Rise of the Rentals

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Th e M Rep o RT | 23 Feature D oes mortgage pipeline hedging require wizardry and rocket science? Some executives at mortgage companies, community banks, and credit unions who don't have much experience in secondary marketing hold this misconception. Frequently these executives believe they are better off sell- ing loans with a best efforts lock, rather than hedging their mortgage pipeline and benefitting from the higher prices available through mandatory execution. However, the executives overcome their fears once they understand that they can exchange their current hedge cost—the pricing differential between the current best efforts price and the mandatory price for the same asset—for a much lower hedge cost that yields higher re- turns. All they need to do is make a few changes, develop a struc- tured discipline, and implement a risk neutral-based hedging strategy. Sounds simple enough, doesn't it? But how is it actually done? Is it wizardry and rocket science? Not at all. It just comes down to taking a disciplined approach to managing the inherent risks of pipeline management. Policies, Procedures, and Reporting T he most essential step is having pre-established policies and procedures and clear and concise reporting. Pipeline managers need to have data they can trust, because if you can't measure it, you can't manage it. The best reports provide a full array of detailed information about the at-risk pipeline, including critical data fields that impact pricing as well as a current mark-to-market valuation. The secondary mar- keting manager must know his or her pipeline, and the reports they use should detail the product mix, the purchase to refinance ratio, and a distribu- tion by origination channel (e.g., retail, wholesale, correspondent, consumer direct, etc.) The Fallout Factor T he next factor to consider is fallout. Accurately tracking and measuring the company's historic pull-through perfor- mance inevitably will translate into better hedge performance. Knowing the historic sensitiv- ity of the pipeline to changes in interest rates will improve the performance of the hedge position. Having the right analytics to accurately incorpo- rate all of these factors into a detailed hedge recommendation supported by a thorough rate shock analysis translates into a disciplined approach to hedging, allowing the secondary market- ing manager to be strategic and proactive in his or her decision- making process. By having the right data and reports and making informed decisions in a timely manner, he or she can execute well-thought-out strategies designed to maximize profitability and minimize risk. After deciding to hedge, com- piling accurate data, and getting reports in order, it's time for the pipeline manager to execute the hedge. Working with a seasoned and experienced hedge advisor to implement the hedge recom- mendations directly off of the reports is recommended. Keeping Your Options Open E xperience has shown that in volatile markets, those lenders that incorporate option tools are better positioned to maximize their gain on sale results. The key to an effective options strategy is to accurately measure and track volatility. By determining the optimal amount of optional and mandatory coverage required by the pipeline, the secondary market manager can successfully hedge his or her pipeline from fallout volatility and market movement. One key ingredient of a suc- cessful options strategy is to implement the options cover- age when implied volatility is relatively low. Then, in an effort to further minimize the cost, apply coverage that matches the optional exposure found in the pipeline—60 to 90 days—and purchase out of the money (OTM) or at the money contracts that provide the correct delta and gamma adjusted coverage for the least amount of expense up front. The result is that as market prices decrease, the amount of pipeline coverage provided by the put option contracts increas- es to help offset the expected decrease in loan fallout due to rising rates. Conversely, as mar- ket prices increase, the amount of pipeline coverage from the put option contracts decreases with the expected increase in fallout due to declining interest rates. In essence, over the term of the option contract, and for a single, upfront premium, the amount of coverage provided by the option contract expands and contracts with fluctuations in prices and changes in the pipeline, all the while maintaining stable profit margins. The use of option contracts in conjunction with an efficient The Rocket Science of Hedging hedging investments isn't some magic trick from above; it's a measure of discipline and communication. By Dean Brown

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