Investor Basis Risk

Best execution is very important when evaluating where and how to sell your mortgage loans into the secondary market. However, deciding when to do so can even be more important. Failure to recognize this very significant element when managing pipeline interest rate risk on a daily basis will drastically reduce your profitability. This element is called “Investor Basis Risk.” Many who don’t recognize this issue will say they do not have any basis risk since they use MBS TBA trades to hedge their pipeline (hedge ratio of choice adjusted); and, that may be true if they are able to securitize their pipeline into MBS securities and retain servicing. However, if they are like most mortgage bankers these days then at least some if not all of the pipeline is subject to the basis risk between the daily price changes between the mortgage originated as priced by the targeted investor’s pricing and the TBA MBS security used to hedge. For example, regardless of whether loans are sold through: loan-by-loan individual sales, Bulk, AOT, co-issue etc…, all of the loans are being priced by investors with their own individual appetite for loans on a given day. It is not mandatory that they price according to the movement of the MBS TBA market – they simply price according to what they want to make on a daily basis given the amount of business and backlog they have. They may consider competitive pressures and the market, but they definitely are not tied to either market movements or competitive pricing in the short run.

The graph below shows the average spread between the pricing available from 8 different investors tracked daily through various executions available and the current coupon FNMA 30 year fixed security price plus effective OAS servicing value. Even when the OAS value of serving and its changes are removed from the equation one can clearly see that some days it just does not pay to sell and some days everything should be sold. When individual investors are tracked on this basis, you can clearly get an idea of who wants business, who does not, and how sensitive they are to market movements.