Hedging Strategies For Mortgage Pipeline: Managing Interest Rate Risk

A mortgage pipeline refers to mortgage loans that are locked in with a mortgage originator by borrowers but are not yet approved. This creates a backlog of mortgage applications, which can be caused by high demand, limited processing capacity, complex documentation, or inefficient processes. As a result, banks are exposed to interest rate risk. Therefore, it is crucial to hedge a mortgage pipeline to protect the value of the assets in the pipeline. This involves using the To Be Announced market, futures contracts, and over-the-counter mortgage options to manage interest rate changes and maintain profitability during variable market conditions.

Characteristics and Values of Mortgage Pipeline Hedging

The To Be Announced market, or forward mortgage-backed security pass-through market, is used for hedging

A mortgage pipeline refers to mortgage loans that are locked in with a mortgage originator by borrowers, mortgage brokers, or other lenders. A loan stays in an originator's pipeline from the time it is locked until it falls out, is sold into the secondary mortgage market, or is put into the originator's loan portfolio. Mortgages in the pipeline are hedged against interest rate movements. A mortgage pipeline is the backlog of mortgage applications that are still waiting to be approved but have interest rate locks. Since rates are locked, fluctuations in prevailing rates during the period between application and loan approval expose banks to interest rate risk.

The "To Be Announced" (TBA) market, or the forward mortgage-backed security pass-through market, is used for hedging. The TBA MBS market is extremely liquid, allowing positions to be added or removed quickly and cheaply. The average trading volume in 2016 was $206.6 billion, second only to US Treasury securities. The TBA MBS can be updated daily to account for the varying pipeline size. As fallout occurs, or as the loan pipeline size increases, the hedge positions will be updated. This flexibility can lead to enhanced profitability as the uncertainty of fallout risk and the origination timeline can be better handled.

The primary risk associated with using TBA MBS is related to the basis risk between the underlying mortgage pipeline and the hedge instruments. However, this basis risk is generally small, and pricing from the agencies and TBA pricing are highly correlated. The management of interest rate risk is typically accomplished by implementing various hedging strategies.

A hedge strategy is generated by applying a complex series of computations and mathematical algorithms. Implementing and managing a hedge strategy is critical to the financial performance of a mortgage bank and involves an extremely complex set of calculations.

Hedging a mortgage pipeline involves spread and fallout risk

Mortgage pipelines refer to mortgage loans that are locked in but are not yet approved or financed. They are hedged against interest rate movements to protect against market fluctuations that may dramatically change interest rates. This is because a mortgage pipeline is the backlog of mortgage applications that are still waiting to be approved, but that have interest rate locks. Fluctuations in prevailing rates during the period between application and loan approval expose banks to interest rate risk.

Supervision of a mortgage pipeline could include third-party experts who serve as the secondary marketing manager, particularly focused on the risk management aspect of the business. This can include regular analysis of the loan assets in the pipeline as well as hedge instruments to measure value changes. The manager assesses which loans represent the most exposure to interest rate changes, then chooses loans that have a matching correlation to those market changes. By selling certain mortgages when interest rates increase, those transactions become more valuable and offset declines in value that may occur with the loans that are retained in the pipeline.

Mortgage lenders and financial institutions rely on a steady flow of approved mortgage applications to generate revenue. A backlog can disrupt their operations, leading to a loss of potential business and revenue. It can also cause delays and uncertainty in the approval process for homebuyers, slow down property transactions, and reduce market activity. Mortgage backlogs can also be caused by prevailing economic or political conditions, such as government shutdowns.

Third-party experts can help supervise and manage the risk of a mortgage pipeline

A mortgage pipeline refers to mortgage loans that are locked in with a mortgage originator by borrowers, mortgage brokers, or other lenders. A loan stays in an originator's pipeline from the time it is locked until it is sold into the secondary mortgage market or put into the originator's loan portfolio. The secondary marketing department of a mortgage originator manages where their house loans and service rights are bought and sold between investors and lenders, thus managing the originator's mortgage pipeline.

Supervision of a mortgage pipeline could include third-party experts who serve as secondary marketing managers, focusing on the risk management aspect of the business. This includes regular analysis of the loan assets in the pipeline and hedge instruments to measure value changes. These managers must establish the real market value of the loans in the pipeline to form a strategy for hedge transactions. They aim to protect the value of the assets in the pipeline by selling loans through forward sales. The manager assesses which loans represent the most exposure to interest rate changes and then chooses loans with a matching correlation to those market changes. By selling certain mortgages when interest rates increase, the transactions become more valuable, offsetting any declines in value from retained loans.

Furthermore, third-party experts can help manage the mortgage pipeline by identifying potential bottlenecks or delays in the approval process. They can provide recommendations to streamline the process and reduce the impact of mortgage backlogs, which can cause uncertainty and dissatisfaction for homebuyers. Efficient management of the mortgage pipeline is crucial to reducing the risk of fallout or price changes. By staying on top of the pipeline, third-party experts can help lenders honour their loan obligations and avoid a buildup of pending applications.

A mortgage backlog refers to a delay in processing and approving mortgage applications

The presence of a mortgage backlog can have significant implications for both homebuyers and lenders. Homebuyers may experience delays and uncertainty in the approval process, which can be frustrating and impact their plans for purchasing a property. Moreover, a mortgage backlog can also negatively affect lenders. Revenue loss, operational strain, and potential compliance risks are some challenges that lenders may face due to mortgage backlogs.

To address mortgage backlogs, lenders may need to increase their processing capacity, streamline documentation requirements, and improve the efficiency of their processes. They may also need to consider the impact of prevailing economic or political conditions on the approval process. For example, government shutdowns have previously slowed down mortgage approvals, particularly for loans pertaining to Freddie Mac or Fannie Mae.

Hedging a mortgage pipeline is a strategy used by lenders to manage interest rate risk. When a mortgage application has a locked-in interest rate but has not yet been approved, fluctuations in prevailing interest rates expose lenders to risk. By hedging the pipeline, lenders can protect the value of their assets. This involves using tools such as the "To Be Announced" market, futures contracts, and over-the-counter mortgage options to manage spread and fallout risk.

MCT's Hedge Advisory blends technology and service to optimise mortgage pipeline hedging

A mortgage pipeline refers to mortgage loans that are locked in with a mortgage originator by borrowers, mortgage brokers, or other lenders. A loan stays in an originator's pipeline from the time it is locked until it is sold into the secondary mortgage market or put into the originator's loan portfolio. The mortgage originator's pipeline is managed by its secondary marketing department.

MCT's employees have true industry experience and trusted relationships to further develop clients' professional networks. MCT provides complete transparency, from understanding hedge recommendations to loan sale best execution. MCT's software and services empower secondary marketing performance, helping clients build, optimise, and price their MSR portfolios.

MCT's trader interfaces directly with clients' secondary marketing professionals to review and adjust active hedge positions based on changes to their mortgage pipeline. MCT's industry-leading best execution analysis helps select the optimal delivery method and destination according to clients' goals. Live and daily reporting supports transparency, optimisation, and involvement for every stakeholder in the pipeline management. MCT emphasises education and training for all clients.

Frequently asked questions