“Unprecedented” was the word of the year in 2020, and with the unpredictable and unimaginable events of this past year, adaptability became the name of the game as everyone adjusted and changed how and why we did things. Working/learning from home while eating every meal at home made us become more flexible with our schedules, as well as with different workflows and means of communication. Many of these changes are becoming the norm as we move into 2021, but one thing that remains constant is the benefit of hedging interest rate risk associated with mortgage borrower rate locks.
The Federal Reserve is expected to keep short-term rates low for an extended period, thus helping a sluggish economy impacted by COVID-19. Mortgage rates, however, are tied to the longer end of the yield curve and do not trade in step with the Fed. By maintaining a prudent hedging strategy constructed using mortgage-backed securities, mortgage lenders can match market movement on the value of borrower locks to the market in which the locks were taken.
Hedging is slightly more complex than using forward commitments to cover borrower interest rate risk. However, hedging locks and then selling loans under shorter delivery period commitments achieves better overall executions and maximizes profitability.
Often, forward commitments are taken down in larger lump sums and later filled with individual loans as they close. Since the commitment has a single expiration date but loans close throughout the commitment period, the loans that fund early during this time will lose the value of their interest carry and may also produce tail pieces resulting in either over- or under-delivery amounts that need to be paired off or extended. If single loan commitments are used rather than lump sum forwards when loans do not close on time, or not at all, the seller may be assessed extension fees and pair-offs. While this seems like a fairly innocuous trade-off at first glance, a repeated, long-term pattern of this results in thousands of wasted dollars.
When converting to hedging, commitments are not taken out until after loans close. This allows access to shorter delivery periods, which yield higher prices, and the ability to pick up small loan balance pay-ups without fear of loan fallout. Hedging enables lenders to sell loans under mandatory commitments on loans after closing, which enables lenders to avoid paying pair-off fees on lock fallout. Not only is this the better way to manage interest rate risk, but it also allows the lender to offer an occasional free rate lock extension or rate renegotiation. In a highly competitive market, not unlike the one that the industry is currently facing, having something like this in the proverbial back pocket can have a tremendous impact on a lender’s ability to retain a customer and deliver a stellar borrowing experience.
For lenders selling mortgages to other non-agency third parties, hedging allows for even greater execution improvement. Again, loans aren’t sold until after they close. Typically, closed loans are packaged together and shown to all available investors using shorter delivery commitments. With closed loans, investors offer their best pricing because loan attributes will not change, in addition to the short delivery period.
If 2020 has demonstrated anything, it is that things can change seemingly overnight, and while the current wave of volume is expected to continue through 2021, nothing is ever certain. Thus, lenders must always be focused on maximizing profitability and managing risk, even during the good times. Hedging, as has been proven time and again, provides lenders with a reliable means of achieving both of these ends.