Our last post provided a simplified example of a hedging approach for your pipeline of servicing assets during a market rally. The good news is that the same approach provides stable margin in down markets as well. When MBS prices fall, the loan asset hedge described in our earlier posts provides protection. In such markets, one expects the servicing asset to appreciate, due to the expectation of slower prepayment speeds for pipeline loans. Leaving aside complicating factors like changes in fallout rates, the MSR/SRP hedge approach described before still serves its purpose - to protect originally priced margin. The chart below shows how this would have worked out in a 3 week long selloff.
If you remember our earlier posts, you already know that the chart above tracks the movement in the MBS market, showing how the MSR/SRP value can cause margin erosion even when the market rallies. The grey line shows the loan value (without the MSR/SRP), which is hedged. The red line tracks hedge effectiveness – the change in margin on the loan, where 100% means that the priced margin has been protected.
In a selloff market one would expect the MSR to gain value. Of course, hedging the asset usually gives away the upside opportunity in favor of stability. In our example case, we see about a 1.5% improvement in margin, vs. about a 6%+ if we weren’t hedging both the loan and the SRP, delivering lower P&L volatility. Hedging mission accomplished!
We have seen how savvy lenders who hedge the total interest rate risk of their pipeline – both the loan and the SRP – benefit from less P&L volatility, lower bid/ask expenses, and less erosion of profit margin in times of market volatility. In practice, it is critical for that lender to model the price sensitivity of each SRP asset in the pipeline so that they can most accurately model the amount of MBS they need to incorporate in their total hedge. Additionally, lenders need to make sure they are able to explicitly view and track the SRP risk associated with their pipeline so they can best understand the impact of this component on their monthly profitability.
Lenders can accomplish this task by modeling the price of the SRP asset in a servicing cash flow model, like our CompassPoint™. This allows them to see the changes in SRP valuation in up and down market environments. Due to servicing valuation considerations that are beyond the scope of this discussion, the changes in loan and SRP values will not be one-to-one for a given change in MBS prices. By separating out the price sensitives of the loan and the SRP, a lender can see how much less hedge coverage they need to sell in various market environments.
Rallying markets should be cause for excitement, not heartburn. By better understanding the components of daily P&L, lenders can more accurately track, and ultimately hedge, their profit margins. This results in less volatility, reduced hedge cost and greater confidence from management in your business.