MBA Capital Markets Committee Options Presentation on 4/16/2019

Good afternoon and thank you Chris, Andy & Buck for the intro and everyone for joining us today to hear a little about hedging with options.

My name is Dean Brown and I’m CEO of Mortgage Capital Management – a pipeline risk management firm started in 1994 and located in SAN Diego, CA – where today it’s not cold, snowing, or hot, but it did rain a little this morning.

Who needs options?

Mortgage bankers, whose Pipelines have high Fallout volatility exposure – and need to avoid the whipsaw effect – what does this mean? Here is an example.

If you are a mortgage banker, you are in the options business. Why? Because borrowers are given the option to close and are not required to close. Hence, when rates drop considerably during the processing timeline, they sometimes either cancel, renegotiate or reapply with another lender if they have not already. The fallout volatility equation exists in every pipeline we have worked with over the past 25 years to some degree. Some pipelines have an average fallout expectation of 20% with a +- 2-3 % change given a significant market move such as .5% increase or decrease in rates, while others have significantly higher exposure to fallout volatility in the range of +- 5-15%. For those companies blessed with very little fallout volatility – no options are required, for the rest it makes sense to protect the pipeline by buying options to negate the risk of being whipsawed in the market. For example, assume you have a $125-mil pipeline with an average fallout rate of 20% and an 8% variance to that rate given a market movement of 2 points.

Your starting position is $100M of exposure after fallout with $100 mil in coverage ignoring hedge ratios, SRP values, Caps, etc… after the market sells off 2 points you would need to sell an additional $10 million in TBA coverage hopefully not all at the down 2 points but nevertheless at a loss while the market is deteriorating, and your pipeline’s closing rate is increasing. If the next day brings a significant recovery and the market improves 2 points and the position again is repositioned to reflect the expected lower or average in this case closing rate and 10 million is paired-off and the original market level two points higher than what was sold the previous day. With just one down and up market movement the position was whipsawed and cost the company up to 2 points in each direction on $10 mil or $400,000. While this level of market volatility is rare and can be somewhat mitigated by active delta hedging, it has happened in the past, but even much lower market volatility of say 1/2 a point could result in a loss of $100,000. Since market volatility can occur at any time, options with 2-3 months before notification will be used repeatedly.

The idea behind buying options to hedge your position is premised on the fact that a Put option increases in value when the market sells off and decreases in value when in improves, Hence the goal is to balance the expected change in pipeline value with the correct amount of option coverage to maintain a flat position and avoid being whipsawed. If you have significant fallout volatility exposure and do not buy options you are betting that the market will stay un-volatile during the pipelines’ s duration, If you buy an option to cover your exposure you have locked-in your cost of hedging upfront. While actual market volatility has not been very high lately so has the implied level of volatility come down to historic low levels.

In addition to fallout, once a loan is closed the borrower has been given the option to prepay, refinance, or curtail the loan at any time. Hence, when rates drop, the value of servicing goes down for the higher refinancable note rates and the opposite occurs for a rate increase. This also applies to the value of the note whether sold as a whole loan or through and MBS execution all of which needs to be accounted for when hedging a mortgage pipeline.

Hence, every mortgage banker is in the options business and should be very familiar with the concepts, mathematics, and strategy for deploying them to manage risk.

MCM uses Options for clients who want to use them to hedge pipeline risk. And it is completely our client’s choice whether to use them or not regardless of their exposure. Back in the day, we used primarily MBS options, but since the financial crises, very few of these are offered by our broker dealer friends, and when we have checked they have come at very high pricing relative to CME Treasury futures options. Hence, most of the options we use today are traded in the 10yr contract for liquidity and pricing considerations.

Pipelines with Float Down Locks, lock and shop, or generous renegotiation policies. Other uses of options in pipeline management:

To hedge:

• 1-time close float down on new construction with a capped rate and price with float down at Docs
• Spot commitments for individual borrowers with new construction 6-12 months out with e.g., @ 4.99% and 1 point
• Lock and Shop Customers who have not found a house but want protection
• Forward Builder Commitments with e.g., 4.99% & 1 Point for 6- 12 months covering large phases of development

Option types:

• Put Options on MBS securities
• Put and Call Options on Treasury Futures – Synthetic Option OAS Spread Management & Put and Call options on Treasury Cash securities – Synthetic Option OAS Spread Management
• A mismatch is included with any of the above selections (even MBS) as the loans originated above include servicing value and the options even the MBS do not.

Sample Trade:

Sample language used for purchasing 1 mil of 10 year Treasury Futures Puts 1 point out of the money in Sep: (29/64ths or .453 $4,530 plus fees)

“Hey John Dean @ MCM Offer me 10 TYU9 puts at 122 at the market”

© 2020 Mortgage Capital Management, Inc.