Using Eris Swap Futures to Hedge Mortgage Servicing Rights

Transcription

1 Using Eris Swap Futures to Hedge Mortgage Servicing Rights Introduction Michael Riley, Jeff Bauman and Rob Powell March 24, 2017 Interest rate swaps are widely used by market participants to hedge mortgage servicing rights. Recent regulatory changes are pushing institutions to avoid so-called over-the-counter (OTC) transactions in favor of those cleared by a central exchange. This paper will examine the Eris swap futures contract as a potential hedge for mortgage servicing rights. In addition to discussing the features and benefits of the various interest rate hedging instruments, it is of critical importance to consider the cost implications in determining best fit for a capital-efficient interest rate hedge. The value of a mortgage servicing rights portfolio is primarily driven by changes in prepayment expectations. While housing turnover is an important component to a prepayment forecast, refinance activity tends to be a much more volatile factor. Refinance activity is a direct function of the difference between the interest rates of the underlying mortgages and the interest rates available to the mortgagors at any given point over the life of the loan. While the number of risks that an owner of mortgage servicing rights can hedge is limited, the biggest one the general level of interest rates may be hedged through a number of different financial instruments. Hedging Instruments Among the different options available for hedging long term interest rate risk, the most commonly used are Treasury notes (or futures), interest rate swaps and mortgage-backed securities. There was a time when Treasury notes were the predominant choice, but there are certain operational disadvantages to using Treasuries. For one, the supply of Treasuries can be tied up on the balance sheets of Federal Reserve Banks, commercial banks, sovereign wealth funds and mutual funds. Moreover, the supply of Treasuries is largely dictated by the budget of the Federal government. It may seem preposterous now, but there was a time in the early 2000s when market participants were legitimately concerned that budget surpluses would eliminate the need for the Treasury to issue longer term notes and bonds. As a result, the LIBOR interest rate swap market became the benchmark of choice for financial institutions. Treasury futures are still widely used by smaller institutions that don t have the back office infrastructure to manage a portfolio of swap positions; however, that barrier to entry has largely been eliminated by the introduction of the Eris swap future product. Mortgage-backed securities (MBS) are also used by many institutions, but they present their own challenges in terms of modeling and convexity risk. Whereas the goal of a hedging program is to reduce risk, relying solely on MBS can be dangerous. Most institutions use MBS alongside Treasuries or swaps to manage rate risk on a servicing portfolio. The focus of this paper will be on using swaps and swap futures. For more information about using Treasuries or MBS, please contact the authors. Modeling Prepayments This paper will not attempt to go into the intricacies of consumer behavior modeling. It should be assumed that this is an activity with a high degree of error and uncertainty. For the sake of this exercise, we shall assume that all variables such as FICO, LTV, geography, home price expectations, loan age and seasonality have been solved for and we are left with a simple model for prepayments as a function of some baseline primary mortgage rate MountainView Risk Advisors and R.J. O Brien. All Rights Reserved. Page 1

2 However, determining the level of primary mortgage rates available to borrowers is easier said than done. Rates available from different lending institutions can vary widely on any given day. There are a number of surveys available, but even those tend to differ significantly. Moreover, survey results are published on a delay from actively traded observable rate indices. Most importantly, primary rates are not actually tradeable and thus cannot be used directly to hedge against rate changes. For the purpose of quantifying and hedging risk, a servicer needs to be able to forecast changes in primary rates across a variety of different scenarios. We will use a simple example as one possible method for doing so. If we take a historical sample of the Freddie Mac Primary Mortgage Market Survey 30 year rate and do a simple linear regression against the 10 year swap rate over the past decade, we come up with the following function: F = 0.825x where x is the 10 year swap rate. In other words, we can assume a 100 basis point move in the 10 year swap rate will results in an 82.5 basis point move in the primary mortgage rate. If we can quantify our exposure to the primary mortgage rate, we can construct an appropriate hedge using 10 year swaps. There is a question left open by this methodology. How does our valuation process handle a large divergence between the observed rate and our modeled rate? The solution employed by the majority of modelers is to add a mean reversion component to their rate function. This assumption is well supported by statistical analysis of the data and common sense modeling practice; however, determining a mean reversion parameter requires some sophisticated statistical analysis. Once again, please contact the authors of this paper for more info. For the sake of simplicity, we will assume that mean reversion is instantaneous and that our modeled rate function is sufficient for determining the level of future prepayments. There are numerous proprietary prepayment models available. The two most commonly used are those developed by Andrew Davidson & Co. and Black Knight Financial Services, but there are others available as well. For the sake of this example, we will assume a simple linear relationship between primary mortgage rates and prepayment rates given by the function P = F If we substitute our primary rate equation for F, we arrive at the following function: P = x Calculating Interest Rate Exposure Once we have a model for forecasting prepayment rates as a function of interest rates, we can project the future cash flows on our servicing portfolio. Suppose that we have a $100 million UPB fixed rate servicing portfolio with a net servicing fee after expenses of 20 basis points, a weighted average note rate of 4%, and a remaining maturity of 300 months. If we discount our cash flows at constant rate of 10%, we arrive at the following values: Scenario Swap Rate CPR Undisc CF 968,568 1,052,421 1,098,796 1,148,510 1,201,878 1,259,252 1,387,618 Value 662, , , , , , ,316 This scenario analysis implies a dollar value change per basis point (DV01) of -$938 at the November 30 th 10 year swap rate of On this date, the DV01 of the Eris 10 year swap future was -$89 per $100,000 face amount, so we would want to execute 11 contracts for a total face amount of $1,100,000. Please note that the sign convention on the swap futures is not how a bond trader would normally think of long and short. The swap futures assumes that to buy is to receive floating/pay fixed and to sell is to receive fixed/pay floating MountainView Risk Advisors. All Rights Reserved. Page 2

3 If we back-test this trade over the month of November, we see an excellent correlation between asset and hedge as graphed in the figure below. Eris Swap Futures The Eris swap futures product presents a number of benefits to a mortgage servicing hedger over a traditional interest rate swap. Some of those advantages include: Operational efficiency because this is an exchange traded product with a centralized counterparty, the need to remit and account for cash flows is greatly reduced. It also eliminates the need to maintain agreements with multiple counterparties. Single coupon and uniform forward start dates while a bond hedger may be ambivalent about this feature, it is of great value to a MSR hedger who needs to frequently rebalance his or her position and needs the ability to roll forward quarterly to maintain exposure to a rolling rate. Unlike with a bond, yield curve exposure does not shorten as a MSR portfolio ages. Bilateral margining a hedger would need to post margin if his or her trades moved out of the money, but he or she could withdraw excess margin as trades move into the money. Pricing transparency bid and ask prices are quoted on Bloomberg, and all trades are netted. There is no concern about a single liquidity source to unwind a trade. Estimated Cost Differentials Among the Three Swap Derivative Alternatives When entering into an interest rate swap contract, there are three choices for doing so: bi-lateral over-the-counter swaps, cleared swaps and interest rate swap futures. Each option has advantages for certain situations. [1] Bi-Lateral OTC Swaps---Traditional execution between two counterparties. Initial margin or performance bond by the end user, the MSR hedger, is not required (as it is in the Cleared Swap or Swap Futures universe) at the outset of an OTC trade, a characteristic attractive to many market participants. However, there will usually be an accompanying credit support annex (CSA), which lays out the terms under which monies are transferred or posted between the two participants. This feature reduces credit risk as the value of the derivative moves. Note though that payments are frequently asymmetric---the end user might have to post at a much lower threshold than the dealer, if the dealer has to post at all. There is also a Credit Valuation Adjustment (CVA). The CVA is the price of the default risk for the institution hedging its risk. This will vary of course, but it could be 2 bps, 5 bps, or more. For the purposes of this paper, we will minimize discussion of this term and roll it all into a spotlight on the bid/ask spread; the true source of cost for MSR hedgers utilizing bi-lateral OTC swaps. Whether it s because the swap dealer has to reserve capital per regulatory requirements and/or it s simply a price the market will bear, bid/ask spreads can be 1bp or more from mid, both on the way in and the way out of the trade. Many MSR hedgers employ a Key Rate Duration methodology. This methodology requires periodic adjustments to hedge positions throughout the year. The more 2016 MountainView Risk Advisors. All Rights Reserved. Page 3

4 volatile the markets are, the more adjustments are needed resulting in higher costs for the MSR hedger. [2] Cleared Swaps---Traditional (standardized) swaps cleared on an exchange. Initial margins are posted by both parties and the exchange actually steps in as counterparty to the trade itself, eliminating counterparty risk. This is an outgrowth of the Dodd-Frank Act and bridged the gap between traditional principal-to-principal basis and the futures markets. The costs for Cleared Swap accounts may involve a monthly minimum charge, and the amount will vary among the dealers. The margin post required for clearing a swap is based on a 5-day Historical Value-at-Risk ( HVaR ). In practice, this margin calculation results in a required post anywhere from 2.5% to 4.0% of the underlying notional amount. [3] Swap Futures---Futures are the wholesale markets for pricing in interest rate space. For several decades, dealers have been referencing or calculating implied rates off the interest rate futures curve, adding in x bps in their pricing to the end users, and then coming back to the futures markets again to lay off their risk, Initial margins are posted by both parties and the clearinghouse (CME in this case) actually steps in as counterparty to the trade itself, eliminating counterparty risk. The margin post is based on the CME SPAN methodology which can be approximated using a 2-day Value-at-Risk ( VaR ). In practice, this margin calculation results in a required post anywhere from 1.5% to 2.0% of the underlying notional amount. Example of $500,000 dv 01 (proxy: $770MM of 7yr receiver to arrive at $500k dv 01) 2016 MountainView Risk Advisors. All Rights Reserved. Page 4

5 Additional Commentary It should be noted that modeling prepayments and mortgage servicing cash flows is considerably more complicated than the example used in this paper. There are numerous other factors that impact value beyond those highlighted above. In addition, many of these assumptions, both with respect to servicing assets and their hedges, may vary from one institution to the next. While there may be internal reasons for a company to choose any one of the hedging alternatives mentioned above, we believe from a pure economic evaluation, the Eris swap futures product provides a distinct cost advantage. Please reach out to a representative from MountainView or R. J. O Brien for more information. The views expressed herein reflect the opinions of the authors and are based upon hypothetical data and information. This material has been prepared for informational purposes only and is not a recommendation to buy or sell any security, financial product, or instrument or to participate in any particular hedge strategy MountainView Risk Advisors. All Rights Reserved. Page 5