Consulting Corner

A Virtuous Portfolio
by Andrew Davidson

Over the past few months there has been much focus on the question of the appropriate size of the retained portfolios at the Government Sponsored Enterprises: Fannie Mae, Freddie Mac and the Home Loan Banks.

Just as Congress is now facing the issue of the size of the GSE portfolios, all financial institutions face similar issues in deciding how much to invest in various market sectors. Some of the same ideas could be used to address the question in both arenas.

A very large concentrated portfolio exposes an institution (or the taxpayers) to the risks of that particular market. Even if the portfolio is well hedged, there are still risks that cannot be fully eliminated through hedging and risk management. In the mortgage market, the uncertainty of prepayments is one of those risks. Even with the best models, there is a risk that borrower behavior will change or otherwise not be as expected.

On the other hand, a portfolio that is too small may constrain an institution from achieving its business (or societal) objectives. For example, a firm that is unable or unwilling to put loans in a portfolio may find that it becomes uncompetitive in other business areas since it may not be able to originate loans that its customers desire. In addition, they may find that they cannot securitize loans effectively if they are not able or willing to accumulate sufficient assets to securitize efficiently. A firm may also find that a larger portfolio provides a stable source of earnings that diversifies some of the cyclical risks of the mortgage market. The growth retained loan portfolios in Sub-Prime REITs is an example of this. Many firms have concluded that developing a portfolio that provides income in the form of net interest margin may be beneficial in offsetting some of the uncertainty associated with the timing of loan production and loan sale margins.

 

 

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