Are Float Down Locks More Cost Effective Than Mandatory Locks?
The latest down tick in the market has generated quite a bit of discussion concerning renegotiations and the difference between float down locks and regular locks given to customers. Most mortgage bankers do not give free float down locks to customers because they don’t hedge their pipelines with option coverage and in many cases can’t get dealers to offer them options to purchase. The reason they don’t hedge with options is usually because options are deemed too expensive, too complicated and/or requiring upfront cash to be used.
question was raised recently about the cost of a 60 day float down versus a normal 60 day lock. This blog will attempt to address the issue.
If one assumes that the same profit level is desired under each type of lock after costs to hedge are calculated and that an upfront fee would be collected for a float down lock, then all one has to do to compare the two lock types would be to compare pricing under each lock scenario. If your best investor’s price 60 days out for a 3.75% note rate FNMA 30 year fixed rate loan is 104 and your targeted profit margin is 1 point and Loan Officer Compensation is 1.5 points, then a 60 day lock under normal circumstances would be at a rebate of 1.5 points. The same lock under a float down scenario with the same price and rate should reflect the at the money option cost of the lock.
If one were to call a dealer who sells option contracts over the counter on FNMA MBS 3.0, the upfront fee would be approximately 20/32 or .625 points. Hence, without taking into account differences and/or complications concerning different notice dates, excess yield, hedge costs etc… one could simply state that a float down lock would cost an additional .625 points to hedge versus a normal mandatory lock. For example, the upfront fee for a float down can be reduced by increasing the capped rate from 3.75% to 4.0%, thereby creating an out-of-the-money exposure on the float down lock. In such a case the mortgage banker would simply purchase an out of the money put option to hedge the value of the loan wherein the cost of the option would approximate the value of the increased rate. If the buy-up factor for the .25% in extra rate is worth 4 to 1 then the option purchased would be set at a strike 1 point out of the money and the fee would be approximately 10/32 upfront or .3125 basis points.
Many pricing structures are available under the float down option pricing mechanism to make the upfront fee less expensive including not allowing float down locks to occur unless the loan is ready to draw documents or setting the market for the float down rate to a 30 day rate and price when there is 15 or more days left etc.
At MCM we can customize a pricing structure for our clients and hedge float down locks effectively using many different option strategies. Please refer to a previous blog wherein we discussed the Rate Protection Plan, which was initially designed for long term float down locks. It would, however, would work equally well for shorter term float down locks.
The problem with renegotiating a mandatory lock and giving customers better pricing when the market improves is that the cost to do so comes right off the mortgage banker’s bottom line, especially if they did not use options in any proportion to hedge the pipeline. In general terms, if a company were to offer every client a better price after the market improved by 2 points and the same percentage of loans closed either way as expected, their gain on sale would be 2 points less. While this circumstance is not likely to occur, because fallout would definitely be lower if the mortgage banker offered a renegotiation when the market improved, the amount of loss would still far exceed the gain from the increased amount of business closed.
We at MCM recommend that renegotiations occur only occur when documents are ready to be drawn, the market has improved significantly and the borrower initiates and insists on the lower rate or they will cancel the transaction. We also counsel our clients to avoid allowing the full amount of market movement to be extended in the renegotiated price.
In the past on loans that received a renegotiation, the Loan Officer’s compensation would also have been reduced to share in the pain. The current comp rules do not allow for a LO comp change to occur, but that doesn’t mean the cost of doing so shouldn’t be tracked and allocated for pricing and management purposes. Loans with a renegotiation are considered fallout to the extent they move all the way to the current market. If loans can be kept to a half way market movement then only 50% of the loan balance would be considered renegotiated.
Copyright 2013 Mortgage Capital Management, Inc.
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