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If there was no demand by consumers for a certain type of car, or for a sofa, or a toothpaste, there would be no economic reason for the manufacturer to produce that car, couch, or toothpaste. The same can be said for a mortgage lending company which is, in effect, a manufacturing plant for home loans. And whether the demand for the mortgages produced comes from a portfolio, or from outside investors, one of the roles of the capital markets department is to not only find a home for those loans but to protect the lender’s pipeline from swings in interest rates and its servicing portfolio from potential losses.
The head of capital markets is responsible for capital markets and secondary marketing functions, including pricing, trading, hedging, secondary market execution, interest rate risk management, investor relations, mandatory commitment desk operations, and production channel pricing analytics. In some companies this person is also responsible for credit policy, shipping, and product development functions, and for managing investor relationships with GSEs (primarily Freddie Mac and Fannie Mae), government agencies, and private investors.
The Director of Capital Markets manages the company’s interest rate risk on its pipeline of mortgage loans, hedging the pipeline and performing a best execution of loans for sale via Fannie Mae, Freddie Mac, Ginnie Mae, and other secondary market investors to ensure optimal pricing is achieved. Thus, the capital markets team manages the company’s interest rate position, including calculating the best execution of loans held for sale in the secondary market, and interfaces with a hedge vendor to ensure locks are appropriately hedged. Many lenders use a hedging firm to determine best price, investor, and delivery method for efficient and profitable loan delivery.
Often lenders, in an effort to improve secondary marketing efficiency and therefore profitability, requested a study focused on the advantages and disadvantages of moving from selling their residential loans under a “best efforts” process to selling them under a “mandatory” process.
Under a “best efforts” selling procedure, lenders make their best effort to process, fund, and deliver the loan to a specific investor. If the loan fails to fund, there is no immediate cost to the lender, as the market risk has been transferred to the buyer. Under a “mandatory” arrangement, a lender commits to deliver a funded loan to the buyer, and therefore assumes any market risk should delivery not take place. This market risk, however, can be hedged, and therefore minimized, with appropriate tools that are used across the mortgage banking and banking industry. Lenders hedging their locked loan pipelines use TBAs (“to be announced” securities, or generic mortgage-backed securities not containing specific loans). Those lenders are “long” on the locked loans in their pipelines, and therefore want to be “short” securities backed by mortgages.
The rationale for a lender to potentially change methodology includes a significant gain on sale improvement, introducing new operational controls and efficiencies, and the ability to gain better access to the capital markets. Selling loans on a mandatory basis, whereby the investor requires that a funded loan be delivered to them under the terms agreed upon, is not without risk. In order to do so, lenders should have a centralized lock desk, effective pipeline data monitoring, appropriate investor approvals, and accurate reporting for both loans and commitments. Success rests upon accurate and timely data, pull through that is able to be forecast within tolerances, standardized and fair lock policies, and a disciplined approach.
Shifting our focus to servicing after a loan funds, STRATMOR has seen that the pace of blocks of servicing being sold and bought, large and small, has increased, which is expected to continue through the rest of 2022 and beyond. Companies who retained servicing, which added servicing for several reasons but often because aggregators weren’t paying for it, now want to re-deploy cash to try to outlast their competitors with declining or leveling off margins and volumes. Protecting the value of the servicing is very important, as is the capital markets team calculating a price for any existing clients to refinance and therefore retain that loan in the servicing portfolio.
Like commodity prices, or a locked mortgage pipeline, for those that keep their servicing the value of MSRs (mortgage servicing rights) can be hedged. The primary source of servicing cash flow is from the strip of interest from the loan earned by the servicer and based on the accounting rules. It becomes an MSR asset when a mortgage loan is sold servicing retained to an investor such as Freddie Mac or Fannie Mae.
Lenders know that prepayment speeds are the key driver behind servicing values: The longer a performing MSR is held in the portfolio, the more revenue the lender will receive. And as interest rates have gone up through the first half of 2022, prepayment speeds have slowed, increasing both the duration and resulting value of the MSR. And if interest rates drop due to a recession, prepayment speeds will rise, which will decrease the life and the value of the MSR.
There are risks to holding and owning MSRs that are often hedged by the capital markets team. The general approach starts with looking at the key attributes of servicing: MSRs lose value as rates fall due to the increase in prepayments, creating “short” duration. The sensitivity is to changes in mortgage rates, which in turn are usually modeled as a spread over the U.S. risk-free 10-year Treasury note. This can be hedged using an instrument that is “long” duration, like 10-year Treasury futures or 10-year swaps. It is important to be aware of “second order” risks such as convexity risk and basis risk but attempts to hedge them can be costly and create complexity and profit and loss (P&L) volatility. Usually, a “long duration” position has positive carry due to an upward sloping yield curve, which can create a cushion to absorb second order risks.
Any servicer should do a thorough analysis of hedge policy considerations. These include risk appetite, approved hedge instruments, trading authorities, and limits on positions. Hedge instrument considerations include the instrument’s duration and delta (change) in different interest rate environments, convexity, volatility, time decay, liquidity, cost of carry, margin requirements by investment banks. All instruments have some type of basis risk which encompass Treasury rates, swap spreads, and MBS primary/secondary spreads.
Third party servicing hedging vendors often use swaps/futures, typically based on U.S. Treasuries, which can be matched duration-wise. But there are basis exposure and margin requirements. Options, primarily puts and calls, on U.S. Treasuries can be used, but there are issues with basis: Treasury rates don’t always move the same way as U.S. Treasuries or MBS.
Some servicers and lenders, rather than hiring a third-party vendor to hedge servicing, use “recapture” as a simple / production hedge. This involves a direct-to-consumer (DTC) department to call on the borrowers in their servicing portfolio before competitors can refinance them. Lenders, however, have had operational capability issues, compliance concerns, and accounting nuances that can create problems. But with mortgage rates having moved higher in the spring and summer of 2022, the overhead of a team dedicated strictly to refinancing is difficult for some companies to swallow, despite many of the teams moving toward purchase business.
Through workshops and peer group data gathering, STRATMOR has found that not everyone hedges MSRs for a variety of reasons. “Exchange-traded contracts or OTC derivatives are too expensive due to margin requirements.” While this does create cash demands, it is not a cost that goes through P&L. With careful management, net positive income over the long term can be achieved while offsetting most of the market risk in the short term. Some management teams believe that hedging servicing is too complicated and doesn’t work. But a disciplined, repetitive approach in evaluating the risk on the servicing portfolio can overcome this. The hedge objective must be defined, risk tolerances established, and operating procedures implemented.
At STRATMOR, we tell our clients that the MSR asset is volatile and can be just as volatile as the MBS market. Understanding the actual cash flow is critical, and capital markets departments know that an effective risk management process is critical to understanding and managing the risks of both an unhedged and a hedged portfolio. Effective risk management is an on-going process that requires continual monitoring, improvement, and regular reporting and communication. Whether or not the pipeline or servicing portfolio is hedged, going through the exercise of evaluating the risk and making a hedging decision is something every company should do.
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