Economic conditions and regulatory pressures have conspired to drive banks into mortgage lending and away from traditional commercial and consumer lending.

As a consequence, bankers are now facing the same interest rate risk that periodically decimates the thrift industry.

Bank mortgage portfolios have grown to $400 billion, from $199 billion in 1985, and holdings of mortgage-backed securities have risen to $157 billion from $25 billion.

We have seen individual regional banks grow their mortgage portfolios to 25% of assets or more.

Quest for Higher Yields

Why have bankers jumped into mortgage lending? The contributory factors vary widely. They include regulatory pressure on commercial lending, a dearth of other consumer borrowings, low capital requirements, a flood of refinancings, and - perhaps most important - a search for higher-yielding assets.

These factors have driven bankers to lust after the mortgage business they had long shunned.

Just how much risk are bankers taking?

No, bankers aren't repeating the thrift experience of the early 1980s. No one is funding 30-year, fixed-rate loans with six-month CDs.

But many banks have experienced rate risk even in the relatively benign rate environment of the past year, as mortgage securities have unexpectedly prepaid.

As customers prepay the underlying mortgages to take advantage of market conditions, mortgage securities have been disappearing from bank balance sheets.

Many bankers were faced with large volumes of cash that could only be reinvested at lower rates.

'Effervescing' Premiums

Institutions that purchased securities at a premium got an even nastier surprise. They were forced to write off premiums immediately as the underlying securities prepaid.

One of my clients commented that he was seeing his premiums "effervesce" - and was taking a direct hit of nearly 10 basis points to current income.

This is rate in a declining rate environment, and it is difficult for all but the most sophisticated institutions to hedge against.

When - not if - rates start going up, bankers will see their net income decline even though they hold adjustable-rate mortgages. If we experienced a 250 basis-point increase in one-year Treasury rates over six months (mirroring the decline in 1991), capped adjustable-rate mortgages would not catch up to market rates for 18 months.

Cold Comfort for Lenders

Yes, ARMs will eventually recover if rates stabilize, but that is cold comfort while earnings and market value languish.

These risks are compounded by the nearly invisible pipeline risk overhanging mortgage originators. If rates rise and consumers exercise their option to fund loans now in the origination process, literally billions of dollars in new mortgages will suddenly hit the balance sheet.

Many of these loans will be fixed-rate mortgages, booked at below-market yields. Even though bankers believe they are originating fixed-rate loans only "for sale in the secondary market," a sudden spike in rates will leave those with unhedged pipelines facing an unpalatable choice between holding low-yield loans or selling at a loss.

Comptroller's Perspective

Mortgage-related risk is attracting the attention of both the Office of the Comptroller of the Currency and the accounting community.

At one of our regional bank clients, the Comptroller's office undertook a full-fledged "audit" of the rate-risk management process. The examiner focused specifically on the mortgage portfolio, and demanded precise information on prepayment assumptions and cap exposure.

What kind of information? "How rapidly did the bank's mortgage portfolio prepay this year? How is that factored into your assumptions for the coming year? How much will period caps cut your margin in a 200-basis-point rate shock? What is your estimate of the basis risk between your cost-of-funds-index ARM portfolio and your liabilities?"

Even though the bank passed the "audit" with flying colors, it had to scramble to answer these questions, and the examiner made it clear that there would be more questions in the future.

The accounting community is addressing many of the same issues through FASB 107.

Largely ignored in the business press, this rule of the Financial Accounting Standards Board will require disclosure of the market value of large-bank balance sheets for calendar 1992. Should rates rise by year-end, the disclosures could be very embarrassing for the banking industry.

Key Questions

What can we do to manage this risk? Back up the industry's investment in mortgages - more than $500 billion - with a commensurate investment in aggressive asset/liability management.

Bank management must have answers to these key questions:

* Do we fully understand the risks inherent in our mortgage portfolio?

* How much will periodic and life caps reduce our income in a rising rate environment?

* Will rising rates dramatically slow prepayments? If so, should we change our funding mix?

* How are we hedging our pipeline? At what cost?

* How much of this year's income is due to declining rates?

* What should we tell our investors to expect next year?

* Are we just measuring our rate risk or actively managing it?

Leading financial institutions are investing heavily to answer these and other key rate-risk questions.

Veteran mortgage portfolio managers such as the Federal Home Loan Mortgage Corp. are replacing their old modeling systems.

Household International, the parent company of Household Finance Corp., also recently announced the purchase of a powerful new system.

These key institutions are building a technological edge - before rates begin to move.

Beyond simply modeling risk, other major banks are moving aggressively to hedge their earnings in the event of a rate spike.

KeyCorp recently announced plans to implement a rate-swap program for the first time. The bank has set a publicly stated policy limit on maximum acceptable rate risk and is commiting the necessary resources to control its risk through swaps.

This may prove to be an expensive choice in the current rate environment, but KeyCorp has decided to pay an "insurance premium" now rather than put its income at risk.

Get the right tools, identify your rate risk, set a policy limit, and insure against any excess risk - these ideas may seem painfully obvious:

However, at a time when cost control dominates bankers' thinking, investments in the future tend to be shortchanged.

It may be difficult to justify an investment in new technology or hedging programs now, but it will be less painful than trying to explain their absence to your stockholders during the next rate spike.

If you have invested in mortgages, invest in rate-risk management.

[Mr. Reich is a principal of Treasury Services Corp., based in Santa Monica, Calif., a provider of management information technology to financial institutions.]

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