Hedging with ALM First Financial Advisors

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.

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.

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 Financial Advisors’ 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 Financial Advisors addresses 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.

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.

ALM First Financial Advisors 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.

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 pair-off 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.

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).