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Dallas Regional Outlook - Fourth Quarter 1999

Regional Perspectives Maturities of Mortgage-Backed Securities Lengthen Mortgage-backed securities (MBS), pass-through,10 and non-pass-through represented 53 percent of total securities in the Dallas Region as of June 30, 1999, up from 40 percent at year-end 1990. The aggregate dollar amount exceeds $47 billion and represents 14.2 percent of the Region's total assets. For the Region, MBS maturities have been lengthening; in fact, MBS maturities over 15 years increased from 38 percent to 62 percent over the two-year period ending June 30, 1999 (see Chart 3). Financial institutions across the nation have also seen an increase in maturity, but not to the same degree. For the nation, MBS maturities over 15 years have increased from 35 percent to 48 percent over the same period. Chart 3 10 Defined as a debt instrument secured by an undivided interest in a pool of mortgage loans. Investors receive pro-rata shares of the cash flows from the underlying mortgages. There are primarily two reasons why investors would seek longer maturities on a bond investment. First, the expectation that interest rates will decline increases the value of the bond. Investors also may want to gain additional yield because higher rates are generally paid for longer maturity instruments to compensate for the uncertainty of what interest rates may do over time. Over the past year interest rates have risen, and, more important, the slope of the yield curve has steepened (see Chart 4), making long-term instruments more attractive to investors. As of August 31, 1998, the spread between the 30-year Treasury bond and 3-month Treasury bill was 50 basis points. Six months later the spread was 81 basis points, and as of August 31, 1999, the spread was 120 basis points. Lenders now have a greater incentive to lengthen the maturity of debt securities. However, the longer maturities expose banks to increased market risk and interest rate risk. Chart 4 In addition, in a declining interest rate environment, there is a higher prepayment risk associated with MBS when borrowers refinance at lower rates. In a rising interest rate environment, the value of the underlying security falls as the present value of the cash flow decreases. Loss exposure on longer maturities in a rising interest rate environment is magnified because the investor will continue to receive the lower interest rate for a longer period. The American Banker recently reported that "investors are shying away from mortgage-backed securities despite a strong housing market and declining prepayment rates."11 Craig Ellinger, associate director for MBS at Chicago-based PPM America Inc., stated, "The fear of inflation and concern that the market could become flooded with securities is hurting the entire fixed-income sector."12 Some analysts are voicing concern that these factors could lead to a liquidity crunch for MBS similar to what was seen in the fall of 1998. 11 "Wall Street Watch: Investors Reluctant to Embrace Mortgage-Backed," American Banker, September 7, 1999. 12 Ibid. Savings Banks Reduce Holdings of Traditional Mortgage Products In contrast to commercial banks, Dallas Region savings banks decreased their investment in residential mortgages (direct loans and MBS) from 65 percent of total assets as of September 30, 1996, to 48 percent at midyear 1999 (see Chart 5). During the past three years, the Region's savings banks increased their allocation of higher-yielding construction and consumer loans. Construction loans increased from 9 to 14 percent of total loans while consumer loans increased from 15 to 20 percent of total loans. Whether this is an attempt to diversify portfolios or seek higher yields is uncertain, but construction and consumer lending typically are associated with greater volatility during economic downturns. Chart 5 Conclusion and Summary In conclusion, Dallas Region banks and thrifts differ in very tangible ways from financial institutions across the county. The Region tends to have a higher share of securities investments, perhaps because of lower funding costs or caution rooted in memories of the last real estate and oil crisis. Lower Region funding costs, on average, counterbalance lower-yielding securities investments resulting in the Region's ROA tracking at or above the national average since 1990. MBS influence many banks' profitability levels, with MBS representing over half the total securities portfolio as of June 30, 1999. While MBS maturities lengthened for the nation and the Region, 62 percent of the Region's MBS have maturities in excess of 15 years, significantly higher than the national average. Dallas Region financial institutions' unique asset mix may very well reduce levels of credit risk, but holding a greater percentage of securities in these institutions' portfolios appears to expose many institutions to increased levels of interest rate risk and market risk. Dallas Region Staff Regional Outlook Information Return to Regional Outlook main page