The Effect of 1994’s Higher Rates on

Interest Rate Risk

Office of Thrift Supervision

Risk Management Division

_________________________

Anthony G. Cornyn, CFA

Assistant Director

Donald Edwards

Radu Filimon, Ph.D.

Arthur Hogan, Ph.D.

Eberhard Irmler

Robert Kazdin

Elizabeth Mays, Ph.D.

_________________________

Office of Thrift Supervision

1700 G Street, N.W.

Washington, D.C. 20552

Reasons for Recent

Increases in Interest

Rate Risk Among

Thrift Institutions

As interest rates rose between

March and December 19941, the

OTS Net Portfolio Value Model

showed a general increase in the

level of interest rate risk in the

thrift industry. A number of

institutions have asked, “If no

significant changes occurred in

our asset or liability structure,

why is the OTS Model showing

that our level of interest rate risk

has gone up?” Aside from the

fact that some institutions have

changed their portfolios signific a n t l y, levels of risk have

increased primarily because of

two factors: extension of fixedrate mortgages/MBS and interest rate caps in adjustable-rate

mortgages/MBS. The Model’s

results are consistent with the

effects one would expect rising

interest rates to have on these

types of instruments. The purpose of this release is to explain

these sources of increased risk.

Part 1: “Extension” of Fixed

Rate Mortgages 

The interest rate sensitivity of

fixed-rate mortgages incre a s e d

during 1994. In March ’94, the

OTS Model estimated that the

industry’s aggregate holdings of

fixed-rate mortgages/MBS

would decline in value by 7.9%

under an immediate interest rate

shock of +200 b.p. In December

’94, the amount of the estimated

decline under the same rate

shock was 8.4%. The main reason for this increase in interest

rate sensitivity was that decreases in expected pre p a y m e n t s

caused the effective maturities of

fixed-rate mortgages to

“extend,” or lengthen.

Investors in mortgages and

mortgage securities are faced

with the possibility that the

mortgages will be prepaid at a

different speed than was anticipated. For most fixed-rate mortgages, prepayments represent a

major portion of projected near

term cash flows, so changes in

prepayment rates can have a significant effect on mortgage

prices. For example, in March

’94, prepayments on a seasoned

8% FNMA MBS were projected

to be 16% per year, a cash flow

s t ream twice as large as that

resulting from interest payments

on the security. Between March

and December ’94, the FNMA60-

day commitment rate for 30-year

Risk Management Series

By E. Irmler, Senior Project Manager

(202)906-5730

1 During this nine-month period, 1-year Treasury yields increased by 275 b.p., 5-

year yields, by 160 b.p., 10-year yields, by 110 b.p., and 30-year yields, by 80 b.p.
Office of Thrift Supervision

page 2

fixed-rate mortgages rose from

8.5% to 9.6%. As would be

expected, that rate incre a s e

resulted in a reduction in projected mortgage prepayments, as

the potential gain available to

mortgagors from re f i n a n c i n g

existing mortgages was reduced.

Dealer prepayment pro j e c t i o n s

for the seasoned 8% fixed-rate

MBS declined from 16% per year,

in March, to 12% in December.

F i g u re 1 plots the expected

monthly cash flows from the 8%

MBS under the two different prepayment speeds. It shows that

the decline in expected prepayments had the effect of “pushing” expected cash flows further

into the future, by generating

smaller monthly cash flows for

a p p roximately the first 48

months and then larger ones

0 60 120 180 240 300

$0.0

$0.5

$1.0

$1.5

$2.0

$2.5

Months

Figure 1. Comparison of Fixed-Rate Mortgage Cash Flows

Under 16% and 12% Prepayment Rates

Cash Flows Projected Under

Prepayments of 16% per year

(as in March ’94)

Cash Flows Projected Under

Prepayments of 12% per year

(as in December ’94)

after that. This sort of change in

the profile of projected cash

flows has been termed “extension,” and represents an effective lengthening of the maturity

of the mortgages involved.

Not surprisingly, the market

price of fixed-rate mortgages

and MBS declined during the

March to December period as

interest rates rose. For example,

the 8% FNMA security depicted

in Figure 1 declined in value

from $101.24 per $100 of outstanding principal in March, to

$95.72 in December. This may be

seen by referring to the Base

Case scenario of Figure 2, which

shows the price profile of the 8%

F N M A MBS, as modeled in

M a rch and December 1994.

Moreover, as illustrated in that

f i g u re, the price sensitivity o f

fixed-rate MBS also changed,

becoming more sensitive to

changes in interest rates. To

facilitate comparison, the result

of a +200 b.p. interest rate shock

on the value of the security is

shown for both March and

December. The security showed

about one percentage point more

price sensitivity in December

than it did in March -- declining

by 10.4% from the base case price

in December, versus a 9.4%

decline in March. 

The increased price sensitivity

reflected in the results of the OTS

Model for fixed-rate mortgages

and MBS between March and

December was consistent with

what one would expect of these

mortgage instruments in a rising

rate environment. For a given

coupon and yield, the longer a
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page 3

security’s term to maturity, the

m o re sensitive is its price to

changes in interest rates. A s

interest rates rise and mortgage

prepayments slow, the effective

maturity of a fixed-rate mortgage security lengthens. Thus,

as interest rates rise, the interest

rate sensitivity of a mortgage

security will increase.

Part 2: Interest Rate Caps on

Adjustable Rate Mortgages

In March 1994, the OTS Model

estimated that the industry’s

aggregate holdings of adjustable

rate mortgages and MBS would

decline in value by 2.9% under

an immediate interest rate shock

of +200 b.p. In December 1994,

for the same rate shock, the

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-400 -300 -200 -100 Base 100 200 300 400

$75

$80

$85

$90

$95

$100

$105

$110

Interest Rate Scenario

Figure 2. Comparison of Price Profile of 8% MBS

in March and December ’94

Value in March

would have

declined by

9.3% under

+200 bp rate

shock

December Price Profile

Value in December

would have

declined by

10.4% under

+200 bp rate shock

March Price Profile

101.24

95.72

91.7

85.8

than one might expect of an

adjustable rate instrument. In

fact, by December some ARMs

(particularly those with aggressive teaser rates) had price sensitivities more commonly

associated with fixed-rate mortgages than with ARMs. 

The effect of the caps on an

ARM’s price sensitivity can be

seen by comparing the prices of

an ARM having no caps with

those of ARMs having various

different caps. Figure 3 shows

such a comparison for four 1-

year Treasury ARM securities in

March ’94. The four securities

shown all have coupons of 6%,

net margins of 225 b.p., 300

months of remaining maturity,

and 6 months until their next

reset. They differ only in terms

of their interest rate caps, and

decline would have been 4.6%.

This large increase in intere s t

rate sensitivity resulted because

i n t e rest rate caps constrained

ARM coupons from adjusting to

the rapid run-up of market interest rates experienced during

1994. The effect was exacerbated

by the heavy origination of very

a g g ressively priced “teaser”

ARMs during this period.

Most adjustable-rate mortgages

owned by thrifts have both periodic and lifetime interest rate

caps. As an ARM’s coupon

approaches its lifetime cap, its

price sensitivity begins to resemble that of a fixed-rate mortgage.

In a period of rapidly increasing

interest rates, the combination of

lifetime and periodic rate caps

make the mortgages considerably more interest rate sensitive
In the -200 b.p. scenario, the fully

indexed rate would have been

335 b.p. below the 8% capped

level. At that distance, there

would have been minimal likelihood that the periodic cap

would have hampered adjustment of the ARM’s interest rate.

Hence, the periodic cap had virtually no value in the -200 b.p.

scenario, and the “Periodic Cap

Only” ARM was essentially

equal in value to the “No Caps”

ARM.

In the +200 b.p. scenario, the

fully indexed rate (8.65% = 6.40%

+ 2.25%) would have been 65

b.p. above the level permitted by

the periodic cap at the next reset.

Because of the high likelihood

that the ARM would be limited

to a less than fully indexed level,

the value of the periodic cap is

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page 4

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-200 -100 Base 100 200 300 400

$85

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$100

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Interest Rate Scenarios

Figure 3. Caps Affect Sensitivity of 1-Year ARM Prices

More in Higher Rate Scenarios

No Caps

Periodic Cap Only

Life Cap = 14%

Life Cap = 10%

end of March, the 1-year

Treasury yield was approximately 4.4%, so the fully indexed rate

for this ARM (i.e., the interest

rate to which the ARM would set

if it were scheduled to reset that

day) was 6.65% (i.e., the sum of

the 1-year Treasury yield and the

margin of 2.25%). The fact that

the fully indexed rate in March

was 135 b.p. below the 8%

capped level, combined with a

steep yield curve, resulted in a

small but significant probability

that the ARM would be prevented from adjusting fully at its next

rate reset date, in 6 months. As a

consequence, in the Base Case,

the estimated value of the periodic cap was $0.28, as shown by

the fact that the “Periodic Cap

Only” ARM was that much

lower in value than the “No

Caps” ARM.

those differences cause the divergence between their price profiles that is shown in the figure.

“No Cap” ARM: The curve

labeled “No Caps” shows prices

for an ARM with neither periodic, nor lifetime, rate caps. Note

that, even though this ARM has

no caps, it does not have the

same price in all scenarios (i.e., it

is not a “pure floater”). It is

slightly interest rate sensitive

because it resets annually and

has 6 months until its next scheduled reset date.

“Periodic Cap Only” ARM: The

curve labeled “Periodic Cap

Only” shows prices for an ARM

that has a 2% periodic rate cap.

At the next reset date, in 6

months, the ARM interest rate

would be capped at 8%. At the
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considerably larger ($2.10) than

it was in the Base Case scenario.

“Life Cap” ARMs: The curves

labeled “Life Cap =14%” and

“Life Cap =10%” show prices for

two ARMs that, in addition to

the 2% periodic rate cap, have

lifetime rate caps (equal to the

indicated levels). The incremental value of the lifetime caps can

be inferred by comparing the

value of those ARMs with that of

the “Periodic Cap Only” ARM.

In the -200 b.p. scenario, the fully

indexed rate would have been so

far below the level of the lifetime

caps, that the lifetime caps

would have had essentially no

i n c remental value. Hence, the

values of the two “Life Cap”

ARMs would have been nearly

the same as the “Periodic Cap

Only” ARM.

In the +200 b.p. scenario, the

incremental value of the lifetime

caps would have been greater

than in the Base Case, as shown

by the wider divergence of the

“Life Cap” ARMs from the

“Periodic Cap Only” ARM. The

lifetime caps increased in value

in this scenario because the fully

indexed rate would have been

closer to the cap rates (i.e., 5.35

and 1.35 percentage points,

respectively, from the 14% cap

and the 10% cap). That closer

p roximity increases the likelihood that the cap may prevent

the ARM’s interest rate fro m

resetting to the fully indexed rate

at some future reset date.

Because the 10% cap is closer to

the fully indexed rate than is the

14% cap, its incremental value is

greater ($2.97 versus $0.18).

In the Base Case scenario, the

i n c remental value of the 14%

lifetime rate cap was still not

material ($0.01), as shown by the

fact that the value of the “Life

Cap =14%” ARM was almost

identical to that of the “Periodic

Cap Only” ARM. Even if the

ARM had been fully indexed, it

would have been more than 7

p e rcentage points below the

level of the 14% cap. The incremental value of the 10% lifetime

cap was considerably greater, as

shown by the greater divergence

of the “Life Cap =10%” ARM

from the others. Even though the

fully indexed rate was still 3.35

percentage points below the 10%

cap, that cap was less remote

than the 14% cap, and, hence,

had considerably higher value

($0.81).

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$85

$90

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$110

Interest Rate Scenarios

Figure 4. By December Rates Had Risen, So the

Effect of Caps Was Greater

No Caps

Periodic Cap Only

Life Cap = 14%

Life Cap = 10%
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page 6

The most important points illustrated by Figure 3 are that, as

interest rates rise, the value of an

embedded interest rate cap

increases at an increasing rate and

the value of an ARM with such

embedded caps declines at an

increasing rate. This observation

implies that, for a given rate

shock, the change in value of an

ARM with embedded caps will

be greater in a high interest rate

environment than in a low one,

especially if interest rates have

recently risen. For example, in

F i g u re 3, if rates had been

shocked upward by 200 b.p., the

“Life Cap = 10%” ARM would

have declined in value by $4.76 -

- primarily as a result of the

increasing value of the embedded caps. If rates had then

i n c reased by an additional 2 0 0

b.p. from that level, the decline

in value would have been an

additional $6.83 -- since the

value of the caps would have

i n c reased by even more than

under the first 200 b.p. rate

shock. 

The situation portrayed in the

p revious paragraph re s e m b l e s

what actually occurred in

December 1994. The short-term

interest rates to which ARMs are

tied rose in excess of 200 b.p.

from their levels in March, so

that in December, the Base Case

scenario was located ro u g h l y

w h e re the +200 scenario had

been in March. Figure 4 shows

the price profiles of the four

ARMs depicted in Figure 3, but

estimated as of December.

2 The

i n t e rest rate sensitivity of the

three ARMs with embedded rate

caps to a +200 b.p. shock may be

seen to have increased fro m

March.

The extent to which the interest

rate sensitivity of any particular

institution’s ARMs incre a s e d

depended upon the degree to

which the embedded caps constrained the adjustability of the

ARM interest rate. That, in turn,

depended on three factors.

First, an institution with ARMs

whose coupons were relatively

close to their lifetime caps in

M a rch would have shown a

g reater increase in sensitivity

than one whose coupons were

further from, and thus less likely

ever to reach, their lifetime caps.

Second, an institution whose

ARMs have 1% periodic rate

caps (e.g., GNMA 1 - y e a r

Treasury ARM securities) would

have shown a greater increase in

interest rate sensitivity than one

with 2% caps, because a 2% cap

is less likely ever to prevent the

ARM from resetting to its fully

indexed rate.

T h i rd, an institution whose

ARMs had interest rates in

M a rch that were below their

fully indexed rates would have

shown a greater increase in interest rate sensitivity than one

whose rates were at, or above,

their fully indexed rates. The

longer, and further, an ARM’s

interest rate remains below its

fully indexed rate, the more constraining is the periodic cap and

the lower will be the A R M ’ s

value compared with a fully

adjustable ARM, and the greater

will be its interest rate sensitivity.

For example, consider two 1-

year Treasury ARMs, each with 6

months until their next re s e t

date, and with 2% periodic rate

caps. Suppose the fully indexed

rate for both ARMs is initially

6.65% and that they differ only in

their current interest rates: ARM

#1 is at the fully indexed rate

(6.65%) and ARM #2 is at 6%.

Suppose interest rates rise 200

b.p., so that the fully indexed

rate changes to 8.65%. Assuming

interest rates do not change further, ARM #1 will accrue interest

at less than the new fully

indexed rate (of 8.65%) for only 6

months, after which it will reset

to 8.65%. ARM #2 will accrue

interest at less than 8.65% for 18

months. That is, it will accrue at

6% until it resets, in 6 months.

On the reset date, the periodic

cap will limit the new interest

rate to 8%. Thus, an additional 12

months will pass before the

i n t e rest rate can be reset to

8.65%. Because the interest rate

of ARM #2 started out below the

fully indexed rate, the periodic

cap imposed more of a constraint

on the adjustability of its interest

rate than in the case of ARM #1

which started out at the fully

indexed rate. As a result, the

value of ARM #2 will be more

sensitive to a rising rate environment.

Effect of Teaser Rates on ARM

Sensitivity

One common practice that

increased the interest rate sensitivity of the industry’s A R M s

during 1994 was the origination

of ARMs at much less than a

fully indexed rate (so-called teaser ARMs). For the re a s o n s

described in the previous paragraph, teaser ARMs are more

interest rate sensitive than fully

2 For simplicity the characteristics of the ARMs depicted in Figures 3 and 4 are identical, even though 9 months would have

passed between the two sets of estimates. For an actual ARM pool, the coupon and time to next reset would change between

March and December.
Table 1.The Volume of Teaser ARMs Increased and Teaser Rates

Became More Aggressive

Aggregate Teaser ARMs Aggregate Non-Teaser ARMs

Balance ($bn.) WAC (%) Balance ($bn.) WAC (%)

Mar Dec Mar Dec Mar Dec Mar Dec

Current Market

Index ARMs :

6 Mo or Less 3.0 3.4 4.50 5.43 23.8 29.2 6.05 6.67

7 Mo to 2 Yrs 11.8 16.8 4.95 5.51 72.5 76.7 6.11 6.82

2+ Yr to 5 Yrs 2.3 4.9 6.75 6.88 11.0 15.3 7.56 7.37

Lagging Market

Index ARMs:

1 Month 4.8 7.8 5.57 5.27 87.3 100.9 6.24 6.33

2 Mo to 5 Yrs 7.3 9.9 6.12 5.82 29.6 31.5 6.73 6.59

indexed ARMs, and the more

a g g ressive the teaser rate, the

greater is the rate sensitivity of

the ARM

In aggregate, the volume of

reported teaser ARMs increased

from 4.0 percent of total assets, in

M a rch, to 5.8 percent, in

December. Not only did the proportion of teaser ARMs gro w

during this time period, but the

newly originated ARMs also had

more aggressive teaser rates (see

Table 1). For instance, in

December, the average reported

interest rate for the largest single

category of teaser ARMs (those

tied to current market indexes

[primarily 1-year Treasury], in

the 7 Month to 2 Year reset category), was about 400 b.p. below

the fully indexed rate of that

time, while in March they had

been only about 200 b.p. below

fully indexed.3 The situation

was even more extreme in the

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case of teaser ARMs tied to lagging market indexes (primarily

cost-of-funds-index A R M s ) ,

whose average reported interest

rate actually declined by 30 b.p.

between March and December.

Part 3: Has Risk Actually

Increased?

To answer the question posed at

the beginning, if a thrift institution’s asset/liability stru c t u re

remained unchanged during

1994, there are good reasons to

expect its level of interest rate

risk to have increased in view of

the effects that rising intere s t

rates have on price sensitivities

of fixed and adjustable rate

mortgages. To say that a static

portfolio implies a constant level

of risk would be analogous to

arguing that, despite the turmoil

in the commercial real estate

market in the late ’80s, the level

of risk in a given commercial real

estate portfolio must have

remained unchanged because it

contained the same loans that it

did prior to the change in the

market environment.

Clearly, the economic value of a

portfolio of assets and liabilities

can change as a result of changes

in outside factors, (e.g., changes

in interest rates or customer

behavior). Similarly, the rate of

change in the value of that portfolio can, and does, itself change

in response to changes in the

market environment. The general increase in the level of risk at

O T S - regulated savings institutions during 1994 was consistent

with what one would expect for

an industry heavily invested in

mortgages in an environment of

increasing interest rates.

* * *

3 The average fully indexed rate in March was 6.9% (i.e., the 1-year Treasury index was 4.4%, plus the average margin of 2.5%),

while the average teaser interest rate was 5.0%. In December, the average fully indexed rate had risen to 9.7% (based on a 1-

year rate of 7.2%), while the average teaser interest rate had risen to only 5.5%.