July 8, 2019 by Deborah Hill
At the beginning of 2019, most market watchers believed the Fed would hold rates steady in 2019 or possibly increase rates. Recently, sentiment changed and watchers forecast a 50 to 100 bps decrease in the Federal Funds Rate. This paper explores mortgage originator vulnerabilities if rates drop further then rise. 
While the quantity of purchase loan applications increased over the past few months as rates moderated, refinance loans grew so strongly they converged on purchase loans. Rates are part of this story, with lows not seen since the 1960’s, almost every homeowner’s mortgage rate is higher than currently offered rates.
As we look at the quality of those applications the first thing we notice is a desire for cash. After 2008, cash-out refinance loan volume dropped off as property values declined. A recent article in Mortgage News Daily included this graphic showing the drop in cash-out refi loans. Now homeowners are back in the black and their desire for cash out refinancing is rebounding.
So, what does this mean for mortgage loan originators and their investors?
Mortgage Investment Rate Risk Basics
Investors who purchase loans from originators in a declining rate environment take on increased prepayment risk. As rates decline, homeowners refinance their mortgages at lower rates and pay off existing, higher rate mortgages in the process. The investor then has to purchase replacement mortgage investments yielding a lower rate, which reduces their return on the asset class.
Once interest rates begin to rise again, the opposite occurs. Refinance/payoff become less common. For investors, they are now subject to extension risk, with lower return holdings which they can only sell at a discount. These risks can be mitigated with options and swaps – but the overall effect can be reduced liquidity.
So, Who Ends Up Holding the Bag?
In the 60’s and 70’s when the spreads on mortgages turned negative many Savings and Loans sank because they tended to hold mortgages on their books. The spread between their returns on mortgages and the rates they paid depositors went negative partly sparking the S&L “crisis.” Today, banks may hold some mortgages but very often they either sell them to the secondary market or employ hedging strategies like swaps or options, reducing their downside risk.
The reasons for the sub-prime crisis of 2007 when default (no repayment at all) brought down several large financial institutions don’t really apply to today’s rate driven risks because today’s loans are largely subject to more rigorous underwriting requirements. However, what created vulnerability to defaults may also create vulnerability to rising rates – suggesting additional questions to ask during due diligence.
Among firms that were major players in any aspect of subprime MBS production, those which were more vertically integrated across production segments were significantly more likely to fail in the wake of the meltdown. Vertical integration results in lenders holding their own loans or securitizations of those loans. Commercial banks, mortgage banks, and investment banks learned to profit from nonconventional MBS in multiple ways simultaneously, earning money both from fees on MBS production and investment income on retained MBS assets.  In many ways, they repeated the mistake banks made before the S&L crisis – holding loans too long/ overexposure to their own portfolio of loans.
Today’s equivalent may be originators who also warehouse their loans in order to reap the servicing fee portion of the borrower’s monthly interest payment. These originators may be overexposed to the risk of increasing interest rates relative to originators who sell their loans in the secondary market soon after origination. This risk potentially takes two forms: liquidity risk and rate risk.
Liquidity risk might affect them if they are currently funding new loans with payoffs, once the payoffs dry up, their ability to write new loans, at the new higher interest rates, will be constrained.
Rate risk applies to banks and credit unions who may experience a negative spread between the rates they earn from their portfolio and the rates they need to pay on deposits.
Whether you are a lender or an investor, here are key areas that impact the portfolio’s ability to weather adverse conditions like rate hikes:
Swap and hedge strategies, in 2008 the system collapsed because entities issuing swaps were over extended – they didn’t expect a large quantity to come due at once, so when that happened, they couldn’t pay and the MBS holders were left uncovered.
- How robust is the portfolio’s hedging strategy?
- Who are the counterparties and how extended are they?
- Are hedges concentrated with one counterparty or spread among several?
Quality erosion is another area that increases risk. While selling to a GSE may not be as profitable as holding a loan, GSEs are backstops if rates rise rapidly so carefully consider:
- What percentage of the portfolio is conforming and below the seasoning threshold? This tells you what percentage could be quickly sold to a GSE. If this percentage is declining, the originator may be lowering their standards – adding more risk to the portfolio.
- What percentage of the portfolio is non-conforming and what percentage is seasoned? How long would it take (and what would it cost) to sell these loans in the secondary market?
- Are there existing secondary market relationships in place or would the originator be starting “from scratch” if the need to develop a secondary market arose?
The best due diligence changes as market conditions change. Understanding past mistakes may help lenders and their investors better prepare for the future and avoid losses.
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