A Critical Tool for 2022: Hedging Mortgage Pipeline Risk
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....-->
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 r...