In the mortgage biz, moving from broker to banker is often considered a rite of passage. For many, it’s a strategic decision that says, “We’re ready to play with the big boys now.”

And there are significant advantages. As a banker, you can control your own underwriting and closing process. Create your own product set and guidelines, and sell directly to the Street or conduits. You can set your own rates and manage your own rate lock policies. And you can generally get better price execution by hedging your own pipeline (or using a hedge advisor) and selling into bulk, AOT, or mandatory trades instead of best-efforts.

But in recent months, smaller firms have been forced to reconsider the costs, and risks, of the decision to move from broker to banker. And because the reasons are so compelling in this market environment, even larger firms should consider borrowing from the broker’s playbook to reduce the risk in some segments of the business.

Reason #1: The Market Can, and Will, Reprice Credit Risk:
Many bankers have learned the hard way that the market can reprice credit risk very quickly…too quickly to unload product that is already in pipeline or sitting in the warehouse waiting for bulk sale. As spreads have widened substantially on Subprime, Seconds, and higher risk segments of the Alt-A market, lenders have suffered substantial losses in the last six months. As a result, many have been forced to close their doors. Others have simply abandoned Subprime and tightened credit standards on Alt-A and Alt-B.
Unfortunately, the highest origination margins are in those higher-risk products, so cutting those product lines means big revenue losses that may be impossible to make up in the A-paper business. Adding to the problem is the fact that margins are shrinking in A-paper from their already slim levels. More and more lenders are turning their focus to A-paper, at a time when the real estate market is suffering and there are fewer and fewer new A-paper lending opportunities.

One alternative to abandoning the higher-risk business is to move to a best-efforts delivery strategy for these loans. Using a best-efforts lock, even at a slightly lower price, will give protection against the possibility that credit spreads will widen further. And although many believe that spreads have already widened as far as they are going to go, the fact of the matter is that a wave of subprime defaults is very possible over the next year, which could cause credit spreads to widen even further. By going back to best-efforts, you can lock in your gross margin at origination and avoid this potential risk.

Reason #2:Bulk Bids May Not Beat Investor’s Rate Sheet Pricing
Incredibly, over the last few months, we are seeing lenders actually get LOWER bulk bids for their high-risk product than they can get for selling loan-by-loan to investor’s rate sheets. As traders have been getting pummeled by widening spreads, and investors are getting slammed with early payment defaults, skittish buyers are actually paying less in some cases for closed-loan bulk trades than they pay for loans one at a time.

The reason for this may be that the loan-by-loan process gives the investor a greater opportunity to review and approve each file before they purchase the loans, versus a bulk process that often involves only a due-diligence sampling.

Whatever the reason, rate sheet pricing (whether mandatory or best-efforts) must be taken into consideration in this market. Even if you choose to stick to a bulk sale strategy, be sure to do a loan-level best-execution analysis of your product to all of your investor rate sheets on the same day you hold your auction. This puts a “floor” price on your auction and if the auction results are poor, you can always go back to the posted rate sheets.

Reason #3: Just Because You Sold it Doesn’t Mean You’re Off the Hook
Many lenders are being reminded the hard way that buyers can, and will, exercise their right to force the repurchase of a loan. When bankers sell closed loans, there is nearly always the risk of repurchase for fraud, misrepresentation, or error.

While the good times were rolling in the real estate market, defaults often cured through sale or refinancing, as rapid property appreciation provided equity to give homeowners more options. Loan buyers were less aggressive in forcing buybacks of defaulted loans, as default losses were generally at or below expectations.

As defaults have increased over the last year, investors are getting more aggressive in pushing defaulted loans back to the originators. And even if your origination shop follows all the rules, you can still suffer. Employment fraud and income misrepresentation, the “little white lies” borrowers tell to qualify for stated-income loans, can result in permanent liability to the originating lender. Inflated appraisals are common, and even if they aren’t, “retroactive appraisals” performed months or years after a loan is originated can produce a solid argument that the property value was inflated, especially if the property value actually declined after origination. Add that possibility to the weak real estate market we are in right now, and the potential buybacks are downright frightening.

This repurchase risk is yet another reason to consider brokering high-risk product, or at least, getting prior underwriting approval from your investor for every loan. If the investor made the underwriting decision, the risk generally passes to the investor (check your contract to be sure). And if you allow the lender to close in their name, rather than in your own, you also remove the risk of being on the hook for closing errors, TIL violations and predatory lending lawsuits if a loan goes into default.

Reason #4: Warehouse Lenders Can Be Tough at Times
It’s what I call adding insult to injury. Over the last six months, lenders have often suffered severe cash flow problems as high-risk loans generated unexpected losses on sale. Then they get the phone call…their warehouse lender is exercising the right to require a bigger haircut, or worse…disqualifying certain collateral altogether. While you are trying to figure out whether there will be enough cash to make payroll, you learn you have until noon Tuesday to come up with $5 million. This is when you wish you had taken Mom’s advice and become a pharmacist.

The inability to come up with the capital needed to support warehouse lines has been the death blow for many lenders, large and small, in this credit-tightening phase of the cycle. While it is too late for them, you can protect yourself from this possibility by keeping the highest-risk product off your warehouse line…by brokering it on a table-funded basis, or by getting it off your line as soon as possible, by selling them loan-by-loan and temporarily abandoning an aggregation strategy.

Reason #5: Negative Carry Can Blow a Great Execution
Volume is down and it is taking you longer to accumulate enough loans for a respectable bulk sale. Not only is this slowing your warehouse turn time and cash flow, one look at the yield curve reveals that you aren’t generating the warehouse income you used to…or worse, some segments of your pipeline actually have negative carry. Every day you have to hold those loans you lose a little more.

It is always important to consider interest carry in your best execution decisions, but in a negative carry environment, it is even more critical to do so. In an extreme example, a teaser rate Option ARM loan may generate 6% negative carry, or 50 basis points if you only hold it for one month.

Reason #6: Overhead Costs Add Up
Let’s face it…we are in the downside of the mortgage banking cycle and it may take a year or two of consolidation before we get into a growth environment again. For smaller mortgage bankers, downsizing to a simplified, sales-focused strategy may be the answer. Brokering loans removes the need for most underwriting, closing and secondary marketing staff. For some firms, this may make the difference between surviving the remainder of this downturn or going out of business.

It Doesn’t Have to be an All-or-Nothing Decision
As you assess your strategic options for weathering this storm, remember that the decision to be a banker or broker does not have to be an all-or-nothing choice. The benefits of being a mortgage banker are significant, but the risks should be weighed independently for each product line. Brokering higher-risk loans may allow you to continue to enjoy the higher origination margins on these loans, while significantly reducing your secondary market risk.