An Update on Emerging Issues in Banking 

Refinancing Waves Alter the Landscape for 

Mortgage Specialists

April 25, 2002 

Summary

The profitability of the nation's residential mortgage lending specialists has 

become more exposed to the effects of a rising interest rate scenario that 

would compress net interest margins and suppress noninterest revenues 

associated with mortgage production and sales. Residential mortgage 

specialists comprise less than 10 percent of FDIC insured institutions, but 

two nationwide refinancing waves have elevated the importance of this issue 

for them. The current interest rate environment affords institutions the 

opportunity to correct material asset/liability mismatches before the rate 

cycle turns and risk reduction strategies become less effective or more 

expensive to execute. 

The FDIC routinely disseminates analysis to insured institutions that may be 

useful to them in managing risk. Such analyses represent the opinions of the 

authors. They are provided for information purposes and do not constitute 

supervisory guidance. 

Unprecedented levels of refinancing spurred by low long-term interest rates 

have contributed to a significant lengthening of asset maturities for many 

insured institutions, particularly for those with large concentrations in 

residential mortgage-related assets. Conversely, the funding mix remains short 

and the growing presence of embedded options in term liabilities would likely 

result in further shortening in a rising rate environment, even as asset duration 

lengthens in response to lower prepayment activity. This shift in balance sheet 

composition has heightened interest rate risk (IRR) for many institutions. As a 

group, savings institutions exhibit the greatest shift in exposure to rising 

interest rates due to their traditional reliance on residential mortgage loans as 

the primary source of revenue. However, similar trends are noted for many 

commercial banks with similar concentrations in residential mortgages. 

The Mortgage Bankers Association estimates that approximately 80 percent 

of the dollar volume of residential mortgage loan applications made during the 

refinancing waves of 1998 and 2001 was fixed-rate, much of which converted 

from adjustable-rate instruments. This rapid turnover in assets, while affecting 

all types of insured institutions, has significantly altered the interest rate risk 

profiles of institutions specializing in residential mortgage finance.1 Since the 

1980s, adjustable-rate mortgages (ARMs) had provided the bulk of ratesensitive assets for mortgage specialists. Over the past few years, the median 

share of ARMs to total first liens for these institutions has fallen sharply as a 

result of elevated refinancing activity and customer preference for fixed-rate 

loans (see Chart 1). 
D

Refinancing activity has had an especially pronounced effect on the risk 

profiles of smaller institutions, most notably those located in metropolitan 

areas. For example, the median percentage of ARMs to total first lien 

mortgages for institutions included in the preceding chart that are located in a 

Metropolitan Statistical Area (MSA) has fallen from 61 percent to 25 percent 

since year-end 1995. Comparable data for non-MSA domiciled institutions are 

58 percent and 34 percent, respectively. Similar trends are noted for federally 

chartered thrifts as well. Institutions located in metropolitan areas are exposed 

to a greater degree of competition and hold larger average loan sizes, both of 

which can foster higher prepayment rates. In addition, unlike larger institutions, 

smaller institutions may not have the origination network needed to replace 

ARM runoff, given the limited volume of new ARM originations. 

While mortgage lenders have been slowly diversifying into other forms of 

lending, commercial borrowers also have sought to lock in longer-term 

financing, which has led to an extension of duration in non-residential 

portfolios as well. In addition to the customer-driven changes affecting loan 

duration, securities portfolio maturities are lengthening as well, as mortgage 

lenders have securitized (and retained) newly originated fixed-rate loans in an 

effort to support net interest margins. These shifts can be seen in the repricing 

data reported in the Call Reports of mortgage specialists.2 The median 

percentage of these institutions' mortgage pass-through securities that mature 

or reprice in over five years has increased from 40 percent to 71 percent since 

year-end 1997. The cumulative effect of these portfolio shifts is reflected in 
Chart 2. Fifty-six percent of mortgage specialists filing Call Reports now report 

long-term asset concentrations in excess of 40 percent of total earning assets; 

approximately 25 percent reported similar concentration levels in the mid1990s.3 While comparable data are not contained in the Thrift Financial 

Reports (TFRs) of OTS-supervised savings institutions, the median ratio of 

fixed-rate loans of 15 years or more to total earning assets for mortgage 

specialists filing TFRs has risen from 25 percent to 38 percent since 1995. 

D

Even as asset maturities have lengthened, the duration of liabilities has 

remained fairly short. The median percentage of time deposits that mature in 

less than one year exceeds 75 percent for all insured institutions, including 

mortgage lenders, and has actually risen modestly over the past few years. As 

depositor preference continues to favor short-term deposits, many institutions 

have also become more reliant on wholesale funding to support asset growth, 

which has increased the rate sensitivity of the funding mix. The reported 

maturity structure of borrowings has lengthened: however, data contained in 

the annual reports of the various Federal Home Loan Banks (the source of 

over 95 percent of term funding for mortgage specialists) suggest that a 

substantial portion of the longer term advances are subject to early redemption 

at the option of the lender.4 As of year-end 2000, the 12 FHLBs collectively 

reported that over 60 percent of advances with contractual maturities of 

greater than three years contained such an option. Repayment of these 

advances will likely be accelerated in a rising rate environment and they will do 

little to offset the growing exposure to higher interest rates embedded in the

asset side of the balance sheet. 

Optionality is also creeping into the deposit mix. In the current low rate 

environment, prepayment penalties on certificates of deposit are 

correspondingly lower and will be less of a deterrent to early redemption if 
interest rates rise. This is particularly true for those institutions that offer

reduced penalties and may result in deposit costs rising more than anticipated 

in a rising rate environment.

Thus, there appears to be little change in the rate sensitivity of on-balancesheet liabilities to offset the continued growth of long-term assets. From an offbalance-sheet perspective, less than 10 percent of mortgage specialists report

any use of interest rate derivatives to mitigate risk. This percentage has

remained fairly stable since long-term asset concentration levels began to rise

in the mid-1990s. Thus, greater reliance is now being placed on holding down

the cost of core deposits, a strategy that may prove difficult for many

institutions given the competitive pressures that likely will exist in an improving 

economic environment.

Interest rate risk has risen for many institutions with significant concentrations

in residential loans and management of that risk is becoming increasingly

complex. Recently, the net interest margins of mortgage lenders have risen 

modestly given low short-term interest rates and a steep yield curve. More 

importantly, the current rate environment appears to afford institutions the

opportunity to act. Correction of material asset/liability mismatches will require 

a trade-off of short-term profits for greater long-term earnings stability. Once 

the rate cycle turns, risk reduction strategies may be less effective or more 

expensive to implement.

This FYI expands on findings noted for New England insured institutions in the 

current Boston Regional Outlook. 

1 For this discussion, residential mortgage specialists are institutions with residential loans greater than 50 

percent of earning assets. Approximately 10 percent of insured institutions meet this definition, 85 percent of 

which are savings institutions. 

2 Comparable data is not contained in the Thrift Financial Reports filed by OTS-supervised savings 

institutions. The charts set forth in this article reflect trends for mortgage lenders that file Call Reports. 

3 Assets that mature or have their next repricing opportunity beyond the next five years. 

4 The Federal Home Loan Bank (FHLB) of Pittsburgh's 2000 Annual Report refers to these advances as 

convertible or putable loans for which the FHLB "provides below-market fixed-rate loans in exchange for the 

right to convert the loans to variable-rate loans and/or at the member's option to terminate the loans. These 

conversion options and/or put options are normally exercised by the FHLBank and members when interest 

rates increase." 

Last Updated 04/25/2002 
Chart 1

ARM Holdings Have Fallen Sharply at Mortgage Lenders, Contributing to a Lengthening of Loan 

Portfolios 

Year 91 92 93 94 95 96 97 98 99 00 01

Median: 

Adjustable 

Rate 

Mortgages 

/ Total 

First-Lien 

Mortgages

61 56.59 56.94 58.28 60.09 54.23 49.57 35.09 34.71 35.79 26.93

Median: 

Loans 

maturing 

or 

repricing 

after 5 

years / 

Total 

Loans for 

Mortgage 

Specialists

6.08 6.11 6.18 5.91 5.75 6.09 7.16 8.73 9.38 8.55 8.76

Median: 

Loans 

maturing 

or 

repricing 

after 5 

years / 

Total 

Loans for 

NonMortgage 

Specialists

22.48 23.88 26.28 26 28.11 31.59 37.14 45 48.15 47.95 48.73

Note: Residential mortgage specialists are defined as institutions with residential 

loans greater than 50 percent of earning assets. Approximately 10 percent of 

insured institutions meet this definition, 85 percent of which are savings banks.

Source: Bank Call Reports
Chart 2

Rising Long-Term Asset Concentrations Suggest Interest Rate Risk Has 

Risen for Institutions Specializing in Residential Lending

% of Institutions with Long Term Assets to Earning Assets of:

Year 91 92 93 94 95 96 97 98 99 00 01

Greater than 50% 11 12 14 15 15 20 22 31 39 38 41 

40 to 50 percent 9 12 11 11 11 10 16 19 17 16 15 

30 to 40 percent 15 15 15 12 12 16 17 15 14 14 15 

Source: Bank Call Reports

Includes mortgage specialists (Call Report filers with residential loans greater 

than 50 percent of earning assets.)