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Publications & Resources

May/June 2012
Balance Sheet Management

Assessing Your Mortgage Portfolio Now For Future Growth

By Mark Cary, CPA

Managing the mortgage loan portfolio is not what it used to be. In the past, the safest loan type in the portfolio was a 1-4 family first mortgage loan. This is not the case anymore and it seems that we’ve gone from one risk extreme to another. 

We are now entering our fifth year of the current credit crisis.  Since July 2007, we’ve witnessed numerous financial institutions fail, the passage of Dodd-Frank, required licensing of mortgage loan officers through the SAFE Act, and three initiatives to help curb the damage from the mortgage mess (HAMP, HARP and a new yet unnamed housing assistance proposal issued February 1).    Not to mention TARP, the Small Business Lending Fund, QE1, QE2, and now potentially QE3. 

As the Federal Reserve enters its fourth year of maintaining the Fed Funds Target Rate at 0-25bps, financial institutions are seeing low-coupon, long-term loans pile up on their balance sheet (as a result of trying to capitalize on a margin spread to help off-set increased provisions for loan losses.) The pendulum appears to be swinging from credit issues to Interest Rate Risk (IRR) issues.

What should institutions be doing now to position their mortgage portfolios for future growth?  The answer is analysis, analysis and more analysis.  In some cases, institutions should also consider re-balancing the portfolio.

Not All Mortgage Loans are Created Equal

More is being asked of financial institutions from a risk management and analytical perspective than ever before by regulators, auditors, investors and boards of directors. Not only do they want to understand potential credit exposure, but they want to go beyond credit and understand the “investment” characteristics of these loans. 

As you evaluate your own mortgage loan portfolio, you’ll want to make sure you include a review of the following:

  1. Interest Rate Risk
    As mentioned above, because rates have been so low for so long, the IRR profile of financial institutions is quickly shifting to higher exposure.

    What we’ve observed over the past 2-3 years is that approximately 90% of the new originations were fixed rate, and of that group, approximately 50% had a term longer than 180 months and a coupon lower than 5.50%.

  2. Measurement of Liquidity
    When evaluating an institution’s liquidity contingency plans, one often overlooked source of liquidity is the mortgage loan portfolio. Institutions should evaluate their loan portfolios to gain an understanding of the liquidity profile of the mortgage portfolio from what I’ll call three broad buckets 1) Agency Grade – Loans that can be purchased/securitized by the agencies FNMA or FHLMC, 2) Private Grade – Loans that can be transacted from one institution to the other, but not with the Agencies and 3) Portfolio Grade – Loans for which the economic value (value of the principal and interest if held to term) is significantly higher than their market value (i.e. what you sell the loans for in the secondary market).

  3. Collateral Value Exposure
    Over the last 4-5 years, our industry has discovered that one of the greatest determinants of potential liquidity is collateral value. Institutions should have processes in place to adequately assess the overall exposure and reduction in liquidity attributable to collateral value erosion. 

  4. Overall Portfolio Value
    Liquidity grades help you segment the portfolio into groups of similar loans to which you can apply required yields and loss assumptions to determine a Mark-to-Market or Mark-to-Model value. Mark-to-Model would apply to assets for which there is not a quoted market. Institutions should ensure that their assumptions are documented and pass regulatory and auditor reasonableness tests.

  5. Risk Layering
    In October 2006, the Joint Agencies issued the Interagency Guidance on Non-Traditional Mortgage Products, which directed lenders to evaluate mortgages on a layered-risk basis.  In other words, a loan for which a borrower has a low credit score in and of itself, may not be a bad loan. However, if you then add layers of risk (high LTV, non-standard documentation, currently delinquent, etc.), the loan quickly requires that more attention should be given it from a potential loss exposure standpoint.   

  6. CPR and Compositions Trends
    The loan portfolio is an extremely dynamic entity. Understanding changes due to prepayments and new originations is critical to managing the portfolio.   Questions you should be answering on a regular basis are: How fast are loans prepaying? How has the profile of my portfolio changed? (I.e. Fixed vs. ARM, Weighted Average (WA) Coupon, WA Maturity, IRR WA credit score, WA LTV, etc.)

  7. Level of Non-Performing Assets
    Non-performing assets require a tremendous amount of management time and resources. Reducing NPAs can be a great source of capital utilization by allowing management to find a definitive resolution for these problems and to re-allocate time and resources to more profitable products and services.

  8. Acquisition Impact
    Usually during an acquisition, loans are reviewed utilizing too broad an approach and institutions find themselves grappling with post-acquisition data integrity issues and risk mismatches. For example, loans could be incorrectly coded from a risk weighted asset standpoint that results in allocating more capital than is necessary. 

    Acquisition due diligence procedures often overlook the “investment” characteristics of the loans being acquired and focus exclusively on credit.  Without evaluating loans from an investment perspective, institutions may experience significant increases in IRR and overall diminished liquidity of the post-acquisition portfolio.

Conclusion

By evaluating the portfolio from these perspectives, changes can be made to underwriting and origination activities that will position your portfolio for strong long-term performance. Make sure your institution considers these components when evaluating your mortgage portfolio. Analyzing and adjusting your portfolio for the above components will assist your institution in growing a mortgage portfolio that performs optimally from an investment as well as a credit perspective.

Mark Cary, CPA is a senior vice president with FTN Financial Capital Assets Corporation. He can be reached at 901-435-8141 or mark.cary@ftnfinancial.com


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