Published in: CUNA Finance Council
As the yield curve significantly decreased and flattened over the course of 2019, primary mortgage rates fell as a result. This caused an increase in prepayment and refinancing activity, which is currently at a two-and-a-half year high. It has also led to significant decreases in Mortgage Servicing Rights (MSR) asset values for many credit unions, making MSR hedging a timely topic.
Step 1. Begin your evaluation.
When considering whether to hedge an MSR asset, the first step is understanding why the asset itself is so sensitive to changes in rates. MSR assets can be likened to interest-only (IO) strips. MSR assets derive their value from the stream of servicing fees of the underlying mortgages. This is similar to IO strips, which derive their value from the interest payments of the underlying loans. Due to this structure, the longer the life of the underlying loan, the higher the value of both MSR assets and IO strips. When interest rates fall, and the incentive to refinance increases, the value of the asset decreases significantly due to the shortening of the income stream with no offsetting principal effects. In addition, MSR assets typically exhibit negative convexity, so as interest rates fall the value of the asset decreases at an increasing pace.
Step 2. Ensure a sound risk framework.
Next, the institution needs to ensure a sound framework is in place to evaluate risk. This includes having accurate measures of effective duration, partial (key rate) duration, convexity, and spread duration. Essentially showing sensitivities to parallel shifts in rates, the slope of the curve, and changes in spreads. Accurately quantifying risk allows the institution to create a hedge that offsets its risk.