“Two Wrongs Can Make a Right”
When managing Gain on Sale through hedging a mortgage pipeline, it is possible in more than one way that two wrongs (i.e., two different errors in critical estimates) can make a right. This blog will explain this phenomenon and help you avoid having to rely on two wrongs making a right by suggesting a course of action where two rights always make a right.
If one were to boil down the hedging activity in secondary markets to three key variables they would be:
- #1 Market Movement
- #2 Fallout Estimates
- #3 Hedge Ratios
In the observation of these three key variables, an interesting paradox becomes evident. Given that secondary market managers (as much as they might not want to admit) have no control over the market nor any ability to predict it consistently. This leaves market direction up for random forecasting. The other two variables that are within the control of the secondary marketing manager are individual loan fallout estimates and TBA MBS hedge ratios. These variables should be evaluated on a quarterly monthly basis if not done every month.
When looking at these three key secondary market variables there are 21 different outcomes or combinations of movements. For instance, the market can rally, stay the same, or sell off. Fallout estimates can be high, on target, or low; and hedge ratios can be too high, too low, or on target. One of the 21 outcomes within these constraints is where the Market rallies, Hedge ratios were too high, and Fallout estimates were too low. In this case two wrongs make a right! As the market rallies the overstated hedge ratios create a loss by creating an artificial short position in a rallying market; on the flip side the understated fallout estimate creates an artificial long position in a rallying market. If done in equal proportion as our analysis assumes, this scenario represents one of the four instances where the firm made the expected gain on sale not by doing things correctly, but by luck. Another example would be where the market was down, and fallout estimates were too high and hedge ratio estimates were also too high leaving the same condition even though wrong twice the company made the expected amount of gain on sale.
Other potential outcomes of course include being on the wrong side of right, being lucky twice, and dead wrong twice. Without going through each potential outcome and scenario, let’s get straight to the point – this works out to be a 50 -50 game over time where gains on sale can be too low or too high 50% of the time when fallout errors and hedge ratio errors are allowed to happen since each is a two-sided sword. Many hedge advisors use static fallout estimates causing large errors and very inaccurate hedge ratios. Not to mention the lack of using options when a pipeline clearly calls for their deployment.
Here at MCM we use a Neural Network AI strategy that accurately forecasts your expected closing rate given any market condition. In addition we employ a strategy of using the TBA coupon that matches the exposure from the loans in pipeline for most of the pipelines exposure and for the rest our OAS based hedge ratios adjusted for OAS servicing value changes come in as extremely accurate for the cases where illiquidity forces one to use the coupon lower or higher than the exposure (like in the case of hedging 6.5% exposure with 6% coupons or hedging 4.0% exposure with 4.5% coverage). In no case would we ever recommend cross hedging FHA/VA loans with UMBS coverage or vice versa as the basis risk is not worth the effort. In addition to not having Fallout or Hedge ratio errors, the MCM Hedge Commander system employs an advanced optimization hedge analytics model that calculates and recommends the correct number of options contracts to employ in order to avoid the whiplash effect of hedging fallout with a moving market.
As you may have experienced when rates go up, your actual fallout goes down and vice versa. The only way to avoid this condition where you pair off at a loss either way is to use the correct amount of options coverage in a basis neutral way. Hence, it is better to be good than lucky
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