In any hedging program – mortgage, currency or otherwise – the best instrument to protect against risk is one that is most similar to the asset you are protecting. In this case, you are protecting the price of the loan such that the net revenue on the loan is the same when you sell the loans as when you bought the lock from the borrower. Utilizing to-be-announced (TBA) securities minimizes basis risk.
Basis risk is the possibility that one asset will change differently from another. For example, if you used U.S. Treasuries to hedge the pipeline, you have basis risk exposure because Treasuries move similarly to mortgage-backed securities (MBS), but not always the same. If on the day you take a borrower lock, the spread to the Treasury is 20 basis points (bps) – but on a later day you take a mandatory commitment and pair out the security, the spread may widen to 30 bps. In this scenario, you have lost 10 bps to basis risk. However, because TBAs are MBS, they will move tightly with the whole loan market, eliminating basis risk when the hedging program is properly executed.
TBAs are easy to trade, highly liquid, and less costly than other options. There are numerous broker/dealers willing to trade TBAs in amounts as small at $250,000, giving you the opportunity to be very precise in your hedging activities.
While more sophisticated secondary marketing operations may manage their analytics, it seldom makes sense for a beginning, or small- to mid-size shop. Advisory firms will have the expertise, tools, and support to manage your data reliably and also offer support and guidance in how you approach hedging activity. Take advantage of them as a resource for information and partner to keep you on track. There are a number of firms out there, and it is a considerable part of your due diligence to select a firm that meets your needs.
Each day, you will submit data electronically to the advisory firm, which will, in turn, submit a position report back to you. If locking or trading activity is particularly high on a given day, or if the market is moving quickly, you may want to submit the data more than once a day. The advisory firm should be able to take in new data and provide a report at your request.
The position report will incorporate the current market conditions, the types and status of the loans in the pipeline, and pull-through patterns, to return a snapshot of the pipeline and a recommendation for trading activity. This report drives the activities you perform each day and is your guide to protecting against interest-rate risk and managing the profitability of the pipeline.
It is most effective for lenders to perform their trading activities. Many advisory firms provide ‘one-stop shop’ types of service and will execute all trades for you, including security trades and whole loan trades to correspondent lenders. The intention is to keep the process easy and simple for you; however, there is a considerable benefit to keeping that function in-house.
As a secondary marketing manager, executing trades and managing the pipeline myself gave me much more of a ‘feel’ for the activity in the pipeline. It also provided an opportunity for me to be a bit savvier in how I chose to manage it. The problem is not that advisory firms cannot do this function well; it is that they can only operate with the information they have available. No one can be as in touch with what is happening in your shop as the person on the ground.
Managing millions of dollars of trades is a mental sticking point for some, particularly those who have some trepidation about the mandatory process. But, remember that this is a very process-oriented function. Although the numbers change, the basic activity changes very little.
Trading $500,000 requires exactly the same work as trading $5,000,000. Once you become comfortable with it, you will wonder what was so hard about it. Lenders that have the discipline to perform well when originating, underwriting, and closing loans can translate that discipline to the secondary marketing function.
As you implement a hedging program, fallout is going to become more important than ever. Fallout has always been important – best-efforts investors watch it closely, too. But now, it is important for you, and the advisory firm, to have a strong understanding of the pipeline's fallout patterns.
In order to understand how to hedge the pipeline, you must have a feel for how it behaves. Fallout is critical because if you fail to account for it, you will over-hedge the pipeline, which will sabotage the goal of staying risk neutral. An over-hedged pipeline will result in an unexpected gain if bond prices fall, which isn't so bad. On the flip side, you will have an unexpected loss if bond prices move up.
In general, fallout will tend to increase as interest rates fall and borrowers seek better deals. Fallout tends to decrease as rates rise and borrowers hang on to their favorable interest rate lock.
Typically, historical pipeline data is the best indicator of fallout – the more data, the better. The fallout ratio that applies to the pipeline will vary based on historical patterns and current market conditions. The advisory firm will incorporate fallout behavior into the hedge recommendations. Periodically, you will supply updated fallout data for them to analyze and incorporate into the daily position report.
The cost to hedge a pipeline is less for one with low fallout versus one with higher fallout. It is important for you to watch fallout patterns and encourage loan originators to keep that number low. You can track fallout by origination channel, loan officer or branch, loan type, type of financing, etc., to get insight into how the pipeline works.
Jennifer Fortier is president of The Artful Enterprise LLC, based in New Orleans. She can be reached at email@example.com. This article is excerpted and adapted from her new book, ‘Demystifying Mandatory – The Beginner's Guide to Implementing and Managing a Hedging Program for Residential Mortgages,’ and is reprinted with the author's permission.