From Market Whiplash to MSR Hedging Strategy | Optimal Insights | May 19

Jim Glennon (: 00:00

Welcome to Optimal Insights. I'm your host, Jim Glennon, Senior Vice President of Hedging and Trading Operations 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 everybody. Great show for you today as always in the interest of making sure you know what to watch, whether you're an originator, capital markets person, or just someone interested in the mortgage industry and some great market commentary.

listening in. We've got James and Alex with us here. We're going to do a little bit of a market update here in a moment. We're recording on Friday ahead of NBA secondary. So hopefully we'll see you all there Sunday or Monday or Tuesday. A lot going on in the market today, which we'll get to here in a minute. It seems to be one of these kind of whipsaw days where we're seeing a sell off where we're realizing that inflation is getting worse and the war in Iran is still going on. So we'll touch on that here in a minute.

We have the OBMMI spiking a little bit along with Treasuries. Treasuries are at 4.6 as I'm recording this and OB-MMI is at 6.4. So let's talk about the market, gentlemen.

Jim Glennon (: 01:26

it's Friday. We're sitting here. It's about 11 o'clock, 1130 Eastern. There's one of these days where the, this seemingly bipolar market has decided that it's worried about inflation. It's worried about Iran, even though these things have been

out there and expected and kind of predicted for weeks, days, and months. What do we make of some of this activity today? And then we can get into kind of longer term. What does it mean? we're down, we're down like a percent on the S and P. The 10 years is just skyrocketed 11 basis points, seemingly overnight. Again, for no new reason, it's just a reason that's been out there since we attacked Iran.

back in late February. I mean, there's anything else that's pushing this market right now?

Alex Hebner (: 02:20

Yeah, I think the market's been on a slow creep upwards ever since. mean, rates bottomed out literally, you know, February 28th, right before, the news of strikes hit the ticker. And ever since then, they've just been creeping up since I'm with you, Jim. I don't see any catalyst for why today we decided to wake up to one, that there seems to be a messy situation with

Jim Glennon (: 02:45

no

gas until, you know,: 2028

I don't know, just feels like the, again, it seems very bipolar, literally, like there, there's two poles that are pulling against each other.

Alex Hebner (: 03:18

Right.

Yeah, these are all things that we've known. We've known the effects of how long, you know, it's gonna take to turn these refineries back on even with a peace deal right now. strange. And again, we've had a second month of hot inflation reading CPI and PPI, which we can get into in a few minutes, but those came out 48 hours ago. It feels as if the market might've been really holding out for some wild card coming out of the Trump Xi meetings in China.

because that does seem to have kicked things off today. That was the only thing that happened overnight.

Jim Glennon (: 03:52

Right. You get the, know, in the middle of it too, you have all these other, I don't know, gorillas in the room. You have the AI trade, right? You had I forget the name now, starts with a C, that this new AI chip maker has their IPO the other day. So there's exuberance around AI. Everyone's focused on that. It's a hundred billion dollar company overnight. That cash had to come from somewhere that boosts the market along with the other chip makers. And then today everybody wakes up and says, wait, there's this other conflict going on.

inflation is an issue. But then almost probably not coincidentally, have ⁓ Besant and Lutnik and others coming out and saying, no, no, no, inflation is transient because it's all based on fuel. We know this to be true. We know this from history. But some days we wake up, we don't believe that like. Core inflation is still high. Core inflation is still increasing even though energy seems to be the boogie man.

James Cahill (: 04:39

also like

No, it also like talks to this point. It's a little, there's a little bit of a, this has been going on for a while, right? Like, I don't know what, you know, kicked it off this morning and last night as opposed to when the inflation reading came out this week, but

The whole Iran conflict was supposed to be two, maybe three weeks, right? It's actually all of March, all of April. We're halfway through May. We're still going. There's no end in sight. know, shy of something, you some wild card coming out. So the fuel refineries are not turned on. Like we've kind of passed the threshold of, if we wrap this up quick enough, we can probably...

back out of it, like it's going to be slower than that. Turning everything back on is going to be slower than that. So maybe fuel impacts are transient. They will get passed through, but when does it, know, when, when do we get the fuel back so that that it can pass? don't know the answer to that. it might be two, three months. Well, I have to adjust my inflation outlook for that.

in the meantime, it feels like it just kind of everyone's been waiting to make this move, right? To say, okay, inflation is actually a problem. Rates are gonna go, might go up.

We have to adjust the trade and probably like the sword just started falling. Right. And so no one's caught it. It's just going to, you know, I 12 basis points right now. It could be 14 by Monday. Maybe it'll be eight. It would reel back a little bit, but it kind of, once it starts moving, the boulder's moving.

Jim Glennon (: 06:29

Right. At the same time, we've been like, there's another side of that coin. We've been lulled to sleep over the medium and long-term where if I had to bet on it, I'd say there's a better chance of the market, the stock market rebounding on Monday than continuing to sell off to your point, probably more like the, know, eight basis point will come down a few basis points on the, on the yield on the treasury next week, because we seem to have developed this, this resiliency in

the stock market and the markets in general. And were just talking about that before we started recording. And that feels like something that didn't always exist. Right. And we have some theories on why. Let's talk about that for a minute. Why these days with news that otherwise would have been horrific for the equity markets. Why do we see these rebounds every single time it feels like? Right. Is it because

Is it the taco trade? it that people don't believe that Trump, the administration is going to allow the war to go on long enough to really damage the economy? Is it because we believe that because the job market is seemingly invincible that we'll get out of this just fine? I don't know. What are some other theories around why the stock market seems to be just unidirectional?

James Cahill (: 07:51

I might go a little cynical and say, it's, you know, it's due to speculation, right? If everyone, if everyone just thinks the line always goes up, Hey, maybe it goes down every once in a while, but that just makes it cheaper.

u know, one of the lessons of: 2008

Jim Glennon (: 08:05

Mm-hmm.

James Cahill (: 08:30

good lesson, but is, like it all, it all kind of came back in the end. You know, if only I'd been buying low, if only I had, you know, had bought a house right after, or even COVID, if only I had done it when rates were low. So if you're seeing this come down, people are taking that kind of historical view and just pushing into it. I would say that kind of a speculation that, well, it just will trend up. I should get in right now is helping to push this around.

Jim Glennon (: 08:58

Yeah, hard to argue against that. If you look back in history, right? If you take out the COVID freak out, which was not just unprecedented, but it was just wild. but it also adds to the, to the thesis that prior to 2007 stock market crashes had been worse. hadn't been as much of like a rescue plan. They've kind of played themselves out. Meanwhile, you also didn't have.

Almost every worker in the country invested in the market in the way of 401ks and things like that. A lot more people had pensions and this kind of thing. Right now, there's a huge amount of capital invested in the equity markets that's just sitting there, that we're not day trading on. Most of us have a 401k, at least in this industry.

After: 2007

But because the Fed stepped in and generally the economy repaired itself, as you said, James, in the end, everything kind of came back. People's money came back and skyrocketed from there. And then same thing happened with COVID. Fed comes to the rescue. People overnight, if you look at your 401k, you want to barf, but a month later, your 401k is bigger than it's ever been. Do people have that same mentality right now? They watch the market tick down a point today. There certainly is not a

A thought of, me go, I'm going to go sell out of my 401k that nobody's doing that. Right. It's maybe I want to get in. Maybe I want to add a couple percentage points to my contributions for the next month because I feel like the market's cheap. There's this ongoing, maybe it's not good, this ongoing thought that no matter what happens next year, the market's going to be up. There's no way that the market takes a downturn. And then you equated it to the housing market too. You guys are talking about how you're watching this housing market.

Alex Hebner (: 10:46

Absolutely.

Jim Glennon (: 10:52

skyrocket and you're waiting for that, that crash, if you will, or at least some kind of dip to jump in and buy. when you're like, how's that going to happen if everybody has that same kind of mentality, right?

James Cahill (: 11:03

Yeah, to make fun of, you know, millennials and Gen Z, I would say there's an online presence of like, okay, well, the market is so expensive and rates are high. It has to change at some point. At some point people can't afford it, in which case the price has to come down.

But whenever the prices start coming down, you know, it's like, okay, time to get in. You know, I want to get it now. I'd rather have it. It's all going to bounce back in the end. So rather have it sooner. And then again, that kind of creates a floor of people moving in as soon as it starts to slip.

Jim Glennon (: 11:36

Mm-hmm.

Alex Hebner (: 11:39

Absolutely. I generationally, think more people with the Silicon Valley democratization of finance over the past, since COVID really, think not only do you have huge amounts of decades long lead times with capital with 401k sitting out there, but you have people that might not even have 401ks putting a little bit in, a little bit in. And I think we've really lost track of just how much money is swilling around out there, especially since COVID. mean, the COVID stimulus is introduced like

they expand the money supply. don't want to quote a bad number here, but by double digit percents, they brought up the money supply. So not only is the amount of capital out there creating a floor, I think it's also creating some asset inflation. It's obviously created asset inflation in the housing market. And to James's point, everyone is conscious that it's better to be in an asset that we'll appreciate, that others want to get their hands on.

So yeah, think you have people conditioned to quote unquote buy the dip.

Jim Glennon (: 12:39

Exactly. what other assets have proven to be reliable over the last decade to continue increasing and give actually good yields, right? Bonds have not barely kept up with inflation, commodities are too volatile, and even housing is slowing down. It has other costs associated with it. So it's like the stock market's the only, and it's historically

you go back 100 years, it seems like the most volatile, but it has the best returns over time. So there's like, where does the money go if people decide I'm over this? I'm over the stock market. you know, so it does feel like all these things culminate in just creating this, this floor that hopefully we're not jinxing right now.

Alex Hebner (: 13:26

Yeah. Yeah. And I want to temper all of our words here in this call. You know, I think, you know, we're reacting to today's market action. I'd like to know, you know, we're talking about stock market numbers. We haven't seen since noon on Wednesday. It's currently Friday. You know, it hasn't even been 48 hours. The S &P has been trading in record territory for the past week or two. we've just had an incredible bull run since the end of March. think we're up, I think the S &P is up 15 % in the course of six odd weeks.

James Cahill (: 13:38

You

Jim Glennon (: 13:39

Yeah.

Alex Hebner (: 13:53

So we got to temper our words here a little bit. these are all just good questions to keep in mind. I think we are living in a historically unprecedented moment in regards to these financial markets, but just keeping things in perspective at the same time.

Jim Glennon (: 14:06

Yeah, and also to remind everybody, we're not giving investment advice here. That's not our job and not our area of expertise. We're just contemplating just some of the seemingly, we seem to be pressing against logic at this point with a lot of the price to earnings ratios and all of this. does, and again, with all these geopolitical issues going on and inflation rearing its head again, which never really got under control. It's just baffling.

Alex Hebner (: 14:09

That too.

Jim Glennon (: 14:35

how we continue to make records in these markets because somehow we think there's a pot of gold at the end of this rainbow ⁓ someday. All right.

Alex Hebner (: 14:44

Yeah, think

what we're running into, and this is my last thought I'll give on this, but I do think we're running into the classic brick wall that everyone runs into in finance and economics, which is the human and emotional aspect. you just said, Jim, know, where prices are a little bit detached from earnings and what they might be indicating. James used the word speculation. You know, I'm just going to lean into, you know, what we're seeing today. We can't really explain it and it might be like an emotional response. So I'll leave it there.

Jim Glennon (: 15:10

Yeah, I can't remember if it was Alan Greenspan who said it, but this was, like I'm going to age myself. This was coming out of the, might have been leading up to the great financial crisis. I can't remember, but irrational exuberance was what they would call this sort of market when you get to a point where all the news articles you read are saying the market's overvalued, period. Yet we break records every day. People are buying more than they're selling. And we seem to, again, we take these opportunities.

when the market dips to buy more and sock it away for a rainy day, which is what we should all be, you we should all have some investment in the market, some investment based on your goals and your discussions with your financial advisor, but it's seemingly healthy some days, other days it does defy logic.

Okay, gentlemen, let's talk some numbers. actually are some economic indicators to chew on this week. Mostly inflation data, would you say? I mean, that's what we're talking about right now. Yeah, so what did we get?

Alex Hebner (: 16:08

Those were the big ones. Yep, we got both

CPI and PPI. Both came in expectedly hot. CPI was up 0.6 % month over month after being up 0.9 % last month. So it actually was a little bit deflationary there for just a moment. But still, it's much hotter than it was prior to the conflict in Iran. And all the juice to the inflation was from energy costs.

e trending throughout most of: 2025

st increase since December of: 2022

Yeah, those were the two big things in the ticker this week. And then in addition to that, we had ⁓ Trump and Xi Jinping were meeting in Beijing. ⁓ Few take away, very few takeaways from that, seems. Trump said that the Chinese will begin to buy US oil, although there isn't a start date or any quantities that have been specified for that. So more to come on that. But all that would really do is probably put upward pressure on.

domestic US energy prices.

Jim Glennon (: 18:04

Yeah, it did feel, I don't know, kind of weirdly good to see that nothing crazy came out of that meeting. I mean, I'm sure when Trump comes back to the U S with his contingent, there'll be some, hopefully some good ideas that came out of it and some good deals. But it got a little hairy there for a while at the beginning of, of the tariff discussions where we were seemingly, you know, nose to nose with the other major economic power in the world and almost, I don't know.

little too much saber rattling. this felt, at least from what we've seen from the news, felt a little bit, a little bit more, I don't know, cordial. And then everybody kind of wants to make a deal and somehow avoid, I don't know, what you would think historically is an inevitable conflict between major world powers. Cause that's just the way the world has been for thousands of years.

Alex Hebner (: 18:58

Yeah, yeah, yeah. Sometimes a lot of people speak with the inevitability of certain conflicts. ⁓ know, it's not something we want to speak our way into and I would agree with you. It's good to see them all in the same room, able to shake hands, enjoy things together. You you see them eating dinner together, which is, it's nice to see. Then final thing the week, which will just have impacts down the line, but Warsh got confirmed for the Federal Reserve.

⁓ He's in and Myron ⁓ handed in his paperwork to resign, so Stephen Myron will be out. He said he will resign on or shortly before Orsh comes in.

Jim Glennon (: 19:36

Yeah, that was, I mean, expected news, but it's finally played itself out. I think hopefully we have an interesting FOMC this time around. It'll be his first, it'll be in June. And ⁓ I'm certainly excited to hear, cause I think you've got people in both camps. Some people saying we're finally, maybe we'll finally get those cuts that the administration has been talking about. But I feel like if we did get that more than half the country's going to feel betrayed by that.

by that move, especially given what fuel prices are doing and this sort of thing. It just seems super counterintuitive. But then you have a camp that says like, we need it because we might be seeing stagflation next year if we don't kind of prime the pumps a little bit.

James Cahill (: 20:09

if you should.

Alex Hebner (: 20:10

Definitely.

James Cahill (: 20:19

If you check the CME, their FedWatch tool, it actually, and today has definitely had an impact on that, but they're primed for a rape hike come December rather than a cut. So it will be interesting to hear what he has to say. It's just the runway for the whole plan of the Fed moving forward. So that'll definitely be interesting to come through.

Alex Hebner (: 20:20

Yeah.

Jim Glennon (: 20:45

Agreed. mean, he, Warsh was a hawk at his previous life, right? At least early on, he has kind of changed his philosophies over time. maybe adjusted it a little bit when he was interviewing for this job, but hopefully deep down he has the best interests of the economy in mind as we move forward. it does seem perilous, especially given everything that's going on this

last few months with the war and inflation and gas prices.

All right gentlemen, anything else?

Alex Hebner (: 21:19

I don't think so. don't think so. Just a couple of things to keep in mind ⁓ upcoming on this week when you, the listener, will be listening to this Wednesday, getting FOMC minutes. That one could just give a little bit more color on ⁓ how seriously the members of the board are treating inflationary and how they might be reacting to them a little bit under the cover that they might not get out of the House final meeting. then just the usual slew of ⁓ jobless claims on Thursday.

consumer sentiment on Friday.

Jim Glennon (: 21:51

Good stuff to keep an eye on and we will, yeah, hopefully right now we're seeing a bunch of you in New York at the NBA secondary.

All right, gentlemen, thanks so much for the time and talk again soon.

James Cahill (: 22:07

Thank you as always.

Alex Hebner (: 22:07

Thanks Jim.

James Cahill (: 22:11

All right, well, welcome back everyone. This is James Cahill. I'm here today with Vimi Vasudeva, the MSR team. And we're gonna be diving a little bit more into what the MSR team does daily, as well as how you should think about hedging these MSR assets. So I'm gonna let Vimi do a little bit of a recap of what we spoke about on part one.

Vimi Vasudeva (: 22:31

Yeah, thanks, James. Last episode, we did go through a high level, know, MSR 101, what is the MSR asset? Why should you care? What goes into the value of an MSR asset? And we primarily did this by James asking me several questions. And now I'm excited that we're doing some role reversal. And I'm actually going to be the one asking the questions of you, James, since you are the front lines of the MSR team.

you're working with this asset and our clients on a daily basis.

James Cahill (: 23:03

This is a live, why do we pay you every day, James? That's an exciting.

Vimi Vasudeva (: 23:03

So James, why don't you start off by giving us a...

Yeah, that's

exactly what it is. This is me just trying to figure out what you're doing all day. why don't you start off by giving our audience a recap of what we do a day in the life of James K. Hall or anyone who's on an MSR analytics and hedging team.

James Cahill (: 23:25

Yeah, so first and foremost, something you might see on the pipeline side is a daily reconciliation. People are waking up in the morning, they're looking at their position, how long or short are they? What does their gain loss look like? Did they have some sort of outlier event? And if so, why? MSR, I would start first with, we do this generally on a month to month reconciliation. So every month through the first first Monday through the first Friday,

I'm receiving data files from various clients with all of their loans and we are running them through the model and saying okay, what does your Gain loss look like this month in comparison to last month? So You know why?

Did you gain or lose on XYZ assets? So did the market work in your favor? Did it work against you? Is it really, is it the prime rate that was shifting? Did you have a large amount of delinquencies or prepayments or other movements that will make the portfolio change in value? That is a general month to month.

We may also have, similar to the pipeline side, a couple of clients who we are looking at it more day to day. These are generally people who are hedging their MSRs. So someone who not only needs to know, did I gain or lose month to month, but is my position in a good shape? Has the market moved in a way that I have new exposure that I want to cover with hedges? So we're helping to reconcile that and sometimes even suggest what they should do.

Vimi Vasudeva (: 25:04

Got it. you're describing there what we call ⁓ a general month-end valuation for an MSR portfolio. And as you said, of course, anyone who's hedging the assets is going to want to look at this every day and adjust their hedge position accordingly. But for those clients that are not hedging and they're really just coming to us for month-end mark, they ever ask you anything intra-month? Like, are they looking for support in terms of, my gosh, interest rates have moved?

quite a bit more since the beginning of the month. Can you help me out here? How do you handle that?

James Cahill (: 25:35

Yes, certainly. So month to month is generally what I'm up to, but also any time during the month, we may see someone coming in and saying, hey, the,

past two months, the war has been going on. So interest rates, we were kind of expecting them to trend down. They've started trending up, pushing up. Prime rates are pushing up. You may have been used to looking at the TBA 5 % as very close to par. Now it's the five and a half. So with the market moving a lot, people may come back and say, Hey, we would like to look at what has happened so far intermonth or even what may happen. So, you know, what if interest rates kind of continued to climb and the OB,

right now is at 6.3. What if it was at 6.5 or 6.6 or beyond? What would my position look like? What would my gain loss look like if it continued to run in this direction?

Vimi Vasudeva (: 26:28

Right, and I imagine that that is not always a reactive scenario, right? So we've got clients who are actually what we call scenario analysis. So every month, some every night, we'll run various scenarios to our analytics in order to predict the potential valuation change given different interest rate scenarios, for example. I remember this was a big thing.

SVB happened, there was some sort of like SVB type of scenario modeling. And of course, there's going to be just general economic modeling, whether it's what happens to my prepays or what if delinquencies go up, etc. does that do to my portfolio value?

James Cahill (: 27:10

Absolutely. And so.

I see, you you could be doing this daily as well, running through various scenarios. So on the morning output, you know, again, to relate a little bit to pipeline, you wouldn't just be looking at, what is my gain or loss or my position? You would be looking at, Hey, what is my position if the market moved a hundred basis points all of a sudden? What if treasuries moved one way? Prime rate moved another. ⁓ example is Silicon Valley bank a few years ago when they went down,

they had too many short-term bonds as interest rates were going up and they lost value very quickly. So, hey, what happens if interest rates move in the same kind of a shift as they would have seen? would happen to my position? So we're able to track those scenarios and just generally looking through them day to day is a big part of what we're up to.

Vimi Vasudeva (: 28:01

Right. those are all that's a great examples of what we're doing here on a day to day basis. But certainly, you we really pride ourselves on our robust cash flow engine and our analytics. But we certainly don't claim to know the exact way that borrowers are going to prepay. And given that prepayments are such an integral part of MSR valuation, there are actually companies out there where their entire business model is around modeling prepayments. And so we are very excited

to be integrated to those partners such as Adco and they do have all the data and all the analysis in order to help our clients with prepayment modeling. And so I'm sure that you see a lot of that too with our clients, right? And maybe you can speak to for those clients that don't license these third party prepayment models, how are they modeling prepays?

James Cahill (: 28:53

Yeah, and so I would first kind of relate to our first segment. We had talked about like LLPAs versus on the MSR side, what matters. It really boils down to prepayment. that's a critical part that you really wanna nail down in your model. And so these integrations allow us to pass through those values. So UPB, the note rate, the FICO score.

small pieces that are going to lend to what kind of a borrower is this, how quickly or slowly are they going to prepay or perhaps even go delinquent. And so with those small adjustments, these models are able to pick up, yeah, this is going to, you know, this person seems very likely they're going to prepay more quickly. A vanilla model might say, you know, over the next 15 years, the loan is going to pay down. We see like 13, 12. And so it's going to be faster. So you need to keep that into account.

If you are not using, say, ADCO or AFT, the MSR model is fully robust and we do have a section for prepayments. It is going to be, stepping through and speaking through and thinking about what happens if

I have a borrower who has a 700 FICO score or a 600 FICO score. Should I look at the general rate and then slow it down, speed it up? So it's a little bit more art to the science if you're building it yourself. Whereas with some of these integrations, there are industry leading professionals who have really sat down and tuned out how their model should work.

Vimi Vasudeva (: 30:27

That probably is a good segue for us to talk about some other partners that we work with and integrations that we have. And I know James, again, being on the front lines here, you work a lot with some of these partners. So I hoping that you could maybe speak to how these integrations work and why they're important.

James Cahill (: 30:44

Yeah, so if you're thinking on the pipeline side, I keep bringing her back, but on the pipeline side, you might be used to an MSR grid. So coming through looking at, what is the to value on this loan? What is the DTI? So the debt versus the actual income of this borrower? How are they going to hit it? These are the fields that we are generally looking at.

Phoenix, Morvest, Citus, different servicers have built out grids that you can build into your model. The sort of flaw with doing it that way and use that lightly, but the improvement perhaps you can make over this is what happens when you have a $251,000 loan instead of a 250? What happens when the FICO score is 723 instead of 720?

it's all gonna fall into the same bucket in the grids. However, those slight variations can have small differences that add up. If you have a number of small differences on one loan or on all of the loans, it is going to change the prices of the individual and of your total portfolio. So we have worked servicers to set up a live integration. So when you run the loans through the file,

they're actually hitting those specific setups. So it's a cashflow level. looking rather than a hard grid, hey, it's a 750 FICO score. This is what happens 750 through 775. We can look more specifically at exactly that rate or exactly this amount and boil it down to a more precise price.

Vimi Vasudeva (: 32:28

Right, so to recap, I would say that we are able to leverage the broker's assumption sets to derive low level cash flows, discount those cash flows back to derive the net present value, right? So this is what the MSR value would be. Again, this is so important

As we talked about on the last segment, the retain release decision is critical, right? And so if you want to get as granular as possible, because it could be a matter of just a couple of basis points that sways you to retain versus releasing. But if you're not granular and you're actually off by a couple of basis points, you might have made the wrong decision. these integrations are crucial. the

the ability to be dynamic and generate a low level MSR value is very important.

James Cahill (: 33:12

There's plenty of people who I know who look at like a retained release. retain it if it wins by 10 to 15 basis points. some of these, if you're three, four, five, six basis points in difference by having a more specific loan level, you're gonna make the opposite choice. it's always good to get as granular with this sort of thing as possible.

Vimi Vasudeva (: 33:36

Yeah, so speaking of granularity, important topic to get granular on is rate modeling, right? Again, we always talk about how prepayments are the biggest driver and what's driving prepayments rates and how are you forecasting rates? So can you maybe share with our audience a little bit of how you help our clients there and what they're thinking about?

James Cahill (: 33:56

Yeah, so just as a baseline, when you're looking at these models, you're actually looking at a 30-year timeline. And so you need to discount that back to today if you think about finance 101. But you're not necessarily going to have

a single discount rate that you're using, like is easy in finance 101, you're going to be looking at a yield curve, you're going to be looking at what is the two year, the five year, the 10 year, the 30 year, so on, and where those different rates are. So as you move through the cashflow, the rate may change. Now it's great that we can look at what the market is today and say, okay, I've got a pretty good idea of what the yield curve now, right here, but

the market is always moving. And so you want an idea of where it could go. This idea really boils down to stochastic modeling. There's a famous book, a random walk down Wall Street. It's really about, if you look at that curve and you send almost random prices through it, random different shocks to see how it could move. So very low probability, but if rates.

all of a sudden skyrocket up and the 30 year skyrockets up and the 10 year skyrockets up, what would happen to your pricing there? If everything was flat for 20 years and then really turned off at the end, what would happen there? So stochastic is the idea of running a thousand different rate paths to come up with a thousand different versions of your model. And then looking at the probability and saying, well, this is most likely, this is the valuation that we're really boiling down to.

Vimi Vasudeva (: 35:37

I would say in practice, we tend to see clients actually running more of an average of like 200 rate paths, right? Because the more rate paths you run and more shocks, of course that would increase processing time of a portfolio. So just wanted to put that out there.

James Cahill (: 35:53

I think I've heard said too is, when this was first introduced, everyone wanted to do a thousand. How can I get a million paths? But it really is after a certain point, the diminishing return on what you're learning. You can get something like 200 and it'd be fully informative. You don't need to go too much further.

Vimi Vasudeva (: 36:12

Right, exactly.

And so James, you have mentioned a few times that you've provided the context of the pipeline. And again, when we, when we refer to pipeline, we're speaking of a mortgage pipeline, the locks that are in an originators system, you have yet to be closed or fall out, I guess. so when we talk about pipeline, that's what we're referring to. And so how would you recommend our audience look at pipeline versus or pipeline with MSR?

James Cahill (: 36:42

I sometimes call it two sides of the house, pipeline and MSR are the two sides of the house. And there are plenty of scenarios where they are fairly separated. not always talking, but when you look at it really at an enterprise level, the whole company, this is one house that bleeds together very well in fact. Pipeline is the origination. It's where all the loans are coming from. You're pricing them out. You are choosing to...

release them, sell them, or to retain them to keep the MSRs. If you are doing that, they are passed over to the MSR side of the house and you'll slowly build up an MSR book. What's unique, useful, and wonderful about these is, as we mentioned part one, generally speaking, if rates are going up, the prices on your loans are going down. It's not so good for the pipeline side, it actually is good for the MSR side.

So when you look at this together, one side could be losing a little bit of money in a rising rate environment and the other can be making a little bit. So there's a way to look at this accounting wise and say, hey, we're kind of netting neutral together. reason that's important and as we'll step into in a minute is to think about it in hedging, right? If on the pipeline side, I'm afraid rates are gonna go up, so I'm putting on coverage. Well, if it's already offset,

by the MSR, I might not need as much coverage. ⁓ So these two, not only flow together, just truly as the loan moves through its life, but also they offset and position wise. So it's a good thing to keep track of both sides and just to have a view of that on an enterprise level.

Vimi Vasudeva (: 38:26

Absolutely. So that sounds like it would be a good segue into our final part.

which is discussing MSR hedging. This is a very interesting and complex topic and we would not have enough time to dedicate to that on this podcast. we do have webinars that we host at OB that go into high level detail here. But just as a very high level primer for our audience, we did want to discuss a little bit about hedging the MSRs, since that is also part of a day in the life of James and the rest of the MSR team here at OB. we've talked about several times, MSRs are high

sensitive to interest rate risk given the prepayment behavior. that can create volatility, right, which can then create big swings and earnings and asset values. And it's just sort of harder to manage that risk and deliver consistent performance, which is what we're all striving to do. I would say that the goal of MSR hedging would be to reduce those swings. And you'd really want to find hedges or assets that highly co-relate to the price movement that we see in the MSR. And so

While a lot of the mortgage market tends to hedge using the metric called duration, like we had touched upon before, we with TBAs, and this is always a little different in that we use DV01 to hedge.

James Cahill (: 39:41

Yeah, so Vimi, with that, why aren't TBAs a perfect hedge?

Vimi Vasudeva (: 39:47

Right, so I would say TBAs are great for primary rate risk on loans, but MSR adds a complexity of repayment behavior, credit behavior, servicing costs, and optionality, right? So the mapping isn't going to be one-to-one.

when we talk about DV01, characterizing how much of a value change will I experience for a one basis point movement rates. And given the nature of the MSR and its sensitivity to different parts of the yield curve, we actually had to looking at KRDs, which is a key rate durations. So key rate durations are used because interest rates don't all move the same way. Sometimes short term rates move a

while long-term rates barely change, or the curve can steepen or flatten, and so on. So a single duration number assumes everything moves together, which isn't realistic, and it can leave you mished. So key weight durations, they break that risk into pieces. So the two year, the five year, the 10 year, and so on. And you can see exactly where your exposure sits and hedge each part more precisely.

For MSR specifically, that matters because their value is tied to movements across the curve, right? Driving mortgage rates, prepayments, as we've discussed so many times. So you need a hedge that's going to match where that risk is, not just how big it is. would just say to kind of wrap it up ⁓ using key rate durations.

you use them because MSR risk isn't just about rates going up or down. It's about which part of the curve moves and key iterations let you hedge that precisely. And if I were to use a simple analogy, it would be something like which gears in the transmission are pulling, just how fast is a car going. Not much of a car goal. So I hope I got that right. James fact checked me there.

James Cahill (: 41:45

Yeah, so the different tenors, so the two rate, the five, the 10, the different gears, it's not just how fast you're going, it's which one is most important at this time. I follow that. I think that's a great analogy.

Vimi Vasudeva (: 41:57

Thank you,

good. right. So again, very, very esoteric topic, we would love to take any questions on that at some point. I think that this has been really valuable, James. It's been helpful for you and I to do this back and forth. And I think that our real message to our audience is that...

If you can connect front end pricing to back end servicing economics, you're going to make better decisions across the entire mortgage life cycle. And so that's why we really like to speak to this topic.

James Cahill (: 42:29

Great. Well, Vimi, thank you very much for the time. I know we all appreciate it and I'll see you in the office.

Vimi Vasudeva (: 42:37

Yeah, likewise, James. Thank you.

Jim Glennon (: 42:39

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