Risky Business

In spite of a year of hectic refinancing and record low rates, the housing market remains strong and mortgage loans continue to be in popular demand. However, due to their long maturities and embedded prepayment options, mortgages present a number of challenges to credit unions. Holding loans in portfolio adds significant interest rate sensitivity when rates rise. The embedded prepayment options make hedging more complicated. These risks tend to limit the amount of mortgage loans that many credit unions can hold in their portfolios. For credit unions planning to sell their production, the ability to hedge the pipeline will become increasingly important as rates start to drift higher.

 

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Managing Your Mortgage Loan Portfolio

In spite of a year of hectic refinancing and record low rates, the housing market remains strong and mortgage loans continue to be in popular demand. However, due to their long maturities and embedded prepayment options, mortgages present a number of challenges to credit unions. Holding loans in portfolio adds significant interest rate sensitivity when rates rise. The embedded prepayment options make hedging more complicated. These risks tend to limit the amount of mortgage loans that many credit unions can hold in their portfolios. For credit unions planning to sell their production, the ability to hedge the pipeline will become increasingly important as rates start to drift higher.

Prepayment Risk
Asset/liability managers urgently need to understand the likely prepayment behavior of their portfolios as well as the potential impact on future cash flows and asset values. Most mortgage contracts give borrowers the right to prepay the principal on the loan prior to maturity without penalty. Borrowers can pay down more than the monthly scheduled principal payment or even pay off and/or refinance the entire loan. Such prepayment options create uncertainty in a lender’s balance sheet. If rates rise, loans are likely to prepay more slowly, and if rates decline, loans might pay off very quickly. Both situations make it very difficult to "match fund" or hedge mortgage loans. They also create "negative convexity," an asymmetrical pattern in the change in asset values, because these values decline quickly when rates rise but do not appreciate as much when rates fall.

Analyzing Prepayment Risk
Prepayment speeds are determined by a number of economic and loan variables and vary across loan types and borrower demographics. A prepayment model attempts to correlate the relationship between the observed prepayment speed and several key variables, including loan terms, refinancing incentives, socio-economic demographics, historical behaviors and interest rate movements. Models are tested by feeding in historical data and comparing the output to actual performance. Consequently, it is extremely valuable for credit unions to maintain and track prepayment history that can be analyzed at a very detailed level. WesCorp manages a very large mortgage securities portfolio and has developed an array of sophisticated prepayment modeling tools. If help is needed, WesCorp has dedicated consulting staff available to assist credit unions with this analysis, as well as with the development of a suitable hedging program.

Mortgage Pipeline Risk
Mortgage pipeline risk is simply the exposure to a change in the fair market value of a loan; from the time the rate is committed to the borrower to the time the loan is closed and ready for sale to the secondary market. Clearly, pipeline risk can be minimized by keeping both the period between application and closing and the time from closing to sale to a minimum. However, grouping mortgage loans into larger lots can provide for better sales execution and simplify operational issues. Over the last couple of years, interest rates have steadily declined, reducing the need for aggressive pipeline hedging programs. Overall, loans in the pipeline tended to appreciate as rates fell during the period from rate lock to sale. But as we start to move into a period of rising interest rates, the reverse will be true and credit unions will need to protect themselves and more actively manage their secondary market pipelines.

Hedging Strategies
The most common way to hedge market risk is to sell a fixed amount of loans expected to close on a forward basis at a fixed price. This can be done by entering into an agreement with one of the mortgage loan conduits, such as Fannie Mae or Countrywide Mortgage. Alternatively, the seller can sell short a similar mortgage-backed security that could be created from the loans in the pipeline. These arrangements are referred to as "mandatory" commitments. However, the problem is to predict how much to sell. If more loans close, then the seller will be unhedged on those loans, and if fewer loans close, the seller will have to buy back the commitment at the prevailing market rate plus any penalty charges built into the contract.

In addition to cash contracts, derivatives can provide very efficient hedging tools. Both exchange-based futures and options as well as over the counter contracts are readily available. With WesCorp’s expanded 704 authorities, we are capable of acting as the counter-party to enter into custom tailored hedging contracts with credit unions for pipeline hedging or for other interest-rate management purposes.

Get Help if You Need It
Accurately forecasting prepayment speeds and developing effective hedging strategies can be a very challenging job. And while pipeline hedging is a necessary and engaging exercise, risk managers need to have a clear set of policies and the analytical tools necessary to evaluate alternative hedging strategies. For credit unions without risk management expertise, an alternative to developing their own hedging strategies could be loan participation sales or asset securitization. By selling entire loans or portions of the loans with high prepayment risk, credit unions can reduce their exposure to this risk. WesCorp operates a loan participation program that facilitates the trade of mortgages and consumer loans among credit unions. Whatever your loan portfolio risk management needs, our staff can help. If you would like to learn more, please call our Investments division at (800) 442-4366, ext. 6307.

 

March 8, 2004


Comments

 
 
 
  • Good article to explain the heging process and variables asscoiated with it. William Lokey CFS
    Anonymous
     
     
     
 
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