model in this scenario? I would say no. To hedge appropriately, you also have to evaluate the liquidity of
the instrument you are using to hedge your pipeline.
This is because your model does not consider the
liquidity when slotting the loan into the hedge instrument. Instead, it is based on quoted TBA securities,
and these quotes might not be indicative of actual
levels. When a TBA, such as Fannie 2.5, has not had
new origination slotted into it for quite a while, the
broker dealer community does not know how to
price it accurately. In addition, because of this risk, the
bid/ask on the TBA is much wider than other TBA
securities that have been used to hedge current production prior to the rally. So, when selling the Fannie
2.5 to hedge your interest rate risk you might (1) not
be able to get the TBA prices quoted on the screen;
(2) have difficulty pairing out of the hedge; and ( 3)
drive up hedge cost due to the wider bid/ask. All these
issues added up can be quite costly and reduce results.
The hedging issue becomes even more pronounced
if markets go back to the previous rate environment.
In early July, this is exactly what happened. Once the
fears of Brexit subsided, rates went back up and new
production slotted into the Fannie 30-year 3.0 coupon
again. Liquidity never occurred for the few Fannie 2.5
securities created during this period. So, what can you
do if you see something like this again?
On our desk, we have seen this environment
before. When the initial locks came in, we took alter-
native measures to hedge those loans. We felt, until
we see liquidity in the Fannie 2.5’s, we would greatly
reduce exposure. So, here are some hedging strategies
we used for our customers:
(1) First, we divided the note rates that slot into the
2.5 security into (1) loans with note rates that can
re-slot up to a Fannie Mae 3.0 coupon and (2)
loans with note rates that have no choice but to
stay with the 2.5 TBA.
(2) For the loans with note rates that can only slot
into the Fannie 2.5 TBA, we reviewed the pipeline
and used two approaches. If the population of
these loans was small, we went ahead and locked
it best efforts. For larger pipelines, we estimated
the pull through on these loans and did a forward
mandatory lock with their investors. This approach
not only mitigated the risk of losing money on
the Fannie 2.5 hedge but also ensured that the
loan will have a buyer when it is funded. In previous market shifts when the origination coupon
changed abruptly, investors stopped offering to
purchase certain note rates or reduced pricing
significantly to manage their own risk. By locking
the price close to the lock date, we were assured
a buyer and a price.
( 3) For the note rates that slotted into the Fannie 2.5
TBA but could re-slot into the Fannie 3.0 TBA, we
used Fannie 3.0’s to hedge those loans. We hedge-weighted the position in order to cover the different duration of the securities. The thought here is
if the market remained in a low rate environment
and Fannie 2.5 TBA liquidity improved, we would
do a coupon swap to Fannie 2.5’s in order to
eliminate the basis risk. If the market backed up to
previous levels, these loans would slot into Fannie
3.0 TBAs, and we would adjust our hedge. The
Fannie 3.0 hedge is very liquid so there is no issue
getting in and out of this security. This is in fact
what happened, and we were well covered.
So, what does this period teach us about hedging?
In my mind, I think you can never 100% trust a hedging model. When the input into the model has flaws
as we see in this scenario, it will not give you the right
answers. To get to the best results, you might have to
think about changing your hedge and sale strategies.
This is not the last time we will have a market that
changes quickly, and reacting quickly is key to success.
When you see a changing environment, think outside
of the box to what can occur during this time. Using
your models as a guide, but also understanding your
pipeline, the model inputs and the implications of
market changes is key. Not taking risk but maximizing
results has always been my goal and should be yours,
too. But, this is what I have always loved about capital
markets. Even with this paradigm, markets are always
changing, and you have to change with them in order
to be successful.
Karin Good, CFA is the SVP of Secondary Operations
at Optimal Blue in Denver, Co. She can be reached at: