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Wholesale commitments.

THE ANATOMY OF A WHOLESALE transaction in mortgage banking is something worth exploring. This side of the business is booming and both would-be participants and current players can benefit from an analysis of the factors that shape these transactions.

The purpose of this article is to examine the different types of wholesale transactions, how each is structured, priced and used. By exploring this area in detail, we hope to allay the confusion among some originators, who do not understand why certain sellers get better prices than others and to explain what additional responsibilities these sellers must assume to obtain more favorable prices.

Basically, there are four ways of selling loans into the wholesale secondary market. First, one can sell whole loans into a security retaining and aggregating servicing, which is earmarked for subsequent sale as block servicing transfers. Second, one can sell whole loans servicing-released on a mandatory-delivery basis. Third, one can sell whole loans servicing-released on a best-effort basis. And finally, one can sell the loans and servicing on a flow basis via transactions called assignments of trade (AOTs), co-issues and concurrent transfers.

The specific method chosen depends on the type of seller and the corresponding appetite for risk. However, certain methods, specifically the first and fourth approaches, are out of the reach of originators who do not have warehouse lines to close and fund loans in their names. These originators--mortgage brokers--depend on a method referred to as table funding to close loans. Table funding, a way of closing and funding loans using the buyer's funds, only permits mandatory and best-effort commitments.

Each transaction has different pricing, delivery requirements, transaction structures and risk characteristics. Assuming the seller has the where-withal to access all of the sales methods, the central question is should the selling party put servicing on its books, thereby selling on a servicing-retained basis? Or, should that party sell loans servicing-released on either a mandatory or best-effort basis? Or instead, should the seller sell loans on a flow basis, assuming the additional risks?

The issue of retaining or releasing servicing boils down to whether or not the seller has the ability to service (or subservice) and can afford to retain the servicing. Absent these requisites, the question is moot. However, if the back-office capability is in place to do the servicing (or subservicing is employed), the question becomes one of capital; specifically, can the seller generate an origination profit, or absent this, can he or she afford a first-year loss, because the accounting rules require the seller to record a loss if the cost of producing the loan exceeds the first-year revenue produced. Because production costs exceed revenue for many mortgage bankers, the answer to this question is oftentimes no.

To circumvent this accounting obstacle, many originators sell their retail production servicing-released and purchase other servicing to replace it. This is done because the accounting rules issued by the Financial Accounting Standards Board, specifically FASB 65, permit "purchased servicing" to be capitalized--thus the expense is amortized--over the expected life of the loan, typically five to ten years. Servicing, that is originated, not purchased, is treated differently. It must be expensed immediately. Although this requirement seems nonsensical to many non-accountants, it is nevertheless the rule.

Additionally, the Federal Deposit Insurance Corporation's capital rules governing purchased servicing only permit 90 percent of the price of the servicing to be capitalized; the remainder must be expensed immediately. Wholesalers not required to comply with these regulations have a definite competitive advantage.


Secondary market pricing reflects the amount of risk the participants assume. The more risk the buyer accepts, the lower the price he or she is willing to pay. Conversely, the more risk the seller takes, the higher the price he or she expects in return. Price and risk, of course, are inversely related. For this reason, higher prices are paid for less risky types of transactions. Based on existing prices, the tiered-pricing structure indicates the market views AOTs as less risky than mandatory or best-effort commitments. But the question is by how much?

Assignment of trade sellers receive the screen (or market) price plus a premium for the servicing. They get the bid price for the security with the desired coupon rate. It the going price for an 8 percent Ginnie Mae is 102.50, for example, the seller receives it. The seller also assumes the interest-rate risk; in the event securities prices rise, good delivery must be made at the committed-to price. If prices fall, delivery remains required at 102.50. The only difference in outcome is whether the seller records a profit or loss on the sale.

Sellers of mandatories get a price about two ticks (32nds), or 6.25 basis points, below the screen price that AOT sellers receive. They also pay an administrative fee of about 25 basis points to cover such expenses as transfer fees, set-up charges, tax service fees and so on. The bottom line is that the mandatory seller gets a price approximately 30 to 35 basis points below the screen.

Best-effort sellers get prices 75 to 150 basis points below the immediate delivery screen, depending on the term of the commitment, typically 30 to 60 days. An administrative fee of approximately 15 basis points, along with a funding fee of around 25 basis points, also is assessed. The bottom line price is 100 to 175 basis points below (or through) the current delivery screen. The price is lower to cover expenses, especially hedging fees, not incurred with an assignment of trade transaction.

Block servicing transfers

A block servicing sale involves a group of pools sold with the servicing rights assigned to another lender. Transaction amounts range from $25 million to $1 billion or more. Specific requirements, such as loan characteristics, seasoning and so forth are established in the offering package. Agency approval must be secured and a fee paid in order to transfer the servicing rights. Getting approval can take 45 days or more. Oftentimes, the highest service release premiums (SRP) are paid for block sales due to the volume efficiencies of the buyers, and the seller's willingness to assume all the risk.

Also, with a block servicing sale, the buyer does not know what is in the pool because the seller's loans are not re-underwritten. Instead, the seller provides warrants to the buyer, protecting the purchasing party against fraud and acknowledging compliance with FHA, VA, Fannie Mae, Freddie Mac and GNMA guidelines and federal laws. If the block of servicing includes mortgages with excessive ratios, which might lead to higher foreclosure costs, the buyer inherits the liability, unless putbacks to the originator are negotiated.

Most wholesalers only perform due diligence of documentation in block trades; they also may do an inspection, though it is generally a servicing operational review, not a re-underwriting of the loans. Instead, documentation is reviewed carefully to ensure that the documents needed from the custodian for pool re-certification are available, complete and correct.

Mandatory commitments

Wholesalers, in much the same way as Fannie Mae and Freddie Mac, offer mandatory delivery commitments to sellers. The contracts require delivery within a specified timeframe. Mandatory delivery contracts typically are available with 30 to 60 day terms, although longer terms are available periodically. The advantage to the seller is a better price than with a best-effort commitment. The originator must deliver even if he or she is unable to produce the loans at the commitment price. This is accomplished by purchasing loans in the open market to make good delivery. Any difference between the mandatory price and the market price represents a loss that must be accepted to make good delivery.

Best-effort commitments

Best-effort transactions commit the seller only to deliver the loans that close. The buyer's risk is not knowing whether delivery will occur, much less whether it will occur in time to fill a pool and issue a security. A month, a week, a day can be important. Although delivery is mandatory if the loan closes, many wholesalers have higher fallout ratios than retail originators because not all sellers always deliver every loan that closes, as they should. The seller enjoys the confidence of price protection in a volatile interest rate environment (a big benefit), while the wholesaler generally pays a reduced, net, service-release premium to cover the heightened exposure. Mortgage brokers generally use best-effort commitments profitably because their volumes and overhead costs are lower than other originators.

The assignment of trade

Loans acquired through assignment of trade transactions generally are new originations. Because this sales method produces the highest price, the amount of AOT business is huge and most companies that can sell this way, do so.

In an assignment of trade, the originator (A) sells a security on a forward, mandatory delivery basis to an investment bank (B). A assigns the pooling responsibility, along with the obligation to deliver, to a third party, the wholesaler (C), who accepts the price A received from B. If the trade is executed at a price of 102-08 for example, B confirms the trade, A signs off on it, and the trade is assigned to C. The originator is released from the security's delivery requirement; the wholesaler is put into the mandatory delivery position and becomes the issuer of the security.

If the transaction is completed in the general delivery period, and if volume is not too great, and if the wholesaler does not have excessive commitment liability with the investment bank, the wholesaler will approve a transaction and confirm the trade. The confirmation states the agreed-upon rate and price, the mortgage term, the type of security and the delivery period. The key point is the seller chooses when to sell the security trade. He or she can pick the time to get coverage, for instance, maybe after a morning rally in the bond market. If the seller does not think the higher price will hold, it can be locked in.

The originator now has a contract to deliver mortgages for the Ginnie Mae to the wholesaler within the delivery cutoff period, typically between the 15th and 19th of the month preceding the delivery month. Loans are funded at a 102-08 price and the wholesaler adds in the agreed-upon servicing release premium.

The premium paid for servicing is determined in one of two ways. Either it is administratively set by the wholesaler, or it is negotiated, based on factors such as the average loan size, the mix of FHA and VA mortgages, and the location of the originations. If the premium is 190 basis points, the all-in or gross price paid to the originator is 104.15 (102.25 + 1.90). (Net prices do not include SRPs.) The only additional charge is a $200 GNMA pool fee.

Today, wholesalers are willing to pay servicing release premiums on assignment of trades that are about 5 basis points higher than those paid on mandatory deliveries. The reason for this "screen-plus pricing" is that because the wholesaler knows the transaction parameters, the delivery period, and has no marketing risk, hedging is not required. This reduces the wholesaler's cost by roughly 10 to 25 basis points. However, what is required of the wholesaler is a capable staff to review the documentation, and to make good, on-time delivery to the custodian, GNMA and Wall Street. The wholesaler's exposure in an AOT is the physical processing of the paperwork, rather than the challenge of originating loans profitably. Loans can be underwritten and documentation reviewed if the wholesaler's staff can do so quickly and efficiently. Wholesalers can pick their products selectively and jettison loans not fitting their guidelines. The originator assumes the full liability for delivering quality loans on time.

All loans must be documented correctly, in increments of $1 million and in deliverable form. Wholesalers usually require a summary sheet of pertinent loan data, such as the case number, the borrower's name, the mortgage amount, the interest rate, the loan term and so on. The information is typed on the security schedule, the seller reformats it, and the documentation is removed and sent to the custodian.

Assignment of trade transactions can be beneficial to all parties if everything is executed properly. Foul-ups can be costly, however. Because the immediate month spread is usually anywhere from 12/32nds to 15/32nds ahead of the next month, the seller who defaults on a trade and must roll it for, say, 12/32nds, wipes out three-quarters of the advantage gained from the 50 basis point better price over a mandatory commitment.


The second type of flow delivery is the co-issue, also known as a simultaneous transfer co-issued. It differs from an assignment of trade in that it involves only conventional collateral, namely Freddie Mac PCs or Fannie Mae MBSs. With co-issuance, the servicing is immediately transferred upon issuance of the security. The issuer/originator assembles all the paperwork, and submits it for final approval to the wholesaler. For agency purposes, the seller becomes the issuer and the wholesaler becomes the servicer simultaneous to the issuance of the security. The investment banker purchases the security from the seller/issuer, but the security holder receives the monthly remittances from the wholesaler. The seller realizes a full screen price in exchange for accepting all origination and market risks.

Concurrent transfer

A concurrent transfer is essentially the same transaction as a co-issue: It transfers servicing at issuance, but can be done with either conventional or FHA/VA collateral. The difference is that it allows the originator to do all the paperwork, thereby creating the advantage of a shorter delivery period. Efficient companies get two additional weeks of closing time, and can still get the loans into the next month's security. As with the assignment of trade, the originator sells the security to Wall Street, controls the secondary marketing decision and assumes all risks.

Because the issuer/wholesaler wants the loans delivered by the 19th of the month, the AOT originator loses 10 to 12 days of closing time each month. In a co-issue transaction, the originator processes the PC or MBS, the security is sold at the last minute, and the wholesaler takes over the servicing. No closing time is lost. Freddie Mac and Fannie Mae approve the transaction at issuance, and the servicing is transferred to the wholesaler, who becomes liable for the monthly remittances to security holders. There is no transfer fee assessed with a co-issue, a money saving benefit for sellers of small pools.

In either a co-issue or concurrent transfer transaction, the paperwork is assigned to the seller. In the event something goes awry, the liability for rolling the security and paying the pair-off costs belongs to the seller, who received a higher price for assuming these additional risks.

In an AOT transaction, the originator must pay the pair-off fee if the whole loan delivery is delayed. If the wholesaler errs in some way, he or she must roll delivery of the security to the following month, or pair it off. To prevent this from happening, a two-week cushion for processing is typically built into the deal. Remember, one mistake in the documentation can render the entire pool ineligible for securitization.


Mortgage originators who wish to sell their production to wholesalers have four methods of sale available to them. Each method has a different market price offset by a variety of combinations of risk and required service on the loans. Originators must evaluate the different prices available and their capacity to perform the additional services and manage the additional risk in exchange for the marginally lower market price available on any given trading day. This is primarily a function of the originator's size, as measured in number of employees and net worth and the available spreads among the four methods.

The largest originators who have sizeable warehouse lines of credit (or are depository institutions with their own funds) would most likely choose selling whole loans into a security and aggregating the servicing for sale in a block. These would consist of loans they had closed already in their own name. Transactions must be at least $25 million, but they secure the highest servicing-release premiums because the seller assumes all the risk.

The next largest firms would usually sell their loans and servicing on a flow basis via AOTs, as they receive the next best pricing--the screen price. Loans are closed in the name of the originator, but then are sold immediately. The originator also receives a servicing-release premium of somewhat less than what is typical with block-servicing transfers. The third general method of sale is table funding with a mandatory commitment, a way of closing loans using the buyer's funds. No warehouse line is required. Current pricing is 30 to 35 basis points less than the screen price. The fourth general method is table funding using best-effort delivery. Here, current pricing is 100 to 175 basis points less than screen pricing, but the originator assumes the least risk and has the least amount of additional tasks to complete on the mortgages. With best-effort delivery, the originator delivers whatever loans close, whereas with mandatory delivery, a fixed amount of loans must be delivered. If the expected loans do not close, the originator must pair-off to obtain those loans.

Most of the estimated 14,000 mortgage brokers deliver using the latter two methods--mandatory or best efforts. Most mortgage bankers and depository institutions use the first two methods--block sales of servicing and AOTs. Each originator must decide which method will be most profitable. Smaller originators unable to obtain warehouse lines have the least choice. Larger originators who have more choice must decide whether or not they can manage the risk of closing and accumulating mortgages more cheaply than their wholesalers. Servicing-release premiums are currently quite high (about 190 basis points) reflecting the economies of scale of large servicers and the tax advantage of selling servicing. At these prices, it does not pay most smaller originators to try to compete by developing a servicing department.

Thomas S. LaMalfa is president of TSL Consulting Co., Shaker Heights, Ohio. Robert J. Griesbach is senior vice president of secondary marketing and servicing acquisitions of Commercial Federal Savings, Omaha.
COPYRIGHT 1992 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Wholesale Lending
Author:LaMalfa, Thomas S.; Griesbach, Robert J.
Publication:Mortgage Banking
Date:Sep 1, 1992
Previous Article:Apples to apples.
Next Article:Borrowing against your servicing.

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