Hedging--not such a bad word after all.
Mortgage bankers must focus on making their secondary marketing operations more efficient and profitable. That means implementing a routine that goes beyond best-efforts execution and making the operational transition necessary to do mandatory execution, which has traditionally been viewed as too risky. Today, several service providers and applications exist to make this transition safe, mitigating risks and putting mortgage bankers in a position to capitalize on mandatory commitment strategies.
There is a misconception in the market that best-efforts execution eliminates all risk. In the same vein, most people associate hedging with the introduction of greater risk. Let's use the first two months of 2008 as an example of why best-efforts is not always the best bet. As pricing volatility increased, investor Web sites seized up with traffic as systems were overwhelmed by lenders rushing to lock loans. Often, investor prices worsened before the loans could be locked, leaving the lender with a dilemma--honor the commitment to the loan officer and suffer the loss or go back to the loan officer with the new price.
Additionally, because of the increased volume and volatility, many loans could not be delivered within the time constraints of their best-efforts commitment and the lenders' pull-through ratios suffered. By the time lenders processed the loans in their pipeline, many loans had already been repriced, often at a significant loss to the lender.
Mandatory executions avoid these operational risks. First, loans are committed on a live market price, so the lender is never in a position of locking in a loss--as may be the case in the best-efforts scenario. Further, because no commitment is made until the loan is funded and available for sale, there should never be an issue with missing a delivery deadline.
That's not to say that all lenders should implement mandatory execution strategies for their entire pipeline; there are numerous factors involved in determining the best approach. Worth noting, there are several opportunities for lenders when it comes to locking loans. This column touches on best efforts and basic mandatory forward commitments. Once a lender gets these basics down, the leap to more sophisticated transactions such as assignments of trade and co-issues is much simpler.
In a best-efforts transaction, the lender passes the interest rate and fallout risk to the investor, with the understanding that the loan will be sold to that investor. If the loan fails to close, the investor typically will not take any recourse against the lender. However, by passing along these risks, the lender foregoes the opportunity for better price.
Under the best-efforts model, the lender retains the risk that the investor may worsen the pricing if it consistently fails to deliver a high percentage of its loans. Conversely, with a mandatory commitment strategy, 100 percent of the loans that are committed, whether bulk or individually, should be delivered to the investor within the agreed time frame. This ensures that, from the investor's perspective, the lender looks like a pull-through all-star.
The primary incentive for implementing a mandatory strategy is to realize the increased pricing that investors pay for mandatory deliveries. While pricing for a flow-mandatory strategy generally beats best-efforts pricing, there is even better pricing available for specifically negotiated commitment arrangements to larger (bulk) volumes.
Delivering into an assignment of trade (AOT) is the process of assigning a mortgage-backed securities (MBS) trade to an investor and then delivering loans to that investor to fill the assigned MBS obligation. Concurrent assignment, also known as co-issue, is the delivery of loan collateral to one of the government-sponsored enterprises (GSEs) with a simultaneous delivery of the servicing rights of those loans to a third party. These strategies allow for more flexibility in timing of the delivery of the loans, better cash flow and possibly a more favorable negotiation of the GSE's charge for securitizing the loans.
Regardless of which option a lender selects, a hedging strategy is essential to any mandatory-commitment approach.
With the right systems in place, interest-rate risk is manageable using the MBS market. It may be more appropriate to think of hedging as margin preservation. Lenders should establish their pricing strategy based on their cost of operations and market pricing. They then implement operational disciplines that preserve this margin. Once this margin has been preserved, they are in a position to capture the maximum revenue available with a forward or mandatory commitment. After all, by definition, isn't a lender already trying to maximize its profit potential? Isn't increasing the value of a lender's loans through a mandatory delivery just one more iteration of existing operational disciplines? Why make it a more dramatic concept than it really is?
Perhaps the biggest challenge for mortgage bankers is managing fallout risk. Fallout, the converse of pull-through, is defined as any loan that fails to close at the price and terms upon which the lock commitment was granted.
While fallout is a reality, lenders cannot--and should not--use it as an excuse to avoid mandatory commitments. Implementing a strategy that provides financial and operational benefits in today's market, by measuring and managing fallout, is a significant opportunity that should not be squandered. Mortgage bankers must focus on tailoring their business and operational models around a risk-management strategy--excuse me, a margin-preservation strategy--that will maximize their profit potential.
Detailed earlier are several factors that can play a role in designing a secondary marketing strategy. For example, different origination tactics can affect pull-through. Retail is less likely to be as heavily impacted by market volatility as a wholesale operation. Geography can also be a key criterion, as a rural market is likely to have less pull-through volatility than a metropolitan area.
Because there are so many characteristics that can affect a secondary marketing strategy, lenders must identify their unique pull-through considerations. It's critical that mortgage bankers engage the appropriate systems and expertise to properly implement these programs. There are a number of services and systems available in the market that can make the transition to mandatory execution safe and easy while eliminating the guesswork involved in mandatory deliveries.
Any plan should be agile enough to adjust to market conditions, as well as the particulars of an institution. Expansions, new employees and new products can all affect pull-through, and having analytics to properly measure a secondary marketing department's performance is crucial.
But perhaps the most critical operational discipline is to implement a centralized lock desk. Some lenders already use a central lock desk; however, many in the market still allow loan officers to lock their own loans directly with investors. But let's look at the risk associated with a lock commitment. Borrowers have the right--but no obligation-to close their loan, which means that lenders can incur fallout risk. The sooner the status of a loan can be entered into the fallout equation, the better lenders can manage the risk.
Now, that's not to say it's easy to convince loan officers to give up control of the lock process--and in this market, there's always the fear of losing top talent. With the right strategy and technology tools in place, it's possible to make the transition smoother, particularly if loan officers still feel as though they are in control of the process and have an operational advantage that results in quicker, smoother closings.
Keeping rates competitive for originators is important, and in some cases it may also be possible to allow loan officers to see pricing from multiple investors alongside a lender's own products. Eventually the originator will chose its own lender's products because the originator has more influence over the processing of the loan, has competitive pricing and will experience less stress in closing the loan, resulting in a more satisfied customer. In this case, the secondary marketing department will ultimately experience higher pull-through rates.
Lock-desk technologies have come a long way, and leveraging the inherent advantages that technology offers can be substantial. The days of Excel [R] spreadsheets are gone, and to remain competitive, lenders must find best-execution technology that is easy to use, accurate and integrates seamlessly with other technology used throughout the life cycle of the loan such as origination, underwriting, and product eligibility and pricing systems. Product eligibility and pricing engine technology has gained traction in this arena, largely because it enables the loan officer to immediately source and price the best-fit, best-priced product for the borrower. It is essential that pricing be 100 percent accurate, because if the pricing is incorrect, losses and angry customers and originators are sure to follow.
Within the context of secondary marketing, margin preservation is highly dynamic. Every day, loans flow into the pipeline, loans fall out and loans are committed out to investors. This means that lenders must adjust their hedge position to accommodate these incremental changes within the pipeline. Valuing the pipeline in real-time and using integrated analytical tools to adjust the hedge position is key to the preservation of the margin for mandatory delivery over best efforts. This, along with early identification of problems with rapidly changing loan-level risk adjusters and eligibility guidelines, can help ensure lenders meet revenue goals.
A successful hedging strategy hinges on a few absolutes: Accurate data, a consistent pricing strategy, inventory control, a centralized locking function and real-time pipeline valuation. Hedging and real-time pricing/locking are two of the best ways to dramatically boost revenue while increasing operational efficiencies, neutralizing interest-rate and fallout risk. Moving past best-efforts execution is a time-tested method for improving profitability, which, in today's market, using contemporary technology and services has become easier than ever.
Larry Huff is co-founder and co-chief executive officer of Optimal Blue. Piano.Texas. He can be reached at email@example.com
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|Title Annotation:||Executive Essay|
|Comment:||Hedging--not such a bad word after all.(Executive Essay)|
|Date:||Jul 1, 2008|
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