Mortgage Options
If you are in the mortgage business, you are in the options business. What does that mean? This blog will detail what that means if you are a loan originator, but it also applies if you are a servicer as well as borrowers once getting a loan have the option to prepay at any time. This blog will focus on why you should be using options in your pipeline hedging strategy and/or at least recognizing that fact when managing your business. I will attempt to use the “KISS” method or keep it simple stupid in order to keep it short and still provide the necessary information.
If you are a mortgage lender who originates mortgages for sale into the secondary market, you are in the options business. The first option encountered by your firm occurs when you grant a rate and point lock to a potential borrower. For example, the borrower applies for a fixed rate 30-year conventional loan on day one of say 6.5% and -1 points (the current level from your rate sheet that your secondary department deems will earn your firm the targeted profit margin from gain on sale if and when the loan closes and is ready for sale.) Three things can happen once you grant the pricing lock to the borrower, (1) the borrower gets approved and the loan closes as expected, (2) the loan is rejected by underwriting for either a borrower or property issue or the borrower cancels for whatever reason and falls out of your locked pipeline, or (3) the borrower closes but only after you grant them a renegotiation in either rate, price or both because rates dropped during the processing timeline and they refused to close unless you gave them a rate at or near the current market. The option part of granting a lock to a borrower is multifaceted, under the renegotiation case the borrower has no obligation to close hence they have an option to close at the pricing your firm offered on day one. The option would be considered out of the money since there is a timing issue to go with another lender and potentially a cost to do so as well, but the fact remains that you granted them an option on day one. Under the second case where a loan is either cancelled or rejected, the option is realized as the loan doesn’t close, but your exposure from that loan remains up until the date of cancellation.
A summary of each scenario:
Case 1: The loan is hedged (by selling a TBA mortgage-backed security) and ultimately sold for the targeted profit after pairing off the TBA security and delivering the loan to an investor.
Case 2: The loan is also hedged but no loan is closed so a pair-off of the TBA security occurs leaving either a gain from the pair-off or a loss depending on whether the market price for the loan went up or down. If your crystal ball is accurate and you hedged the correct amount, your targeted profit is realized if not either too much profit is made or a shortfall is realized.
Case 3: The loan is sold but the gain on sale is impacted by having the rate and points collected be reduced by the renegotiated amount. For example, if the loan closes from the above example at 6% and -1 point a reduction in margin would have occurred of 2 points (.5% multiplied by the buydown factor of 4) leaving you with a closed loan with a 1-point gain on sale loss. While other fees are collected and the loan origination fee is received by your loan officer, your gain on sale would have been highly impacted under this scenario.
The cost of the option you granted up front is determined by the relative closing rate for all loans under different market scenarios. If your firm closes 80% of all locks without any renegotiation and without any variance to that percentage, you effectively have zero options cost because your secondary department would only hedge 80% of all loans originated as required. However, this is never the case as the percentage of loans that fallout vary depending on the type of loans originated, market conditions, loan officers originating the loans, competition, and many other factors causing your closing rate to fluctuate usually between 90% in the best of circumstances down to 60 % in the worst. Hence, your at-risk pipeline can end up being 10% higher or 20% lower depending on what happens in the market between the time you originate the loans and when they are ready for sale. When rates increase between the time you granted a lock and the time it closes more loans are usually closed as borrowers know they can’t get a better rate than what was locked in therefore they jump over whatever obstacles exist to get the loan and more loans close as a result. Under this market scenario 80 % of your loans will be sold if only hedged with a TBA at the expected gain on sale while 10% will be sold at a lower gain on sale subject to the actual market movement during the period. If the market sold off 2 points and your targeted margin is 1 point, one would expect a margin reduction of 1 point on those loans (1 point gain on sale pricing minus 2 points price movement upon sale = -1) leaving you with an average gain on sale of .7778 points or a reduction of .222 bps for the pipeline as a whole. In the case where the market doesn’t move significantly during the processing timeline approximately the average closing rate should occur and your expected profit from loans sales equals your target margin of 1 point. In the event conditions worsen significantly and rates drop 4 points during the processing timeline and significant events occur causing borrowers to cancel at a higher rate and renegotiate at an even higher rate than normal leaving your company with a closing rate of just 60% your gain on sale will suffer by having excess pair-offs of TBA hedges versus inventory to sell. For example, if 60 % is sold at a 1-point profit as expected and 20% more TBA hedges remain in excess of loans, a pair off 4 points times 20% of the original expected pipeline or a 33-basis point loss would be experienced. If your company only experiences a reduction of 10% to a 70% closing ratio your expected gain on sales would be .428 points or a reduction of 57 percent. This is why your pipeline needs to be hedged partially with options as a component to your hedging strategy. An option will increase in coverage value when rates increase compensating you and allowing your increased closing rate to be fully covered and maintain margins in an increasing rate environment. In a decreasing rate scenario, your coverage of TBA’s is reduced and the coverage value of your options also decreases leaving you with no excess pair-offs and a margin that stays the same. In the event the market doesn’t move scenario your margins generally remain the same except for the cost to purchase options.
The amount of option requirements to optimally hedge a mortgage pipeline is dependent on the price elasticity of your fallout function (how sensitive your pipeline’s closing rate is to market movements both up and down) and can be measured and managed. Some pipelines require a great deal of options coverage especially if a policy is put in place where all loans get a renegotiation after a certain market improvement threshold is reached say 1.5 points better or more, a significant amount is originated through the wholesale channel, or most loans are taking more than 30 days to close. Pipelines with lower sensitivity to price movements in the market tend to be those with a no renegotiation policy, lower loan amounts, shorter lock periods, retail originated through experienced loan officers, purchases, and loans to first time home buyers…. Hence, most mortgage pipelines need a determinable amount of options to effectively hedge and maintain a targeted margin over time. Here at MCM we use our Closelytics deep learning AI system to evaluate our client’s fallout elasticity and levels with expert human monitoring to determine options requirements. The true hedge cost is ultimately driven by market volatility and the amount of options coverage needed by your pipeline at any given moment. If options cost 50 basis points per month to purchase on average and you need 10% of your hedge in options your expected hedge cost would be .05 points leaving you with a gain on sale margin of .95 points. If options costs are higher, your hedge cost is higher, if lower then lower. Also, the amount of options required is not a fixed amount given the market movements that occur daily and the sensitivity to these changes as loans move through the pipeline from say in process to docs. Pricing should include this estimated hedge cost. The cost of hedging will vary depending on market conditions and your pipeline sensitivity, but either you risk not buying any options and suffer under whatever the market brings, or you do the smart thing and incorporate them into your hedging strategy and avoid unfortunate events.
Although the discussion above assumed an instantaneous change to rates either way the analysis ends up the same in favor of options use with lower costs and higher gains on sale over time. If you assumed you could delta hedge away market movements efficiently, and this assumes you have good information on fallout and your fallout elasticity curve the results still favor options. Even with perfect information about fallout and ready and able traders replicating an option by delta hedging is difficult if not impossible especially for those not doing it full time. Doing so opens you up to a whipsaw position where you are buying after a rally and selling after a selloff – the opposite of what you gut will be telling you to do. If the market moves back and forth several times over any period, the whipsaw effect could make things even worse than ignoring fallout changes. Thus, if you’re in the mortgage business you should get comfortable using options as part of your hedging strategy as you are granting them every time you take a lock.
In the case where your company offers long term float down locks to borrowers looking to build or buy a house that will close 4- 9 months in the future or offers builders a forward builder commitment with rates that are capped and closed at the lower of current or the capped rates, this situation obviously requires options in the correct amount to hedge this exposure granted in the amount and strike measured by the pricing set.
For more information contact Dean Brown @ 858 483 4404 x101 or email: info@mortcap.com.
Mortgage Capital Management, Inc.
1660 Hotel Circle N. #700
San Diego, CA 92108
858-483 4404 x101