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A Critical Tool for 2022: Hedging Mortgage Pipeline Risk

Date:

Robert Perry

According to Freddie Mac’s latest quarterly forecast, relatively low mortgage rates coupled with first-time homebuyers and other demographic tailwinds are expected to lift home purchase mortgage originations from $1.9 trillion in 2021 to $2.1 trillion in 2022. The GSE also expects refinance activity to soften due to the rising trend in mortgage rates, with refinance originations projected to decline from $2.7 trillion in 2021 to $1.2 trillion in 2022. [1]

If your 2022 business plan includes the sale of mortgage originations or demands the flexibility to sell as needed for risk management and income generation, it’s also important to understand your current mortgage pipeline process and ensure that your institution can hedge your mortgage pipeline effectively when needed. We recommend periodically evaluating your mortgage origination process for interest rate risk and delivery management. We often find there are opportunities to enhance profitability and better manage risk in each area.

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.

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). If rates rise, the secondary market value of the locked loan commitment declines. In periods of heightened market volatility, 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 either forward-sale commitments or hedging in the capital market – or a combination of the two.

[1] Source: Freddie Mac; http://www.freddiemac.com/research/forecast/20220121_quarterly_economic_forecast.page

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.

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 gain flexibility in their pipeline management process and 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
    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.

About Author:Robert Perry, Principal
Mr. Perry has more than 30 years of experience in the banking and bank-consulting businesses. Mr. Perry has shared his in-depth knowledge and financial management background at many conferences, training and educational events in the areas of ALM and investment strategy, profitability and portfolio strategies, as well as hedging and derivatives use. Mr. Perry has been quoted and published in various publications including WIB CFO Digest, WIB Directors Digest, Credit Union Business, Bloomberg News, and many more.
Robert Perry is a Principal at ALM First, joining the firm in 2010. Mr. Perry leads ALM First’s ALM and Investment Strategy Groups and is responsible for the development of asset liability and investment portfolio themes for the firm. He also provides strategic focus for financial institution client portfolios that are primarily invested in the high credit quality sectors, and is instrumental in balance sheet hedging strategy development.
Before joining ALM First, Mr. Perry previously served as Managing Director of the ALM and Investment Strategy division of DataTech Management in Los Angeles, California, and Chief Investment Officer for First Coastal Bank in Manhattan Beach. Previously, Mr. Perry was a Principal and Product Portfolio Manager at Smith Breeden Associates, Inc., where he managed Smith Breeden’s Enhanced Cash and Enhanced Equity Strategies. He also managed Smith Breeden’s bank consulting group, which included the non-discretionary asset management and risk-reporting businesses. Prior to joining Smith Breeden in 1991, he worked as an analyst in the risk management area of Centura Bank in North Carolina.

This content contains information derived from third-party sources. We believe that this third-party data is reliable; however, we cannot guarantee this data’s currency, accuracy, timeliness, completeness, or fitness for any particular purpose.
 
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 article 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.
 
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