By Mike Vough – Vice President, Hedging and Trading Products, Optimal Blue
and Geoffrey Sharp – Managing Director, Head of Product Development and Sales at Eris Innovations
In both low and high origination environments, non-agency loans, such as jumbo, Non-QM, and Private-Label Security, are always flagged as potential growth areas for lenders. What has prevented these perennial projected growth areas from gaining steam?
Part of the issue holding back these types of loans from gaining more of a foothold comes down to the classic chicken or the egg causality dilemma. A liquid secondary market begets more production, and more production creates more liquidity in the secondary market. This situation is commonly seen in agency hedging when the market moves quickly, and new originations are slotting to coupons not yet liquid and commonly traded by broker-dealers. Originators must also deal with an opaque price discovery process due to the lack of a liquid secondary market. Could the lack of a trusted pricing strategy be leading to less origination, thus impacting the liquidity of the secondary market for these assets?
The lack of reliable pricing for bulk deals (or even in investor rate sheets) leads to originators using less sophisticated pricing strategies to price new originations that may not be fully grounded in reality. There is some convenience to pricing originations, bulk deals, and securitizations using the “finger in the air” approach of a simple spread over a selected US Treasury. However, this creates headaches for those trying to derive hedging strategies for short-term warehousing and longer-term investment strategies. If you cannot reliably and confidently price a loan, how can you hedge it with confidence? The flip side is that many vendors can supply complicated models with a great deal of flexibility, but the number of options and lack of tried-and-true strategies can leave lenders overwhelmed with too many options. Z-spreads, stochastic rate paths, Option Adjusted Spread (OAS), N-Spreads, and other modeling complexities add additional anxiety to this process.
If you made it this far, you may still be wondering what you can use to hedge these loans. Unfortunately, there isn’t a liquid jumbo forward contract available, like there is in agency originations. You could use Treasuries, but in addition to not having an embedded credit component, there is no way to build a tradable, forward term structure – a key component to financial modeling and loan pricing. It is unfortunate that U.K. regulators phased out LIBOR in June 2023, as it used to have a credit component with the capability to build a tradable, forward curve based on LIBOR swaps. Although to-be-announced (TBA) agency securities might seem appealing, despite their poor liquidity ever since the Federal Reserve stopped buying agency mortgage-backed securities (MBS), the risk characteristics of TBAs are not suited to pricing and hedging non-agency loans.
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