Mortgage banking and its ALM interaction

Mortgage Banking and Its ALM Interaction

Mortgage banking is intimately connected to ALM. Mortgages are long-term, fixed-rate assets that consume balance sheet capacity, create interest rate risk, and can be securitized to manage capital and liquidity.

The Mortgage Balance Sheet Impact

Mortgages create multiple ALM challenges:

1. Duration risk: 30-year mortgages have high duration. When rates rise, they lose value. When rates fall, borrowers prepay.
2. Funding mismatch: Mortgages are long-term; deposits are short-term. Maturity mismatch creates EVE risk.
3. Capital consumption: Mortgages require capital. Growing the mortgage book consumes capital that could be used elsewhere.
4. Liquidity: Mortgages are illiquid. They can't be sold quickly without a secondary market (or securitization).

Mortgage Securitization as an ALM Tool

Securitization removes mortgages from the balance sheet, freeing up:

• Funding capacity: No longer consuming deposits/wholesale debt


• Capital: Lower risk-weighted assets


• Interest rate risk: Removing long-duration assets

Banks typically securitize 50-70% of mortgage production, keeping 30-50% on balance sheet. The economics:

Mortgage held on balance sheet:

• Rate to customer: 6.50%


• Funding cost: 4.00% (FTP)


• Credit cost: 0.30%


• Operating cost: 1.50%


• Profit: 0.70%


• Capital consumption: 4%

Mortgage securitized:

• Rate to customer: 6.50%


• Securitization cost: 0.25% (servicing, guarantee, etc.)


• Credit cost: 0.30%


• Operating cost: 1.50%


• Profit: 4.45%

But: Bank no longer owns the mortgage; gets paid a fee

• Effective profit to bank: ~0.45% (lower because the origination fee and servicing income don't cover the spread you'd earn by holding)


• Capital consumption: ~0.5% (much lower)

Securitization is profitable but less profitable than holding. Banks securitize primarily for capital efficiency and balance sheet capacity, not to maximize spread profit.

Real Example: Mortgage Portfolio Management

Bank has:

• $25B in mortgages (40% of assets)


• $15B in other loans (24%)


• $12B in securities (19%)


• Other assets: $8B (13%)

Mortgage origination request: $2B per quarter

ALM analysis:

• Current EVE sensitivity: -10% of capital under -200 scenario


• If we add $2B mortgages to balance sheet:

- New EVE sensitivity: -12.5% (exceeds 12% limit)

• Options:

1. Cap originations at $800M (don't securitize), retain $200M (securitize 75%)
2. Securitize 70% of $2B, retain $600M on balance sheet (EVE sensitivity: -11.2%, within limit)
3. Use interest rate swaps to hedge half the mortgages (cost: 30 bps, but reduces EVE sensitivity to -11.5%)

Most banks choose option 2: securitize a portion to manage balance sheet constraints.

Takeaway

Mortgage banking and ALM are inseparable. Mortgages consume balance sheet capacity and create duration risk. Securitization is the primary tool for managing this risk while still growing mortgage business.

Mortgage Banking: Deep Dive into Origination, Portfolio, and ALM Integration

Mortgage banking is a high-volume, low-margin business that's tightly managed within ALM constraints. Understanding the operational side is essential for negotiating with business lines.

Mortgage Origination and Gain on Sale

When a bank originates a mortgage:
1. Mortgages are created at customer rate (6.50%)
2. They are immediately sold or securitized at market rates
3. The spread between what the bank gets and what it paid is "gain on sale"

Example:

• Mortgage originated at 6.50%


• Immediately sold to an investor at 6.25% (the investor takes the duration risk)


• Gain on sale: 25 bps * principal = profit

For a $1B mortgage portfolio originated and sold:

• Gain on sale: 25 bps = $2.5M profit


• Plus servicing income: ~25 bps annually = $2.5M/year ongoing

For mortgages retained on balance sheet:

• No gain on sale (you're not selling)


• But you earn the full 6.50% spread (minus funding, credit, ops costs)


• Plus servicing income

Mortgage banking is profitable on a spread basis, but securitization is often more profitable due to the gain-on-sale and upfront capital relief.

Portfolio Seasoning and Prepayment Risk

As mortgages age, prepayment behavior changes:

• New mortgages (0-6 months): Low prepayment (people don't refinance immediately)


• 6-12 months: Increasing prepayment (refinancing window opens)


• 1-3 years: Peak prepayment (if rates have fallen, customers aggressively refinance)


• 3+ years: Declining prepayment (rate refinancing has already happened; prepayment is primarily due to home sales)

ALM models this with S-curve prepayment models that account for:

• Interest rate environment (if rates fall 100 bps, prepayments accelerate)


• Seasonality (summer prepayments > winter)


• Loan seasoning (age matters)


• Customer characteristics (credit quality, original LTV, etc.)

A bank holding $25B in mortgages of mixed ages sees prepayment behavior changing constantly. After a rate drop, old mortgages prepay faster, shortening portfolio duration.

Takeaway

Mortgage banking is operationally complex and tightly constrained by ALM. Understanding origination economics, securitization incentives, and prepayment dynamics is essential for ALM managers negotiating with mortgage business lines.