Understanding Inflation And Residential Mortgage Exposure

An examination of the useful tools for minimizing risk.

Sarah Wolak Headshot
Sarah Wolak
A question mark made of dollar bills.

Your presentation mentioned FASB’s “Portfolio Layer” hedging method. Can you expand on this and its benefits?
For most, hedge accounting and hedge relationships when using a derivative are critical in order to achieve desired accounting outcomes. FASB introduced in March of 2022 a new hedging model within ASU 2022-01, the Portfolio Layer Method. This accounting model allows for an easier and more flexible approach to pooling together fixed rate assets in order to apply one or multiple derivatives, which would assist in mitigating interest rate risk.   

Daniel Morrill, CPA of Wolf & Co.
Daniel Morrill, CPA, principal,
Wolf & Company, P.C.

Can you talk about how inflation impacts residential mortgage pipelines?
If inflation were to continue at an elevated rate beyond the Federal Reserve’s target, this will compel the Fed to continue raising the federal funds target rate and quantitative tightening, both of which would likely cause benchmark rates to rise. As benchmark rates rise, oftentimes mortgage rates rise as well. This would have the effect of slowing housing demand, and therefore softening mortgage pipelines. 

What are some of the risks that residential mortgage holders face in today’s market?   How can mortgage professionals help?
Rising rates can increase payment requirements of a borrower, which could lead to credit issues. Also, coupled with this, housing values may decline. 

Your presentation mentioned that several balance sheets now have overall asset liability profiles exposed to inflation induced rising rates. What does this mean for the future of the depository industry?
Certain pockets of the industry have found themselves to be fairly liability sensitive at this point in the cycle, which with the Fed continuing to raise rates, has reduced margins and earnings.  This dynamic has to be managed carefully, understanding the risks within each unique institution and using tools (whether derivatives or otherwise) to mitigate these risks. 

What effects do the anticipated recession have on these shifts in liquidity if any?
This is the most critical question facing the industry today, how would a potential recession affect inflation, Fed policy, liquidity and finally interest risk within the system. While the potential outcomes are many and varied, the best approach one can take is to understand one’s own risk position. Modeling the balance sheet across a range of possible outcomes to truly understand where risks to earnings and capital reside, will then inform the practitioner with enough information to make an educated decision regarding if risk mitigation efforts (using derivatives or otherwise) should be pursued or not. 

What are the potential risks of not adapting these strategies?
The consequences of not protecting the balance sheet against adverse outcomes in advance can be quite serious. Many have said, it’s difficult to buy insurance once the house is on fire.  Instead, one should use the current moment to analyze and prepare for risks before they present themselves if possible. 

Sarah Wolak Headshot
Sarah Wolak,
Staff Writer
This article was originally published in the Mortgage Banker Magazine September 2022 issue.
Published on
Sep 20, 2022
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