MCM Rate Protection Plan Reduces Fallout and Provides Long-Term Market Assurance

The Rate Protection Plan 

(RPP) from Mortgage Capital Management is a lock structure designed for longer-term rate locks for borrowers buying homes under construction. Qualifying homes can be part of a larger development being sold by a developer or as a stand-alone owner/contractor-built home. The program offers potential borrowers peace of mind when experiencing long processing times. It provides the worst case pricing in rate and discount points. If the borrower waits until the home is completed to lock, rates may move up, which may cause the borrower to not qualify for the loan. The RPP eliminates that possibility because borrowers know the worst case scenario and can lock at lower market pricing, even if the market declines before they are ready to close.

Let’s assume that the 60-day price for today’s market is 3.75% at -1 point on a mortgage company’s rate sheet and the home will be available to close 180 days.  If the mortgage company doesn’t offer an RPP, then borrowers only have two options: float or lock if available.

Float

If borrowers float until they are ready to close, they risk rising rates, potentially not qualifying for the loan or accepting a much higher rate and payment.

Lock

By locking in at a much higher rate for the extended lock period to cover the 180 days (if even allowed by the lender), borrowers are usually offered a guaranteed but, at a significantly increased price.

The price would reflect the actual roll cost in the market – currently around .375 basis points per month, plus a hedge cost. Thus, for 180 days, the roll cost might be: 6 months x .375 points + .25 points for hedge costs = 2.5 points.

A lender might offer financing at 4.25% and -1 point cost, but the lender would be risking the loan not closing. If rates decline, the borrower has no option with the current lender to obtain a lower rate unless both parties are willing to renegotiate, which is a form of fallout.

Fallout risk

Many borrowers would seek a loan with another lender to obtain a lower rate, leaving the lender with a significant pair-off loss. For example, if the market remained the same under the period, the lender’s rate sheet would show 3.75% at -1 points, while the borrower is locked in at 4.25% and -1 points. This difference in pricing would give the borrower plenty of incentive to shop around before closing.

Some mortgage bankers use an upfront fee to keep borrowers from falling out under such circumstances. A lender may collect a 1-point fee that is credited toward closing costs and retained by the lender in the event the borrower cancels the transaction. The borrower receives the higher rate and is protected from rising rates under a worst case scenario, but has to pay the high forward-market pricing locked in under the normal locks structure. In the event the market improves significantly, the borrower may still decide to go elsewhere when the incentive to do so is greater than the 1 point they paid upfront.

The better tool for both the borrower and the mortgage company in this situation is a float down lock structure wherein the borrower pays an upfront fee for protection against rising rates, but can benefit from rates not moving much or decreasing during the construction period. For example, if the 180-day float down pricing is struck at 4.25% and -1 points as a worst case scenario and the market does not move during the period, they would be able to lock the loan at 3.75% and -1 points on day 150.

If the market improved significantly during the period on day 150, the borrower would lock in the lower rate and points. If rates increased during the period, the lock pricing would be protected at 4.25% and -1 points.

Another way to pay for the upfront fee (or at least reduce upfront cost) is to add an extra .125% to the cap and rate sheet price when the loan is ready to draw docs.  To the lender, the extra .125% may be worth at least .5 points and would reduce the borrower’s perception that the lock structure is not affordable. While the mortgage company would spend more on option costs to hedge the loan during the period, the extra .125% would provide a reasonable compensation for taking the extra risk.

Margin protection

A mortgage banker offering a float down program needs to protect its margin on the loan by purchasing option coverage to hedge the potential change in value of the loan in a rising rate environment or a falling rate scenario. Hedge coverage in the form of option contracts can mitigate potentially costly pair-off costs in a decreasing rate environment.

A mortgage banker needs to measure the correct amount of option costs needed in order to price the float down in the market on day one, and manage the hedge so that the margin originally priced on day one is achieved on day 180+ when the loan is closed and sold to an investor. The cost of an RPP option is not as simple as just calling a dealer to get a put option quote. Many other factors come into play because the value of the loan is not fully reflected in the mortgage-backed security price or potential price changes. Other factors affecting the pricing of float down locks, but not limited to the following are: servicing value, interest income, and the profit margin on loan.

Customized programs

MCM has many years of experience pricing float down risk and can customize a program that minimizes costs and maintains margins so mortgage bankers can provide the best service to their borrowers.

The following table indicates example pricing for a float down lock program designed to use the rate sheet as a basis to price:

In this table, the 180-day rate protection plan base cap pricing is set according to the rate sheet plus rate and discount adjustments.  

Other requirements to successfully manage the RPP include, but are not limited to: the ability to purchase option contracts from dealers, issue mortgage backed securities and track float down locks as a separate exposure in the pipeline.

For more information about the Rate Protection Program from MCM, contact info@mortcap.com

© MCM 2013