S&Ls; Twist Old Loans Into New Package for Fresh Profits : More Thrifts Turning to Trading Mortgage-Backed Securities in Liquid Secondary Markets

Savings and loans still view the tried-and-true residential loan as their dominant asset.

But faced with ever-tightening profit margins, they are looking for new ways to squeeze income out of their residential loan businesses. That search has led many thrifts to become more active in the secondary mortgage market, where thrifts traditionally have bought and sold loans.

Instead of simply buying and selling loans, S&Ls; increasingly are buying and selling marketable securities that use mortgages as collateral.

For S&Ls;, the key to the appeal of mortgage-backed securities is liquidity, said Mike Wilson, associate director of research for the Chicago-based U.S. League of Savings Institutions. “A loan might make a good investment (to an S&L;) but if you want to sell it quickly, it could be difficult. And if it doesn’t meet certain standards, it’s going to be tough to sell it at all.”

At the end of 1987, mortgage-backed securities accounted for $191.8 billion, or 15.1%, of total assets at institutions insured by the Federal Savings and Loan Insurance Corp. That is a dramatic increase from 1982, for example, when mortgage-backed securities accounted for just $61 billion, or 8.5%, of total assets held by FSLIC-insured institutions.

“Interest in mortgage-backed securities has soared during the past two years,” according to Wilson. The bulk of those mortgage-backed securities held by S&Ls; have been the “plain old vanilla variety”--securities that are offered by the Federal Home Loan Mortgage Corp. (Freddie Mac), the Government National Mortgage Assn. (Ginnie Mae) and the Federal National Mortgage Assn. (Fannie Mae), Wilson said.

Those government-chartered institutions, which buy home loans in order to boost the liquidity of lending institutions, introduced mortgage-backed securities during the 1960s as one more way to help keep lenders liquid.

Mortgage-backed securities now account for a hefty percentage of the assets held by those quasi-government agencies. For example, the loan portfolio of Fannie Mae, which celebrates its 50th birthday on Wednesday, includes $140 billion in outstanding mortgage-backed securities and more than $100 billion in acquired loans.

When loans are sold outright, whether by a Fannie Mae or a private corporation, the seller receives a cash payment. But when loans are used as collateral, the buyer acquires “securities that are backed by the (homeowners’) principal and interest payments,” Wilson said.

Turning loans into collateral for marketable securities “is a change from the days of loans being just loans,” according to Bob Hamer, treasurer of Home Federal Savings & Loan. “Loans are becoming more of a commodity and there’s an increasing demand (among investors) for that type of commodity.”

S&Ls; traditionally have bought and sold loans to fine tune their loan portfolios. Cash generated by loan sales often is used to make additional loans or bolster an institution’s liquidity. S&Ls; are using mortgage-backed securities for much the same reasons, according to Wilson. And, many mortgage-backed securities help S&Ls; satisfy regulatory requirements that they keep a minimum amount of their assets in loans.

Investors view mortgage-backed securities as generally safe investments, but the securities do have some drawbacks.

For example, it is hard to predict when residential mortgages used as collateral will be paid off, especially when interest rates dip and consumers line up to refinance their home loans. That uncertainty runs counter to the goals of investors who plan on collecting interest and principle payments for the scheduled life of loans.

And, because the securities offerings are often complex, “about half of (S&Ls;) don’t feel comfortable with them yet,” Wilson said.

Mortgage-backed securities can be intimidating. For example, one fairly common securities package channels interest and principal payments to different investors. That package has been dubbed STRIP, for Separate Trading of Interest and Principal Security.

For San Diego-based Imperial Corp. of America, the parent company of Imperial Savings, mortgage-backed securities account for about 20% of current assets, up from just 3.4% in 1984.

Mortgage-backed securities accounted for about 6% of Home Federal’s assets at the end of 1987, but Hamer said that total could swell to about 20% of total assets within five years.

At Great American First Savings Bank, mortgage-backed securities accounted for 21.5% of the S&L;’s $15.2 billion in assets.

“That represented an important part of our overall profitability during 1987,” according to James A. Krzeminski, senior vice president.

Great American views mortgage-backed securities as a “more liquid investment than the underlying mortgage loans,” according to Krzeminski.

Some of the securities offerings that have evolved during the past year “can be really bizarre, even to financial industry professionals,” Wilson said. “There are people in the business who have pretty much sworn these things off until they get a better understanding.”

Hamer linked the ever-increasing complexity of the secondary market to the number-crunching ability of high-speed computer programs that easily handle computations that were too time-consuming just a few years ago.

Not surprisingly, most of the mortgage-backed securities purchased by local S&Ls; were acquired from the federally chartered Ginnie Mae, Fannie Mae and Freddie Mac.

But home loans aren’t the only instruments being used as collateral. In San Diego, S&Ls; also have used multifamily residential loans, car loans and credit card payments as collateral for securities.

Elsewhere, a major life insurance company recently used a super computer to help craft so-called “death bonds”--tradeable securities that collateralize loans taken out on life insurance policies.

S&Ls; are attracted to some of those complex securities offerings because they qualify as assets that can be used to meet regulatory net-worth requirements.

The market for mortgage-backed securities is growing increasingly complex, but the theory that drives them remains relatively simple.

S&Ls; hope to make a profit by selling the security-backed loans at a price that is slightly higher than their cost of originating the loans. But S&Ls; might accept a loss on a securities offering if they can make it up by collecting processing fees on those home loans, Hamer said.

S&Ls; in the past have preferred “vanilla” securities, but institutional tastes are expected to change because an estimated 70% of home mortgages now are used as collateral in mortgage-backed securities.

With that residential market nearly saturated, thrifts have begun to explore securities that are backed by commercial mortgages, according to Ernie Elsner, a senior vice president of Duff & Phelps, a Chicago-based firm that rates securities offerings.

Less than 1% of commercial mortgages are now used as collateral for mortgage-backed securities, according to Elsner. But Duff & Phelps recently rated six commercial transactions for California thrifts, including Great American and Coast Savings Bank.

“By selling a portion of their commercial real-estate loan portfolios to institutional investors . . . (S&Ls;) can increase funds available for mortgage origination,” according to Elsner.

The use of fixed-rate commercial loans as collateral for mortgage-backed securities “looks to be a big growth area in the future,” according to Richard H. Keyes, first vice president for Great American.

Experts agree that investors might find fixed-rate commercial mortgage-backed securities to be even more attractive than securities backed by residential loans. That enthusiasm is generated by the fact that commercial loans, unlike residential loans, usually are not paid off early.

Consequently, while the extremely complex nature of the commercial securities will slow market growth, S&Ls; eventually will view the offerings as “more predictable” than offerings backed by residential mortgages, Elsner said.

Moody’s, Standard & Poor’s and Duff & Phelps all hope to become the industry leader in the crucial area of rating those increasingly complex offerings. Ratings will help issuers improve the liquidity of offerings, and investors will feel more comfortable, Elsner said.

Moody’s has gone as far as supplying “after-the-fact” ratings to investors who purchased securities offerings that previously were rated by Standard & Poor’s, according to an executive at a San Diego thrift.

In many cases, Moody’s ratings were lower than those issued by Standard & Poors. “That caused quite a stir, because the investors are now not sure of the quality of what they’re holding,” the executive said.