Mortgage Pipeline Hedging

Hedging with ALM First Financial Advisors

Large Client Base

Connected Trading Desk

Strong Analytics

Margin Enhancement

In the “nickel and dime” mortgage origination business, you need to grab income from every possible source. As such, it is important that you are not using Mandatory or Best-effort commitments to manage interest-rate risk. Even though those approaches have been industry standard, there are reasons more and more financial institutions are hedging their own mortgage pipelines.

Hedging your pipeline with ALM First Financial Advisors can provide key advantages:

  • Less expensive: It can be more cost effective to manage the interest-rate risk on your own or with our help. Financial institutions utilizing Mandatory and Best-effort commitments with the agencies are overpaying to have them hedge the IRR and provide liquidity. By decoupling the liquidity source from the hedging, ALM First Financial Advisors can reduce the cost in two primary ways: calculating your specific pull through rate (calculated daily with real-time data, thereby hedging more efficiently), and achieving better securities execution with the Street as a $21B fixed income asset manager.
  • Increased income: Most institutions sell their loans at closing to avoid the associated duration/interest-rate risk. In our model, those loans are 100% hedged with TBA MBS at closing, allowing you to hold them on the balance sheet while the appraisal is still considered current (generally up to 120 days) to earn interest income without the risk of rates moving against you. By having the liquidity source separate from the interest-rate hedging, you also gain increased flexibility to sell to whomever offers the best daily price versus being tied by a forward commitment/rate lock.
  • More clarity: Our advanced analytics and reporting system gives you insights into your pipeline on a daily and monthly basis. Our analytics also give management greater transparency into lenders that might need training on best practices for locking loans which will help to reduce fall out.
  • Reduced effort: Our turn-key solution means you simply send us a daily pipeline file and then can deliver loans to whomever give you the best bulk execution. In addition to the daily and monthly performance reports, we also prepare the GL accounting report to help reduce effort for your finance team.
  • Capital Markets exposure: As a $21B asset manager who deals with the primaries, we have an active fixed income trading desk. We will share market insights and reports to keep you abreast of developments in the mortgage markets. Because we only work with other insured depositories, we are very familiar with the issues and challenges facing your institution.

As an example, utilizing $10mm a month with hedging efficiency/analytics (shorting TBA MBS vs. best-efforts rate locks) and 90 days of (hedged) carry on the balance sheet could net out to roughly $500k annually. All your institution does is send us a daily pipeline file and we do the rest (pipeline analytics, hedging, execution, performance reporting, accounting entries, etc.)

Contact us for more information, access to our webinar series, and even a no-cost trial phase with our pipeline hedging.

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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 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 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 Financial Advisors select the TBA MBS coupons to hedge?

ALM First Financial Advisors generally select 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).

All investing is subject to risk, including the possible loss of the money you invest.

“ALM First” is a brand name for a financial services business conducted by ALM First Group, LLC (“ALM First”) through its wholly owned subsidiaries: ALM First Financial Advisors, LLC (“ALM First Financial Advisors”); ALM First Advisors, LLC (“ALM First Advisors”); and ALM First Analytics, LLC (“ALM First Analytics”).  Investment advisory services are offered through ALM First Financial Advisors, an SEC registered investment adviser.  Balance sheet advisory services are offered through ALM First Advisors.  Financial reporting services, loan introduction services, and other special project services are offered through ALM First Analytics.  Neither ALM First nor any of its subsidiaries provide legal, tax, or accounting advice.