The GUT-FLOP: Pipeline Management Theory for Loan Officers

"Should I Lock or Float?"

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.

Core Concepts:
The 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 certain 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.

Risk allocation

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
    1. 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.
    2. This means that whatever lock or float considerations that could harm the deal should be avoided.
  • Purchase versus Refi business
    1. 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.
    2. 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.
    3. 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
    1. 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.
    2. 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.
    3. 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.
    4. Time Frame. 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.
    5. 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
    1. 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
    2. 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.
    3. Stop Loss. 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.
Some 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.

Remember, above all else, lock/float decisions based on on fluctuating MBS prices and seemingly intelligent market analysis are only ever reliably correct on an INTRADAY basis. In other words, once you give up today's opportunity to lock, there are no guarantees for tomorrow. The highest and best use of real-time MBS Prices and Analysis is to inform timely intraday locks. If you can consistently beat the market on something longer than an intraday basis, get out of this business and day trade full time. Just remember, even people who have been very right in the past can become very wrong in the future, so take a balanced approach, involve your clients in the decision, and avoid over-committing to either extreme on the risk spectrum.

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