By now, most mortgage bankers have come to believe that, if there is a light at the end of the tunnel, it's probably just a truck barreling down on them.

But believe it or not, the 250-basis-point rise in interest rates that created many of the industry's woes in 1994 may correct some of the market's most pernicious problems in 1995.

The situation that mortgage bankers have been coping with boils down to too much capacity chasing too few borrowers. When this happens to a commodity product, whether it's a mortgage or an airline seat, price cutting is sure to occur. The response from portfolio lenders, particularly large California banks and thrifts, was predictable: Irrational pricing became the order of the day.

Having substantially strengthened their balance sheets in the past five years under regulatory pressures, these institutions seemed to have unlimited appetites for portfolio product. Unlike mortgage bankers, who cannot tie up capital in an extended warehouse or portfolio, these institutions could originate an ARM product at less than the secondary market prices, hold it until the roll date, then sell it.

With the rise in yield at the roll date, when the introductory rate expires, the expectation was that the loans could then be sold at break- even, or even at a profit. And the process would then begin again.

The problem with this scenario is that these institutions are suffering from a bad case of tunnel vision in that they only remember the last five years of falling rates. They've failed to take into account the Federal Reserve's stubborn anti-inflation stance, which has dramatically driven rates up and will probably drive them higher still.

Many adjustable-rate mortgages that were indexed to a cost-of-funds measure and are now being held in portfolio have life caps at or near the current yields on 30-year mortgages. Of course, their present yields are a lot lower. These could only be sold at substantial discounts.

The periodic caps could prevent these loans from reaching market yields for a long time. This not only produces a drag on earnings but limits capital flexibility. The averaging feature of the cost-of-funds index will also further delay the time when the asset yield will reach current market levels.

Given the sharp and swift rise in rates, the combination of payment cap and the negative amortization feature will cause substantial increases in loan-to-value ratios. This will certainly produce increased credit risk and will likely lead to increased credit losses. The resulting rise in LTVs, combined with payment shock resulting from the rise in rates, would worsen this problem. For the taxpayers' sake, let us hope that property values hold up, or we could have an extension of the Resolution Trust Corp.'s life.

Clearly, regulators and a large segment of the industry continue to overlook the major inherent flaw in any loan whose rate is based on an average cost of funds. First, if you are lending on an average cost and borrowing on a marginal cost in a rising rate environment, you could be losing money on each new loan.

The second problem with indexed ARMs is that, when rates fall, you don't reap the benefits of wider margins. Theoretically, as rates fall, the averaging effect should keep yields up while funding costs fall. The problem with this theory is that consumers have been so conditioned by past refinancing booms that they will quickly refinance into a current-rate product, either adjustable or fixed. This problem will be compounded as technological innovation drives down origination costs and consequently reduces the cost of refinancing.

From a rate perspective, an indexed ARM is a great loan for the consumer who benefits in a rising rate scenario and refinances in a falling rate scenario. But this loan is a poor product for investors.

Unknowingly, or at least unintentionally, the Federal Reserve may have come to the rescue of the mortgage banking industry. The rapid rise in rates will create illiquid balance sheets at underwater prices, short- circuiting the cycle described earlier. The same institutions are also likely to be punished with increased credit losses.

Combined with a flatter, and possibly an inverted, yield curve, which should lead to consumers' favoring fixed-rate mortgages, price competition from savings and loans is likely to be sharply reduced in coming months. Unfortunately, this will have come too late for many mortgage banks and the many employees victimized by downsizing in recent months.

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