In September of 2021, the 10-year treasury sat just over 1.50% and mortgage rates were in the 3% range for many borrowers. Housing prices were soaring and financial depositories across the country were dealing with margin compression as investment options felt limited with interest rates hovering around all-time lows. Institutions grappled with challenges on pricing loans that may hang around for a longer period than expected as borrowers may seek to hold onto their low mortgage rates for as long as they can. Shorter duration assets like auto loans were being priced aggressively to generate some form of spread over the risk-free rate and generate profits.
Fast-forward one year to a very different environment. Interest rates are substantially higher, and many assets originated last year are now at substantial discounts – some also with significantly longer expected average lives. Despite the nominally low interest rates, institutions who hedged those assets are not as concerned about either the interest rate risk or their profits as they properly capitalized and funded those assets for the long term.
Today, hedged and funded on the run mortgage loans look very attractive in a risk-adjusted return on capital (RAROC) framework. Marginal return on equity (ROE) on loans should be higher when interest rates are higher and more volatile, which is the environment we are currently in. Take, for example, two common loan products: current coupon 6% 30-year mortgages and 4.50% auto loans, both funded with short term funding at Fed Funds plus 25 basis points and hedged with Fed Funds interest rate swaps.