Understanding Inflation And Residential Mortgage Exposure

An examination of the useful tools for minimizing risk.

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Staff Writer

Mortgage Banker interviewed Daniel F. Morrill, CPA, principal, Wolf & Company, P.C., after a recent seminar before The Financial Managers Society he participated in on the topic of Inflation and Residential Mortgage Exposure – Mitigating the Risks.

What trends have you observed in the past two years that caused you to notice meaningful shifts in liquidity?
In early/mid 2020, the combination of fiscal and monetary stimulus provided in unprecedented magnitude resulted in the banking system becoming flush with liquidity. This can be seen most clearly in the rate of growth experienced in the M2 money supply during that time. However, in the front half of 2022, the combination of the Federal Reserve’s monetary tightening, the record tax payments made to the federal government in April and the emergence of meaningful loan growth has certainly diminished this previously ample liquidity.

What are some of the hedging strategies discussed in your presentation that can mitigate the risks associated with inflation and residential mortgage exposure?
The use of pay fixed interest rate swaps and interest rate caps can be useful tools in the effort to minimize risk associated with continued rising rates and its corresponding impact on longer fixed rate assets such as residential mortgages.

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.