Mortgage lending continues to represent a significant portion of business for most credit unions and banks serving consumers. These home loans provide an important revenue stream and help depositories stay competitive, not to mention serving a vital societal need. To reduce market risk and make more loans, 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.”
Why hedge 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.
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 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 commitmentThis 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.
Hedging with capital market instrumentsAs 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.
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.
Learn how ALM First can assist your institution with Mortgage Pipeline Hedging, visit our website or contact us .
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.