MIAMI – The “smooth ride” mortgage lenders have enjoyed the last couple of years is over. That was the sobering message credit union attendees to the CUNA Lending Council conference heard from Fannie Mae’s Stephen Pawlowski, director transaction management, single family homes. For the last three to four years, he said, the mortgage market has seen an unprecedented period of low interest rates, strong credit fundamentals including consistent home price appreciation, and a relatively “dormant” Federal Reserve with the Fed funds rate sitting at 1% and a yield of 4-5%. “But that was then, and this is now,” said Pawlowski who elaborated on where the mortgage market is headed. Among his observations: the Fed is more active and has already raised the Fed rate 250 basis points since June 2004; deposit costs are rising; the yield curve is flattening as higher rates put pressure on margins; many assets being held in portfolios are “underwater” and are declining in value; there is a mismatch between asset durations and liability durations; and the risk profile of the loan portfolio is changing. “The Fed is tapping on the brakes, we shouldn’t be surprised at the Fed’s actions,” said Pawlowski who predicted the Fed funds rate could hit 4.25 by the end of 2005. “The market has been humming along with favorable market conditions, but now we’re entering a period of uncertainty. Credit unions involved with mortgage lending need to be aware of how much credit risk they’re holding in their portfolio,” he advised. “Mortgage credit and interest rate risk has grown significantly as mortgages and mortgage backed securities now occupy a healthy portion of the balance sheet,” Pawlowski added. Exacerbating that condition, he explained, is the fact that “few institutions know what their loan portfolio is worth today. Unlike bond portfolios which are actively managed, loan portfolios are generally passively managed in terms of interest rate risks. Lenders may do a yearly assessment or they may not do one at all. Moreover, few institutions know where or how they could sell parts of their loan portfolio quickly.” The reason for that, said Pawlowski, is most loan portfolios are held to maturity which provides a false notion that active management isn’t necessary. After three years of record low interest rates, the Fannie Mae exec said most loan portfolios are virtually brand new. “A lot of fixed-rate products with low interest rates are embedded with high interest rate risk resulting from rates going up,” said Pawlowski, “so these products are losing value and trading at a discount. Duration mismatches will compress margins.” He stressed that, “Actively managing your loan portfolio helps minimize risk and maximize returns. No matter who you are, if you have mortgages in your portfolio you have to deal with both sides of the asset liability equation.” But for credit unions specifically he emphasized that, “The entire mortgage investing universe faces the same extension risk problem you face, but most of the players have more tools at their disposal to manage interest rate risk.” In a rising rate environment, mortgage prices are doubly vulnerable, said Pawlowski. When rates rise, there are naturally many more sellers than buyers. This exacerbates the price pressure on mortgage assets and can cause mortgage spreads to gap wider. “If you’re not actively managing your mortgage portfolio, this is what you’re going to have to deal with,” he warned. -

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