Managing Liquidity in the Secondary Market
Liquidity is a key factor in every mortgage bank operation. The ability to provide the products borrowers want, the capacity to move them off warehouse lines quickly, and then the expertise to sell the loans at a profit are all vital. Avoiding pipeline-aging risk and the additional interest charges and higher haircuts on warehouse lines that often come with it is a top priority. Funding quality loans without underwriting errors helps mortgage bankers sell their loans in the secondary market and maintain liquidity. However, when mortgage refinance volume slows down, interest rates rise, or home values decline, maintaining liquidity may involve more than following guidelines and best practices. There are additional areas a mortgage banker may want to explore to help manage liquidity and avoid pipeline backup.
Expanded Product Lines
Loan buyers, like mortgage bankers, often look to differentiate themselves from the competition. Many aggregators of agency and FHA/VA loan programs have been looking to diversify into the non-qualified mortgage (non-QM) and jumbo loan spaces. As a result, mortgage bankers may want to consider adding these products offerings to their lines.
Mortgage bankers are always on the lookout for underserved markets. Non-QM is currently one of them. Many borrowers are excluded from the qualified mortgage market. With solid credit scores and income streams, many of these borrowers would be considered for a qualified loan if it weren’t for a small snag in their application. Fear of the loan not being sold on the secondary market is what has prevented many mortgage bankers from originating non-QM loans.
Because today’s non-QM loans are not subprime, they don’t have the same risk of default. They are manually underwritten using strict standards. Mortgage bankers that want to offer this product can expect increased quality control and due diligence before securitization. Although it’s likely each loan will be looked at instead of one in ten, non-QM loans can boost liquidity.
Enhanced due diligence is a requirement for non-QM and jumbo loans.
Jumbo loans are another area mortgage bankers may want to explore. Like non-QM loans, there is a demand for higher loan amounts from borrowers and investors. A single mortgage-backed security (MBS) is likely to have multiple investors. Jumbo loans are bought by hedge funds or private investors, such as regional banks, insurers, and pension funds. Purchase pools range from $1 million to over $100 million.
As expected, due diligence is also thorough on this product. Because of strict guidelines and enhanced scrutiny, delinquency and foreclosure rates on jumbo loans are very low, but mortgage bankers should plan on a review of nearly all of their jumbo loans before purchase. However, their large size and profit margin can make up for the additional due diligence.
Mortgage bankers can also evaluate the number of companies that buy their loans. To mitigate risk, many warehouse lenders recommend a minimum of three companies, but having up to five could allow for more liquidity. In today’s mortgage market, it is hard to depend on one or two investors to purchase every loan. The last thing mortgage bankers want is to be forced to purchase loans off their lines to keep in their portfolio. This can be a major drain on liquidity if the loan is for a large amount.In addition to improved liquidity, having buyers compete for your business will generally allow you to negotiate better pricing with investors. Of course, having clean files without errors and delivering them consistently is always important to investor relationships.
Finally, a move from a best-efforts to a mandatory selling model could add more liquidity to a mortgage operation. Although best efforts involves transferring risk and is general considered the safer option, the added security is paid for in pricing. In contrast, mandatory execution offers superior pricing in addition to the benefits of lock extension control and the ability of underwriters to send to multiple outlets. Which option makes better sense for your operation? It depends. In addition to market conditions, there are a number of other considerations to be reviewed. A look at loan volume, efficiency, interest rate risk, and fallout risk as it relates to their individual operation can help a mortgage banker weigh the pros and cons of each model.
Will better mandatory pricing compensate for the added risk? That is the fundamental question in moving from a best-efforts to a mandatory execution model. Whenever there is a drop in loan volume, there is an increase in competition between the investors in the secondary market. This often results in the margin between best efforts and mandatory pricing thinning. Are you in a position to capitalize on this opportunity? Can you can manage the volume, efficiency, and risks associated with this model?
Loan volume is an important factor in selecting a selling model. For the spreads between best efforts and mandatory to make sense, a certain loan volume is required. Small operations or mortgage banks with inconsistent loan volume often benefit from a best efforts model. Large operations with a consistent volume of loans in the pipeline are candidates for a mandatory model. This model allows loan substitution to avoid pair-off fees, plus there could be additional savings available through aggregating the hedging and loan manufacturing processes.
How efficient is your operation? Have you streamlined sales, processing, underwriting, funding, and loan delivery? How frequently do loans get hung up in your process and back up the pipeline? Are you able to originate loans in bulk? If you have an efficient, standardized loan process with pipeline consistency, you may be in a position to move to a mandatory model.
Interest Rate Risk
Interest rate risk is built into the price for the best efforts model. When a mortgage banker moves to a mandatory model, hedging is often used to minimize the additional risk. Hedging can be done either in-house or through a vendor. If an outside vendor is needed, the expense should be weighed against the cost of reduced pricing under the best efforts model.
Another consideration when comparing models is your operation’s fallout rates compared to loan volume. How does the risk of occasional pair-off fees balance against the benefit of higher prices? This is often dependent on the current market. Fallout rates are often lower when interest rates are increasing because borrowers are typically happy with their rates and not tempted by a lower rate. Of course, the opposite is generally true, too. Fallout tends to increase when interest rates are on the decline. During times of interest rate volatility, a check of your past performance during similar situations could prove helpful.
Expanding product offers, additional investors, and a mandatory model could be options for improving liquidity when the refinance market slows.
Maintaining liquidity is a balancing act between the primary and secondary markets. It not only involves selling the loans borrowers want, but also being able to package those loans for sale to investors in the secondary market. As interest rates rise and refinances dry up, mortgage bankers can focus on new avenues to maintain income levels. Expanding product mix, adding a few investors, and considering a mandatory model are a few options mortgage bankers may want to consider when looking at their liquidity.
Managing Liquidity in the Secondary Market
This blog post was published by Axos Bank on September 5, 2019 and last updated on September 5, 2019