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Controlling the fluid pipeline.

Now you see it, now you don't - managing the pipeline flow is a real challenge these days. Mortgage lenders must employ strategies that channel the most profits out of refis without letting good purchase business seep through the cracks.

With every economic cycle there is always at least one period when economic and inflationary factors come together to allow for sharply lower interest rates - prompting homeowners and investors to refinance their existing mortgages. During these times, borrowers turn their attention primarily to fixed-rate mortgages, which presents mortgage bankers with an excellent opportunity to pick up market share, generate fee income and add valuable servicing. But with these opportunities come challenges that require a great deal of planning and management throughout the refinance period, to enable the refinances to be handled profitably while creating the least amount of disruption to the normal purchase-oriented business.

A mortgage banker's success during a refinance period can hinge on the planning and preparation done prior to the onslaught of volume. A high-volume refinance period such as the current one that began in late 1991 creates many situations that can hinder the efficiency of an operation. Among these are: the potential for dramatically higher application volume; pressure on processing staff; a larger pipeline with mixed behavioral characteristics; more risk due to interest rate volatility; lower response from third-party service providers; expanded warehouse line needs; and post-closing constraints.

The lowest interest rates normally exist in the last stages of an economic downturn just prior to recovery. These lower interest rates normally act as fuel for the recovery. Such a period frequently makes for increased credit-market volatility. With this in mind, this article will address the interest-rate risk segment of the refinance risk profile as well as touch on other risks that sometimes go unnoticed.

Anticipation and preparation

An important function within the day-to-day operations of any mortgage banker's secondary marketing department should be the analysis of the credit markets with an eye toward spotting trends. The trends affect the coverage percentages and the type of coverage used on the pipeline. They can also indicate the likelihood that conditions may soon exist whereby borrowers would refinance their existing loans. Chart 1 shows the average 30-year, fixed-mortgage rate from 1975 through mid-1991. Note the periods when refinances dominated originations and the amount of time between each period. This chart will give you an idea of the potential for refinances and at what levels these refinance applications might emerge.

The 1986 refinance period followed a long period of very high rates. The current period follows a time of relatively stable rates. The volume of originations from 1986 through today at levels above 10 percent represents a significant reservoir of potential refinance applicants.

In the fall of 1991, it was evident that the stage was set for lower rates with the potential for rates low enough to promote widespread refinancing. Real gross domestic product (GDP) growth had been dropping since 1989 with the index of coincident indicators dropping sharply since the second quarter of 1990 (See Chart 2). During the same period, the inflationary trend was headed downward.

Further evidence of an economic slowdown bordering on recession could be seen by analyzing the monthly copper chart (See Chart 3). Copper prices have proven to be a very reliable indicator of industrial activity. Other indicators such as employment also showed a decided slowing. Although now we have the benefit of hindsight, the fundamentals at that time pointed to lower rates. When the potential exists for a refinance surge, the following areas should be reviewed as to how each will affect your pipeline management strategy:

* company philosophy and major business lines;

* pricing policies;

* loan registration policies and registration procedures;

* loan programs;

* staffing;

* warehouse lines;

* system constraints;

* makeup of servicing portfolio;

* historical fallout levels of refinances.

Company philosophy and

major business lines

During refinance periods, commissioned originators tend to ignore their calls on Realtors to stay by the phone awaiting potential refinance applicants. Once the refinance volume drops, these originators' volume will have to come from the same Realtors who may have felt ignored during the refinance period. A number of steps can be taken to keep Realtors from becoming alienated during such periods. Some of these steps might be to:

* reduce commissions on refinances;

* increase commissions on purchase mortgage business during the refinance period;

* limit refinances in the originator's pipeline;

* require certain mixture of purchases versus refinances;

* monitor calls made on assigned Realtor offices;

* require phone inquires to be handled by noncommissioned loan officers;

* decrease required discount points for purchases;

* increase required discount points for refinances.

Any of these actions must include a thorough analysis of the effect these steps might have on your origination staff. Commissioned originators view a refinance period as an opportunity to generate unusual income numbers. Thus, any new policies must be explained completely, with the originator agreeing with the changes and understanding that the purpose of the move is to maintain vital Realtor contacts.

Decisions that are made in anticipation of a refinance period will be influenced by the mortgage company's mix of business; retail versus wholesale. The steps outlined here obviously only apply to retail operations. Wholesale business requires no "purchase promotion," however, pricing as well as loan registration policies are critical issues in a wholesale refinance environment.

Pricing refinances

A pipeline of refinances can be much more expensive to hedge; especially if you choose to use an increased percentage of optional coverage to manage the interest-rate risk (either Treasury or mortgage-backed security options). In addition to hedging cost, there will be increased processing costs as a number of applications will require some level of processing although they may never finally close due to rejection or withdrawal. Other applications will be processed through closing - only to see the borrower rescind the transaction. These costs need to be considered when pricing refinances. An increase in the discount points on refinances can defray some of the cost while putting the emphasis on purchase mortgages and Realtor contact.

Loan registration policies

and procedures

Proper loan registration policies for refinances can protect against excessive fallout - by restricting the registration of those loans that might tie up your processing staff and systems and never close. The best time to review you loan registration policies is prior to a refinance cycle. When doing so, specific areas should be addressed, such as maximum length of locks on refinances; upfront nonrefundable fees; policies on renegotiation of rate locks; policies on extensions involving processing delays; and policies regarding loans floating with market.

Given the level of sophistication of today's applicants and the ease with which they can make multiple applications, the shorter the lock period and the higher the upfront charge, the better the chance that applicants will complete the refinance with your company. Loose restrictions will allow you to learn the true meaning of the phrase: "Now you see it, now you don't."

The upfront fee should be competitive within your origination area, but significant enough to assure that you only get serious applicants. You may find that you can charge a minimum application fee for all loans but can only charge significant fees upon rate and point lock-in. Individual states may have restrictions on the fees that can be charged. You must also keep in mind that should the applicant close and rescind, all fees must be returned to the applicant. Regardless of your policies regarding upfront fees, there is always the chance that interest rate volatility with cause applicants towalk," or at the very least, request a lower rate. Your policies regarding renegotiation should allow for some flexibility but should be set within the following parameters:

* Only renegotiate if there has been meaningful movement from the time of lock-in (i.e., at least 1 percent in discount or one-quarter percent in rate).

* Only relock if the loan is approved and set for closing.

* Set policies holding the originator responsible for applicants that renegotiate (i.e., a reduction in commission or loss of coverage).

One of the more difficult situations to manage pertains to loans that must be extended due to processing delays beyond the control of the applicant. Many states require that the rate be extended with no increase in points in these cases. Discretion must be used when increasing the refinance applicant's points when the delay is caused by your company or a third party contracted by your firm.

Loans floating with the market present the biggest challenges associated with the refinance pipeline. In the case of refinances, these either represent applicants that need a lower rate to make the refi worthwhile, those that are optimistic that lower rates are ahead or those that have locked at another company and are using you as a hedge against rates dropping. Regardless, many will never close if rates go up, and a large volume of loans that have not yet locked could lock any day if rates pick up. This situation holds the potential for inflicting sizeable marketing losses. Policies should be set regarding allowance of unlocked, or floating, refinances, daily cutoff time for rate lock of floats and requirements for lock/closing after the loan approval.

Loan programs

Certain loan programs carry stronger appeal for the refinance applicant. In analyzing your product menu, keep in mind the motivations of the applicant, which will include establishing a fixed rate (replacing an adjustable), reducing the term, obtaining cash to pay off a home-equity loan and obtaining cash for other purposes.

Your product menu during strong refinance periods should include aggressive, reduced-term programs such as 10-year, 15-year and 20-year fixed rates. Markets with concentrations of transient homeowners will require a wide array of five- and seven-year products. All loan programs should allow for alternative documentation to enable faster processing. Remember, the shorter the processing time, the less chance for fallout. As the refinance cycle progresses, it will be imperative that pipeline analysis include a product-by-product breakdown of purchases versus refinances on a day-to-day basis.


The mortgage banking industry failed miserably in 1986 to efficiently handle the volume during that memorable refinance cycle. Much of the failure can be attributed to poor planning and improper staffing. Staffing analysis and planning should be an integral part of any company.

It's important to understand the volume/staff relationships by functional area in order to determine what increases (or decreases) in personnel are needed with the rise and fall in volume. These relationships should be on a per-loan-file basis. Prior to closing, these projections should be based on application volume. After closing, these projections should be based on closed loan volume or expected closing volume (closed or pull-through" percentage times total application volume). One of the most difficult areas of planning in a mortgage banking operation has to do with the determination of "average volume." Permanent staffing should be based upon the average volume with temporary staffing and overtime to handle the cyclical increases.

Refinance cycles differ from normal cyclical increases as the volume increases may be more dramatic, can last longer and may end more suddenly. Normal overtime may not be adequate to handle the workload. Accurate closing volume projections are imperative during such a period. Daily application volume should be tracked, pull-through projected, and steps taken to staff accordingly. The normal lag time between application date and closing (usually 45 to 75 days) should allow for staffing and training.

Warehouse lines

The same volume analysis used for staffing must be used along with funding projections to project warehouse balances. Unlike staffing, where personnel needs can almost always be met (with varying levels of expertise), warehouse needs may not always be as simple to arrange. Inability to arrange sufficient lines may limit your ability to accept new applications at some point. Warehouse projections should be an ongoing part of the business but dramatic increases in application volume due to refinances will require immediate attention.

System constraints

Swelling pipelines will strain every part of an operation including the data processing systems. A thorough review of equipment capacity and memory will prove beneficial. Additional PCs or terminals may be required during peak periods. The efficiency and speed of any system will be reduced by additional pipeline. For the occasional and temporary increases, it may prove more efficient to rent hardware. Efforts to eliminate loans that will never close will pay great time benefits within most systems. This can be done by requiring loan officers to review their pipeline on a weekly basis and cancelling those loans that appear to be "dead deals."

Makeup of servicing portfolio

The main purpose of this article is to discuss the steps to be taken in managing the refinance pipeline, but any discussion should include at least a mention of the servicing portfolio. While most investors and agencies prohibit a direct refinance solicitation of loans serviced for them, you should make available to your borrowers a contact person within your company should they have an interest in discussing refinance possibilities. It may make sense to reduce the fees required for refinancing if the applicant's loan is already being serviced by your organization; especially if you are not paying a commissioned loan officer. If monthly statements are used by your servicing operation, they can be a handy way to let your borrowers know about how to inquire about refinancing.

Refinance periods will result in increased prepayment rates. The makeup of your portfolio will determine how dramatic the runoff will be. It may be necessary to make a servicing purchase to offset the loss due to prepayments. One benefit might be the potential for slower prepayments if the servicing that is purchased is newly originated due to the lower note rates in the refinance cycle.

Historical fallout levels of refinances

As a precursor to any pipeline management program, it is important that historical data be available on the percent of lock-in loans that close. Ideally this information should be available by product type, loan stage (i.e., application submitted, approved, closing documents drawn, loan closed) and should reflect the percentage change in pull-through with price movement from lock until closing or cancellation. Chart 4 shows such an example.

With regard to refinances, this data should also be compiled by loan purpose. For example, information would be available for 30-year, conventional, conforming, fixed rates at the application stage for purchases and refinances. You will see a decidedly different chart for refinances as opposed to the purchases. The purchaser is bound by a real estate sales contract to perform by a certain date. The typical refinance applicant does not have this same sense of urgency to close.

Analysis and management

Proper preparation and planning makes for improved results when analyzing and managing the refinance pipeline. Even with this, the most seasoned pipeline manager must have accurate, timely information in order to make the decisions necessary to manage the interest-rate risk associated with a pipeline of quoted and closed refinance loans.

Pipelines normally are made up of 70 percent purchases and 30 percent refinances. The current refinance period saw pipelines exceeding 80 percent refinances. As stated before, refinances will perform differently in relation to fallout. Given this, different pull-through percentages must be applied to calculate the levels of coverage needed. In addition, the pull-through percentages will move more dramatically in response to interest rate volatility. A 1.0 percent move in discount points up or down will cause a much larger change in the pull-through of refinances than in purchase loans. Thus each company's pipeline will react somewhat differently.

It would be ideal if historical data were available on refinances within your company. If it is not, normal pipeline pull-through percentages could be viewed with the changes in response to market movement exaggerated. It is imperative that your pipeline be broken down by note rate, product type, purpose and by processing stage. A marketing system that does pull-through analysis on an individual loan basis would produce the best results. For most a weighted-average analysis must be used.

In addition to the gross position, the price in relation to the current market must be available. From this, the net value can be computed by applying the proper pull-through percentage. Pipelines constantly change with new loans, changes in existing loans and market movement. As stated, a pipeline composed of a high percentage of refinances requires different management techniques. One technique that might be employed would be to have an increased percentage of optional coverage due to the exaggerated changes in pull-through with market volatility. Managers could also perform constant analysis of the unlocked pipeline, and could possibly cancel expired floats if the borrower refused to lock and close, as well as offer an incentive for short-term lock-ins. Some level of hedging should be used as well.

Another factor to closely monitor is the varying behavior of loans that are offered at what might be termed "status" and "nonstatus rates." In interest rate environments such as the current one, mortgage bankers will see an interesting phenomenon with pull-through percentages when comparing two rates that fall within one interest rate range to two rates that fall within two interest rate ranges. For example, when someone locks into a rate of 8.875, we have found that the pull-through percentage is much higher for this rate, because of a psychological satisfaction at having locked in at that rate as opposed to going up to 9 percent. In this example, 8.875 percent would be a "status" rate and 9 percent would be a "nonstatus" rate. Interestingly, the difference in the pull-through percentages between these two note rates are much wider than one would expect given a .125 percent difference in two other given note rates within the 8 percent range. Therefore, because of this psychological factor, mortgage bankers can expect applications locked at these "status" levels to behave much differently in terms of pull-through percentages. These rates are termed "status" rates because of the borrower's tendency to brag about this rate to his or her contemporaries.

Unlocked refinance loans must be looked at differently from the usual unlocked loans associated with purchase mortgages. A certain level of optional coverage must be in place to protect against the rapid lock-in of floating loans. These rapid locks will occur only with sharp increases in rates, creating the potential for marketing losses. This is the reason the unlocked loans must be separated by processing stage and reviewed just like locked loans. This is also why a policy requiring these loans to lock and close within a specified period is needed. It may prove beneficial to offer enhanced pricing with lower discounts points to approved, unlocked loans in an effort to have them lock and close within a 10- or 15-day period.

Some level of optional coverage must be used for both pipeline and unlocked loan coverage. Much lower percentages of mandatory coverage can be used for refinances because much lower percentages of these loans will close, regardless of market movement. Conversely, much lower percentages of loans will never close regardless of market movement. Keep in mind that these applicants have previously qualified for a mortgage loan at a higher interest rate. The chances of rejection due to credit are much less, therefore, for refinances. Many mortgage bankers experienced pull-through levels in excess of 95 percent in the spring of 1986.

Table 1 is an example of a sample coverage matrix based upon the varying coverage levels and types of coverage needed for different note rates separated by loan purpose. This example assumes all locked loans in the pipeline are locked at current market levels.

Once you have established the coverage levels corresponding with the expected pull-through percentages brought about when no market movement is in place (no interest rate volatility), and having the historical data that shows how pull-through percentages will change with market movement, effective pipeline management will rest with continued monitoring of the pipeline with adjustments accordingly. It is important to understand and anticipate the end of a refinance craze. Chart 5 shows how decreases and increases the average interest

rate in 30-year, fixed-rate mortgage loans from October 1991 until March 1992 affected the weekly percentage of refinance loans during the same period. It is easy to see what a minor uptick in rates will do to the refinance volume.

Assessment results

"Those who do not learn from history are destined to repeat it." This well-known quote applies very aptly to the completion of a refinance cycle. Mortgage bankers should take time to compute the pull-through figures for the refinance applications that have either closed or cancelled. Assuming that the production source mix doesn't change, those statistics will prove invaluable when refinances again dominate the pipelines of mortgage bankers - and you can be assured that they will.

In summary, refinance cycles require a great deal of planning and intense management. The secondary marketing department must keep in mind that the goal should be to protect against loss, not to attempt to produce extraordinary gains during such an origination period. The increased volume will allow for increased origination fees and the creation of servicing that will have an ongoing value to the company. These factors alone should allow for the mortgage banker to prosper during such a cycle provided marketing losses are avoided.

Don M. "Dusty" Lashbrook is the senior vice president of marketing for Maryland National Mortgage Corporation based in Baltimore. He is currently responsible for marketing, risk management and post-settlement operations.
COPYRIGHT 1992 Mortgage Bankers Association of America
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Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Title Annotation:mortgage lending strategies
Author:Lashbrook, Dusty
Publication:Mortgage Banking
Article Type:Cover Story
Date:Apr 1, 1992
Previous Article:Boardroom view.
Next Article:A peak year for private pass-throughs.

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