What follows will synthesize years of verbal
and written analysis, discussion, best-practices, advice, strategies, opinion, fact,
folly, and wisdom on the topic that can be most sweepingly identified with one of our favorite
questions: “Should I lock or float?” It will not
address every situation or set of circumstances. In order to get an overview in
a central location, it will be intentionally broad, simply introducing core
concepts with brief definitions. Because the "lock or float" question is so very highly-charged and infinitely more complex to answer than to ask, it requires a multifaceted approach, drawing on several considerations and attempting to reconcile them together into one methodology. This then, is the 1st ever written record of the
Grand Unified Theory of Floating or Locking Origination Pipelines, or GUT-FLOP.
pipeline as a managed fund.
It might not be fun in the short term to lock
certain loans and see prices improve or to float
loans and see prices worsen, but it’s a necessary evil of risk
management, and will make for the “fun” that you’re really
after, long-term net profit. Think “slow
and steady wins the race.” Those who
fight the urge to chase every last ounce of potential
profit and spread out their risk generally come out ahead in the long run.
There are several different variables to
consider when allocating risk in our industry.
By “risk allocation” we’re basically talking about allocating a certain
portion of your pipeline to different levels of risk based these
variables. The analogous activity for a
managed fund would be deciding what portions of the portfolios money will be
allocated to different risk levels.
Aggressive risk = higher potential return,
higher potential loss. By allocating
different loans to different lock/float timings among other things, the
originator is doing the same thing as a fund manager allocating different
monies to investments with differing levels of risk. In the end, the yardstick is the same: what
makes us the most money.
For most of us, our first risk allocation
consideration: What Pays The Bills
If you think about the money you need to pay the
bills, and reverse engineer to come up with a minimum number of loans needed to
generate it, factoring in fallout, this should usually be allocated to our
LOWEST risk category.
This means that whatever lock or float
considerations that could harm the deal should be avoided.
Purchase versus Refi business
In general, most originators will want to
allocate purchase business to a lower risk category which will usually mean
purchase deals should be more predisposed to locking.
Keep in mind that some pipelines will be such
that purchase transactions will cover the primary risk consideration of paying
the bills. In this case, the two risk
categories are interchangeable.
Even if purchase deals CAN be allocated to
higher risk categories, there is the additional consideration of customer
service and client necessity that suggests that purchase loans that are not
part of the “paying the bills” allocation should still be more predisposed to
locking than refinancing borrowers that have no pressing necessity for a loan
other than trying to lower their rate.
Considerations for deals in addition to those
allocated to above minimum risk categories
If one has a large enough pipeline that there
are extra deals beyond those allocated in the categories listed above, riskier
allocations can be considered.
Here too, client preference is a
consideration. Just because YOU have the
ability to take on more risk of rate movements doesn’t mean YOUR CLIENT wants
to. Out of this group of deals, the clients
that do not WANT risk are used to fill low risk slots, usually meaning either a
predisposition to locking or other risk management strategy.
Rate Sensitivity. Even if a client doesn’t necessarily care
about locking or floating, it’s up to you as the manager of your portfolio to
know when rate sensitivity can kill a deal.
A good example is DTI. If a small
increase in rates means the DTI will disqualify the deal, it should logically
be allocated to a lower risk category, thus predisposed to locking.
Purchase deals are usually the most sensitive to time frame. If a purchase has not already been assigned
to a lower risk category because it’s a purchase, the next consideration would
be the time frame. Is there a time frame
after which this deal is no longer viable?
The closer you get to that, the lower and lower the risk level to which
it should be assigned. The same is true
for time sensitive refi’s.
Client Preference. Plain and simple, the nature of a lock or
float should be disclosed to a client.
If the client is not comfortable floating, even if you are personally
guaranteeing the rate, most of us will agree this would automatically get
slotted in a low risk category.
Risk Management Tools
Rather than intrinsic qualities of a deal, these
are tools or strategies that can mitigate a portion of risk across any category
where floating is an option
Float Downs / Renegotiations. Different lenders have different float down
and/or renegotiation policies that can help you round out your risk strategy
nicely. In cases where today’s price
level is satisfactory to all parties involved, and the hit you’ll take for a
float down or Renegotiation will not kill the deal, these can nearly bring
normally floated deals into your lowest
risk categories. Some of the more
aggressive policies border on “having cake and eating it too.” Understand that the cost for the
renegotiation or float down is something you are paying in exchange for being
moved into a lower risk category. It’s
up to you to decide if it’s worth it.
This is both an essential tool your risk management arsenal, but also a
fairly brutal one. Simply, you set an
income level on a particular deal at which you’ll absolutely lock at a loss
from your original float, in order to remove the risk of any future
losses. Employed shrewdly this can
prevent most deals from dying. It will
FEEL like this has a big impact on your bottom line, especially if the stop
loss point is reached and rates improve before the deal is closed, but if the
risk of making nothing on the deal is getting bigger and bigger each day, that
risk can eventually be bigger than the income lost by not locking earlier. If rates do in fact get worse, the stop loss
then turns out to be a net positive on your pipeline.
Final Deep Thoughts
It would be great if we could forget all of the above and
simply help you do a little bit better on each loan, but it doesn’t now, nor
will it ever, work like that. The gains
that one realizes from floating, over time, come from an average gain, factoring
in good decisions and bad. To try to
generally float everything when you think rates will improve and vice versa for
locking has a good chance to be more frustrating and costly than employing a
measured risk management strategy. The
originators that most consistently earn profits from floating have gains and
losses, and the average among them is positive by design. There are glory stories and horror stories of
floating. Your chances of both are lower
in the short term if you employ a strategy.
But in the long term, if you can average higher profit than you
otherwise would simply locking every deal, that is not only glorious to some
extent, but there was little to no risk of a horror story.