Does your credit union originate single-family, fixed-rate mortgage loans and sell them in the secondary market? If so, why? Credit unions that sell their loans may have different reasons for doing so. Understanding the reasons your institution sells its loans is important, because it can help you determine which secondary market outlet can best help you meet your goals.
CUs face three major risks when they retain single-family, fixed-rate mortgage loans in portfolio: interest rate risk, prepayment risk, and credit risk. For most credit unions, mitigating one or more of these risks is the main reason they choose to sell their single-family mortgage loans. Let's look at each of these risks individually.
Interest rate risk is the risk that a change in interest rates will adversely affect the value of a credit union's fixed-rate mortgage loan portfolio. If interest rates rise, the fixed coupons on the mortgages will not adjust to new market rates. Consequently, spread income may fall if the liabilities funding the mortgages adjust to higher rates. Hedging the interest rate risk of mortgage loans can be very difficult and costly.
Next, there is prepayment risk, which is the risk associated with a member's option to prepay the mortgage note in its entirety ahead of schedule. Usually this is a free option for the member. While the loan might have a 30-year stated term, it is extremely unlikely that the mortgage will last until maturity.
In today's environment, not a day goes by without your members receiving solicitations about new mortgage products aimed at lowering the monthly payment on their existing mortgage loans. If interest rates drop, even by a quarter of a point, your members may look to refinance their loans at a lower rate. Your credit union may have made a loan with an expectation that it would remain on the books for at least seven to 10 years, if not longer. If the loan prepays before maturity, it may be difficult for your credit union to find another investment with similar returns or fund a new mortgage with a similar coupon to replace it.
In general, downward movements in interest rates will prompt your members to refinance. But prepayments can be driven by other factors besides the movement of interest rates. Your members may prepay their mortgages even when rates are higher. For example, your members may decide to refinance because they want to cash-out a portion of the equity from their home's value. They might also prepay when being forced to sell the home due to job loss, divorce, relocation, or a death in the family. Due to the unpredictable nature of mortgage prepayments, it can be extremely difficult for credit unions to successfully hedge against prepayment risk.
The third major risk involved with mortgage lending is credit risk, the risk that the mortgage obligation will not be repaid and that a loss will occur upon foreclosure. Credit unions seem to be competent in managing this risk. Think about the last time your credit union experienced a credit loss in its single-family mortgage portfolio. Can you even remember the last time your CU lost money due to a member defaulting on a mortgage loan? Whether it's superior underwriting skills or possibly their cooperative nature, credit unions have some of the lowest levels of mortgage lending credit losses in the housing finance industry.
Question Remains
After reviewing the major risks associated with retaining fixed-rate mortgage loans in portfolio, the question remains: Why is your credit union selling its single-family mortgage loans? If credit losses are minimal, are you most concerned about interest rate and prepayment risk?
If your CU is selling its loans to reduce its exposure to all three of these risks, you may already be selling to one of the two largest buyers of conforming mortgage loans, Fannie Mae and Freddie Mac. They both have numerous programs for purchasing mortgage loans and relieving sellers of all three of the major risks discussed.
If your credit union is comfortable with sharing the credit risk of mortgage loans, but is looking to reduce interest rate and prepayment risk, you may want to consider an alternative buyer, the Federal Home Loan Banks (FHLBanks). The FHLBanks have programs for purchasing conforming fixed-rate mortgage loans. These programs, which distribute the credit risk of a mortgage between the seller and the buyer, may provide a pricing advantage to credit unions when compared with other secondary market investors. A FHLBank will purchase the loan from your credit union and relieve the credit union of most interest rate and prepayment risks associated with holding the loan on the balance sheet. When it comes to credit risk, the credit union and the FHLBank structure a credit sharing arrangement.
By retaining a portion of the credit risk associated with the loan, the credit union benefits from a potentially better price for the loan plus a monthly credit enhancement fee from the FHLBank. In addition, your credit union is not charged a guarantee fee, which typically averages approximately 20 basis points. Fannie Mae and Freddie Mac average guarantee fees charged were 20.2 and 22.0 basis points, respectively, based on 2003 Fannie Mae and 2002 Freddie Mac financial reports.
Once you determine whether your credit union wants to accept all, some, or none of the continuing risks associated with mortgage assets, you are ready to answer the next question: which counterparty offers a program that fits my credit union's preferred risk tolerance? If you want to eliminate all three risks, there are some established buyers for your loan products, including Fannie Mae and Freddie Mac. If your credit union determines that credit risk is manageable, it's important to seek secondary market partners, like the FHLBanks, that can reward you for your credit expertise.
Steve Cibull is Assistant Vice President, Federal Home Loan Bank of San Francisco. A seminar on the profit opportunities in the residential mortgage market is set for June 9, 2005 at the San Diego Marriot Hotel and Marina. To register, call 415-616-2757.
