The current environment of volatile interest rates is hazardous not only to servicing portfolios but to loans in lenders' pipelines.
These loans, which have been committed but not closed, are subject to a variety of hazards that make risk control crucial, industry experts point out.
Robert N. Husted, managing director of ESN Risk Management Services Inc., a servicing consultant in New York, said that lenders simply must hedge their pipelines, especially in today's market.
"It's a challenging program right now with rates whipsawing up and down 90 basis points," Mr. Husted said. "To hedge, you have to be on your toes because interest rates might drop 40 basis points from the average rate in the pipeline."
These days, loans may stay in the pipeline somewhat longer than they did at the peak of the refinancing boom. This is because of the richer mix of loans to purchase homes, which take longer to close than refis.
This leaves lenders more vulnerable to having commitments below market rate when rates rise or having loans fail to close when rates fall.
A servicing broker told of a client who said his company would not be able to hedge in light of today's rate environment.
"He said he didn't want to pursue hedging, because he thought it was too late - that rates had already dropped," said Tom Healy, director of the mortgage strategies group at Meridian Capital, Fort Lauderdale, Fla.
"But it is never too late to hedge," Mr. Healy added.
A hedging program is important, Mr. Healy said, for more than just servicing.
"You have to handle the interest rate volatility for the whole mortgage company," he said. Mr. Healy also recommends using originations, which rise as rates decline, as a natural hedge for servicing, which becomes more valuable as rates rise.
Larry Swedroe, vice chairman at Residential Services Corporation of America, said lenders should spend the money to hedge a pipeline to insure against losses, rather than pinch pennies in this crucial area. He also said lenders should limit the number of rate locks offered to borrowers and close loans as quickly as possible, to prevent being stuck with low interest rates when they rise again.
Options can be especially useful, said David Lereah, chief economist at the Mortgage Bankers Association of America. He said all the large mortgage companies used options for hedging both pipelines and servicing portfolios.
Lenders tend to prefer options as a hedging strategy because there is no risk that the strategy will backfire and result in a heavy loss. If the hedge proves unnecessary, the options can be allowed to expire and the only loss is the transaction cost. This up-front payment is, in effect, a premium on an insurance policy.
"Companies have become more comfortable with hedging so I think we'll see more of it," Mr. Lereah said.
In the last week, with interest rates going up after a steady downward trend for two months, he said the big companies were spared losses because of hedging.
"In terms of pipelines, fallout risk is increasing because customers are rate shopping more and more," Mr. Lereah said.