Using TBA MBS as Hedging Alternative to Agencies Could Potentially Save Your Institution Millions

Understanding and tracking hedge cost is critical in any mortgage pipeline hedging process. When forward committing loans to investors, there is an implied hedge cost that is equal to a price difference. The hedge cost amount is dependent upon the forward delivery contract expiration; for example, 45 days or 90 days are typical for institutions using these contracts to manage market risk.

Taking the difference between the spot price (shortest delivery window) and the forward price will provide a hedge cost figure in price format that a secondary manager can lock in at any given point. For example, the difference between the 1-day price and the 45-day price represents the price give-up for locking in the market price today for delivery in 45 days. If the 1-day price is 105.17 and the 45-day price is 104.92, then the implied hedge cost is 0.25, or 25 basis points. Put into annual terms, this would be about 2 points, or 2%. On a $300M pipeline, 2% would equal a hedge cost of $6M. Hedge cost for 90-day delivery is even more drastic, at 0.79% (105.17 minus 104.38). This is 3.16% annualized or about $9.5M in hedge cost for a $300M pipeline. Figure 1 shows the calculations for a 45-day and 90-day delivery.

Figure 1: Hedge Cost of Forward Delivery

The hedge cost numbers from investors are not static. They are always moving as a result of the market. They could substantially change particularly when market stressors occur, such as the recent March 2020 events which have led to a reduction in market risk appetite and liquidity concerns. Figure 2 shows the implied hedge costs over time from Fannie Mae and shows these costs have increased substantially…

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