Jan. 20: What MLOs made in 2019; primer on mortgage rates & pricing: why is my rate sheet pricing different?
People in our biz continue to interview, and plenty of loan officers, branches, and companies are making moves out there as a remarkable 2019 wrapped up and 2020 dawned. Are you keeping LOs on the payroll who are doing 1-2 loans per month? Some successful companies do while others stick to minimum production levels. And it’s always less expensive to retain someone that hire someone new and train them. Plenty of things go into making a loan officer happy, including adequate programs, decent pricing, senior management responding to requests, benefits, and compensation. Focusing on this latter item, LBA Ware analyzed data from a sample group made up of 68% IMBs, 27% banks and 5% credit unions to see what happened with LO comp in 2019. Analysis finds base commission for LOs effectively unchanged from 2018 to 2019 despite increased industry focus on cost reduction.
The firm’s analysis of year-over-year data from its CompenSafe ICM platform reveals compelling trends about how mortgage lenders nationwide are managing commissions for loan originators (LOs) who work for lenders that used CompenSafe to automate incentive compensation management for the full calendar years 2018 and 2019. Their volume was up nearly 30 percent from 2018 to 2019. “The controlled, sample dataset consisted of retail, first-lien production from LOs that funded at least six loans in one of the calendar years. The LO commissions were for a wide range of large and small lenders across the United States, comprised of 68 percent independent mortgage companies, 27 percent banks and 5 percent credit unions.”
“The average base commission earned by LOs in 2019 was 94 basis points, on par with 2018’s average of 93. After accounting for commission tiers and minimum/maximum caps, LOs earned an average of 102 basis points per loan in 2019 compared with 2018’s average of 101 basis points. The average 2019 loan amount was $259,652, up 9.43% year-over-year. This higher average loan amount helped push the average LO commission per loan from $2,332 to $2,591 (an 11.11% year-over-year increase).”
CEOs are keenly interested in the study showing that, “Loan originators continue to account for the lion’s share of compensation expenses, with LO commissions accounting for 69% of lenders’ total incentive compensation expenditure.” And that, “Overall LO employment was nearly flat for our sample group from 2018 to 2019, with the total number of LOs on payroll down a mere 0.14% year-over-year.”
So there wasn’t much change from one year to the next. LBA Ware’s CEO summed things up.
“This data implies that lenders may not get serious about reducing LO commissions until they’re in significant financial pain, which isn’t predicted to happen until later in 2020, when refinance volume is expected to wane.” [Editor’s comment: Refis saved everyone in 2019, including LO commissions, and many wish that market compression would have lasted a little longer and been a bit more severe, so we could have seen the adjustments the industry really needed.]
How are mortgages priced?
Robbie Chrisman sent this note for loan officers explaining how rates, and rate sheets, work. (Questions or comments should be directed to him using the link.)
When looking at a rate sheet, or a mortgage rate in your pricing model, each rate has a corresponding value next to it (e.g., 4.25 percent at 102.375). But how is that number calculated; how are mortgages priced? And why do some lenders offer lower rates than others?
The determination of mortgage rates has become a complex interaction of market levels, risk-based analysis, securitization and credit enhancement costs, servicing valuations, and capital considerations. Mortgage rates, and rates in general, tend to rise when the outlook is for increased economic growth, higher inflation, and a low unemployment rate as the demand for capital increases. Rates in general, including mortgage rates, tend to fall when the economy is slowing down, inflation is falling and the unemployment rate is rising as the demand for capital slows.
A common question from MLOs, who perhaps are occasionally asked by their clients, is, “Why aren’t mortgage rates the same as Treasury rates?” The basic answer is premiums for risk and leverage. For risk, humor aside, would you rather loan your money to your neighbor, or the U.S. Government? (One can equate risk to safety.) And owners of Treasuries can borrower against their holdings, leveraging their investment and increasing their return.
As a side note, contrary to popular belief, the Federal Reserve doesn’t set mortgage rates. The Fed raises and cuts short-term interest rates in reaction to broad movements in the economy, and in fact only directly controls the Federal Funds Rate and the Discount Rate. But mortgage rates rise and fall according to those same global and domestic economic forces that drive the Fed’s decision making, like retail sales, home sales, housing starts, Treasury auction results, and manufacturing outputs. Loan officers should understand that mortgage rates and Fed rates move independently of each other, but usually in the same direction. This most recent economic cycle has bucked the trend slightly, as mortgage rates have remained relatively low as the inflation rate has remained below the Federal Reserve’s target of 2 percent, but the U.S. economy keeps growing, and the unemployment rate has fallen to its lowest level in roughly 50 years.
When the economy is on an upswing and inflation is high (the money people borrow now will be worth less when they pay it back in the future), investors demand higher yields on all fixed income securities, including securities backed by mortgages (MBS), forcing lenders to raise mortgage rates. High rates mean MBS with higher monthly payments but a shorter duration. Investors are buying MBS to receive monthly principal and interest payments since it is a fixed-income bond, which also means the price drops as rates increase. The stream of payments is calculated for an assumed duration of time since consumers have the option to prepay (refinance) a mortgage.
For instance, if a borrower obtains a mortgage at the prevailing rate of 5 percent, but the rates for that type of loan subsequently drop to 4 percent, rise to 6 percent, and then fall to 3 percent over the course of several years, homeowners will likely refinance their mortgage at some point when interest rates have dropped. It would likely be well before the original 30-year, 15-year, or whatever length mortgage product it was originally financed for, since economic cycles typically last 7-10 years.
Not coincidentally, the average life of a 30-year mortgage ranges from 7-10 years. Duration calculations determine the sensitivity to interest rate changes by estimating the number of years until an investor receives the present value of all income from MBS (including interest and principal). An instructor would explain it to a finance class as the fair value calculation by a discounted cash flow method to measure the average maturity of the bond’s promised cash flow.
When the worldwide, or U.S., economy starts to falter, or inflation falls, interest rates tend to drop for consumers. In the secondary markets low rates mean investors can purchase MBS with a longer duration but lower monthly payments. It is a seesaw act. The more MBS that investors buy, the higher the prices on those securities, so lower the rates drop since lenders don’t need to offer as high of a rate on the rate sheet to hit a target margin. Lower rates mean more (faster) prepayments, and the end of cash flows from higher-yielding MBS due to refinances.
That principal, returned by borrowers refinancing, is then invested at lower rates to generate new income, which misses out on the higher yields and larger cash flow streams than at other points in the economic cycle.
So much of the industry, in the primary and secondary markets, is tied to prepayment speeds: how fast borrowers refinance. When interest rates inevitably rise again, borrowers tend not to refinance but investors don’t want to be stuck with too many loans with low interest rates in a high interest rate environment, so they’ll start looking to buy mortgages with current coupons/higher rates. These forces in the secondary market impact the primary markets and mortgage lenders raise their rates for borrowers to create new pools for investors to buy, starting the cycle again.
An easy way to think about it is that lower interest rates have longer durations, since they are less likely to refinance. Other factors, like loan size and loan-to-value, also play into calculations. When a mortgage is paid off early, the expected stream of principal and interest payments ends and a lump sum (which lacks any future interest) is received. Predicting the effects of prepayments on the value of MBS is what requires the advanced mathematical models, but discounting the expected value of future cash flows from MBS is how mortgage rates are determined.
The heart of the challenge facing a lender is managing the difference between the price investors will pay to buy a specific mortgage on the secondary market, factoring in the costs of origination, competitive positioning, capacity constraints, profit margin, and what the borrower will commit to pay for that mortgage. This is where “the rubber meets the road” for originators who every day look at their own rates versus those of their competitors.
When a company funds a mortgage loan, two commodities are created: a loan (monthly principal and interest payments) and the right to service the loan (collect the monthly payments). Most aspects of the mortgage loan origination process center around the primary market, where the borrower agrees to obtain a loan from a lender for specific terms for a specific price. But the primary market would not exist if not for sales and purchases of loans in the secondary mortgage market. Put another way, what happened to the price of typewriter ribbons when word processors grew in popularity?
In terms of cash flows, when a loan is sold in the secondary market, a non-depository lender’s money is returned quickly so it can lend the money again to another mortgage borrower, gain flexibility in managing their long-term interest rate exposures, and manage credit risk. Meanwhile, investors buy these securities because they want stable payments for a long time. Investors, like Fannie and Freddie or Ginnie, exist to keep money flowing through the mortgage finance system and lend stability.
The MBS market is highly liquid with prices determined by what buyers are willing to pay for securities. And whether these securities are backed by 30-year, 15-year, non-QM, ARM, or loans below a particular loan balance, MBS prices rise and fall as demand rises and falls.
Let’s take a simple look at some numbers. A 4 percent note rate is not equal to a 4 percent fixed income bond UMBS from Fannie or Freddie trading at 103 because that’s a TBA (the precise pool characteristics “to be announced” in the future) vanilla fixed-income security. There are more variables than taking a 4 percent security on Bloomberg and putting a 4 percent note rate mortgage directly into it, hence why the rate sheet is not going to have that same screen price. In fact, currently a 4% note rate is placed into a 3% security for the reasons below.
The 4 percent coupon MBS “bucket” expects 4 percent payments from the borrower every month to the bondholder, but the rate on the mortgage is going to have to be more than 4 percent because of the “Gfee” (roughly 6 bps on GNMA, 50 bps on FNMA/FHLMC), which is taken off the top of the price and given to Fannie or Freddie or GNMA in order to guarantee cash flow on the bond. In addition to the Gfee, there is a servicing strip (25 bps on Conventional, 44 bps on Government loans) that is collected by the servicer to process the monthly collection of payments. Excess servicing value, what is left over after taking the pass-through rate and servicing strip out of the original note rate, can be multiplied by the buy up/buy down schedule in order to normalize cash flows. In order to help normalize price, excess servicing, the cost of the Gfee, and the buy up buy down multiple are removed from price (passed on to the borrower).
Mortgage rates vary from lender to lender for a variety of reasons. The secondary market may not like the bonds backed by mortgages funded by a lender whose loans refinance quickly. Lenders have different appetites for risk, different overhead costs, different products, different servicing strategies, and different Gfees. LOs should understand that lenders should earn a profit on each loan (if not, why be in business?) and that well-run companies use these profits to create reserves to cover losses, buybacks, expansion costs, declines in servicing values, and so on. A lender that is only “living for the day” without an eye on the future may not have creating reserves as a priority, and price accordingly.
Sure, there are loan characteristics (read: less risky, less likely to refinance, and less difficult to bundle in an MBS) that will help borrowers get a lower rate. It is much easier for a borrower to obtain a good rate on a low LTV, single family residence with a high FICO score because those characteristics help void the need to compensate for the additional risk investors see in cash-out refinances, adjustable-rate mortgages, and loans on manufactured homes, condominiums, second homes and investment properties because they are deemed riskier.
There is an old joke about a heart surgeon and a car mechanic discussing their services and fees. The mechanic doesn’t understand why repairing a set of valves in a car shouldn’t be priced the same as the work the surgeon does repairing heart valves. The surgeon reminds him that when he does his work, the “car” is running. LOs have a very complicated job, not only dealing with borrower psychology, unreliable real estate transactions filled with surprises, deadlines, competitors, and the pricing considerations listed in this write-up. But the explanation above should provide an explanation for how rate sheets work, why the capital markets staff is important, and why your rate sheet is not showing the same MBS prices as a screen or your competitor.
Thank you Robbie!
The reason women don’t play football is because 11 of them would never wear the same outfit in public. (Phyllis Diller)
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