Are You Due For an Annual Interest Rate Risk Check-Up?

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11-6-13-wipfli.pngThe Federal Deposit Insurance Corp. (FDIC) issued a recent letter to financial institutions saying the agency is increasingly concerned that some banks and thrifts are not sufficiently prepared for volatility or a sustained rise in interest rates. The FDIC is reemphasizing the need for oversight by the board and management, policy frameworks and prudent exposure limits, effective measurement and monitoring of interest rate risk, and risk mitigation strategies. But it also has introduced some new statements in its latest letter worth noting:

“…institutions with a decidedly liability-sensitive position could experience declines in net interest income and potential deposit run-off in a rising rate environment. Moreover, rate sensitive liabilities may re-price faster than earning assets as coupons on variable rate loans and investments remain below their floor.”

“If interest rates were to rise markedly, institutions that have concentrated bond holdings in long-duration issues could experience severe depreciation of a magnitude that could be material relative to their capital position. Institutions that rely primarily on a long-duration fixed-income portfolio for liquidity could have difficulty meeting short-term cash needs if other marketable assets or funding sources are not readily available.”

“…significant, unmitigated levels of interest rate or market risk can lead to losses and liquidity constraints when prevailing rates change significantly.”

Long duration assets, such as step-up bonds or fixed-rate mortgages, will likely be a focus of the FDIC during its next exam of your institution and should be an important concern for the asset liability committee (ALCO). Due to historically low interest rates, bankers have been forced to extend the duration of the investment and loan portfolio in an effort to increase margins; at the same time, depositors are favoring shorter term certificates of depositors or money market funds as they anticipate rising rates. Some banks have a high risk due to extending cash flow on the asset side and not matching the re-pricing on the liabilities side. This has also manifested in significant unrealized losses on securities available for sale. While these unrealized losses do not affect regulatory capital, they do affect GAAP (Generally Accepted Accounting Practices) capital, which can affect market perception and the overall health of the institution should liquidity needs emerge.

The board has the ultimate responsibility for the risks undertaken by its institution. In response to the most recent letter, it is imperative that the foundations listed below are continually and proactively addressed and revisited by the board and management.

  1. Has the board approved the interest rate risk policy in the last twelve months and evaluated the bank’s policy limits? We often hear that the limits set within a policy are the “industry standards.” The policy limits should reflect the institution’s risk appetite that is commensurate with the institution’s strategic plan and capital position.
  2. Have the internal controls of the model been reviewed by an independent third party? Although management may seem to understand the asset-liability committee process and the model it is working with, it is crucial that each institution have its model independently validated. Key assumptions such as prepayment speeds (the change in the behavior of long term assets due to a change in rates, and decay (the speed with which the accounts “decay” or roll off your balance sheet) can alter the model results in ways to make the institution look like it is within policy or vice versa.
  3. Is the board receiving appropriate reporting from management? At minimum, the board should receive a quarterly interest rate risk analysis. The board should get analysis more often if it is managing risk outside policy limits. The income simulations should have a minimum horizon of two years, preferably with a static balance sheet rather than a dynamic balance sheet. The immediate interest rate shocks should include changes in rates of at least 300 and 400 basis points, nonparallel rate shocks (shocks of the yield curve using twists or changing slopes) and account for basis risk and yield curve risk. The market value equity simulation should also include changes in rates of greater magnitude and include nonparallel rate shocks.
  4. Has the board and management considered alternative risk measurement and monitoring tools? Analyzing the bank’s interest rate risk position using alternative methods can provide varying pictures of how well the bank is postured in the current and expected interest rate cycles. In addition to the static interest rate risk and market value of equity calculations, the Asset Liability Committee should consider a variety of modeling techniques such as gap Analysis (the difference between a bank’s rate sensitive assets and rate sensitive liabilities distributed by maturity), stress testing and earnings simulations in a variety of interest rate scenarios.

Economists are still predicting rates will remain fairly flat for the near term; however, rates are unlikely to remain low forever. The time is now to evaluate the bank’s interest rate risk appetite and act if the current position puts the bank’s capital position at risk.

No More Balloon-Payment Mortgages? No Problem

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5-24-13_Bryan_Cave.pngEditor’s note: On May 29, 2013, the Consumer Financial Protection Bureau amended its new rule to delay implementation of the balloon payment injunction for two years for small lenders with less than $2 billion in assets who make fewer than 500 first-lien mortgages per year. The delay lasts for two years after the implementation date of January, 2014.

Among the many sea changes within the Consumer Financial Protection Bureau’s new mortgage regulations, the rules’ harsh view of the balloon-payment loan is among the most disappointing for community banks. The CFPB clearly does not like these loans and has taken a major swing at them. Beginning in 2014, creditors will be prohibited under the Truth in Lending Act from making covered loans absent a good faith review of the borrower’s repayment ability. The risks of non-compliance with this rule are grave and include a defense in foreclosure that essentially has no statute of limitations. So-called “qualified mortgages” will enjoy a presumption of compliance with this new Ability-to-Repay (ATR) standard, but balloon notes are not generally favored.  Here is a five-step roadmap for coping with these new restrictions.

First, assess the damage. Start by determining how many of your existing loans are within the scope of these rules. Be careful to separate true consumer loans from others. It bears emphasizing that commercial-purpose balloons are not covered, in most cases even if they are secured by the borrower’s principal dwelling. On the other hand, there is no general small creditor exemption for covered transactions. And while the rules do not apply to home equity lines of credit, they do apply to closed-end home equity loans so long as they are secured by a dwelling and constitute consumer credit.

Of course, your bank may be among the few small creditors that will qualify to make “rural balloon-payment qualified mortgages.” If so, even these loans will need to have at least 5-year terms. Under the general ATR rule, loans may include a balloon payment, but consumers must be deemed capable of making any balloon payment due within the first 5 years of a loan (or at any time during the loan if it is higher-priced). 

Second, expect ALCO excellence. For creditors, the demise of balloons under these new rules is primarily an interest rate risk (IRR) story. Short-term balloon loans are popular because they are a simple means of managing IRR. The CFPB acknowledged as much but believes only a limited class of rural creditors should be encouraged to continue making such loans, notwithstanding evidence that consumers understand and like them. Thus, your bank’s asset/liability management committee (ALCO) or other IRR management body should be springing into action right now if balloons are a material part of your portfolio. Among other things, the effective date of these new rules—January 10, 2014—should be circled on the ALCO’s calendar; laid over existing internal policies, procedures, and limits; and entered into IRR models and simulations. 

Third, renew or modify certain loans. Depending on what strategies emerge from your ALCO’s deliberation, you may end up trying to renew or modify a certain number of existing mortgages before the new rules take effect. This is because, while existing balloon mortgages are not covered by the new origination rules, their renewal could be. To understand this, fast-forward to 2014:  the CFPB has specifically noted that “any change to an existing loan that is not treated as a refinancing” under the Truth in Lending Act is not subject to its new ATR restrictions. This means that, even in 2014, you might be able to modify certain loans and retain their balloon-payment features.  The viability of this prospect turns on whether, under applicable state law, the existing obligation has been merely amended or, rather, “satisfied and replaced” by a new one. There has long been variability under state law on this issue.     

One thing that is clear under the new rules is that existing balloons will not qualify for the “non-standard mortgage” refinancing exemption from the general ATR requirements. This Dodd-Frank concept exempts creditors from the strict new ATR underwriting requirements when they are refinancing borrowers into conventional mortgages from certain existing loans that pose a risk of “payment shock” (e.g., certain adjustable-rate loans). The CFPB concluded that balloon mortgages do not pose the sort of risk targeted by this exemption and thus will not qualify to be “streamline” refinanced this way. 

Fourth, ramp up to make ARMs. To compete in 2014 and beyond, creditors may need to offer some form of adjustable-rate mortgage (ARM). This obviously presents a challenge if ARMs are new to your organization. Even the CFPB has acknowledged that many creditors would prefer to offer balloons as a means of managing interest rate risk “without having to undertake the compliance burdens involved in administering adjustable rate mortgages over time.” In 2014, these burdens will include not only new underwriting mandates but also a new rate adjustment notice (under the CFPB’s new servicing rules). It will also be important that loan officers understand ARMs well enough to describe them to consumers.   

Fifth, and finally, demand help from your systems vendors. These service providers can not only walk you through add-ons and modules that will help you comply with the new rules, but they can also help train your loan officers and underwriters. While more complicated than balloons, ARM loans are conducive to a variety of systems solutions. These tools should put you well on your way to making a smooth transition away from balloons. 

Conclusion

The CFPB’s sweeping mortgage reforms will have a major impact on product terms and offerings. Given the CFPB’s stated views, don’t expect further regulatory relief for balloon-payment mortgages. With proper planning, however, your institution should be ready to live without them and to distinguish yourself in the crowded mortgage marketplace on efficiency and customer service.