This advanced white paper explores the mechanics and limitations of hedging mortgage pipelines with to-be-announced (TBA) securities. It details how lenders use TBA trades to manage duration risk and how assumptions like pull-through rates and effective duration impact hedge performance. The paper highlights how convexity and basis risk introduce exposure during large interest rate shifts, which can erode lender margins even when hedged. Several mitigation strategies are discussed, including frequent rebalancing, enhanced simulation modeling, and supplementing TBAs with treasury futures or derivatives. With support from Milliman’s MS2 mortgage hedging software, lenders gain access to sophisticated tools traditionally reserved for large institutions—empowering hedging lenders to manage pipeline risk more precisely across economic environments.

Key questions

• What are TBA securities? The TBA market allows investors to buy unknown pools of mortgages in advance of their origination on the condition that the mortgages all have the same mortgage type, tenor, and security coupon rate.
• How does duration play a role? Duration is a measure of the decrease of the value of a debt instrument (or other asset) to a unit increase in the rate of interest. Duration can be used to approximate the change in the value of an asset for a given change in interest rates.
• What is the pull-through rate? The pull-through rate is a percentage of locks that result in a closed loan.
• How does duration matching factor in? A duration hedging strategy can be effective in mitigating the interest rate risk assumed by a hedging mortgage lender.
• What does the negative convexity of mortgage assets mean for TBA duration hedging? When hedging interest rate risk, there is a basis risk between TBAs and the locked loan portfolio. The convexity differences between the lock portfolio and TBAs could be significant during periods of large interest rate movements.
• Why incorporate pull-through assumptions? A hedging lender must have robust tools to model and evaluate the impact of changing pull-through rates on the net position. The hedging lender rebalances their hedge position in reaction to changes in interest rates. This adds to trading costs and potentially realized losses on trades during market volatility.
• What can lenders do to mitigate these risks? We discuss three strategies, including supplementing TBAs with additional financial instruments to hedge the negative convexity risk of the mortgage pipeline.
• How does MS2 help mortgage originators? MS2 streamlines the calculations and trading workflows for TBA and market hedging, helping mortgage lenders manage pipeline risk more efficiently.