Three Steps for Hedging Mortgage Pipeline Risk
Principal, ALM & Investment Strategy
July 25, 2018
Mortgage lending is a sizable part of most consumer banks’ business, providing an important revenue stream and helping them stay competitive. To reduce market risk and free up liquidity to make more loans, many institutions sell groups of mortgages to a purchasing agent (e.g., GSEs such as Fannie Mae or Freddie Mac), which packages them with like mortgages for sale in the secondary market. The time between the loan going on the lender’s books and its sale to the purchasing agent is called the “mortgage pipeline.”
Managing the pipeline is a critical part of mortgage lending that calls for skilled management to keep risk under control and ensure profitability. Hedging is often used to offset risk and increase efficiency, but it can be confusing – even daunting – to some because it involves complex computations and the use of models to manage risk and determine pricing. Yet, when done right, hedging strategies offer lenders more selling flexibility, greater efficiencies and the ability to hold loans on the balance sheet longer – all leading to higher returns. Usually, this process is most successful when financial managers work with qualified investment advisors that have proven hedging experience.
Managing the pipeline for secondary sale
When a mortgage lender grants a homebuyer a loan, the borrower locks in the current rate and the loan enters that lender’s pipeline. If rates fall, the borrower is free to choose another lender without penalty. But mortgage loan commitments are considered firm on the part of the lender (e.g., the originator), so the institution may be left with a hefty portfolio of loan commitments with significant risk from pipeline fallout and/or price fluctuations between the time of loan commitment and when the loan is sold off. This is where good pipeline becomes essential. The most common strategies for pipeline management are using forward-sale commitments and hedging the pipeline with capital market instruments.
Forward sale commitment
This type of commitment requires the mortgage originator to make either a “mandatory” or “best-efforts” commitment for future delivery of the loan to the purchasing agent. A “mandatory” commitment requires the originator to deliver a set dollar amount of mortgage loans at a certain price by a specific date; if the originator can’t deliver, the agent charges a “pair-off” fee. A “best efforts” commitment doesn’t require a pair-off fee, but the price for the loan will be less favorable, often with a large markup.
Figure 1: Mandatory versus Best Efforts, Fannie Mae
Hedging with capital market instruments
As discussed, a lender might experience “pipeline fallout” when loan commitments don’t close, because the borrower isn’t obligated to take the lender’s mortgage. But instead of the significant costs incurred with forward-sale commitments, originators that internally hedge the pipeline can increase profitability.
A successful hedging program includes three key steps:
- Maintain models and accurate data
To improve the accuracy and timeliness of forecasts, it’s important to ensure accurate and timely data. Also, automated data recovery and integration should be available with the institution’s modeling software. And they must be able to maintain sophisticated, reliable models for trading and monitoring their positions.
- Create pipeline stages and estimate the likely fallout
Originators use pipeline fallout ratios to estimate pull-through ratios (one minus the fallout ratio). The pull-through ratio is the likelihood that a loan commitment will be funded. Variations in interest rates and time to closing affect fallout rates, with rising rates usually increasing the borrower’s incentive to close and vice versa.
- Computing the Hedge Dollar Amount
Forward contracts can mitigate pipeline fallout risk by protecting open positions from adverse price movements. Because the originator has a long position in mortgages, taking short forward contracts on “To Be Announced” (TBA) mortgage-backed securities (MBS) protects the originator if prices decline as the hedge position’s value would rise.
- Maintain models and accurate data
To determine the amount that needs to be hedged, the risk manager must measure the duration and convexity risks associated with the mortgage assets, and then adjust for the estimated fallout. The hedge position is calculated by adjusting the dollar duration of the mortgage pipeline by the projected fallout. The firm places the hedge by selling short the appropriate amount of TBA MBS.
A well-planned mortgage pipeline management program reduces the risk of price volatility of loans in the commitment phase. Eliminating all risk would mean a perfect score, even if the hedge position resulted in a loss. Adjustments to the hedging process should reflect post-process evaluations of the accuracy of predictions.
While internal hedging can bring substantial cost savings, its success is reliant on the accuracy of the data input, the effectiveness of modeling and the expertise of the risk manager at controlling costs and implementing a hedging strategy. For best results, most financial institution originators partner with firms that are experienced in analysis and capital markets and can offer expert advice.