sell decision. The vast majority have both liquidity and capital significantly in excess of regulatory minimums. Self-imposed capital and investment policies tend to be the constraint driving mortgage loan sales. For institutions with excess capital and liquidity, restrictive policies ensure suboptimal performance. In effect, such policies force an institution to always operate far below capacity. Unused, excess capacity represents untapped earnings potential and shareholder value unrealized. As long as the addition of mortgages does not displace other more attractive portfolio assets, it is in the economic interest of a financial institution to hold rather than to sell.

Source: Fall of the House of Fannie, Forbes, October 6, 1997, pgs. 74-78.

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.