Published in: CU Business
Over the course of 2019, the yield curve has significantly decreased and flattened causing primary mortgage rates to fall. This has caused an increase in prepayment and refinancing activity, which is currently at a two-and-a-half year high. As a result, many institutions have experienced significant decreases in the value of their Mortgage Servicing Rights (MSR) assets, making MSR hedging a timely topic.
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.
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.