When treasury rates were falling was we didn't really have a drop in mortgage rates at the same time, just because treasury yields drops from 1.5% or 1% down all the way to 50 basis points. And now we're, it's a, roughly around 70 basis points. It doesn't necessarily mean that mortgage rates were falling at the same rate or the same pace. And in fact, they were not. And, and so that's really what led to the widening of the primary secondary spread.
Mike Ensweiler:Welcome everyone to the eighth episode of In Your Best Interest: An ALM First podcast, a show that will explore common depository challenges, give you an insider's view of the latest market trends and share stories and insights from industry leaders. I'm your host, Mike Ensweiler. Many expect the extremely low mortgage rate environment to contribute to historically high levels of refinancing activity as household balance sheets and incomes improve. According to Fannie Mae, the low rates probably will boost refi volume close to$1.8 trillion a year, which would be the highest level since 2003, when it was two and a half trillion. According to Fannie Mae, the average annual rate for 2020 will be 3.2% down from 2019 3.9%. This would beat the record of 3.65 set in 2016. According to Freddie Mac data, Fannie Mae expects rates to drop to 2.9% in 2021. While it's a great time to be a borrower, this week's episode will focus on maximizing mortgage profitability for originators in this current environment. Today, we are joined by Alec Hollis. Who's a managing director of ALM strategy group at Alun first. One of the areas Alec manages is our mortgage pipeline and mortgage servicing rights hedging areas, and he works a lot with secondary mortgage marketers. Thank you so much Alec for joining us today.
Alec Hollis:Absolutely. Mike, it's my pleasure to be here. And this is a fantastic opportunity for us to have some great discussion.
Mike Ensweiler:You know, before we get into the theme of the day, which is enhancing or better said, maybe maximizing mortgage profitability in this environment. Tell us a little bit about yourself.
Alec Hollis:So generally, um, I am a Dallas native, so I was born here, raised here and basically been living here my whole life. I went off to college at the university of Notre Dame and I made my way back to Dallas. In general, I enjoy playing sports. Some of the other things I like are kind of creative aspect of music. So I enjoy playing guitar. I play guitar a lot and I can guarantee you probably won't hear any of my recorded sound from a guitar perspective on this. So, uh, no worries from that.
Mike Ensweiler:I have heard your recording.
Alec Hollis:Oh have you? Wow. Well, that's, I'm not sure whether it'd be a scared or excited about that, but that's great.
Mike Ensweiler:You know, one of the interesting observations I have is that, you know, we're on podcast episode number eight, um, and uh, in three of those, and it's the people who seem to take a really deep dive into, to math and analytics and are super intelligent you, Robert Perry, David Ritter, you guys are all rocker roller, guitar type people.
Alec Hollis:Yeah. And I imagine there's a bit of a correlation there. I think it's been, it's interesting to see others as well, that are musically inclined. And it's interesting. Yeah. So definitely Robert and David Ritter, we have a lot of guitar conversations. Robert is, as you might expect, maybe the most well versed in the theory of music.
Mike Ensweiler:I would definitely expect followed closely by David and you.
Alec Hollis:Exactly.
Mike Ensweiler:You know, you've been very engaged in the residential mortgage industry for the better part of your career at ALM First and really been instrumental in working with our clients, whether they be credit unions, banks, non-depository mortgage originators in the areas of mortgage analytics, modeling, pipeline management, secondary marketing, servicing asset valuation, and hedging, and I'm sure a whole lot more. Um, so, you know, in the midst of this current refi boom and low rate environment, let's, let's start off by just walking us through the mortgage market in 2020, it's been a very volatile year. It's been a very interesting year. And so for the uninitiated what's happened, you know, from January until today. And how did we get here?
Alec Hollis:Yeah, 2020 has definitely been by one way to put it at least an interesting year. Um, you could call it a virtual year almost. Um, we, at this point had more time in a virtual fashion than we have actually spent together in many respects, especially here in the office and from an interest rate perspective, it's really no different it's, it's pretty wildly different than what it was at the beginning of the year. And it was really hard to predict that this sort of thing could have happened. But ultimately what we did see is rates were on a downward decline over a multiyear period. So probably beginning around 2018, late 2018, we saw the 10 year treasury rate, max hit a near term high of around 2% or 3%. Um, and then ever since then, it's been a steady decline downwards. And so there's been pressure, uh, relatively, um, it's been a little bit back and forth of course, a little range bound over time period, but it really accelerated at the beginning of this year after the COVID-19 was announced as a pandemic and ultimately as the economic consequences of it and it came more known. And so that's really when everything unfolded in terms of the mortgage market today and where we are now with the mortgage market in terms of TBA pricing, loan pricing from Fannie and Freddie, all of the other activity that's going on right now. So it all began with the COVID environment, of course, with the backdrop of the fact that we have seen rates steadily decline even a year or two prior to that event. And what we saw with that is we saw a very volatile time period in the month of March. We saw spreads widen extensively for and rapidly, in a short period of time. And then of course the Fed announces its intentions to support the market and reallywhat that entailed as well was support of the TBA market and agency mortgage backed securities. So after the initial shock of that economic consequences of COVID led to some really large steep loss in value in terms of MBS prices for a very short period of time, perhaps a couple of days, it subsequently rebounded and actually increased quite significantly to the environment that we are today. And at the end of March, beginning of April, that is kind of where we are now. Um, so things adjusted pretty rapidly. And now where we are is, is the, you know, FNCL 2 the 2% UMBS coupon is a 1.03-1.04 price right now. And what it also means for lenders is their loans that they're producing primary rates on mortgages are about 3%. A 3% loan is about 1.03-1.04 price. So loan prices are significantly higher than what they were beginning the year at the beginning of the year, a reasonable expectation for a gain on sale was around 1.5%, maybe 2% net gain on sale. Now it's almost double that profits are actually soaring right now for a lot of mortgage lenders when it comes to their gain on sales, they're two or three and a half, 4% at this point in time. And, and we've seen it kind of shrink perhaps a little bit from that initial onset, but that is ultimately the environment we're in right now is a very high premium mortgage market with very low yield on TBA MBS and primary rates around 3%, which means that primary, secondary spreads are very wide in the primary, secondary spread is the difference between rate to the borrower. So that would be 3%, for example, less the yield on MBS, assuming a par price. So that's a decent proxy for profitability to lenders overall, and that's the environment we're in right now is a wide primary, secondary spreads, very high premium MBS.
Mike Ensweiler:Yep. And that makes perfect sense. You know, I was just reading a Fannie Mae forecast, and this is something you touched on, but I want to see if we can just take a little bit deeper dive and, and their Senior Vice President and Chief Economist, Doug Duncan stated that the economy's climb back from the sudden and severe setback of the second quarter is fully underway, but we believe the future pace will be driven largely by the path of the novel coronavirus and how the public responds to coronavirus related information. So I guess, you know, from your seat in the stadium, how has the pandemic impacted the mortgage industry or at the very least our client base?
Alec Hollis:So one of the, one of the impacts or actually, I mean, it's multifaceted, of course and one of the most notable impacts is just the decline in treasury rates that we saw as a result of the additional federal reserve programs that are intended to help, uh, prop the market through this economic uncertainty and the, through the economic impact of the COVID crisis. So that's one of the biggest impacts is just the steep fall in rates and the increase in yields as a result of the federal reserve buying activity and, uh, additional market participants that have resulted from that boost in confidence as well. So, uh, we do see a good amount of but what we also did not see when treasury rates were falling was we didn't really have a drop in mortgage rates at the same time, just because treasury yields dropped from one and a half or 1% down all the way to 50 basis points. And now we're, it's a, roughly around 70 basis points. It doesn't necessarily mean that mortgage rates were falling at the same rate or the same pace and in fact they were not. So that's really what led to the widening of the primary secondary spread. So from a financial impact, um, that's one of the biggest impacts of the, of the pandemic was the widening of those primary secondary spreads because, um, mortgages, there's just a supply, uh, operational issue. So of course that's the other area that's very much connected. And part of the whole multifaceted dynamic of what's going on in the mortgage market is the operational side. So there's been a deluge of mortgage applications. Of course, um, some of the highest levels we've seen in in fact this year is already, I believe surpassed last year's in terms of a mortgage application refis. And we see right now a lot of clients just struggling with the ability to keep up with that, um, in terms of loan processing and in terms of keeping up and managing with the locks. And we see it across the board as well. Um, there was issues with, um, custodians actually funding some of the loan sales from Fannie and Freddie. So sometimes there were delays and enforced, uh, extension fees. Uh, some of our clients saw that that hasn't been as notable recently, but that was one of the big, um, client issues that we heard about back in the March or April timeframe was, you know, we're taking out five, 10 day locks and then the loans don't get funded and we have to have extensions fees. We have extension fees, uh, for the commitments. So, um, part of that is operational it's it's across the board. And so keeping up with that volume really is been the name of the game. But, um, ultimately that was one of the big impacts as well as on the operational side. And in part that might explain why a mortgage rates didn't drop as fast as treasury rates as simply because, um, participants or lenders were saying, we'll let other people chase that business. We can't because we simply don't have the operational capacity. So in order to even stave off some additional loans that are coming in, we'll make it worth our time and maybe even increase rates. And so that's some of the unexpected consequences actually, but we saw in the short run is actually rates, mortgage rates actually were increasing at some points, even when treasury rates were falling. It's an interesting time period, but I think it's stabilized now, but there still is a lot of mortgage activity going on, um, in terms of applications and loan processing and volume, um, that's being pushed through for our clients and keeping up with that. So trying to keep their head above water, I think is really the name of the game right now. And from our perspective, especially from the financial markets, um, rates of more or less been stable ever since the beginning slash middle of April rates are more or less been at Bay. We haven't seen any massive moves, um, nor have we seen any really big market events that have kind of jittered or cause any fear. Um, since that mid April time period, of course the risk is always there.
Mike Ensweiler:Yep. And that makes perfect sense to me, Alec, you know, in the institutions I'm talking to, you know, I'm hearing a number of them say that they're struggling with, like you said, ramping up the production due to technology, staffing, operational issues, you know, all of those things they need, you know, on the origination side, but what are clients telling you their biggest challenges are today from a secondary marketing standpoint?
Alec Hollis:So beyond kind of the operational side that we were talking about, I think one interesting part of the discussion are for clients that aren't used to the secondary process. So I think some of the most successful clients right now are actually the ones with operations that are well established and can handle the volume. Of course it's been challenging across the board, even for the most established, but the, that are in the best position already have operations already have secondary options to sell for liquidity and procedures in place for managing risk. Of course, um, the harder part becomes, you know, the hypothetical institution where they portfolio 99% of all production and sold maybe a couple of loans and then all of a sudden they have this increase in demand And they are forced to kind of decide, okay, we need to figure out either how to handle this demand and how we can help the customer or the client or the member, um, versus, um, weighing that option versus selling loans and deciding whether or not they can portfolio it. So I think some of the more challenging, uh, elements from a secondary perspective are for the ones that actually just don't have as much experience around it. That's one side of it. Um, of course the other is the financial side of it as well, which, you know, during market turbulence, it always makes it challenging to manage your margining and manage collateral and manage and keep, keep, uh, everything, you know, at bay in terms of a market volatility, just making sure to handle the volatility. That's, that's also been one of the other elements that we've discussed quite a bit, but again, the market's been relatively stable the last two to three months. So that hasn't been a big topic of discussion. I'd say the most recent one right now has been we're... we haven't been selling loans. Um, how do we decide which ones are worth selling? Which ones should we portfolio? Now we're committing for it at 90 days and we know that at this time in this market, you have a great premium for a one day price or a 10 day price, but at a 90 day price, you're taking a pretty big price hit, ultimately. So, you know, 60 day 90 day commitments, um, could be anywhere from 60, 70 bps on price down to even a point down in terms of relative to the one day or 10 day in terms of delivery window. So, um, right now forward commitments are actually quite, uh, the forward curve, so to speak, uh, if you go out from one day further out in the future and Fannie pricing, it's pretty steep right now.
Mike Ensweiler:You know, there's in that I, I like where you're going with this. So, you know, there's a saying that you, you want to make hay while the sun shines. So here's the hot topic and I'm sure what everyone wants to know as a mortgage originator in this environment right now, how do I maximize my profitability?
Alec Hollis:Right. Everyone who's in the sun wants to make some hay. Absolutely. And we got to give credit to Robert making hay Perry for that one as well. Um, that Bloomberg article was, uh, perhaps priceless. Um, but yeah, so the, the Bloomberg article actually was focusing on that idea of a wider, uh, primary secondary spread, even for independent mortgage banks and other institutions that are more used to, um, taking forward commitments. Um, but overall gain on sale are, across the board, so are so much higher. So, um, right now that's where a lot of profitability is stemming from those as well. The additional volume helps to kind of distribute costs, um, on a per unit basis. So that, that helps as well from an efficiency standpoint, uh, we can distribute, uh, fixed costs, uh, more efficiently across more volumes. So more of a mortgage, the mortgage business is a volume game. I'm sure colloquially, we've heard that said multiple times, it's, you know, the more you can do the more you can distribute your costs and the more revenue you generate from your gain on sale. So that coupled along with very wide primary, secondary spreads has been the name of the game. And I think for institutions that are really looking to maximize profitability, I think it's not just about profits. I think it's a win, win across the board. If operations can be set up to where they can really serve the member and the customer as best as possible and help them through this process, um, because you know, getting a mortgage loan right now can be very beneficial, especially for bars that can get a lower rate. And so, um, it's about expanding the business, I think. So, um, ultimately when you, when you're able to increase your ability to manage risk and to have different liquidity outlets when they're needed as well, and to be able to handle the volume through kind of an investment in the operation, then that enables an institution to be able to scale. And so the scaling aspect is helpful, um, because when you can do more volume, even if you can't balance sheet, uh, or portfolio the loan, um, the gain on sale right now is really contributing across the board. So a lot of the profitability of the lenders. So the more you do the, you know, the more benefit so to speak, um, from a profitability standpoint, but also just tying it back to, uh, beneficial, like excellent customer service as well. It's, you know, you're providing a service in being able to do that. Um, so, um, from that perspective, I think having an efficient secondary perspective along with operation is really the one, two punch.
Mike Ensweiler:So, yeah, I'd like to expand on that a little bit. And on the profitability side, you know, you talked a minute ago about the Fannie Mae kind of forward curve and what pricing looks like. And there's a huge disparity between, you know, the one day and the ten day. So thinking about that and the commitments I'm making to the agencies, if that's my outlet to sell, when does it make sense to hedge that pipeline versus forward commit it?
Alec Hollis:So of course, um, you know, forward committing is always an option and it's basically, um, an implicit hedge as well because you're locking in a price. And when it comes to hedging with TBA or basically MBS securities, which many of these loans end up becoming. So any loan that's by Fannie or Freddie ultimately be, become securitized in one form or another. Um, and the, the, the hedging program that we typically look at, we typically run for clients involves using those mortgage backed securities or TBA MBS, which is a forward settling transaction. So it's actually a derivative. Um, but, um, not necessarily requiring the same derivative approval process for credit unions because it's tied to the mortgage business. And by the way, technically any commitment to the agency is considered a derivative and any lock to the borrower is also considered derivative according to GAP. So, um, ultimately the TBA MBS is a very acceptable hedge, um, uh, for using to hedge the interest rate risk of interest rate locks with borrowers. And ultimately though from a size perspective, as, as the question was asked, um, let's say maybe the rough number that's typically used is about$10 million in sold volume, but it really is a case by case in many cases and, and TBA MBS is of course not the only way to go. And in some cases it makes sense to use, uh, forward commitments, particularly if, if the product type is, is either doesn't have a very liquid hedge that you can actually use. So then you either cross hedge or, um, just use forward commitments to manage risk as the locks come in. And so overall, um, you know, there's really no size to begin a hedging and secondary program. In my opinion, all institutions should be considering, uh, if they don't already have the ability to sell and generate liquidity when they need it. Um, it's a very extremely useful balance sheet tool. And, um, right now I think the profitability is there as well. So, um, overall others really no minimum size and begin thinking about a secondary risk management and hedging. Um, but from a TBA perspective and using mortgage backed securities, the hedge, the kind of unspoken rule is I say unspoken rule, that's kind of internally. A lot of times what we say is, is perhaps 10 million, because anything smaller than 10 million in a sold volume kind of results in, um, results in kind of a rough way to having a small number of I'll put it this way, having a small number loan, say five loans trying to match against mortgage backed securities at that point, it's perhaps worth if you're selling only a handful of loans just to forward commit them.
Mike Ensweiler:So, you know, one of the things that you talked about is, is, um, the sales, these loan sales. And so as a result of it, a lot of our clients at least, um, retain servicing. So they're making these sales and they're ending up with a lot of servicing assets, which comes with a lot of price volatility. So as I grow these assets and they become material to my balance sheet, how do I want to manage that volatility?
Alec Hollis:Yeah, that's a fantastic point to bring up. That's one thing that we really haven't touched on actually is the servicing marketplace. So really that's the, probably the one pain point I would say across the board in terms of the mortgage industry has been the servicing side, um, institutions that have not hedged their servicing assets have, have actually been, uh, experiencing quite a bit of painful write downs. And as a result of, uh, just a really steep decline in rates and really fast prepayment speeds that we've seen, which is, you know, destroyed a lot of value from an MSR asset perspective and also eliminated a lot of, uh, income, uh, from servicing. So, um, really that's one of the, one of the components of managing mortgage risk. And most, most of the institutions we work with are retaining servicing. So they're holding onto the servicing asset and I'm servicing the pipe, hedging, the MSR asset itself is, is perhaps not as popular as it should be, um, because it entails, you know, hedging to a model. Um, because a lot of times, uh, there's not live bids coming through for a season servicing assets. Some of course you can use, there are a lot of sources you can use for, for the traded, uh, servicing assets. But, um, the way that is typically hedged though, is because it's a negative duration assets. So as you, um, experience fall and rates and an increase in prepayment speed, basically what it means is your servicing portfolio shrinking, which means you lose all future income. It looks like an IO strip or an interest only strip derivative from an MBS security is because when the asset prepays, you don't receive any principal back, you just lose out the future value of all the income that was associated with the assets. So the heads of the asset, it's a big negative duration. You hedge it with, uh, long, uh, MBS securities and perhaps treasury securities and, uh, institutions actually that were hedged, uh, going into this year. Actually, we're really happy about it. I can imagine. Um, particularly because in some ways the hedge effectiveness actually worked out in a lot of the, in the favor of a lot of institutions because when the primary secondary spread widened considerably. So those that were hedging their pipeline with TBA MBS, um, when mortgage yields fell a lot faster than a mortgage rates did, basically that what that meant was they're short positions for their pipeline, hedge, you know, experienced a kind of a sizable loss, um, relative to the pricing on loans, which really actually did not experience a gain as much as it otherwise would have had that market stress event not occurred in, in what unfolded had had that actually occurred as well. So, um, a lot of institutions were facing underwater hedges, particularly independent mortgage banks. I'd say they were the ones that were hit the hardest relative to, uh, credit unions and banks simply because they don't have the balance sheets. So any loans that, you know, we're nonconforming or non QM, so to speak, and they couldn't portfolio, a lot of those bids just dried up completely. So they're sitting on an underwater hedge without anybody to actually buy their loan servicing also kind of dried up a lot of big market participants that purchased servicing assets simply exited, um, at least in the short term. And we've seen, of course, things stabilize a lot since then and things have been, uh, really stable, but, um, overall, what that meant was that, uh, from an MSR hedging perspective, if you were hedge coming into this year, you did very well. Um, when treasury rates fell as fast as they did and mortgage rates didn't fall as much as they did, ultimately, what that means is, um, you were protected, uh, on your long positions, uh, that were kind of hedging your negative duration MSR asset. Um, what, when it's also one element that does become a bit challenging about MSR, uh, hedging as well. We particularly see this for independent mortgage banks is just the liquidity side to it. Um, because when you're hedging, when you're hedging your mortgage pipeline, you have income that comes from the loan sale. That's perhaps it's only 60 days out if you're holding onto your loan or your lock or your funded loans, but for the MSR asset, if you take a hidden value, um, or then you don't necessarily, it's marked through earnings, the change in value, but the actual cashflow you don't receive. So basically what that means is if you have a increase in value on your MSR asset, that's, that's an increase in earnings. And then if you're hedged, then you have a theoretical loss on the hedge, but that is also marked or anything. So theoretically your earnings are stable, but your actual cashflow profile is less stable. So you're trading a little bit of cashflow, you're trading earnings stability for a bit of variability in your cashflow as a result. If you just look at only that asset itself and not in combination with your whole pipeline. But the MSR asset itself, if that makes sense is, you know, gaining a value. So it's a great earnings earnings increase, but then you have to fund the hedge because it's marked to market on a daily basis. So you might have a gain, a$1 million increase in the MSR asset, but then it's offset by your million dollar loss earnings are flat or stable basically, but you have that million dollar funding that you have to put to your hedge position. So ultimately the liquidity profile also makes it a bit challenging as well.
Mike Ensweiler:I think it's just one of those things that probably A) isn't yet material for a lot of institutions and B) something I don't think, um, enough institutions are looking at. Well, you know, it seems like we're just getting started and we're already budding up against the clock. So in the final few minutes we have here, Alec, what are the top three takeaways or things that I should be thinking about as an originator as we head into Q4 and 2021?
Speaker 2:Um, so I think from a top things that we top a couple of top items that we're thinking about right now is really just, um, in response to some of the markets, just continuing to bolster the secondary program. I think taking advantage of some of the gain on sales is definitely tactical, meaning, you know, the opportunity is there and from a pricing perspective, and you can take advantage of that and increase your volume. And then that ultimately impacts profitability in a positive way. You know, we've already seen a lot of institutions that we're working with, increase the profitability of the pipeline considerably just through the increase in volume, coupled with the increase on gain on sale. So, um, one of the elements I would encourage institutions to think about is if they're not currently, you know, set up with secondary program to consider what it would take and the benefits that it could bring to them from a liquidity management perspective, as well as from a customer service perspective. From being able to offer more products and offer service and increases your servicing capabilities to the members so that when an individual that's, you know, say comfortable with a particular lender says, Hey, I want like, you know, assistance on a mortgage loan or to get a mortgage on that you don't have to turn away business that you can help, um, that you can, you can say yes, yes we can. So, um, it really, I think it's just continuing that element of, uh, being able to provide exemplary service along with managing the risks that comes with it and the institutions that can do so in a safe and sound manner, um, also are able to achieve long run profitability. Um, so again, that's perhaps not anything that's new, um, that's, you know, more or less the name of the game, but that's definitely one, uh, one piece that we're talking about a lot with clients is, is, um, just that, that part of it is how do we look at which loans we want to portfolio versus which ones we want to sell and just continue to go down that path.
Mike Ensweiler:Great info and very informative. Thank you so much, Alec, for joining us today.
Alec Hollis:Yeah, it's my pleasure, Mike, really appreciate it. And this is, uh, some really great things you're putting on with these podcasts. So it's, it's really actually my, uh, my pleasure to be here. It's fantastic.
Mike Ensweiler:I want to thank you again, Alec, for taking time to chat with us, on maximizing mortgage profitability in this environment. At the end of each episode, I would like to take a moment and let you know about some additional resources we have available. We have a webinar on mortgage assets coming up. You can visit our website for more details on this and additional educational offerings, as well as our resource center for recorded webinars, articles, and more related to mortgages, mortgage assets, and so on. As always stay safe, stay healthy, and thank you for listening to In Your Best Interest an ALM First podcast.
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