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Jun. 24, 2011: Hedge Capacity view from the trenches; Wells Fargo updates
Rob Chrisman
[I am on vacation, and my access to
e-mail is sporadic and not timely. In my place are daily
commentaries from a series of very knowledgeable mortgage industry
people with different backgrounds, and they have been given very
little direction about what to write about. The third is below.
Our views may or may not coincide, but I thank them for their time
in volunteering and helping out.]
Hedge Capacity
Utilization
Given the fact that
current mortgage pipelines are not exactly large, one may not
think that tracking trading capacity or the lack thereof would
be a concern given production levels. However, it is precisely
in times when lower than average volume levels are the norm that
consideration for the topic should be addressed. Last summer
many mortgage banker’s pipelines were bursting at the seams with
more production than could be hedged using mortgage backed
securities traded to securities dealers. Many
were forced then to sell locked production on a mandatory basis
for future delivery and some even ran out of that capacity.
Others increased profit margins significantly to slow down
volume or executed both strategies. The time to tackle the issue
is before it becomes a problem.
The first ratio to
consider is the TBA Ratio: current TBA Sales
(with all dealers) / Total Nominal Trading line with all dealers
(Nominal due to the fact that many lines are curtailed do to
mark-to-market considerations). If you have $135 million sold
forward through mortgage backed securities- TBA and a total line
of $180 million your ratio is 75% capacity (135/180.) The next number to consider is the open
direct trade or mandatory line percentage ratio (Mandatory
Ratio or MR) defined as the total
amount of loans sold to conduits or investors that have not yet
settled divided by the total amount of trading line provided by
all investors/conduits. So if you have $75 mil. of loans sold
single loan mandatory or thru direct trade and the total lines
available in this manner is $100 mil. the ratio would be also
75%. The overall hedge capacity ratio would therefore also come
out to be 75% by adding the two amounts sold: ($135+$75$210)
and dividing by the amount that could be sold: ($180+$100$280)
or 210/280 75%. This situation would
allow for an additional sold volume of $70 million.
While many mortgage
bankers will rely on the MR in times of over capacity (thinking
that the amount is unlimited – our experience is that these
lines are not unlimited. Furthermore, once a loan is sold on a
mandatory basis, the loans must be delivered or paired off. However, only negative pair-offs are
usually allowed, so when the market sells off and you need to
pair-off a mandatory trade you will not get the benefit of the
hedge like you would with a TBA trade.
After calculating
what your current Hedge Capacity Ratio is, one should consider
that volumes could increase unexpectedly and/or Fallout ratios
in the pipeline could decrease given a significant market move
with higher rates. For example, if your pipeline increased 50%
and you are assuming a 70% closing ratio, could you cover the
additional amount of business on a hedged basis? Assuming that a
50% increase in pipeline required new sales of mortgage backed
securities of $45 million the new business could be hedged with
existing trading capacity. However, if shortly after such a
pipeline expansion occurred, a dramatic rise in rates occurred
thus driving up your expected closing rate from 70% to near your
company’s historical reject rate of 10% or 90% closing rate;
what additional capacity would be required? First, if the
original amount available was $70 million from the example less
the pipeline surge coverage amount of $45 mil. $25 mil would
be left leftover. However, the increased
pipeline closing rate would require an additional $38 million
exceeding capacity by $17 million. During
such a time your securities dealers and investors more than
likely would not allow you to exceed your lines and therefore
your company would either have to make customers wait in line to
get a lock until hedge capacity is available or go long and risk
that the prices you will eventually get for the amount long
doesn’t exceed you profit margins. Either way not a good
position. This also assumes that your
mandatory/direct trade lines clear as normal, i.e., that
investors purchase loans on the agreed upon time schedule.
However, during expanding production markets we have noticed
that the investors/conduits increase the amount of time it takes
to purchase loans thereby increasing the amount of line
outstanding.
We think that by
monitoring the Hedge Capacity Ratio, pipeline production trends,
and keeping enough capacity available to handle potential
pipeline growth and increased closing ratio events, you will be
better served than waking up one morning to find out that you
can’t cover the exposure locked the previous afternoon. The
solution is to monitor your capacity and constantly look for
ways to increase it.
Skin in the Game
There has been much
talk and wrangling over the potential changes to the
securitization market over the Financial Reform Act’s provisions
for retaining a 5% position on each non-conforming loan and
changes to servicing compensation. Most
of the time simple solutions are the best solutions. Hence,
perhaps regulators and FASB should reconsider the capitalization
rules for mortgage servicing rights on both purchased and
originated MSRs. Yes, mortgage servicing rights have value,
however the value should not be recognized upfront before the
actual amount of income and expense have been received.
Furthermore, mortgage servicing right are not just an IO strip
that can be traded like an MBS, they are much less liquid and
bear responsibility both to investors and borrowers.
Currently, either
type of MSR must be capitalized leaving those with thin equity
levels on their balance sheets the necessity to sell servicing
in order to maintain liquidity and/or profitability and/or raise
capital. Also, the FASB rules have had an additional side
effect: more loans have been originated and approved by
underwriters simply because they followed the investor’s
guidelines versus making “good” loans. In
the old days before mortgage servicing rights were capitalized
and most mortgage banks retained servicing, underwriters
followed guidelines, but were free to not approve a loan that
they thought was not a good investment. Owners
and underwriters knew that loans that went bad had a future
detrimental impact on the company’s bottom line through default
processing and foreclosure costs not to mention reduced cash
available due to increasing advances. As the market has evolved
due to the impact of the capitalization rules changes and the
housing market crises, underwriters now make sure that they
follow rules to the “T”, but have relinquished some or all of
the responsibility to the investor since they followed the
“rules” and sold the loans servicing
released. This does not mean that they necessarily make worse
loans – but it does mean that they have not made an investment
decision – that is made by the investor. The best decisions are
made by those closest to the transaction – those who make the
loans.
By going back to the
“Old Rules” of not capitalizing mortgage servicing rights
several benefits would accrue: lenders would have skin in the
game, real value would be generated in the mortgage banking
business thereby strengthening the industry, the concentration
or market share of the largest lenders would be reduced
increasing competitiveness (economies of scale are not
infinite), and better loans would be
originated by enhancing the role of each company’s underwriters
not to mention the accounting, hedging, and other headaches that
can be attributed to the process to estimating the value of
something that may or may not payoff early or go into default.
Simplicity sometimes has its benefits….
Dean A. Brown
CEO
Mortgage Capital
Management
Dbrown@mortcap.com
Wells Fargo's
correspondent clients received a 14-page Newsflash on, "New
Condominium Documentation Vendor Available for Prior Approval
Loans, New eDelivery Vendor Added; Exhibit 22 Revised,
Conventional Appraisal Policy Updates, FHFA’s Uniform Mortgage
Data Program Updates, Standard Price Policy for Agency Real
Estate Owned (REO)." Across the hall, on another floor, in
another building, in another town and another state, Wells Fargo
Wells Fargo Wholesale Lending in recent weeks has sent out
updates on Utah's recording fees increasing, "Streamline the
Loan Process and Order Tax Transcripts via Rapid Reporting, how
New York Purchase Transactions May Not be Originated With CEMA,
Compensation and Anti-Steering: Home Equity Compensation
Reminders and Clarification, Compensation and Anti-Steering:
Update – Appraisal Fee Reimbursement, how the Benefit to
Borrower Changes were effective May 21, how Title-related
Information Consolidated in Broker Guide, Enhancements to Fannie
Mae DU Refi PlusTM: Resolving Social Security Number
Discrepancies and Required Rental Income Documents, how
Secondary Financing Now Allowed on Co-op Transactions in the
High Balance Conforming Loan Program, Non-conforming Policy
Changes for Loan Amounts up to $750,000 or $1.5 million
(Depending on State) topics, FHA Financing Allowed for New
Construction and Proposed Condominiums in a Flood Zone -
effective last month, an update on Government Appraisals (a
reminder that Appraisal fees for Government loans should not be
collected from the borrower until the borrower receives the
initial disclosures.), New Streamlined Sign-up Process Makes
Ordering Tax Transcripts Even Easier, Non-conforming Policy
Changes for Loan Amounts up to $750,000 or $1.5 million
(Depending on State), Enhancements to Fannie Mae DU Refi PlusTM
– Resolving Social Security Number Discrepancies, Home Equity:
Value Differences Between Multiple Valuation Products, a New
Mortgage Broker Fee Disclosure for Home Equity Lines of Credit,
information on Illinois Civil Union, and the introduction of a
new net funding process (Wells Fargo Wholesale Lending is
simplifying the process the processing and payoff of Wells Fargo
Home Mortgage (WFHM) to WFHM transactions. This new net funding
process will allow us to net and directly apply the funds to pay
off the first mortgage.)"
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