There are a number of conflicting theories on what makes a company successful when they enter into, or have been, operating in a hedging environment. Some people like to express a very deep understanding of the secondary market and how it correlated to their pipeline and performance, while others feel it is truly dependent on the model that is being used to manage risk and execute a price. While these two ideas are very important, truly successful hedging is a result of balancing the two. This success is dependent on some mortgage and market fundamentals as well.
Breaking it down into its simplest form, the mortgage industry is based on a series of assumptions and historical behaviors that are tied to market movements. The best-efforts market is based on a fall-out model that assumes a certain amount of activity based on rate movements: Up, down or flat during the lock period. The lack of a true financial commitment to deliver makes this market the most expensive and assumptive. The mandatory market is based on its name. It consists of a contractual and financial reward and your commitment to deliver loans at the contracted levels regardless of rate movement. It also comes with a penalty if you fall short and do not meet your contracted delivery levels. The ability to fulfill delivery amounts in a timely fashion pays a premium as your counterparties are covered via actual loan sales or in cash (i.e. pair-off). This practice is usually handled by firms committing to a lower amount than their actual pipeline, so there is a built-in variance for fallout and market movement. This is not actually a true hedging process, but rather, just making a smaller bet of pipeline reaction. The ability to properly understand your pipeline and how it reacts to rate movement is truly what makes a successful model.
To truly understand that statement, you need to break it down into a few sections.
Understand your pipeline
Your pipeline is just that, pieces of aggregated data that only you can understand. It is a fluid collection of loans with varying data points that are ever-changing. Origination platform, loan officer, office, region, office, relationship, marketing sources, management oversight and their concentration within your pipeline all have an effect on your pipeline. Many look at the pipeline in aggregate and expect it to react as others do. I could not disagree more. Why is one company so successful at running a wholesale platform and another at a direct response platform? Why can one company be concentrated in purchase transactions while another is solely focused on refinances? Each of these pipelines will react differently to market movement. Even within similar models, the ability to accurately report data in real-time, along with the allocation of stages, risk factors, etc. can make or break performance levels. Also, it’s not only business models and data review and integrity that influence the results of a hedging platform. Lock desk policies, management, level of flexibility, and tolerance to change margins based on market activity are critical pieces of the equation, as are other intangible items (confidence in sales updates, operation capacity and efficiency, warehouse liquidity, investor turn times, etc.). A pipeline is a living thing that continues to evolve as the market changes. It’s not just the risk model or keeping an eye on the mortgage-backed securities (MBS) market that influences performance, but the overall management of the pipeline, data and internal decision-making as well.
Another key component in understanding your pipeline is understanding the stages it undergoes. Most hedging models make assumptions that are based on stages or milestones. The theory states that the earlier the stage, the less likely that loan is going to actually close. The later in the process, the more likely that loan is going to close. Even this thought process can vary. Some firms can lock at application, some at loan approval, some at clear to close, and others at anytime in between. In the age of quality control (QC) and loan origination software (LOS) updates, new stages can be created or have their definitions changed. How can you possibly use a standard model to assume these actions when you have so much variance? The stages of the pipeline must be understood, monitored and clearly defined in relation to your lock process and policies.
When discussing pipelines, there are a number of terms often referenced time and time again: conversion, pull-through, and fall-out. Their true relevance is to determine how active your company is in understanding and flushing out the open pipeline. If a company sits back and waits for the pipeline to respond, it is taking a chance and the cost of hedging can be costly and inefficient. Being a banker provides you with some very valuable tools that can help in affecting your pipeline. Moving a closing date up or back, extending a lock commitment, or a float-down program can all provide sales with valuable tools that impact closings but are not picked up in any pipeline report. Pull-through is not a simple calculation of locked volume divided by closed volume; these other factors must be accounted for.
Additionally, a great sales process which pro-actively secures loans for timely delivery can be completely undone by an inefficient shipping and post-closing process that continuously misses deadlines. These factors can erode profitability, even for those with the best market insight, risk models and lock policies.
Now that we’ve addressed the pipeline and how essential its management is to true execution, let’s take a look at the hedging process and how it works in relation to your pipeline.
In basic terms, hedging is the process by which lenders protect themselves against interest rate/pricing risk, and it allows them to deliver loans on a mandatory, direct trade, or Assignment of Trade (AOT) basis. In a hedging environment, the lock desk processes a lock and commits a price to sales (the buy side price). Lenders are essentially "long the market," seeing appreciation as the market rallies. But what happens when rates rise and the market value of the lock decreases? This is the market risk lenders look to offset through the hedge, or more specifically by selling To be Allocated (TBA) mortgage-backed securities (MBS). By selling, a lender is "short the market" and will see a gain when rates rise and the market value of the lock falls. Lenders should short a percentage of locked volume based on historical pull-through. The final result here is a locked pipeline of loans which are "long" in the market along with a trade account of "short" positions to cover the interest rate risk. It often sounds confusing to many mortgage bankers, but it's really a pretty simple equation.
Most companies feel that if they hit their expected pull-through, they are covered. Others look at the bottom line, and if it's in a black font rather than red, they're doing well. These approaches drive me a bit crazy. Are lenders and secondary managers in this business to just make some money and retain the status quo in a challenging market, or are they looking to maximize revenue and net profit? When rates undergo a rapid shift (up or down) lenders need to take a closer look at the pipeline and manage it proactively. This probably sounds like a new idea to many secondary marketing departments, but they can actually manage the pipeline and increase revenue. Being passive is a big mistake.
Every pipeline is unique, and its characteristics change daily. Understanding how the pipeline's makeup reacts to market volatility and taking initiative to improve data are keys to managing a hedge position that's custom-tailored for the firm.
Lastly, the pipeline is constantly changing with varying levels of daily activity. Each day it has new locks coming in, existing locks coming off (either expiring or closing), loans moving up or out of stages, and loans being purchased. Within each of those actions, reporting must be fluid and effortless, while the fall out of those actions need to be analyzed and reacted to. Running a report and sending it over to be dropped into a model is too often a process that does little to benefit a company. This process will keep you safe, but does not tell the full story or provide a pro-active manner in managing the pipeline. Is anyone actually looking at the data in the reports for outliers and red flags in order to take corrective action? Is some of the data stale or dated?
In summary, the unfortunate irony found too frequently in this industry is that hedging is supposed to minimize risk, but it can actually do just the opposite if the pipeline, data, and policies are not managed correctly. Lenders should not just rely on the hedge reports, particularly when the market is volatile. Managing your pipeline and ensuring the data is accurate and timely is key, along with accounting for the ever-changing allocation.
Frank Fiore is president of Matchbox, a full-service advisory and implementation partner to the mortgage banking industry. He may be reached by phone at (516) 236-6711, e-mail [email protected]
or visit www.matchboxllc.com.