In November 2024, CME Group and Optimal Blue announced a new derivative, Mortgage Rate (OB30C) futures, that closely aligns with the mortgage rate offered to borrowers today (known as the primary mortgage rate). This innovative contract provides direct exposure to the primary mortgage rate that cash settles to the comprehensive and timely Optimal Blue 30-Year Fixed Rate Conforming Index. Calculated from actual locked rates with consumers across 35% of all mortgage transactions nationwide, the Optimal Blue Mortgage Market Index (OBMMI) includes multiple mortgage pricing indices developed around the most popular mortgage products and specific borrower attributes to provide configurable trending of rates over time.
What is the primary-secondary spread, and how does it impact mortgage companies today?
The mortgage rate that consumers see quoted on CNBC, Yahoo Finance, Nerd Wallet, and other publications is commonly referred to as the primary rate. This rate represents the mortgage rate an average borrower would receive if shopping for a mortgage today. The primary rate is typically paired with another rate known as the secondary rate, which is the yield needed to price liquid to-be-announced (TBA) pools of mortgages to a price of par or 100. The difference between the primary rate and the secondary rate is commonly referred to as the primary-secondary spread. Below is a visual representation of how multiple rates and spreads are envisioned by market participants to "build up" to the primary rate and drive how capital market participants price and hedge mortgage and mortgage-related assets.
2 Uniform Mortgage https://capitalmarkets.freddiemac.com/mbs/products/umbs
Mortgage capital market participants have ways to directly hedge their SOFR or Treasury reference rates using Treasury and/or Swap Futures and Options. The Secondary rate can be hedged using TBAs (to-be-announced mortgage securities) or TBA Futures. However, the primary-secondary spread does not have a direct hedge available in the most used trading ecosystems today.
What is unique about the Mortgage Rate futures?
There is a unique relationship between the primary and secondary spread influenced by the general fixed income market's direction. When rates trend upwards, mortgage companies experience fewer originations, leading to increased pricing (lower margins) to win business. Conversely, when rates drop, the higher volume of business allows lenders to increase their margins to manage underwriting capacity. Below are examples highlighting this inverse relationship between rate movements and the primary-secondary spread.
Using the Mortgage Rate (OB30C) futures to hedge a mortgage lock pipeline
Mortgage Rate futures can hedge various mortgage-related assets, such as a pipeline of unfunded mortgage locks, a servicing portfolio, construction or long-term loans, aged loan portfolios, and more. In the example below, a $150 million unpaid principal balance (UPB) unfunded mortgage pipeline was hedged by going long on Mortgage Rate (OB30C) futures. Except for two days, the use of Mortgage Rate futures as a hedge outperformed the TBA hedge strategy, achieving 99% effectiveness compared to approximately 80% using just TBAs.
Optimal Blue’s generative AI assistant, the Profitability Assistant in CompassEdge, identified three main reasons for the $70K notional / 80% hedge effectiveness using the TBA-only strategy: a $36K loss due to decreased servicing valuation, a $31K loss from pull-through changes, and a $20K loss from loan sales. These drivers are critical as lenders typically include future expectations of servicing, pull-through, and gain on sale into the primary-secondary spread. When mortgage originators expect more fallout than expected or less profitable loan sales than expected, there are typically margin adjustments made to counterbalance any future profitability impacting factors. Unlike TBAs, the Mortgage Rate (OB30C) futures directly incorporates changes in the expected profitability of the mortgage lending industry.
Using the Mortgage Rate (OB30C) futures to hedge a servicing portfolio
The principles of hedging the primary rate also apply to hedging a similar asset, the mortgage servicing rights (MSR) portfolio. Hedging an MSR portfolio can be complex due to the lack of a one-for-one hedge for the primary rate. MSR modelers often use advanced modeling options such as primary-secondary spread regression, option adjusted spread (OAS), enterprise hedging, and recapture as a duration offset to neutralize hedging challenges. These sophisticated strategies can be costly.
The Mortgage Rate futures aims to simplify hedging an MSR portfolio. For this analysis, I modeled an ~$8 billion UPB MSR portfolio of agency conventional loans for November, excluding the impact of float. Using OBMMI as the par rate in the prepayment model significantly reduces the profit and loss (P&L) variance and the basis risk between asset and hedge.
With the two simplifying assumptions of no float and using OBMMI as the par rate, I developed a hedge strategy to match the dollar-value change of one basis point or 1/100 percent-rate change (DV01) of our MSR portfolio. Using the simplifying assumptions mentioned above, the DV01 of the MSR portfolio a shade under -12K meaning that for a 1-basis-point (bp) move in rate the value of the MSR portfolio would change by 12K. To replicate that with Mortgage Rate futures, a hedger would need to buy 240 contracts or a $120 million of UPB to match the DV01.
It’s important to understand the relationship between the par rate (OBMMI) and the MSR valuation. In the chart below, you will see that the valuation of the MSR portfolio will go up when OBMMI increases and decrease in value when OBMMI decreases. When the OBMMI decreases, it shows that market of borrowers will have more refinance incentive, which negatively impacts the MSR portfolio.
Determining hedge effectiveness and rebalancing
Hedgers must determine their risk tolerance threshold – that is, how often they should rebalance their hedge to align with their DV01. As the market fluctuates, the net DV01 will change, and in this instance, striving for perfection can be the enemy of great. It is essential to recognize that additional hedge costs can cut margins. In this example, we will use a 5% risk tolerance to trigger a rebalance. In other words, we will not adjust our hedge unless its effectiveness falls below 95% or exceeds 105%.
Using this risk tolerance, we would have to rebalance seven times during November, adding an additional ~$10 million of Mortgage Rate futures. The MSR portfolio decreased in value by $97K and our hedges increased by ~99K. The total profitability for November was $1,843, resulting in an 98% effective hedge strategy.
Beware of anyone who promises 100% hedge effectiveness. Even with simplifying assumptions, we did not achieve perfection. But we came close. The inverted yield curve and trading market dynamics of the Mortgage Rate futures can impact hedge effectiveness. Once the Mortgage Rate futures starts trading, it should be a valuable tool for mortgage market participants to consider as a hedge for various mortgage-related assets.
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