Mandatory vs. Best Effort Loan Commitments. Servicing Values Affect Pricing

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If you’ve worked in the secondary market department or hung around someone who manages interest rate risk for a mortgage banker, you may have heard a few strange buzz words that seem unrelated to the mortgage business.  Terms traders use like delta neutral and beta weighted.

Let’s look at these terms.

  • Delta:  We’re not talking about a body of water.  This term refers to the incremental value between one number and another.  When you hear a trader talk about being delta neutral he/she means that the hedged position offsets the loan pipeline position.  Generally, mortgage bankers like to end the day with a delta neutral position.
  • Beta:  Yes this too is one of the Greek letters and no we aren’t talking about college fraternities.  Beta measures the expected volatility of a hedged position to monitor the profitability of a loan pipeline. This is necessary because, as benchmark interest rates move up and down, the value of a loan pipeline will not move in step with the underlying hedge, so different ratios are used to ensure

So now that we’ve got some understanding of secondary market “buzz” words, let’s look at some current secondary market pricing issues facing traders today.  I asked Brad Nease of Mortgage Capital Management (MCM) to comment on a few issues I’ve heard from clients.

CW:  It appears the delta between best efforts and mandatory has contracted recently? 

Brad:  Spreads were has high as 50 to 100 basis points 6 months ago. Currently the spread is around 25-30 basis points. If someone is using single loan mandatory it might be as low as 5 -10 basis points depending on the investors

CW: Why has this happen?  Is something going on in the MBS pricing?

Brad:  One of the reasons may be investor have lowered the price to acquire servicing.  Many investors bake the servicing released premium into the price used to acquire loans from mortgage bankers.   Another reason is investors have decided to back off pricing on mandatory commitments. 

CW:  Where is the best execution price today?

Brad:  AOTs continues to be the best all in price, followed by direct trades, bulk trades, single loan mandatory and best efforts.  AOT is traded directly with street firms.

Spreads have narrowed between mandatory and best efforts commitments to as low as 5 basis points. From our perspective, a mortgage banker should be agnostic about the type of commitment it uses for loan sales.  They key is to find the best execution to ensure the company generates maximum gain on sale.