Insights from Catalyst

By Mark DeBree , CFA, Managing Principal, Catalyst Strategic Solutions 

As credit unions settle into the new COVID-19 operating world, they're working hard to help their members. One avenue credit unions are actively pursuing to help their members is loan refinancing. And to no one’s surprise, mortgage refinancing activity is especially strong.

The question credit unions are asking is: Does booking 30-year or 15-year mortgage loans make sense at current rates, or should we be originating and selling them?

Before we answer that question, I strongly support credit union refinancing activity in the current market. Refinancing helps credit unions and members by:

• Improving the affordability of loan obligations
• Creating goodwill and member value – especially when we approach members with refinancing opportunities (versus waiting for members to contact us…or a competitor)
• Ensuring loans remain on the credit union’s books, even if at a lower rate
• Offering potential to improve loan performance
• Opening the door to recapture loans lost to other financial institutions

Back to the question at hand, should a credit union book mortgage loans or should they sell them? To answer this question, let’s start by looking at mortgage rates (With rates constantly on the move, a quick place to view current rates – updated every Monday morning – is Catalyst Strategic Solutions’ Industry Rate Comparison page).

Chart 1 shows that mortgage rates are certainly testing the lower boundary experienced at the end of the Great Recession. Many credit unions incurred notable losses coming out of the Great Recession and were, understandably, slow to reenter the mortgage markets. However, that decision weighed on credit union earnings and capital growth rates for years. Trying to learn from the past and not leave potential earnings on the table, should we grow our portfolios or sell off originations?

A look at the relative value of mortgage rates will give us some answers to that question. We start by looking at current market spreads relative to the 10-year Treasury. The 10-year Treasury rate was chosen due to its use as the index to price conventional fixed rate mortgages.

In Chart 2 below, we show that mortgages currently have an attractive spread, nearing the peaks experienced during the Great Recession. This suggests that mortgages could offer significant value to a credit union’s income stream. As of May 7, 30-year mortgages were 263 basis points (bps) above the 10-year Treasury (per Federal Reserve Economic Data), and 15-year mortgages were spread 210 bps above. The average spread between 2014 and 2019 was 171 bps for 30-year mortgages and 101 bps for 15-year mortgages. These are very attractive spreads.

However, before we jump into booking as many mortgages as we can, let’s take some potential credit losses into account. Table 1 below shows annual net charge-offs back to 2009, which covers the back end of the Great Recession, when losses were realized. Seeing how net charge-offs increased into 2010-2012 provides valuable insight when considering booking mortgages now. You can view quarterly peer statistics here.

To normalize the spreads, given the COVID-19 economy, let’s reduce current mortgage spreads by the peak level of net charge-offs from 2011 (39 bps). In Chart 3 below, mortgage spreads were reduced starting the last week of February, when COVID fears and uncertainty took root. Applying a credit adjustment to the spreads, they do narrow but remain very attractive relative to the past several years and the 2014-2019 average spreads. This suggests that if you expect your loan losses to be close to 39 bps or less, mortgages could offer strong value to your income stream.

Next, let’s look at the current COVID economy relative to the Great Recession. Are these downturns similar enough for us to apply the same loss estimates? I would argue the answer is NO. Unemployment levels stemming from the Great Lockdown are already higher than those of the Great Recession. The impact to GDP and economic activity seems to be potentially deeper.

As a result, it is possible that the losses credit unions realize could be greater. To account for this, in Chart 4 below, we reduce current mortgage spreads by an additional 39 bps (doubling the peak loss in the Great Recession). With this adjustment, do mortgages still offer value to credit unions?

Based on the data, we still see that mortgage spreads remain higher than the average levels despite doubling the peak charge-off rates from the Great Recession. As a result, it does appear that mortgages can offer an attractive income stream to a credit union’s balance sheet, despite the heightened potential for loss.

When evaluating the attractiveness of mortgage spreads in the market for your credit union, the decision between originating and selling, versus originating and booking, these loans will be driven by your credit union’s unique expectation of future loan losses. If you believe your future loan losses on new originations will be less than 50 bps (to be safe), booking mortgages may be an attractive option. If you feel your charge-offs are going to be closer to the top range of 75 bps, the “originate and sell” option may be a better decision for your credit union.

As you come to the decision on your mortgage loan strategy, always be sure to consider the impact from a concentration and interest rate risk perspective. With some potentially large credit losses looming in the future, ensure that your capital position can support adding the long-term risk generated by these loans. You also want to manage the concentration proactively. One of the most significant drivers of failure within financial institutions is heightened credit losses occurring in concentrated positions.

At Catalyst Strategic Solutions, our Advisors assist credit unions with these decisions as part of our daily routine. Because we work with credit unions day-in, day-out, we understand there is rarely a one-size-fits-all solution. Every credit union has a different management philosophy and membership base. Catalyst has been helping and supporting credit unions through these tough decisions for more than 30 years. If you want to speak with our Advisors about a spread analysis for your credit union or need help finding value in the market for your balance sheet, contact us today.