Demystifying Hedging Strategies in a Volatile Market | Nov. 11, 2024

Alex Hebner: 00:00:31

Welcome to Optimal Insights, your weekly source for real time rate data and expert capital markets commentary brought to you by Optimal Blue. Let's dive in and help you maximize your profitability this week.

Jim Glennon: 00:00:44

Welcome to Optimal Insights, your weekly source for timely market analysis and expert commentary from Optimal Blue. I'm your host, Jim Glennon, Vice president of hedging and Trading client services at Optimal Blue.

Our clients and industry partners have long relied on Optimal Blue for trusted insights and commentary, and these podcasts are an evolution of our commitment to keeping the industry informed. Let's dive into today's episode. Welcome. We have Jeff McCarty, director of product Management.

And of course we have Alex Hebner, one of our wise experts on the desk to give us some econ updates today and some updates about the election. Welcome, gentlemen.

Jeff McCarty: 00:01:19

Thanks for having us.

Jim Glennon: 00:01:20

Thank you.

Jim Glennon: 00:01:21

We'll get an election download from Alex here in a few minutes and some econ wisdom from him as well after that.

We're going to talk a little bit about hedging, something that's very near and dear to the three of us and our teammates on our desk, and we're hoping to demystify it a bit for all types of listeners today. And Jeff, a lot going on as well. Just in the world and in the economy we got election results.

Minimal drama this time around, it feels like, and the market reaction was mostly positive.

We did have a bit of a backup in rates on Wednesday, but we've pretty much given all that back where we've got the OBMMI back down to 6.7 where it was pretty much before the election.

Jeff McCarty: 00:02:04

Yeah, a lot of volatility intraday the past three market days, but really stayed within a range.

And we've been in a range for the past three weeks since the sell off or rise in rates started at the beginning of October that we've talked about on this podcast the past few weeks. So we're really at this point we're in a range of minimal volatility, at least in mortgages.

Alex Hebner: 00:02:29

Right. So volume is struggling, continuing to struggle a little bit. We're ahead of where we were last fall if you look year over year.

But still we've come off of those highs that we saw when rates got down. Right. Close to 6% in September.

Jeff McCarty: 00:02:46

Yeah. And looking at just the past few days, I mean, I think we saw maybe a little bit of.

You've been talking about some of the money sitting on the sidelines, a little bit of a move to equities over the past few days, right?

Jeff McCarty: 00:02:59

Yeah, it's kind of Seemed the day after the election, I think we all are, stomachs dropped a little bit. Major backup in rates. Market sold off like a point in price, but seemed to give all that back like we said in the last few days.

So it is possible that, you know, some of that money that was sitting on the sidelines was in bonds. So you have bonds selling off and then folks turning, investors turning around and spending that cash to invest in stocks.

And then bonds then became attractive again the very next day. So we saw, we saw the market rally and again, you know, getting rates back down to about 6.7 and hitting all time highs in the stock market.

Jeff McCarty: 00:03:36

Yeah, interesting movement and we'll, we'll watch that closely and Alex will get into that a little bit more here in a few minutes.

Jim Glennon: 00:03:42

th of: 2025

So this will be a client exclusive event that'll feature some great topics ranging anywhere from AI trends to profitability strategies to market insights. We're going to have some really great speakers, some internal speakers, but also some really interesting third party speakers.

So Tony Hawk is going to be at the event. Legendary skateboarder Tony Hawk.

Jeff McCarty: 00:04:19

year old self of the early: 2000

Jim Glennon: 00:04:31

Yeah, dude's a legend. I think that's going to be really fun.

And also Mike Frattantoni who is the chief economist for the Mortgage Bankers association, he will also be a guest speaking. So there's some really heavy hitters there and more to come.

Jeff McCarty: 00:04:43

Yeah, some really good content. You know, it's not going to be just exclusively focused on OB functionality, although we will have a good bit of that.

We're going to be rolling out some new features. Again, a lot focused on some AI features, some usability of the OB system. But beyond that it's going to be a lot of more industry general topics.

So, you know, best practices, what's going on in the market. We're going to bring in some guest speakers from clients and from other parts of the industry.

So you know, it'll be a good mix of what's going on within ob, but also just, you know, broader what's going on within the market.

Jim Glennon: 00:05:22

Yeah, no matter who you are in your organization or what your role is, whether you're, you know, broker, loan officer, originator, operations, capital markets. We're going to have something for everybody.

We'll have different tracks depending on what you're trying to, what you'd like to learn, what you'd like to be exposed to. So really well rounded event should be.

Jeff McCarty: 00:05:39

A lot of fun, too.

Jim Glennon: 00:05:40

Yeah, I think we're gonna have a lot of social we're going to have a lot of social events as well. So it should be a really fun event. So Visit our website, summit.optimalblue.com to register. All right, let's go check in with Alex.

Jeff McCarty: 00:05:55

As always, welcome Alex Hebner, our resident econ expert.

Alex Hebner: 00:06:00

Hey, Jeff, thanks for having me.

Jeff McCarty: 00:06:02

You know, why don't you just give us a quick recap of what happened last week with the election?

Alex Hebner: 00:06:06

Yeah, definitely. The election was definitely the most significant event that occurred last week.

I think occupied most all people's minds, whether you're in our industry or not. I mean, I mean, the short of it, Republicans really clean the, clean the floor this time around.

first time. Remember back in: 2016

So this time he has a pretty clear mandate from the American people that he is, he's president of the United States. With winning both the Electoral College and that popular vote and then down ballot as well, Republicans performed equally as well.

They picked up three or four seats in the Senate. They're sitting at 53 of the 100 seats in the Senate right now with one race still undecided down in Arizona.

So they've definitely won the Senate and then the House. They've made, they've made inroads there as well. They've picked up two seats. Democrats have lost two.

There's a larger number of uncalled elections there as well. But they're sitting much closer to that threshold to have a majority of the House.

Jeff McCarty: 00:07:09

One of the things I thought was maybe worth reiterating because, you know, the Republicans did, you know, they kind of have this, this obvious mandate, but just for us specifically.

And Chris Maloney made this point, I think, a couple weeks ago, you know, really no explicit plans like maybe there were, we heard last time during the last Trump administration in terms of the GSEs and what that means, you know, in terms of giving the GSEs out of government conservatorship. Really no talk about that that we've heard of recently?

Alex Hebner: 00:07:43

No, not at all. Housing Housing policy in general played a really small part in this election, despite its outweighed significance to so many voters.

As we've covered for the past couple of weeks, the Trump administration in regard to housing policy is pretty scant.

They have some rough plans of opening up federal land to building, which would, you know, about 30% of the cost of a new home is wrapped up in the land cost and the land value, as Maloney pointed out a couple weeks ago, opening up federal lands, federal lands aren't always in already populated areas.

And so building mass numbers of housing out on some federal land in what is currently a pretty rural area, I would say that that's questionable policy at best. And it's kind of hard to see how that would fix the outstanding issue of millions of homes shortage.

Jeff McCarty: 00:08:36

Yeah, yeah.

So, you know, certainly for probably most of the listeners of this podcast, you know, we're probably looking at just stability overall for the foreseeable future while the, you know, the Trump administration focuses on other sets of policy in the economy or in the government at large.

Alex Hebner: 00:08:56

Yeah, I would agree. I'd see how we would see a major shake up in the US Housing market, barring some sort of downturn.

Jeff McCarty: 00:09:04

All right, so obviously, as we had been talking about leading up, the election was not the only thing that happened last week. We had a Fed decision. Can you review what happened with the Fed decision?

Alex Hebner: 00:09:14

Yep, yep. The Fed decision was much more already called ahead of time.

Everyone was kind of expecting 25 basis points here, with an additional 25 basis points likely to come in December. Really? That one was already kind of decided just based on the data we've been seeing from employment and, and inflation numbers. Powell did get some.

Because this was less than 48 hours after the election.

Powell did get some politically charged questions during his press conference, such as, you know, if Trump were to ask you to step down, would you do so? He was adamant that he wasn't.

But from a strictly economic data perspective, the Federal Reserve decision this time around was pretty mute and was already accounted for by the markets.

Jim Glennon: 00:09:54

So that's the message to take away. Right. Even after all the political questions, the Fed's going to continue to look at data and view their dual mandate. Right.

Keeping employment full and keeping inflation around 2%.

Alex Hebner: 00:10:09

Right, right. A rate cut cycle generally happens in a deteriorating economic environment.

And I think after looking at the past couple of years, you can say that the current environment, when you're strictly looking at employment and inflation, is very slightly deteriorating.

We've seen a slight uptick in unemployment and the Inflation rate, while it's come down over the past year and a half, it does seem to have stalled out above that, that 2% target. In fact, during the press conference, you know, Powell made mention of that.

That progress has been made, has being a past tense vert has been made towards that 2% target.

And so they seem to be kind of not, not admitting defeat, but maybe admitting that they can't really make any more sustainable progress on inflation given the time being.

Jim Glennon: 00:10:52

Without hurting the economy, potentially.

Alex Hebner: 00:10:55

Right, without hurting the economy. And with unemployment ticking up, they're going to continue with those rate cuts to support the American employee.

Jeff McCarty: 00:11:03

Speaking of inflation, the data does keep rolling in. That's the big number coming out this week is some more inflation numbers.

Alex Hebner: 00:11:11

Yep, we have CPI this Wednesday followed by PPI, the usual CPI. PPI, 24 hour turnaround. We get both of those back to back. CPI's expense expected to be in a similar range to last month, up 0.2.3%.

PPI was actually neutral last month. A lot of it was a very interesting release. Goods were 0.2% back while services were 0.2% up. So it was a net neutral release.

But it was interesting to dive into those numbers and look at how goods were getting cheaper.

But yeah, we're getting those two this week, Wednesday, Thursday, and again, they're kind of looking to be much like last month, just a slight uptick.

Jeff McCarty: 00:11:47

All right, great recap as always, Alex. Thanks for joining us.

Alex Hebner: 00:11:51

Thank you, Jeff. Always appreciate it. Thanks for having me.

Jim Glennon: 00:11:53

Thanks, fellas. All right, for this segment today, we thought we'd talk a little bit about hedging and demystifying what hedging is for everybody.

You may be a capital markets person and you either have a good feel for what hedging is or you may be doing it yourself, or you may be working with us to hedge your pipeline.

Or if you're maybe you're an originator, broker, loan officer, you work elsewhere in the organization, maybe you don't know what hedging is, you've heard about it and you're curious what it is and maybe how you can even help your organization be more successful with hedging.

Jeff McCarty: 00:12:25

Right now is particularly interesting. Hopefully we're at another kind of peak in rates. We're all hoping for a decrease in rates in the coming future.

And at that point we'll start thinking about renegotiations and just a big move in prices means, as we'll explain here, means that hedging is all the more vital and all the things that Go around hedging.

Jim Glennon: 00:12:48

Right. So what are the economics of some of these things that you just mentioned? Right. And why do we hedge in the first place?

Like what's the, what's the point? So the point is really protecting margin, right?

When you lock a loan with a borrower today, you're guaranteeing that borrower an interest rate for 15, 30, 45 or more days. So what happens after you lock that loan?

Jeff McCarty: 00:13:09

Right.

Jim Glennon: 00:13:09

You've locked it with the borrower, you've locked it either in optimal blue or in your los, and then your capital markets department gets a hold of it. Right. And at that point they're applying coverage for that loan. Right.

Some businesses will do what's called a best efforts lock, which is basically taking out a lock with an investor at the same time that you're guaranteeing that lock to the borrower. So that's a pretty simple back to back transaction, right? You, you lock with the borrower, capital markets locks with the investor.

That's pretty much done until that loan gets closed and hopefully delivered. With hedging, you're going to do a bit of what the investor is doing, but you're going to do it internally.

ogy that goes back to the mid-: 2000

It used to be that most airlines, for whatever reason did not hedge the cost of fuel, which is typically, other than people, I think the largest cost for an airline. Right. So you had Delta, American Airlines, United, not hedging fuel futures, yet you're selling tickets four, six, eight months in advance, right.

When you have no idea how much fuel is going to cost when those people actually sit on the airplane.

So Southwest though had a long standing practice of hedging with oil futures so that they could guarantee a 500 seat today for a plane that's going to take off in six months. They knew what their cost of fuel was going to be because they were hedging it. And fuel went up twofold during that period of time.

This is after the great financial crisis.

And a lot of those airlines had historically low or negative earnings during that time, whereas Southwest came out looking like they normally would, but with good profitability. So what they were basically doing was buying oil futures, essentially guaranteeing the cost of fuel out six plus months in the future.

So it's a very good way to look at what your capital markets group is doing with your loans, with your locks.

They're just saying, okay, we know that we can place a transaction into the market that's going to guarantee this interest rate, whether Rates go up or rates go down for the foreseeable future.

Jeff McCarty: 00:15:20

Yeah. And the important thing, you're guaranteeing a rate and a price, right? I mean, the, you know, it's the rate at a certain price.

I think, you know, as we'll kind of give an example of, you know, with a renegotiation, you may not be renegotiating a rate down, you may be renegotiating a price up as well. Right. So just reiterating that point. You know, you have guaranteed the borrower a rate and a price on day one, and that price is not guaranteed.

In fact, it almost certainly will not be at the same spot when that loan closes and sold on the secondary market on day 30, 45, whenever that is. And so hedging is exactly what Jim said, right?

Hedging, you are taking down coverage, you're taking down some protection, so that if rates and prices move in either direction, you're protected against that move during that 30 or 45 days.

Jim Glennon: 00:16:16

You're basically, you know, there's two sides. You've got your loan that if rates go down, that loan is going to become worth more money as the rates go down, right.

As you get closer and closer to closing that loan, then you have your hedge that if rates go down, your hedge is actually going to lose money, right? It's going to lose to the same extent that your loan is gaining as rates are going down.

But the other, the opposite also happens half of the time, right? Rates go up. And as rates go up, that loan is worth less and less as we get closer to the closing date, but that hedge is going to become worth more.

So again, similar to the airline analogy, where if fuel prices were to go up between now and when you sit on that plane, that hedge that you've taken out is going to gain value over time.

So that when you go to pay for that fuel that's become much more expensive, you're going to have that hedge that's worth more money than it was the day that you purchased it. So that's going to help counterbalance the increase that you're paying for that fuel.

Jeff McCarty: 00:17:14

But we should reiterate the, you know, the other side of that that you started with, right? So rates go down and the price of the loan goes up, your hedge is losing money, right? So there's no free lunch there.

Of course, on day one, you don't know which direction the markets are going to move. You're guessing that's you shouldn't be in this business, right. You should be playing the Stock market, we're not here to gamble.

And so definitely want to reiterate that point that, you know, you're not trying to make or lose money, not gamble in either direction. You're trying to break even with the hedge essentially so you can make money in other parts of the process.

Jim Glennon: 00:17:52

You're trying to be neutral, neutral to the market, but protecting that margin.

And also if you are hedging, which you may also hear it called delivering mandatory, that is typically going to be more profitable for a mortgage bank than if you are delivering best efforts. Because we're all trying to be as competitive as we can be, especially in a market like we're seeing right now.

But just in general, this is a super competitive business. Every basis point you can squeeze out is going to give you that advantage.

So how could we all, whether we're, you know, broker, loan officer, originator, or we're an ops, or we're in capital markets, how can we all help being as successful as possible, our hedging practices? So, you know, a couple things you can do. As Jeff said, there's no free lunch.

Whether you are, you know, if rates do go down and you have borrowers who come to you legitimately and say, hey man, I know rates are lower, I need a lower rate, we're going to attempt to renegotiate. Right. Or we're going to attempt to float down. And it may seem simple. You may say, well, the market's better.

Why can't I just give that borrower a better rate? It's, as Jeff said, it's because of that hedge. That hedge has lost some money right. Where that loan is increased.

So any, any concessions you make are going to come out of the company's pocket in that kind of situation. Same thing with, you know, extensions. You know, there's no free extension, really. There is a time cost to a hedge.

So if you lock your loan, if you're kind of serially locking your loans for 15 days and always needing extension to go further out, that does cost money. So what we can do is just be as accurate as possible when choosing our, our lock periods. Right.

And not renegotiating every lock in our pipeline, but just trying to react more to borrowers that we know are going to be more sensitive to interest rate movement.

Jeff McCarty: 00:19:32

Yeah, I think the important part of both of those is just recognizing that you've got competing priorities. Right. You've got to, you certainly have to keep, keep the borrower happy.

And, you know, you want to try to maintain the deal, but at the same Time recognize that, you know, you can't just give the borrower everything because it is, as Jim, you said, it's coming out of the company pocket.

So, you know, I think as an originator you have to try to figure out that balance of what the borrower needs and trying to maintain the deal versus, you know, doing what's best for, for the company overall.

And I think that comes with, you know, good communication with your secondary team, making sure you understand their policies, making sure you understand what they're needs are and then just, you know, good communication and education of the borrower, understanding what they need and how much competitiveness maybe you're, you're dealing with on the borrower.

Jim Glennon: 00:20:24

Side and understanding your pipeline. Right. Only locking loans that you're fairly confident are going to close.

You know, you may hear your capital markets folks or your, your AE talk about pull through. Right. We're typically going to aim to have at least 9 out of 10 loans actually close. 9 out of 10 loans that get locked. Right.

If your pull through is poor at 5 out of 10 loans that you lock pull through, that ends up coming at a cost as well. So back to the analogy of whether it's Southwest or just the idea that over time rates get better.

All these loans that are in the pipeline are worth more. But we've also applied hedges to those.

And depending on previous performance of your organization, you're going to hedge not 100% of those loans, but you're going to hedge a high percentage. So if you end up with a closing ratio that is far less than what you're hedging for, you're going to have more hedges with losses.

Jeff McCarty: 00:21:24

Right.

Jim Glennon: 00:21:24

And those loans that had gains built up to them never closed. So you never realize those actual gains from those loans. You just take the loss of those hedges. Yeah.

Jeff McCarty: 00:21:33

And the way you're framing it now I think is a good way to think about it too. Right. Thinking about all this in aggregate. Right. Some of this is about playing the long game.

So you know, everybody's trying to make every deal they can work. I certainly understand that right now, you know, where every loan counts. And so you're trying to save every loan.

But at the same time, if you, you know, you can think about the big picture, think about the long game.

This helps the secondary and capital markets team get sharper with their pricing, you know, not have to worry about losses in certain scenarios because they know they have reliable pull through and you know, not going to get slammed with the entire pipeline of loans getting renegotiated. Down, all the way down to current market, for instance. So, you know, it is about keeping track of that bigger picture in a lot of this.

Jim Glennon: 00:22:21

Definitely. And then the later part of the process I think is the only piece we haven't covered. What happens with those hedged loans when they do close?

Let's say we've closed 90% of the loans that were locked in our pipeline and we then turn around and we sell them.

So another big reason why delivering mandatory or hedging is more profitable than best efforts is we're going to take those loans and we're going to auction them off to the highest bidder.

So instead of guaranteeing that, we're going to Deliver a loan 45 days in advance to a single investor, we're going to take Jeff McCarty's loan today that just closed and we're going to auction it off to 10, 15, 30 different investors and take the absolute best price for the Jeff McCarty loan. And that ensures that you're getting just a super liquid, super sharp price for that loan.

It tends to be 15 to 35 to 40 basis points better than what you would get through a best efforts commitment.

Jeff McCarty: 00:23:19

Some of the things we've been talking about over the past couple weeks too come into play there. Right. You know, if you, if you sell the loan when the loan's closed, you have more certainty around even things like income.

And we talked about some of these mission score products and CRA pay ups and things like that.

And investors, when they have more certainty around those types of loan characteristics, they're going to be more willing to pay up versus, you know, as you know, right, on day one, a loan is locked, you're still verifying borrower income and things like that. And investors aren't going to be as willing to pay up for what they think the income is on day one versus what they know the income is on day 45.

Jim Glennon: 00:23:58

Right, that's a good point. Right. There's some things that just don't fit on a rate sheet. Right.

But when you're auctioning loans off, you can put all types of data in these loan tapes that investors are going to price and they're going to take in all that data and choose from what they have an appetite for.

And that might be, they're going to say the income, they might be some low income borrowers they're looking for, like you said, or cra, which also relates to income, or the area where the subject property is located. It's just a more granular way to look at A loan.

Jeff McCarty: 00:24:29

Yeah. So I think summarizing some of these things, again, hedging takes out this risk between day one and day 45.

It's not about guessing which way the market goes. It's about saying whichever way the market goes, we're going to mitigate that interest rate risk of the market moving in either direction.

And it's preserving your margin kind of globally across your entire pipeline and across every scenario, rather than looking loan by loan, saving every deal, while also understanding you do have to save certain deals. There may be some borrowers. Renegotiations are a thing. There's always going to be renegotiations, but it's about limiting how much you can do that.

So you can preserve margins globally and, you know, your company can become more efficient and push down some more of those margins on average to every loan. So you can win more deals overall.

Jim Glennon: 00:25:27

Right. That's key. Yeah. The more efficient we can be, the more we're all playing a role in preserving those margins and maximizing them.

That, that ultimately comes back and just more competitive pricing, which gives us a better. A better spot to compete with other banks.

Jeff McCarty: 00:25:43

Cool.

Jeff McCarty: 00:25:44

Well, this is what we'll be. I think we'll be coming back to a lot.

And as we get into certain rate environments, certain scenarios, certainly, again, if we see a long term reduction or when we see a long term reduction in rates, we'll talk about some specifics going on in the market that we can relate back to.

Jim Glennon: 00:26:03

This definitely. Yeah, We've talked about just the tip of the iceberg here, but hopefully we've demystified this subject for a lot of folks out there.

But we will definitely talk about it again in the future. Okay, Jeff, let's close this thing out. Another great conversation today. Great week. We made it through the election, it seems, with minimal drama.

Good conversation today. Talking about hedging.

Jeff McCarty: 00:26:27

Yeah, I don't know about. According to my emails and social media posts, I'm not sure about minimal drama, but in terms of market movement. Minimal drama.

Jim Glennon: 00:26:35

Drama, yes. So, yeah, keep an eye on inflation data this week. Otherwise, that's it for today.

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