What is Refinancing risk?
Refinancing risk is the probability that a bank
- will not be able to refinance maturing deposits, liabilities, or
- if they are refinanced, the maturity and interest rate of the financing will adversely affect net interest income.
- The risk that an early unscheduled repayment of principal on mortgage-backed securities(MBS) will occur when the underlying mortgages are refinanced by borrowers. All MBS buyers assume some level of prepayments in their initial yield calculations, but an increase in the level of refinancing (which usually occurs as a result of falling interest rates) means that MBSs mature faster and will have to be reinvested at lower rates.
- For a mortgage borrower, the risk that he or she will not be able to refinance an existing mortgage at a future date under favorable terms.
In banking and finance, refinancing risk is the possibility that a borrower cannot refinance by borrowing to repay existing debt. Many types of commercial lending incorporate balloon payments at the point of final maturity; often, the intention or assumption is that the borrower will take out a new loan to pay the existing lenders.
A borrower that cannot refinance their existing debt and does not have sufficient funds on hand to pay their lenders may have a liquidity problem. The borrower may be considered technically insolvent: even though their assets are greater than their liabilities, they cannot raise the liquid funds to pay their creditors. Insolvency may lead to bankruptcy, even when the borrower has a positive net worth.
In order to repay the debt at maturity, the borrower that cannot refinance may be forced into a fire sale of assets at a low price, including the borrower’s own home and productive assets such as factories and plants.
Most large corporations and banks face this risk to some degree, as they may constantly borrow and repay loans. Refinancing risk increases in periods of rising interest rates, when the borrower may not have sufficient income to afford the higher interest rate on a new loan.
Most commercial banks provide long term loans, and fund this operation by taking shorter term deposits. In general, refinancing risk is only considered to be substantial for banks in cases of financial crisis, when borrowing funds, such as inter-bank deposits, may be extremely difficult.
Refinancing is also known as “rolling over” debt of various maturities, and so refinancing risk may be referred to as rollover risk.
Types of Refinancing Risk
There are two distinct types of refinancing risk. Refinancing risk refers to the risk that homeowners will, or will not, be able to refinance their mortgage loans. For homeowners, refinancing risk exists when there is a chance that it will be impossible to take advantage of better financing options in the future due to rising interest rates.
However, mortgage holders face an opposite risk, also known as refinancing risk. For a bank that issues a mortgage loan, or an investor who purchases a mortgage-backed security, the risk is that a homeowner will be able to refinance, paying off the loan early and not paying future interest that the lender or borrower was counting on for income.
Mortgage backed securities are a type of investment that many individuals can get involved with in order to speculate in the real estate market. When a primary mortgage lender initiates a mortgage with an individual, they will often package it with other mortgages and sell them to investors. These packages are made up of hundreds of mortgages.
Owning a portfolio of mortgage-backed securities has what is called refinancing risk. When interest rates in the mortgage industry become very low, there is always the possibility that existing homeowners will want to refinance their mortgages. When borrowers can get out of their mortgage and into a lower interest rate, they will refinance When this happens, the mortgage-backed securities holders lose out on a lot of their returns. Once the home is refinanced, the mortgage-backed securities holder will not be able to continue receiving payments from the homeowners. This will reduce the amount of yield that is possible with this type of investment.
On the other end of the spectrum, mortgage-backed securities holders also have to be aware of what could happen if interest rates increase. If rates increase substantially, a mortgage payment can increase very high and cause a foreclosures to occur. If the mortgages are adjustable rate loans, many people will have mortgage payments that they can no longer afford to make. They will default on these loans and this will also ruin the investment of the mortgage-backed securities holders.
Unable to Refinance
“Refinancing risk” is a term that is also used to describe a situation in which an individual cannot refinance their existing mortgage. For example, many people take a balloon loans for business purposes or for their mortgage. When they take out a balloon loan, it is typically so that they can have a very low mortgage payment. They will only have to pay the interest that is accruing each month as their mortgage payment. They do this with the idea of refinancing into a traditional loan before the balloon payment comes due.
While this scenario is possible, sometimes people run into problems along the way. When they go to refinance the existing loan before the balloon payment comes due, they might be unable to get approved. If their credit has deteriorated during the loan term, they may be unable to qualify for a new mortgage.
Refinancing risk is the uncertainty of the cost of a new source of funds that are being used to finance a long-term fixed-rate asset. This risk occurs when an FI is holding assets with maturities greater than the maturities of its liabilities. For example, if a bank has a ten-year fixed-rate loan funded by a 2-year time deposit, the bank faces a risk of borrowing new deposits, or refinancing, at a higher rate in two years. Thus, interest rate increases would reduce net interest income. The bank would benefit if the rates fall as the cost of renewing the deposits would decrease, while the earning rate on the assets would not change. In this case, net interest income would increase.
A number of indicators can be used in management of refinancing risk. Maturity profile, short-term refinancing volume and average term to maturity are often used as indicators in the ongoing refinancing-risk management.
The volume of short-term assets is a significant element in the overall assessment of refinancing risk. In recent years, the balance on the central government’s account has been more than sufficient to cover all redemptions and interest payments for more than one year ahead.