Mortgage extension risk, driven by rising long term interest rates and other structural factors, is a growing threat lurking in the balance sheets of many mortgage-backed securities investors.

Prudential regulators are also scrutinizing activities related to interest rate risk to confirm that firms under their supervision have sound practices in place for measuring, monitoring and controlling these risks.

During the past few years, many market participants substantially increased their holdings of MBS guaranteed by GNMA, Fannie Mae, and Freddie Mac. A wide range of financial companies hold guaranteed MBS, including commercial banks, investment banks, community banks, insurance companies, credit unions, money managers, government-sponsored enterprises, real estate investment trusts and hedge funds.

The major catalyst for this significant shift was the bursting of the housing bubble, which led to widespread credit losses and erosion of liquidity and capital. This prompted a number of game changing actions, including the unprecedented intervention by the Federal Reserve through multiple rounds of quantitative easing starting in November 2008, which reduced long term interest rates to historic lows. For the week that ended on Feb. 26, the Fed was holding over $2.3 trillion of U.S. Treasury and agency debt securities and almost $1.6 trillion in agency MBS.

Against this backdrop, many of the surviving financial firms had access to funds from very inexpensive, near zero interest rate deposits and other short term funding. However, driven by weaker loan demand, fear of further credit losses and a desire to preserve liquidity and capital, most depositories slowed their non-government guaranteed lending and instead invested their excess cash in the more liquid and safer Ginnie Mae, Freddie Mac and Fannie Mae MBS. The unprecedented economic environment also drove many financial market participants to take on rate risk to boost margins while limiting credit risk. Commercial banks and saving firms held over $1.5 trillion of MBS by December 2013.

The recent period dramatically illustrates the twin options of mortgages, the right to prepay and the right to default.

Mortgage liquidations increased dramatically during this period, driven by record low interest rates coupled with other systemic factors such as massive delinquencies and foreclosures, as well as unprecedented loss mitigation actions and the implementation of less costly refinancing programs. The right to prepay results in an uncertain life for mortgages that have legally fixed maturity dates (e.g. 15 or 30 year maturities). This embedded prepayment "option" is a wild card that is sensitive to interest rate movements and to other factors such as delinquencies, loan modifications, and repurchases. As such, the duration risk associated with these particular instruments must be closely monitored and managed.

The pendulum is now swinging to the other side as interest rates increase and prepayment speeds, especially of guaranteed MBS, are falling precipitously, extending the maturities of MBS. This trend is likely to cause future declines in MBS values. A number of important structural factors are contributing to this development, such as:

  • Rising long term interest rates, albeit with some downward volatility due to risks in emerging markets and geopolitical issues;
  • A steep decline in the number of newly defaulting loans primarily due to improving housing values, stronger underwriting standards of newer loans, loss mitigation and more sustainable mortgages due to refinancing at record low rates;
  • A substantial drop in refinancing activity after multiple refinancing waves.

The dramatic deceleration in MBS prepayments requires particular attention, since it comes on the heels of a prolonged period of fast prepayment speeds. Regulators are concerned that institutional MBS investors grew accustomed to short durations. Less experienced managers may not be sufficiently prepared to swiftly and reliably respond to this momentous pendulum swing in prepayments. Regulated financial institutions such as banks, credit unions and bank holding companies are required by their respective prudential regulators to manage interest rate risk. While non-regulated institutions are not required to do so, most apply varying degrees of hedging to mitigate some of the risk.
A variety of alternative future interest rate scenarios should be reviewed in evaluating rate risk exposure. The array of scenarios should be sufficiently meaningful to identify basis risk, yield curve risk, and the risks of the embedded prepayment option. The scenarios must be rigorous and credible in light of current rates, the interest rate cycle and the steep drop in delinquencies, foreclosures and mortgage repurchases. Firms that leverage third-party models and/or outsourced solutions should also validate the underlying methodologies, assumptions and analytics.

Missteps in identifying and properly responding to these important extension risk factors may take a big bite out of profits and capital.

Alex Kangelaris is the CEO and managing partner at Wall Street Emprises LLC. He has over 25 years of mortgage industry and capital markets experience. Bob Carroll is a college professor and lecturer. He has 30 years of banking and mortgage industry experience, specifically in asset-liability and portfolio management.