Question: I’ve heard that financial institutions can hedge their mortgage pipeline by shorting TBA mortgage-backed securities. What are the advantages, as well as the compliance issues?
To generate more funds for ongoing mortgage processing, financial institutions can sell the loans in their mortgage pipelines to a government-sponsored enterprise (GSE), like Freddie Mac or Fannie Mae. Typically, this is accomplished through forward agreements, of which the two most common are “best efforts” commitments and “mandatory forward” commitments:
- Best efforts commitment – An institution agrees to meet the GSE’s mortgage terms on a “best efforts” basis. If the loan closes, the institution must deliver it to the secondary market at the agreed-upon terms. If the loan doesn’t close, the institution doesn’t have to deliver the loan, so there is no financial loss. However, there is a significant markup expense to an institution to compensate the GSE for taking the risk. These commitments aren’t financially efficient, but may be appropriate if there is doubt about whether a loan will close.
- Mandatory commitments – A financial institution must deliver the loan to the GSE at the agreed-upon terms, which includes a delivery date. Of course, this involves risk if the loan doesn’t close, or it closes at different terms than the original agreement. In those cases, the GSE will calculate a “pair off” fee, determined by the undelivered portion of the commitment and the corresponding market fluctuations, which also can be costly.
Another way to hedge the mortgage pipeline is by using secondary market instruments, such as “To-Be-Announced” mortgage-backed securities (MBS). The TBA market was created to provide liquidity so that funds are available for mortgage lending. 1“TBA” denotes the forward mortgage-backed securities (MBS) trade, and pass-through securities issued by Freddie Mac, Fannie Mae and Ginnie Mae.
When an MBS investor buys a TBA, s/he engages to purchase a security backed by a pool of loans in an institution’s pipeline at the time of purchase. When the institution makes a mandatory commitment, those loans eventually will enter a TBA pool. Because the institution owns the loans, it “forward sells” its loans into the structure where the GSE will place its loans in the future. This is done by “shorting” a TBA MBS.
To better understand the advantage for a financial institution to short-sell a TBA MBS, let’s look at an example of a typical mandatory forward commitment. When an institution agrees on a mandatory basis to sell loans 30 days forward to Fannie Mae, the GSE must hedge the loan by embedding a hedge fee into the forward price. Instead, short-selling the TBA MBS acts as an internal hedge and gives the institution more flexibility. The date is not set, but once the loan is delivered, the TBA MBS is purchased back. If rates rise, the purchase price is lower than the sell price and the institution realizes a gain.
Because the institutions can hold the loans on its balance sheet for up to 120 days from the appraisal date before selling, the incremental income of retaining these mortgages prior to selling can be significant. Other benefits are that the TBA MBS positions can be increased or decreased daily to ensure appropriate hedge ratios, which are much easier and efficient than committing to the GSEs. This presents much more flexibility in rebalancing.
The bottom line is that shorting TBA MBS to provide an internal hedge for mortgage pipeline can provide financial institutions added flexibility and efficiency, as well as added income.
1Securitizations, Examination Manual,” July 2013, Federal Housing Finance Agencywww.fhfa.gov/SupervisionRegulation/Documents/Securitizations_Module_Final_Version_1.0_508.pdf.