What is Mortgage Pipeline Hedging?

Residential mortgage banking is an important business line for many financial institutions. Managing the risks of the mortgage pipeline can often be the difference between good and great business results. Implemented successfully, mortgage pipeline hedge strategies protect the lender from the unpredictability of interest rates, thus reducing financial risk. Furthermore, successful strategies also can enhance profitability, sometimes significantly over time. As a trusted provider of financial services and capital markets solutions, the foundation of ALM First is building partnerships. ALM First helps clients enhance performance, maintain regulatory compliance, and improve their mortgage pipeline risk management process. Ensuring secondary marketing risk is properly managed is a step forward in an institution’s business strategy, allowing for greater focus on other value-add initiatives in mortgage banking.

Key Components of Mortgage Pipeline Hedging

  • Fallout analysis and pull-through reporting
  • Daily position reporting
    • Pipeline exposure report
    • Tracks lock, origination and loan sale activity
    • Trading log
  • Access to capital markets
    • Execution of hedge trades
    • Hedge cost analysis and best execution
  • Performance reporting
    • Ex-post assessment of profitability
  • Accounting reporting
    • Call report entries
    • Accounting for pipeline activity
  • Access to experts
    • Policy architecture
    • Assistance with regulatory compliance and auditors
    • Training
  • Strategy consulting
    • Meet your secondary marketing needs
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Benefits of Mortgage Pipeline Hedging

  • Reduce risk and improve performance
  • Simplify pipeline management and improve transparency
  • Improve control over loan delivery timeline, allowing for lucrative warehousing strategies
  • Gain access to capital markets experts
  • Increase flexibility relative to forward committing with an Agency
  • Improve fallout projections
  • Meet regulatory requirements
  • Better serve your customers through proper pipeline risk management

 

How does ALM First do it differently?

ALM First prides itself in its independent, holistic advice. As balance sheet consultants, our core philosophy revolves around assessing the greater need of a client’s balance sheet. As a trusted partner, we help our clients manage risk, enabling them to grow and scale. Through our partnership, ALM First provides:

  • Access to Experts
    • ALM First has extensive experience and expertise in fixed-income portfolio management. When it comes to hedging, capital markets, and strategy, ALM First is your trusted expert.
  • Unbiased Strategic Consulting
    • As a consulting firm, we focus on strategic positioning to improve institutional performance and profitability while ensuring the institution stays ahead of regulatory. At ALM First, we help your institution set an appropriate strategy given your unique needs and goals.
  • Flexibility
    • As your partner, we provide as much assistance as you would prefer, from full-service hedge advisory to augmenting in-house efforts. Plus, our transparency will always keep you informed.

Mortgage Pipeline Hedging FAQs

What are TBA MBS?

The TBA MBS, or to-be-announced mortgage-backed securities, market is a forward market for buying/selling agency mortgage-backed securities. It allows for purchasing or selling MBS securities with a settlement date in the future (e.g., 30-day forward settlement). TBA stands for “to-be-announced” because the specific security is not known until settlement; rather, the characteristics of the security are defined by the contract characteristics and any stipulations (“stips”) that are agreed upon. General characteristics of TBA MBS contracts include issuer (FNMA/FHLMC), maturity (30-year/15-year), coupon, price, par amount and settlement date. For example, if one were to enter into a FNMA 30-year 3% coupon for May settlement at a 98 price, it is known with certainty come settlement the security will have a 3% coupon with a defined remaining maturity at a dollar price of 98.

Are there advantages of hedging with TBA MBS?

Yes. Using TBA MBS greatly adds to the flexibility of the secondary market risk hedging program, as positions can be added or removed quickly and cheaply, should the loans “fall out” or the pipeline risk profile change. The ability to cheaply alter positions stems from the fact that the TBA MBS market is extremely liquid; according to SIFMA, the average trading volume in 2016 was $206.6 billion, second only to U.S. Treasury securities. Thousands of institutions, including depositories and mortgage originators, use TBA MBS instruments to hedge the price risk of their mortgage production prior to sale. TBA MBS offer great hedging benefits, as the basis risk between mortgage pricing and TBA MBS pricing is generally very low. The flexibility of using TBA MBS can lead to enhanced profitability, as the uncertainty of fallout risk and the origination timeline can be better handled compared to using mandatory or best efforts committing, where managing such risk can be more punitive in terms of pricing or pair-off fees assessed. Additionally, this flexibility allows originators to continue to hold warehoused loans and earn interest carry, while maintaining the ability to sell to the investor with the most favorable price to the lender.

What are the risks of using TBA MBS to hedge the mortgage pipeline?

Although small, the primary risk associated with using TBA MBS is related to basis risk between the underlying mortgage pipeline and the hedge instruments. Committing directly to the agencies removes the basis risk, as the deliverable assets ultimately are the loans themselves. ALM First’s general experience indicates the basis risk is small, however, and pricing from the agencies and TBA pricing are highly correlated.
Risk may also stem from other estimations made in the hedging process, such as fallout estimates and price sensitivity estimates. ALM First addressed this risk through constant analysis of historical price data to ensure the estimations are in-line with reality. Risk from operational activities, known as operational risk, can also be a factor.

What are some factors contributing to hedge ineffectiveness?

Offset ineffectiveness, sometimes called “tracking error”, indicates how well the actual changes in mortgage pipeline pricing were mitigated by the hedge instruments themselves. Hedging is rarely “perfect”, as estimates must be made to account for future events. A “perfect” hedge would indicate perfect knowledge regarding future events. Even for mandatory committing, ineffectiveness and tracking error could relate to a number of factors, loan fallout estimates, pipeline exposure and price sensitivity estimates, rebalancing lags (for committing or TBA MBS), and basis risk stemming from imperfect correlation between the pipeline loans and the hedge instruments.

How does ALM First select the TBA MBS coupons to hedge?

ALM First generally selects coupons for mortgage pipeline hedging that will most effectively eliminate the risk exposure at the most favorable cost to the hedger. Factors such as liquidity are very important in this assessment, as highly liquid instruments can be cheaply added or removed. To determine the cost to hedge, a cost of carry model is used to assess multiple hedging combinations in an effort to minimize hedging costs.

Will my institution have risk relating to under-delivery? Is retaining mortgages for a period of time economically viable?

Back to the idea of flexibility, TBA MBS hedge positions can be updated daily to account for the varying pipeline size. What this means in practice is as fallout occurs, or as loan pipeline size increases, the hedge positions will be updated accordingly. Therefore, there is no risk of not having enough mortgages to sell; the existing loans can be simply sold into the cash or 1-day delivery window. With mandatory forward selling, the institution is subject to over-delivery or pairoff fees.
Retaining mortgages for a period of time is a strategy to enhance profitability through earning interest income or “carry” on closed and funded loans. The price risk of these loans would be hedged until they are committed or sold. The extra interest income can be financially beneficial.

What is the hedging impact to the Institution in a volatile market (pricing difficulty of repurchasing TBA MBS)?

An increase in implied rate volatility, all else equal, typically leads to wider spreads, as the market reprices the asset class for higher options costs. Spread widening has a negative impact on long positions (the mortgage asset) and a positive impact on short positions (the hedge).