Forward Commitments Gone Wrong. Adequate Oversight Needed
I must have hit a nerve over the post regarding the evolving originator environment and the decisions many owner/operators are now facing. Ok, I’m direct, but, on a weekly basis, I listen to owner/operators discuss the challenges that confront their business. Allow me to add some humor to the situation.
The truth is, it is a very difficult world for undercapitalized mortgage banks to operate in today.
We perform a number of studies for mortgage bankers and warehouse lenders. One of the studies is a risk analysis of key areas of a mortgage bank. These areas include: Financials and financial reporting, mortgage operation, secondary market, board oversight and mortgage technology. One of the key areas of risk is the activities in the secondary market area, especially when management is engaged in hedging activities.
Things we look for are: written policy and procedures surrounding hedging activities, experience of secondary market staff, daily reporting of activities, performance measurement and board oversight. Board oversight is a very important aspect of a successful company.
Several years ago, at the beginning of the subprime meltdown, I had the opportunity to audit a large national subprime company. I was hired by their board. While they trusted managements, they suspected something was amiss, but were not secondary marketing experts and could not identify the source of the problem. One of the key red flags was the company had over $20M in early payment defaults (EDPs) from a major street firm. The company did not have the cash to repurchase the loans or pay the short fall from Scratch and Dent investors (bids were a 10 point discount).
Here is what I found:
Management had taken down a one year $1 billion forward commitment with the street firm we mentioned above. They obtained a slightly higher price for a one year EPD arrangement. At this time, EPDs were around 120 days. As I drilled down further, the board had no idea of the terms of the deal. And most importantly, the board had not approved the company’s interest rate risk management policy and procedure and there was little discussion at board meetings of secondary activities. Management may have been wrong in doing the deal, but the board was even more accountable for not providing adequate oversight.
The following is a sample of a what a mortgage banking board should be discussing in meetings:
- Review of previous meeting minutes
- Financial Report: Earnings, balance sheet, liquidity
- Loan Production: Branch activity, margins, and products
- Internal Audit: Quality control reports, fraud control
- Secondary Marketing: Investors, shipping, margins, forward commitments
- Warehouse report: Compliance with covenants
- Operations: Service levels, turnaround times
- Personnel: Break-down of number of people per departmen. & productivity per person