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Profit hedging.

A new way to smooth out the irregular earnings of mortgage banking companies is to hedge profits. Such an approach is designed to take the sting out of bouncing interest rates.

JEREMY NILE, PRESIDENT OF AAA Mortgage Company, needed new capital to enable his company to reduce its warehouse cost, increase production capacity and reduced the leverage of the balance sheet. In December 1991, Nile orchestrated a successful initial public offering of AAA stock. Now he wondered how he could stabilize AAA's earnings to increase the stock's performance.

Nile asked Jennifer Ortega, the firm's chief financial officer, to compare AAA's earnings instability with the industry's, to determine whether or not income volatility correlated to interest rates, and to assess the impact of that on the initial public offering (IPO) and future stock price movement. Nile wondered if there is a connection between interest rates and profitability, which seems only logical, then why not simply set out to hedge earnings volatility.

Searching for reasons

To find a connection between interest rates and profitability, Ortega analyzed the Mortgage Bankers Association of America (MBA) cost studies, financial statements and operating ratios for the mortgage banking industry and the records of publicly traded mortgage companies. She found income volatility was common. She also determined AAA's earnings were slightly more stable, but not enough to expect significantly better stock performance.

In her report to the company's top management, which contained Figures 1 through 4, Ortega noted income from secondary marketing contributed the most to overall earnings instability and drove the volatility of production income.

Ortega's search for a correlation between earnings volatility and interest rates led her to index the difficulty of hedging in different actual market periods. She derived the index by making allowance for:

* the change of rates from year to year;

* the general level of rates;

* the sequence of changes in rates during a year; and

* the frequency of VA rate changes during a year.

The relationship between rate direction and profitability was inconclusive, but she found a high correlation between the degree of hedging difficulty and earnings stability.

Sustained bull markets with no dramatic intervening reversals were characterized by "low difficulty" hedge index readings. This environment produced high returns on capital, prompting capital inflows to the mortgage banking industry. She noted the recent examples of 1985 through 1986, and August 1990 through December 1991.

Ortega detected low or negative returns on capital during periods having "high difficulty" hedge readings. The type of markets that generated "high" readings were bear markets with high volatility and erratic price behavior. Recent examples were 1983 and more significantly 1987 and 1988. During these periods, mortgage companies closed their doors or consolidated and capital flowed out of mortgage banking. AAA experienced rough times also, but returns on capital remained positive. Nile's company achieved positive returns the old-fashioned way. It sold servicing.

Ortega observed in the course of doing her research that the common method of handling earnings volatility entailed selling servicing rights. Figure 3 charts this industry tendency. Figure 4 compares overall industry earnings with servicing sales for 1988, by size of servicer. It reveals that mortgage companies used servicing sales to offset poor secondary marketing performance regardless of their size.

Ortega concluded the main reasons for variable earnings at her company and comparable firms were:

* the cumulative effect of receiving "underwater" (or less than market rate) lock-ins due to price subsidies or market movement after publishing rate quotes;

* contracting production thus, causing excess origination overhead;

* traditional methods of risk management; and

* common methods of managing earnings volatility by selling servicing.

Net income from servicing operations tended to smooth the more volatile production earnings, but servicing sales diminished this benefit.

A new strategy

After reviewing Ortega's report, key managers investigated possible changes to improve income stability and avoid selling servicing as a hedge against earnings volatility. AAA's board of directors approved operational changes designed to moderate the adverse consequences of daily lock-ins. Additionally, the board created a task force to recommend action addressing the company's risk-management approach and the risk associated with contracting production.

Jonathan Smith, secondary marketing manager, spearheaded the task force to evaluate the current hedge and to design changes to facilitate profit stability. After completing the first task, the group explored the possibility of reducing corporate exposure during slowdowns in production.

Jonathan Smith's discovery

Smith found four major shortcomings in the company's existing, reactive hedging system that contributed to earnings instability:

* Profits were not hedged. Bull market paper gains in the pipeline evaporated after the markets reversed.

* Losses were locked in. Bear markets caused hedges to be placed in loss positions. However, mortgage convergence (forward drop) minimized hedge cost, unless production slowed.

* Bad executions occurred during fast moving markets. Markets occasionally overreacted to news. The discipline demanded by AAA's hedging system required hedge action under these conditions.

* Hedging costs increased in choppy markets. AAA's hedging approach resulted in too many coverage adjustments, especially for the approved locked-in loans if rates rotated around the rate that loans were locked in at. The efficient borrower curve reflected in Figure 6 and described later under the subheading "The tradition of managing coverage," shows that coverage changes from 50 percent to 75 percent if rates move just 10 basis points, which is about a 1/2 point in price.

Smith discovered his company was bound by the tradition of managing coverage and underutilized its computer power. To handle secondary marketing's income volatility, the task force recommended that AAA move away from single-point-in-time analysis (matching immediate risk with coverage) and begin managing profits using computers to model the effect of rate changes on profits. This approach also applied to measuring and hedging the negative effect of market movement on production flow.

Computer-aided simulation enabled AAA to begin looking at changes in profits as rates moved with time. The task force arrived at its conclusions by considering Ortega's income stability analysis, the company's traditional hedging methodology and the history of AAA's risk management.

The tradition of managing coverage

The question "How covered or uncovered are we?" was asked daily throughout AAA by those concerned about the lender's pipeline risk exposure. The firm managed coverage using a traditional risk-management approach. AAA managed some fallout uncertainty using over-the-counter mortgage-backed securities (MBS) options, but they primarily reacted to market price movement and daily production flows by selling mandatory. The extent of coverage increased on loans in the pipeline as rates rose and decreased as rates declined.

Management designed a mechanical system to quantify the risk in the pipeline. They used a framework that assigned a probability for a loan closing at a loss. This they called the "efficient borrower approach".

The task force members compared the efficient borrower approach with actual delivery experience, and to do this comparison, they statistically smoothed their delivery experience. To study the effect of time and interest rate changes on the different pull-through (loans that actually close at the original locked rate) measures, Jonathan simulated each one. Though Figures 5, 6 and 7 reflected only the firm's percentage of loans in the pipeline that actually went to closing on the retail side for conforming 30-year, fixed-rate mortgages, he recognized different delivery experience for different loan products.

Smith detected no hedge action that offset the borrower's behavior. AAA's actual deliveries inconsistently varied in steps as rates changed, but gravitated toward a statistically smooth curve. The variance depended on the psychology of the borrower. Smith detected some of the market factors influencing the borrower's decision to close, namely, the level of interest rates, the magnitude of change in rates and media exposure about interest rates movement.

In order to view their fallout risk more practically, Smith statistically smoothed delivery experience establishing minimum and maximum deliveries for extreme rate movements and a stable market norm. Comparing Figures 6 and 7, he noticed as locks approached expiration, the efficient borrower curve did not reflect their delivery reality.

Variances between the efficient borrower approach to calculating risk and statistically smoothing delivery experience helped explain earnings volatility. Positive earnings swings occurred when the difficulty to hedge was low. Negative earnings swings occurred when the difficulty to hedge was high. Smith attributed the negative variances to the inherent bullish bias of the efficient borrower approach. AAA performed inadequately in erratic bear markets like the industry as a whole.

None of the approaches to risk calculation objectively looked forward in time to consider the impact of rate movement on pipeline risk and hedge performance. Rather, they focused on risk as defined by current market prices.

Point analysis (looking at one point in time) drove AAA's management information system. It matched coverage with specific loan products because hedge tools tended to be the delivery vehicle. They micro-managed risk (matching specific products with specific hedges) from lock-in to ship-out. As reactive or dynamic hedgers, they used point analysis to adjust coverage as prices moved requiring near perfect and continuous reaction to market movement.

The historical context

Smith pondered the question of how point analysis and the micro-management of interest rate risk evolved at AAA. Before mortgage-backed securities, structured financing and Fannie Mae, AAA dealt directly with investors such as insurance companies, pension funds and thrifts. AAA arranged commitments with investors, then produced the loans filling those commitments. To protect against the investor not buying the loans, AAA used operational controls.

A manual management information system developed to track commitments from application to funding by the investor. The company's early use of computers expedited monthly accounting statements and the processing of mortgage payments, but risk management piggybacked the accounting system.

With the birth of the mortgagebacked security market, AAA soon learned how dramatically risk shifted. Fallout risk became more pure. Mortgage products became more homogeneous, allowing borrowers to shop rates more easily, thus increasing competition. No longer could a lack of production in a particular product be renegotiated with the investor. But, throughout this evolution of product, management information remained the same (i.e., matching loans-in-process to specific commitments).

AAA focused on forming pools with the purpose of minimizing losses for each security sale or avoiding pair-offs, that is liquidating a MBS position due to a lack of product. This micro-management process smoothed monthly earnings and cash flow, until the effects of abrupt rate movements finally flowed through. Operational controls were insufficient to manage uncertainty, so AAA's management looked to quantitative risk measurement and financial management tools.

To combat fallout (or loans in the pipeline that fail to close) and its variance, AAA developed a method to calculate risk and incorporated standby options in its hedge arsenal. Options were used to hedge a portion of the possible variance between expected and actual fallout. Ortega's earlier study noted that the use of options directly contributed to earnings stability that was slightly better than the industry standard.

Like the industry, AAA experimented with different hedge tactics and means to measure risk, but always in the context of matching loans with hedges. A departure from this approach would be necessary to move toward profit management through simulation analysis. But the evidence seemed clear that AAA could simulate pipeline risk and the relationship of various hedge tools and thereby project profit and loss for various rate changes.

The task force presented its findings, conclusions and recommendations to AAA's board of directors. The board approved the change to "profit"-oriented risk management, including managing the risk associated with contracting production. The board called the new hedge orientation the "profit management approach."

Managing profits

The profit management approach focuses on managing bottom-line results. It uses "what if" planning to match the ever-changing reality of the pipeline. Opportunities to capture profits, while limiting exposure to market reversals, becomes the objective.

Two major benefits of the new approach are improved communication and an environment conclusive for continuous improvement. Creating a report reflecting the projected change in profits as rates change allows everyone in the firm to evaluate the risk to profits and contribute to formulating strategy.

AAA's board understands the general method and tactics used by the firm's hedging operations, but it does not manage the detail of their daily operations. It instead chooses to fulfill its oversight obligation by setting limits on secondary marketing, expressed as maximum negative "projected" changes in profits. Large variances in "projected" profits or, actual profits, signal that there are system weaknesses that need to be investigated.

AAA's profit management approach and the limits set by the board give Smith, the secondary marketing executive, greater flexibility, fluidity and confidence in hedging. He gains flexibility using all hedge tools. He can stay fluid by adjusting hedges as opportunities arise or risks vary, given market conditions. He confidently applies tactics consistent with agreed-upon strategies by examining the projected impact on profits.

Daily operations

Smith micro-manages at loan lock-in by selecting the "best" tactic for a specific loan product. To fairly evaluate the cost of various hedges, he simulates rate changes with time. This comparison among various instruments helps determine the most cost-effective hedge. Before making his final hedge selection, he considers his hedge under different market conditions, because no single hedge vehicle outperforms all other tools in all market environments.

Smith micro-manages again near loan closing. This time, he runs a "best" execution routine, looking for the "best" delivery vehicle. He finds the "best" hedge vehicle is not always the "best" delivery vehicle.

Between loan lock-in and closing, Smith hedges profits looking at the big picture. Aggregating the different loan products and hedges improves hedging efficiency.

AAA's profit management approach projects net profit from all products and hedges as rates change, relationships shift and time passes. Smith makes separate assumptions concerning yield spreads and pull-through rates to identify, pitfalls or opportunities.

By implementing a profit-hedging orientation, AAA eliminates the four major shortcomings of its old reactive system:

* Profits no longer evaporate as bull markets end.

* Profit opportunities emerge in bear markets.

* Major credit market moves breed opportunities, not confusion.

* Fewer hedge adjustments occur during choppy markets, matching pullthough reality.

Fear no longer drives the hedging decision, and implementation is not complicated by a panic-stricken market. In fact, through the new profit management approach, AAA capitalizes on that type of market.

In the past, Smith spent much of his time watching the market and recalculating his pipeline exposure. Now, he devotes more time to operational efficiency and refining other areas of risk management.

Hedging production

AAA views the current environment of highly affordable homes and low interest rates as very good for mortgage originations. The Mortgage Bankers Association of America's forecast for 1993 refinancing volume is $315 billion to $515 billion, assuming 30-year, fixed-rate mortgages remain around 8 percent. Senior management wonders, "What happens if rates fall early in 1993, then rise significantly?"

Several factors influence AAA's production trends, but a national reduction in production due to higher rates would severely curtail its originations, even with production expansion plans. Overhead costs outpace income when production contracts. Typically, in rising markets or stable rate environments, refinances represent 25 percent or less of AAA's new loan volume; currently refinances make up more than 50 percent of AAA's volume.

Smith realizes profits are very vulnerable given refinance sensitivity to rate movement. So, he simulates the negative and positive impact of refinance production changes to the origination budget. Next, he uses a portion of the profits over budget to purchase coverage against rising interest rates. This action offsets some anticipated excess overhead risk. Smith now can turn his attention to other matters, comfortable with his company's new profit management approach.

A view from the top

The following is an excerpt from AAA President Nile's opening statement at the firm's first meeting of its shareholders:

"AAA begins a new era of stable earnings growth, the greatest stumbling block to consistent stock performance. Stability of earnings eludes many mortgage bankers, but we worked hard to design ways to avoid this historical problem. The board of directors and senior managers desire stable earnings growth, while considering the various risks facing the institution. I highly commend Jonathan Smith and Jennifer Ortega for their efforts in discovering ways to manage profits more effectively.

"Our self-examination revealed a pipeline risk-management system incompatible with earnings stability. Though we used traditional interest rate risk-management methods, we focused on immediate risk rather than anticipating and hedging the impact to income under different interest rate environments.

"Now we measure the potential gain or loss of the mortgage pipeline and corresponding hedges as rates change over time. Thus, we connect risk management with earnings stability. We call our new way of managing interest rate risk, the 'profit management approach?'"

Les Parker, CMB, is director of mortgagebacked securities for First Financial Government Securities, Inc., Tulsa. Greg Crosby, CPA, is chief-financial officer and research director for First Financial Government Securities, Inc.
COPYRIGHT 1993 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Title Annotation:mortgage banks hedge profits to soften effects of fluctuating interest rates
Author:Parker, Les
Publication:Mortgage Banking
Article Type:Cover Story
Date:Mar 1, 1993
Previous Article:View from the secondary.
Next Article:Cultures in transition.

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