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13 Mar 2023  (1211 Views) 

Banks in America may suffer large losses on their mortgages
American banks will face big problems with their mortgages. 

They offer 30 year mortgages at fixed interest rate. In the early 2010s, following the 2008 financial crisis, interest rates on 30-year fixed-rate mortgages fell to historic lows, often around 3-4%. In 2020 and 2021, interest rates remained near historic lows, with rates for 30-year fixed-rate mortgages often hovering around 2-3%.

Assume that a bank had offered a fixed rate loan at 3%, and the rate has now increased to 6%, the value of the mortgage would have dropped 30% due to the difference in interest rate. 

If the bank had taken long term deposits at less than 3% interest, the bank would be fully hedged on the mortage and would not suffer any loss due to the change in interest rate.

However, it appears to me (and I may be wrong) that the US banks are not matching the mortgages and funding cost in this way. The bank is taking a risk on changes in interest rate. 

If the bank has $100 billion in mortgages of 30 years mortgages issued at 3%, and it is not hedged with any long term fixed rate funding, the bank would have to suffer a loss of $30 billion on the mortgages.  

The bank does not need to recognize this loss immediately. They would have classified the mortgages are "held to maturity" and would be allowed to carry the mortages at "cost". This means that they will write off a loss over 30 years, i.e. the loss is their cost of funds for the year (at the market rate) and the fixed rate that they receive on the mortgages. The loss would be about $1 billion a year over 30 years. (The actual loss will be somewhat higher in the earlier years, and will reduce in later years.)

However, if the bank faces massive withdrawals, they will have to sell their mortgages at the current depressed values and take an immediate loss on the mortgages that are sold.

The recent sharp hike in the interest rate will cause many banks to suffer large losses. 

What happens if the banks issued fixed rate mortgages at high interest rate and interest rate dropped subsequently. In theory, the bank would have made a large profit on the mortgages. 

However, the banks had a practice of allowing borrowers to refinance the mortgages at lower fixed rates by paying a penalty. The penalty is quite low, relative to the change in value of the mortgages. 

For example, if the 30 year mortgages were issued at 6% interest and the rate dropped to 30%, the bank should have charged a refinancing fee of 30% (representing the difference in value of the mortgages at 6% and 3%). Instead, the bank charged a refinancing fee of 3% (or less).

Home borrowers benefited by refinancing their mortgages at lower interest rate when the interest rate dropped during the past decade. 

When the interest rate went up sharply during the past year, the banks had to carry a large loss. 

I expect many banks in America to face serious financial problems. This will apply to the big banks as well.

Disclaimer: I do not have a full understanding of how the banks finance their mortgages. This article may exaggerate the problem. 

Tan Kin Lian

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