The mortgage question

The transfer and management of risk in mortgage portfolios is one of the most pressing matters in financial markets today. Most discussions tend to concentrate on the susceptibility of these mortgage books to changes in interest rates or credit quality. It’s rare, therefore, when the focus turns to how derivatives could be used to help create supply of a certain type of mortgage product.

But that is exactly what the UK Treasury, via its Debt Management Office, is looking into. They are reacting to chancellor Gordon Brown’s desire to create a long-term fixed-rate mortgage culture in the UK. With outstanding mortgages as a percentage of GDP at 65% and rising, Brown is rightly concerned about the potential impact of a rise in interest rates on the UK economy, as the vast majority of mortgages held in the UK are floating rate.

As our two-part cover story, beginning on page 34, explains, one of the reasons for the lack of a fixed-rate mortgage market in the UK is the absence of market hedges for prepayment risk. UK finance officials have therefore been working on a potential solution with the mortgage lending industry and leading derivatives banks.

Their answer, which our story reveals for the first time, seems to be the creation of gilt options – which would also be a huge bonus for life insurers crying out for a tool that would allow them to reduce the volatility of liabilities in their funds, and therefore improve their capital positions.

But, as the second part of our cover story (page 39) shows, mortgage lenders aren’t convinced by the proposals – because they don’t believe borrowers want fixed-rate mortgages.

The trend in continental Europe is in the opposite direction. There, mortgage lenders that offered predominantly long-term fixed-rate mortgages are being forced to bow to pressure from borrowers and offer new products – most of them floating rate.

In many European markets, prepayment risks have been nullified through prohibitive penalties for borrowers looking to get out of their mortgage. But the European mortgage industry remains backward in terms of its risk management practices – across Europe, as much as 60% of mortgages are still funded through the lenders’ deposit bases.

That must change, and the transition to more active risk management techniques – which aren’t just limited to credit risk and a bank’s regulatory capital but also include interest rate risk, prepayment risk, currency risk and operational risk – should provide a windfall for banks, advisers and technology companies.

But active management of risks in a mortgage portfolio – often through securitisation (see our special report on page 57) – can create its own problems. Look at the US market. Last summer, extreme interest rate volatility almost caused a market meltdown, and the blame was laid squarely at the dynamic hedging of loan books with swaps (Risk December 2003, page 22).

As a result, as our story on page 42 shows, regulators in the US are now targeting the huge US mortgage agencies, Fannie Mae and Freddie Mac, because of concerns about the systemic risk that their active risk management policies may cause in the event of further extreme interest rate volatility.

It looks like the discussion about appropriate risk management techniques for mortgage lending, whether in Europe or the US, will be pretty active too.

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