A Portfolio in the Storm

James Eibel
January 17, 2008 | COMMENTS

“An optimist sees an opportunity in every calamity; a pessimist sees a calamity in every opportunity.” 

--Winston Churchill

The subprime meltdown has broadly impacted the mortgage market. The resulting credit crunch has led to lower prices and higher rates for all mortgage assets. A primary culprit has been the breakdown in secondary market liquidity. Unlike mortgage bankers, credit unions have the capacity to hold mortgage originations either until secondary market liquidity improves or even until maturity. By utilizing their capacity to portfolio mortgages, credit unions can play a constructive role addressing the current credit crisis and profitably regain market share.

A sampling of financial trade publications suggest we may be in the midst of the most significant credit event since the 1980s S&L crisis. Some estimates place the total carnage from the subprime crisis as high as $400 billion, or 3% of GDP. Just as with the S&L crisis, the pain is not uniformly distributed. While most credit unions are not in the eye of the hurricane, all are impacted by the storm's aftermath. Instead of hunkering down, credit unions have the opportunity to shine through the crisis by leveraging strengths and serving members' credit needs.

As losses have mounted for lower credit quality mortgages, pricing and secondary market liquidity for all mortgage assets have been impacted. With respect to pricing, fixed-rate mortgages rates have widened approximately 100 basis points versus comparable Treasuries over the course of 2007.

Further impacting mortgage market pricing are Fannie Mae and Freddie Macs' efforts to improve their bottom lines. In addition to recent guarantee fee increases, both agencies will be adding 25 basis point delivery fees for all mortgages purchased and surcharges for loans with credit scores below 680 and loan-to-value ratios above 70% beginning March 2008. The National Association of Home Builders condemned the new fees as “a broad tax on homeownership that ultimately will be passed along to consumers.”

While mortgage bankers have no choice, credit unions can adopt a portfolio strategy to avoid the secondary market “tax” and gain a built-in pricing advantage. A portfolio strategy can capture increased spreads and fees for the benefit of the credit union and its members. When this pricing advantage is combined with the freedom to institute underwriting standards and products, portfolio lenders are uniquely positioned to thrive in the current market. For mission-focused credit unions, portfolio lending provides flexibility to respond to members in financial distress and perhaps even the ability to restore healthy lending relationships.

While the thought of portfolio mortgage lending might lead some to invoke the S&L crisis as an objection, there are few parallels. Credit unions today have far more diversified assets and liabilities, greater financial flexibility, higher capital (averaging 11.5% and growing), and little exposure to rising interest rates. In fact, portfolio mortgage lending could help combat the industry-wide problem of declining interest margins.

Deteriorating economic conditions led the Federal Reserve to drop the fed funds rate 100 basis points in late 2007. Most credit unions remember the last Fed easing cycle as an extended period of declining interest margins. Fortunately, robust mortgage sale income provided a significant off-set. Given the Mortgage Bankers Association's forecast of a 20% reduction in mortgage originations for 2008, a repeat scenario seems unlikely.

During the previous cycle, credit union margins declined because asset durations were shorter than those for liabilities. At most credit unions, mortgage portfolios declined due to rapid prepayments and loan sales. At the end of the cycle, credit unions were flush with low-yielding liquidity and experiencing declining loan sale income. By increasing portfolio mortgage lending during 2008, credit unions can blunt the impact of the rate cycle by remaining fully-invested, maintaining a better asset/liability match, and increasing portfolio yields.

While diversifying a portfolio with fixed rate mortgages is a sound strategy, too much of a good thing could lead to an exposure to rising rates. If this is a concern, a tried and true strategy is to partially fund new portfolio loans with stable, long-term, fixed-rate funding from either a Federal Home Loan Bank (FHLB) or a corporate credit union. By incorporating ALM to pretest, monitor, and rebalance the strategy over time an institution can maintain or even improve its interest rate risk exposure while engaging in portfolio mortgage lending.

For institutions needing fixed-rate funding, the credit crunch and resulting flight to quality have provided the AAA-rated, government-sponsored FHLBs with a significant pricing advantage. In addition, several FHLBs have developed special discounted borrowing programs to address the mortgage crisis. One of these programs is the Federal Home Loan Bank of Indianapolis ' (FHLBI) HomeRetain.

Under HomeRetain, members may borrow at the FHLBI's cost to refinance and fund portfolio mortgages to low and moderate income borrowers (defined as 115% or below the area median family income). This and other FHLB community investment programs provide credit unions with even greater latitude to respond to members in financial distress. More information on HomeRetain is available at www.fhlbi.com or by calling 800-688-6697.

James B. Eibel is a CFA, a graduate of the Mortgage Bankers Association School of Mortgage Banking, and a vice president of Federal Home Loan Bank of Indianapolis. Jim can be contacted at 317-465-0423 or jeibel@fhlbi.com.