What is Counterparty Risk?
A counterparty is a company that agrees to perform a transaction or service with or for another company. Counterparty risk is the fallout that would occur in the event one party fails to hold up their end of the deal.
Mortgage bankers do business with various counterparties and have a large amount of counterparty risk. Let’s look at some of those relationships...
- Warehouse Lender: Mortgage bankers rely on warehouse banks to finance their loans until the paper is paid for by the loan investor in the secondary market. Warehouse agreements describe the terms and conditions that allow a mortgage banker to obtain advances from their warehouse facility. Mortgages originators write loans and provide commitments based on the assumption that when their loans are ready to fund, the warehouse lender will be there to provide funding liquidity.
- Loan Investors: Mortgage bankers rely on secondary market investors to purchase their pipeline of closed loans once they've funded. Mortgage bankers fund loans through warehouse lenders based on the assumption that an investor will purchase those loans in the secondary market.
- Broker/Dealers: Mortgage bankers who actively manage their interest rate risk do so by selling mortgage-backed securities in the TBA MBS market. This "short position" serves as a hedge against interest rate risk and the value of their loan pipeline. These forward trades are executed with broker / dealers who then enter into arrangements to sell those securities to another counterparties such as banks, insurance companies , and mutual funds. Sometimes mortgage bankers deliver loans against the trade and issue their own securities with GNMA or one of GSEs. Other times they may assign the trades and loans to investors under an assignment of trade (AOT) transaction. And finally, some mortgage bankers may pair out the trade and use the gains/losses to offset gain/losses generated from loan sales to investors in the secondary market. Mortgage bankers rely on broker/dealers to take delivery of the securities or provide liquidity on pair off fees.
What happens if one of the counterparty fails to deliver? Let me provide two historical scenarios:
- Many will remember American Home Mortgage (AMH). They were active in the correspondent channel, buying pay options ARMS from mortgage bankers. The ARM program was unique and no other investors would purchase the product. When AHM filed BK, many mortgage bankers that delivered this product to AMH and found they were unable to get the loans purchase. Mortgage bankers under pressure from warehouse lenders were required to sell loans to scratch and dent investors at deep discounts. Which was a major hit to the originators bottom line.
- During the mortgage meltdown in 2008, some warehouse banks were forced to abruptly shrink their balance sheets. An easy way to accomplish this was to reduce or eliminate its warehouse lending business. Some mortgage bankers with only one warehouse lender found themselves scrambling to find new lines during the height of the mortgage liquidity crisis. Some TPO mortgage bankers found there were no warehouse lenders at this time offering lines if loans were originated from mortgage brokers.
We recommend mortgage bankers have a minimum of 2 warehouse lenders, 2-3 secondary market investors and 2-3 broker/dealers. Always prepare for the worst case scenario. Andy Grove’s book, Only The Paranoid Survive, says it all.