As a mortgage originator grows, it becomes apparent that many processes which worked in the past need to be changed to accommodate the larger volume. Most owners or managers are familiar with the origination process and can make good decisions regarding changes to those processes. The secondary market, however, typically is a mystery and not as well understood.
Originators with a best efforts strategy often hear that they can make more money selling mandatory if they have enough volume. However, they have no way of assessing that statement. In addition, there are many other considerations a mortgage company must evaluate before making a decision to sell their loans mandatory.
The improvement in price achieved by selling loans mandatory is often referred to as the best efforts – mandatory spread. This is the difference achieved by pricing to the loan officers based on best efforts rate sheet and the price achieved by selling the loans mandatory. However, this revenue opportunity does not come without a cost. When selling mandatory, the loan originator now has to manage the fall out assumptions and the interest rate risk from lock to commitment of loans at funding – a task that previously was passed on to the best efforts investor. To accomplish this, the originator must implement a hedging strategy.
An originator can implement a hedge strategy in several ways. They can hire the appropriate talent to perform this task or they can outsource this task to a hedge provider to manage it for them. If they decide to manage it in-house, they still must decide what analytical tools to use. This can be a complicated decision and one that will be addressed in a future column. In addition to how to manage the hedge, there are many other internal changes that an originator must address when making the transition to a mandatory commitment strategy. These include:
Loan Delivery: In my experience, this can be more important than the best efforts – mandatory price improvement on an operation. When growing it becomes very onerous to manage each lock individually with the investor. By moving to a mandatory strategy, most originators say the improvement in operations creates about 1 -3 bps improvement to profits. Loans are delivered in bulk instead of individually improving loan delivery efficiencies. Also, loans data is final (no management of loan data during the underwriting process) and loan substitutions in commitments are allowed so there is much more flexibility in delivery.
Lock Desk: For a mandatory strategy, a centralized lock desk is a necessary. Some shops let their loan officers manage the locks. This will not work with a mandatory strategy. I recommend implementing a centralized lock desk first while you still are operating with a best efforts strategy. This will reduce dramatically the work required of a lock desk and will pave the way for the transition to mandatory commitments. When a new lock comes in at a best efforts shop, the lock desk must turn around and lock the loan with the investor. Data changes have to be managed on an individual loan basis. With a mandatory strategy, this does not have to be done. In addition, the lock desk would have to administer any lock changes with the investor based on the investors lock policies. With a mandatory strategy, lock policies are determined by the originator. This includes extensions, relocks, renegotiations and other changes. This means there can be consistent policy that can be published for all loans locked by the originator. In addition, the economics of the lock policy are managed by the originator and not passed along to the investor.
Underwriting: I suggest, although it is not required, that you create a common underwriting guideline per product when selling loans mandatory. Best efforts shops lock loans with the investor as soon as they lock a rate with the customer. It makes sense to underwrite to the investors guidelines. When selling mandatory, the investor is not selected until funding of the loan. Therefore, underwriting to a single guideline gives the secondary markets group the most flexibility to sell the loan to the investor with the highest price. Issues arise when investors have soft overlays that are different from other investors. In that situation, there should be a mechanism to include or exclude investors available for the sale of the loan.
Pricing: Many originators begin a mandatory strategy for selling loans but continue to use best efforts pricing for origination. I highly recommended that the originator transition to one pricing strategy per program to match the common underwriting guidelines. Many loan officers are used to picking the investor with the best price so this might require a cultural change within the organization. And this could take time. If the originator decides to continue to offer pricing based on investor best efforts rate sheets, extra care should be taken to make sure that best efforts pricing offered can be sold mandatory at a profit. Sometimes, investors offer a very aggressive best efforts price for a short period of time. In such cases, it could be more aggressive than mandatory pricing. This typically is a short-term phenomenon and will adjust back to a price that is lower than mandatory. But any origination occurring during that time could experience a loss. I would recommend either (1) adjusting origination spreads to compensate for the difference or (2) locking loans best efforts at the time the lock is taken from the customer.
Investor Management: When going from a best-efforts to a mandatory strategy, it is important to make sure that (1) your current investors are aware of the new delivery strategy and (2) they are evaluated to ensure that they are the best outlets for the new strategy. Many investors offer incentives on the delivery method used by the originator. By notifying investors of the change in strategy, it will ensure that the originator will make the most profit from the change.
There are a lot of opportunities to improve profitability and efficiency with a mandatory strategy. I have seen many customers successfully go from best efforts to mandatory but the work on the above items needs to be done first. For originators who have volume over $10 million per month and a net worth over $3 million that want to get to the next level, this is a worthwhile endeavor. But as you could see from the items described above, many operational changes have to take place to be successful.
This article was featured in the May issue of Mortgage WOMEN Magazine. View the entire article here.
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