The Challenges Of Hedging Enterprise Interest Rate Risk

Written by Rob Kessel & Bob Gundel
on March 06, 2013 No Comments
Categories : Required Reading

13417_duediligence The Challenges Of Hedging Enterprise Interest Rate Risk REQUIRED READING: When lenders think about their company-wide – or enterprise – interest rate (IR) risk, they often compartmentalize the sources of risk, isolating and analyzing each component of the risk individually instead of looking at the overall risk to the firm that a given move in rates can cause. While it is vital to understand the individual components of IR risk, failing to look at the broader enterprise IR risk profile can lead lenders to make decisions with incomplete information.

Lenders who view IR risk from a more global perspective can make better strategic decisions and investments, better prepare their firms for adverse rate environments and more effectively manage their earnings volatility.Â

When thinking about a lender's enterprise IR risk, we can identify three principal components of the lending business where changes in interest rates can affect the firm's profitability: (1) originations; (2) secondary (pipeline) operations; and (3) servicing that includes both pipeline servicing values – whether released-service release premiums (SRP) or retained – and the mortgage servicing rights (MSR) portfolio.Â

Let's briefly consider the IR risk associated with each component.

Originations. As interest rates decline, houses become more affordable, more refinances are available, and origination volume (and often margins) increase. There are more transaction profits (division net income) from more loans and higher margins. Rate increases lead to the opposite effect with more concern about fixed costs and breakeven volumes.

Secondary operations. As interest rates decline, the pull-through (estimated loan closings) decreases, leading to possible hedge mismatch. Increased rates lead to a higher pull-through, also leading to hedge mismatch.

Servicing. As interest rates decline, prepayments increase, leading to loss of MSRs (or lower SRP) and possible asset impairment. Interest rate increases lead to fewer prepayments and higher MSR/SRP values.

Although each component of the business has risk exposure to changes in interest rates, the magnitude of the risk and the tools and strategies to manage each component's IR risk differs. Understanding how the risk of the individual business component works, and weighing and combining that risk across the firm, is paramount to any successful enterprise IR risk hedging program.

In order to develop a better understanding of the total enterprise risk, let's take a closer look at the risks associated with each individual component.

Origination IR risk

Origination sensitivity to interest rates is one of the more complex and challenging components of IR enterprise risk for lenders to model and plan. That being said, it is also one of the most important drivers of a lender's profitability and overall financial health.Â

Interest rate levels are the largest drivers of origination volume and purchase/refinance characteristics of mortgage pipelines. When rates decline, homes become more affordable to borrowers via lower payments, and borrowers with existing mortgages look to refinance – which typically causes both origination volumes and the percentage of refinances in the pipeline to increase. In a declining rate environment, as volume increases, lenders tend to widen out profit margins due to pipeline capacity issues (i.e., they desire to slow production through less competitive pricing).Â

Low-rate, high-margin, high-volume environments have the potential to be the most profitable for mortgage bankers if they analyze and manage their risk effectively, as well as avoid over-extension. Conversely, when rates are on the rise, pipeline volumes contract as homes become less affordable and the economic benefit of refinancing decreases.Â

When rates are on the rise and margins and pipeline volumes are thin, it is especially important to understand and manage how these declining volume and margins relate to available cash, balance sheet health, fixed and variable cost structures and the resultant profitability of the firm. Lenders adjust margin levels based on the competitiveness of origination landscape, shrinking profit margins when they want to put out more competitive pricing to the street, in the hopes of increasing market share. When the origination landscape is highly competitive, loan officer compensation levels also have the potential to increase as lenders pay up in an attempt to retain their existing talent. Â

Lenders desiring to model origination IR risk in the enterprise context need to define their assumed production, margin and cost changes given a movement in interest rates, as well as fixed and variable revenues and expenses.Â

When a lender's specific assumptions are implemented within robust analytics, a net present value (NPV) of future cashflows can be derived across different interest rate scenarios (shocks). This analysis not only quantifies origination IR risk, but also produces future impacts on the lender's cash position and balance sheet health, given those rate scenarios. Â

Lenders can use this analysis to better prepare themselves for varying future interest rate environments and can take preventive measures to manage and reduce earnings volatility. Modeling and understanding where breakeven volume/margin/origination levels exist is of the utmost importance, particularly during times of heavy competition or slow originations, when lenders can be tempted to make potentially suicidal cuts to profit margins.         Â

Pipeline risk

The interest rate risk of the mortgage pipeline is another component of enterprise risk that needs to be understood, modeled and managed. When rates move, it impacts the pricing of pipeline loans and hedge instruments, alters hedge ratios – hedge ratios help determine how much to buy or sell of a given hedge instrument – and alters the estimated percentage of loans in the pipeline that will pull through and close.Â

By granting a borrower a loan lock, lenders are locking in interest rate exposure for the defined lock period. The market value of that loan lock fluctuates with changes in interest rates, with the market value decreasing when rates rise, and increasing when rates decline.Â

The conundrum faced by hedgers is that when rates decline and the loans in their pipeline have market related gains, they typically pull through and close a smaller percentage of the pipeline, whereas when rates increase and loan locks experience market related losses, they typically pull through and close a larger percentage of the pipeline. Because of this sensitivity to rates and corresponding changes in value and pull-through, lenders who sell mandatory typically hedge their loan pipelines in order to offset the interest risk exposure of their loan locks and funded inventory held for sale. Additionally, rate movement impacts the MSR/SRP component of pricing for loans in the pipeline.Â

When rates move, it impacts prepayment assumptions (CPRs), as loans become more or less likely to refinance, which causes changes to base and excess MSR values. Agency buy-up/buy-down multiples are subject to the same dynamic. Having strong MSR/SRP analytics is important in the pipeline model, even if the lenders don't retain or have plans to retain in the future, as they are still subject to investor changes in SRP and buy-ups/buy-downs when prepayment speeds change during the lock period.

Understanding how MSR/SRPs are likely to change in value and adjusting hedge coverage appropriately to offset these changes is a key piece of managing pipeline risk. In order to model the impact of interest rate changes, lenders perform an interest rate shock on their pipelines to predict the likely changes each component identified above will experience in different rate environments.Â

Servicing IR risk

The final component of enterprise risk is the interest rate risk of the MSR portfolio. The value of an MSR is equal to the NPV of the expected net future cashflows of the MSR asset given certain assumptions.Â

One key assumption – prepayment speed – is the largest driver of MSR values, as prepayment assumptions are used to calculate how long the servicer is supposed to receive servicing cashflows. Since prepayment speeds are the largest driver of MSR value, MSRs are positively correlated to interest rate levels; when rates increase, MSRs gain value as prepayment speeds decrease. Conversely, when rates drop, MSRs lose value as borrowers look to refinance, which increases prepayment speeds.Â

Prepayment speeds are rate path dependant, meaning that we need to make assumptions and model future rates in order to derive their value. So not only are MSRs sensitive to the current rate environment, but they are also sensitive to how we are modeling future rates and expected future prepayments. In order to model the impact of interest rate changes, lenders perform an interest rate shock on their MSR portfolios similar to the shock performed on the pipeline.Â

Putting it together

Now that we've identified the principal IR risk components that comprise a lender's overall enterprise risk, we can start to measure and model the magnitude of risk a given move in rates has on a lender. What we find when we look at risk in the context of the total enterprise is that the different components of risk may partially offset each other, but often vary greatly in order of magnitude.

The interest rate risks associated with the pipeline, although non-trivial, can be modeled and hedged with a reasonable level of assurance and accuracy in most market environments. That leaves us with originations and MSR portfolio elements of IR risk to consider.Â

We also need to consider the negative correlation between MSR values and origination volume and profitability. When rates decrease, MSR values decline, as refinances increase and MSR portfolios experience runoff. Conversely, when rates are declining, origination volumes increase and profit margins tend to widen out.Â

As loans fund and are sold in a low-rate, high-volume, high-margin environment, they are replacing loans in the MSR portfolio that have paid off, helping to avoid an impairment. Conversely, when rates are rising, and production and profit margins are contracting, MSR values are increasing as higher rates equate to a decrease in prepayments (both modeled and actual), which can strengthen lenders' balance sheets. Additionally, the servicing income lenders earn during times when originations are slow and margins are tight helps to replenish the cash position and maintain the operating budget. This offset in value between originations and MSR creates what is often known as the ‘production’ or ‘natural’ hedge.Â

The effectiveness of this natural hedge is completely dependent on the size of originations and the MSR portfolio. Enterprise risk managers are keen to quantify the exact magnitude of these value changes.

By fully understanding the interest rate risk of each individual component, and weighing that against the overall risk of the greater enterprise, lenders can concentrate and focus their hedging strategies on the areas that have the most impact to the firm's profitability and overall financial health.

Rob Kessel is managing partner and Bob Gundel is senior hedge manager at Compass Analytics LLC, headquartered in San Francisco. They can be reached at (415) 462-7500.

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