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Pricing for profits.

Pricing mortgages off the screen is not the way to make profits. Mortgage bankers must factor in the other key variables that together determine the profitability of their pricing.

In days past, when there was less competition and lower rate volatility, secondary marketing performance bench marks were often very simplistic. The mandate frequently was to break even in terms of security execution, thereby leaving 50 basis points of servicing on the table as "gravy."

An occasional month of secondary marketing losses was tolerated--after all, gross profit margins were high, and servicing assets were valuable enough that small pieces of the servicing portfolio could be broken off to subsidize secondary marketing losses. And, if there was a thrift or banking parent, it may have been possible to bury losers in the portfolio. (This strategy never made economic sense, because unreversed market-value losses, by definition, come back over time in the form of reduced earnings.)

Today, all-in spreads are much narrower, and interest rates are more volatile, so mortgage bankers who manage their operations and their risks more effectively are building a formidable advantage over loosely managed operations.

Pricing strategies followed by mortgage bankers differ significantly from one institution to another, sometimes, though not always, reflecting competitive forces. We have seen some mid-western institutions charging a point upfront to lock the rate on a mortgage application. This typically reflects a greater overall spread earned by the mortgage banker (adding together upfront points and points at closing), and also results in a lower fallout in virtually all rate-change scenarios. This is the case because the borrower must forfeit the fee if he or she walks away from the commitment (meaning a greater rate decline is needed to provide the consumer with an incentive to take down a mortgage elsewhere). The reduced sensitivity of fallout to interest rate changes results in a lower hedge cost (more about this later). However, the increased profitability gained by charging the upfront fee almost always substantially reduces loan volume.

Because of competition, in many markets, imposing an upfront fee would all but dry up origination volume. In some markets, such as California and Texas, some institutions even offer a float-down commitment, which provides the borrower with the benefit of any rate decline during the life of the rate lock--in some cases, whether the borrower asks for it or not. This type of rate-lock commitment dramatically increases the cost of hedging, for reasons that will be explained later. Unless this business is done at a substantially higher spread, making this type of commitment clearly has a negative effect on the profitability of each commitment. Whether it makes sense to offer this type of commitment--where the borrower is given the benefit of subsequent rate drops during the lock period--depends first on whether these commitments are profitable at all. Second, it depends on the extent to which volume is increased by offering such a commitment.

The current interest rate environment has dramatically increased the volume of refinance applications. Pricing a refinance commitment is more challenging, because the borrower is unlikely to close the loan if rates fall, but is very likely to close if rates rise during the rate-lock period. Refinance commitments typically have more upside potential than the float-down commitment, because the borrower is not automatically entitled to a lower rate as rates decline. Some mortgage bankers attempt to maintain the same net level of profitability on refinance applications as on other applications by charging a fee to lock the rate on refinance applications.

In our observations of the industry, it has been surprising to see how infrequently mortgage bankers go beyond their intuition and rigorously analyze the profitability implications of their own pricing decisions and rate-lock strategies.

Quantifying quandaries

The building blocks of profitability are well known, but systematic analysis is often inhibited because it is not always easy to quantify some important elements. For example, how does a mortgage company's hedge cost vary among different product types? Or, how much more should a mortgage company charge for a 60-day lock than for a 30-day lock? Should the company structure and price refinance commitments differently than purchase commitments? How does the value of servicing vary among product types? Being able to answer these questions is the key to making economically sound pricing decisions, which in turn is key to survival in today's marketplace. This article will set forth a practical methodology for accurately computing commitment profitability.

Practitioners typically have the most trouble trying to quantify a reserve for hedge costs (or in some cases, understanding why there should necessarily be one.) Most mortgage bankers realize that in making rate lock commitments to borrowers, they are issuing put options. To accurately determine this value, an understanding of option theory is needed. Unfortunately, few can quantify the value of the options that they are giving away. In this discussion, we will show how to determine the value of the options that have been given away.

Determining the value of servicing can also be difficult. Current market prices may be readily available, but if a mortgage lender intends to retain the servicing, it must also establish an accurate appraisal of the economic value the servicing holds for the institution. This should be based on that institution's own cost of capital and cost of servicing. This article will address the subject of how to obtain this piece of the profitability equation.

The profitability equation

The following section will describe the commitment profitability equation and present a table quantifying all the variables of the equation. All-in profit will be calculated for both government and conventional loans of different expiration dates for both refinance and purchase commitments. In the example that has been constructed, the mortgage banker is following a simple strategy of pricing commitments to the screen (i.e. equal to forward-market security prices). The analysis is based on the market conditions present on October 30, 1991.

Profit from loan origination is determined according to the following equation:

Profit = Inflow-Outflow

Inflow = Forward price of underlying mortgage.

+ Value of servicing created

+ Points collected upon application, if any

+ Interest accrued from closing date to forward settlement date in excess of interest paid on warehouse line.

Outflow = Par minus discount points collected at closing

+ Reserve for cost of hedging interest rate risk during the commitment period

+ Points paid to intermediaries such as loan brokers

+ Administrative and other expenses associated with loan origination not recovered from application fees. (Costs associated with servicing of loans should be reflected in "value of servicing created.")

Now that we have established the profitability equation, we will review an actual example. Exhibit 1 shows a profitability analysis for ABC Mortgage Company for typical mortgage loan commitments with the variations that were described earlier. Definitions of each item on the table are found in the glossary. (See sidebar.)

Interpreting the numbers

A few generalizations are apparent from Exhibit 1. Notice the shaded columns: servicing value, hedge cost and all-in profit. First, the cost of hedging refinance mortgages is substantially higher than for purchase mortgages. Later we will explain that this is because refinances carry greater fallout risk (or are more "put option-like") than purchases. (See Exhibit 2 for closing ratio assumptions.) Second, the value of servicing declines as the note rate increases. This reflects the greater prepayment risk for mortgages of higher interest rates. Third, commitments of longer time periods cost more to hedge.

From the analysis, it is evident that the example mortgage banker, who has priced all his loans "to the screen," (i.e., equal to the likely settlement month, forward-market prices) is, perhaps unknowingly, building in a substantially smaller profit margin on some commitments than on others. Producing a table like this should be a daily ritual at every mortgage banking company.

Let's look at a couple of specific examples from Exhibit 1. Each line represents a different possible commitment that could be offered to a loan applicant. Exhibit 1 is comprised of two major categories, purchase mortgage commitments and refinance mortgage commitments. Under each category is a block for 30-year, conventional, conforming loans and a block for 30-year, government loans (others could have been shown but were omitted in order to keep the example simple). Within each block are a variety of different commitment term and note rate combinations that a loan applicant might choose. (For purposes of the example, all pricing numbers are expressed in decimal rather than fractions.)

For example, on the fifth line is the pricing analysis for a commitment on a 8 1/2 percent, 30-year, conventional, purchase, fixed-rate mortgage, with a 45-day, rate-lock period. Because ABC Mortgage Company requires 10 days on average to process a loan from closing to settlement against a forward commitment, given a current date of October 30, this loan can be ready by the Public Securities Association (PSA) standard security settlement date in January. As previously stated, the pricing rule followed by this mortgage banker is to quote "screen prices," allowing a 50 basis point servicing spread (including the guaranty fee). Therefore, because the January, 8 percent, Freddie Mac, forward price was 98 11/32, the discount points at closing would be 1.625 (rounding to the nearest 1/8th).

This pricing follows the old "break-even" rule. Unfortunately, this is where many mortgage bankers stop in making their pricing decisions.

Typically, mortgage bankers do not give proper attention to the following items, which have a significant impact on profitability:

* the value of the servicing created; * the net interest earned from the

expected loan closing date to the

mortgage-backed security (MBS)

settlement date; * the cost of hedging interest-rate

risk; * any fees collected or paid; * origination and overhead costs.

These items often vary considerably from one commitment to another, yet our hypothetical mortgage banker is pricing all his commitments strictly on the basis of forward-market prices. Let us go back to complete the analysis of the profitability of the 8 1/2 percent, 30-day, conventional, purchase mortgage commitment. On the inflow side, the loan can be sold in the forward market for 98.344. The value of servicing (expressed as a percentage of the loan amount) was determined to be 1.740 (more about how this is calculated later). An interest spread of 0.262 is earned from the expected loan closing date to the forward-commitment settlement date (this is equal to the difference between the interest earned on the mortgage and interest paid on the warehouse line of credit). Thus, the total inflow is 98.344 + 1.740 + 0.262 = 100.346.

On the other side of the equation, the buy price of the loan is 98.375 (par less 1.625 discount points), hedge cost is 0.091 (more details about this will follow), and origination cost and overhead cost are assumed to be .25 each. (Actual costs would be specific to each institution.) Thus the total outflow is 98.375 + 0.091 + 0.50 = 98.966. This makes for an all-in profit of 100.346 - 98.966 = 1.380.

Now let us examine a commitment on a 9 percent, 30-year, conventional, refinance, fixed-rate mortgage, with a 60-day rate-lock period. Based on the same 10-day processing time to take a loan from closing to settlement against a forward commitment, this loan can also be ready for January settlement. Again following the pricing rule of quoting "screen prices," allowing a 50 basis point spread for servicing and guaranty fee, because the January, 8 1/2 percent, Freddie Mac, forward price was 100 30/32, the discount points at closing would be -0.875 (rounding to the nearest 1/8th).

To determine actual profitability, we follow the same process as before. On the inflow side, the loan can be sold in the forward market for 100.938. The value of servicing was determined to be 1.640 (lower than for the 8 1/2 percent note because the higher note rate brings a shorter expected life under any interest rate scenario). An interest spread of 0.133 is earned from the expected loan closing date to the forward-commitment settlement date (lower than before, because this loan will be held for fewer days prior to settlement against the forward commitment). Thus, the total inflow is 100.938 + 1.640 + 0.133 = 102.711.

On the outflow side, the buy price of the loan is 100.875, the hedge cost is 0.303 (much higher than for the other commitment because of the greater fallout risk). The origination cost and overhead cost are still each 0.25. The total outflow is 100.875 + 0.303 + 0.20 = 101.378. Thus the all-in profit is 102.711-101.678 = 1.033. This is 0.347 less than for the other commitment, even though both were apparently priced to break even. To produce the same expected profit, the mortgage banker would have charged 3/8 more discount points at closing on this latter commitment for a refinance. (It may be more complicated than this, however, if charging the 3/8 additional points changes the fallout function.) At any rate, the optimal approach to pricing involves simultaneous consideration of profit margins per commitment and volume.

How to use profitability analysis to set prices

Determining the cost of producing a loan is the first step in determining the price at which it should be sold. Obviously, the goal of a mortgage company is to do better than break even. In fact, the goal should be to maximize profits. Different pricing levels imply different volume levels, as well as different profits per loan. Trial and error will help you determine the effect of price levels on loan demand; prices should be increased to the point that the profit-per-loan-times-volume equation is maximized. But to do this, it is necessary to accurately quantify total profit per loan as a function of price.

Mortgage product is complicated to evaluate because of the hedge cost and servicing elements. (Even though the mortgage loan may be sold into the secondary market, the servicing revenue stream will continue for as long as 30 years.) The pricing of less-generic products, such as refinance loans, balloons, mortgage broker-originated business and builder commitments, is more complex. Many mortgage bankers in competitive markets play "follow the leader" when setting prices. This could lead to problems if the competitors being followed have lower costs of servicing or origination, or are managing risks more effectively.

Each mortgage banker should establish a minimum cutoff price for each product, below which the lender simply will not offer that particular product. Above that level, pricing should be set to maximize the equation of profit per loan times volume. It is clearly not possible to carry out this approach without a detailed, disciplined, daily profitability analysis.

An important final aspect of this pricing discussion is how to calculate the hedge costs and servicing value pieces of the equation.

To explain how we arrive at hedge costs, we will need to step back a little and review some fundamental issues in modeling a mortgage pipeline.

Mortgage bankers are well aware of the asymmetric risk involved in making rate-lock mortgage commitments. When interest rates rise, a higher-than-average number of commitments close. When interest rates fall, a lower-than-average number of commitments close. As a result, the "upside" in mortgage origination is smaller than the "downside." Because of inefficiencies in the way that borrowers exercise their option to "walk away" from rate-lock commitments, the rate-lock commitment is less valuable than a market put option. While it is significantly cheaper to reverse than a market put option, it is also a more complicated option to replicate, simply because of the need to capture the essence of the inefficiency. It is a mistake to view the rate-lock commitment as a simple put option. Doing so invariably increases the cost of the hedge and leads to less consistent profitability. A framework for correctly offsetting the risk of a rate-lock commitment is outlined later.

The key to evaluating different types of commitments is determining the sensitivity of their fallout ratios to interest rate changes. This task entails estimating a conditional relationship between interest rate changes and commitment closing ratios (adjusted for partial rate concessions) for a broad range of movements, up and down, in interest rates. Once this is accomplished, it is then possible to determine associated commitment profit-and-loss profiles.

The level and shape of the fallout function determines the commitment profit-and-loss profile. For a given market scenario, unhedged profits per commitment will, by definition, equal [closing ratio x (initial spread + change in MBS price)]. The "initial spread" is the difference between the commitment price (par minus points deducted at closing) and the forward-delivery MBS price, at the time the commitment is made. (See Exhibit 2.)

The cost of hedging is ultimately computed by determining the purchase price of the portfolio of hedge instruments needed to reverse the commitment profit-and-loss profile. The larger the downside relative to the upside (i.e., the more asymmetric the profile), the larger will be the cost of the hedge. Thus, it will cost more to hedge refinance than purchases, because refi applicants are more likely to "walk" in a falling rate scenario than purchase mortgage applicants.

Value of servicing

Because the cash flows to mortgage servicing rights are not deterministic, that is, known in advance, but rather, vary depending upon the course of interest rates, to arrive at a true economic value, a "stochastic" pricing model must be used. This is a model that randomly generates hundreds of interest-rate scenarios that are constrained to be consistent with the current term structure of interest rates and current market volatility. The most widely accepted stochastic model is the Option-Adjusted Spread model (also known as the Monte Carlo simulation model).

Within this framework, it is possible to model ancillary revenues and costs on a functional basis related to percentage of loans remaining, current balance, declining balance, payment amounts and prepayment amounts. Payment, escrow and prepayment float earning rates are pegged to simulated periodic interest rates. Escrow and cost growth over time can be functionally related to inflation, which in turn is modeled relative to future interest rates (e.g., assuming a constant real rate of interest). A prepayment function based on national averages or one specific to the experience of the institution may be assumed. Such a model can determine the current economic value of servicing, as well as the sensitivity of that value to changes in interest rate levels. This is done by averaging the results of hundreds of randomly generated interest rate scenarios.

Institutions that don't have the ability to generate such analyses in-house may be able to gain access to this type of model through consultants or Wall Street investment firms that have stochastic models available.

It is well understood that the right to service a 30-year, fixed-rate mortgage is more valuable than the right to service a 15-year, fixed-rate mortgage. It is also well known that, for a given mortgage type and remaining maturity, the right to service a higher-note-rate mortgage is less valuable than the right to service a lower-note-rate mortgage.

However, more subtle factors can also have a large impact on servicing value. For example, there is good reason to believe that a borrower who, given the choice, prefers a higher note rate/lower point combination at origination expects to remain in his house for a shorter period of time (i.e., prepay sooner). Thus, such a mortgage may well be expected to prepay at a higher rate under any interest rate scenario. The effect of this on relative servicing values may be dramatic, as much as 1 1/4 to 1 1/2 cents per basis point of retained servicing (after guaranty fee), under the extreme assumption of a 10 percentage point increase in CPR. This would translate to a 0.40 per 100 reduction in servicing value for a typical package. This increased prepayment bias can thus have a significant effect of the previously presented analysis, which assumed a constant prepayment function (i.e., prepayment rate as a function of the spread between the mortgage note rate and the prevailing refinance rate).

This potential tilt strongly reinforces the previously established point that mortgages of higher note rates carry lower servicing values, thus requiring that the mortgage banker not cut the discount points charged on such loans as much as differences in security prices alone would dictate.

In the 1990s, it will be necessary for all types of financial institutions to extract maximum profit from their operations. Rational pricing of mortgage commitments will continue to increase in importance in determining success of mortgage banking operations.

Glossary of Exhibit 1


Commitment term--number of days to expiration of rate-lock commitment.

Note rate--mortgage interest rate.

Closing points--discount points to be collected at closing.

Settlement month--first month in which loan could be ready for settlement against a forward MBS contract.

Security rate--coupon rate of security into which loan could be delivered.


Security price--forward price for MBS of indicated security rate settling in indicated month.

Excess servicing/basis points--number of basis points of servicing created, in excess of 50 {note rate-(security rate + .50)}. Note: base servicing could be defined at a different level; would not affect net value.

Excess servicing/value--economic value of excess servicing created

Base servicing/basis points--number of basis points of base servicing created, 50 in this example (this number is somewhat arbitrary, and does not affect net value since an increase in base servicing decreases excess servicing, and vice versa).

Base servicing/value--economic value of base servicing, equal to value of 50 basis point fee plus residual value. Residual value is equal to the value of miscellaneous revenues (e.g., escrows) minus the costs of servicing.

Fees collected--fees collected on application, in points.

Interest spread--interest differential earned between expected loan closing date and expected forward settlement date (based on difference between mortgage note rate and warehouse financing rate and numbers of days loan is carried).


Buy price--par minus points to be collected at closing.

Hedge cost--cost of reversing interest rate risk created by the rate-lock commitment.

Fees paid--fees paid (e.g., to brokers) on closing, in points.

Origination and overhead costs--costs, expressed in points, of origination and general overhead allocated to origination function.

Marketing spread--difference between security price (plus value of excess servicing) and quoted buy price (100--closing points).

All-in profit--net profit of origination. [Exhibit 1 and 2 Omitted]

Stephen R. Rigsbee, Sirri S. Ayaydin and Charles A. Richard III, are principals of Quantitative Risk Management Group, a interest rate risk management consulting firm based in Chicago.
COPYRIGHT 1992 Mortgage Bankers Association of America
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Author:Rigsbee, Stephen R.; Ayaydin, Sirri S.; Richard, Charles A., III.
Publication:Mortgage Banking
Date:Feb 1, 1992
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