IR-156 an Efficient Approach Mortgage Pipeline

interest rate products

An Efficient Approach to Mortgage Pipeline Risk Management


1

On the surface, the right of homeowners to prepay their mortgage seems an innocuous little detail; at closing, it is little more than a side note to the more important details of the loan (i.e., amount, term, interest rate, etc.). For the mortgage lender, however, it is most emphatically not innocuous. This prepayment right is, at its core, what causes the prices of mortgages to behave differently from prices of comparable Treasury securities, given a similar change in interest rates. It also gives rise to the forces that make managing mortgage pipeline risk so challenging.

More specifically, the prepayment right generates the various phenomena that give a mortgage its “negative convexity.” As is well known, when interest rates rise, Treasury securities lose value, as do mortgages. Conversely, when interest rates fall, Treasury securities gain value but mortgages experience price compression. That is, they gain value to some extent but then level off due to the homeowner’s prepayment option, the right to pay off the mortgage at par at any time. This embedded cap on the upside performance of the mortgage is an example of negative convexity at work.

Despite the inherent difference in response to changes in interest rates, it is possible to use exchange-traded risk management tools, such as CME Group Interest Rate futures and options, to manage mortgage pipeline risk. This can involve using combinations of U.S. Treasury futures and options on those futures, Interest Rate Swap futures and options on Treasury futures, or simply options on Treasury futures alone. All of these alternatives offer effective and cost-efficient mortgage pipeline hedges.

To demonstrate these mortgage pipeline hedge possibilities, this paper will present a simplified analysis of pipeline risk to suggest that pipeline and warehouse are parts of a unified whole, and that fallout and prepayment risk are simply aspects of interest rate risk. Next, it will outline an analysis of pipeline holdings emphasizing the optionality of these assets. Using this foundation, the paper will demonstrate the effectiveness of three hedging strategies:

• 10-YearTreasuryNoteputoptions

• Acombinationof10-YearTreasuryNotefuturesandoptions

• AcombinationofCBOT10-YearInterestRateSwapfutures and10-YearT-Noteoptions

Finally, after a brief discussion concerning option choice and hedge construction, the paper will reiterate the several benefits that accrue to users of these exchange-traded derivatives.

intRoduction

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2

A SiMPlifiEd AnAlySiS of PiPElinE RiSk

Mortgage hedging discussions often distinguish between pipeline and warehouse risk and among fallout, prepayment and interest rate risks. For the purposes of this discussion, the term “pipeline” includes “warehouse.” “Pipeline” as used here extends from rate lock tosaleintothesecondarymarket–typicallyaperiodof60to90days. Similarly, fallout and prepayment risks are considered special cases of interest rate risk.

To understand the motive for these simplifications, consider that before a mortgage closes, falling interest rates can result in applicants withdrawing their loan applications, which is known as fallout. Similarly, interest rates falling after the closing can result in homeownersrefinancingtheirmortgages.Bothsituations,falloutand refinancing, are caused by the same factor – falling interest rates – and in both cases, the result is the same: a mortgage drops out of the pipeline. From this perspective, there is no reason to distinguish between fallout and prepayment risk, nor between pipeline and warehouse risk.

Conversely, if interest rates rise before or after closing, the homeowner will be more likely to stay the course. In that case, the number of mortgages in the pipeline will remain the same, but each mortgage will be worth less than par. As a result, the lender cannot realize full value from the sale of the paper.

exhibit 1: thE EffEct of fAllout on PiPElinE VAluE

interest Rate change (bps)

Market Value of one Mortgage

number of Mortgages Pipeline Value full Pipeline Value

-100 $204,120 15 $3,061,800 $10,206,000

0 $202,831 50 $10,141,528 $10,141,528

+100 $192,397 45 $8,657,865 $9,619,850

Clearly, the challenges that accompany pipeline management are a direct result of interest rate risk, and rising and falling interest rates can each have negative implications for pipeline managers.

This is not to deny the importance of fallout risk or correctly estimating prepayment speeds; the damage that fallout or prepayment can do to a mortgage pipeline is significant. Although fallout risk varies from region to region and even among banks within a city, a simple example will illustrate the potential for damage.

Assumealenderhasissued50ratelocksfor$200,000parmortgagesand, at the moment of issue, these mortgages have an aggregate value of$10,141,528.Consideronlytwoextremesituations.

Suppose this lender’s fallout experience is such that if interest rates drop100basispoints(bps),thefalloutislikelytobe70percent;only15ofthese50mortgageswillremaininthepipeline.Incontrast,ifinterestratesrise100bps,thefalloutwillbe10percentand45mortgageswillremain.Exhibit1 shows the initial value of one mortgage (at zero interest rate change) and the values of one mortgageat-100bpsand+100bps.The“pipelinevalue”columnmultipliesthe-100and+100marketvaluesofonemortgagebythenumber of mortgages remaining and the “full pipeline value” column multipliesthe-100and+100marketvaluesofonemortgagebytheinitial50mortgages.


3

Basedontheinitial$10,141,528value,the100bpinterestratedrop caused a reduction in the size of the pipeline of slightly morethan$7million.The100bpinterestraterisecausedalossinthevalueofthepipelineofalmost$1.5million.Clearly,falloutrisk is not trivial.

A common observation among mortgage lenders is that for a given number of rate lock commitments, some applicants will close no matter what interest rates do. A larger group will most likelycloseifinterestratesremainstable.Yetanothergroupisextremely likely to fall out if interest rates drop. This observation has guided earlier pipeline hedging recommendations, many of which suggest a three-pronged approach to pipeline hedge design: sell the first group forward, hedge the second group with futures and hedge the third group with options.

The primary weakness of this approach lies in its inattention to the characteristics that shape the prices of mortgages and the failure to realize that the entire pipeline exhibits these characteristics, not just the most problematic segment. As a result, this type of hedge fails to address the real pipeline issues and thus has failed to satisfy numerous pipeline managers who have tried to hedge.

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4

A diffEREnt APPRoAch to PiPElinE RiSk

When a lender makes a mortgage loan, the essential transaction is for the lender to buy the homeowner’s “bond.” Ordinarily, a logical way to manage the risk that comes with owning a bond is to sell futures. This works well for owners of U.S. Treasury securities, as Exhibit 2 illustrates.

Thisexhibitinvolvespositionsthatarelonga10-YearTreasuryNote(the5.125percentmaturinginMay2016)andshortanappropriatenumberofJune10-YearT-Notefuturescontracts(TYM8).RisinginterestratesdrivethepriceoftheTreasuryNotelower and falling interest rates drive the price of the Treasury Note higher. The short futures position exhibits the opposite response. The solid line (“Total” in the legend) represents the net, or hedged, position. Note how closely this line follows the zero line. The futures position neutralizes the effects of interest rate change across a wide range of interest rates.

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T 5 1/8 MAY 2016 TYM8 TOTAL

exhibit 2: hEdging A long tREASuRy PoSition with 10-yEAR t-notE futuRES

Given that a mortgage is also a bond, according to the common wisdom, it seems logical to expect a similar futures hedge to generate similar results. Unfortunately, a mortgage lender with this expectation will be disappointed. Exhibit 3 displays the net resultofapositionthatislonga5.5percentcouponconventional30-yearmortgage(FNCL),whichishedgedwithasimilarshortJune10-YearT-Notefuturesposition.Inthiscase,bothrisingandfalling interest rates lead to negative results. A common refrain is that this type of hedge doesn’t work because of basis risk.

Note: In the exhibits in this paper, a negative for the number of contracts indicates a short position and a positive in the number of contracts indicates a long position.


5

To hedge mortgages with Treasury futures is to engage in a crosshedge and any crosshedge has exposure to basis risk. A crosshedge involves hedging a position in one market (e.g., a corporate bond or a mortgage) with a position from a similar but different market (e.g., Treasury futures). The basis risk arises because the corporate bond, for example, contains credit risk which the Treasury security underlying the futures contract does not.Becauseofthisaddedelement,thecorporatebondpricewill respond to changes in the market assessment of the credit situation and to changes in interest rates. The Treasury issue underlying the futures contract will respond only to changes in interest rates. The difference in the responses is termed basis risk.

Even though basis risk is real, this seems an inadequate explanation for the failure of the hedge illustrated in Exhibit 3. Such an explanation overlooks the actual character of a mortgage pipeline. Exhibit4displaystheprice-yieldplotofthe5.5percentmortgage position alone.

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5 ½% Current Coupon TYM8 TOTAL

exhibit 3: hEdging A MoRtgAgE PiPElinE with 10-yEAR t-notE futuRES

exhibit 3a

Pipeline contents Price yield Modified duration convexity dV01 full Value

5.5%CurrentCoupon 101-04 5.1947% 4.04 0.30 0.0410 $10,141,528

hedge Position Price dV01 # contracts

TYM8 119-19 0.0822 -50

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6

Again, rising interest rates drive the price of the mortgage lower. However, falling interest rates do not have the same effect as they do in the case of the Treasury security of Exhibit 2. Rather, as interest rates fall, the price rises until roughly the minus 25bpsareaonthehorizontalaxismoreorlesslevelsoff.Thisleveling off, or price compression, is a manifestation of negative convexity, which results from the homeowners’ prepayment rights.

In effect, the lender has bought bonds from homeowners and sold the homeowners call options – the right to prepay or call away the mortgage. Any mortgage in a pipeline, then, is a combination of positions that are long a bond and short a call option. Further, this combination is equivalent, in risk-reward terms, to a synthetic short put position. Exhibit5 displays a payoutdiagramforapositionshort150June115.510-Year T-Note puts. Note the close resemblance between this plot and the one in Exhibit4.

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TYM8 115.5

exhibit 5: ShoRt 10-yEAR t-notE Put PoSition

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5 ½% Current Coupon TYM8 115.5 TOTAL

exhibit 4: PRicE-yiEld of A 5.5 PERcEnt MoRtgAgE


7

Once the mortgage pipeline is seen as a portfolio of short puts, it should become apparent that the way to immunize against the effects of changes in interest rates is not to go short Treasury futures but to buy puts. Exhibit 6 illustrates how such a hedge can work.

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5 ½% Current Coupon TYM8P 116.5 TOTAL

exhibit 6: hEdging MoRtgAgE PiPElinE with long 10-yEAR t-notE Put PoSition

lEt ActuAl PiPElinE chARActERiSticS ShAPE thE hEdgE

exhibit 6a


5.5%CurrentCoupon 101-04 5.1947% 4.04 0.30 0.0410 $10,141,528

hedge Position Price delta dV01 # contracts

TYM8P116.5 0-44 -0.24 150

Inthisexample,a$10millionparpipelineishedgedwithapositionthatislong150June116.510-YearT-Noteputs(TYM8P)atapriceof0-44(thatis,44/64thsor$687.50perput).Theputposition mirrors the mortgage position fairly closely. As a result, the net position results in something close to neutral. To be sure, wheninterestratesdropmorethan40bps,thenetpositionsuffers a slight loss, but when interest rates rise, the net position enjoys a gain.

A commonly raised objection to this type of hedge is its apparent cost. A purchaser of options pays the premium in full when the positionisestablished;inthisexample,150putsat$687.50perputwillcost$103,125.Whilethismayappeartobeasignificantcost for some institutions, after considering the benefits illustrated in Exhibit 6, it should become clear that the benefits outweigh the costs.

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8

An alternative to the long put hedge is a combination of short futures and long calls. An intriguing fact about futures and options on futures is that long or short futures can be combined with long or short puts or calls to create synthetic option positions. Thus, positions that are short futures and long a call can replicate a long put position and this combination should be able to neutralize the short put exposure of the mortgage pipeline position.

Giventhe$10millionparpipelineexposure,theinitialhedgemightconsistofapositionthatisshort49June10-YearT-Notefuturesandlong60June123.010-YearT-Notecalls(TYM8C).Atapriceof43/64thsor$671.88,these60callswillcost$40,312.80.Inpractice,thisalternativecanseemabitcomplicated. As interest rates rise or fall, hedgers must adjust the futures position to keep the hedge in balance. Fortunately, there is an easier way that will produce satisfactory results.

Suppose the pipeline hedger determined that to protect this examplepipelineof50mortgages,hewouldneedtobuy60June123.010-YearT-Notecallsandsell49June10-YearT-Notefutures.Becauseashortfuturespositionwillgainwheninterestrates rise and prices fall, as will a long put position, he can reduce thefuturespositionandbuysomeputs–inthiscase75June

An EquiVAlEnt PoSition foR coSt-conSciouS hEdgERS

116.510-YearT-Noteputs.Atapriceof44/64ths,or$687.50,these75putswillcost$51,562.50.Thetotaloptionpositioninthisversionofthehedgewillcost$91,875.30,whichisstilllessthanthecostofthepositionthatissimplylong150puts.

Interestingly, for the most part the puts will be self adjusting. As interest rates shift, the interaction of the put and call prices will basically keep the hedge in balance. Exhibit7 illustrates this.

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CASH MKT ISSUES FUTURES/OPTIONS TOTAL

exhibit 7: hEdging MoRtgAgE PiPElinE with 10-yEAR t-notE Put-cAll coMbinAtion

exhibit 7a


5.5%CurrentCoupon 101-04 5.1947% 4.04 0.30 0.0410 $10,141,528


TYM8 119-19 0.0822 -30

TYM8C123.0 0-43 0.24 60

TYM8P116.5 0-44 -0.24 75


9

The total line in Exhibit4, which represents the net of the pipeline and the combined hedge position, stays close to the zero line until interest rates drop morethan50bps.Exhibit8 reinforces the graphic message by contrasting the results of the unhedged and hedged pipeline at several points along the interest rate continuum.

If the job of a hedge is to create a neutral position – no gains when interest rates fall and no losses when interest rates rise – this hedge is very effective. The largest losses in the hedged column amountto0.08percentofthe$10,141,528initial pipeline value, a trivial amount in contrastwiththe5.14percentlossfortheunhedged position when interest rates rise 100bps.

exhibit 8: thE unhEdgEd-hEdgEd contRASt

interest Rate change (bps)Value changes

in the unhedged Pipeline

Value changes in the Pipeline hedged with

t-note futures and options

-100 $64,472 $48,317

-50 $66,406 -$852

-25 $49,535 -$1,349

-10 $25,520 $808

InitialRateLevel 0 0

10 -$30,447 $72

25 -$90,900 -$3,667

50 -$216,990 -$8,014

100 -$521,690 -$8,013

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10

AfurtheralternativeinvolvessubstitutingCBOT10-YearInterestRate Swap futures for the Treasury Note futures in the hedge. A combinationofInterestRateSwapfuturesand10-YearT-Noteoptions generate a risk-reward profile similar to that of the T-Note futures and T-Note options combination.

An added benefit from the use of Interest Rate Swap futures involves the issue of basis risk. The swap rate underlying this futures contract contains credit risk. Thus, as interest rates change, Swap futures prices will reflect both the interest rate change and the market reassessment of the credit situation. A mortgage-Swap futures hedge is still a cross hedge, but it seems reasonabletoexpecttheuseofCBOTInterestRateSwapfuturesto at least reduce the basis risk.

Exhibit9 shows this version of the pipeline hedge using June 10-YearInterestRateSwapfutures(DIM8)togenerateresultssimilartothehedgeusingT-Notefutures.Exhibit10contraststhe results of the unhedged and hedged pipeline at several points along the interest rate continuum.

SwAP futuRES cAn REducE bASiS RiSk

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CASH MKT ISSUES FUTURES/OPTIONS TOTAL

exhibit 9: hEdging MoRtgAgE PiPElinE with 10-yEAR intERESt RAtE SwAP futuRES

exhibit 9a


5.5%CurrentCoupon 101-06 5.1795% 4.04 0.30 0.0410 $10,147,778


DIM8 115-27+ 0.0892 -25

TYM8C123.0 0-43 0.24 60

TYM8P116.5 0-44 -0.24 75

Boththegraphicandtabularaccountsshow this to be a valid approach to hedging a pipeline. The largest negative variation from neutral amounts to only 0.10percentofthe$10,141,528initialvalue of this pipeline. Clearly, it is possible to construct a robust pipeline hedge using combinations of CME Group Interest Rate futures and options.

exhibit 10: thE unhEdgEd-hEdgEd contRASt with SwAP futuRES


Value changes in the unhedged Pipeline

Value changes in the Pipeline hedged with t-note futures

and options

-100 $60,658 $65,791

-50 $64,028 $7,861

-25 $48,284 $2,839

-10 $25,051 $2,512


10 -$29,909 -$1,483

25 -$89,756 -$7,793

50 -$215,160 -$16,748

100 -$519,130 -$10,411


11

Questions remain concerning how to choose the options and how to construct the hedge.

At a given moment, the options market offers a variety of choices of expirations and strike prices. Options on Treasury futures have up to seven expiration months listed: the first three consecutive contract months (two serial expirations and one quarterly), plus the next four months in the quarterly cycle. Exhibit11 includes the first three consecutive months and one of the next quarterly expirations, September2008.

The matter of expiration choice depends on the individual pipeline experience. Given the average time between rate lock and sale in your pipeline, a reasonable choice is an option with a slightly longer time to expiration. It is almost always wiser to trade out of an option rather than deal with the mechanics of optionexpiration.Forexample,onFebruary15,theMay2008expirationwas70daysawayandtheJune2008expirationwas98daysaway.Accordingly,ifyournormalpipelinetermwas60days,the May expiration would be a good choice, but if your normal pipelinetermisasmuchas90days,theJuneexpirationwouldbethe right one.

thE choicE of oPtionS

exhibit 12: A SAMPlE of AVAilAblE oPtionS on 10-yEAR t-notE futuRES

Strike Price Put Price impliedVolatility

delta call Price impliedVolatility

delta

117.0 1-05 9.21% -0.35117.5 1-18 9.26% -0.40118.0 1-32 9.26% -0.44118.5 1-47 9.23% -0.49 1-52 9.39% 0.51119.0 2-00 9.24% -0.53 1-37 9.41% 0.47119.5 1-24 9.47% 0.42120.0 1-12 9.51% 0.38120.5 1-01 9.52% 0.34121.0 0-57 9.76% 0.31121.5 0-52 10.13% 0.28122.0 0-49 10.64% 0.26122.5 0-46 11.11% 0.24123.0 0-43 11.52% 0.22

exhibit 10: thE unhEdgEd-hEdgEd contRASt with SwAP futuRES


Value changes in the unhedged Pipeline

Value changes in the Pipeline hedged with t-note futures

and options

-100 $60,658 $65,791

-50 $64,028 $7,861

-25 $48,284 $2,839

-10 $25,051 $2,512


10 -$29,909 -$1,483

25 -$89,756 -$7,793

50 -$215,160 -$16,748

100 -$519,130 -$10,411

exhibit 11: tREASuRy oPtionS tRAding tERMS

option Expiration first trading day last trading day number of days traded

May2008 1/28/08 4/25/08 88

June2008 7/20/07 5/23/08 308

July2008 3/24/08 6/20/08 88

September2008 1/8/08 8/22/08 227

Optionson10-YearT-Notefuturesalsopresentanarrayofstrikeprices. For example, the exchange offers June options on these futures with strike prices at half-point intervals. Exhibit12 displaysasampleoftheoptionsavailablewithJune10-YearT-Notefuturestradingat118-17and59daystooptionexpiration.

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12

Asageneralrule,optionswithdeltasinthe0.20to0.30range are the best choice, for two reasons. First, they cost less initially. For example, in Exhibit12theJune118.5callcosts1-52(inoptionquotes,1-52/64ths)whiletheJune123.0callcost43/64ths.Indollarsperoption,thedifferenceisbetween$1,812.50and$671.88.

As important as cost is, though, performance is probably more important.Withfuturesat118-17,the118.5callisat-the-moneyandthe123.0callisout-of-the-money.Forthepurposesofamortgage hedge, the out-of-the-money call is also preferred because it effectively responds to large declines in interest rates. In contrast, the at-the-money call responds to all declines in interest rates. Mortgage hedgers should be primarily concerned withhedgingthenext25bpsmoveratherthanthenextfivebpsmove. The out-of-the-money call also offers greater value to the mortgage hedger because it is likely to produce a greater return on investment (ROI) than the at-the-money call if both options expire deep in-the-money.


13

Pipeline hedge construction can be accomplished effectively given the relevant quotes, the ability to price the options, and a spreadsheet. To begin with, a good quote service or broker should be able to provide mortgage and futures prices at various interest rate levels for whatever mortgage coupons are relevant to any specific pipeline situation.

Basedonthesemortgagequotes,thehedgercaneasilydeterminethedollaramountshis pipeline will gain or lose if rates rise or fall to the interest rate levels of concern. Any reasonable option pricing program will allow the hedger to calculate option prices for these interest rate levels and for the typical period of time in the specific pipeline.

Once these values are entered on a spreadsheet, it is a straightforward matter to determine the number of puts or the combination of futures, calls and puts that will constitute reasonable hedges. There is no magic formula for constructing these hedges, but neither is this a hard puzzle to solve.

A notE on hEdgE conStRuction

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14

Even with the market emphasis shifting increasingly to conventional prime mortgages, pipeline risk remains a challenge. Fortunately, the set of risks confronting managers of pipelines of these high-grade loans can be efficiently and cost-effectively managed with CME Group Interest Rate futures and options. Specifically, U.S. Treasury futures, options onU.S.TreasuryfuturesandCBOTInterestRateSwapfuturescanallservewellinpipeline hedging programs.

Moreover, CME Group products offer significant efficiencies and benefits relative to over-the-counter (OTC) derivatives, including counterparty risk mitigation, vast pools of centralized liquidity, transparency of price discovery, clear and transparent market valuations and significant operational and balance sheet efficiencies.

thE bottoM linE


15

hEAdlinE

subhead Body

futures trading is not suitable for all investors, and involves the risk of loss. futures are a leveraged investment, and because only a percentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited for a futures position. therefore, traders should only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade. the information within this brochure has been compiled by cME group for general purposes only. cME group assumes no responsibility for any errors or omissions. Although every attempt has been made to ensure the accuracy of the information within this brochure, cME group assumes no responsibility for any errors or omissions. Additionally, all examples in this brochure are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience. the globe logo and cME group® are trademarks of chicago Mercantile Exchange inc.

© 2008 cME group inc. All rights reserved.

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iR156.2/100/0408

IR-156 an Efficient Approach Mortgage Pipeline

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Transcript of IR-156 an Efficient Approach Mortgage Pipeline