OUTSOURCING PIPELINE HEDGING: CHOOSING AND USING A THIRD-PARTY PROVIDER

The following is an excerpt from Chapter 5 of Volume III of The Mortgage Professional's Handbook:

OLD SCHOOL VERSUS NEW SCHOOL

Douglas Mayers, Senior Vice President, Client Solutions Group
MIAC Capital Markets, LLC

Within the field of pipeline risk management and hedge analytics, there’s an “Old School” and a “New School.” The Old School methodology is characterized by any or all of the following:

  •  Excel or Access database underpinnings
  • Pipeline mark-to-market (MTM) based on proxy pricing from the TBA market
  • Pipeline coverage weighted only for Pull-Through
  • One-dimensional fallout analysis, and/or pull-through model
  • Definition of a flat position means achieving a zero net position
  • Absent or simplistic shock reports
  • Shock reports that demonstrate perfect symmetry between the Gain/Loss on the loans and Gain/Loss on the Hedges.
  • Sensitivity analytics that exclude duration and convexity of MSR component

The Old School methodology is also marked by the absence of a disciplined accounting for all of the risks to the embedded value of the pipeline. The Old School does not:

  • Measure “value at risk” from day 1 of the locked position via a client-specific, daily loan-level best execution
  • Measure price/value sensitivity through an accurate and market-validated calculation of durations and convexity at the loan level and hedge instrument level
  • Measure and shock the MSR value or SRP component of the pipeline

Firms stuck in the Old School are at risk of being blind-sided, thinking that they were covered appropriately, but are misled into believing that they were flat, or even long.  In reality, they are short to begin with and become significantly shorter really fast in a big rally.

When the market eventually craps out, and it may do so violently, the Old School adherents and their clients are likely to over-react by adding too much coverage in inappropriate coupons in an attempt to cover for an anticipated increase in pull-through.  They will once again have their guard down, thinking they are covered properly, when in fact they are set up to get blind-sided again. 

The absence of a dynamic risk model that integrates pull-through, durations, and MSR/SRP sensitivity is analogous to an NFL front line that is missing a Right and Left Tackle, leaving the quarterback exposed to a blind-side blitz. 

The New School Methodology: Covering the Blind Spots
The New School perspective is that adherents of the Old School are not measuring everything that they should, so their reports distort the reality of the client’s position.   Old School analytics/reports may show that the client went into a particular market event with a flat (or even long) position, but if measured properly, they will typically be over-hedged by 10 to 20%.  To make matters worse, the coupons they are hedged with are typically the most sensitive to changes in the market.    

The “New School” of pipeline risk and hedge analytics addresses the blind spots inherent to the Old School approach.  Here is how to cover the “Old School Blind Spots:”

  • Run daily loan-level best execution from Day 1 of the lock position based on the client’s specific risk profile and AOT (or other) contract terms
  • Perform loan-level sensitivity analysis on the MSR component in the loans and AOT contracts to accurately measure all pipeline and market risks
  • Calculate durations at the loan-level and hedge instrument level to calibrate the hedge on a duration-weighted basis and hedge to the client’s actual execution
  • Deliver integrated best-execution and hedge analytics in one exercise to measure all exposures and optimize the position

Read the rest of this chapter in The Mortgage Professional's Handbook!

Douglas Mayers is Senior Vice President, Client Solutions Group at MIAC, and has been with MIAC since 2008.  In this capacity, he is engaged in sales, marketing, and business development for the full line-up of MIAC’s secondary market risk management software and associated professional services.

Doug has a broad range of experience in the secondary market, including positions in sales and sales management for correspondent mortgage acquisitions; whole loan and distressed asset pricing and trading platform development;  agency MBS pooling and delivery; and MBS acquisitions operations.  

Doug began his career in the industry with Lomas and Nettleton in 1985, and has held a variety of sales, marketing and management positions with Fannie Mae, Countrywide, Bayview Financial, and Indymac Bank.