A rising interest rate scenario could lead bank mortgage lenders back to the securitization markets, a paper from Fitch Research hypothesizes. The combination of rising rates and slowing prepayments might expose liability-sensitive banks to repricing risks and net interest margin compression.
This reduces their incentive to retain long-term, fixed rate mortgages on balance sheets. Securitization, Fitch said, "enables mortgage originators to transfer interest rate risk to investors with a preference for long duration assets, such as pension funds and insurance companies."
On the other hand, the paper also notes that if higher mortgage rates have an effect on housing affordability, lenders are more likely to offer adjustable-rate mortgage products that banks would keep on their balance sheets.
"An important obstacle to the growth of floating-rate mortgages in the U.S. is that interest rate risk would be transferred from originators to borrowers, which runs counter to the current public policy focus on mortgage product simplicity and consumer protection," Fitch said.
There is also a comment on the mortgage interest tax deduction and how it could affect housing affordability. Fitch said "The reduction of tax benefits, for which we have no recommendation for or against, might depress home prices for higher income borrowers in the near term, but also encourage lower debt levels in the future."
Sluggish home value movement poses a lingering challenge to the credit performance of mortgage loans. Diminished expectations of home price appreciation among consumers could promote positive selection for lenders of higher quality, stable borrowers and reduce incentives to speculate, helping to mitigate credit risk.
But, the report continued, reduced speculation and lower housing market activity might slow prepayment rates. "Slowing prepayments in a mortgage market dominated by 30-year fixed-rate obligations pose clear interest rate risks (i.e. negative convexity), particularly if rates continue to rise," Fitch said.
