If your institution is like most of the depositories we work with, then mortgage lending is a substantial part of your business. However, it’s important to understand your current mortgage pipeline process and periodically evaluate whether your institution is exposing itself to unnecessary interest rate risk by not hedging or overpaying the agencies to hedge. We often find there are opportunities to enhance profitability and better manage risk in both of these scenarios.
It is common for institutions to sell groups of mortgages to a purchasing agent such as Fannie Mae or Freddie Mac. These government sponsored entities (GSEs) package the loans 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.”
Benefits of hedging 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 may offer lenders more selling flexibility, greater efficiencies and the ability to hold loans on the balance sheet longer – all leading to potentially higher returns. Usually, this process is most successful when financial managers work with qualified investment advisors that have proven hedging experience.
Pipeline management strategies
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 management 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 vs. Best Efforts
Pipeline management strategies
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 potentially increase profitability.
A successful hedging program includes the following:
- 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.
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 may result in substantial cost savings and enhanced profitability, 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. Most financial institution originators partner with firms that are experienced in analysis and capital markets and can offer expert advice.
Contact us today to learn how ALM First may assist your institution with Mortgage Pipeline Hedging.
Disclosure: ALM First Financial Advisors is an SEC registered investment advisor with a fiduciary duty that requires it to act in the best interests of clients and to place the interests of clients before its own; however, registration as an investment advisor does not imply any level of skill or training. ALM First Financial Advisors, LLC (“ALM First Financial Advisors”), an affiliate of ALM First Group, LLC (“ALM First”), is a separate entity and all investment decisions are made independently by the asset managers at ALM First Financial Advisors. Access to ALM First Financial Advisors is only available to clients pursuant to an Investment Advisory Agreement and acceptance of ALM First Financial Advisors’ Brochure. You are encouraged to read these documents carefully. All investing is subject to risk, including the possible loss of your entire investment.
The content in this message is provided for informational purposes and should not be relied upon as recommendations or financial planning advice. We encourage you to seek personalized advice from qualified professionals regarding all personal finance issues. While such information is believed to be reliable, no representation or warranty is made concerning the accuracy of any information presented. Statements herein that reflect projections or expectations of future financial or economic performance are forward-looking statements. Such “forward-looking” statements are based on various assumptions, which assumptions may not prove to be correct. Accordingly, there can be no assurance that such assumptions and statements will accurately predict future events or actual performance. No representation or warranty can be given that the estimates, opinions or assumptions made herein will prove to be accurate. Actual results for any period may or may not approximate such forward-looking statements. No representations or warranties whatsoever are made by ALM First Financial Advisors as to the future profitability of investments recommended by ALM First Financial Advisors.