Managing the Cycles of Mortgage Banking
Mortgage banking activities have been in the headlines for the past several years. The lowest interest rates in 40 years have spurred a record number of refinancings and a red-hot home sale market. The surge in refinancings has caused prepayment volumes for existing mortgages never before imagined. According to the National Association of Realtors, houses sold at an annual pace of 6.48 million units in March. That rate is 5.7 percent above Februarys rate and 12.7 percent above sales in March 2003.
A mixed blessing
The impact on financial institutions has been mixed. Net interest margins have declined as excess cash flows from prepayments of mortgages have been reinvested at lower rates. Institutions with large servicing portfolios have absorbed significant impairment chargesadjustments that recognize the loss in value of an asseton mortgage servicing rights (MSRs). Institutions with large production capacity have capitalized on the record production levels with dramatic increases in origination fees and secondary market gains. However, as refinancings have slowed recently, several large mortgage players have lowered their earnings expectations.
Managing the ups and downs
Mortgage banking remains a difficult business to manage. Rising
market rates create lower demand, but portfolios have to be
adjusted carefully because the trend eventually reverses.
Maintaining the personnel and the physical resources required
at any given time in the cycle is a careful balancing act
that requires skill, experience, and organizational support.
Several challenges face the mortgage banking industry:
- The business will continue to be highly competitive, and further consolidation is likely.
- Accounting remains a major challenge. Recent clarification of financial accounting standard FAS 133 (dealing with the treatment of rate locks and MSRs in the pipeline) and initiatives targeted at eliminating the FAS 140 (which requires the capitalization of the MSR and the recognition of current-period earnings) LOCOM ceiling on impairment charges are evidence of attempts to bridge the gap between accounting and economic values and make both asset valuation and hedging more transparent. (LOCOMlower of cost or marketis an accounting method used to establish an assets dollar value; the amount established is the lower of the cost of the asset or the current market value.)
- Financial markets demand higher returns to compensate for income volatility. Profit margins are thin, and economies of scale are necessary for reasonable returns. Even for the most significant market participants, identifying appropriate limits, controls, and exposure represents a significant challenge.
- Accurate valuation and hedging of the MSR asset are difficult but necessary. Instruments that protect an assets value are not currently available in the capital markets, and thus it is difficult to guard against that assets possible decline in value with a high degree of confidence.
- Technology will continue to transform the business. Prepayment and pricing models are subject to risk, as are interpretations of model outputs used in management decision making.
By Trent W. Cowsert, John Kolb, and Leslee Martin, Supervision and Regulation