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Concentration Risk Limits on Mortgage-related Assets and the Unintended Consequences

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Not all mortgage-related assets are created equal.  Therefore, using a one-size-fits-all approach in establishing concentration risk limits can lead to missed opportunities or a false sense of security.

Concentration risk policies are intended to reduce the impact a risk event could have on a credit union’s balance sheet, financial structure, and/or business model.  The NCUA cites the Basel Committee on Banking Supervision when defining the concept, stating:

A risk concentration is any single exposure or group of exposures with the potential to produce losses large enough (relative to capital, total assets, or overall risk level) to threaten a financial institution’s health or ability to maintain its core operations.

An effective risk management policy and process should incorporate an understanding of the aggregate risk exposure present in a credit union’s financial structure. This is key to ensuring that the overall risk level in the credit union’s financial structure does not exceed the institution’s risk threshold, nor does it place the overall health or viability of the institution at risk.

Concentration risk limits on mortgage-related assets and their unintended consequences on a credit union's balance sheet, business model and/or financial structure.

Supplemental to an effective aggregate risk management process would be limits on certain key areas, or “hot spots,” that fit the definition of a risk concentration, as referenced above from the Basel Committee. Frequently, mortgage-related assets are lumped into a single category and defined as a risk concentration based upon the underlying collateral (mortgages). However, the risk present across all types of mortgage-related assets is not the same. Consider the risks present in:

Some of the above carry liquidity risk, some carry credit risk, others carry interest rate risk (IRR) – and some carry a little of all the listed risks. However, the degree of risk is different for each. The interest rate risk profile of a floating-rate collateralized mortgage obligation (CMO) is materially different than that of a 30-year conventional mortgage. The liquidity risk in a 50% LTV first lien HELOC with a 15% average utilization rate is materially different than the Government National Mortgage Association (GNMA) mortgage-backed security (MBS) pass-through.

Part of an effective overall concentration risk management policy is to document the risk(s) addressed by a particular limit. Instead of setting a single limit on all mortgage-related assets, management teams should invest the time it takes to identify the risk(s) across all types of mortgage-related assets, and set limits where it is determined a concentration exists. As mentioned above, setting a single limit on mortgage-related assets can lead to missed opportunities or lull decision-makers into a false sense of security. Having a robust process to identify and manage the aggregate exposure of risks that could significantly threaten a credit union’s net worth is a critical component of the asset/liability management (A/LM) process.

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Concentration Limits and Interest Rate Risk – a Moving Target

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Over the last few years, many credit unions have been asked to complete concentration risk policies and develop limits founded on some type of analysis.  Some institutions have also included limits in their policy designed to mitigate exposure to interest rate risk as a supplement to more traditional asset/liability management practices.  These limits should be carefully reviewed to ensure that they are still appropriate, given any potential changes that may have occurred in the credit union’s financial structure.

The nature of concentration risk limits is that they are designed to limit too much risk from any single exposure, or group of exposures, that could threaten the viability of the credit union.  Mortgage-related assets are often cited as an area that should be constrained through a concentration limit.  However, the nature of interest rate risk and asset/liability management is significantly more complicated than a single limit can capture.

Concentration risk limits designed to mitigate interest rate risk often fall short of helping to manage the overall asset and liability mix of the credit union.  Interest rate risk and asset/liability management (even as the name implies) involves more than just assets, and limits designed to mitigate interest rate risk exposures should be tested regularly as the changing mix of both assets and liabilities can have a material impact on the interest rate risk profile of the credit union.  It is this interconnectedness of the overall financial structure that makes concentration risk limits designed to mitigate interest rate risk exposures difficult to test to ensure they are appropriately managing risk.  Instead of setting individual limits, test the entire structure, in aggregate, to ensure that the overall enterprise does not have too much interest rate risk.  This aggregate monitoring of interest rate risk is a cornerstone to sound asset/liability management, and should not be overlooked in favor of concentration risk limits to quantify interest rate risk exposures.

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Investing At “Record” Low Rates…

The Fed’s first 3-year “forecast” revealed that almost half of the Fed Governors believe the Fed will keep short-term rates very low through 2014.  Coupled with continued weak loan demand, many credit unions feel like they are forced to do more with investments.  These two factors may cause more credit unions to extend investments moving forward into 2014.  Here are a couple of things to consider:

  1. Ask yourself, does that make sense? Regardless of what your broker tells you, it is always a good idea to apply the “reasonableness test” to any new investments that your credit union is evaluating.  Honest mistakes can be made.  A recent example is a broker showing a credit union a 13% market devaluation in a +300 basis point (bp) rate change on a 15-year final maturity callable.  The mistake was made because the market value model that was used showed the callable being called at the 5-year point, even in a 300bp rate increase.  In reality, a 15-year final maturity callable should devalue by roughly 30% in a 300bp rate change.  Callables will NOT get called if rates rise.   Make sure your credit union is evaluating the risk to final maturity if you consider investments with optionality, like callables, or mortgage-related products.  Buying long maturity callables with the expectation that they will be called can be a risky strategy
  2. How does this fit within policy? All investment decisions of relevance should be examined from an overall risk perspective, to ensure the new purchases still fit within policy limits.  Not just investment concentration limits, but overall aggregate risk policy limits (calculating impact on overall financial results)

There are many other areas that could be considered, such as overall credit union strategy and how new investments fit within this strategy.  Is the credit union positioned for long-term success if rates stay low and loan demand remains weak?  Lengthening investments can provide some revenue relief in the short-term, but will not provide relief from the long-term structural and operational challenges that many institutions are facing in this environment.

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Rate of Growth and Loan Concentration Limits

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As you consider establishing concentration limits on loans, it is important to know how the rate of growth could impact risk.

We understand that loan growth is anemic for many financial institutions.  However, at some point, loan demand will increase and the rate of growth is something decision makers will need to consider.  In fact, some credit unions may need to consider their rate of growth now as we are seeing a rapid increase in indirect lending (often called “point of sale” lending).

The following shows the change in loan concentrations as a percent of assets for two credit unions that no longer exist.  Each experienced brutal losses in the portfolios that grew unmanageably.

credit union A

credit union B

Aside from absolute concentration limits, factoring in a threshold for change (growth) in concentration can serve as an early warning sign that a business line may threaten the credit union’s safety and soundness.

Taking the two example credit unions above, extraordinary growth was experienced year-over-year-over-year—yet no effective action was taken to understand the risk and/or stop the growth before it was too late.

As the economy improves and lending demand grows, it will be necessary to perform continuous, rigorous analysis as a portfolio is growing.  Management should constantly step back and ask questions such as:

  • Why is this portfolio growing so fast?  Are we experiencing “too much of a good thing”?
  • What is missing from our current analytics?
  • Are our assumptions too optimistic?  What if our assumptions are wrong?
  • What forces are out of our control that could cause this business line to go south—and go south fast?
  • Are we making more exceptions in our underwriting?  Is there a pattern with a particular loan officer and/or third party?
  • Are we relying on this line of revenue to the detriment of our other lines of business?  What can threaten this line of business, and how fast can we recover should it be dramatically reduced?
  • Are our internal controls rigorous?  How can we test this to ensure we are adhering to our standards?

When evaluating options for concentration limits, credit unions should also consider establishing guidelines for portfolio growth.  While we have shown only two examples, these situations occur all too often.  The message is that rapid growth in a particular asset class can play a key role in creating unacceptable risk.

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Establishing Concentration Limits

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Establishing concentration limits that enable you to make sustainable, sound business decisions while trying to satisfy new regulatory pressure is very tricky.

The supervisory letter on concentration risk states that examples of concentrations within an asset class include…

“Residential Real Estate Loans—collateral type, lien position, geographic area, non-traditional terms (such as interest-only, payment option, or balloon payment), fixed or variable interest rates, low or reduced underwriting documentation, and loan-to-value (LTV).”

If you are contemplating multifactor concentration limits as described above, consider the following example and how this approach could impact your strategy and business decisions.

Let’s assume:

8 real estate types, with
4 different LTV ranges for
20 ZIP codes (geographic areas) and
6 credit score ranges, would result in

3,840 total risk limits for the Residential Real Estate Loans

Keep in mind the above example is just for Residential Real Estate.  Imagine applying the same multifactor approach to other asset categories.  The number of limits can become daunting and unmanageable.

We recommend listing every limit on a single piece of paper to help decision makers understand the magnitude of their potential policy commitments.

Slicing and dicing portfolios absolutely is a key component of portfolio analysis and risk management.  However, we are concerned that the establishment of these limits in policy is being rushed in anticipation of the next exam or, during the exam process, examiners are pressuring credit unions to establish concentration limits quickly.

Rushing to establish concentration limits without appropriate analysis, including potential impact to strategy and business model, could result in unintended consequences with serious implications.  Not to mention the red flag noted in the supervisory letter regarding changing concentration limits if a credit union is outside of policy.

We highly recommend following a deliberate process to establish limits.  Test drive your limits under various economic scenarios to understand, in advance, how they will impact strategy and business decisions.  This includes the changes that may be necessary to the credit union’s business model in order to manage within the new limits.

This blog addresses only a sliver of the issues regarding concentration limits.  There certainly will be more to follow, such as the correlation between the speed with which concentration increases and poor financial performance.