Better Best Execution
As Seen in Secondary Marketing Executive
October 2016 – Digital Issue
By Don Brown
One thing learned by those who attended law school is to avoid using the terms “never” and “always,” if at all possible. There’s usually an exception to any absolute. The term “best execution,” in and of itself, leads to a similar challenge. Is it “good,” “better” or “best” execution? How does one know? What factors are to be considered? And, are there additional factors?
These are challenging questions. Many, if not most, settle for comfort and “good enough.” It’s easy for lenders to settle into comfortable habits, whether it is in their hedging analysis or the breadth or freshness of the investors they consider. Most lenders find a methodology that works for them. Few constantly and relentlessly reassess and hone that strategy as their business circumstances develop.
Without a doubt, one’s best execution strategy must change as one moves from a best-efforts style to a mandatory style of committing; from servicing released to servicing retained; or from an assignment of trade/direct trade, to a bulk, to a government-sponsored enterprise (GSE) direct/co-issue, or to a servicing-retained strategy.
In the end, the ultimate best execution analysis is a multidimensional problem that gets exponentially more complicated as the potential counterparties and the commitment strategies expand. It has to take into account not only pricing, but also the posture of one’s investor and GSE relationships, coupon maximization, specified pool optimization, high balance thresholds, and myriad other factors.
This is a process that is begging for automation. No matter how good a lender is, when programmed correctly, machines can out-calculate staff every day. What’s more, machines can spot patterns in data that humans would struggle to find.
Like the concept of infinity, an absolute “best” execution may not be achievable. However, given the power of today’s technology and the availability of the relevant information, it’s imperative for one to include as many factors as possible in one’s best execution strategy so that one can maximize one’s business opportunity.
Discussing best execution with mortgage aggregators or warehouse lenders sometimes results in raised eyebrows. They assert that service and relationships matter, and they are correct.
It is important to note that we are not talking about revenue when describing what needs to be optimized. It’s better to frame this as a business opportunity.
Although revenue is a primary factor in determining one’s overall business success, it is not the only factor. Focusing exclusively on the current price can result in one missing critical elements of the entire best execution analysis – elements such as relationship, cashflow, trade posture and trade composition, to name a few.
Relationships, over the long run, are also critically important. As we all know, it is easy to get along with one another when times are good. It is during bad times when one discovers everyone’s true colors.
Any mortgage lender that was in the business during the turbulent years of 2006 through 2008 knows what it is like when the chips are down. One must always be aware of who is willing to work together in those times.
Markets change quickly in the mortgage world. It’s nice to have an umbrella when the rain comes down hard. Factoring in something for the relationship in today’s equation could pay big dividends when circumstances change.
Simple Best Execution
Simple best execution looks at the problem from a two-dimensional perspective: price and time.
Essentially, this is the paradigm from the 1990s. Lots of fax machines were emitting rolls of curly or legal-size rate sheets. Each investor had its own pricing structure, including adjusters, service-release premiums (SRPs) and other variables. Loan officers and pricing managers had to be experts in interpreting rate sheets and eligibility, rifling through the indexes of guideline manuals to find the best products for their borrowers. This was a time-consuming process that was rife with the opportunity for error and was a drag on the amount of time loan officers could focus on what they do best – selling.
As product eligibility and pricing engines (PPEs) emerged, the initial focus was on automating the ability to search multiple best efforts rate sheets and limit that search by including a determination of whether a loan would be eligible to be sold to any particular investor. By automating the search, the PPEs disrupted the arbitrage advantage that the investors enjoyed due to the static availability of information and their individualized price calculation methodology.
The eligibility component is critical. Any best execution analysis that fails to include eligibility is, by definition, inadequate. If you can’t associate a price with the ability to consummate a transaction, then the price is irrelevant. It’s like a 20-year-old college student comparing the cost of various beers. It’s irrelevant because, in theory, he is not eligible to buy alcohol at all.
Although the PPEs initially automated this process and layered in eligibility, if you were selling to any sort of mandatory commitment style, this was not a complete best execution strategy. It was missing the element of market- and trade-based pricing strategies, which could be used both as a foundation for generating the pricing one put to the street, but also where one eventually sells one’s originations.
Breadth of the Best Execution Analysis
A meaningful best execution strategy had to include a broader foundation of commitment strategies. It had to include at least market-based strategies such as direct trade/assignment of trade (AOT), co-issue, GSE strategies and bulk bidding. This was the idea behind our firm’s investment in, and subsequent acquisition of, Secondary Interactive.
The first step is to include the AOT pricing structures. Each investor has a model it uses for pricing, and it freely distributes that model to its buyers. By providing a market pricing source and a screen for entering and managing the variables that feed that model, one can generate a market base price. Once generated, this can be used as the foundation for one’s pricing strategy; to value the loans for which one has committed a rate to a borrower, but one has not yet sold; and to determine the optimal place to sell that loan.
Broaden this concept, then, to ensure that one is considering the AOT models for all investors – again, layering eligibility over the top of it all.
Next came the co-issue executions. These became quite popular about five years ago and remain a viable alternative for many originators. Rather than managing SRPs, one is now managing servicing grids, layering on market pricing, eligibility and adjusters, all the while blending this with a consideration of the best efforts and AOT pricing, as previously discussed.
Why include those structures? Because one never knows where the best opportunity may emerge.
Beginning around 2012, we observed multiple originators beginning to flock toward agency executions. This was driven by the paucity of mandatory investors and the posture of the pricing models, which were generating aggregator pricing, which included SRPs but was less than or equal to the agency cash window price, which did not include any servicing value.
Because many of the originators were not operationally equipped or financially inclined to retain the servicing asset, they sought out co-issue structures, which began to emerge in force. Again, these were not for everyone, mainly because of the net worth and minimum delivery requirements, but they did provide a viable alternative to many lenders. Including these structures into one’s best execution analysis – not at the exclusion of the prior structures, but in addition to them – was critical to ensuring that one was considering all of one’s available options.
Many originators are capable of retaining their servicing assets. These originators must layer yet another factor into the equation. When one is looking at servicing-retained executions, one must factor in one’s own view of the value of servicing, as well as one’s own loan-level adjustor structure.
Some originators that flocked toward GSE executions did so to avoid the seemingly onerous overlays and adjustments imposed by the aggregators. However, they quickly learned that retaining those loans that fell outside the boundaries of the aggregators’ parameters meant a book of servicing for which you may not be able to get top dollar. Clearly, there was a reason for the overlays.
Thus, as one gets to the point where one is layering retained execution strategies into one’s best execution analysis or one’s rate sheet calculation, one must ensure that one includes one’s view on servicing valuation and loan-level pricing adjusters.
In addition, to truly maximize this strategy, it is important to include the profitability and cashflow implications of retaining the asset in one’s best execution analysis.
Some lenders can retain all of the assets they originate. That makes it easier. However, if one is cashflow-constrained and can only retain some of its originations, which does it keep? What if the quantity of loans that win in one’s comprehensive best execution analysis exceeds one’s retention capacity? Which does one keep? One needs to have a plan to optimize this decision.
Finally, as many in the industry already know, we have entered the world of bulk bidding. This is not the bulk bidding of the early 2000s, in which the price was based on the entire package of loans. Today, bulk bidding is a bit of a misnomer. Essentially, it is loan-level pricing for a group of loans that have been submitted to the investor simultaneously. The evolution of this structure will be the subject of another entry; however, the focus here is how you include that pricing and compare it with the aforementioned structures.
The key is to be able to analyze this spot market style pricing with the standing pricing structures mentioned previously. We have observed that although bulk pricing is good, it does not win every time. This is largely because it allows a broader array of investors to incorporate more strategic and immediate transaction objectives into their bids. However, the standing pricing structures still prevail in a significant portion of the pipeline. Any best execution that cannot clearly and, if possible, automatically compare bulk pricing bids with standing pricing structures is missing a critical element.
Timeliness of Underlying Assumptions
A key factor in any best execution analysis, beyond the components of that analysis, is the timeliness of the data evaluated. Using a current pricing structure with yesterday’s, or even this morning’s, market data is incomplete. There has been a lot of criticism on the need for real-time data. Fair enough. We were able to survive for years without it. However, it is available now. It’s hard to understand the argument that anything other than the most real-time data possible is better than an analysis that incorporates the best information available at the time of decision. Anything short of that may be acceptable but is certainly not optimal.
Finally, there is the concept of cadence. Many fall into the routine of examining execution at a specific time of day or, worse yet, day of the week and assuming that they are achieving best execution. This could be true. However, again, one is haunted by the question of whether it is adequate.
Ideally, a loan should be evaluated for sale when it is operationally optimal for the originator. This can differ based on the business circumstances of each originator. However, it certainly does not follow the cadence of once a day or once a week.
We have a client that reviews its inventory of loans for sale hourly by tracking fundings closely. Whether this is the only factor leading to its success, it consistently performs at the top of our client base.
Best execution is a nuanced practice that gets increasingly complicated as your alternatives increase. This article doesn’t even scratch the surface of a true optimization analysis. This type of analysis must factor in the time dimension of different coupons, maximizing pools for factors such as high balance loans and more. However, that is the subject of another article.
For now, one needs to know that the ability to incorporate all of the factors discussed into one’s best execution in an automated fashion is available. Lenders should review their practices, or those of their secondary service providers, and ensure that they are benefiting from these types of analyses.
Click here to view this article in the October 2016 digital issue of Secondary Marketing Executive.