Last week’s U.S. employment figures pointed to a continued strengthening job market while this week saw a spate of softer-than-expected inflation data, but the 10-year Treasury yield closed each week at the same level. Mortgage rates, however, whipsawed around by 0.25-0.375 percent over the last several trading days, exemplifying the basis risk of hedging a pipeline with U.S. Treasuries. Stating something many of you already know, basis risk is the possibility that the value of two assets hedged against one another will move differently.
Economic releases, whether inflation, employment, or GDP growth, directly influence Treasuries, but may not have an instantaneous impact on mortgages. This is what makes it difficult, if not impossible, to hedge a mortgage pipeline with U.S. Treasuries. Treasuries move similarly, but not always the same, to mortgage-backed securities (MBS). There is additional risk in MBS due to unscheduled prepayments of principal due to refinancing, foreclosures, and home sales.
The last few weeks have reminded us that using To-Be-Announced securities (TBAs) is a superior underlying hedging instrument for a mortgage pipeline. Using TBAs, you hedge your loans in the pipeline with the instrument deriving the price of those loans. TBAs are forward contracts meant to offset the gains or losses of the loan price from time of rate lock to final sale for a lender. Using TBAs to hedge the pipeline separates the hedge from the end investor outlet.
Hedging as a practice is not meant to be a profit center, but rather used to mitigate risk. Implementing an effective hedge strategy with TBAs allows lenders to deliver loans via mandatory loan sales to investors. Instead of locking in with the investor early in the origination process, like with best efforts, a lender is able to run a best execution at the time of sale and select the highest price. Selling loans on a best efforts rather than a mandatory basis is a glorified gamble for capital markets staff. Sure, in a falling rate environment, you are going to record more profit, but any profit you feel like you have left on the table over the past seven weeks would have been more than offset by the losses you took as rates ran up through the first five and a half months of 2022.
Our experienced hedge advisory allows you to be your most successful. We offer clients more selling flexibility, greater efficiencies, less risk, and the ability to hold loans on the balance sheet longer. Experiencing liquidity issues with higher note rates? BAM Marketplace is the first open, transparent loan exchange, giving you transparency into all available executions, even if you aren’t an approved seller. Make sure your existing investor pricing is strong and competitive. Find buyers that fit the profile of the loans you are originating. As always, contact us if you are looking for a better suite of secondary marketing products or more guidance on how to manage market volatility.