Together we are living, working, and fighting through a yet to be written new chapter in history and we are facing new challenges at every turn. COVID-19 (Coronavirus Disease 2019) has claimed over 7,000 lives, demanded factory shutdowns, quarantines and isolation, and company closures worldwide. While writing this, the S&P 500 alone was down 29.6% from all-time highs and 30-year mortgage rates have fallen yet again in the wake of an emergency decision by our Federal Reserve. This past Sunday, the Fed announced it was cutting short-term interest rates to zero, along with initiating a new Quantitative Easing program to purchase $700 Billion in treasuries and mortgage-backed securities to help weather the effects of this virus. This development should prove to provide stability and liquidity in a market that’s been in a frantic state as of late.
As discussed in our most recent blog post, this new market paradigm presents some familiar challenges, along with some challenges seldom seen or never seen before. Primarily, we are seeing spreads widen and hedge ratios tested. Anxiety and volatility have skyrocketed.
Optimal Blue has been hawkishly examining every facet of its model in an effort to smooth out the volatility we have experienced in positions. However, regardless of what hedge ratio method is used, positions at times have been difficult to manage. Duration and empirical models are being tested, as price relationships between coupons vary wildly and investor basis remains uncertain. Models should be updated frequently to keep up with current conditions, but results should also be closely monitored to ensure that positions are not overtraded.
All of this said, some investors have decided to step back and assess what’s happening in the marketplace. Softness in pricing can be seen across all execution types (i.e. best efforts, mandatory, cash) in published price structures as well as live bids. This poses a dilemma for our clients and sellers throughout the industry. Lenders must decide whether to hold loans until pricing settles into a more reasonable range or sell into a soft market. Of course, it is possible that this standoff gets more dramatic, but it could also thaw in the wake of Fed easing. It is unlikely that anyone knows for sure.
So, what should lenders do? First, as mentioned in our recent blog and likely by your Optimal Blue analyst team, continue to raise margins to manage operational capacity, protect against volatility, and to make up for investors doing the same. There are also some additional options to consider for hedging your position. None are sure wins, and each is not without uncertainty.
- Sellers can continue business as usual and selectively offer loans to investors when the market is relatively stable. The risk here is that investor pricing worsens relative to hedge instruments, so net gains thin even further. The opportunity here is that Fed intervention continues to instill confidence in markets and gains improve.
- Lock loans best efforts. This strategy would lock in the price. The opportunity here is investors basis is locked in. The risk is that spreads ease and gain return, but the position has already been committed best efforts. Some lenders are also employing this strategy as a way to alleviate credit constraints.
- A combination of 1 and 2 listed above. Take some high/low interest rate loans out of the position and lock best efforts. This strategy is often employed in times of volatility. It can help eliminate liquidity risk in note rates that may be removed from investor rate sheets in a strong move up/down in the market.
Lenders should discuss and understand all factors, risks, and opportunities inherent in hedging and lending, and should be acutely aware of these things right now. The above is good primer to get the conversation going. At Optimal Blue, we want to help you use our platform to weather the storm more confidently. Please do not hesitate to contact your dedicated analyst team to discuss further, if needed. We are here to help!