REQUIRED READING: The last several years have presented a tremendous amount of disruption as it relates to operating an efficient, profitable retail mortgage business. Many brokers that were either unable or unwilling to adjust to industry challenges have closed their doors, merged or been acquired.
However, some mortgage brokers have looked at the industry challenges and change in the competitive landscape as opportunities. These companies have shifted their business strategies in order to capitalize on the opportunities and are now operating as bankers. The broker-to-banker transition is not as simple as it may sound and can prove to be quite challenging for even the most successful brokers.
As a broker transitions to a banker, all of the functions that were previously outsourced to the wholesale lender must be addressed and managed in different ways. Some aspects of the transition are intuitive, and others are not.
Technology, data and internal processes and procedures between sales and operations must be seamlessly tied together to streamline operations. A successful integration of these items allows the banker to deliver consistently high levels of customer service through superior loan execution. Due to the requirements of a banking model, fixed and variable expenses increase.
A focus on loan profitability and the factors that have the potential to erode profitability must be managed accordingly. As a result, a diligent focus on expense management and accounting must also be proactively managed. Investor and warehouse-line relationships are extremely important, and metrics such as loan quality, loan pull-through and days on the warehouse line must be managed in real time in order to maintain favorable relationships with these partners. Most importantly, risk must be identified and proactively managed at all steps of the process on a daily basis.
In essence, aspiring bankers must change the way they examine, interpret and manage their business due to the constantly changing, interrelated parts that are inherent in the banker model. In many – if not all – broker-to-banker transitions, the transformation is a ‘learn by doing’ approach. The old adage ‘You don't know what you don't know until you know it’ stands true with the aspiring banker. This learning process can unknowingly expose the new banker to a tremendous amount of risk.
Coupled with evolving regulations and investor requirements, bankers must stay in front of all changes that affect the unique aspects of their business. One of the best ways to mitigate risk, focus on loan profitability and handle the various interrelated functions and responsibilities required to successfully operate as a banker is to hire and develop a staff that is experienced, trustworthy and engaged.
It is equally important to identify gaps in the model at different stages of the transitioning banker life cycle and partner with companies that can help with key aspects of specific functions in order to reduce risk and increase margins. Finally, it is crucial to partner with investors and banks that extend warehouse lines of credit whose business practices and general philosophy closely match the banker's business goals and objectives.
Getting started
One key banker function that has a direct relationship with both risk and loan profitability is the secondary marketing function. The newly transformed banker will generally start working in a best-efforts – rather than a mandatory-capacity – with their investor partners. The reason for this is simple: Investors and warehouse-line providers are well aware of the various risks associated with the broker-to-banker transition. They have seen many companies fail during this transition. As a result, they embrace the ‘walk before you run’ approach.
Best-efforts delivery can represent the ‘walk’ category, because it is not different from operating as a broker. In many cases, brokers and bankers who operate in a best-efforts environment have the ability to earn superior pricing for high pull-through and exceptional loan quality. These pricing incentives, however, are generally capped by the investor at a maximum available best-efforts price.
Mandatory delivery, which allows the banker to capture additional margin, falls into the ‘run’ category due to heightened risk and several factors that are directly related to experience operating as a banker. Investors and warehouse-line providers want to make sure items such as operational efficiency, financial management and the general experience of operating as a banker are working well before they insert mandatory delivery into the equation, due to the potential for error and subsequent profit erosion. Most importantly, a significant error could result in a catastrophic consequence for the business.
As any established mortgage banker knows, the main reasons to operate as a banker are generally focused on improved customer-service delivery gained through enhanced operational loan execution and more control over margins and profitability on a loan-to-loan basis. Mandatory delivery as part of a secondary strategy is a key ingredient in any banker's value chain and serves as a reward in the natural progression toward becoming a successful mortgage banker, potentially increasing competitive advantage in the process.
Those taking the broker-to-banker path should ask themselves the following basic questions if they are considering incorporating mandatory delivery into their business model:
- How does mandatory delivery work?
- What are the risks associated with this strategy?
- What will I gain from mandatory delivery that will allow me to increase or recapture my competitive advantage?
- How will mandatory delivery affect operations?
- What approvals are required?
- What types of mandatory delivery are available, and where should I start?
- What qualities and philosophies of a hedge firm are important?
Most small to midsized mortgage banking firms will work with a hedge firm to manage their exposure to the interest-rate risk of their locked pipeline as part of a mandatory strategy. When a loan is locked, the banker effectively takes a long position on the loan. The hedge firm then takes a short position on a corresponding security; in most cases, this is a to-be-announced (TBA) mortgage-backed security. The TBA responds in a parallel fashion to mortgage interest rates. As a result of the short position, the banker is interest-rate neutral, meaning that it is indifferent to changes in interest rate because profit on the loan is effectively ‘locked in.’
Investors reward high pull-through, which is the primary reason that mandatory delivery results in the best price the investor can offer. The spread between best efforts and mandatory delivery minus the hedge cost equals the net profit from this more involved strategy. The reason for the increased margin is directly related to the transfer of hedge cost, management and fallout risk from the investor to the banker.
Daily hedge costs vary depending on the hedge firm and market movement. At the current time, net mandatory-delivery margins are between 20 to 50 basis points (bps). Margin variability is generally driven by product, investor appetite and the market in general.
In the pipeline
Managing pull-through is a critical component of a mandatory delivery strategy. Reviewing the historical pipeline, investor report cards, lock-desk policies and other customers' pull-through experience allows the hedge firm to more accurately hedge to a predetermined pull-through percentage. Accurately matching the hedging percentage to the pull-through percentage is critical to creating the interest-rate-neutral pipeline.
If the pipeline is under-hedged and interest rates increase, the predicted pull-through percentage may exceed the hedged pull-through percentage. This will reduce revenue, because there are not enough hedges to cover the additional loans that will be sold at lower prices from the time of the initial lock.
Conversely, if the pipeline is over-hedged and loans don't pull through, as can be the case in a market rally, the banker will incur unnecessary hedge costs, thus eroding profits that are made on the loans that are sold at strong premiums. Therefore, some of the main components of an effective hedge strategy are good reporting and an intimate knowledge of a banker's pipeline.
A consistent, thorough pipeline analysis allows mortgage bankers to fully understand the dynamic characteristics of their pipeline in relation to their business model, the current market and loan-specific items that affect pull-through. Loan-specific items – such as loan-to-value ratio, loan amount range, FICO score range, doc type, transaction type, property state location, occupancy type and debt-to-income range – should be regularly analyzed and interpreted in order to develop the most accurate pull-through estimate possible. This analysis should also be specific to each branch and each loan originator. Branch and loan originator analysis enables management to manage and train to any deficiencies in a proactive manner.
There are many benefits to mandatory delivery that can enhance a banker's competitive advantage. The obvious reward of mandatory delivery is margin lift. An increase of 30 bps on a $10 million pipeline adds significant revenue that can be reinvested back into the company for items such as technology, marketing, experienced personnel and general infrastructure. This additional profit can also be retained in order to build net worth – a key factor in moving up the banking ladder. Increased net worth opens doors with investors, warehouse lines and other partners that can significantly enhance a banker's business model.
A well-designed mandatory strategy can also lead to a competitive advantage in the marketplace through increased flexibility. Mandatory delivery enables the company to define its secondary policy regarding interest-rate-related adjustments resulting from investor change due to underwriting guidelines, rate re-negotiations, lock expirations and lock extensions.
These policies can benefit the company, loan officers, customers or all three – either directly or indirectly, depending on the policy chosen. In essence, the company can choose to focus on margin capture, flexibility of secondary policies that can improve loan officer relations, customer satisfaction or a combination of the three. The main point is that the company serves as the interim investor. This allows the company to customize these policies to their business model and overall philosophy.
Operational requirements
Because the company becomes the interim investor, it is imperative that the lock desk be centralized and managed by a detail-oriented, experienced individual in order to maintain accurate data on all loans as they come in the door. The centralized desk streamlines operations, because all aspects of the secondary function are handled in-house prior to the loan's being sold to the investor.
As a result of the need for a high level of data integrity, it is imperative for bankers to invest in a product and pricing engine that integrates well with their loan origination software. This is crucial, because the hedge firm will require constant communication regarding new locks, the overall pipeline and associated pull-through forecasts based on the market and the type of business in which the company engages.
Generally speaking, investors, warehouse lines, broker dealers and hedge firms require a minimum net worth of between $1 million and $3 million to gain approval for mandatory delivery. There are several different types of mandatory delivery: single loan mandatory, rate sheet forwards, direct/live/negotiated trade, assignment of trade (AOT) and bulk mandatory.
Most bankers moving to mandatory delivery will most likely start out with the first three types of trades, saving AOT and bulk trades for more volume and experience. A minimum monthly closed volume of $10 million per month is recommended for these delivery methods. Various situations and needs, however, may cause the minimum volume requirements for effective implementation to vary.
Once a mortgage banker is confident that both the historical and current pipeline reports are accurate, the most important decision when moving to mandatory delivery is to identify hedge firms that have a proven track record of successfully guiding bankers through the transition from best efforts to mandatory. There are a lot of moving parts with mandatory delivery, and a partner that focuses on continual communication, involvement and education is paramount to success. The hedge firm should also help to design a secondary strategy that matches the company's objectives. Furthermore, it is vital that the hedge firm employ a conservative strategy.
The baseball analogy that ‘a lot of singles is better than a home run’ is extremely relevant when initially playing the mandatory-delivery game. It can also be said that this analogy should be embraced for the life of a mandatory strategy, because if the hitter ‘takes his eye off the ball’ and loses his discipline, he may take his business down ‘swinging for the fences’ by speculating on the market.
Scott Reid is founder and managing partner of Alpine Mortgage LLC, headquartered in Bedford, N.H. He can be reached at (603) 935-5900.
