The Benefits of Mortgage Pipeline Hedging

Mortgage lending is a sizable part of most credit unions’ business, accounting for more than half (51.8%) of the industry’s $1.17 trillion in total loans. Mortgage origination serves a vital member need and provides an important revenue stream for the credit union. To reduce market risk and free up liquidity to make more loans, many institutions sell mortgage loans 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 application and its sale to the purchasing agent is called the “mortgage pipeline.”

Managing the mortgage pipeline is critical in any economic environment. However, current discussions about the Fed tapering its asset purchase program, and the economy continuing to adjust to Delta variant concerns, are likely to increase volatility in the market. The need to manage interest rate risk is paramount for mortgage lenders as they seek to 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. 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

Key Differences of To-Be-Announced Trades

To-Be-Announced (TBAs) trades are another option that can be used to hedge the mortgage pipeline. TBAs are forward contracts meant to offset the gains or losses of the loan price from time of rate lock to final sale for a lender. Implementing an effective hedge strategy with TBAs allows lenders to deliver loans via mandatory loan sales to investors.

While delivering loans via best-efforts platforms can reduce interest rate risk and increase flexibility, it comes at a high cost. In our team’s past experience, delivering loans via mandatory execution has generated a 25-50 basis point pick up per loan vs. best-efforts delivery. Most credit unions deliver loans predominately to the GSEs or Federal Home Loan Banks as they prefer to retain the mortgage servicing rights (MSRs).

Using TBAs to hedge the pipeline bifurcates the hedge from the end investor. Instead of locking in with the investor early in the origination process, the lender is able to run a best execution at time of sale and select the highest price.

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 from pair-off fees, originators that properly hedge the pipeline anticipate for this fallout and increase profitability.

Best Practices for Successful Hedging Programs

In general, there are three key steps successful hedging programs share:

1. Maintaining 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.

2. Creating pipeline stages and estimating 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.

3. Computing the hedged 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 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 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.

Anthony Olson is Director of ALM Strategy Group at ALM First in Dallas.

Robert Perry is Principal at ALM First Financial Advisors in Dallas.