By Emily Hollis, CFA
Most credit unions are in the business of originating mortgage loans. Some do not retain all the loans that they originate but, instead, sell to FNMA or FHLMC (GSEs) on a periodic basis. This is done for liquidity needs or to decrease interest rate risk. The GSEs usually sell these loans in the secondary markets.
The length of time mortgage loans are retained through the process of originating and selling is called the “mortgage pipeline.” During this process, the credit union can be exposed to market rate movements and thus pricing risks from the time the loan coupon is committed to the time of sale.
Originators manage this process in one of two ways; financial forward agreements directly with the GSEs or internally hedging their pipeline with capital market instruments (usually with the aid of a consultant or investment advisor). This form of hedging is permissible under Part 703.21 of the NCUA rules and regulations.
Financial Forward Agreements
A financial forward agreement is a contract between two parties to either buy or sell a specific financial instrument at a specified date in the future. As an example, a purchaser agrees to buy a home from a seller with a closing date 30 or 60 days forward and locks in a rate today so he/she isn’t exposed to changes in rates between now and when the loan closes.
The mortgage originator (the credit union) commits to fund the loan from the purchaser at the agreed upon forward closing date. If interest rates increase, the value of the committed loans will decline and the originator is exposed to market value losses. The two most common forward agreements used by mortgage originators are best efforts commitments and mandatory forward commitments.
Best efforts commitments occur when the credit union agrees to the GSE’s mortgage terms on a “best efforts” basis. If the consumer closes the loan, the credit union is required to deliver the loan to the secondary markets at the agreed upon terms. If the loan does not close, the credit union is not required to deliver and therefore experiences no financial loss. Best efforts sales have their place with uncertainty; however, they are not financially efficient with huge mark-up costs to the credit union. The mark up is a way to compensate the GSE for taking the risk that the loan may have already been sold to the secondary market, and has not been delivered into one of its mortgage pools (a to-be-announced “TBA” security).