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Market Intelligence

Turmoil In Mortgage Market Creates Lending Opportunities For Community Banks

Issues surrounding U.S. subprime mortgage-backed securities (MBS) in the third quarter of 2007, which then spread to other classes of financial assets, continue to negatively impact the performance of financial institutions both domestically and abroad. Although the subsequent liquidity crisis and lingering credit crunch has been wide-reaching, the number of community banks with significant exposure to this type of mortgage has proven to be relatively small.

As large banks curb their mortgage lending activities to preserve the capital they need to cover market value deterioration to their securities portfolios and losses incurred from charging-off bad loans, many otherwise creditworthy borrowers are finding it difficult to obtain mortgages. Add that to the current disfavor many would-be borrowers feel toward mortgage brokers, and it becomes clear that lending opportunities exist for community banks with clean portfolios and sufficient liquidity, enabling them to recapture a portion of the estimated $3.4 trillion U.S. residential mortgage market*.

A brief look at the factors contributing to current difficulties in the mortgage market, as well as a recap of the potential risks and funding strategies community banks use to invest in mortgage assets, can help you decide whether you should consider getting into this potentially valuable line of business – or, if you already are, whether you should be doing more of it.

How We Got Here

Emerging research on the current mortgage crisis points to multiple contributing factors. The negative net international investment position of the U.S., resulting from 20 years of large and continuing trade deficits, has enabled foreign investors to accumulate a sizable amount of U.S. dollar-denominated assets. Fueled in part by the lucrative fee income and seemingly limitless liquidity, large banks turned increasingly to loan sales and asset securitization to create the financial assets needed to meet the increased demand of foreign investors.

It was demand for financial assets such as mortgage-backed securities that facilitated the decade-long growth of the subprime mortgage industry from a relatively small niche segment to a substantial portion of the U.S. mortgage market. Unfortunately, the increased reliance on asset securitization encouraged many large banks to loosen their lending standards. To keep up with the competition, underwriting standards at some financial institutions were lowered to the point that prospective borrowers were able to qualify for a mortgage based on a loan-to-value (LTV) ratio of 100%, enabling buyers to purchase a home with zero down payment.

Such imprudent lending standards also contributed to the unprecedented levels of housing price appreciation experienced by the U.S. real estate market between 2001 and 2006. As we now know, the boom in real estate values that was driven by careless credit growth proved to be unsustainable. Beginning in late 2006, default rates on subprime loans grew to levels nearly four times greater than defaults on traditional, 30-year fixed-rate “prime” mortgages.

Last summer’s collapse of several Bear Stearns-managed hedge funds that were heavily invested in subprime MBS finally exposed the fact that some lenders had completely abandoned sound mortgage underwriting practices, and instead were relying on increasing real estate values to enable borrowers in default to liquidate collateral and repay their loans.

Mortgage Loans Reconsidered

Fortunately, many community banks avoided the siren song of the subprime mortgage market and stuck to prudent lending policies. For these financial institutions, now is the time to consider (or reconsider) the 30-year fixed-rate conforming mortgage loan.

Even with the current slowdown in both residential housing and the overall economy, the sheer size of the mortgage market still contains a considerable number of potential borrowers with well-documented income and assets, a strong credit history, and enough personal liquidity to make a reasonable down payment. With prospective homebuyers suspicious about the veracity of some mortgage brokers, and concerned that large banks are too busy dealing with problem loans to approve new mortgage requests, many are looking to their local community bank for mortgages.

Mortgage Investment Risk in a Nutshell

As you may know, banks investing in whole loan mortgages are exposed to four main risks: credit risk, liquidity risk, interest-rate risk,and prepayment risk.

Credit risk, generally speaking, is the risk of incurring a loss due to a homeowner/borrower defaulting on his/her loan. For mortgages guaranteed by the Federal Housing Administration (FHA) or Veterans Administration (VA), credit risk is minimal. Private mortgage insurance is also available, and this risk can be assessed by the insurance issuer’s credit rating. For conventional mortgage loans without private insurance, the credit risk depends on the credit history of the borrower and can be measured somewhat by the mortgage’s LTV. Community banks have an advantage assessing the credit risk of a new mortgage when they are underwriting a borrower that has a longstanding banking relationship with the institution.

Liquidity risk is the risk of incurring a loss in the event the mortgage loan must be sold hastily. This risk is typically measured by the bid-ask spread for mortgage loans being traded in the marketplace. While there is an active secondary market for whole loan mortgages, the present uncertainty about all classes of mortgage assets (prime, subprime, Alt-A and home equity lines) has led to a considerable widening of bid-ask spreads.

Interest-rate risk is the risk of incurring a loss on the value of the mortgage asset should overall market interest rates change. Given that a mortgage loan is a fixed-income debt instrument, its price/value will increase when interest rates decline and decrease when interest rates rise.

Prepayment risk is the uncertainty related to the cash flow that will be generated from a mortgage over the life of the loan, which stems from the fact that a mortgage borrower is often granted the option to prepay the loan at any time during its term. This presents a funding challenge since funding needs will change based upon market rates.  Prepayment risk is perhaps the most challenging risk to manage in a mortgage loan because it creates volatility in the earnings derived from this type of asset. To avoid this volatility in earnings, some banks rely on the secondary market to sell mortgage loans they have originated.

Mortgage Loan Funding Options

Traditional approaches to funding whole loans typically rely on either short-term or long-term liabilities. Short-term funding usually consists of retail deposits or a combination of deposits and short-term wholesale funding such as brokered CDs, repurchase agreements (repos), or FHLBank advances.

While funding mortgage loans using this short-term approach produces a large initial net interest spread between the yield earned on the mortgage asset and the cost of the liability incurred to finance it, difficulties can arise should overall interest rates change. Since the yield on the earning asset is fixed, the net interest spread will narrow when short-term interest rates rise. The net funding gap (long-term assets supported by short-term liabilities) can also adversely affect the net interest spread.

As with most traditional mortgage funding approaches, using short-term funding to finance long-term fixed-rate mortgages requires a trade-off between a high initial net interest spread at the outset but potentially volatile earnings should interest rates change during the life of the loan.

Another popular approach to funding mortgage loans is using strips of either fixed-rate bullet (repos or FHLBank advances) or amortizing borrowings, which attempt to hedge against potential prepayments. This strategy can help to reduce some of the dispersion in net interest spread that can occur when market interest rates change after the inception of the mortgage loan, although the difficulty in accurately forecasting loan cash flows based on prepayment expectations still results in earnings volatility.

FHLBank’s Prepayment Linked Advance Reduces Volatility

One of the more effective strategies for reducing the volatility of both net interest spread and earnings when funding fixed-rate mortgages with wholesale funding is FHLBank Pittsburgh’s Prepayment-linked Advance (PPLA). The PPLA is a fixed-rate advance with mortgage prepayment characteristics. By indexing the PPLA to a specific pool of mortgage loans, monthly principal and interest payments due on the advance match the prepayment characteristics of the funded mortgage assets, provided an appropriate index pool was selected.

Although the initial net interest spread between the yield on mortgage assets and the PPLA may be narrower, increases or decreases in prepayment speeds that can result from changes in market interest rates usually have little impact on earnings volatility. For more information on PPLA, contact your relationship manager or call the Money Desk at 1-800-288-3400 (press option 2).

MPF® Program Offers Secondary Market Alternative

The Mortgage Partnership Finance® – or MPF – Program offers members of the FHLBank System a competitive alternative to selling their 1-4 family fixed-rate mortgages to other secondary market investors or retaining them on their balance sheets. More than 70 FHLBank Pittsburgh members currently participate in the MPF Program.

Under the MPF Program, FHLBank funds conforming fixed-rate mortgages with terms up to 30 years. FHLBank then pays members a fee for assuming a portion of the credit risk, while FHLBank takes on the interest rate risk of the mortgages. This mortgage loan funding solution offers members a viable way to serve their customers. The application process is easy, and a qualified team of MPF Program professionals stands ready to help you with training.

To sign up for the MPF Program, or for more information, contact Business Development Manager Jeff Acquafondata at 1-800-288-3400, x5190, call MPF Customer Service at 1-800-288-3400, x5475 or contact your Relationship Manager.

By understanding the risks and rewards of conforming fixed-rate mortgages, and selecting a funding strategy that meets specific investment criteria, community banks can take advantage of the uncertainty in the current marketplace to attract creditworthy borrowers in need of mortgage financing. 

*Source: Mortgage Bankers Association.

DISCLAIMER
The FHLBank Pittsburgh has taken reasonable steps to compile the data presented in this article.  FHLBank Pittsburgh makes no representations or warranties, express or implied, as to the accuracy, completeness and timeliness of any assumptions or any other data presented in the article.

The information presented in the article is not investment or business advice, nor is it an offer to extend credit or buy any security or financial product. Readers must not rely on any of this information when making any investment, business or credit decision.

FHLBank Pittsburgh products are governed by various agreements between FHLBank Pittsburgh and its customers, as well as certain FHLBank Pittsburgh policies and applicable regulations. In the event of any inconsistencies between information contained in this article and such agreements, policies and regulations, the agreements, policies and regulations will be determinative.

“Mortgage Partnership Finance” and “MPF” are registered trademarks of the Federal Home Loan Bank of Chicago.