Over the past eight years, mortgage banking has been prosperous, thanks to a low rate environment in which refinances have abounded.
However, this may be changing. We are just now seeing the beginning signs of a long-anticipated rising rate market. The tale is told in the numbers. The Fannie Mae par rate reached its low point in early July, at 2.25%. Since then, the industry experienced a choppy but steady increase in rates.
From July to early November, there was a gradual creep-up from the low to 2.5%. Then, rates rose quickly – another 50 basis points (bps) in November. After that surge, the market reverted to a more choppy but consistent upward march – another 20 bps to where it is now, in the range of 3.18%.
Let’s face it: In a larger historical context, rates are still extremely low. However, in the context of the recent past, it certainly represents a rising rate trend – an environment the industry has not experienced since the middle part of the last decade. To navigate this environment, lenders will have to be prepared for the change in their pipeline’s dynamics to measure performance and focus on maximizing efficiency by implementing available technology.
Change in cashflow
The most immediate and significant change lenders will experience in a rising rate environment will be in their cashflows. Rather than the nagging and disruptive settlement charges lenders pay to the broker/dealers on their hedge positions in an improving market, they will experience the opposite in a declining market. Loans will be sold below the price at which they were locked, and the lenders will realize lump sum cash infusions from the broker/dealers on the monthly settlement dates.
In an improving market, most lenders tend to migrate away from a best efforts strategy. In an improving market, cash flows on a regular basis, as loans are sold. Due to improved market pricing, those loans are worth more at the time of sale than they were when the lender gave the borrower the interest rate lock commitment (IRLC). Conversely, a lender’s hedge position is generally in a losing posture, which causes lumpy cash outlays on settlement dates.
These cash outlays can be confusing and disconcerting. The key to overcoming this concern is to understand clearly the gain on sale, on the loan side. To measure that, the lender needs to know the base price when the IRLC was granted to the borrower, the predetermined profit margin the lender priced into the loan, and the final commitment price when the lender agreed to sell the loan. These numbers should be readily available in the lender’s secondary reporting and should enable management to understand how the gain on the sale of the loans compensates for the negative hedge position.
The opposite occurs in a declining market. In that case, the loans are being sold at a lower price than what they were valued when the IRLC was granted. The positive hedge position should offset this decrease in value. However, with cash coming in from both investors and broker/dealers, it tends not to raise the red flags that the improving market cashflow pattern creates.
To get to one’s overall profitability, however, the same analysis applies. If one can understand one’s pricing and one’s margins, then one can quickly determine one’s profitability.
The key is having the right data at one’s fingertips. At our firm, we provide customers with an executive summary, as well as a mark to market report, that enables them to quickly identify all of the necessary information so they can clearly explain to management the cause and impact of the changing cashflow due to the deteriorating market environment.
Here’s a warning against attempting to determine – and, subsequently, manage by knowing – the overall loan-level profitability. This measure might as well be called “the unicorn”: It seems like it should exist – and its beauty is alluring as a key performance indicator. However, what is easy in a best efforts world is not so easy in a mandatory environment.
The reason for this is that there is no one-to-one correlation between the IRLC and the trades used to manage the risk incurred when one provides a potential borrower with an IRLC.
First, there is the pull-through assumption. Any hedge makes an assumption as to how many IRLCs will mature into saleable loans. Regardless of how one arrives at that assumption, the dollar volume of the IRLCs in the hedge and the amount of coverage will not match. This alone makes it impossible to designate which trades would be attributed to specific loans; and consequently, it is impossible to accurately calculate the exact gain or loss on any specific loan.
Additionally, to manage a hedge position efficiently, it is often wise not to trade in and out of coverage with each new IRLC. For example, if $1 million of new IRLCs are granted on Monday and one has a pull-through assumption of 80%, one would establish a hedge position by selling forward $800,000. Let’s assume the lender is using to be announced’s (TBAs) as its short position.
On Tuesday, another $1 million is locked, and $500,000 falls out. The lender now has a total position of $1.5 million. However, unless the lock periods or note rate of the new IRLCs was significantly different, one would not pair out of $400,000 of the coverage and then sell forward another $800,000. Instead, the lender is more likely to simply sell forward another $400,000 of TBA coverage. The result is that the lender has now “muddied the waters” in trying to figure out which hedge position applies to which loans.
Finally, there always will be a mismatch between the dollar value and the coupon mix of the IRLCs and that of the hedge position. The hedge, or short position, is established in $500,000 or sometimes $250,000 increments. If one’s IRLCs in a day, after pull-through assumption, equal $549,000, one can sell forward either $500,000 or $750,000. With the former, one will be long $49,000 (more IRLC than trades), and with the latter, one will be short $201,000.
The same mismatch happens because the note rates don’t match exactly the hedge coverage that the lender put in place. The result is hedge inefficiency, some of which is inevitable in managing any pipeline. The key is to minimize the inefficiency by understanding the hedge position as clearly as possible and preferably in real time.
For the foregoing reasons, we encourage customers to wean themselves off of the loan-level market to market as a key performance indicator. There are some firms that choose to attempt to identify this measure; just know that any such calculation by its nature involves assumptions as to what security was used to cover what IRLC and what the price of that security was at the time the IRLC was granted.
The better practice is to transition from a loan-level performance mechanism to a periodic (typically monthly or annually) pipeline performance measurement. Using the data points described previously, a lender can measure its secondary performance over its predetermined profit margin and come up with numbers that will make sense to its accounting team as it balances the books.
No margin calls
Getting back to the declining market posture, another positive outcome is that broker/dealer margin calls are unlikely. In an improving market, one’s hedge position runs negative. Depending on the policy of each broker/dealer, one may be subject to a margin call if that position mounts beyond the threshold. In a deteriorating market, the hedge position is in the positive, so there is no longer any need to prepare for a margin call.
Those margin calls, although necessary to keep the broker/dealers financially healthy (as they are always required to post their margins with their clearing house), can be disruptive to one’s cashflow and cash planning functions. In a declining market, they are not an issue.
It is also critical during a declining market to keep an eye on one’s net income. Normally, volume will drop as rates rise. This will lead to a decreased net income, primarily because of the decrease in volume. It is important to distinguish that decrease in net income from one’s hedge performance.
Just because the market is declining does not mean that one’s hedge performance has deteriorated. It may feel like it when one looks at one’s net income, but the culprit is not the hedge.
On the net income report we provide to our customers, we are careful to pair that information with overall market movement. This gives our customers a clear visual to see how the net income is tracking with the market. If there is a divergence between the two, there may be an issue with one’s hedge performance or operational challenges. However, it is critical to keep these concepts separate.
Modeling pull-through accurately is the single-biggest variable in effectively managing a pipeline. Historically, there has been a lot of focus on market movement as a critical variable affecting one’s pull-through assumptions. That focus is changing, mainly due to the regulatory changes over the past decade, as well as the relatively consistent low-volatility environment.
Generally, in a rising rate market environment, we anticipate that the character of the pipeline will change. The portion that is for purchases, rather than refinances, will take center stage. Generally, pull-through on purchase loans tends to be more stable. Borrowers are focused on closing their real estate deals. Once appraisals have been completed, the borrower has a much greater tendency to stick with the rate unless there is a significant market change. Accordingly, we anticipate modeling pull-through coverage at a higher rate.
However, in the era of big data and massive computing power, the need to speculate has decreased immensely. Our practice is to study pipeline behavior across multiple loan characteristics and then to adjust the model based on the results of that analysis. For example, one’s pull-through may be affected by the status of the loan, the type of loan, the originating branch or loan officer, the state, the sales channel, or a multitude of other potential loan characteristics.
Additionally, it may be that multiple factors are working in concert. For example, the impact of a market change on pull-through is likely to be great in the early stages of the origination process. Loans in the coastal states are likely to be more volatile, as are loans from a call center origination process. The amount of adjustment necessary can be extremely nuanced. The best practice is to review one’s pull-through at least quarterly – or more frequently if one starts seeing actual pull-through percentages diverging from one’s model.
Back to fundamentals
Regardless of the market circumstances, it is always important to remember the fundamentals of pipeline management.
First, it is important to systematize one’s processes to gain efficiencies. No longer is it necessary to rely on spreadsheets with manual data entry or mark to market valuations that estimate the value of an IRLC. Modern software-as-a-service platforms allow lenders to manage the post-lock origination process as one consistent platform. It’s important to insist on a model that accurately values one’s IRLCs, based on one’s specific secondary marketing investors and/or commitment strategies. Such a valuation certainly should have eligibility factored in. If a loan can’t be sold to a certain channel, there is no sense in using that channel as a source of valuation.
Such practices also enable a lender to diagnose why changes are occurring in its pipeline, giving it the ability to pinpoint and resolve any inefficiencies in the hedge and/or origination process in real time. This will give the lender the ability to maximize its processes and, just as important, provide clear, accurate reporting to management, regulators and auditors.
Second, a system enables one to increase the frequency with which one reviews one’s pipeline. Once a day is no longer adequate. The ultimate goal is a real-time view, aided by a system-to-system integration with your loan origination system. A lender should be uploading both pipeline and market data several times a day to make sure it is acting on the best information possible as it sets its hedge and commits loans leaving the pipeline. Simply put, an analysis that relies on yesterday’s market data is no longer acceptable.
Additionally, it is important to solidify relationships with one’s investors. Although it is tempting to take advantage of a flashy price, one must consider whether an investor can purchase a loan in an efficient manner and whether it will be around if times get tough.
Unlike four years ago, we now have an environment that is crowded with investors buying loans on a mandatory basis. Many of these entities rely on the mini-bulk strategy, which enables investors to focus their buying strategy by increasing pricing on loans that meet their investment thesis and strategic operational needs. However, don’t lose sight of your relationships with investors that are likely to stand the test of time in an increasing rate market environment.
As one investor recently told me, “We love our mini-bulk sellers, but we know that our relationship with them is primarily transactional. If a customer is selling us trades, whether direct trade, AOT or co-issue, we have a much deeper relationship with that originator and can improve pricing over the long run accordingly.” It is important for lenders to know who they can rely on when the waters of the market are rougher and murkier than the relatively calm seas we are sailing on today.
Certainly, there are several critical items to be aware of in a rising interest rate environment. However, the fundamentals don’t change, and technology is constantly improving. Lenders should review the technology they are using often to make sure they don’t fall behind, know their cashflow, maintain solid relationships, and have clear insight into the dynamics that affect their pipeline and their profitability.
Don Brown is founder and managing director of Optimal Blue Secondary Services, providing content-managed mortgage eligibility, pricing, real-time compliance, pipeline risk management, best execution, and loan allocation software and services. He can be reached at firstname.lastname@example.org.