If a long-term matching strategy for funding a mortgage portfolio will not provide reasonable margins in the 1990s, how much interest rate risk should be assumed?

Remember, the long-awaited interest rate risk components of risk-based capital requirements and insurance premiums are still being advertised as "on the horizon."

Certainly, this means that the levels of interest rate risk that can be assumed will be dependent on how much capital is available to put at risk.

Are companies willing to reserve or set aside earnings to compensate capital for interest rate risk taken but no hedged?

Consequently, while the yield curve remains so steeply sloped, a funding strategy of predominantly short-term liabilities for newly originated, fixed-rate mortgages can produce 300 to 500 basis points of gross margin.

Protecting the Spread

Purchasing hedge protection through caps, or with swaptions, or some medium debt, can insulate a significantly degree of the spread for what will probably be relatively longer lived assets than those written during even the past few years.

However, if the market's inflation expectations are trimmed significantly, the yield curve would flatten.

That could still leave a fairly wide short-long spread. In a positive but stable yield curve environment, some significantly level of interest rate risk will be required for profitability.

Today's yield curve relationships are not likely to last indefinitely. While they do, they provide attractive returns for moderate gap risks.

A Matter of Good Business

Knowing how to monitor and measure the risks will be strategically critical. Understanding and utilizing gap, duration and convexity measurements, and running simulation models are simply business requirements.

Knowing the shortfalls in these methods -- namely, just how accurate and meaningful they are -- is equally important.

These tools will not only help to answer the question of how much risk is in the balance sheet -- both on and off -- but will also provide the guidelines to determine if earnings are in line with the levels of risk.

In addition, alternative strategies need to be in readily executable procedures for the time when the longer-run outlook changes.

What about credit risk? Again, the secondary agencies have squeezed out much of the earnings spread owing to this component. Is there sufficient spread left in the nonconforming mortgage markets? How long will that remain, in light of growth of private securitization and of efforts by the agencies to expand the definitions of conforming product?

Managing Credit Risk

These are questions that need to be considered. On the other hand, significant profitable opportunities exist to enter the commercial lending arena of community bankers who are skilled at managing those types of credit risk.

On the retail front, acquisition of prime locations from weak or failed institutions in areas of strategic importance can strengthen the branch network.

A "retail banking" approach in the right areas and with tightly controlled overheads can yield the benefits of local lending and regional clout.

Pay Attention to Customers

Expand the depositor base and build loyalty to achieve the benefits of cross-selling. The No. 1 strategic mission should be customer satisfaction and service.

Institutions will be competitively positioned if they can emphasize a product differentiation based on factors other than price, for example market segmentation, service, knowledgeable staff, or processing speed.

Clearly, to get close and stay close to the customer, management needs to find out what the customer wants; do not assume you know. Again, measuring results is important. Consider how to achieve customer satisfaction, and how to know when it is happened.

Another strategy that may prove beneficial is to invest in technology and automated systems to boost productivity and turnover times, as well as to improve accuracy.

And remember that nonconventional servicing such as adjustable rate mortgages, recourse, and Ginnie Mae mortgages are available at deeply discounted prices.

Thrifts with good collection and foreclosure departments can invest in portfolios with higher than average delinquency rates or potential.

And thrifts that are skilled in asset-liability management and financial planning areas can invest in high coupon and high servicing margin portfolios and then manage the interest rate risk through synthetic products.

Finally, fee-based sub-servicing is a good option for thrifts with efficient, automated operations that can service loans at a cost lower than the master servicer's in-house setup. Capital requirements and interest rate/prepayment risk continues to be borne by the master servicer. Mr. Fletcher is first senior vice president of the Federal Home Loan bank of New York. This is an edited version of a speech he delivered at a conference of the Community Bankers Association of New York State.

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