For people outside of mortgage banking, understanding the occupations within lending can be a mild challenge. “What does a doc drawer do?” “Huh? Funder? What’s that?” And for those inside of residential lending, understanding what capital markets and secondary marketing people do can also be confusing. “You talk to Wall Street… about what?” “What is that stuff on your computer screen?” “Why can’t you adjust your margins to help me?” “What the heck is a ‘specified pool’ and why do you talk about hedging it?” Providing a primer on these last two items should give you some insight into secondary marketing, especially since they can directly impact a lender’s profits, or losses, and therefore the viability of the company.
The key to margins over the decades been capacity. In 2020, lenders adjusted margins higher to dampen the number of loans being locked. Put another way, the fastest way to slow business down is to make your prices worse. During those “drinking from a fire hose” days of the pandemic, STRATMOR found lenders everywhere were raising margins/making prices worse, because their operations staff could not handle the volume in a timely manner. Few lenders wanted to handle refinances that were taking months to close due to appraisal or underwriting backlogs and suffer the complaints of the delayed borrower.
But the issue brings up the topic of margins, and pricing in general. There are five points of pricing, and every originator should understand them. The first is demand: does capital markets have a buyer for the loan, especially specified pools (see below) or non-Agency loans like jumbo or non-QM? And for Agency products, is there demand by investors such as insurance companies and pension funds? Securities backed by mortgages (mortgage-backed securities, or MBS) have historically enjoyed very good demand by investors, especially when those loans are made to borrowers who have good credit quality
Second, lenders need to consider their competitive position in the market. Are you the only lender in town? Do you want to push competitors out of the business through cutting your margins or even doing loans at a loss? Do you want to be known as the price leader?
The third point is margin need, or budget. This is especially important in banking where the required return on assets is important. What is the cost of funds (for a credit union or bank, what is it paying on deposits) versus the interest rate earned on the asset?
The fourth consideration is market share. As a lender, are you gaining or losing market share? This is obviously less of a concern for a smaller lender than a larger lender. STRATMOR helps lenders of all sizes and has found that market share is very important to large, national lenders.
And the last price point is capacity. As noted above, a very fast way to turn on and off the spigot of loans is to adjust pricing. If your “back office” does not have the capacity for additional volume, raise pricing. If lenders, as they are in the summer of 2022, are finding themselves with excess capacity, they can either cut overhead (including staff) or adjust pricing accordingly.
When pricing, secondary marketing staffs balance all of the above. Traditionally “the thumb” has been on the capacity side of the scale for several years for most of those in the industry. So, depending on the above, some have had primary/secondary (P/S) spreading, and others not so much. When analyzing the P/S spread, lenders must take into account the huge increase in costs which the MBA has pegged at over $10,000 per loan. Lenders of every size must contend with the g-fee imposed by Freddie and Fannie (unlike jumbo or non-QM loans which have none), increasing compliance costs, servicing compliance, foreclosure, and buyback reserve costs. These costs, even though for prior funded loans, have to be covered by the current fundings and eat into margin and the spread. Some companies have more or less cost depending on their book of business.
On the revenue side of a lender’s equation is the market for MBS backed by loans of a certain size, or geography, or made to borrowers of certain credit profiles or loan-to-value. Pools of loans made up of certain traits are called “specified pools” and have varying degrees of demand in the secondary markets. Often investors will pay higher prices for pools of these loans, based on the particular appetite of the investor. Secondary marketing staff spend time finding outlets for these loans, and either pass the better pricing on to originators or use the income to bolster the overall financial condition of the company.
Why do these pools have a greater demand? One important and well-understood aspect of specified pool trading is that the level of pay-ups is highly correlated to the dollar prices of TBA (to be announced, or generic) passthroughs. The reason for this is fairly straightforward: higher dollar prices create a greater economic benefit to holding prepayment-advantaged loans. The yield pickup gained for a slower prepayment assumption, for example, shrinks as the price declines. (The same logic holds for products, such as jumbo-conforming loans, that prepay faster than generic conforming-balance loans.) Put another way, a pool of loans made up of borrowers with higher credit scores will behave, over time, differently than a pool of loans made up of lower credit score borrowers. The same with LTV groups, or loan sizes.
These issues, and a myriad of others, occupy the secondary marketing teams of lenders across the nation. The pricing set forth on rate sheets and in pricing models is made up of varying components, and not simply based on how the CEO or head of capital markets feels that particular day. And picking up some incremental gains from producing specified pools is but one example of how secondary marketing groups add to the revenue of lenders.
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