Lending

Time to Rethink Mortgages

CUs originated, and sold, record volumes of first mortgages in 2009.

August 02, 2010
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Credit union earnings have been pummeled during the past two years by high loan losses, low yields on investments, share insurance premiums, and write-downs of capital deposits in corporate credit unions.

The one potential bright spot is that the yield curve—the difference between shorter- and longer-term interest rates—is unusually steep. As a result, the spread between what credit unions charge on loans and pay on savings should also be high, boosting net income.

With a weak economy, however, savings growth is strong while loan demand is almost nonexistent. All that cheap money languishes in even cheaper investments, rather than contributing to the bottom line through higher-yielding loans.

Despite the weak economy, credit unions originated a record volume of first mortgages in 2009: $94 billion. It’s a shame they couldn’t hold more of these loans. Instead, credit unions sold $51 billion, also a record. Credit unions could have taken a big step to even the imbalance between loan and savings growth last year by holding more mortgages in portfolio.

The reason for the increased loan sales was, of course, good asset-liability management (ALM). With very low interest rates, adding substantial amounts of fixed-rate mortgages to a balance sheet is financial suicide. And, with interest rates low, consumers are unwilling to take on the substantial risk of adjustable-rate mortgages (ARMs)—that is, most versions of ARMs currently available.

Today’s standard mortgage products weren’t designed with the needs of depository institutions in mind. Instead, they were tailored to the investors who buy mortgage-backed securities. Thirty-year, fixed-rate mortgages are attractive to borrowers and some investors. But credit unions, relying on mostly short-term funding from members, can hold them only in moderation. ARMs are great from an ALM point of view, but can be very scary to borrowers.

What if credit unions created their own first mortgages, specifically designed to be both member- and ALM-friendly, so that they could be safely held in portfolio? State Employees’ Credit Union, Raleigh, N.C., has a successful product that fits this description. It’s a two-year ARM with a 1% cap. It takes six years for the loan rate to increase by 3%, and then only if interest rates increase that much and stay up.

Another approach: Create a “partially adjustable-rate mortgage” or PARM. The loan could be originated with an initial fixed-rate period of one to three years, and then adjusted only at a fraction of any change in the index.

Many credit unions’ average cost of funds adjusts at about 40% of changes in the one-year Treasury rate. So why not create a loan with a rate that changes by 40% of the change in the index? If the index rises 1%, the rate rises 40 basis points. At a 40% adjustment, it takes a 2.5% increase in the Treasury rate to generate a 1% increase in the loan rate, thus controlling payment shock.

The problem with standard ARMs is they put all the risk on borrowers, while providing more interest-rate protection than credit unions really need. Not surprisingly, they’re not very attractive to borrowers unless interest rates are very high.

A PARM would split the risk between the borrowing member and the credit union. As long as the initial rate is sufficiently below the 30-year fixed rate, a PARM could be quite attractive to the borrower while safe for the lender.

If loans don’t have to be sold for ALM reasons, the remaining issue would be liquidity. Adjusting rates would give significant control over volume. Adding PARMs to a product mix could give both members and credit unions a useful new tool.

BILL HAMPEL is senior vice president of research and policy analysis/chief economist for the Credit Union National Association. Contact him at 202-508-6760.

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