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Hedging A Pipeline Of Locked Loans Isn’t Free

Volatility in the ‘To Be Announced’ markets will kill a lender’s gain

Rob Chrisman
Rob Chrisman
Locked Loans

Residential lending is one of the few industries where someone can lock in a rate and price at a future date, often 30 or 45 days. To keep that concept in perspective, if you went to the local gas station, or grocery store, and told them you wanted to buy a gallon of gas or milk 45 days from now, the clerk would absolutely refuse. But the futures market has been created to do just that: lock in prices now for things like bacon, orange juice, wheat, gold, and corn in the future, hedging any impact of prices on their profits. There is a cost, usually the bid/ask price spread, the drop in price from one month to the next, and commissions paid in trading the contracts.

Senior management or owners of lenders often want to know the “cost to hedge” a loan or a locked pipeline of loans. It is not an easy question to answer. Hedging is a loan level activity where each loan’s program, interest rate, lock period, etc., is analyzed. Company policies like extensions and renegotiations enter into it. Specifically, extensions and renegotiations increase it, and while the production team is helped, the capital markets department usually incurs the expense. And the price drop in the securities market often changes during the lock period. And then there’s always the “what is the cost of a loan that falls out” question, since the expenses incurred in a loan that doesn’t fund must be absorbed elsewhere.

Manufacturing loans faster, and bringing loans to market quicker, reduces a lender’s interest rate exposure to some degree. Thus, the reason bond loans can be an issue for some lenders. Unfortunately, many hedge vendors look at the problem 2-dimensionally, when it’s a 3-D issue. The problem isn’t necessarily all “speed-to-originate,” but rather “hedge-model efficiency.” What assumptions are being made about the duration/beta of the hedge instrument, and pull through, broken down by product groups and cross referencing at what stage in the loan life cycle loans have fallen out in the past.


Killing Gains

Volatility in the To Be Announced (TBA) markets will kill a lender’s gain on sale. Lenders can be profitable in a rising rate environment, and profitable in a falling rate environment, but sudden swings in the bond market, and therefore interest rates, will kill you every time and all models break down.

The TBA market is where most capital markets groups hedge their locks. Without diving too deeply into the hedging process, a lender is, in effect, buying a lock from a borrower. To offset the risk of interest rates going up and the corresponding price decline in the value of that loan, or to offset the risk of interest rates going down and the corresponding chances of the lock falling out, lenders sell mortgage-backed securities.

And it is good to remember that hedging itself is used to protect the margins originally priced into the loan. The key to margins over the past few years has been capacity. There are five points of pricing: demand (capital markets have a buyer), competitive position, margin (needed or budgeted/required return on assets), market share (are you gaining or losing?), and capacity. When pricing, you balance all of the above but the “thumb has been on the capacity side of the scale” for several years for most of those in the industry.

This article was originally published in the Mortgage Banker Magazine August 2023 issue.
Rob Chrisman
Rob Chrisman

Rob Chrisman began his career in mortgage banking – primarily capital markets – 35 years ago. He is on the board of directors of Inheritance Funding Corporation, of Doorway Home Loans, of AXIS Appraisal Management, and of the California MBA. He is also a member of the Secure Settlements Advisory Board, an associate of the STRATMOR Group, and of the Mortgage Bankers Association of the Carolinas and its membership committee.

Published on
Aug 10, 2023
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