Magazine article American Banker

Package This -- Fixed-Rate Lending Still a Risky Business

Magazine article American Banker

Package This -- Fixed-Rate Lending Still a Risky Business

Article excerpt

It should come as no surprise that as interest rates have risen, a number of financial institutions, from community banks to Federal Home Loan banks, have suffered serious losses on their investments.

Despite all the lessons that could have been learned from the savings and loan crisis of the 1980s, when rising rates depressed the value of the fixed-rate mortgages on which a substantial portion of the S&Ls depended for income, banks and thrifts have taken on heavy risk again.

The main lesson is the same as it was 15 years ago: It is dangerous to finance long-term, fixed-rate loans with short-term funding sources.

This time around, most lenders took the position that they had to offer long-term, fixed-rate loans, because their borrowers would not accept variable-rate ones. And they thought that they didn't really have to worry about these fixed-rate liens, which they immediately sold on the secondary market.

But lenders sometimes forget that someone has to hold these mortgages. Fannie Mae and Freddie Mac bought them, packaged them as pass-throughs, and sold them -- in many cases right back to the banks that made the loans in the first place.

Sure, the diversification inherent in trading whole loans for pass-throughs mitigates the investor's credit risk. But when interest rates change, all mortgage assets are affected the same way, and switching from whole loans to pass-throughs offers no protection.

What makes this an even more serious problem is that as interest rates have fallen, refinancings have lowered the average yield on the fixed-rate loans outstanding to such a degree that any further decline in borrowing costs seems highly unlikely. …

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