With all the recent turmoil in the subprime and Alt-A secondary markets, the ability to stay profitable originating these products has been severely reduced. Fifteen-year industry veteran and co-head of MIAC’s Secondary Solutions Group, Tina Reid, provides some well-practiced ideas on how to make money and thrive in an Agency-Only Strategy.
In the last few weeks, not a day has gone by that I have not heard another company say they are going to “focus on Agency production”. From the largest to the smallest lenders, market conditions are pushing everyone in the same direction.
Unfortunately, many who have specialized in Alt-A or Subprime business are ill-prepared for the rigors of an Agency strategy. For these companies, there is a reason why they had a Non-Agency focus in the first place. For most, it was because the margins on Agency loans was very slim and the competition fierce.
Agency margins are slim because, quite frankly, they have become commoditized. By and large, every lender offers the same products. Every lender uses the same underwriting engines. And as everyone knows who took Economics 101 back in college, for commodity products, the low-cost producers win.
And remember those low margins? In the months ahead, lenders will fondly remember the margins they got in 2006 on Agency loans. The industry has massive overcapacity, even after the latest round of layoffs, and everyone is chasing the same business. We can expect those margins to get slimmer and slimmer, as originators and buyers slash profit margins to compete for what business is left.
No problem, you’ll just compete on service, right? Unfortunately, every other mortgage lender has eager and starving salespeople, to so you can’t hang your hat on that. In a market with excess capacity, good service just keeps you in the door with your competition. Bad service gets you booted out.
The good news is, you don’t have to be a giant company to be an effective low-cost producer. But you do need an extraordinary focus.
Survival Strategies
For most companies, a good outcome will be simply to generate enough revenue to ride this out and hold the origination infrastructure in place to be ready for the next upswing in the cycle. Others will be forced out of business entirely. To improve your chances of survival, particularly if you do not have deep experience doing MOST of your volume in Agency business, you will need to look very closely at your operations and secondary marketing to make sure it is exceptional.
And when I say exceptional, I’m not exaggerating. I believe those that survive and prosper will be the ones that have dedicated efforts to ferret out every nickel of cost, find every basis point of revenue, and cut every minute of time possible from the process. Let’s start with operations.
1. Obsessive attention to error prevention: In the Agency business, the cost of a mistake on one loan can erase the revenue you made on 20 or 30 others! This will be especially true in this market. We will have smaller than normal per-loan revenue and larger than normal cost of failure (being forced to sell scratch-and-dent has become excruciatingly expensive, as capital has dried up in that market also).
Look at your own Post-Closing operation. When errors or omissions are found, do you have Post-Closing simply play clean-up? Do you have a team that discusses material or recurring errors to address the PROCESS directly, so that you can prevent such errors in the future? Do you have people that are OBSESSED with error prevention? If you don’t…get some! A strong, process-oriented manager can help you identify process and system controls to prevent errors without causing workflow bottlenecks or unnecessary redundancy.
2. An unrelenting demand for clean data: Does your firm track data errors discovered in the process? Do you know where your data problems are? Do you have people working on fixing this right now? One of the most critical elements in managing a fast moving, low-margin, high-volume pipeline is to have data that can be relied upon by management, traders and investors. If you want to maximize efficiency and profitability of your execution, clean data is an absolute must.
3.Eliminating redundant and unnecessary work: If you examine your processes, you may be surprised to find people putting the same information into different systems. Not only is this a potential source of data errors, but also you have people doing the same work twice. Can this data be transferred electronically? Do you have “checkers-checking-checkers” in your process? Are people doing things that are no longer needed because “that’s the way we always have done it?”
4. Reducing pipeline and backshop turntime: How fast can you get loans to market? For some lenders, this will be super critical as the availability of warehouse financing gets squeezed, so that keeping borrowings down becomes a must for survival. For everyone, being able to have loans “ready to go” in a minimal amount of time allows Secondary to take advantage of available opportunities that may be short-lived. Can your battleship turn on a dime? How fast and flexible are you, really?
5.Optimize the use of document imaging: When you walk through your backshop, do you see piles of files everywhere? If you do, your backshop process is probably sequential…files pass from Mary’s desk to Tom’s desk to Sue’s desk, etc. And a lot of time is spent looking for files. Document imaging allows the file to be handled once, when it hits the back door…and then Mary and Tom and Sue can do their jobs simultaneously. If a problem is suspected in a file, managers don’t have to go searching for it…it’s right there in the computer, and employees all over the country can pull the file up simultaneously to review it together. This provides tremendous benefits for efficiency and reduction of pipeline turntime. As an added bonus, some major investors are now accepting delivery of imaged documents, further reducing cost and time in warehouse.
6. Use EDI. The largest Agency buyers will all allow you to deliver files electronically and fund loans using only data and a collateral package. The result is dramatically improved warehouse turn times, lower costs, fewer suspenses, and in many cases, better pricing! The catch? You need clean data - very clean data. They will test you on this before you are allowed to play.
Typically you will follow up with a full file. However, some investors will allow you to follow up with a full file in imaged form.
Key Secondary Marketing Survival Strategies
1. Be prepared to sell your servicing rights on new production: Even if you think you would like to retain them. Retaining servicing should not be an all-or-nothing, forever decision. Have you done a granular analysis of all the types of servicing you are originating, to determine at what price it no longer makes sense to hold each? Are you so committed to the strategy that you’d be willing to pass up a price 50-75 basis points higher than your internal value? Are you willing to book current period losses attempting to compete on servicing value with the aggregators? If not, have you determined the maximum value at which you will retain servicing? Do you compare the execution opportunities on individual loans with a variety of investors against your internal levels on at least a WEEKLY basis?
If you don’t have relationships established on the Correspondent side of the major lenders, now is the time to get them in place, even if you are currently retaining servicing. The competitive landscape may force you to change your strategy quickly, and you will want to be ready.
2. Be certain you are hedging the right risk: Are you incorporating the value of your servicing rights in the value of the pipeline you are hedging, and shocking them? Does your system recognize that FNMA and FHLMC will move their BuyUp and BuyDown multiples if the market moves?
Even more critical is this: most lenders are selling all or part of their Agency production as whole loans or in AOT agreements. If you are, think carefully about whether you are even hedging the right risk! Traditionally, risk management systems bucket agency loans into the MBS coupon they are expected to go into, you sell forward that coupon and Voila! Perfect hedge! Unfortunately, that won’t work these days. Your delivery takeout is NOT a MBS, it is a whole loan or AOT investor! And all of their pricing grids contain adjustments, excess servicing assumptions, price caps, etc. that cause the change in the value of your pipeline (especially in a rally) to be substantially different than a MBS. Does your risk system handle this well? The losses in a rally related to hedging your Agency pipeline “the old fashioned way” can quickly exceed your entire profit margin.
3. Utilize a flexible and robust best-execution system daily: Can you find the best execution for every loan, on a loan-level basis, every day with your risk management system? Do you do it? Can you recognize short-lived opportunities and act on them quickly? If you get a new agreement or rate sheet, can you have every aspect of it in your system the same day? Does your best execution capture every basis point or nickel of cost associated with each loan, with each investor outlet? Do you have the ability to factor in differences in delivery costs for easy versus difficult investors? Do you even have an estimate of what your delivery cost by investor is? Do you know their suspense ratios and are you tracking their funding times?
4. Have multiple investors for every major product: Unfortunately, thinking you can get the best price by promising all your business to one investor almost never works. It is best to keep them competing against one another in order to get the best price, and you won’t be able to afford to leave basis points on the table in the coming environment. Yes, relationships matter. But you do need to have multiple relationships.
Perhaps more importantly, I have found after very extensive analysis of Agency pricing over the last 15 years that there are persistent differences in how different investors structure their pricing that allow you, if you are doing a loan-level best execution, to pick up significantly better overall results. Historically, this pickup has been in the 20-25 basis point range.
5. Get ready to gear up your fallout analysis: As the Fed begins to lower rates, we can expect to see rallies in mortgages, which typically results in higher fallout. This is especially true for Agency product in an excess-capacity environment. Be sure to have a fallout measurement system that observes the fallout behavior of borrowers and brokers in different market environments, and that measures the market opportunity of every lock individually, not just by looking at macro-time periods. We expect higher fallout volatility in the next 12 months, and that can cause significant underperformance of hedges if not managed properly.
What Gets Measured Gets Managed
As you look at the above strategies and think about others, how are you doing? Does your company provide reports and trend analysis to measure most of the above items? The simple act of monitoring performance in operations and secondary, on very specific activities, can improve performance, simply by getting managers focused on key drivers of productivity.
At MIAC, We are Experts in Agency Execution
The MIAC team includes leading experts in Agency mortgages and servicing rights, to help you make the most of the challenging times ahead, as well as software systems designed to make decision making easier and more effective for you. Give us a call, we can help.