Synthetic Puts

The use of options as a tool to hedge a mortgage pipeline is nothing new and have been used since they began trading back in 1983. Options can be an effective tool to reduce risks associated with residential mortgage loan fallout or renegotiations due to market movements. They can also be effective for extended term locks and float down locks.  There are two main choices for the type of option instrument to use, options on Mortgage Backed Securities (MBS options) and options on Treasury securities either Futures or Cash.  For this review, we will only consider the 10-year Treasury futures contract options; however, MBS options are preferred if available and fairly priced.

Option contracts come in the form of Puts and Calls. As with any transaction, there is a buyer and a seller. This holds true for option contracts as well, the pipeline manager or hedger could be a buyer (option holder) of PUTS or CALLS or they could be a seller (writer) of them, but this is never recommended because it opens the door to an unlimited amount of market movement – something no mortgage banker should take on. 

An Option can be defined as: A financial derivative that represents a contract sold by one party (option writer) to another party (option holder).  By the way MBS TBA sales are also derivative instruments! The contract offers the buyer the right, but not the obligation, to buy (Call) or sell (Put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period or on a specific date (exercise date). The price paid for the option by the holder is called the option “premium”. 

Call options give the option to buy at certain price, so the buyer would want the price of the underlying security to go up in order to receive a return on the premium paid.

Put options give the option to sell at a certain price, so the buyer would want the price of the underlying security to go down in order to receive a return on the premium paid.

For the purpose of utilizing Puts and Calls to hedge a mortgage pipeline, the pipeline manager should seek to limit exposure to the company from volatility. This is best achieved by being a buyer of the contracts rather than a seller (writer) of the contracts. One might think of it like paying a one- time premium for an insurance policy. A premium is paid to protect against a risk that may occur. If risk occurs and there is reasonable price movement, the contract can be acted upon to recover the loss. If risk of loss never comes to pass, then the hedger is out the premium only. If one is the writer of the option contract, then he/she has the exposure of unlimited market movement and is responsible for paying for the loss that may occur.

A locked loan in a mortgage company pipeline represents a form of a free PUT contract to the borrower or stated another way the borrower has the right to take the loan, but not the obligation. Because the borrower does not have to close the loan with the lender and there is usually a relatively low cost to applying for a loan, the lock agreement leaves the mortgage company at risk to market price changes associated with a TBA MBS hedge. While fallout can be statistically measured based on past performance the cost of buying after a rally and selling after a downturn leaves many chasing their tails or being “whipsawed” by the market. This has significant costs in a volatile market.  Another source of exposure to volatility comes from long term float down locks and forward builder commitments whereby the borrower/builder is given a cap on pricing and allowed to float down if the market stays the same or gets better over building time-frame.  Put contracts and Synthetic Put contracts are utilized to absorb the changes in a firm’s pipeline position from fallout associated with these market movements and the exposure from Float Down Locks. For example, when the market sells off a Put contract increases in value and provides more coverage allowing the hedger to not have to sell after a downturn and decreases in value and coverage amount when the market rallies.  

A synthetic PUT can be defined as the sale of a TBA MBS in conjunction with the purchase of a Call contract on the like instrument, either the like TBA MBS or the 10-year Treasury futures contract. This acts the same as a Put contract given a constant spread relationship, correct amount to sell, and accurate hedge ratios. A Put contract protects or gains value when the value of the underlying TBA loses value. In the case of a Synthetic Put, the financial instrument TBA MBS is sold short and a Call contract is purchased on the financial instrument. If the market value drops, the underlying financial instrument will gain in value and the Call option would expire worthless. In the event of a market rally, the Call will pay for the losses on the additional MBS short and provide a buffer against having to pair off additional pipeline coverage. In the case of the Put contract, you are long loans and short MBSs and own a Put contract. If the market sells off the MBS will gain in value the relatively same as the loans change in value sans servicing value, but the fallout will decline on the loans causing a higher percentage of loans to close. The change in fallout on those loans remains exposed to poorer prices. The correct amount of Put contracts whether Synthetic or actual Puts will make up that difference created by the fallout change.

Mortgage Capital Management’s analytics provide the calculations for the changes that occur due to market movements and provide the recommendations based on those movements on how much optional coverage to add to protect against the potential reductions in the mark to market value of a client’s pipeline. This hedge position optimization is provided to show how much option coverage would be required to effectively neutralize potential mark to market value changes associated with market movement and the changes in fallout.

MBS options are very good instruments if available and economically priced to use because they are derived from the securities that are used to price mortgages and to hedge the mortgage pipeline. Much like other markets, there are good times to buy/sell and not so good times to buy/sell. In the case of option contracts, the cost of a premium of the contract is higher when volatility is elevated, and the cost recedes when volatility is low. In addition, the pipeline manager who utilizes Treasury Puts and Calls would want to pay attention to the spread between the current coupon yield of the underlying MBS compared to the yield of the 10-year Treasury contract on an OAS basis. This is important to allow the hedger to derive the most value possible out of the option contracts purchased. History tells us the yield spread between these two instruments are not constant, but that they do correlate with mean reversion being a powerful tool. When the spread is wide between the two and has stopped getting wider, this may mean that the price of the MBS has lagged the price of the 10-year Treasury OAS adjusted like what happened in early 2008 when spreads reached historic levels. That trend tends to reverse itself and the spread will narrow back down all things being equal through mean reversion. By recognizing that this occurs and by tracking the OAS spread, the hedger can get a good view and consequently a good understanding whether to be a buyer of treasury Put contracts versus a buyer of a Call contracts with TBA MBS forward sales (Synthetic Puts). If MBS TBA puts and calls are not available to a pipeline risk manager for hedging long term float down locks and/or volatile fallout; and the firm does not want to take on the basis risk or potential MBS - Treasury spread movement, one should use an equal coverage value amount of Treasury Puts and Synthetic Puts - dollar, OAS hedge ratio, and strike price adjusted. This is called basis risk management.

So, what are some examples of causes of spreads widening or narrowing?

Widening:

·       Investors response to the Housing crises

·       Supply and Demand imbalances

·       Large Sales of MBS product by loans originators

·       The end of an Investors large purchases of MBS Product

·       Political and Economic Turmoil sends investors to safe havens

Tightening:

·       Fear of War dissipates, or political conflicts go away

·       Lack of price volatility in Financial Markets

·       Fear of economic collapse dissipates, or economies stabilize.

·       Supply and Demand imbalances

·       Large purchases of 10-year Treasury Securities by investors

While these do not seem like they may occur frequently, the fear or speculation that something may happen does tend to happen more frequently causing the spreads to widen and narrow in short periods of time. During the 2008 Housing crises, investors shunned MBS securities as demonstrated by the spread widening that occurred.

An example of how this might look is as follows:

Below is the spread between the current coupon, Fannie Mae MBS security OAS Yield and the 10-year Treasury contract OAS Yield with the corresponding MBS price level in an XY graph presentation:

One can see that the spread is relatively wide at above 70 basis points in yield and relatively low below that level for the period depicted in the graph. Also, of interest is to know where the price level of the MBS security is at any given point in time relative to the OAS spread. The black dot points to the current level and indicates that given a price level of 104.25 the OAS spread is relatively low and would otherwise be over 80 BPS given the price level. So currently, the OAS spread is slightly on the tight side. This indicates that one might expect the spread to widen or prices of the FNMsA30 3.5 to reduce relative to the price of the 10-year Treasury futures contract OAS hedge ratio adjusted.

Let us assume that volatility is low for the purposes of the following example thereby offering us lower priced premiums. In the market represented above where spreads are tighter than would be expected given the current price level and history, one would want to buy Synthetic Puts since we expect spreads to widen thereby gaining from Treasury Calls gaining in value faster than expected given no change in MBS price level.  Had the spread been wide, we would then be more motivated to buy Treasury Put contracts as we would expect the price yield spread to tighten e.g., MBS stays flat and US 10-year prices decline. This balancing act of managing the basis risk when purchasing Treasury Puts and/or creating Synthetic Puts requires an active management philosophy and the ability to measure risk and react relatively quickly. To avoid this basis risk, one should actively seek to balance the amount of Treasury Put and Synthetic Put coverage to minimize overall risk or stick to the preferred options – options on TBA MBS securities. However, the risk from the Synthetic Put Options strategy is not so high (like if you were the writer of a Call or Put) that one should not consider the use of Synthetic Puts when combined with Treasury Puts; and, if managed correctly the cost of hedging will go down during volatile markets. If markets remain flat there would have been no need for any options but looking back provides 20/20 vision.

One of the downsides to MBS options in today’s market is that there are very few Dealers that make a market in these instruments relative to historical norms. This tends to cause illiquidity resulting in higher premiums or the inability to trade the MBS option contracts at all especially for smaller firms. In addition, they are traded in $1,000,000 trade amounts, which can create less than optimal option positions for smaller firms. This is where 10-year Treasury options come in. Because there is a correlation between the two instruments, one can use the 10-year Treasury contract just as one would an MBS option to protect the pipeline. The advantages of 10-year Treasury options are they are liquid, priced competitively, can be paired off at any time, and they are traded in $100,000 increments.  The risk of buying 10-year Treasury options can be described by the graph below that indicates the OAS spread movement over a longer period that requires accurate and active management:

In the case of utilizing 10-year Treasury Option contracts, if spreads are wide for the period reviewed, one would expect the spread to narrow or the price of the 10-year Treasury to over perform relative to the price of the current coupon MBS when rates rise, or MBS securities to outperform relative to 10-year Treasuries when rates fall. The movement of spread can be from either positive or negative movements of price or rate levels.

Perceived Market Condition:

·       WIDE SPREAD => BUY 10 YEAR TREAURY FUTURES PUTS OPTIONS

·       NARROW SPREAD => BUY SYNTHETIC PUTS (10yr Calls plus MBS TBA Sales)

·       BASIS NEUTRAL => BUY EQUAL AMOUNTS OF EACH (OAS HR, Strike, and      $’s adjusted)

By utilizing the strategy described above or managing the amount of coverage provided by both outright Puts and Synthetic Puts one can limit the basis risk associated with Synthetic 10-year Treasury Options hedge. This will optimize their use in effectively neutralizing fallout risk due to market movement. Ultimately, the use of these contracts will help to stabilize profit margins that the company has priced to make on the loans they hedge, costs from renegotiations, and float down locks. By not using options, one is expecting the market to be flat and/or the fallout volatility in the pipeline to be flat. In either case, no options would be required to avoid excessive hedge costs.

To further reduce the effects of basis risk one should keep the amount of OAS hedge ratio adjusted coverage provided by both Treasury Puts and Synthetic Puts (Treasury Call purchases with MBS TBA forward sales) equal thereby keeping the effects of spread widening or tightening on either side of the equation equal.

For further discussions on this strategy, please contact us here at MCM – your competitive advantage!

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