A Glimpse into the Financial Risks of Mortgage Loans amid Falling Interest Rates

Recently, Reuters reported that data from the Mortgage Bankers Association (MBA) of the United States showed that the 30-year fixed-rate mortgage contract rate dropped to 6.49% in the week ending September 5, the lowest in nearly 11 months. Meanwhile, mortgage applications rose by 9.2% month-on-month, and refinancing applications increased even more, approaching half of all applications.

The rapid decline in interest rates is mainly driven by two aspects: First, weak labor market data has raised expectations that the Federal Reserve will ease its policy; The second is that the benchmark Treasury bond yield has declined simultaneously, lowering the pricing benchmark for mortgage interest rates. The market's expectation of a possible 25 basis point easing at next week's meeting has already been reflected in advance by some asset prices. This expectation itself amplifies the volatility of interest rate-sensitive assets.

In the short term, the direct effect of the decline in interest rates is a refinancing wave and an increase in home purchase applications. However, it should be noted that such an increase is more of a cost replacement for existing high-interest borrowers rather than a sustained credit expansion. A relatively high proportion of refinancing indicates that new loans have not fully increased, and the debt service burden on the household sector has somewhat eased. However, this does not equate to a systematic improvement in the quality of the mortgage portfolio.

The risk of maturity mismatch between assets and liabilities thus becomes prominent. During periods of declining interest rates, banks and non-bank institutions may encounter pressure from narrowing interest spreads and duration management: on the one hand, the spread between deposits and loans may be squeezed due to the lagging reduction in deposit costs or market competition; On the other hand, the duration changes of bonds and mortgage assets require institutions to adjust their duration matching strategies. In the short term, if leverage is increased or returns are pursued to fill the gap, it may amplify the overall risk appetite of the market.

The time lag of credit risk deserves vigilance. Refinancing has improved the immediate cash flow of some borrowers. However, if the economic fundamentals do not recover steadily and employment and income rebound and decline subsequently, the funds replaced may be used for consumption or to undertake higher-risk asset allocation, which may instead increase the systemic leverage level through other channels. In addition, regionality and the concentration of borrower groups remain potential trigger points for default.

Regulatory authorities and market participants need to focus on three key risk points at the current stage: First, credit quality retrospection under operational and compliance pressures; Secondly, the prepayment and reinvestment risks of the MBS and fixed income portfolio; Thirdly, the fluctuation of the interest rate center caused by the uncertainty of the monetary policy path has led to a sharp repricing in the bond and mortgage markets. If policy expectations fluctuate, the market's shift from "expectation of easing" to "policy tightening" will cause greater volatility than a one-way adjustment.

At the capital market level, investors should clearly incorporate the increase in the rate of prepayment into pricing and scenario analysis, assess the erosion of long-term returns by changes in the yield curve, and at the same time be vigilant against strategies of over-allocating high-risk or maturity extension tools in pursuit of returns. Hedging strategies should take into account the repricing risks in the context of rising interest rates rather than merely optimizing performance in the case of low interest rates.

The regulatory side should strengthen supervision over the quality of loan approval and post-loan spot checks to ensure that the rapid increase in volume does not come at the cost of relaxing risk control. Meanwhile, regulatory information disclosure should enhance the transparency of the expected prepayment scenarios for MBS, helping market participants better assess reinvestment risks and duration exposure. Liquidity provisions should also be given priority to deal with possible market repricing shocks.

Overall, the current round of interest rate cuts has provided borrowers with a window for short-term cost relief, but this window does not automatically translate into a long-term repair of the housing market or the credit system. The focus of the market and regulation should shift from the superficial interpretation of short-term application volumes and interest rate data to an in-depth examination of the transmission effects brought about by credit quality, maturity mismatch and policy path uncertainty, to avoid ignoring potential medium-term risk exposure in cyclical opportunities.