Mortgage pipeline hedging falls under the broad umbrella of secondary marketing. The goal of pipeline and secondary marketing risk management is to consistently deliver loans profitably to investors while minimizing risk to the institution. How can an institution improve and enhance its profitability in delivering loans? Consider these areas when improving pipeline hedge performance:
- Fallout and pull-through
- Hedge cost
- Warehouse carry
Fallout and Pull-through
It is important to understand how operational aspects of mortgage banking impact the hedging aspect of the business. Often, excessive fallout can be a result of aggressive locking and/or can indicate problems within the lock desk operation. Excessive and volatile fallout costs your institution, as volatile fallout is hard and expensive to hedge. Controlling fallout, while not directly part of mortgage pipeline hedging, is extremely important to successful pipeline hedging.
To control fallout, consider being more active in communicating with borrowers, making sure they know what to do and by when. Providing checklists and a timeline could be beneficial. Also, lock desk policies play a role. Consider locking only loans that already have credit and appraisal reports produced. The associated fees could create an exit barrier and indicate that the borrower is serious. Reference channels are another strong advantage. Establishing relationships with local brokers can help improve trust and expand lending; some evidence suggests broker-referrals have lower fallout. Remember, actively managing the pipeline is important to hedging; poorly managed pipelines add hedge costs to your institution. Locks that are inactive should be purged regularly, as they create extra hedging costs for your institution.
Hedge costs arise from the cost of carry of the hedge instruments, as well as any hedge slippage (sometimes called offset ineffectiveness). Driving hedge costs lower can be done in a variety of manners, depending on the current hedge process of the institution. Some institutions, particularly smaller ones, hedge using forward committing on a loan-by-loan basis to the end investor, either on a mandatory or best efforts basis. Hedge costs can be driven lower by exploring alternative methods of hedging, primarily to-be-announced (TBA) mortgage-backed securities (MBS). These instruments are highly useful to hedgers looking to mitigate interest-rate risk arising in the mortgage pipeline. The hedge cost equals the cost of carry of the instrument, plus any hedge slippage; this cost can be compared to forward committing. The hedge cost of forward committing equals the difference between the 1-day (or nearest term) price less the contract expiry price (60-day, for example), plus any pair-off (PO) or over-delivery (OD) fees. The difference in the near-term and the expiry-term prices represents the implied cost to hedge, and compensates the end investor for the interest rate exposure.
Hedge Cost (TBA) = Cost of Carry + Hedge Slippage
Hedge Cost (Forward Committing) = Price (1-day) – Price (expiry term) + Fees (PO or OD)
When calculating hedge costs for TBA instruments, the cost of carry is embedded in the asset’s price movement (the flip side of this trade is an investor earning a return, known as the dollar roll). Ultimately, the hedge cost equals the price movement differential over a given period. The hedge cost for forward committing is the price give-up. For the year 2017, this has averaged to be roughly 0.18 points per month, or just under 6/32nds per month, depending on the contract expiry. Using a TBA-based strategy of selling at the 1-day price and hedging with TBA MBS produced an average hedge cost of 0.12 points per month, or just under 4/32nds, again, depending on the TBA product used. This was using a simulated hedge strategy of 4% coupon conforming 30-year loan production hedged using Fannie Mae 3% coupon TBA MBS.
While a TBA-based strategy might have a little more variability in the hedge cost month-over-month, on average it can provide hedge cost savings compared to forward committing. It can also be beneficial for clients operationally who want to move away from individual loan-by-loan pipeline management; clients with high amounts of origination volume tend to get the most benefit from this strategy.
Warehouse carry can be a significant source of profitability in mortgage banking. Warehouse carry is the interest income generated from holding originated loans on the balance sheet for a period of time prior to selling, rather than selling upon origination. For example, a lender might hold them in “Loans Held for Sale” for 60 days or even longer, hedge the interest-rate risk, and earn a spread. Institutions with excess balance sheet capacity and low cost of funds tend to benefit most from this strategy.
It is important to consider warehouse carry in best execution analysis. Institutions may make decisions based on maximizing net gain on sale, but with much less warehouse carry, and thus overall pipeline profitability could fall short of its potential. The opportunity cost of carry give-up should be factored into different investor pricing and contract expiry.
What is Right for You?
The table below shows the results of a simulated strategy of a 45-day average time in the pipeline, a 60-day warehousing period, a cost of funds of 0.50%, and $20 million per month in origination volume. The first strategy forward commits locks at FNMA’s 45-day forward price. The TBA warehousing strategy holds loans for 60 days after origination, hedging using FNMA TBA MBS 3% coupon. The TBA no-warehousing strategy simply hedges using FNMA 3s to hedge instead of forward committing. Once loans are originated, they are sold at the 1-day price and the hedges are removed. The TBA warehousing strategy added over $1 million to the bottom line when compared to FNMA forward committing, and $500,000 to the bottom line with the no-warehousing strategy.
Institutions without the analytical capabilities, good market access/execution, and operational requirements may find the best option to be committing directly with investors on a forward basis. However, institutions partnering with hedge advisory firms that utilize analytical and operational capabilities may find the benefits are worth the efforts.