By Robert B. Segal
Risk management has undergone a remarkable evolution over the past decade. The range of strategies has expanded as the technology of risk modeling has developed. This enhanced capability is permitting greater effectiveness, as well as the wider use of innovative strategies to manage the balance sheet.
As a result, bankers have a better handle on the risks they’ve put on their balance sheets. This is a critical first step to understanding how their institution will perform over time. The assessment, however, is not static. Risk characteristics for the balance sheet components change over time due to market movements and shifts in customer behavior.
Mortgage assets continue to dominate community bank balance sheets. According to the FDIC, real estate comprised about 50 percent of total assets as of June 30. Residential mortgages made up about one-third of all loans.
When a financial institution puts mortgages on its balance sheet, they make an estimate about the average life of the loan. Mortgage markets, however, are constantly changing, and that means the institution’s original asset strategy may no longer be effective. Depending on how the institution is positioned, returns for a large part of the balance sheet may be negatively impacted by interest-rate movements.
Risk-based capital requirements are part of the equation, especially for lenders looking to put greater emphasis on commercial lending. Liquidity is another factor, as is the ability to manage the loan-to-deposit and loan-to-asset ratios.
Even though a borrower’s payments may be fixed by contractual agreement, there are still ways to modify mortgage cash flows to benefit the bank. These strategies enable financial institutions to restructure the balance sheet and improve cash flow, while mitigating interest rate risk.
Holding securities created through government-sponsored enterprises (GSE) from the mortgages, rather than holding raw loans in the portfolio, diminishes credit, interest rate and liquidity risk. By exchanging mortgages to GSE-backed securities, the financial institution transfers these risks to Fannie Mae and Freddie Mac. At the same time, the institution continues to earn the coupon on the securities. Other benefits include:
- Improved liquidity: Holding securities provides more liquidity than loans. Should the need arise, securities may be sold with a simple phone call. Selling raw loans may take 90 days or longer. Securities allow for higher borrowing capacity by increasing the availability of collateral for pledging. The Federal Home Loan Bank advances up to 75 percent of the amount of residential loans, but will lend to 95 percent for agency securities. The repurchase market also requires securities for collateral, generally up to 95 percent of their market value.
- Reduced risk-based capital: Holding a security reduces risk-based capital requirements because banks are required to hold 20 percent capital for a security versus 50 percent capital for residential loans.
- Increase current income: Selling loans at par or higher enables the institution to book a “gain on sale,” as well as capitalized servicing rights, while reinvesting at current rates.
- Optimize balance sheet: Transforming loans to securities enables the institution to adjust its loan-to-deposit or loan-to-asset ratio, while providing a ready source of funds for reinvestment to alternative asset classes.
Bi-Weekly Mortgage Loans
Bi-weekly mortgage payments from in-house accounts also offer advantages. With a bi-weekly mortgage, one-half of the regular mortgage payment is deducted automatically from a checking account every 14 days, or 26 times a year in all. By making more frequent payments, the borrower makes what amounts to a 13th mortgage payment, and pays off the debt much sooner. For a bi-weekly mortgage, a loan that normally takes 30 years to pay off will take about 22 years to pay off at current interest rates. The typical bi-weekly borrower is well-organized and understands the value of paying off the mortgage over a shorter time.
Convenience is a major benefit for the borrower. Many consumers are paid every other week, and this lines up well for paying the mortgage that way, especially since the payment is deducted directly from an account at the bank.
Bi-weekly mortgages are a good fit for consumers who wish to build equity in their homes more quickly and want to save a lot of money over time. Loan performance tends to be strong and most lenders report few delinquencies. Lenders solicit for bi-weekly mortgages at point of sale and during the life of the loan and, according to most, the latter approach is more effective at generating volumes.
Solicitation letters are typically simple, one-page documents that illustrate the benefits of switching to a bi-weekly payment plan, including a shorter amortization period, faster home equity accumulation and savings on interest payments.
Lenders generally report a 10 percent positive response rate from mailings. The program is more popular with fixed-rate borrowers, as they’re more likely to be fiscally conservative and inclined to want to pay down their loan.
Lenders charge initial setup fees ranging from $100 to $400 and recurring fees of $1 to $5 per transaction. Other financial benefits include float income, and monthly or annual administration fees. In addition, financial institutions build stronger relationships with their best customers.
When people think of active management, they generally picture a mutual fund manager aggressively trading securities in an effort to outperform an index. For financial institutions, active management means making sure your assets, including mortgage loans, are worked to maximize profitability while maintaining the appropriate level of risk.
Robert B. Segal is a chartered financial analyst and portfolio manager at Danvers, Mass.-based J. William Mantz Investment Advisors (www.jwmantz.com), an investment advisory firm serving more than two-dozen community banks, primarily on the East Coast. “At the Margins” is a regular feature in Banking New York focusing on banking strategies and balance-sheet trends.