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Looking for a better hedge.

If the markets where you lend demand low rates and early locks, T-note futures are definitely worth considering.

Headlines such a "National Recovery Gathers Momentum" or "Unemployment Rate Declines Again" echo the belief of many key players in the economy that we are truly on our way out of the deepest, longest recession since the 1930s.

Most of us in the mortgage industry expect a gradual shift from refinances to purchase mortgages during the balance of the year. But some regions, particularly some western states, are still several quarters--if not years--away from recovery. Southern California's aerospace industry will be forever downsized, while The Boeing Co., a dominant employer in Seattle, is losing contracts to European consortiums.

Should West Coast originators be discouraged? Not at this writing. At the start of April, for the third time in 15 months, interest rates had reached new lows and the refinance market was thriving.

Coupon interest rate data reveal national lows for 10-day delivery to the sponsored agencies on January 7, 1992 at 7.9 percent, a second dip to 7.39 percent occurred last August 20, and a third trough of 7.25 percent hit on March 8, 1993.

The voters and credit markets combined to raise rates around last fall's election, and the boldest of prognosticators failed to predict this third drop in rates. But the current lows are sufficient to bring back year-earlier refinances for a second refinance. Even those borrowers that stood on the sidelines last fall are not missing out on the attractive rates available in the spring of 1993.

So the pipeline is humming, and mortgage bankers are selling whole loans and pools to Fannie Mae and Freddie Mac at a brisk pace.

Master commitments with Fannie Mae and Freddie Mac allow originators to sell each day's loan commitments forward 10, 15, 30 or 45 days at the cash windows. Naturally, with the interest rate risk transferred to the agencies, the longer delivery times incur discounts.

For example, take the March 18, 1993, Midanet quotation (pricing data from Freddie Mac). With a note rate of 7.375 percent, the 10-day delivery price was 100.205, translating into a price of $100,205 for a $100,000, 30-year fixed loan with a coupon rate of 7.375 percent. This 10-day delivery presumes the loan has cleared underwriting and is about to fund.

Otherwise a longer delivery is required. The same loan that day would sell at 99.788 for 30-day delivery and 99.638 for a 45-day delivery. The longer delivery creates a loss of $567 on the $100,000 loan compared with a 10-day delivery. Yet most originating environments require a loan commitment to borrowers to be at a competitive rate. This frequently means a forward sale.

Market pressures are demanding that the lender quote rates as low as the competition, provide a loan commitment to the borrower at an early stage of processing and sell forward to avoid interest rate risk on that loan. If rates rise while that commitment is outstanding, the borrower will most likely "put" it to the lender, in the option sense, completing the loan without fallout.

Without the forward sale, the lender would have to sell the approved and funded loan into the 10-day delivery. With higher rates, this will guarantee a loss on delivery. Without another strategy, such as portfolio lending, hedging methodology or securitization, that's the only game in town for competitive markets.

Mid State Bank, headquartered in rural Arroyo Grande, California, has found another means of dealing with interest rate risk. With 24 branches on California's coast, this community bank shares common motivations with other medium-sized originators across the country: market share, product expansion, earnings potential, growth and servicing portfolio income. But these originators also tend to suffer from a common deficiency--a lack of resources including well--trained personnel who possess the essential skills to manage the mortgage pipeline with sophisticated hedging and securitization techniques.

How does Mid State deal with this dilemma? Community banks typically have a loyal following among their customer base and, in non-metropolitan areas, they may face less demand for extended interest rate locks for customers. Mid State has devised a clearly successful fundamental approach.

Operating as a Freddie Mac and Fannie Mae seller/servicer, all loans are sold through the cash window. Because of modest competition and customer loyalty, no rate locks are given at the time of application. A loan commitment can be provided, with the rate floating. Then, when underwriting has approved the file, the borrower is notified, the secondary marketing manager provides the par, or better, 30-day delivery note rate to the customer, and the borrower's documents are drawn with his/her approval.

This eliminates all lender interest rate risk in rising markets. The 30-day delivery allows sufficient time to complete escrow activities, rescission, funding and closing.

Alternatively, this bank will on occasion wait until after the loan has closed, at which time it's sold on a 10-day mandatory delivery basis. The upside of this maneuver is a price from Freddie Mac or Fannie Mae that's 20 to 25 basis points better than the 30-day delivery. The downside, of course, is the rate risk created while the loan is in inventory. With either approach, lenders such as community banks in less competitive markets can transfer most of the rate risk over to the borrower.

Of course, mortgage bankers without strong customer loyalty don't have Mid State Bank's luxury of floating the note rate until approval. But 45 days is typically enough to close a new loan, with 30 days being a bit too brief a time period in most instances. So the simplest strategy is to sell new loans forward 45 days prior to their approval. Unfortunately, there is a half point or more cost to this action as noted.

Another alternative for the not-so-big originator is to hedge the forward-sold pipeline using Chicago Board of Trade (CBOT) interest rate futures contracts. The CBOT array of instruments includes Treasury bill futures, 5-year Treasury notes, 10-year Treasury notes and Treasury bonds of 15-years or longer maturity.

We suggest the contract best suited for pipeline hedging is the 10-year Treasury note. Although not as large a market as the Treasury bills and bonds, typical trading involves $20 billion in open interests, or the face value of the futures contracts currently outstanding. This market breadth is sufficient to prevent a few players or trades from affecting the general trend of yields and prices.

The dollar cost of trading for each contract is merely the initial margin of $1,350 plus transaction costs of $20 or so in the form of commissions. Accounts are settled daily so that profits can be withdrawn immediately, providing the maintenance margin of $1,000 remains in the broker's account.

What distinguishes the ten-year T-note from the other Treasury futures is its duration. Traditionally, both mortgages and ten-year T-notes have had durations of from six to ten years, however, mortgage durations have been foreshortened considerably in the past two years due to refinances. Because duration is an interest rate-sensitive measure of a security's maturity, given its initial price and future cash flows, 30-year mortgages and 10-year notes essentially have similar maturities.

This is important because as market interest rates change, price changes in the two dissimilar securities tend to be strongly correlated. Finally, the underlying Treasury note security has an approximate 8 percent coupon rate. This is not far from recent 30-year fixed rates, again suggesting good price behavior correlation between mortgages and 10-year Treasury-note futures.

Using Treasury-note futures contracts to hedge the mortgage pipeline is known as cross hedging. Much of the following discussion will reveal just how effective this cross-hedge technique can be.

Consider these two mortgage pipeline interest rate risk management strategies: The first alternative is to quote borrowers' competitive rates, given the 10-day delivery par or better coupon yield. But the loan cannot be closed for 35 or 40 days, so we sell forward for 45-day delivery. Of course we suffer a $500 or $600 cost due to the lower price received with the longer delivery.

The second alternative begins with the same coupon rate quote to the borrower, based on the par or better yield for 10-day delivery. But this time, we don't sell forward at all. Instead we initiate a trade in the futures market, selling short one Treasury-note futures contract.

Why sell short? Think for a moment about interest rate-sensitive securities such as mortgages, corporate bonds and Treasury issues. As rates rise, prices fall. Our risk with the unsold loan when the rate is already locked is that its price will decline as time elapses and rates rise. We plan to sell it for 10-day delivery approximately 30 days after the loan commitment is given. By that time we could experience a loss of several points.

If, as we grant locked loan commitments, we sell short a futures contract, we are covering most, if not all, of the exposure to loss on the mortgage. The value of the short position on the contract will increase as interest rates rise. It's somewhat analogous to the short sale of stock. Sellers are betting on declining prices. They receive their cash inflows at the beginning of the transaction, when prices should be highest.

The short in the futures trade also expects prices to be declining and receives daily settlements to the account as prices decline (as a result of rising rates). As time elapses and the mortgage loses value, the futures contract account balance increases for the short, offsetting the losses.

Rules of thumb

Two rules of thumb for hedging are readily apparent. The first is that you want to receive your inflows when prices are highest. The second rule states rising rates require selling short. Because our concern is over rising rates, we follow the second rule. And by initiating the trade when interest rates are lower (at the beginning), we have received our inflows when prices are highest.

So how does this all work out? Using data from the first three months of 1993, we find the cost of selling forward, our first alternative, given in Figure 1.
Loan amount $100,000
Type 30-year fixed
Average 10-day par or better price $100,306
Average 45-day price, same note rate $99,813
Average loss on forward sale $493

The loss is close to half a point on each loan. What if we had sold into 10-day delivery (the second alternative)? Figure 2 reveals the gains that would have been made, due to declining interest rates during 1993's first three months.
Length of time for float 28 days
Average coupon rate 7.86 percent
Average 10-day price at lock date $100,315
Average sale price for 10-day delivery $101,778
Average gain/loss on sale $1,463

Of course the risk is that this gain figure would have been a loss, due to rising rates. And if it had been close to zero, we would expect the originator to be profitable.

What if we had hedged in a naive fashion, selling short one futures contract for each $100,000 loan on each business day for the first three months of 1993? The outcome follows in Figure 3.
Length of contract holding period 28 days
Average short sale price (inflow) $107,427
Average liquidation price $110,309
Average loss on futures trading $2,882

The losses from hedging with 10-year Treasury-note futures are almost double the gains from declining mortgage rates with the 10-day delivery sales during this period. Clearly, the naive hedge during this period proved more expensive than the first alternative, that of selling forward into 45-day delivery.

Why are the futures contracts doubly sensitive to market interest rates? We suggest several causes. Mortgage pricing is determined by Fannie Mae and Freddie Mac, not through open market conditions such as exist at the Chicago Board of Trade. The pricing departments at Fannie Mae and Freddie Mac seem to have more "inertia," providing a more stable market environment to their seller/services.

Mortgage investors tend to be wary of falling rates due to the unique pricing characteristics of whole mortgages and mortgage-backed securities. During declining rate markets, price compression and negative convexity affect investors' perceptions, limiting the degree of premium pricing.

A third factor may be that with lower interest rates experienced in the Treasury-note market, the duration of the underlying security--the 10-year Treasury note--is considerably longer than the duration of mortgages, especially in a refinance market. The longer the duration of a cash flow, the more sensitive it is to changing market interest rates.

One quick improvement to the hedging technique is obvious from the results observed during this period. Sell short in the futures market 50 cents on the dollar for each mortgage. Figure 4 provides the results of this revised naive hedge.
Average gain from 10-day delivery $1,463
Average loss on futures ($2,881/2) $1,441
Overall gain or loss from hedging $22
Earlier losses from 45-day delivery $493
Savings by hedging $471

By hedging, we save 95 percent of the losses incurred during this period merely by selling forward. What's to stop your secondary marketing group from jumping right into the hedging arena by trading futures?

Two key issues--we don't know how good a technique this is for the future, or the cost of implementing such a program, both in transaction costs and staffing.

We contacted the CBOT futures marketing office to learn that typical transaction costs for an active trader through an existing investment banking firm run $20 to $30 for each roundtrip trade. In our examples, this would be the cost for each $200,000 in mortgage originations. By far the major cost is for staffing for an in-house hedging specialist or manager. Start with salary/employee benefits, then consider training, hardware and software. Another approach is to hire outside consultants to hedge on the firm's behalf, perhaps the only feasible solution for mid-sized originators. But given the results of Figure 4, the economic incentive at least during this time period was clearly there to investigate hedging.

From our data over the first three months of 1993, we enhanced our understanding of how effective this hedging technique would be in the future. Figure 5 provides the results of regressing the losses on futures trading against the gains from sale into 10-day delivery.
Number of observations 32
X coefficient -.512
R squared .499

The results of regression suggest several insights. The appropriate hedge ratio is 51 cents per dollar of mortgage originations. The minus sign in front of the X coefficient implies selling short. Finally, the low R squared signifies that only 50 percent of the variation in the prices of Treasury-note futures contracts can be explained by price changes in mortgages into 10-day delivery. The two markets simply are not strongly correlated, typical of cross-hedging techniques.

Should your firm investigate this or a similar hedging program? The answer lies in the cost of staffing and facilitating the program. Better instruments may be available; for example, the five-year Treasury note, or options on over-the-counter mortgage-backed securities. What you would be seeking is a hedging security more highly correlated to mortgage pricing.

The bottom line is that when faced with competitive market pressures, demanding both low mortgage coupon rates and early rate locks for borrowers, hedging with Treasury-note futures contracts can cut losses to a minimum in the long run. Try our approach instead of selling forward 30 or 45 days. We think you may well be pleased with the results.

Dan Guisinger is mortgage operations director at Mid State Bank, Arroyo Grande, California. Ralph Battles is the real estate finance instructor at Cal Poly State University, San Luis Obispo, California.
COPYRIGHT 1993 Mortgage Bankers Association of America
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Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Author:Guisinger, Dan; Battles, Ralph
Publication:Mortgage Banking
Date:Jun 1, 1993
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