Asset valuations are often performed because they are required by a variety of regulations and accounting rules. Accordingly, they are often conducted reluctantly and superficially. This should not be the case. An understanding of the performance dynamics of these assets, gleaned from thorough asset analyses, provides invaluable decision-support information.

A case in point is the axiom that investing in mortgage loans and mortgage servicing rights provides a “natural hedge” as rates fluctuate. This stems from the belief that principal-only and interest-only strips (POs and IOs, which loans and servicing rights tend to emulate) behave counter-cyclically. This is usually not the case. At best, it can be said they provide a “natural mitigation” of the effects of rate fluctuations.

The problem is that changes in value for each of these assets, as rates go up and down, are neither linear nor symmetrical. The graph to the right shows the change in value for a portfolio of loans (blue line) and servicing rights (red line) as rates fluctuate. In this analysis, I modeled conventional fixed-rate 30-year mortgages with a 6.5% coupon. I had to use a servicing portfolio 25 times the size of the loan portfolio to equate the total values.

MSRs (Red Line):

As rates rise, the servicing portfolio increases in value, but somewhat slowly. Prepayments slow as rates rise—but not by much. Speeds are already fairly low, and the value increase is further mitigated by the higher yield requirements demanded in a rising-rate environment.

When rates drop, however, values plummet. We have trained mortgagors well to refinance when market rates fall 50 basis points below the current coupon.

Mortgage Loans (Blue Line):

Increasing market rates decrease the value of existing fixed-rate portfolios. As rates rise, the existing yield on current fixed-rate loans becomes increasingly less attractive. Compounding this is the reality that below-market-yield mortgages will stay on the books longer, as the propensity to refinance disappears and prepayments drop.

Conversely, decreasing market rates increase value. As rates fall, the existing yield on fixed-rate loans becomes increasingly more attractive. Mitigating this, however, is the fact that above-market-yield mortgages will prepay faster—so the benefit of holding these higher-yield assets may be short-lived.

Total (Green Line):

Overall, the downside changes of both asset types far exceed their upside potential. Thus, the total impact resembles an inverted smiley face. Hardly a hedge.

Understanding the performance dynamics of all assets on the balance sheet is much more important than simply knowing what you could sell them for. Only with proper analyses—not simply “a valuation”—can a decision-support system be developed to manage your interest rate gap.

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