One of the primary goals for any secondary marketing manager is to develop systems and controls for measuring and managing mortgage pipeline risks in order to make better decisions regarding secondary marketing execution.
The end-game is to enable the company to realize the profit margin that is baked into the pricing on “day one” of the lock with the borrower. Many companies seek to lock in this profit at the loan level through a “best-efforts” investor commitment. Currently, investor policies and market dynamics are discouraging this practice by providing pricing that is significantly discounted to single loan mandatory delivery commitments, and even more heavily discounted to “AOT” execution (a.k.a. direct-trade or mandatory bulk). Spreads between best-efforts and AOT execution ranged between 40 and 50 basis points during most of 2008, and in early 2009 have increased to over 100 basis points in some situations. The best-efforts hedging strategy is one which has its own set of risks for mortgage bankers which are not easily measured or managed.
A common maxim among financial professionals is “if you don’t measure it, you can’t manage it”. Capturing the additional secondary market revenue available through the AOT execution requires hedging the pipeline. Given the short menu of mortgage products being originated for sale into the secondary market, the obvious choice of hedging instruments is Agency MBS – the most liquid, discoverable, and highly correlated vehicles available. However, most mortgage bankers are not delivering the single MBS to the market. They are instead delivering two assets to the market: 1) whole loans, and 2) servicing rights. This is a critical distinction and introduces a layer of complexity in the measurement and management of mortgage pipeline risk.
When the largest players in the mortgage industry (the “Aggregators”) purchase agency-eligible mortgages, they “bifurcate” the asset by passing through the loan to the MBS market and stripping out the servicing and excess servicing for their own long term investment. Mortgage servicing rights (“MSR’s”) are an asset class that are correlated to the MBS they are associated with but have distinctly different valuation components that react quite differently to changes in the market. The Aggregators understand these dynamics very well by virtue of their immense exposure to MSRs and thus value and hedge these assets discretely.
The Servicing Released Premium (“SRP”) paid by the Aggregators to correspondents reflects their valuation and sensitivity of the MSR component of a given loan. The SRP posted by the Aggregator therefore has embedded in it all of the risks that the Aggregator perceives related to the current and future value of the MSR and is therefore a significant component of the mortgage pipeline risk for the mortgage banker. The Aggregators seemingly commit to an MSR valuation for a certain period of time in the form of an SRP grid in their AOT contracts with mortgage bankers. By doing so, they would appear not to have the opportunity to adjust the SRP daily. However, they do manage to pass through changes in their valuation of the MSR, embedding these adjustments in their daily pricing of the loan asset (usually expressed in the form of the Base Note Rate (BNR) or other feature adjustments.The more complex the pricing structure is, the more opportunities there are for the Aggregators to arbitrage the risks. All of these potential adjustments must be measured daily in order to evaluate the exposures that need to be managed in a given pipeline. Therefore, in addition to a rigorous analysis of the probable pull-through, best-practices for mortgage pipeline risk management must include:
- daily, comprehensive, loan-level best execution analysis, and
- daily, sensitivity/duration analysis of the loan asset, the MSR, and the hedge instruments to measure value changes related to rate shocks;
The integration of these elements results in the daily production of an accurate P&L, and pipeline sensitivity analysis that measures all of the risks that impact the daily management of the client’s position and P&L.
Once a complete measurement of all of the mortgage pipeline risks has been accomplished, the management and hedging of the risks can begin. Professional, modern day hedging is a dynamic activity that accounts for changes in value correlated to changes in interest rates. The goal is to strike the correct balance between the sensitivity of the assets (loans and servicing rights) and the sensitivity of the liabilities (hedge vehicle) in order to preserve the net profitability of the position across a range of potential rate shocks.
Professional hedging is not about micro-management of the locked pipeline. It is not about matching off the risk of every loan that comes in the door – that’s the purpose of Best Efforts execution. Best Efforts is a form of hedging – it’s just a very expensive one (and getting more so all the time).
Professional hedging is a “macro” exercise based on micro-measurement and micro-analytics described above that result in establishing, 1) the actual market value of the loans, servicing, and hedge instruments, and 2) the durations and valuation sensitivity of the whole loans, servicing rights, and hedge instruments.
This methodology produces rate shocks that are based on the firm’s actual loan level execution – servicing released whole loan delivery, so the firm is hedging the right risk from “day one” of a new rate lock. This goes well beyond the common practice among mortgage bankers to determine best execution on a “post mortem” basis.
Furthermore, servicing released mortgage bankers aren’t delivering TBA MBS, so it’s inappropriate to be hedging to that execution. Most firms involved in hedging don’t perform loan level best execution and tend to hedge only to the MBS execution. They often utilize a slotting and bucketing approach that results in hedging with the wrong TBA coupon much of the time. Also, this approach ignores the servicing component and the negative convexity associated with it which produces a position that is over-hedged in a rally and under-hedged in a sell-off. Ultimately, this is an antiquated approach that produces higher hedging costs even in a flat market and in a volatile market tends to produce massive pair-offs for the firm that can wipe out a months worth of profits.
By contrast, modern professional hedging utilizes the best-practices described above for measuring and managing mortgage pipeline risk, producing a more predictable and stable P&L, and enabling firms to realize the margins that they had anticipated in their transfer pricing. As to the source of those margins, the adequately hedged firm should be indifferent. In some months, the margins may result from mark-to-market gains on hedges that exceed mark-to-market losses, and in other months it may be reversed. The goal is to ensure that the firm is optimizing their secondary market execution regardless of the level of interest rate volatility.
Tina Freeman, CFA, Managing Director, Secondary Solutions Group
Douglas Mayers, Senior Vice President, Client Solutions Group
MIAC Perspectives – Spring/Summer 2013
Best Practices in Mortgage Pipeline Risk Management