3 Ways Mortgage Pipeline Hedging Helps Manage Risk

Sounds complicated? It is. First things first. What is a mortgage pipeline? In its simplest terms, the mortgage pipeline refers to the backlog of lender’s mortgage applications that have locked-in an interest rate but are still waiting to be approved by the lender.

In addition, many banks and lending institutions sell groups of mortgages to a purchasing agent such as Fannie Mae or Freddie Mac who then package the loans like mortgages into mortgage-backed securities to be sold on the secondary market to investors. The mortgage pipeline also refers to the pipeline of those loans that have closed with a lender and are waiting to be sold to the purchasing agent.

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1. Managing The Mortgage Pipeline

A mortgage loan stays with the mortgage originator or lender until one of the following happens:

  1. It falls out, meaning the loan process does not complete and fails to close
  2. It is sold to a purchasing agent to be sold in the secondary mortgage market
  3. It stays in the originating lender’s loan portfolio.

Due to the complexity of mortgages and the lengthy process to close on a mortgage loan, fallouts can occur when potential borrowers seek financing elsewhere usually when interest rates drop or the loan does not proceed to close for other various reasons.

The chance of a mortgage actually closing and being funded increases as the loan progresses through the various stages of the process as the potential borrower is less likely to seek financing elsewhere. Mortgage servicing rights valuation may also help by offering tools and assistance with all your mortgage needs. When a loan closes, the bank or mortgage originator is obligated to provide the client with mortgage financing at the locked-in interest rate regardless of the changes in the interest rate since the time of lock-in.

2. Hedging To Offset Risk

When a potential borrower locks in an interest rate to buy a home, fluctuations in prevailing rates during the period between when the rate is locked in to loan approval exposes banks to interest rate risk. Mortgages in the pipeline are hedged against interest-rate movements. Hedging is complicated and takes into account such things as fallout risk – which is the risk that loans in the pipeline fail to close and pull-through ratios –the likelihood that a loan commitment will be funded.

Not all loans that are in the pipeline will close and become a mortgage loan for sale in the secondary market. Variations in interest rates and time to closing affect fallout rates, with rising rates usually increasing the borrower’s incentive to close and vice versa. Using hedging to manage interest rate risk uses the concept of offsetting interest rate risk with an inverse financial instrument.

By creating an offsetting financial event that is the direct inverse to the value change of the underlying hedged asset- in this case a mortgage asset-the risk is offset. In the case of a mortgage asset, if interest rates increase, there will be a corresponding decrease in the value of the mortgage asset and vice versa.

3. Buying Long And Selling Short

Hedge transactions also often use a combination of buying long and selling short. These transactions serve to offset or cancel the effects of changes in the interest rate, which help to maintain the value of the underlying asset or mortgage in this case. For example, if interest rates rise, the short position goes up the same amount that the long position goes down and the value of the underlying asset is preserved.

Hedging can be used to offset risk but the process can be daunting. It is a very complicated process that involves many complex calculations, intricate concepts, and the use of a variety of financial models to determine the risks and outcome.  Determining the actual transactions to accomplish this is complicated and is best left to experienced financial managers and those who have a history of hedging experience, preferably in mortgage-backed securities.

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