One market dynamic that accompanied declining interest rates during the first three quarters of 2024 is a notable increase in hedging of mortgage servicing rights (MSR) assets. Public company filings and conversations with mortgage hedging software providers and advisors shed light on the reasons behind this trend in MSR asset hedging, including the use of SOFR-based valuation models and the advantages of Eris SOFR Swap futures over traditional interest rate swaps.
More hedging as rates decline
SEC filings show that large mortgage industry players such as LoanDepot, Inc. and Onity Group Inc. have utilized Interest Rate Swap futures to hedge their mortgage asset exposures for several years. Mortgage industry participants may have been surprised, however, when United Wholesale Mortgage’s parent company disclosed the use of Interest Rate Swap futures for MSR hedges in their Q2 filing earlier this year.
In a break from their historical practice of not hedging interest rate moves, UWM Holdings recently disclosed the use of Interest Rate Swap futures to hedge MSR assets for the second consecutive quarter. Their Q3 filing showed the company booked a $227 million gain from these hedges, providing a meaningful offset to the decline in MSR asset value they experienced.
United Wholesale isn’t the only firm to start using Swap futures recently. Rob Powell, SVP for RJ O’Brien’s Fixed Income Group, reported a recent uptick in client activity. “In the past 12 months, we’ve had at least a dozen new customers start using CME Group’s Eris SOFR Swap futures. At least half of them are using them to hedge MSR assets, and several of them are completely new to hedging altogether.”
Mike Riley, Sr. Director of Hedge Advisory of SitusAMC, isn’t surprised to see new hedging activity. “The current outstanding mortgage universe consists of a lot of very low WAC (weighted average coupon) product with little to no refi incentive, so even if a servicer has no interest in hedging prepayment risk, there is still material interest rate exposure attached to custodial float income, and Swap futures are a perfect solution for managing that risk,” he said.
Keegan Zimmerman, VP of Hedging & Analytics for InCenter Capital Advisors, agrees. “There’s a view out there that we’re past the period of peak rates, but for those that have made MSR’s a part of their strategy by holding the asset instead of selling, it made sense to hedge to protect from downside risk. The WAC on these MSR’s are so far out-of-the-money that the hedge isn’t really against prepayment risk, it’s more just simple rate risk,” he said.
Choice in valuation models impacts choice of hedging instrument
Hedging MSR assets typically requires forecasting valuation of the assets in future scenarios, a task enabled by modeling software and hedge advisory services. A hedger’s choice in model framework can impact their choice in hedging instruments.
“Institutions that started hedging during the LIBOR transition tend to hedge with Treasuries,” explained Riley, noting that the regulatory-driven requirement to cease using LIBOR derivatives in late 2021 occurred when the liquidity in the SOFR derivatives market was below its current levels. “Those who started hedging more recently tend to use SOFR.”
Zimmerman says that InCenter Capital Advisors utilizes a SOFR-based model exclusively. “Using SOFR gives us the bedrock, fundamental underpinnings of the swap curve to ensure we have an arbitrage-free model,” he said.
According to Al Qureshi, President of Blue Water, it is important to use “a single, risk-neutral framework that incorporates mortgage rate, mortgage spread, implied volatility and a base valuation curve. We aim for a consistent measure of probabilities and expectations rolled into a valuation model that has depth and breadth, and is grounded in tradable instruments. At Blue Water, our valuation model is TBA- and CME Eris SOFR-centric.”
Comparing Eris SOFR Swap futures with interest rate swaps
When asked how they compare Eris SOFR Swap futures and interest rate swaps for clients, the advisors and software providers highlight multiple benefits of Eris SOFR.
“For new hedgers, especially, the transparency and lower initial margin really stick out,” said Powell, referring to the 60-70% lower initial margins charged by CME Clearing for Eris SOFR positions, compared with OTC swaps.
Others pointed to the compatibility of futures with MSR hedging models, which call for establishing exposure at key rate duration (KRD) points. “Hitting those KRD buckets requires rolling positions in order to stay at the 10-year point over time, for example,” said Riley. “It’s much easier to roll futures contracts. Rolling OTC swaps can be painful.”
Dan Libby, Director of Hedging and Funding Services at MIAC, points out the increased importance of hedging as the market matures. “The MSR market itself is becoming more efficient, as more institutional investors enter the space. Firms that tie up less capital in their hedges will be better equipped to compete in the space,” he said.
Ginnie Mae provides another reason to hedge
Several of those surveyed noted rates moving back up starting in mid-September will test the will of hedgers whose hedges are no longer making money, while noting that rate volatility makes hedging more important to survive and remain competitive.
Disciplined hedging of MSR assets will also pay dividends in the form of reduced capital requirements from government-backed mortgage guarantor Ginnie Mae, based on their November 7 announcement. Under the program, which starts at the end of 2024, “Ginnie Mae announced that issuers who have a track record of managing their interest rate exposure through hedging and who meet prescribed eligibility requirements may qualify for Risk-Based Capital Ratio (RBC) requirement relief.”
MIAC’s Libby believes the timing of the announcement is not coincidental, and sees it spurring increased demand for hedging. “We have seen a lot of interest already from clients in understanding its implications. Our backtesting suggests accounts may be able to realize 30-40% downward MSR Value Adjustment for purposes of calculating their RBC,” he said.
As institutions face potentially large swings in MSR valuations caused by interest rate volatility, it’s easy to understand why Ginnie Mae and the institutions themselves are embracing the value of hedging.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
