Our institution has a strong focus on single-family mortgage originations. How can we use mortgage servicing rights to our best advantage?

Retaining the mortgage servicing rights (MSR) when mortgages are sold can bring substantial returns on capital for institutions that have competitive advantages in servicing mortgages. However, because of the price volatility inherent in MSR assets, it’s important to evaluate hedging opportunities carefully.

MSR assets are essentially interest-only (IO) strips on mortgage bonds. Owners of these assets receive the interest portion of the payments of the underlying bond for a period of years. Likewise, MSR assets grant the owner a stream of servicing fees over the life of the associated mortgages, so the longer the life, the better. If interest rates fall, however, more borrowers will decide to prepay the mortgage. This will cause the IO’s price to decline because the income stream will be shortened with no offsetting principal effect. As with most mortgage bonds, MSRs tend to exhibit negative convexity; e.g., as interest rates decline, asset values decline at an increasing rate.

Exhibit 1 illustrates the price volatility of a MSR portfolio. In this example, the base market value is $26 million. Looking at the simulated price movements, we see that a down 100 basis points (bps) interest-rate shift means the asset loses nearly $15 million, or more than half its value. The up 100 bps rate shift reveals a much less significant increase in value, approximately $7 million, illustrating the negative convexity.

There are two approaches that institutions commonly follow to hedge the market sensitivity of MSR asset portfolios: static or dynamic.

With a static approach, firms typically use option contracts and hold them until expiration. For MSR assets specifically, typical hedging instruments are call options on Treasury note futures or interest-rate floors. As interest rates decline, both these options increase in value at an increasing rate, so the declining value of the MSR asset is offset, see Exhibit 2.

Exhibit 1

Alternately, a dynamic hedging approach usually involves rebalancing a combination of Treasury note futures and mortgage-backed securities, prompted either by an updated sensitivity profile, or a predetermined change in interest rates. Rebalances are typically done when interest rates move outside a predetermined corridor; 20 bps or 25 bps moves are common.Exhibit 2

During periods of low realized volatility, dynamic strategies outperform static ones, because the frequency of rebalancing would decrease and the associated costs wouldn’t be incurred. Plus, firms that bought options with the static approach paid for convexity protection that was unnecessary.

Exhibit 3Exhibit 3 illustrates an example of dynamically hedging an MSR asset. The net line shows a decrease in the volatility of the MSR asset, as the line is much flatter than that of the asset.

Hedging strategies require frequent monitoring, as well as maintenance of sophisticated trading models, making them very complex to administer and require a significant investment of operational resources. This may be why some firms choose not to engage in hedging activities. However, in the long run, hedging MSR assets can be profitable. When used effectively, it can deliver substantially higher risk-adjusted returns on capital and give an institution a significant competitive advantage within the mortgage banking marketplace.

Hafizan Hamzah is a Director in the Investment Management Group at ALM First. ALM First Financial Advisors, LLC provides asset-liability management, investment management, hedging services and other strategic and financial services for over 200 financial institutions across the United States. Mr. Hamzah can be contacted at [email protected].The Investment Management Group can be contacted at [email protected]

Hafizan Hamzah

Director, Invesment Management Group at ALM First