[I am on vacation, and my access to e-mail is sporadic and not timely. In my place are daily commentaries from a series of very knowledgeable mortgage industry people with different backgrounds, and they have been given very little direction about what to write about. The third is below. Our views may or may not coincide, but I thank them for their time in volunteering and helping out.]

Today's contribution comes from:

Dean A. Brown
Mortgage Capital Management

Hedge Capacity Utilization

Given the fact that current mortgage pipelines are not exactly large, one may not think that tracking trading capacity or the lack thereof would be a concern given production levels. However, it is precisely in times when lower than average volume levels are the norm that consideration for the topic should be addressed. Last summer many mortgage banker's pipelines were bursting at the seams with more production than could be hedged using mortgage backed securities traded to securities dealers.  Many were forced then to sell locked production on a mandatory basis for future delivery and some even ran out of that capacity. Others increased profit margins significantly to slow down volume or executed both strategies. The time to tackle the issue is before it becomes a problem.

The first ratio to consider is the TBA Ratio: current TBA Sales (with all dealers) / Total Nominal Trading line with all dealers (Nominal due to the fact that many lines are curtailed do to mark-to-market considerations). If you have $135 million sold forward through mortgage backed securities- TBA and a total line of $180 million your ratio is 75% capacity (135/180.)  The next number to consider is the open direct trade or mandatory line percentage ratio (Mandatory Ratio or  MR) defined as the total amount of loans sold to conduits or investors that have not yet settled divided by the total amount of trading line provided by all investors/conduits. So if you have $75 mil. of loans sold single loan mandatory or thru direct trade and the total lines available in this manner is $100 mil. the ratio would be also 75%. The overall hedge capacity ratio would therefore also come out to be 75% by adding the two amounts sold: ($135+$75=$210) and dividing by the amount that could be sold: ($180+$100=$280) or 210/280 = 75%.  This situation would allow for an additional sold volume of $70 million.

While many mortgage bankers will rely on the MR in times of over capacity (thinking that the amount is unlimited - our experience is that these lines are not unlimited. Furthermore, once a loan is sold on a mandatory basis, the loans must be delivered or paired off.  However, only negative pair-offs are usually allowed, so when the market sells off and you need to pair-off a mandatory trade you will not get the benefit of the hedge like you would with a TBA trade.

After calculating what your current Hedge Capacity Ratio is, one should consider that volumes could increase unexpectedly and/or Fallout ratios in the pipeline could decrease given a significant market move with higher rates. For example, if your pipeline increased 50% and you are assuming a 70% closing ratio, could you cover the additional amount of business on a hedged basis? Assuming that a 50% increase in pipeline required new sales of mortgage backed securities of $45 million the new business could be hedged with existing trading capacity. However, if shortly after such a pipeline expansion occurred, a dramatic rise in rates occurred thus driving up your expected closing rate from 70% to near your company's historical reject rate of 10% or 90% closing rate; what additional capacity would be required? First, if the original amount available was $70 million from the example less the pipeline surge coverage amount of $45 mil. = $25 mil would be left leftover.  However, the increased pipeline closing rate would require an additional $38 million exceeding capacity by $17 million.  During such a time your securities dealers and investors more than likely would not allow you to exceed your lines and therefore your company would either have to make customers wait in line to get a lock until hedge capacity is available or go long and risk that the prices you will eventually get for the amount long doesn't exceed you profit margins. Either way not a good position.  This also assumes that your mandatory/direct trade lines clear as normal, i.e., that investors purchase loans on the agreed upon time schedule. However, during expanding production markets we have noticed that the investors/conduits increase the amount of time it takes to purchase loans thereby increasing the amount of line outstanding.

We think that by monitoring the Hedge Capacity Ratio, pipeline production trends, and keeping enough capacity available to handle potential pipeline growth and increased closing ratio events, you will be better served than waking up one morning to find out that you can't cover the exposure locked the previous afternoon. The solution is to monitor your capacity and constantly look for ways to increase it.

Skin in the Game

There has been much talk and wrangling over the potential changes to the securitization market over the Financial Reform Act's provisions for retaining a 5% position on each non-conforming loan and changes to servicing compensation.  Most of the time simple solutions are the best solutions. Hence, perhaps regulators and FASB should reconsider the capitalization rules for mortgage servicing rights on both purchased and originated MSRs. Yes, mortgage servicing rights have value, however the value should not be recognized upfront before the actual amount of income and expense have been received. Furthermore, mortgage servicing right are not just an IO strip that can be traded like an MBS, they are much less liquid and bear responsibility both to investors and borrowers.

Currently, either type of MSR must be capitalized leaving those with thin equity levels on their balance sheets the necessity to sell servicing in order to maintain liquidity and/or profitability and/or raise capital. Also, the FASB rules have had an additional side effect: more loans have been originated and approved by underwriters simply because they followed the investor's guidelines versus making "good" loans.  In the old days before mortgage servicing rights were capitalized and most mortgage banks retained servicing, underwriters followed guidelines, but were free to not approve a loan that they thought was not a good investment.  Owners and underwriters knew that loans that went bad had a future detrimental impact on the company's bottom line through default processing and foreclosure costs not to mention reduced cash available due to increasing advances. As the market has evolved due to the impact of the capitalization rules changes and the housing market crises, underwriters now make sure that they follow rules to the "T", but have relinquished some or all of the responsibility to the investor since they followed the "rules"  and sold the loans servicing released. This does not mean that they necessarily make worse loans - but it does mean that they have not made an investment decision - that is made by the investor. The best decisions are made by those closest to the transaction - those who make the loans.

By going back to the "Old Rules" of not capitalizing mortgage servicing rights several benefits would accrue: lenders would have skin in the game, real value would be generated in the mortgage banking business thereby strengthening the industry, the concentration or market share of the largest lenders would be reduced increasing competitiveness (economies of scale are not infinite),  and better loans would be originated by enhancing the role of each company's underwriters not to mention the accounting, hedging, and other headaches that can be attributed to the process to estimating the value of something that may or may not payoff early or go into default. Simplicity sometimes has its benefits....

Through a combination of cutting-edge software solutions and industry-leading expert counsel, MCM offers proven, time-tested expertise in pipeline risk management, secondary marketing consulting, hedging services, and personalized consulting.

Editor's Note:

Wells Fargo's correspondent clients received a 14-page Newsflash on, "New Condominium Documentation Vendor Available for Prior Approval Loans, New eDelivery Vendor Added; Exhibit 22 Revised, Conventional Appraisal Policy Updates, FHFA's Uniform Mortgage Data Program Updates, Standard Price Policy for Agency Real Estate Owned (REO)." Across the hall, on another floor, in another building, in another town and another state, Wells Fargo Wells Fargo Wholesale Lending in recent weeks has sent out updates on Utah's recording fees increasing,  "Streamline the Loan Process and Order Tax Transcripts via Rapid Reporting, how New York Purchase Transactions May Not be Originated With CEMA, Compensation and Anti-Steering: Home Equity Compensation Reminders and Clarification, Compensation and Anti-Steering: Update - Appraisal Fee Reimbursement, how the Benefit to Borrower Changes were effective May 21, how Title-related Information Consolidated in Broker Guide, Enhancements to Fannie Mae DU Refi PlusTM: Resolving Social Security Number Discrepancies and Required Rental Income Documents, how Secondary Financing Now Allowed on Co-op Transactions in the High Balance Conforming Loan Program, Non-conforming Policy Changes for Loan Amounts up to $750,000 or $1.5 million (Depending on State) topics, FHA Financing Allowed for New Construction and Proposed Condominiums in a Flood Zone - effective last month, an update on Government Appraisals (a reminder that Appraisal fees for Government loans should not be collected from the borrower until the borrower receives the initial disclosures.), New Streamlined Sign-up Process Makes Ordering Tax Transcripts Even Easier, Non-conforming Policy Changes for Loan Amounts up to $750,000 or $1.5 million (Depending on State), Enhancements to Fannie Mae DU Refi PlusTM - Resolving Social Security Number Discrepancies, Home Equity: Value Differences Between Multiple Valuation Products, a New Mortgage Broker Fee Disclosure for Home Equity Lines of Credit, information on Illinois Civil Union, and the introduction of a new net funding process (Wells Fargo Wholesale Lending is simplifying the process the processing and payoff of Wells Fargo Home Mortgage (WFHM) to WFHM transactions. This new net funding process will allow us to net and directly apply the funds to pay off the first mortgage.)"