Pipeline Hedging:

The New Imperative for the Independent Mortgage Banker

An MCT Trading White Paper Commissioned by NYLX

April 2011

INTRODUCTION
Change is a natural part of life. While we all accept this to be true, mortgage bankers have had tremendous change thrust upon them in recent years. Whatever the new regulation may be (RESPA, HVCC, TILA, SAFE Act, etc.) these changes typically require the development and deployment of new operating processes, investments in new (or upgraded) technologies, additional headcount, and ultimately, higher costs and reduced margins for the mortgage banker. Most recently, changes to the Loan Officer Compensation Rules are (again) requiring that mortgage bankers change their ways. Specifically, LO compensation policy changes will require that mortgage bankers alter their currently flexible compensation plans with LOs, modify their up-front pricing practices, and comply with new anti-steering guidelines. While bankers search for the right tools (technology) and the right policies to achieve the most favorable balance between rate competitiveness and compliance with the new regulations, most agree that these changes will present additional challenges to their profitability. It appears, for example, that bankers will have significantly reduced pricing flexibility. Pricing mistakes that occur at the lock desk level will now be more costly to the mortgage banker than ever before. As a result of the costs to comply and the new lock desk pricing challenges facing the independent mortgage banker today, there is an urgent need among mortgage bankers to identify new ways to maintain the profitability of their organizations. For many bankers, a secondary process that fully leverages the secondary mortgage market for additional profitability is no longer a nice-to-have. To compete effectively, while maintaining true to regulatory requirements, a secondary market process that features a pipeline hedging strategy is the new imperative for mortgage bankers. This white paper will outline a readiness checklist for mortgage bankers as they consider moving from a best-efforts delivery platform to a mandatory delivery model, and will identify key characteristics of an effective pipeline hedging strategy.

PROFIT READY FOR THE TAKING!

Leveraging the secondary mortgage market by implementing a conservative pipeline hedging strategy is a proven approach to reduce costs, raise efficiency, and lift profitability for mortgage bankers. In over 10 years of historical experience with over 300+ clients, the average net gain-onsale lift that mortgage bankers (MCT clients) have achieved over their best best effort execution, is +35 to +45 bps. For a $20M/month seller, that is an additional $70,000 to $90,000 that goes right to the bottom line. The single biggest determinant of this profit lift available to mortgage bankers is the gross pricing spread between best efforts and mandatory/direct trade executions with investors. These gross pricing spreads change from day to day, but over time average approximately +50 to +75 bps. (In 2009, gross pricing spreads widened to over +150 bps, in 2007 they were as narrow as +30bps).

Investor Pricing Spreads Between Mandatory and Best Efforts Execution

In addition to the gain-on-sale achieved through the pricing spread, the efficiency of the mortgage bankers operations and the ability to actively manage pull-through can significantly add to the overall profitability. Properly employed, a sound pipeline-hedged, mandatory-execution secondary market strategy provides new levels of control, cost-savings, and flexibility to best-efforts lenders.

A READINESS CHECKLIST
Fortunately, due in part to investments and process changes that mortgage bankers have had to make to comply with new regulations in recent years, most mid-sized (and even most small mortgage bankers) have the necessary elements in place to implement an effective pipeline hedging program. The quick readiness checklist for moving beyond best efforts to a platform conducive to pipeline hedging includes the following:

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Centralize Your Lock Desk Most bankers implement a centralized lock desk when correspondent investors start to more closely track pull through performance and adjust pricing accordingly. By centralizing the lock desk, the mortgage banker has significantly more control over pull-through. (Pull through variability is the single biggest risk factor in most pipeline hedging programs) o Technology Tip: A Product and Pricing Engines (PPEs) is a recommended technology needed to support product eligibility and the lock request and confirmation process. Enable Accurate Pipeline Reporting An LOS system that can produce an accurate locked loan pipeline report and follow the loan from initial lock to funding is essential. Compliance from underwriters and loan originators is important in maintaining the accuracy of the loan data. Technology Tip: An effective integration between PPE and LOS is important to avoid any data quality issues. Evaluate Your Business Profile

Origination Volume >= $5M/month of Fixedrate Conventional and Government Loans Ideal number is $10/m month in hedge eligible product Uniform note rates not required

Adjusted Tangible Net Worth > $1M Required for Mandatory Approval by Most Tier-1 investors Required to secure credit to trade TBA MBS (the preferred bonds to hedge loan pipelines)

3rd Party Approvals With Investors - Not just individual mandatory but Flow Mandatory, Direct Trade, and AOT Delegated Underwriting Conventional and/or FHA Broker/Dealer (to trade TBAs) Warehouse Bank (to fund uncommitted loans)

NOTE: Not required: seller/servicer relationships with FNMA/FHLMC/GNMA

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KEY CHARACTERISTICS OF AN EFFECTIVE PIPELINE HEDGING STRATEGY

There are several approaches that a mortgage banker can take when choosing to implement a pipeline hedging strategy. Small to mid-size mortgage bankers should consider each of the available options. For most mortgage banking firms without a fully-staffed capital markets group, it often makes economic sense to work with a hedge advisory firm to help make the transition from best efforts to mandatory a smooth one. When evaluating these firms, and their strategies and resources, weighted preference should be afforded to a solution demonstrating these essential attributes: 1. A Proven Track Record As you consider different hedge advisory firms, it is advisable to work with a firm that has a track record of success. Given recent changes, the mortgage industry is rife with newly formed consulting firms that promote themselves as experienced hedge advisory firms. A good candidate advisory firm should have a breadth of experience supporting many clients through the process of moving from best efforts to hedged/mandatory executions. In addition, while experience is important, results are what matter. Ask for references of active and previous clients, and get input from your investors AEs and the Investor Mandatory Desks where you will be selling your hedged loans. A Conservative Hedge Strategy There are a variety of different pipeline hedging strategies that can be pursued to increase the gain-on-sale performance. Some strategies involve making assumptions about the direction and volatility of interest rate changes and can incur unnecessary risk, while other strategies are more conservative, neutralize basis risk, and are optimized to safely capture the spread between executions. While chasing profitability through assumptive trading has an exciting lure, over time, strategies that maintain an interest-rate neutral position will provide steadier and more predictable results vs. exotic timing strategies. For mortgage bankers that are new to pipeline hedging, a conservative approach is highly recommended. Doesnt Use The Take-Out Investor As Your Hedge When asked, most correspondent investors will tell their sellers that they prefer not to be used as a hedge. Why? Because invariably there are issues to explain and costs to push back to the seller associated with unfulfilled delivery commitments. Instead, investors prefer to avoid these issues by having the mortgage banker independently manage their interest rate risk and involve the investor when there is a closed loan (or group of closed loans) that are ready for sale. With this approach, investors are able to efficiently buy the closed

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loans they want and the mortgage banker is able to confidently commit closed loans to the investors, with fewer, if any, unfulfilled commitments. 4. Uses TBA Mortgage Backed Securities The To-Be-Announced (TBA) Mortgage Backed Security is the workhorse security for the mortgage banker that is hedging a pipeline of agency-eligible loans. These securities introduce no basis risk* when properly used to hedge agency-eligible loan collateral and are easier and less expensive to manage than forward commitments, options, or other types of securities. The TBA market is very large and highly liquid with the ability to make trades in increments as small as $250,000 cost-effectively. For mortgage bankers with a net worth of $1M, credit is widely available through regional broker/dealers.
* Please contact MCT Trading for a further explanation of basis risk and TBA Mortgage Backed Securities.

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Provides Loan-sale Support Besides working with you daily to manage the hedge position, insist that your hedge advisory firm provide analytical support to determine your bestexecution on all loan sales. The best execution analysis should include your entire universe of eligible investors and should include all applicable deliveries, mandatory, direct trade, AOT, and best efforts prices. Provides Effective Reporting Insist that your hedge advisor provide intuitive, easy-to-understand reports. Dont let them drown you in 100+ page reports that require hours to decipher. Your reports also need to track actual performance vs. an agreed upon metric. The most effective reports are those that track your net profit lift over what you could have earned had you sold your loans best efforts to an investor. Additionally, reports that allow you to actively manage pull-through at the loan level are important for optimizing gain-on-sale performance. Educates You On Evaluating Performance There are many moving parts to optimizing gain-on-sale performance through a pipeline hedging strategy. Lock desk policies, pricing practices, operational efficiency, and other origination processes all can impact performance. To achieve peak execution, it is important that your hedge advisor work with you hand in hand and involves you in all relevant aspects of the process. Choose a hedge advisor that will teach you all you need to know about pipeline hedging and will help you establish the know-how to evaluate your performance. Performance should be reviewed regularly with your advisory firm.

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Understands Security-based Pricing Tools and Helps You Build Relationships with Your Trading Partners When hedging your pipeline and selling mandatory, the mortgage banker stops selling to a published rate sheet. Instead, loans are committed to investor trading desks where prices are quoted by buyers who use security-based pricing tools to determine prices that they will pay for your loan collateral. Choose a hedge advisory firm that will explain to you how investors derive these prices. Additionally, ask your hedge advisory firm to help you establish professional and constructive relationships with the buyers on your investors trade desks. As is true in most aspects of business, relationships matter and establishing them with all of your trading partners will serve you well long into the future.

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Integrated with Technology In any hedge model, timely delivery of accurate pipeline data is essential for maintaining optimal coverage. As a mortgage banker, your interest rate risk begins the moment a lock request is confirmed to the LO or borrower. The ability of your hedge advisory firm to see that lock, instantaneously, through data integration with your lock confirmation system (PPE or LOS), enables a hedge to be placed at the same market levels as the lock. Ask your hedge advisor how they get visibility of new loan locks and your existing locked loan pipeline.

10. Resourced to Be Available To You When You Want Because the secondary mortgage markets are always moving, it is important to be able to make quick decisions on your lock desk. Ask your hedge advisory firm what level of support they provide. Can you speak to a trader or analyst who knows your account during business hours? Your hedge advisory firm should always be available to support your practical and timely decision making. Ask and confirm that they are resourced to do so.

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CONCLUSION
To survive and prosper during the past several years of industry undulations, todays mortgage banker has needed focus, discipline, and the flexibility to adapt and embrace change. The latest regulatory changes to loan originator compensation represent yet another wave over which some will rise, while others will be washed out. Fully leveraging the secondary market for maximum gainon-sale is the sure key to success in the current environment. Mortgage bankers who commit the mindshare and resources to incorporate a conservative hedging strategy will be gaining the experience, competence, increased efficiency, and enhanced profit required to thrive in the coming years. Engage this changing model in a focused and disciplined fashion, with the right tools, practices, and partners and you should sail smoothly on.

About MCT Trading MCT Trading, Inc. is a risk management and advisory services company providing independent analysis, training, hedging strategy and loan sale execution support to clients engaged in the secondary mortgage market. MCT was founded in San Diego, California in May 2001. The company has expanded nationally to include field offices in Philadelphia, Dallas, Charlotte and San Francisco. MCT is recognized as a leading provider of mortgage pipeline hedging service and an industry innovator. The firm currently supports more than 60 active clients on the HALO (Hedging And Loan sales Optimization) Program. For more information, please visit www.mct-trading.com or call our offices at (619) 543-5111.

This paper was commissioned by NYLX, Inc. NYLX is a market leader for automated mortgage data applications, making Investor product pricing & eligibility information actionable for Lenders. From point of sale to secondary market, NYLX applies technology & best practice to address industry need. For more information, visit www.nylx.com.

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