I consider myself a lucky  guy. Standing in my inner circle are a group of highly experienced industry leaders. It's been this way for me since day 1. Anyone know Joan Walton? They've seen it all. From application to securitization, I've got someone to talk to when I'm feeling uncertain or just need a simple perspective re-alignment. Plus they tend to police me when I get out of control.

This morning I published some "color" on how a secondary marketing department approaches the construction of  loan pricing. I also shared applicable observations about the risks embedded in hedging a pipeline of mortgage loans.

HERE IS THE POST: MBS Print New Record High. More on Loan Pricing Strategies

I sent the details of this post to Brad Nease, President of MCM (Mortgage Capital Management), wondering what his take on my comments might be today.

He was quick to respond:

We would agree that liquidity is a key issue with 3.5’s and will continue to provide a floor to rates until the TBA market gets more comfortable with the security.

A spike in fallout and renegotiation requests is always the case in a falling interest rate environment, whether there’s a potential current coupon/security change or not.

We believe an excellent tool in managing this risk is using a small percentage of your trade coverage in options on MBS.    Their value increases when pull through increases and decreases as fallout increases.  In addition, we perform an extremely intense, loan by loan, historical analysis of a Client’s fallout and then update it monthly.  This profile is used in each and every report run and they adjust as rates move up and down. 

As far as building up your capital levels, we live in a different world today than we did 3 years ago.  We as an industry must increase our capital.  Liability is being pushed down to the LO level.  Early prepay, early default, etc., are risks that are being shared throughout the origination chain.  Fraud has a completely new definition than it did 3 years ago.  What I mean by that is, the definition of fraud has greatly expanded and investors are much more apt, at a moment’s notice, to send out an accusatory fraud letter, whether proved or not, than they were 3 years ago.

As far as the ‘flight to safety’/’unwinding of duration’, we don’t have a crystal ball,  we are in the business of making loans.  Managing risks and keeping an eye out for a more fundamental shift vs. the more daily technical interest rate moves are a part of our everyday lives as pipeline managers.


How might this be useful to a loan officer?

For one, if you didn't know already it, there are additional costs baked into your loan pricing that aren't intended to increase profitability. Instead they're built into your pricing to better manage risk and pay the bills.  This should not be frowned upon though. From a risk management perspective, when you better manage risk, lenders are more willing to work with you. They are more willing to compensate you for reliability. As a result, everyone's loan pricing improves and margins appear smaller to the loan officer. It's a win/win for all parties involved.

What about interest rate risk?

When thinking about managing risk from an originator's point of view, we can never say enough about the importance of being prepared. If you can't discuss what's moving mortgage rates, you can't identify and evaluate your potential risks. You never want your guidance to become a guessing game.  This is a lot of responsibility for one person to handle, but if you are able to identify and explain potential risks to your clients, you won't be alone in the decision making process. You transfer risk off your personal P&L. 

There are multiple ways in which interest rate risk can affect your pipeline.  There are day over day rebate improvements that might not justify a reduction in the note rate offered and only add to the originators bottom line. The opposite can occur just as easily though, especially when you narrow down your lock/float horizon to a day over day decision. But when it comes down to it  Lock/Float isn't that black and white.  There are many more considerations to account for...

For example, let's say you're floating a note rate  priced close to par. Did you know that note rates priced close to par are generally the most vulnerable to rebate reductions? What note rates carry the most duration? Is the note rate you've quoted one of these rates?

What is duration?

Duration is the sensitivity of a bond's price value to a change in interest rates. What duration tells us is how much a bond's price will change based on a given change in yield. An originator might view duration as the sensitivity of their loan pricing to changes in MBS yields.

Plain and Simple: Duration is just a really fancy word for interest rate risk

Other considerations include:  How sensitive is your borrower's DTI to a shift in loan pricing? Can afford to lose the deal if rate  goes higher? Is your lender increasing their turn times? Has your lender been more aggressive than other lenders? Are you anticipating a long list of stipulations?


Tomorrow at 830 AM the Bureau of Labor Statistics will release the findings of the July Household Survey & the Non-Farm Payrolls Survey.  Together these two surveys make up the Employment Situation Report, the most highly anticipated dataset available to the market.

The current market environment is reflective of a general lack of committed participation. Trading volume is low, flows are inconsistent, and no one is willing to catch a falling knife until it's reached the outer limits of its recent range. This is to be expected at this stage of summer. August is the slowest month of the year in financial markets. Many decision makers have surrendered their Blackberry(s) and are detached from the world of finance.

This implies the market is highly susceptible to impulsive directional moves. Watch out for chopatility!

RISK REPORT: Borrowers who are on a timeline of less than 30-days to closing face the most interest rate risk. The farther out your closing date, the more short-term volatility you can withstand.  I would consideing locking all loans closing within 30 days, especially those with higher loan amounts. This guidance is not based on a particular bias toward the market's directional reaction to 830am data. Instead it is based on the  illiquid nature of the 3.5 TBA MBS market. Furthermore, because lock desks have recently experienced an influx in new loan applications (relatively), secondary will be reluctant to offer lower mortgage rates as this  would increase the chance of osing a portion of their locked pipeline to another lender. Fall out is not our friend! Collectively, the major lenders appear to have colluded to put a floor on home loan costs. The only way I see mortgage rates moving any lower is if the Federal Reserve is forced to restart quantitative easing. I definitely do not see this happening in the next 30 days. If it happens at all (most likely outcome).  READ MORE ABOUT THESE RUMORS

The following base rates are most sensitive to falling "rate sheet influential" MBS prices:  4.25%, 4.375%, 4.50%, 4.625%. These coupons carry the most "duration" relative to the rest of the coupon stack.

The Nonfarm Payrolls & Unemployment Report is expected to present more mixed news. In June the report said payrolls dropped 125,000 in the month as 208,000 government jobs were lost due to Census layoffs. But private payrolls rose 83,000, the sixth straight gain.  In July, trends are anticipated to be similar. Economists look for a 63,000 decline in Non-Farm Payrolls as temporary jobs for the Census are once again terminated. Private payrolls are anticipated to rise 91,000. The unemployment rate is expected to tick up one-tenth to 9.6%.

This blog post, Private Payrolls : Perspective on Jobs Data and the Market's Motivation,  provides a theory as to why this month's data might determine the directionality of interest rates in the month to come. It also calls attention to the specific metrics the market will be scrutinizing.