Read Chapter 1

CHAPTER 1 … WHY?

If you’ve picked up this book, you must be wondering about whether you should implement a mandatory execution program.  Or, you may have already decided to go down that path and have questions about how to prepare.

Of the many mortgage bankers that I’ve spoken with who use solely best efforts execution, I find most tend to want to stick to that model.  But I also sense that they know that a mandatory execution might be better for the bottom line.  I’ve heard all manner of sentiments about why bankers do not want to go to a mandatory execution.  The big one is the fear of the additional risk, and a belief that the price pickup is not worth the operational changes.

This purpose of this book is to explain the daily routine of executing a hedging program, explore the benefits and pitfalls, and outline how to get ready to implement a hedging program. Although there are numerous approaches to managing your pipeline, this book focuses strictly on what I advise as the best approach for lenders who are new to hedging.  While hedging practices can get much more sophisticated (and complicated), I don’t think it is necessary or advisable for any mortgage bank on its first venture into a hedging program.  This book offers a very conservative approach that should meet you, and your business partners’, comfort level.

Why Mandatory?

The most obvious reason to consider mandatory execution is the price pickup.  But there are other benefits including more control over lock activities, flexibility in pricing and product, and operational advantages that increase efficiency and profitability.  Most recently, regulatory changes are requiring operational changes that mesh well with the requirements for successfully executing a hedging program.  At the same time, best efforts execution presents risks and costs of its own that I believe are unnecessary for many mortgage bankers.

Is Hedging For You?

A hedging program is ideal if you fit the following profile:

  • Net worth of $1.0 – $1.5 million – in general, this is the minimum net worth to get mandatory execution approval from warehouse banks, investors, and broker/dealers.
  • Monthly production pipeline of $8 – 10 million and up of fixed rate conventional and government loans – At $10 million, you will see considerable benefits from a hedging program.  At $8 million, you will see benefits as well, but I would not necessarily advise a hedging program unless the prospects for growing production look good.
  • Multiple investor options (or at least one you sell a lot to)  of which some or all offer mandatory execution – to take full advantage of a hedging program, you must have investors that offer competitive mandatory pricing.
  • Willingness to rethink some processes and policies — Shifting from a best efforts model to a mandatory model requires a certain shift in thinking.  No longer are you approaching risk management on a loan-by-loan basis.  The hedging approach is an aggregate approach – you will not be matching each activity with a particular loan any longer.  Instead, the trading activity you engage in is a result of the overall makeup and performance of the pipeline and the condition of the markets at any given time.

About This Program

While there are various approaches and structures that may work, the approach I outline in this book is a conservative approach that is very effective for small- to mid-size lenders.  I have many years of experience executing a hedging program this way and am confident that it is easily done by competent lenders with minimal risk and considerable value.  The approach I outline in this book offers an opportunity to take advantage of improved pricing, efficient loan delivery, and more systematic and controlled operations, while balancing risk and return.

The sole objective of this approach is protecting against interest rate risk by maintaining a neutral position while getting the maximum possible revenue on the sale of loans.  While there are strategies that involve making predictions about the market, they present unnecessary risk and do not fit the goal of neutralizing basis risk and optimizing execution.  I do not advise using the hedging program as an income source, but only as a means of limiting risk.  Consequently, I am confining the discussion in this book to methods and approaches that best limit interest rate risk in the simplest, most profitable manner.

By implementing this hedging program, you are taking on new responsibility for watching the pipeline.  Just as you watched that the pipeline was carefully covered by best efforts commitments, you will watch that the pipeline is carefully covered by the hedging program. In a best efforts program, essentially, you pay the investor to perform these activities.  I think you’ll find that you will be well-rewarded by taking this task in-house

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