Managing Risk: Secondary Market Activities and Board Oversight

I recently attended a Board of Directors meeting of a mid-size commercial bank that owns a mortgage banking operation.  I was invited to make a presentation on the risks associated with actively managing interest rate risk of a mortgage pipeline. 

The mortgage company has been successful and profitable for the bank, but the board members wanted more granular information about the various risks they should be aware of as it relates hedging a pipeline and selling loans through mandatory commitments.

I covered five kinds of risk at the meeting:  Liquidity, Interest Rate/ Fallout, Basis, Credit and Counterparty Risk. 

1. Liquidity Risk:  Will there be adequate liquidity in the market to provide hedge instruments and take out commitments for loans originated by the mortgage company?
2. Interest Rate and Fallout Risk:  The Bank is interest rate risk adverse and wants to be close to a delta neutral position at all times.  Does management have the tools, policies and procedures to monitor and measure fallout risk to ensure the company is delta neutral?
3. Basis Risk:  Is management using the proper hedge instruments to reduce basis risks?  Basis risk can occur when hedge instrument price movements does not follow the price movement of the underline asset being hedged.
4. Credit Risk:  Is the mortgage company originating loans that may not meet credit guidelines of its investor partners, resulting in unsalable loans?
5. Counterparty Risk:  Does the company have risks that the party on the other side of a transaction – MBS dealer or investor – will fail to perform?

There are other risks associated with operating a mortgage bank, but I focused on those relating to secondary marketing activities.  Because the mortgage company was originating, hedging and selling FHA and GSE eligible loans, I informed the board that the management had greatly reduced these risks.  There was risk, but management had implemented policy, procedures, controls and reporting to manage these risks. 

Let’s review how management addressed the risks:

1. Liquidity:  There is ample liquidity and demand in the market for GSE and FHA/VA loans.  The government owns all four entities that guarantee these securities and investors continue to buy them even after the Federal Reserve discontinued its purchase activities.
2. Interest Rate and Fallout Risk:  Management has engaged Mortgage Capital Management (MCM), one of best risk management consultants to provide the analytics and reporting to assist management with managing interest rate and fall out risk.  Management has also created and enforced strong lock policies and controls.
3. Basis Risk:  There is minimal risk since the company is using mortgage backed securities (MBS) as its hedging instruments.   MBSs track the price movement of the loans being hedged.  MCM also makes hedge adjustments based on price movement of the assets and hedges.
4. Credit Risk: Management has adopted the most conservative credit standards of its investors and has extensive pre funding quality control to ensure all loans are salable and meet investor guidelines.
5. Countyparty Risk:  Management realizes it does have counter party risk because it has a limited number of broker dealers and take out investors.  It has a process to monitor the financial strength of its partners, but it is also expanding its broker dealer and investor partners.

We applaud the bank board of directors in asking management to address and explain the risks associated with actively managing its mortgage pipeline.  Directors of banks have the responsibility for broad oversight of the activities and management of the company.