REQUIRED READING: Understanding Best Practices In Pipeline Risk Management

of the primary goals for any secondary marketing manager [/b]is to develop systems and controls for measuring and managing pipeline risks in order to make better decisions regarding secondary marketing execution. The end game is to enable the company to realize the profit margin that is baked into the pricing on day one of the lock with the borrower. Many companies seek to lock in this profit at the loan level through a best-efforts investor commitment. Currently, investor policies and market dynamics are discouraging this practice by providing pricing that is significantly discounted to single loan mandatory delivery commitments, and even more heavily discounted to assignment of trade (AOT) execution (i.e., direct trade or mandatory bulk). Spreads between best efforts and AOT execution ranged between 40 basis points (bps) and 50 bps during most of 2008, and have blown out in early 2009 to over 100 bps. Best efforts is a hedging strategy – a very expensive one – and one that has its own set of risks for mortgage bankers that are not easily measured or managed. A common maxim among financial professionals is, ‘If you don't measure it, you can't manage it.’ Capturing the additional secondary market revenue available through the AOT execution requires hedging the pipeline. Given the short menu of mortgage products being originated for sale into the secondary market, the obvious choice of hedging instruments is agency mortgage-backed securities (MBS) – the most liquid, discoverable and highly correlated vehicles available. However, most mortgage bankers are not delivering the single MBS to the market. Instead, they are delivering two assets to the market: whole loans and servicing rights. This is a critical distinction and introduces a layer of complexity in the measurement and management of pipeline risk. When the largest players in the mortgage industry (the aggregators) purchase agency-eligible mortgages, they bifurcate the asset by passing through the loan to the MBS market and stripping out the servicing and excess servicing for their own long-term investment. Mortgage servicing rights (MSRs) are an asset class in which they are correlated to the MBS with which they are associated, but they have distinctly different valuation components that react quite differently to changes in the market. The aggregators understand these dynamics very well by virtue of their immense exposure to MSRs, and thus, value and hedge these assets discretely. The servicing-released premium (SRP) paid by the aggregators to correspondents reflects their valuation and sensitivity of the MSR component of a given loan. The SRP posted by the aggregator, therefore, has embedded in it all of the risks that the aggregator perceives related to the current and future value of the MSR, and is, therefore, a significant component of the pipeline risk for the mortgage banker. The aggregators seemingly commit to an MSR valuation for a certain period of time in the form of an SRP grid in their AOT contracts with mortgage bankers. By doing so, they would appear not to have the opportunity to adjust the SRP daily. However, they do manage to pass through changes in their valuation of the MSR, embedding these adjustments in their daily pricing of the loan asset – usually expressed in the form of the base note rate or other feature adjustments. The more complex the pricing structure is, the more opportunities there are for the aggregators to arbitrage the risks, so all of these potential adjustments must be measured daily in order to evaluate the exposures that must be managed in a given pipeline. Therefore, in addition to a rigorous analysis of the probable pull-through best practices, pipeline risk management must include a daily, comprehensive, loan-level best execution analysis. It should also include a daily sensitivity/duration analysis of the loan asset, the MSR and the hedge instruments to measure value changes related to rate shocks. [b][i]P&L concerns[/i][/b] The integration of these elements results in the daily production of an accurate pricing and loan statement (P&L) and pipeline sensitivity analysis that measures all of the risks that impact the daily management of the client's position and P&L. Once a complete measurement of all of the pipeline risks has been accomplished, the management and hedging of the risks can begin. Professional, modern-day hedging is a dynamic activity that accounts for changes in value correlated to changes in interest rates. The goal is to strike the correct balance between the sensitivity of the assets (loans and servicing rights) and the sensitivity of the liabilities (hedge vehicle) in order to preserve the net profitability of the position across a range of potential rate shocks. Professional hedging is not about micromanagement of the locked pipeline, nor is it about matching off the risk of every loan that comes in the door – that's the purpose of best-efforts execution. Best efforts is a form of hedging – it's just a very expensive one (and getting more so all the time). Professional hedging is a macro exercise based on the micro-measurement and micro-analytics described above that result in establishing the actual market value of the loans, servicing and hedge instruments, and the durations and valuation sensitivity of the whole loans, servicing rights and hedge instruments. This methodology produces rate shocks that are based on the firm's actual loan-level execution – servicing-released whole loan delivery, so the firm is hedging the right risk from day one of a new rate lock. This goes well beyond the common practice among mortgage bankers to determine best execution on a post-mortem basis. Furthermore, servicing-released mortgage bankers aren't delivering a to-be-announced (TBA) MBS, so it's inappropriate to be hedging to that execution. Most firms involved in hedging don't do loan-level best execution, so they tend to hedge only to the MBS execution, utilizing a slotting and bucketing approach that results in hedging with the wrong TBA coupon much of the time. Also, this approach ignores the servicing component, and the negative convexity associated with it, and that produces a position that is over-hedged in a rally and under-hedged in a sell-off. Ultimately, this is an antiquated approach that produces higher hedging costs even in a flat market, and in a volatile market, tends to produce massive pair-offs for the firm that can wipe out a month's worth of profits. By contrast, modern professional hedging utilizes the best practices described above for measuring and managing pipeline risk, producing a more predictable and stable P&L and enabling firms to realize the margins for which they have planned for in their transfer pricing. As for the source of those margins, the firm should be indifferent – in some months, the margins may result from mark-to-market gains on hedges that exceed mark-to-market losses, and in other months, it may be reversed. The goal is to ensure that the firm is optimizing its secondary market execution, regardless of the level of interest-rate volatility. [i]Doug Mayers is vice president of the secondary solutions group at Mortgage Industry Advisory Corp., New York. He can be reached at douglas.mayers@miacanalytics.co

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