FHLBank Pittsburgh Mortgage Asset Management Spring 2005 Seminar Residential Mortgage Loans Hold or Sell? Hold or Sell Page 1
FHLBank Pittsburgh
Mortgage Asset Management
Spring 2005 Seminar
Residential Mortgage Loans Hold or Sell?
Hold or Sell
Page 1
Reasons to make residential
mortgage loans:
• Important customer relationships
• Business opportunity
Hold or Sell
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Once an institution has committed to
making residential mortgage
loans it has two choices:
• Hold the loans
• Sell the loans
Hold or Sell
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Benefits of Holding
• Relatively low credit risk
• Higher yield than MBS
• GSE loans are fungible
Hold or Sell
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Mortgage Servicing Rights
Benefits of holding
Page 5
Hold or Sell
FDIC-Insured Office of
Mortgage Lenders* Thrift Supervision
Net interest margin 2004 3.05% 2.89%
Net interest margin 2003 3.36% 2.90%
ROA 2004 1.18% 1.17%
ROA 2003 1.38% 1.29%
ROA 2001 1.05% 1.07%
ROA 1999 1.03% 0.98%
ROE 2004 11.61% 12.79%
ROE 2003 15.08% 14.29%
* Institutions whose residential mortgage loans, plus mortgage backed securities, exceed 50%
of total assets
Mortgage Servicing Rights
Risks of holding
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Hold or Sell
Financial risks
Interest rate risk
Credit risk
Liquidity risk
Operations risk
Reputation risk
Legal risk
Repricing risk
Basis risk
Yield curve risk
Option risk
Interest rate risk for residential mortgages
• Potential for a gap or mismatch between assetsand liabilities because of the longer term andmarket volatility
• Difficult to estimate prepayment speeds andunderstand the optional component in residentialmortgages
• Be aware of interest rate caps on ARMs
Mortgage Servicing Rights
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Hold or Sell
Option risk
• High coupon residential mortgage loanshave more call risk
• Low coupon mortgage loans have moreextension risk
Mortgage Servicing Rights
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Hold or Sell
FDIC roundtable discussion on IRR management
“From an investor’s perspective, there is a “flaw” in the basic mortgage that is usedhere in the United States: it has an option in it”.
“When you invest in a mortgage, there are three things that can happen-and two ofthem are bad. One event is that rates go up and the value of the loan goesdown. A second event is that rates go down and the customer pays off the loan.A third event is that rates stay exactly the same and you earn exactly what youthought you were going to earn”.
“…asset liability management is an art, not a science. I think you have to look atyour models as a series of tools that help you build a circle around what your realexposures are and what your opportunities are.”
Mortgage Servicing Rights
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Hold or Sell
Managing the risks
• Utilize forecasting models and understand thesensitivity of model assumptions
• Partially fund the longer term loans with longerterm advances◦ Ladder medium term and long term fixed rate
advances◦ Use fixed rate amortizing or prepayment advances
• Use off balance sheet derivatives
Mortgage Servicing Rights
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Hold or Sell
Managing the risks by selling the loan
• 60% of loans originated in 2003 were soldand securitized
• Thrift industry statistics◦ Long term mortgages 31% of 1-4s and 17%
of total assets
Mortgage Servicing Rights
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Hold or Sell
Sales have benefits and risks• Benefits◦ Reduce interest rate and credit risks◦ Generate potential gains
• Risks◦ Reinvestment risk◦ Generate potential losses if the loan sales are not
hedged or loans have been priced incorrectly◦ Potential loss of customer relationships if the loan is
sold servicing released
Mortgage Servicing Rights
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Hold or Sell
Sales decision should be based on abest execution analysis
• Where do I sell?
• How do I sell?
• What is my true economic sales price?
Mortgage Servicing Rights
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Hold or Sell
Where do I sell?
• FHLB
• Fannie Mae
• Freddie Mac
• Correspondent
Mortgage Servicing Rights
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Hold or Sell
How do I sell?
• Cash vs. MBS security
• Best efforts vs. mandatory and hedgingimplications
Hold or Sell
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Secondary MarketingBest efforts cash vs. mandatory MBS security
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Best efforts Mandatory
30 day MBS forward
cash price FNMA price
(SRP excluded) (Feb. settlement)
6.00% loan price 100.994
6.00% loan / 5.50% security price 101.6875
Adjustment for days -0.1319
Price 100.994 101.5556
Difference -0.5616
Note:
The MBS forward assumes a 25 basis point guarantee fee & a 25 basis point servicing fee
Hold or Sell
Pricing components
• Interest rate / coupon
• Lock length
• Guarantee fee
• Contractually specified servicing fee
• Buy ups and buy downs
• Pull-through
• Other adjustments
Hold or Sell
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Secondary MarketingPricing comparison
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Best efforts FHLB - sch./sch.
30 day 20 business daycash price cash price
(separate SRP) (retained servicing)5.875% loan price - $200,000 loan 101.285 101.498
Adjustment for day difference -0.029Fees to investor -0.175 0.000
SRP / Model Servicing Value 1.700 1.200SRP adjustment for non-escrows -0.250 N/A
Volume bonus 0.100 0.050PV of CE fee N/A 0.370
PV of CE obligation N/A 0.000Price 102.660 103.089
Difference -0.429
Conforming Fixed Rate
Hold or Sell
What is my true economic sales price?
• Value of servicing – retained or released
• Value of servicing remittance method
• Value of credit enhancement fee
• Value of credit enhancement obligation
• Value of interest carry on delivery
Hold or Sell
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Retained mortgage servicing rights
• MSRs are a modified interest only strip
• Many types of underlying loans
• Value varies significantly by type ofMSR
Hold or Sell
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MPF credit enhancement fee
• Paid to member for assuming a portion of thecredit risk (credit obligation) on mortgagedefaults
• Determined by the quality of the loans at thepool level and the MPF program selected
• Fee paid monthly over the life of the loans
• Sensitive to prepayments
Hold or Sell
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Credit enhancement obligation variables
• Cumulative prepayment rate (CPR)
• Cumulative default rate (CDR)
• Severity of actual losses
• First loss account
• Obligation cap percentage
Hold or Sell
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Credit enhancement obligation
Hold or Sell
PSA 0.00% 0.02% 0.04% 0.07% 0.15% 0.25%
150 0.51% 0.41% 0.32% 0.18% -0.20% -0.67%
200 0.48% 0.39% 0.30% 0.17% -0.19% -0.63%
250 0.41% 0.33% 0.26% 0.14% -0.16% -0.54%
300 0.37% 0.30% 0.23% 0.13% -0.15% -0.49%
500 0.26% 0.21% 0.17% 0.09% -0.10% -0.35%
700 0.21% 0.17% 0.13% 0.07% -0.08% -0.27%
Annual Losses After First Loss Account
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Value of interest carry on delivery
• Choose appropriate delivery datebased on actual cycle times
Hold or Sell
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Hedging
• An interest rate lock commitment (IRLC) is a crossbetween an option and a forward commitment
• Pricing and risk
• Mitigate risk by hedging
◦ Estimate fall-out on locked pipeline
◦ Control interest rate lock-in agreements
◦ Manage pair-offs and market movement
◦ Prepare mark-to-market and position reports
Hold or Sell
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Fallout risk
• Rate lock does not close
• Borrower renegotiates rate or discountpoints
• Loan closing date is extended
Hold or Sell
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Factors affecting fallout
• Market interest rates• Type of origination• Length of lock• Purpose of loan• Type of loan• Processing status of loan
Hold or Sell
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Hedging methodologies
• Pull-through
• Delta
• Modified Delta
Hold or Sell
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Secondary Marketing
Position and mark-to-market reporting
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Pipeline
Wavg Gain Gain Probabilty
Principal Interest Probability Days to Buy Sell (Loss) (Loss) * gain
Product Balance Rate of Close Close Price Price % $ (loss)
30 YR FIX 3,000,000 5.882% 84% 37 100.50 101.50 1.00 30,000 25,200
20 YR FIX 2,000,000 5.512% 81% 21 100.25 101.30 1.05 21,000 17,010
15 YR FIX 1,000,000 5.289% 87% 25 99.75 100.85 1.10 11,000 9,570
7 YR Bal. 1,200,000 5.127% 81% 30 100.75 101.25 0.50 6,000 4,860
ARMS 1,000,000 4.230% 89% 25 100.10 101.75 1.65 16,500 14,685
Total Pipeline 8,200,000 5.407% 84% 29 100.34 101.37 1.03 84,500 71,325
Hold or Sell
Background on Wilary Winn LLC
• Wilary Winn provides independent, fee-basedadvice to financial intermediaries, includingbanks, credit unions, finance companies, andmortgage bankers.
• Our services include assessments and valuationof complex financial assets, including mortgageservicing rights and credit enhancement feesreceivable, as well as the development andimplementation of interest rate risk managementprograms.
Hold or Sell
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Wilary Winn LLC
First National Bank Building
332 Minnesota Street, Suite W-1420
St. Paul, MN 55101-1314
651-224-1200
Frank Wilary [email protected]
Douglas Winn [email protected]
Hold or Sell
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