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Like all industries, the mortgage banking industry faces risks
in its business and market environment. To date, IndyMac has an
exceptional track record of properly hedging and managing its assets to
mitigate the effects of interest rate risk, valuation risk, credit risk,
liquidity risk and the risks inherent in the mortgage industry's
cyclical nature.*
Interest Rate Risk
A critical element of risk management for IndyMac is managing our
interest rate risk. Changes in interest rates can impact the value of
our loan production and our loan servicing assets. We hedge to protect
our loans held for sale and our pipeline of loans in process should
interest rates increase from the date we commit to make the loan, which
would decrease their value in the marketplace. In our portfolio of
servicing-related assets, we hedge to protect their value should
interest rates decline, which would in turn cause higher than expected
levels of prepayment. In our portfolio of loans and securities we hold
for investment, we match fund the assets with liabilities of
comparable duration to protect the net interest income on these assets
in the event interest rates rise. While our hedging strategies have
proven to be very effective in managing interest rate risk to date,
there can be no guarantee that they will be effective in all interest
rate and market environments.
IndyMac's effectiveness in hedging interest rate risk was particularly
evident in 2002. Interest rates at historical lows resulted in high
levels of prepayments on our mortgage servicing portfolio, creating
impairment of $183 million on the related assets. Through our risk
management practices, all but $3 million of this impairment was offset
by income from our hedging instruments.
Valuation Risk
As a result of our mortgage banking activities, we create and hold
assets in connection with the sale or securitization of mortgage loans.
These assets are primarily mortgage servicing rights, AAA-rated
interest-only securities and non-investment grade securities (including
residual securities). These assets represented 6% of total assets at
December 31, 2002, in the aggregate, with less than one percent being in
the form of non-investment grade and residual securities. To provide an
appropriate valuation for these securities, we utilize complex financial
models that incorporate significant assumptions and judgments, which
could vary significantly as market conditions change.
Credit Risk
We hold a portfolio of loans for investment and non-investment grade
securities and residuals collateralized by mortgage loans. We also
provide construction lending to consumers and developers to build
residential properties. Such assets have a higher risk profile than
permanent mortgage loans. While the majority of our loans are secured by
residential properties, there is no guarantee that, in the event of
borrower default, we will be able to recoup the full principal amount
and interest earned on a loan.
We have adopted prudent underwriting and loan quality monitoring systems
and procedures. These include the establishment and review of an
allowance for loan losses that management believes is appropriate and
the ongoing assessment of the likelihood of nonperformance. Such
policies and procedures, however, may not prevent unexpected losses that
could adversely affect our results. In addition, while we have
discontinued our home improvement and manufactured housing lending
programs, we continue to liquidate these loan portfolios, which have
greater credit risk than that of our mortgage loan portfolios.
At December 31, 2002, the balance of these portfolios was $88.2 million,
net of reserves.
We also sell loans to the government-sponsored
enterprises (GSEs) and whole loans to outside investors. In these
instances, we are subject to repurchase risk. While we have established
what we believe to be adequate loss reserves, there can be no guarantee
that the amount reserved is sufficient to cover all potential losses
resulting from such repurchases.
Liquidity Risk/Access to Capital Markets
We finance a substantial portion of our assets through consumer deposits
and borrowings from the Federal Home Loan Bank of San Francisco. We also
obtain financing from investment and commercial banks. While there
is no guarantee that these sources of funds will continue to be
available to us, or that our borrowings can be refinanced upon maturity,
there are
no known trends, demands, commitments, events or uncertainties that we
believe are reasonably likely to cause a decrease in liquidity.
We utilize three sales channels to sell loans to the secondary market:
whole loan sales, sales to the GSEs, and private-label securitizations.
A disruption in the securitization market could adversely impact our
ability to fund mortgage loans and our gains on sale, leading to a
corresponding decrease in revenue and earnings. Likewise, a
deterioration in the performance of our private-label securities could
adversely impact the availability and pricing of future transactions.
Cyclical Industry Risk
When interest rates are low, home buying and mortgage refinancing tend
to peak. Our historical experience has been that as rates rise, we are
able to command a larger market share in a less crowded market. In 2000,
the last time interest rates trended up, the mortgage market declined by
20%, while our mortgage production grew by 48%. Even so, with an eye to
our industry's cyclical nature, we are working to diversify our revenue
stream and add stability to our earnings. To this end, we expect to grow
our mortgage investments and mortgage servicing activities to provide a
base of core net interest and fee income, with a national focus on the
production of home equity lines of credit as interest rates rise.
In addition, over the next five years, we plan to expand our branch
network in the Southern California area. This will serve to lower the
overall cost of funds through deposits and enhance overall net interest
income, while building better "brand" recognition and franchise value
over time.
Multiple reviews of our risk management practices begin in each of our
divisions and continue up to senior management and board members through
our Asset and Liability Committee, and our Audit Committee. Oversight by
our new Enterprise Risk Management Division, in addition to strong
oversight as a federally regulated depository institution by the Office
of Thrift Supervision, combined with the objective view of our external
auditors all contribute to create a climate that is highly sensitive to
the risks of our business. We believe we have built a solid framework
and are well positioned to execute our ambitious growth plans within a
well-managed and risk conscious environment.
*For a more extensive and detailed discussions of our risks, please see our Annual Report on Form 10-K, Item I: Business — Key Operating Risks.
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