Financial markets have seen significant change since the beginning of 2018. In anticipation of the Federal Reserve’s recently announced rate hike, and predictions of two or three more this year, swap and treasury securities were sold off following a severe flattening at year-end. The 2/10-year treasury spread rebounded to 61 bps following a then decade-long low of 50 bps in early January. As of March 12, the 2- and 10-year yields sit at 2.26% and 2.87%, respectively. Economic opinions remain optimistic as higher growth and inflationary expectations persist, typically associated with higher interest rates and steepening yield curves.

Figure 1:

Mortgage rates have increased in response to the rise in long-end yields. At December month-end, the national average offering rate for a 30-year fixed mortgage was 4.08%, climbing to 4.41% by March 9. However, higher rates didn’t dampen demand for mortgages; credit unions had the largest mortgage volume in their history in 2017. More than $174 billion in first mortgages were originated in 2017, following 2016’s record-setting volume of $172 billion.

These changes in mortgage volumes are shown in Figure 2. With the rise in mortgage volumes, the structure of the balance sheet for most financial institutions has changed. Short duration assets, such as auto loans, have been popular products. Particularly, indirect auto lending has contributed to the popularity, despite comparatively high credit costs and stiff dealer fees cutting into marginal returns. Financial institutions that focus heavily on consumer lending can often find themselves unable to respond to changing consumer demands. Recently, low interest rates have encouraged borrowers to apply for mortgages, and financial institutions have opted to fund a growing number of more profitable, longer-duration assets.

Figure 2:

With the recently announced rate hikes and with the expectation of more to come, financial institutions, especially those with a high number of mortgage loans, should be aware of the possible effects to their balance sheet. In contrast to consumer loans, mortgages have significantly more interest rate risk. There are three metrics that can help analyze the ways changing interest rates affect a balance sheet: economic value sensitivity, economic capital ratio, and earnings-at-risk.

Economic value sensitivity is a factor of the “optionality” of mortgage loans in which cash flows are closely tied to the trajectory of interest rates. A mortgage prepayment option is like a call option on a bond. When interest rates decrease, the borrower has the right to “call” the note (payoff the outstanding balance of the loan). This allows the borrower to “buy” the mortgage from the lender at par, even if the economic value of the loan is substantially above par. For the lender, this will reduce their economic value sensitivity exposure as cash flows contract and average lives shorten; analysts refer to this as the convexity effect. However, as rates increase, prepayments will slow, since the borrower will not be motivated to prepay. This will cause cash flow and duration extension, longer average loan lives, and shorter deposit average lives, creating increased sensitivity to interest rate changes. In comparison, since auto loans are short duration assets with no optionality, they face little interest rate risk. In actuality, analysis shows auto prepayments linked more closely to loan age, rather than changes in interest rates.

The second metric, economic capital ratio, measured as net economic value (NEV), will also be affected by changes in interest rates. The size and direction of the change will be determined by the construction of the balance sheet and can be measured by the duration gap. Duration gap shows whether the depository is asset-sensitive or liability-sensitive. Many institutions are liability-sensitive, which means that it will take assets longer to reprice than it will take liabilities. As discussed earlier, yield curves usually steepen as long-end rates rise more rapidly than short-end rates under periods of economic growth. This will not only increase liability-sensitivity, but will also lead to reduced mortgage valuations, all else equal. However, rising rates also can offer a benefit to the institution, derived from the depository franchise. Ultimately, the impact to the value of the firm will depend on the interaction between the asset and liability base.

The final metric, earnings-at-risk, illustrates how rising interest rates also affect profitability and earning volatility. Cash flows lengthen to a longer horizon as average lives extend for mortgage loans. Therefore, institutions with a liability-sensitive, earnings-at-risk profile should expect increased income volatility. Asset-sensitive institutions will experience an increase to income volatility, as well, but rising rates will put them closer to an interest rate-neutral profile.

As financial institutions continue to expand products to meet consumer demands, balance sheet risk management is crucial. A rising rate environment should not deter an institution from meeting the demands of the marketplace. Whether it be through various hedging strategies, secondary marketing efforts, or even whole loan trades, every institution can succeed as rates rise because opportunities lie along the entire yield curve. Institutions just need the skills and knowledge to pursue them.

Michael Oravetz

Associate, ALM & Investment Strategy at ALM First