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Interest rate risk proposals mean increased capital.

Bank and thrift regulatory agencies are considering two approaches for measuring interest rate risk (IRR) to comply with the FDIC Improvement Act. The regulators' goals are to develop a capital requirement that captures the IRR associated with an institution's assets, liabilities and off-balance sheet positions. Mortgage company subsidiaries should take note of these developments because the capital requirement will reflect IRR associated with the subsidiary's off-balance sheet (OBS) servicing, mortgages in the pipeline and contracts used to hedge the pipeline.

The two approaches

The Federal Reserve Board, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation (bank regulators) jointly issued an advanced notice of proposed rulemaking amending risk-based capital requirements. Their proposal calculates an institution's IRR exposure by slotting assets, liabilities and off-balance sheet positions into maturity and amortizing/non-amortizing buckets that have been given different risk weights. The weights were determined using modified duration to approximate the price sensitivity of different instruments to a 100 basis point upward and downward change in market rates. The dollar amount in each bucket is then multiplied by the risk weight to get a net position. Only a net position exceeding 1 percent needs capital support. In contrast, the Office of Thrift Supervision (OTS) proposes using an option adjusted spread (OAS) model to calculate the institution's market value of portfolio equity (MVPE), assuming a 200 basis interest rate shock. MVPE is the net present value of the cash flows associated with all the financial instruments of the institution. To help calculate the MVPE more accurately, the OTS proposes to expand the information collected through the Thrift Financial Report (TFR). Similar to the bank regulators, the OTS will only require additional capital when a change in the MVPE is greater than 2 percent. While the trend has been for regulators to develop uniform capital standards, it is unlikely that the bank regulators and the OTS will reconcile their different approaches.

There are several pressing concerns that could affect mortgage company subsidiaries under both approaches. First, the OTS approach will likely cause declines in the value of off-balance sheet (OBS) servicing to be supported by capital, even though the OBS servicing itself does not contribute to that capital base. Second, there is a general failure to account for mortgage fallout on an individual company basis or, in the case of the bank regulators, to give any value to the mortgage pipeline.

Off-balance sheet servicing

The OTS proposes that savings associations report the amount of both on-and off-balance sheet servicing in order to determine IRR capital. The bank regulators have not addressed servicing treatment at all, thus increasing the possibility that they will adopt OTS's approach regarding OBS servicing.

In the upward rate shock scenario, the OTS proposal accurately reflects an increase in value of OBS servicing portfolio. However, in the downward rate shock, institutions may be penalized by having to hold additional capital against an asset that is not counted toward capital. As long as the originated servicing remains off-balance sheet, a drop in the value of the servicing cannot, by definition, decrease an institution's capital. In fact, the presence of off-balance sheet servicing provides a capital reserve for the institution and the regulator because originated servicing can be sold to boost capital. One industry leader views the OBS servicing treatment as requiring a thrift to hold reserves against an asset that has some value, but already has been totally written off. It would be punitive and serve no economic purpose.

MBA believes that the proposal works contrary to OTS's stated purpose of "creat[ing] better incentives for savings associations to make decisions on the basis of their economic merit rather than on their accounting effect." In the eyes of savings associations, there is no difference in economic value between the on- and off-balance sheet servicing. The OTS proposal, however, encourages savings associations to sell originated servicing in order to put the servicing on the balance sheet and have it count toward capital. Increased transfers might disturb consumers who often prefer that their servicing stay with the original lender.

Treatment of the mortgage


Using the OAS model, the OTS will calculate the value of off-balance sheet "hedging" contracts and estimate the value of fixed-rate mortgages in the pipeline that are likely to dose. Unfortunately, the OTS has indicated that it is impractical to measure the potential adjustments that an institution might make in its hedge as a result of an inter est rate shock. Also, it is our under standing that the OTS will apply pre determined pipeline fallout figures in the various rate shock scenarios, starting from a base closing percentage. Give that the OTS assumes no opportunity to adjust hedge coverage during the rate shock period, the OTS should amen their stress test to reflect more realistic interest rate movements and incorporate actual fallout experience of mortgage bankers.

In contrast to the OTS, the bank regulators have not specifically addressed their treatment of firm commitment to originate mortgages. The inclusion of mortgages in the pipelines is necessary to offset lenders' mandatory commitments to sell loans into the secondary market. Without inclusion o the mortgage pipeline, banks and their subsidiaries could show greater IRR than is actually present and might be encouraged to hedge their pipelines improperly.

For example, the bank regulators' proposal may show no loans closing in a rising rate environment, causing the company to "pair off" on mandatory deliveries. Of course, in reality this is not the case. More mortgages will close as rates rise. Companies also will adjust their mandatory and optional commitments to sell the loans to the secondary market agencies.

To develop a workable IRR strategy, MBA believes that, at a minimum, the following concepts should be considered by the OTS and bank regulators:

* The bank regulators should recognize mortgages in the pipeline to offset the hedge instruments reported.

* The regulators should allow banks and thrifts to report loans in the pipeline on a net basis (i.e. after fallout) in both the upward and downward rate shock tests. Fallout assumptions would be based on the company's historical experience. A company specific fallout number is extremely important given variations among companies in their product mix, ability to recapture borrower fallout and wholesale versus retail fallout experience.

* The regulators should use a more reasonable interest rate shock test. Final interest rate rules from the bank and thrift regulators could adversely impact the future attractiveness of fixed-rate lending and servicing to depository institutions and their subsidiaries. Moreover, a rule that adds on a capital charge for significant investments in fixed-rate mortgages and mortgage-backed securities serves to shrink the pool of interested investors in MBS. This in turn could drive up mortgage costs for consumers.
COPYRIGHT 1992 Mortgage Bankers Association of America
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Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Author:Vidal, Vicki
Publication:Mortgage Banking
Date:Dec 1, 1992
Previous Article:TQM in mortgage banking.
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