Hedging is used to offset risk, but the process can be confusing as it requires complex calculations and difficult models. To kick things off, let’s address what a mortgage pipeline exactly means. A mortgage pipeline refers to loans that have been locked-in by a mortgage originator by borrowers or mortgage brokers. Other banks and lending institutions sell groups of mortgages to a purchasing agent such as Fannie Mae or Freddie Mac.
Those purchasing agents will package the loans like mortgages into mortgage-backed securities and they will be sold on the secondary market to investors. A loan will go to the lender’s books and then sold to a purchasing agent, and the time between the two is called the mortgage pipeline.
It is important to manage the pipeline as it keeps risk under control and ensures profitability. However, as complicated as the process may be, hedging mortgage pipeline risk can be very efficient if done right, and here is how you can do it:
Manage the Pipeline for Secondary Sale
Mortgages are complex and it can be a long process to close on a mortgage loan, and because of this, fall outs can occur when potential borrowers seek financing elsewhere. This can happen when interest rates drop or the loan does not close due to other various reasons. As the loan goes through the various stages of the steps to close on the loan, the chance of the mortgage closing and getting funded increases, because the potential borrower is less likely to seek financing somewhere else. Mortgage hedging software is a platform that helps with day-to-day loan pipeline management, trade positions management, and loan sale best execution.
Hedging Offsets Risk
Mortgages in the pipeline are hedged against movements in interest rates. Hedging involves things such as fallout risk and pull-through ratios. Fallout risk is the risk that loans in the pipeline will close and pull-through ratio is the probability that a loan will eventually need to be funded. When an interest rate is locked in for a potential borrower who wants to buy a home, a bank can be exposed to interest rate risk due to changes in prevailing rates during the period between when the rate is locked-in to loan approval.
Hedging is important to offset risk because not every loan in the pipeline will close. Meaning they might not become a mortgage loan for sale in the secondary market. Changes in interest rates and closing times can impact fallout rates, as rising rates tend to increase the borrower’s incentive to close and vice versa. Inverse financial instruments are used in hedging to manage interest rate risks. This will establish an offsetting financial event that is the direct inverse to the value change of the underlying hedged asset. In this case, a mortgage asset offsets the risk. If interest rates decrease for the mortgage asset, there will be a corresponding increase in the value of the mortgage asset. The inverse is also true.
Buying Long and Selling Short
By using a combination of buying long and selling short, hedge transactions can manage risk. To maintain the value of the mortgage asset, hedge transactions are designed to offset or cancel the how changes in the interest rate effect the value of the asset. Put in its simplest terms, if interest rates decrease, the short position goes down the same amount that the long position goes up and the value of the underlying asset is preserved.
The process of hedging to manage mortgage risk can be intimidating and complicated. The use of a variety of financial models to help manage the risks and outcomes involves many complex calculations, intricate concepts, and can be very daunting, even for the most experienced financial wizards. Because of its complexity, using hedging to manage mortgage pipeline risk should be left to experienced financial managers or individuals who have a history of hedging experience, preferably in mortgage-backed securities.
This article is for information and educational purposes only and does not form a recommendation to invest or otherwise. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.