Option Contracts are the least used, most abused arrow in a risk manager’s quiver. For many successful risk managers in the mortgage banking industry they wouldn’t hedge a portfolio without them. Others wouldn’t touch them.

Two hurdles that must be overcome to use options effectively are (1) understanding the dynamics of the risk you are
hedging and (2) evaluating the option position(s) in the proper context.

In the previous segment we considered why some loans are sold on a best efforts basis. We contrasted a best efforts commitment from mandatory sales and option trades. We identified situations where best efforts may not be the most cost effective approach to managing risk.

Best Efforts are often best used when the secondary market for the loan product is illiquid and pricing does not correlate with more liquid markets. Best efforts sales and option coverage often gain favor over mandatory forward sale commitments for mortgage products with volatile fallout profiles.

For markets that can be hedged with a liquid instrument but display volatile fallout characteristics making frequent
adjustments to a mandatory coverage position can drive the cost of hedging above the mandatory vs. best efforts price spread. It is in these instances that options can often play a key role.

The first step is to get an understanding of the risk that pipeline fallout poses. The second step is to be able to apply that understanding through an exposure modeling tool. The third step is to understand how a hedge portfolio comprised of a mix of mandatory forward sales and option trades would fare over a variety of market outcomes to that of a hedge portfolio comprised of best efforts forward sale commitments.

Is it worth it? I believe one must first look at the potential. Say, you normally sell your best efforts commitments 60 days forward. For a second assumption let’s say you make $20 million of best efforts commitments per month.

Third, let’s assume the price difference between a 7 day mandatory commitment and a 60 day best efforts commitment is 1 ¼ price points. The potential benefit before fallout shrinkage and hedging costs per month is $250,000. If that number was enough to get your attention, then the next step may be warranted.

The process of understanding fallout risk begins with constructing a tracking mechanism. This tracking mechanism will need to capture the attributes of the loan that influence its tendency to fallout of the locked mortgage pipeline.

This tends to be a process of elimination. So the discovery process is best served by trapping more rather than fewer attributes.

The second step is to identify fallout reasons. A fallout reason is a term we use with our product PowerSeller to identify an event that is worth noting for fallout. Among the list of fallout reasons: The loan closed, the loan was denied, the note rate for the loan was reduced without charging the borrower a buy down fee. These fallout reasons are then categorized based upon whether or not shifts in interest rates might entice the borrower to trigger the fallout reason.

The tracking process requires a daily regimen of capturing and scoring these fallout reasons, the loans key attributes and trapping market information. The first harvest comes when you perform studies focused on providing a closing ratio matrix. The matrix will indicate the percentage tendency of class of loans to close without modification for a specific time period and set of attributes. Example the attributes might be loans that were introduced through a wholesale channel and were for the purpose of receiving a cash-out refinance. The class of loans might me that they were conforming fixed rate thirty year mortgages. The period of time might be from July 1st through September 30 of the prior year.

By comparing the results of studies between time frames you will form a confidence level for the stability of the pipeline tendencies over several observations.

Next time we will examine how we apply these findings and how we perform comparative evaluation of possible hedge portfolio mixes.

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.