Over the past 12 months we’ve seen many shops moving away from best efforts locks as a means to manage interest rate risk. These operations are now using mandatory delivery commitments. Actively managing interest rate risk makes a lot of sense for many companies. Gain-on-sale (GOS) margins can increase by 30-50 basis points when doing so...
In many cases, the extra revenue goes directly to the bottom line. Yes there are additional hedging costs, and yes, many companies hire a 3rd party hedging firm to provide risk management analytics and consulting services. However, even with these costs, the upside revenue gains are significant.
From an administrative perspective, moving to mandatory commitments requires changes in lock polices, risk assessment and new disciplines. One of the key components of successfully managing interest rate risk is hiring an experienced, knowledgeable and analytically oriented secondary market manager. A second component is to structure a compensation package that is aligned with the goals and objectives of the company.
Let’s look at some DOs and DON'Ts of secondary manager's compensation plan:
- Don’t compensate a secondary manager based on production volume only, with payments determined by basis points. Without an incentive to maximize GOS on every loan and a sensitivity to the firm’s capacity constraints, volume may not necessarily turn into profits. We’ve seen some secondary managers making large bonuses while the company struggles to profit under this type of plan;
- Don’t compensate a manager based on only the amount of GOS generated by his/her efforts. A company may have aggressive production goals and the financial capacity to support this growth, but needs a sharp price. A secondary market manager with a GOS only incentive is not going to be motivated to sharpen the price at the expense of degrading the GOS.
- Do share a percentage of the pre-tax profits. This approach will align the manager’s objectives with the company’s objectives. He has to be driven by both production, service and GOS;
- Or, consider combining a production and GOS component together to compensate a manager. This plan may establish production and GOS targets the manager must meet before any bonuses are paid. In addition, the comp plan may have a quality control component included.
Secondary market revenues are a large piece of the revenues and profits of a mortgage bank. They are predicated on both volume and GOS. A secondary market manager needs to be incentivized based on the overall objectives of the company. A good approach is to have the comp plan based on profits or a combination of volume and GOS.