By Emilian Belev
Special to MPA
Major risks are a byproduct of the crisis
With the end of the blissful go-go days of an ever-rising housing market and ever-prime mortgages, the notion of risk has become our close companion. For several years, risk has been a recurring theme in numerous articles and discussions in the media. Surprisingly, the result of all this publicity was not better risk awareness, as the hopeful would think. The single artifact of the risk polemic was the stigma on mortgage professionals as the main culprits for the crisis. The lessons learned and risks uncovered for the industry as a whole quickly bleached out from the chronicles.
With easy money, tailwinds in the housing market, and a complex regulatory environment, the lessons from the mortgage crisis are more critical than ever before. The author – an investment and mortgage professional with risk management close to heart – set out to collate the elements of risks that anyone reading these lines should be concerned with. The assumption is that the reader belongs to one of several groups – investors, lenders, borrowers, or the miscellaneous in-betweens including brokers, originators, and servicers. Each of these groups represents a different vested interests and, consequently, risks. The relevance of a particular risk to a certain constituency is not set in stone, and market forces dictate that each participant be mindful of the interests of players up- and downstream. In short, read what is labeled relevant for you, and then read twice what is relevant for your suppliers and clients. The first will hopefully give you the comfort that to an extent you may already be aware of the risk that your business faces directly. The second will put you in the mindset of your counterparties and help position your business more competitively.
Investors are conventionally thought to assume the most prominent risks in the mortgage market. This built-up and accessible understanding provides a convenient starting point.
An obvious type of uncertainty of mortgage investments is related to future shifts in interest rates. Once having their capital tied up in a fixed-rate mortgage, investors would be concerned if interest rates rise, as it is an opportunity cost of lost profit to them, and an explicit drop in value if they need to liquidate the mortgage prior to maturity. The latter would occur due to the higher discount interest rate in the present value of the future fixed cash-flow stream. On the other hand, investors in adjustable rate mortgages tend view favorably an increase in the market interest rates as it entails an increase of their cash inflow.
Conversely, a decrease would be seen as disadvantageous. The ultra-low interest rate environment cannot persist in the future, so one could assume that, currently, fixed-rate mortgages put investors at higher interest rate risk than adjustable rate mortgages, as rates have little room to move further down, but have much higher leeway and likelihood for an upward move. A loss-compounding effect occurs due to higher sensitivity of mortgage market values to shifts in the interest rates in a low-interest-rate environment – a quirk of the math of the mortgage value calculation.
The rise or fall in a certain market interest rate (e.g., the 30-year treasury rate) might not necessarily entail a rise or fall in the reference rate for the mortgage (e.g., a 15-year mortgage). Also, a mortgage investor in a collateralized mortgage obligation (CMO) consisting of different tranches should be concerned with the risks specific to his tranche, which might actually be contrary to the general rule if the interest rate applicable to the particular tranches moves in direction opposite to the market reference rate. Another nuance in the general rules has to do with the reset period of an adjustable rate mortgage (ARM). While it is thought that a rise in market interest rates does not cause a drop in the value of ARMs because they "adjust," this may not be the case if the shift in market rates happens to be in the middle of an extended period over which the ARM rate does not change by contract. In all of these cases, specifically tailored risk calculation tools are required to properly gauge potential losses.
Another defining risk of mortgage investments is prepayment risk – the potential of borrowers to pay back prematurely the balance of their loans. The reason for prepayment is the ability of borrowers to refinance at lower market interest rates. Prepayment curtails the upward potential of mortgage value when market interest rates drop. Prepayment risk concerns predominantly fixed-rate mortgages, as adjustable-rate mortgage interest rates would tend to adjust with a drop in the market interest rates. But similar to interest-rate risk, the longer the reset period of an ARM, the higher the potential that mortgage value is affected by prepayment.
Due to downward pressure on interest rates, recent refinancing activity has been extremely high, but not likely to continue with the same intensity. First, monetary authorities might soon be scaling down stimulus as the general economy picks up pace, taking up with it market interest rates. Second, any prolonged period of low interest rates produces lower and lower prepayment over time, as the pool of borrowers that refinance gets reduced by the number of people that already have taken advantage of the low rates – a phenomenon known as "burnout."
Reinvestment risk adds to prepayment risk as insult adds to injury. The returned mortgage capital will seek new investment returns in a lower interest rate environment, which, generally, spells lower profitability. The recent period of unprecedented low interest rates, however, indicates that there are exceptions. The increased base of borrowers drawn into refinancing due to extremely low rates, combined with lower cost of capital to investors (easy Fed money), dominated the lower mortgage rate effect, resulting in record profits for the mortgage business, prominently exemplified by the reported net income of institutions like Well Fargo and JPMorgan Chase. Given the belief in future rate increases, this type of windfall profits is not likely to persist.
The last risk in this group is on top of many minds as soon as the notion of investor risks springs up. We put it last not because it is minor, but to have it resound more memorably. This is credit risk, also known as default risk.
Credit risk has three aspects that, in conjunction, determine the potential of a borrower to repay as agreed. These are often referred to as the three "C"s of credit – character, capacity, and collateral. The first "C" – character – takes its name from the borrower's moral character to honor loan payments. The usual gauges for character are credit history, available from one of the major credit bureaus, and credit scores that quantify the quality of a borrower's character. Historically, credit scores have shown good predictive ability of borrowers' defaults, but oftentimes they are perceived to adjust too slowly, or be affected too significantly by minor events in the borrower's history. Despite these shortcomings, they remain the primary measuring tool at the hands of lenders and, by extension, investors in regards to a borrower's character.
The default potential is also determined by the borrower's capacity to repay. Capacity is synonymous with the means to service a loan of particular size. Consequently, it is determined by income, net worth, and assets available. Sources of this information are employment records, bank accounts, financial statements, and other independent attestations to a borrower's income, net worth, and assets. This information is not directly available to investors; they depend heavily on lenders’ good will for all the due diligence in this respect.
The final and most elusive "C" of credit is collateral. Collateral is what stands as the last resort of redemption to the investor, if character and capacity fail. Certain experts even give collateral top importance to default behavior. Their view is that a borrower would necessarily default soon after the value of collateral property drops below the amount owed on the loan. This is known as "ruthless default." Empirical evidence supports this type of behavior to some extent, especially in cases where the difference between the loan balance and the collateral value is substantial. The more "underwater" a property is, the higher the chance that the home loan borrower will hand over the keys to the lender and walk away. Therefore, the proper valuation of collateral is a crucial aspect of credit risk management. Having reliable and professional appraiser counsel is indispensible for this purpose.
While "capacity" is the trigger of the sub-prime mortgage mess, "collateral" acted in a subtle way to perpetuate and exacerbate the crisis. As borrower capacity came under question with many subprime defaults surfacing, values of properties were pushed down due to foreclosures. This depressed the valuation of real estate collateral in any further rounds of loan origination, causing tighter credit, more depressed property values, and defaults on heavily "underwater" properties. These feedback relationships created a powerful downward spiral of depressed lending and depressed real estate values slumping to levels not possible with compromised borrower capacity alone.
Another pitfall of investors was the assumption that geographical diversification of loans meant actual diversification of mortgage risks. While over the long run investment returns of residential real estate in different regions are not very highly related, in a crisis like the recent one, the magnitude of borrower capacity problems in certain regions questioned borrower capacity everywhere. The ensuing "lower lending → lower house value" downward spiral made the pervasiveness of the problem worse. A big number of non-performing loans and depressed real estate collateral values caused mortgage-backed securities – typical collateral in overnight interbank lending market – to plunge in value, prompting banks to scale down lending across their full portfolio, including business and consumer lending, due to sheer short-term illiquidity. Financial institutions that were low on cash or heavily invested in mortgage-backed securities did not survive. Others were bailed out by the government, which deepened the budget deficit and increased public debt and macro uncertainty. This "sum of all fears" resulted in an economic slump and higher national unemployment that further eroded borrower capacity, added another dimension to the downward spiral, and made collateral values and defaults everywhere highly correlated.
These powerful dynamics were called "black swans" by financial statisticians, due to the rareness of such events. Risk managers named them "tail risk," alluding to both the low frequency and high magnitude of the events. Regardless of what we call them, a lesson learned from the crisis is not to take the low correlation between markets for granted, but apply robust risk models that will unravel high correlation when it matters the most – when losses are compounded across the portfolio.
Borrowers and long-term lenders (i.e., investors) are the counterparties to the same transaction, so their risks should be highly related. In some cases they face same predicaments, and in others, they meet their highest risks in diametrically opposite scenarios.
Similar to investors, borrowers face interest-rate risk. For borrowers, however, the disadvantageous interest rate movements are opposite to investors'. Borrowers of fixed-rate mortgages would have missed an opportunity when interest rates drop. Borrowers of ARMs would welcome a decrease in interest rates that lowers their payment. A pre-crisis variety of ARMs offering a teaser initial rate was loaded with risk, as teaser rates quickly adjusted to higher levels, leaving borrowers with much larger mortgage payments than initially expected. An extreme version of these loans called for negative amortization, which is the accrual of additional loan principal due to the teaser payment (calculated with a fictitious interest rate) falling short of the actual interest charged. These contract clauses were often overlooked by the unsophisticated public eager to make quick returns in real estate. The severity of this interest rate risk was so high that it impacted borrowers' capacity to repay such loans, and translated into credit risk.
Unlike interest rate risk, default risk to borrowers aligns in the same direction as default risk to investors. Borrowers’ direct loss in default is limited to their equity in the property. Yet, this does not guarantee that a borrower will walk away from a mortgaged property, once it goes "underwater." The turmoil of foreclosure and tarnished credit is a strong motivator to keep up with mortgage payments.
A drop in collateral value could prompt a default, but only if the borrower believes that the value would not recover and will further deteriorate. The perceived future loss should be sufficiently big for the borrower to accept the hurdle of abandoning his home. If the property was purchased for investment purposes, this hurdle is nonexistent, and the entry into "loss-cutting" default mode is quicker.
Mortgage professionals that link borrowers and investors take on a number of roles – mortgage brokers, bankers, portfolio and wholesale lenders, and servicers. Intermediaries' source of revenue is fees, not long-term capital appreciation and interest, which gives them a different perspective on risks. They are often seen as a hybrid with lenders, as some put up capital to finance the mortgages they originate until they are sold. This, however, is distinct from the role of the long-term mortgage investors, and we should think of such short-term lenders as intermediaries, because their risks are similar.
This thought has been confided to me by otherwise well-informed mortgage professionals: "Why should we be concerned with mortgage risk? I make the mortgage today, and in a few days I don't own it anymore. " The flaw in this logic, uttered not only by one and not only once, is in large part the reason for this article.
The fact that intermediaries make their living by assuring transactions between willing borrowers and lenders, makes them sensitive to the same risks faced by borrowers and investors. The alternative is shortsighted and short-lived ventures of amateurship and fly-by-night outfits. The more financially viable the borrowers, the higher the demand. The more financially viable the investors, the better supply and lower the cost of capital. The more clients and better supply, the higher the closings, and your fees. Imbalance on the demand or supply side will equally affect your bottom line – in a downward direction.
Sustainable business opportunities are unclear unless one understands the economic forces that shape the financial wellbeing of clients and suppliers. Spending an advertising budget where real estate collateral values dip, or a major employer closes up shop, won't be much of an investment. Betting business on refinancing, after a prolonged period of low rates and an increasingly hawkish central bank, won't be much of a bet. If low closing and high default due to inadequate credit quality plague supposedly prime loans that you refer to lenders , you won't be getting the best terms from that lender in the future, or you could be forced to repurchase bad loans. Under recent regulation, you could be required to keep a percentage of the mortgages you sell upstream on your books, as "skin in the game." Likewise, loan servicers' stream of continued fees will depend on loan credit performance and prepayment, just like investors will depend on the stream of underlying cash flows. In these cases, you better keep your investor-risk hat on. These are all examples how understanding the end-to-end mortgage market risks is key to a viable mortgage intermediation business.
Consequently, all the risks in the mortgage environment can be viewed as direct risks to the intermediary. A seismic shift in monetary policy would spell a return from the refinancing binge to the run-of-the-mill days of home purchase financing, requiring new strategies. The increase in collateral values and the stabilization of major financial institutions will precipitate the comeback of private capital to the mortgage market, creating new opportunities for intermediaries, in part offsetting the effects of the monetary tightening. If, however, the economy sputters in its recovery again, a continued monetary support could flare up inflationary expectations, nominal interest rates, and the cost of debt, which, perversely, is what monetary policy aimed to reduce. A thorny macro recovery could delay recovery in the housing market, depressing home buying and refinancing, and suppressing mortgage business growth.
A major risk to mortgage intermediaries is a byproduct of the crisis. The often-depicted image of borrowers as innocent victims of the lending pros' ruthless practices has created a sentiment and regulation biased towards consumer protection. In this environment, intermediaries and lenders are under the threat of lawsuits unless their origination and servicing fall under a narrow set of regulations, initially proclaimed in the Dodd-Frank Act, and recently implemented as the Qualified Mortgage (QM) and Servicers rules by the Consumer Financial Protection Bureau (CFPB). The QM rule gives grounds for borrowers to sue lenders in all but a few cases that conform to "safe harbor" provisions, which put constraints on lending and mortgage intermediation.
Simultaneously, the QM rule makes some notable exceptions from the safe harbor requirements for loans made to Government-Sponsored Enterprises like FNMA and FHLMC. This creates an artificial competitive advantage for intermediaries that carry the GSE seal of approval. This also shifts credit risk to taxpayers, due to government guarantees implicit in GSEs. The QM rules and the new Servicers rules impose higher operating costs to intermediaries, eliminating the "no-doc" and "low-doc" loans and introducing new procedures and record-keeping requirements for both paying and delinquent borrowers.
These profound changes in the regulation landscape are more than a hint that government involvement will continue to morph the mortgage business environment, representing one of its major uncertainties. These uncertainties, however, are also an opportunity for mortgage professionals to have their voice heard and support regulations tomorrow that are better than those yesterday, regulations that embed lessons learned from the crisis, without stifling the entrepreneurial spirit and homeownership in America.
To dispel the air of risk, gloom, and danger, we finish on a positive note. Understanding mortgage market risks represents a unique opportunity for the astute mortgage professional. Nothing will better demonstrate your ethical stance and professionalism to your clients than educating them about mortgage risks and the measures and options to manage those risks. With low sophistication and no robust tools at their disposal, gauging mortgage risks on their own is an impossible task for borrowers. If part of your offering is an overview of how the loan options you suggest meet the requirements of the client's risk profile, this will only help your professional image stand out, and nurture long-term client relationships and referrals. Likewise, a demonstrated commitment to risk-managed loan origination, a disciplined prospect pre-evaluation process, and orderly documentation will promote your status with wholesale lenders and mortgage investors as a cost-efficient source of quality loan opportunities that warrants better terms and expedient closing.
For portfolio and wholesale lenders, risk management has an even clearer impact on the bottom line, both in terms of profitability during the loan-holding period, and in terms of resale price in the secondary market. Mortgage investors risk their capital in the long run, so they will be benefit the most from having a better idea of the risks of a particular mortgage pool they purchase. If the loan package they buy from a mortgage banker or portfolio lender comes equipped with better information on the risk profile of the mortgage portfolio in a format compatible with investors risk management practice, it will reduce uncertainty to investors, their risk-management costs, and consequently, the discount they require on the loan portfolio price.
One might view advertising the risks of something they sell as a questionable sales technique, but, especially after the mortgage crisis, investors are aware that that not knowing the risks is the same as taking the highest risks; so, in effect, the added risk information decreases investors' uncertainty level, and makes their assessment of the mortgage pool more favorable. This all demonstrates that the risk information that ripples from the level of the simple borrower through various levels of intermediation, and ending up with the investor, benefits everyone along the way, reduces the cost of doing business, and diminishes the systemic dangers to the industry. As such, it represents a paradigm shift that we, as mortgage professionals, should pursue vigorously.
Emilian Belev has extensive experience in the financial risk management area. He is a holder of the CFA Charter and the Certificate of Advanced Risk and Portfolio Management. Emilian heads the Enterprise Risk Analytics research at Northfield Information Services and is founder of the mortgage risk consultancy BorrowMind.com. Over his career, Emilian has pioneered several innovative methodologies for pricing mortgage products and mortgage investment vehicles, as well as new methods for the assessment of their risks. His personal interests are in pro bono work with educating the public about the risks of mortgages and residential real estate. This prompted him to create the BorrowMind.com web service at the height of the real estate bubble and mortgage craze, in clear recognition of the ongoing excesses and risks on the horizon. He would be glad to hear your questions, thought, and comments at firstname.lastname@example.org.