Approaches to hedging a mortgage pipeline are varied. Approaches range from very straightforward to arcane. Some practitioners are very specific in targeting hedges, others are more global. Some view hedging as the allocation of loans to a commitment to sale. Others view allocation as marketing view hedging as immunizing the pipeline from negative value shifts.

One theme that tends to be true among better performing secondary teams is that they defer committing to specific investor take-out until the optimal moment is perceived to have arrived. Another common thread is whenever prudent the secondary team will choose to manage risk, rather than paying the price to eliminate risk.

Want an example of paying the price to eliminate the risk? When a seller takes a best efforts commitment of an investor the seller is paying the price. How? The price received is lower than the mandatory price. Also, price received tends to be lower for more deferred deliveries. For example, all things equal the price you're for a 10 day commitment is typically better than for a 60 day commitment.

Those that manage risk feel that even after including the cost of the requisite talent and tools the price spread justify the risk. They are also buying into the philosophy that a best efforts marketing strategy makes one a follower and not a leader in their marketplace. This is especially true if the standard operating procedure considers only one best efforts takeout. Being a price taker and not a price maker creates other risks.

Any time the market shrinks or the takeout investor backs away the follower runs the risk of becoming nonviable.
When markets pull back, followers have less room than leaders to tighten their margins and strength their prices. When everyone is chasing fewer mortgage applicants it’s not hard to figure out who goes hung.

Why do secondary teams defer committing to a specific investor take-out until the optimal moment is perceived to
have arrived?

Being able to get a better price for a shorter delivery commitment is one reason. This is sometimes called the
“Convergence” factor. Loan fallout and the need to be flexible is another.

SFAS 133, as amended by SFAS 138, provides that one may indicate that the risk being hedged in a fair value
hedging relationship is the risk of changes in its fair value attributable to changes in the designated benchmark
interest rate (referred to as interest rate risk). This is an interesting position. This promotes the concept that
there is a difference between determining your best takeout (best delivery execution) and hedging (preservice)
loan’s value.

This concept would indicate that in hedging we are preserving a base line value (benchmarking a consistent achievable takeout). This activity is separate and apart from whatever market execution that can be exploite once the loans have been closed and are a known quantity.

This idea of hedging the baseline would indicate that the best policy for marking to market locked (unclosed loans) would be versus a consistent baseline and not using a potential best execution scenario. Why?

First, when or if the locked loan will close and be eligible for delivery is still unknown. Second, the ebb and flow of the best execution spread over the baseline will introduce noise, diluting the secondary managers ability to track interest rate exposure and management success.

Greg Crosby manages the secondary marketing software and services product line having joined ASC in June 1997. Greg has been involved in the mortgage industry since 1981. His fields of experience include secondary marketing, financial and performance auditing, construction and design of financial conduits, software development, commodity and securities portfolio management, and design of risk assessment systems. He developed the Risk Manager and Servicing Shepherd™ software products. Greg has served as a chief financial officer, with both commercial banks and investment securities brokerage firms, and has served as an advisor and board member to companies ranging from service providers to financial conduits. Greg is considered an industry expert in the fields of secondary marketing and risk management has authored numerous articles, papers and a book titled The Theory and Practical Application of Improving Secondary Marketing Performance with Software Tools.