In June of 2021, the 10-year treasury sat just under 1.50% and mortgage rates were in the 3% range for many borrowers. Housing prices were soaring and financial depositories across the country were dealing with margin compression as investment options felt limited with interest rates hovering around all-time lows. Institutions grappled with challenges on pricing loans that may hang around for a longer period than expected as borrowers may seek to hold onto their low mortgage rates for as long as they can. Shorter duration assets like auto loans were being priced aggressively to generate some form of spread over the risk-free rate and generate profits.

Fast-forward one year to current day and a very different environment. Interest rates are substantially higher, and many assets originated last summer are now at substantial discounts – some also with significantly longer expected average lives. Despite the nominally low interest rates, institutions who hedged those assets are not as concerned about either the interest rate risk or their profits as they properly capitalized and funded those assets for the long term.

Today, hedged and funded on the run mortgage loans look very attractive in a risk-adjusted return on capital (RAROC) framework. Marginal return on equity (ROE) on loans should be higher when interest rates are higher and more volatile, which is the environment we are currently in. Take, for example, two common loan products: current coupon 6% 30-year mortgages and 4.50% auto loans, both funded with short term funding at Fed Funds plus 25 basis points and hedged with Fed Funds interest rate swaps.

Loan Product
 30 Year FixedAuto Loan
Loan Rate6.004.50
Short-FundingFF + 0.25FF + 0.25
Fixed Swap Rate2.902.90
All-In Funding Cost3.153.15
Options Cost1.000.00
Credit & Servicing0.501.00
Net Spread1.350.35
Leverage Multiplier20x (1 / 5%)13.3x (1 / 7.5%)
ROE on Risk-Based Capital30.15%7.82%

ROE = ((L x S) + F) x (1-T), where L = leverage multiplier, S = net spread, F = all-in funding cost, and T = tax rate

A 30% ROE on a portfolio of single-family mortgages is a nice risk adjusted return. Keep in mind, however, this return is not without risk. Options cost, or whipsaw costs, for example, are elevated. This is because the likelihood of 6% mortgages refinancing in a world where mortgage rates drop to 4% is high. This compensation stems from interest rate volatility expectations, and the institution may end up keeping all this compensation, or it could be eaten up by realized prepayment costs depending on the future path of interest rates.

The auto loan example, in contrast, faces a much tighter net spread and ROE. While auto loan rates have moved up a bit, some are struggling to originate loans with a 4 or 5% coupon due to competitive local markets. In general, auto loan rates (and other consumer products for that matter, shown below) haven’t moved nearly in lockstep with the path of interest rates. Thus, profitability faces a tougher headwind. It is also interesting to note that in today’s market 5-year and 10-year swap rates are essentially identical, hence the same fixed swap rate in the example. Duration is cheap when the curve is flat, and this helps the relative attractiveness of longer-duration assets.

TypeProductAverage Offer RateChange
ConsumerNew Auto4.183.880.30
Used Auto4.464.140.32
Home Equity6.155.160.99
Credit Card12.8212.210.62
Mortgage1/1 ARM3.932.921.01
3/1 ARM4.343.101.24
5/1 ARM4.362.971.39
7/1 ARM4.533.011.52
15 Year Fixed4.712.492.22
 30 Year Fixed5.453.102.35

Source: S&P Global, ALM First

For institutions who have seen mortgage growth slow significantly, some are starting to focus on other asset classes such as personal loans or auto loans. With the endless discussion around the chances of a potential recession, institutions need to be actively modeling different loss expectations, and realizing that the unique auto loan market may change over the next 24 months. We are in a historic time where autos are appreciating assets in many instances due to a complex set of factors, mainly supply-driven. Trying to properly price an auto loan with the uniqueness of today’s market may prove more difficult than in the past.

As interest rates continue their upward path, maintaining a disciplined approach to product pricing is perhaps as important as ever. Simplistically speaking, as interest rates move, and if product offer rates are not adjusted to account for the yield curve, then effective credit spreads are unintentionally shifted. As interest rates increase credit spreads narrow, and vice versa for lower rates. At ALM First, we’ve witnessed a narrowing across the board for many product rates. Using a pricing model, like our Profitability Calculator, can help institutions maintain intentionality in pricing risk and create consistency in spread and margins. Contact us to discuss your pricing model in more detail.

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