Hedging, Fair Value and the IRLC
Updated: 3 days ago
1- Every mortgage lender experiences market risk.
The interest rate environment is continuously moving up and down. Each rate movement impacts the value of a mortgage lender’s assets and commitments. This interest rate movement causes a mortgage lender to experience market risk from when the lender issues an interest rate lock commitment (IRLC) to a customer until the loan held for sale (LHFS) is sold. The IRLC protects the consumer from market risk while simultaneously exposing the mortgage lender to market risk. If the rates move up, the future loan revenue is less, and the lender may lose money unless a hedge mechanism is created to protect the amount of future revenue.
The most common hedging strategy deployed by mid-sized mortgage companies is to sell forward TBA-MBS commitments to protect the IRLC and then receive a mandatory delivery commitment to protect the LHFS until it is sold. The purpose of the hedge is to preserve the future gain on sale by establishing a transaction that exhibits the same degree of value change but in the inverse direction relative to a mortgage loan. The secondary marketing department adds enough mark-up into the lock commitment issued to a customer so that the future gain on sale revenue plus or minus the hedging activity will generate enough revenue so that the mortgage company makes a profit.
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