With the possibility of a recession looming, some financial institutions could be under significant pressure without adequate liquidity.
The increase in the 10-year treasury yield from 1.5% to 3.6% since the beginning of the year has resulted in the closure of about a dozen non-bank mortgage lenders, who have either shut down operations or sold significant assets to other entities. With the possibility of a recession looming, some financial institutions could be under significant pressure without adequate liquidity. As we saw with Silicon Valley Bank (SVB), if these lenders were forced to sell certain loans, it could be the nail in their coffin. In this piece, let’s uncover the risk in classifying loans as held for investment (HFI).
In this piece, let’s uncover the risk in classifying loans as held for investment (HFI).
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Key Takeaways
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Table of Contents
- Accounting Classification Implications for Financial Reporting
- CECL Provisioning and Its Impact on Financial Statements
- Valuation of Loans Held for Long-Term Investment (HFI)
- The Rise of HFI Loans and Their Impact on Originators’ Balance Sheets
- Managing Risks Associated with HFI Loans
Accounting Classification Implications for Financial Reporting
When SVB was confronted with selling its treasury bonds to meet liquidity needs from a run on the bank, it had to reclassify investments classified as held to maturity (HTM) to available for sale (AFS). This resulted in a nearly $2 billion loss recognized in earnings. This was because the investments were not marked to market, and the significant drop in value was not reflected in earnings.
Similarly, financial institutions that originate mortgage loans can also elect held-for-long-term-investment (HFI) for loans if one can attest, they have the ability and intent to hold to maturity or payoff.
However, this accounting treatment introduces significant downstream risks if liquidity needs force a sale. If market conditions shift or funding pressures mount—like what we saw during the recent interest rate surge—institutions may find themselves needing to liquidate these loans prematurely. Doing so could trigger losses not previously recognized on the balance sheet, as the amortized cost may far exceed current fair market value. As such, the HFI classification, while appealing in a stable environment, can mask exposure in a downturn—making it a critical focus for risk management and financial reporting scrutiny.
CECL Provisioning and Its Impact on Financial Statements
Electing to classify the loans as HFI also requires the company to recognize an estimate of lifetime losses of their loans upfront as the loan is originated. This is referred to as Current Expected Credit Losses (CECL) provisioning.
Lenders use empirical data to estimate how many of these loans will default and then subtract the CECL provision amount from their bottom line. Increasing rates and elevated credit risk could be a perfect storm for the value of these loans.
Example:
Consider a non-bank mortgage lender that classifies a new pool of residential loans as HFI during a period of rapidly rising interest rates. At origination, the loans appear sound—borrowers have strong credit scores, and default risk seems minimal. However, as the economy softens and housing affordability declines, the lender must revise its assumptions and recognize higher expected credit losses. A CECL model update indicates a 3% lifetime loss rate on a $250 million loan portfolio—forcing a $7.5 million hit to the income statement, despite no actual defaults having occurred yet.
This non-cash expense immediately reduces net income and may impact covenant compliance or capital adequacy metrics. If the company lacks a cushion or has thin margins, this shift alone could trigger tighter investor scrutiny, impair growth plans, or limit access to financing.
Valuation of Loans Held for Long-Term Investment (HFI)
Companies that elect to account for loans as HFI are required to disclose the estimated fair value in their footnotes. Public companies may only value these loans at quarter-end, and typically these valuations do not go through audit scrutiny until the year-end audit.
For private companies, the value of these loans may not be reviewed until year-end. These loans are usually valued with an internal discounted cash flow (DCF) model or obtained from a third-party valuation specialist such as Compass Analytics, Situs AMC, and DebtEx.
This lack of real-time market calibration can mask the true economic impact of holding underperforming or illiquid loans. Valuations based on internal DCF models or lightly vetted third-party estimates may not reflect current market conditions—especially in a volatile interest rate environment. As a result, lenders may be underestimating their exposure and failing to communicate the full extent of risk to stakeholders. If liquidity needs force a sale before maturity, the gap between amortized cost and fair value could translate into unexpected losses—just when capital is needed most.
The Rise of HFI Loans and Their Impact on Originators’ Balance Sheets
As the demand from aggregators slowed down, originators were forced to hold more of these loans on the balance sheet. The loans that went into HFI were usually loans that the lender did not see a viable exit (sale or placed into securitization) for or bought back from the GSEs and Ginnie Mae.
Some lenders specifically place these loans in the HFI bucket to eliminate the market value fluctuation associated with these loans. As rates rose, the loans have become less attractive because newer originated loans paid more in interest.
Although the economy remains resilient, the probability of credit default is also expected to increase when mortgage holders are no longer able to afford their monthly payments.
Managing Risks Associated with HFI Loans
Holders of HFI Loans must consider the following points to avoid a crisis:
1. Is the risk and uncertainty associated with HFI loans buried in your financial statements?
When the risks tied to HFI loans aren’t clearly disclosed, stakeholders may be left with an incomplete view of a company’s financial health. This lack of transparency can result in investor mistrust, regulatory scrutiny, or even restatements if unexpected losses surface. Particularly in periods of economic volatility, hidden exposures—such as high concentrations of loans in declining markets or loans with deteriorating credit quality—can turn into significant liabilities almost overnight.
Tip: Proactively enhance your financial disclosures around HFI loans. Include details on credit quality, valuation methodology, and how management is monitoring changes in risk. Use your MD&A (Management Discussion & Analysis) section to highlight any macroeconomic trends that could impact loan performance. Doing so helps build trust with stakeholders and shows regulators that you’re taking a forward-looking approach to risk management.
2. How often are you valuing HFI loans? How comfortable are you if they are internally marked vs. third-party pricing?
Infrequent or inconsistent valuation of HFI loans can distort the true picture of a company’s balance sheet. Relying solely on internal models—without external validation—may introduce bias or outdated assumptions, especially in a fast-moving interest rate or credit environment. If these valuations materially differ from what a market participant would pay, it could lead to misleading disclosures and trigger problems during audits, investor reviews, or M&A due diligence.
Tip: Establish a formal valuation cadence—quarterly at minimum—and supplement internal DCF models with third-party benchmarks whenever possible. Partnering with a valuation specialist or obtaining periodic fairness opinions can help validate assumptions, improve audit readiness, and demonstrate rigor in your financial controls. This not only strengthens internal decision-making but also increases confidence among external stakeholders.
3. Does your cash forecast include the impact of mark-to-market on HFI loans?
HFI loans are typically recorded at amortized cost, but that doesn’t mean their fair value fluctuations can be ignored—especially when cash flow planning is on the line. If a lender is forced to sell HFI loans due to unforeseen liquidity needs, the gap between book value and market value could result in unexpected losses and a shortfall in available cash. This is especially risky in periods of rising rates or declining asset quality, when loan values may drop sharply.
Tip: Incorporate downside scenarios into your cash forecasting that assume a sale of HFI loans at current fair market value—not just amortized cost. Regularly stress test your liquidity under adverse market conditions, and build buffers accordingly. By aligning your cash planning with realistic valuation inputs, you’ll be better equipped to respond quickly and confidently in the face of market disruption.
4. What cushion do you have until you must sell some of your HFI loans?
HFI classification assumes a company can hold loans to maturity—but in reality, external pressures like liquidity crunches, covenant triggers, or funding gaps can force premature sales. If the company doesn’t have sufficient financial flexibility or access to alternative capital, it may be compelled to sell loans at a deep discount—resulting in realized losses and potential erosion of equity. In extreme cases, this can tip a lender into financial distress or even insolvency.
Tip: Quantify your “liquidity cushion” by mapping out how long you can sustain operations without selling HFI assets. Factor in seasonal cash flow patterns, debt obligations, and adverse market scenarios. Maintain access to flexible credit facilities or short-term funding sources so that you’re never in a position where you must sell HFI loans under pressure. This approach preserves optionality and helps avoid value-destructive decisions in volatile markets.
5. Do you include the impact of valuing HFI loans in covenants monitoring such tangible net worth (equity) and leverage ratio?
Many loan agreements and credit facilities include financial covenants tied to balance sheet metrics like tangible net worth, leverage ratios, or fixed charge coverage. If the estimated fair value of HFI loans drops significantly, but the amortized cost remains unchanged, a company may overestimate its compliance buffer. This creates a dangerous blind spot—where a sudden need to mark down or liquidate loans could result in an unintentional covenant breach.
Tip: Even if HFI loans are not marked to market on the books, model their estimated fair value impacts in your covenant calculations as part of routine monitoring. Simulate scenarios where fair values decline, and identify how close you are to covenant thresholds. This proactive approach gives you time to renegotiate terms, build capital reserves, or adjust strategy before you’re caught off guard.
6. How effective are your hedges on your HFI portfolio?
If a company’s hedges on its HFI portfolio are not effective, it could face losses if interest rates rise or credit risk increases, potentially leading to financial instability or insolvency.
Tip: Regularly review your hedging strategies alongside changes in loan characteristics, market conditions, and risk appetite. Perform back-testing to evaluate hedge effectiveness and stress-test against rate shocks or credit events. If gaps are identified, work with a risk advisor or capital markets specialist to rebalance exposures or add new hedge instruments. Proactive hedge management helps preserve asset value and supports long-term balance sheet stability
Conclusion
If interest rates keep rising and credit risk increases, the value of HFI loans will continue to decline. In an economic downturn, the value of these loans may face even more downward pressure. Therefore, it’s crucial for non-bank mortgage lenders to effectively manage the risks associated with HFI loans by including their value in cash forecasts and covenant monitoring.
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