In the next post, MCM will cover why it’s never a good idea to close and sell loans that don’t meet investor requirements or expectations, why not to skip options when a pipeline source or renegotiation policy dictates they’re necessary, the importance of keeping your pipeline data clean, and why you’re better off not pricing loans to the best execution price.
Since 1994, MCM has helped mortgage bankers maximize profitability, decrease earnings volatility and powerfully manage their risks. MCM provides state of the art Pipeline Risk Management services at all levels of mortgage banking, from clients looking to take their first steps towards hedging a pipeline, to those with considerable experience with pipeline management selling on a securitized basis, servicing retained.
In the second of this three-part blog series, Mortgage Capital Management (MCM) helps readers understand the top 10 most common mortgage pipeline hedging mistakes that can eat away at profits. People typically think that hedging a mortgage pipeline is as easy as putting on a trade to cover locks. While that may be true to a certain degree, it’s not that simple. This post covers why mortgage banks should never close and sell loans that don’t meet investor requirements or expectations, why not to skip options when a pipeline source or renegotiation policy dictates they’re necessary, the importance of keeping your pipeline data clean, and why you’re better off not pricing loans to the best execution price.
You can catch up on the first post that addresses the importance of a having a concrete policy for managing risk pipeline positions, and why not to hedge long-term and short-term locks the same, or float-down locks and builder commitments the same as long-term locks here. [hyperlink]
4. Mistake: Closing and selling loans to investors that do not meet investor requirements and expectations
Once loans are allocated or sold they are no longer hedged with TBAs. In fact a trade was probably paired off or allocated when the loan was committed. If the loan was committed to an investor and does not meet the investor’s guidelines, the loan will have to be re-committed to another investor at market movement price and a new loan will have to be swapped in for the vacated commitment, or be paired off. This means your position is long and is subject to market movement, which can have a negative consequence on a company’s profitability. This scenario occurs if the company is strictly looking at a best execution for price, but is not looking at each investor’s underwriting criteria.
MCM recommends that companies review each investor’s guidelines and compare the differences between underwriting overlays to diminish the possibility of rejected loans or loans subject to negative market movement.
5. Mistake: Not using options when a pipeline source or renegotiation policy dictates their use is necessary
If a company allows renegotiations in a positive market movement this will have a negative impact on your profitability if your loans solely are hedged with TBAs. Basically, in the case of renegotiations, the company is offering a free float down with no ability to cover the cost of the float down, thereby giving up the price differential that was granted for the float down. If a company originates some or all of its volume through the wholesale channel, the locked pipeline is more prone to swings in fallout with market movement in price. In an improving price market, brokers may be more prone to cancel a loan already locked with Company A to get the better price with Company B. This will cause fallout to increase more than a retail locked pipeline. Likewise, if the markets sell off, the broker is going to do everything in his/her power to meet all underwriting conditions for the loan to close, reducing fallout.
MCM recommends the use of options as a hedge to protect against the fallout volatility associated with effects of price movement on wholesale pipelines’ potential renegotiations. Using option coverage helps protect against a whipsaw affect with market swings.
6. Mistake: Not keeping pipeline data clean – allowing users to abuse the tracking system
Unclean pipeline data can range from the status of a loan not being updated, to incorrect loan characteristics entered, to changes to loans that are not approved by secondary marketing. Improper tracking of loan status can play a huge part in miscalculations of fallout because the fallout associated with each status is different. If these mistakes go unchecked, they can lead to a long or short position that will subject the company to market movement risk. Likewise, if loan terms or pricing is updated without the knowledge and approval of secondary marketing, the profit margin expected on the loan at original lock date will not be realized because proper changes to discount points may not occur.
MCM recommends instituting a policy that secondary marketing must authorize any change that has the potential to impact the pricing of a loan before the change can occur. This will prevent negative impacts to profitability and help avoid surprises if margins are not being achieved.
7. Mistake: Pricing loans on a best execution basis to deliveries that are not available when loans close
We see many companies that price loans to investors with the best execution price to attract loans and be competitive. While this does allow the company to offer the best prices, it also can subject the company to a lower margin or lower profitability. Many times a loan is priced to the best price of a specific investor the day of the lock, but as the loan goes through processing it does not meet that particular investor’s underwriting guidelines. Instead, the loan is approved with another investor’s guidelines and is not as competitively priced. Ultimately, the loan is sold to the lower-priced investor reducing profitability. In addition, in our experience many investors will promote an overly aggressive price to generate business only to pull back in the pricing shortly thereafter. This practice allows the lender to offer a great price out to borrowers and brokers and will likely result in more locks, however, when the loans are closed and ready to sell, the great price is nowhere to be found and results in lower margins.
There may be multiple solutions to these issues including publishing rates with an average of investor pricing. This practice will help even out the give ups with the gains. In addition, MCM recommends that companies establish policies and procedures to control the change from one program to another. This will allow secondary marketing to monitor and approve changes or re-price the loan accordingly.
Copyright 2013 Mortgage Capital Management, Inc.