Cost Structures: Fixed or Variable?
Mortgage departments are increasingly focused on the cost side of the equation as volume slows and can become increasingly profitable as fixed costs are optimized or repurposed. Outsourcing select roles may prove beneficial to your institution in multiple ways. Economically speaking, moving from a fixed cost to a variable cost structure can help maintain profitability as that overhead will move with the market. The end effect is a stable margin given variability in volume. As volume shrinks, for example, the overhead cost structure will shrink with it, leading to a constant margin. With a fixed cost structure, lenders can experience economies of scale, since margins improve as volume rises and the cost is spread across more loan units; however, when volume shrinks margins can become very low or even negative. Below are various components of a secondary mortgage department and thoughts on assessing the cost versus benefit for your institution.
Reengineering the Lock Desk
A mortgage lock desk is a department or team that issues mortgage rate locks, and ensures they are properly requested, extended, revised, and renegotiated according to the lender’s designated risk and profitability targets. Mortgage lock desks are critical because mortgage loans are touched on average between 3-4 times. The lock desk ensures profitability as those loan attributes change as well as the corresponding loan level price adjustments issued by the GSEs. Policies and procedures (P&P) are also vital to ensure consistency in pricing and compliance. Policies usually document and address procedures regarding pricing, rate lock initiation, extension requests, and other components. The lock desk can also be reengineered to include a variable-rate component, if desired. This can be accomplished with a lock desk outsource, which often serves to bolster in-house functionality. Outsourcing a lock desk means an institution hires an external firm to provide a full-time resource to work with internal teams to handle lock requests, renegotiations, and general lock desk responsibilities. Furthermore, they can help draft and ensure P&P adherence.
Product and pricing engines (PPEs) represent another vendor service utilized by many financial institutions. The cost/benefit of these relationships should be evaluated. While a PPE can certainly make life easier for one institution, for another it could be unnecessary or overkill. A PPE generally functions as software to manage profitability margin, rate sheet generation, streamline the loan rate locking and subsequent revision process, help loan originator scenario pricing, and help in applying policy and procedure adherence as it relates to worst-case pricing scenarios or extension costs. If the institution has a servicing retained platform with only two investors, is this additional expense needed? If the institution has a servicing released platform with multiple investors, one could argue a PPE is absolutely necessary. The relationship and necessity of these PPEs should certainly be reviewed and assessed.
Maximizing Investor Options
A great way to drastically increase your profitability without making major changes is by ensuring you are maximizing your loan sale execution potential. This holds true for all lenders but is especially critical for depositories or the servicing retained space. An institution that sells their loans servicing released has a plethora of investor options when selling their loans. They can sell to the agencies or to the numerous aggregators that buy closed loans and securitize with the agencies. If your institution sells loans servicing retained then you are limited to Freddie Mac, Fannie Mae, Ginnie Mae, and the Federal Home Loan Banks. Seeking your partnership approval with all agencies that fit your lending strategy is a great way to truly maximize your return on the sale of your mortgage pipeline. Including the Federal Home Loan Bank in your pool of investor options along with the other agencies can increase execution by 50 basis points with best execution analysis. 50 basis points extrapolated to an institution’s annual salable funded loans is a significant boost to profitability. Furthermore, for institutions looking to serve borrowers outside of their servicing comfort zone, such as FHA/VA products, expanding products to include servicing released options can serve to increase volume and service to borrowers.
Loan Sale Execution & Hedging Interest Rate Risk
Another loan sale strategy that could increase profits is moving from a best-efforts commitment style to hedging interest rate risk with mortgage-backed security to-be-announced forward contracts (MBS TBA forwards) and sell/deliver loans short-term via mandatory commitments. When a borrower locks in an interest rate and a price with your institution, they are transferring interest rate risk (pricing risk) to you. The most common way to hedge this risk, particularly with lower-volume institutions, is by turning around and making a best-efforts commitment with one of your investor options. All the institution needs to do is manage the commitment. The best-efforts commitment does not need to be made whole if the loan falls out or does not deliver into that commitment.
A mandatory commitment carries a significant price increase over a best-efforts price. The mandatory commitment will need to be made whole whether a loan is delivered into the commitment or the commitment is paired-off (canceled), in which case a fee will be assessed relative to the market movement since the commitment was made. To hedge the interest rate risk during the loan origination process until the institution decides to sell the loan mandatory, the institution should hedge that risk with MBS TBA forwards. In addition to increasing gain on sale, using TBA hedging would also allow an institution (depository) to retain funded loans on their balance sheet for a few months collecting the interest payments (interest carry) before committing mandatory and delivered to the agencies. The net execution values of TBA hedge settlements, mandatory loan sale price increase, and interest carry will provide the institution with a truly maximized sale execution and significant profitability boost.
Regardless of institution size, partnering with the right vendors to help reduce internal hiring needs while simultaneously bringing years of experience, knowledge, and customer service should be a focus for all mortgage lenders right now. Auditing current vendor relationships as well as sourcing the right vendor relationships for your institution can be a challenge.
Here are a few helpful questions to ask as you consider vendor options:
- Is there a variable cost structure? If you’re looking to reduce costs during times of lower volume, this is an essential question.
- Are their contracts month-to-month? This is a key indicator for the confidence a vendor has in their product as well as their approach to the partnership. A month-to-month contract shows that the vendor is equally interested in your institution benefiting from this partnership.
- How is communication with the vendor? Do your requests get submitted to a queue that takes time to receive a response? Can you pick up the phone and call them directly? Are they open with their execution/philosophy, or are they more guarded in their response? Customer service is critical in vendor selection.
The most common vendor services are lock desk, mortgage pipeline hedging and mandatory execution, underwriting, and quality control. We recommend you start there as you evaluate potential adjustments to remain profitable.
Want to discuss your institution’s secondary mortgage market options in more detail? Contact us to learn more about the solutions ALM First offers.
