Top 10 Mortgage Pipeline Hedging Mistakes

Top 10 Mortgage Pipeline Hedging Mistakes

In this three-part blog series, Mortgage Capital Management (MCM) helps you better understand the top 10 most common mortgage pipeline hedging mistakes that can eat away at your profits. People typically think that hedging a mortgage pipeline is as easy as putting on a trade to cover locks. While that may be true to a certain degree, it’s not that simple. In this first post, MCM addresses the importance of having a concrete policy for managing risk pipeline positions, and why not to hedge long-term and short-term locks the same, or float-down locks and builder commitments the same as long-term locks.

1. Mistake: Not having a concrete policy for managing risk pipeline positions; allowing the manager to “bet” the market

As a simplified example, take a company with a pipeline of $100 million and a profit margin of one point (100 basis points). With no policy in place to set limits as to how long or short senior management will allow a position to be, the manager may believe the market is going to rally so he/she elects not to put on trades (hedges) to cover the $20 million in locks. In this case, 80 percent of the pipeline is hedged and 20 percent is exposed to market movement. If the market were to move against his/her belief by 50 basis points, the company’s profit would be reduced by 50 basis points on $20 million, which is equivalent to $100,000, reducing the profit to $900,000 or 90 basis points. Even if the manager then covers the position because the market did not move the way he/she expected, the $100,000 reduction in profit is still realized.

Financial markets tend to be volatile, and a 50 basis point movement in the market like the example above may be just a one-day occurrence. If the manager were to continue exposing the pipeline for an extended period of time, the reduction in expected profits would diminish even further and potentially all profit would be lost.

MCM recommends senior management take a close look at the maximum time they will allow a position to be long or short and to put policy limit triggers in place to flatten or reduce the length of exposure. Ultimately, a trigger protects the expected profit margins..

A short-term lock is defined as those loans that close in 75 days or less from the original lock date, which is atypical escrow term for standard purchase transactions. A refinance transaction is generally less than 75 days. Long-term locks are defined as any original lock term that exceeds 75 days.

There are two dynamics at play here. –First, locks that have extended terms have a higher probability of fallout as longer lock periods present more opportunity for interest rates to fluctuate. The longer the lock term the more closing uncertainty. Second, long-term locks generally are utilized in a different set of circumstances. They tend to be reserved for individuals who may be shopping for a home but haven’t found one yet. These shoppers are looking for a guaranteed rate to lock in today’s prices. Or, they may have committed to buying a home that is under construction and won’t be ready for up to 6 months. If the company hedges with TBAs on these longer-term locks and the market improves, the chance of the loan falling out is greatly increased. If the loan does fallout in a rising price environment, the pair-offs associated with the trade will be high since there is no loan to sell to offset the hedging losses.

MCM recommends mortgage banks use of out-of-the-money put options to hedge long-term lock loans until they are ready to go to closing. The cost associated with the options would be far less than the potential pair-off costs of a TBA trade in an improving market, and typically the borrower would pay for the cost of the option up front.

3. Mistake: Hedging float-down locks and builder commitments the same, or the same as long-term locks

A float-down lock is associated with an individual loan that has a set lock date, term and loan amount. A builder commitment is an option by the builder to guarantee a group of borrowers a set rate. Often this is the case when a builder does not want to lose the opportunity to sell a home that is under construction. The builder commitment is designed to guarantee a specific rate to borrowers and the builder pays the upfront fee for option coverage. The float-down option hedge is structured quite differently for specific borrowers who may be at a price today that can be floated down when they are ready to close. Although long-term locks utilize option coverage like the float-down and builder commitment, the structure is specific to that locked loan and it does not carry the float down feature. Therefore the option structure is different.

MCM recommends companies hold each of these types of longer-term structured products in separate buckets and hedge them independently from each other. This strategy ensures that various loans programs are differentiated and hedged appropriately to minimize hedge expense and ultimately maximize profit margins.

In the next post, MCM will cover why it’s never a good idea to close and sell loans that don’t meet investor requirements or expectations, why not to skip options when a pipeline source or renegotiation policy dictates they’re necessary, the importance of keeping your pipeline data clean, and why you’re better off not pricing loans to the best execution price.

Since 1994, MCM has helped mortgage bankers maximize profitability, decrease earnings volatility and powerfully manage their risks. MCM provides state of the art Pipeline Risk Management services at all levels of mortgage banking, from clients looking to take their first steps towards hedging a pipeline, to those with considerable experience with pipeline management selling on a securitized basis, servicing retained.

Copyright 2013 Mortgage Capital Management, Inc.