Portfolio runoff is a decrease in the assets of a mortgage-backed securities portfolio due to the prepayment of the securities held in that portfolio or other factors that cause the loans to no longer be as profitable as they were.
BREAKING DOWN Portfolio Runoff
Portfolio runoff is the routine, ongoing thinning of a mortgage-based portfolio as existing loans are paid off. As these loans are satisfied, they fall off the roster for the portfolio, and are no longer part of the assets included in that portfolio.
It is a risk these portfolios face, which can lead to pre-payment risk and that usually forces the fund to reinvest the proceeds at lower yields than where the original securities were purchased.
Lenders and financial institutions will sometimes simply refer to “runoff,” or anticipated runoff, which is the volume or amount in loan assets they must maintain or acquire in order to keep their portfolio steady at its current levels.
Most mortgage-backed securities have an embedded call option held by the borrowers of the underlying mortgages backing those securities. When interest rates fall or home values rise, an incentive is created for homeowners to refinance their mortgage, which leads to portfolio runoff for the investors in those mortgages.
How Lenders Mitigate the Impact of Portfolio Runoff
In an effort to try and reduce portfolio runoff, or offset the impact of unexpected losses, some lenders have implemented tactics such as offering prepayment penalty mortgages. These allow the lender to impose and collect penalties if the borrower pays off all or much of their mortgage early, or if they refinance or sell the property tied to the mortgage. To further minimize potential risk, the lender may package mortgages with different prepayment penalties or terms together so as to better diversify their portfolio.
Loans that are delinquent or that have been the subject of a default or foreclosure will also contribute to portfolio runoff, perhaps with a fallout that can extend for a long time.
When there is a mortgage crash or other major banking event, it can take several years or longer for lenders and the financial industry as a whole to recover and absorb the damages. Nearly 10 years after the mortgage crisis of the late 2000s, some major banks in the U.S. are still dealing with the portfolio runoff from the risky loans that remain from those portfolios.
In addition, as larger or more successful banks take over smaller ones, the bigger bank must assume the other lender’s mortgage portfolio and incur the impact of that portfolio runoff. ?