The mortgage banker that is able to implement marketing strategies that incorporate a deep understanding of the cost to hedge the production pipeline will be greatly rewarded. Performance gains will result from market efficiencies and economies realized from a strategy in which performance goals, risk policies and the realities of the markets are aligned.

In mining for the cost of hedging one begins to see that in many cases the cost of hedging is not a constant value. The cost of hedging (COH) will provide more than a number to be placed in a budgeting worksheet it will tell a story. The story will speak to the culture of the organization and management's hedging style. The student of the COH learns about the amount of real control the organization has over it's marketing outcomes. The research effort will reflect whether or not the organization's risk management goals are consistent with their risk management actions.

One surprise that may be in store is that the cost of hedging can vary greatly from period to period. Another surprise might be that the hedging style being employed and thought to be market neutral actually has a market bias.

One may find that the cost to hedge loans acquired through certain channels and even loan officers are more costly to hedge or have more cost volatility than others.

The cost of hedging will be beneficial in determining which products should be sold best efforts (at least for now).
Understanding why you are successful and when you will be less so are invaluable pieces of intelligence.

Calculation Pointers

Let's consider some of pitfalls and useful methods in isolating, uncovering and applying the cost/contribution from hedging.

As is always the case in performing an analysis, the better the quality of the data driving the readings the
more useful the analysis. First we want to use the market levels and not the loan's lock price as a starting point.

The lock in pricing vs. the initial market levels is important but should be used to assess the economics of the lock desk operations and not the efficiencies of the hedging function.

By the same token, it is beneficial to track the lock commitment or loan versus a consistent take-out target. Thus, removing the impact of best delivery selection (“Best Execution”) activities from the cost of hedging question.

To give it a baseball analogy, we are able to now see why we win and why we lose. Is strong hitting covering up the fact that the team suffers on the mound. Is best execution and a low volatility market covering up a larger hedging vulnerability? Was market direction and not risk management the angel that has kept us safe?

It does not take many days on the job to realize that the pipeline and the trading position are both fluid ever hanging portfolios. Trades should be tagged so that the allocation of their day to day value changes is consistent and not ambiguous.

The pipeline population itself must be complete. Trade value changes are allocated over the population of closed (successful lock commitments) loans. This requires that no outstanding rate locks exist for the product/rate/channel group being considered. Therefore, the study itself will always need to be looking back in time to an ending point no more proximate than would allow all the pipeline to have reached a terminal point (either closed or fallout).

By taking several readings over time and market cycles a better understanding of both cost of hedging tendencies and their variances will be seen. Avoid the “Average” trap.

The catalog of hedging outcomes becomes more beneficial when annotated with commentary on the types of edges used during the period, the hedging approach used, the types of reports used to drive marketing decisions and key modeling assumptions such as assumed fallout curves versus actual fallout experience.

Producing cost of hedging readings and then studying those readings represents a significant investment of time and discipline that may not currently be part of the on-going regimen. It may not provide the immediate impact of offering out the latest mortgage product or bringing in a new loan producer. But in the long run it will provide the means to win the pennant.

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.