Q&A with the Credit and Collateral Risk Team

David Messina, Credit and Collateral Analytics and Modeling, Managing Director at FHLBank San Francisco, shares his credit and collateral insights with Relationship Manager and Senior Vice President John McCormack.

Photo of Davide MessinaQ: David, as a brief intro, maybe you could provide an update on how the Bank values its pledged collateral and what causes you to alter haircuts?

Great question. As you know, the Bank is a fully-secured lender with respect to its Advances and Letter of Credit lines of business. The collateral accepted to secure outstanding credit has to meet our eligibility criteria – typically in the form of housing finance-related mortgage loans and securities. The Bank values these instruments to reflect current market conditions, using both third party valuation models and our own in-house analysis. The margin assigned to these types of fixed-income investments protects the Bank against a decline of market value and other liquidation risks over an anticipated liquidation period. These risks include credit, liquidity, interest-rate, and prepayment, to name a few. When the uncertainty surrounding any one or multiple risk factors increases, margins tend to increase as well. When they decline, margins typically decline up to a certain point.

Q:  Thanks for the refresher, David. It seems that collateral margins have only been increasing lately, do you know what is driving this change, specifically?

Another good question. Because of increased market volatility associated with the ongoing COVID-19 pandemic, we’ve observed that price changes for mortgages and other loans backed by real estate assets have been much more pronounced than they were in periods prior to the COVID-19 outbreak. We conduct regular stress testing of our mortgage collateral, and the increased volatility caused a more adverse stress test outcome for multifamily and commercial loans than before the pandemic. As a result, we’ve had to increase the margin, or haircut, on the value of these loans to cover the possibility however unlikely – of an adverse market event causing prices to decline even further at some time in the future.

Q: Market volatility has been high, but what about the asset’s fundamentals? Specifically, are you observing any significant impact from borrower payment deferrals on the value of mortgage collateral?

Unfortunately, we are seeing some negative effects on the fundamental valuation side from COVID-19. The impact has been more pronounced on commercial real estate loans where some asset classes, such as retail and hospitality, have seen significant (double digit) valuation declines, year-over-year. The impact on single family residential mortgage values has been more nuanced. There are two main reasons for the divergence in valuation trends between residential and commercial loans:  1) the Fed has been much more active in purchasing single family residential loans in the form of Agency MBS as compared to CRE loans in the current QE program, and 2) a combination of steadily increasing single family home prices, limited excess housing inventory, and increased affordability because of lower mortgage rates have increased equity values in residential RE. Which, in turn, have provided valuation support for single family mortgage credit. In contrast, CRE property valuations are showing signs of stress, especially for hospitality, retail, and office, as a result of the economic fallout of the pandemic and uncertainties about the track the recovery might take going forward.

Q:  That makes sense, but are the Bank’s margins just going to keep moving higher?  When can members expect to see haircuts start to come back down?

Although we can’t say for sure one way or the other, the margin measures we are taking today are designed to safeguard the Bank and our members’ capital against unfavorable price movements in an adverse, or even severely adverse, risk scenario --the stress test concept. If the uncertainty regarding COVID-19 effects on the mortgage market begin to subside, the margins can be gradually scaled back down to pre-crisis levels, as market conditions and fundamentals improve.

Q:  Recently the Bank surveyed members on COVID-19-related mortgage payment forbearance. Are there any takeaways that you’d be willing to share?

John, we can’t discuss the specifics of the survey results for legal reasons. But generally speaking, the mortgage forbearance rates in the Bank’s member collateral portfolios, on an aggregate level, were consistent with nationally observed rates of mortgage payment forbearance. A number of members reported that some borrowers with forbearance status are actually making payments. We will continue to monitor the forbearance situation through submitted loan-level data, field reviews, and member surveys.

Q: Is there any borrowing capacity impact for loans with payment forbearance?

In July, we started to apply market value discounts on loans that were in payment forbearance, and increased the discounts again in October, based on feedback from our mortgage loan pricing vendors. The rationale being that in a liquidation scenario an investor would be unlikely to bid the same price for a performing loan as they would for a corresponding loan with payment forbearance. The longer the forbearance period for a given loan lasts, the greater the uncertainty regarding its future performance, hence the increase in market value discounts in October as compared to July. On a more positive note, as the economy begins to recover, we expect forbearance loans to gradually become current again, at which point the discount would be reduced or removed entirely.

Q: Thanks for the update.  If you don’t mind changing subjects, could you talk about what’s happening with the LIBOR rate index, and specifically how it pertains to pledging ARM loans?

LIBOR has been in the process of being phased out by the Federal Reserve as well as other Central Banks and regulatory agencies around the world for several years now. The Bank is also planning for the eventual removal of the LIBOR index, which is currently slated for December 31, 2021.  Given that this date is less than 18 months away, the Bank will begin taking special precautions on the increasing risk associated with LIBOR-indexed loans such as market, liquidity and legal risk – in the form of price discounts, beginning in Q2 2021.  The Bank expects to institute price discounts gradually, with increases over the course of the year to allow Members reasonable time to transition to alternative indices such as the U.S. Treasury (CMT) or SOFR.

Q:  Does this mean LIBOR-indexed loans are going to be ineligible before the end of 2021?

At this time, we have no plans to make LIBOR-indexed loans ineligible during 2021, although this could change depending on future market conditions and the legal and regulatory environment. As more information about replacement indexes becomes known, we will work with our members to transition away from LIBOR and other legacy indices, such COFI, to replacement indexes.  The Bank strongly encourages its members to start planning their transition away from LIBOR well before the end of 2021 to minimize the effects of any negative borrowing capacity adjustment from future market price discounts.  

Q: What about loans indexed to COFI?

This is a great question. As we both know, the Bank has announced that COFI will be discontinued at the beginning of 2022, close to the targeted end-date for LIBOR. Members can expect us to manage COFI-indexed collateral in a similar way to LIBOR-indexed collateral, including the application of discounts next year. While fewer members are going to be affected than with LIBOR, the negative impact on borrowing capacity can, again, be minimized by starting the transition to another index as soon as possible.

Q:  Thanks David. Last question: any thoughts on the possible impact of the proposed 50 basis points fee recently sanctioned by the FHFA for Fannie and Freddie?

Although it’s a little early to make predictions (the initiation date on the fee was recently rolled back to December 1, 2020), the additional fee should reduce prepayment speeds on some fixed rate products, which, from a collateral perspective, should increase the value of MBS and mortgage loans on an option-adjusted basis, all else being equal. The reason for this is that, generally speaking, MBS investors require additional compensation to account for the early repayment of principal – that is prepayment risk. When mortgage refinancing activity is high, the spread or compensation required for investors to assume that additional risk tends to increase as well – prices are lower. Conversely, when refinancing risk is low, the spread tends to narrow (prices are up). The overall price impact, however, could be obscured by a host of other factors, such as guidance from the FOMC regarding future asset purchases, the future benchmark interest rate, and the expected risk of borrower default rates, which also triggers early repayment in Agency products. Overall, mortgage refinancing will likely continue to be an attractive option for many home borrowers, even with an additional 50 basis points, just given where prevailing long-term interest rates are today.

November 12, 2020 | FHLBank San Francisco