WASHINGTON - The "smooth ride" mortgage lenders have enjoyed thelast couple of years is over. That sobering message was reinforcedrecently to credit unions by Fannie Mae's Stephen Pawlowski,director transaction management, single family homes. For the lastthree to four years, said Pawlowksi, the mortgage market has seenan unprecedented period of low interest rates, strong creditfundamentals including consistent home price appreciation, and arelatively "dormant" Federal Reserve with the Fed funds ratesitting at 1% and a yield of 4-5%. "But that was then, and this isnow," said Pawlowski who elaborated on where the mortgage market isheaded. Among his observations: the Fed is more active and hasalready raised the Fed rate 250 basis points since June 2004;deposit costs are rising; the yield curve is flattening as higherrates put pressure on margins; many assets being held in portfoliosare "underwater" and are declining in value; there is a mismatchbetween asset durations and liability durations; and the riskprofile of the loan portfolio is changing. "The Fed is tapping onthe brakes, we shouldn't be surprised at the Fed's actions," saidPawlowski who predicted the Fed funds rate could hit 4.25 by theend of 2005. "The market has been humming along with favorablemarket conditions, but now we're entering a period of uncertainty.Credit unions involved with mortgage lending need to be aware ofhow much credit risk they're holding in their portfolio," headvised. "Mortgage credit and interest rate risk has grownsignificantly as mortgages and mortgage backed securities nowoccupy a healthy portion of the balance sheet," Pawlowski added.Exacerbating that condition, he explained, is the fact that "fewinstitutions know what their loan portfolio is worth today. Unlikebond portfolios which are actively managed, loan portfolios aregenerally 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 partsof their loan portfolio quickly." The reason for that, saidPawlowski, is most loan portfolios are held to maturity whichprovides a false notion that active management isn't necessary.After three years of record low interest rates, the Fannie Mae execsaid most loan portfolios are virtually brand new. "A lot offixed-rate products with low interest rates are embedded with highinterest 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 andmaximize returns. No matter who you are, if you have mortgages inyour portfolio you have to deal with both sides of the assetliability equation." But for credit unions specifically heemphasized that, "The entire mortgage investing universe faces thesame extension risk problem you face, but most of the players havemore tools at their disposal to manage interest rate risk." In arising rate environment, mortgage prices are doubly vulnerable,said Pawlowski. When rates rise, there are naturally many moresellers than buyers. This exacerbates the price pressure onmortgage assets and can cause mortgage spreads to gap wider. "Ifyou're not actively managing your mortgage portfolio, this is whatyou're going to have to deal with," he warned. -

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