The Downside of Hedging Interest Rate Risk with Mandatory Loan Commitments

We are often asked whether or not a mortgage banker should be actively managing interest rate risk via mandatory commitment loan sales. 

We recently provided information from a prominent hedging consultant firm regarding the pricing spread between best efforts pricing and mandatory pricing.  As was noted, the wide spread between mandatory one-off's and best effort pricing that was observed in early 2009 has since narrowed considerably. HERE is the data. HERE is more perspective on WHY.

Many owner/operators see the large spread in commitment prices as an easy method to add 30-50 basis points in gain on sale to the bottom line.  We agree, mandatory commitments offer the opportunity to increase profits and even lower rates, but we must point out the risks associated with mandatory committing. There are controllable and uncontrollable risks associated with managing interest rate risk yourself. 

Let’s take a look at a couple:

1. Controllable:  One key strategy of managing the interest rate risk of a mortgage pipeline is to calculate the pull through or funding ratio of forward locks.  A common strategy is to determine the historical funding ratio over some period time based on loan characteristics, channel and interest rate movement.    After determining this ratio, the VP of Secondary Market takes down hedges or loan commitments to mitigate any movement in interest rate.  The objective is to protect the gain-on-sale on the loans that are expected to fund. The key risk is whether the funding ratio is accurate.  Sloppy lock policies, mortgage operation train wrecks and poor data can blow up the funding ratio.  Companies with undisciplined managers and poor implementation and enforcement of internal policies often times have poor results when making the switch from best efforts to mandatory commitments.  Whether they under hedged or over hedge, the result is the same:  The actual gain-on-sale is much lower than the expected gain.
   
2. Uncontrollable: Even if your funding ratio is accurate and predictable, a large jump in interest rates can cause severe financial loss for a company.  Over the years, we’ve seen interest rate spikes of 100 basis points and resulting prices declines of 6 points or more in a 4-5 day period. 
   

Let’s review an example of the impact on a company when there is a sharp rise in interest rates:

Wholesale mortgage banker A has a net worth of $3 million and is using it's historical funding ratio of 50% as a benchmark.  Banker A is funding $200 million per month on average. Lets say rates jump 100 basis points and rebate prices drop 6 points.  His $100 million in forecasted fundings  (50% funding ratio) now turns into $150M in funding (more files lock and close when rates rise).  The unanticipated spike in funding needs results in pipeline losses of $3.0 million,  which wipes out the entire operation.  This has happened in the past to some very smart mortgage bankers. 

In my travels, I’ve seen several companies move to mandatory commitments with horrible results.  It can work, but understand there are real risks associated with managing the interest rate risk yourself. Your reporting methods must be consistent and well organized.