The Federal Reserve Board has proposed regulations to establish capital requirements for interest rate risk. The Mortgage Bankers Association has advised the Fed to make some changes in the proposed regulations. Following are excerpts from the MBA's comment letter.
Servicing--Of significant concern to MBA is the use of modified duration for measuring the value of mortgage servicing rights. Duration-based models are designed to measure the volatility in market values for bonds; duration of "x" implies that for a 100 basis point shift in the yield curve, the market price of the particular bond, will move "x" percent in the opposite direction. Unfortunately, this duration measurement fails to properly track changes in the value of servicing assets resulting from movements in interest rates. Servicing reacts similarly to interest only strips (although they do not have identical properties). As interest rates rise, the value of mortgage servicing rights increases because prepayment speeds on the underlying loans decrease. The opposite occurs in falling interest rate environments due to refinances. Unfortunately, the model as drafted would not recognize that mortgage servicing acts as a hedge against fixed-rate loans held in portfolio, inventory or traveling in the pipeline. To properly reflect the interest rate risk associated with on-balance sheet servicing rights, the methodology must incorporate the proper estimation of negative duration of servicing.
As mentioned earlier, if interest rate risk for on-balance sheet servicing is taken into consideration. we believe it is imperative that risk-based capital "credit" weights be reduced to 50% from 100%, which corresponds with the weights assigned to the underlying mortgage assets. Our rationale is that by incorporating interest rate risk of servicing, PMSRs and ESFs as assets on the balance sheet will have no more credit risk than the underlying mortgages.
Off-balance sheet servicing, however, should not be incorporated into the IRR calculations unless its value is recognized as an asset that increases capital. Currently, accounting rules do not provide for mortgage banking enterprises to recognize the value of originated servicing on their balance sheets. As a result, originated servicing does not pose a "balance sheet exposure" to the bank and never pose a balance sheet risk even if the servicing is sold. It is inequitable, therefore, to require a bank to (and potentially hold capital) against an asset that has no value for net worth purposes.
Mortgage Pipeline and Inventory--The regulation instructs banks to report off-balance sheet activities, such as futures contracts, forward-rate agreements, and firm commitments to buy and sell mortgages. However. the proposal does not specifically include the amount of mortgages to be originated or closed. It is our understanding, however, that the agencies have considered including a reporting requirement for mortgages in the pipeline. We believe this inclusion is necessary to offset lenders' mandatory into the secondary market. Without inclusion of the mortgage pipeline, banks will show greater risk than is actually present and will be encouraged to hedge their pipeline improperly.
Unlike loans held in portfolio, the risk of loss associated with a mortgage pipeline occurs when rates are dropping and loan prices have been guaranteed by the mortgage company. When rates drop, more borrowers "fall out" in anticipation of lower rates, leaving the lender with an insufficient number of closed loans to deliver under a mandatory delivery commitment. As a result, the lender will have to pay "pair off" fees on all or part of the mandatory commitment. Fallout, therefore, is the key factor that contributes to interest rate risk in the pipeline.
Without the inclusion of mortgages in the pipeline, the draft assumes that no loans close in a rising rate environment, causing the company to pair off. Likewise, in a falling rate environment, the agencies' proposal assumes that zero loans close, again causing the bank to pair off. Of course, in reality this is not the case. More mortgages will close as rates rise and companies will adjust their mandatory and optional commitments to sell the loans to the secondary market agencies.
To develop a workable interest rate risk strategy, MBA believes that, at a minimum, the following concepts should be considered:
* The agencies should recognize mortgages in the pipeline to offset the hedge instruments reported.
* The agencies should allow banks to report loans in the pipeline on a net basis (i.e. after fallout). Fallout assumptions would be based on the company's historical experience. A company specific fallout number is extremely important, given variations among companies in their product mix, ability to recapture borrower fallout and wholesale versus retail fallout experience. For example, some of the commitments, particularly in the wholesale business, are delivered on a "best efforts" basis. Unfortunately, it would be uncertain as to how that type of commitment would be traded. If a company had an outstanding commitment to acquire $10 million worth of mortgages on a best efforts basis and their experience would indicate a 25 percent fallout, the mortgage company should report the commitment as $7.5 million. Historical fallout could be verified during examinations. This appears to be reasonable considering that the agencies have indicated that examiners will review management capabilities as part of their interest risk assessment of an institution.