BLOG VIEW: Moving from best execution to mandatory represents a significant milestone in the evolution of a mortgage lender’s secondary marketing department, but the growth doesn’t stop there. Adding custom, or specified, pools helps lenders diversify their execution strategy, thereby maximizing profitability and adding additional cash flow to secondary activities. What’s more, there is growing demand in the investor community for the ability to carve out these pools, which pay a premium.
However, mortgage lenders must take an “eyes wide open” approach to structuring and trading spec pools, lest they find themselves in over their heads. Doing so requires an understanding of how these pools differ from the more traditional mandatory execution vehicle (i.e. To-Be-Announced or TBA pools) and the market factors that must be present for this strategy to be successful.
As most lenders know, nearly all loans are eligible for normal TBA pools. These pools can be delivered into existing open trades, or lenders can create a specific trade related to the “front” month or multi pools. Ultimately, what lenders need to know about these pools can be summed up in the name – TBA. Because there is an element of the unknown, pricing for these pools reflects the risk investors face in purchasing them. Of course, investors are given the specific identity of the pools 48 hours prior to settlement, but until this point, only general characteristics are known, which makes analyzing the future performance of loans within these pools tricky.
Specified loans, on the other hand, let investors know exactly what they are purchasing up front because all loans within the pool will share common characteristics, and creation of these pools involves obtaining an Employer Identification Number (EIN) from the Internal Revenue Service (IRS), thus adding a layer of knowledge to the pool. Examples of loans that can be used to create specified pools include loans with balances up to $225,000, USDA loans, Section 184 loans, manufactured housing loans, loans with similar FICO scores or investment property loans.
By carving out a group of similar loans, lenders can deliver to investors a pool in which future loan performance, specifically pre-payment risk, can be more easily calculated. As a result, investors can make better predictions to extend the life of the pool and are willing to pay more for this stability. Depending on the type of specified pool, investor pay-ups can range from 25 bps to more than six points.
Of course, anything that promises great reward comes with increased risks – and specified pools are not an exception to that rule. The biggest risk lenders face in the specified pool market is, ironically, the market itself. Demand for specified pools corresponds to changes in the market. It can take anywhere from three to seven days to create and get a pool certified and posted. In that time, if the market moves, investor demand could decline for a particular type of pool, thus eliminating the pay-up for that pool, or even worse, the pool could then trade below the TBA-eligible pool.
However, there are strategies to avoid such a scenario, including trading pools that are on the cusp of pay-ups forward before final certification to lock in the pay-up while market conditions still favor that pool. Strong relationships with the dealer community can also help keep lenders on the pulse of where demand may be heading so that they can respond in time with the market as much as possible.
For mortgage lenders seeking to diversify their execution strategy, the reward specific pools deliver far outweigh the risks they might pose. With the proper advice and strategy in place, specified pools provide an opportunity for lenders to maximize their execution and add to their bottom line.
Troy Baars is president of mortgage hedge advisory firm Vice Capital Markets.
