Top 10 Mortgage Pipeline Hedging Mistakes Part III

by MCM Analyst 12/20/2013

In the final of three posts, MCM will discuss why it’s critical to independently verify and confirm trades in secondary marketing, why you should avoid cross-hedging risk positions when there’s no need to do so, and finally, how duplicating loans in your tracking system affect your fallout calculations.

Since 1994, MCM has helped mortgage bankers maximize profitability, decrease earnings volatility and powerfully manage their risks. MCM provides state of the art Pipeline Risk Management services at all levels of mortgage banking, from clients looking to take their first steps towards hedging a pipeline, to those with considerable experience with pipeline management selling on a securitized basis, servicing retained.

BLOG #3

In the final installment of this three-part blog series, Mortgage Capital Management (MCM) helps readers understand the top 10 most common mortgage pipeline hedging mistakes that can eat away at profits. Hedging a mortgage pipeline is not as easy as putting on a trade to cover locks. This post covers why it’s critical to independently verify and confirm trades in secondary marketing, why you should avoid cross-hedging risk positions when there’s no need to do so, and finally, how duplicate loans in your tracking system affect your fallout calculations.

You can catch up on the second post that covers why mortgage banks should never close and sell loans that don’t meet investor requirements or expectations, why not to skip options when a pipeline source or renegotiation policy dictates they’re necessary, the importance of keeping your pipeline data clean, and why you’re better off not pricing loans to the best execution price here. [hyperlink]

Read the first post that addresses the importance of a having a concrete policy for managing risk pipeline positions, and why not to hedge long-term and short-term locks the same, or float-down locks and builder commitments the same as long-term locks here. [hyperlink]

8.      Mistake: Not independently verifying and confirming trades in secondary marketing

Not independently verifying and confirming trades can be one of the most costly issues that can occur at any point in time. There are a couple of issues that can arise when trading. –First, if the trades are not confirmed by an individual independent from the trade, then prices, security types, coupons and settlement months can be entered wrong. This can lead to surprises nobody wants to have. Secondly, pairing out an incorrect trade and not being balanced can lead to costly mistakes if there is a large negative market movement over a short period of time. Not to mention, having to pay bid/ask spreads twice on a trade error is bad enough.

MCM recommends the person who confirms trades with dealers and the trader not be the trader! Have an independent individual in the company be responsible for ensuring that all confirmation information is correct from the dealer and the trader, and is consistent with what was entered in the trade blotter and the software that tracks trades. Confirm everything. This simple practice can help alleviate costly mistakes that can take a large chunk out of profitability.

9.      Mistake: Cross-hedging risk positions without the need to do so, e.g., sell FNMA 15 yr. 3.5’s to hedge GNMA 30 yr. 3.0’s

Cross-hedging may be occasionally necessary, but not as a longer-term practice in hedging a pipeline. This is an area where basis risk or convexity can work against the trade and ultimately reduce profitability. Even though the position may be flat overall, and you think the position is well covered, markets and appetites for various products may move securities prices differently. Consider the following: You have a flat overall position, but the position in FNMA15 3.5 coupons are short (excess coverage) and the position in GNMA30 3.0s are long (too little coverage) and prices of a current coupon FNMA30 3.5 moves 1 point in a negative direction. The GNMA 30 year loans that you are long in can move at a much more rapid pace negatively than the pace at which the FNMA15 3.5 coupon trade may gain in value. In addition, the loans associated with the GNMA low coupon will certainly want to close and borrowers and loan officers will work extra hard to get the documentation necessary to close thereby reducing fallout at a faster pace.

It is also not uncommon to see one instrument, for example the FNMA15 3.5, come into favor more with investors for non-market driven reasons. For example, you may have security price and loans in that security range on the GNMA 30 3.0 unchanged, but the price of a FNMA15 3.5 coupon actually improves. When the FNMA15 3.5 coupon trade is paired off, the price movement results in a higher pair-off fee and the loans matched to the GNMA30 3.0 coupon are unchanged. The final result is less profit and the inability to make the margins that were expected.

While it is necessary to cross-hedge occasionally, MCM recommends using a current coupon FNMA30 trade, while looking to get your position back in balance as soon as possible to avoid the potential of convexity or basis risk that can eat away at expected margins.

10.     Mistake: Creating duplicate loans in your loan tracking system without regard to the impact to your fallout calculations

Many companies allow branches or brokers to lock in loans without actually having the loan application in hand. The loan gets locked in with basic information and the loan file follows later to be completely entered in the Loan Origination System (LOS). We have discovered many instances where the loan was entered into the LOS again once the file was received. This results in a loan being locked twice and consequently hedged twice. If this goes unchecked, the duplications result in increased hedge costs because trades either have to be paired off or positions are mistakenly shorter for an extended period of time. If the market is improving, additional higher pair-offs will result.

MCM recommends companies have a program in place to check for duplications. This can be done through a program on the origination system that identifies duplications or by a person who confirms that the new loan file was not previously locked. The end result will be a cleaner, more accurate pipeline and attainment of expected margins.

Since 1994, MCM has helped mortgage bankers maximize profitability, decrease earnings volatility and powerfully manage their risks. MCM provides state of the art Pipeline Risk Management services at all levels of mortgage banking, rom clients looking to take their first steps towards hedging a pipeline, to those with considerable experience with pipeline management selling on a securitized basis, servicing retained.

Copyright 2013 Mortgage Capital Management, Inc.