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Myth Busters: The Capital Markets and Mandatory Execution Episode

By Scott Colclough

There are some names or phrases that when uttered strike fear into the hearts of many due to the misconceptions surrounding them. Bloody Mary. Beetlejuice. Mandatory Execution. Unlike Bloody Mary and Beetlejuice, mandatory execution isn’t an urban myth, and saying it three times in a row is not going to make an additional regulator magically appear.

For lenders not currently engaged in mandatory execution, the mechanics around making the transition can be daunting as can be making that decision in the first place. Often, that decision is clouded due to the myths surrounding mandatory execution and a hedging philosophy. However, some of the more common myths can be easily dispelled.

Myth: It’s Too Expensive

Pricing pickups achieved by using advanced executions typically dwarfs the costs of switching to such a strategy while also netting additional benefits for a lender. Additionally, it tends to be cheaper using a third-party vendor than it is to create an internal system. Even with a perfect blueprint and experienced staff, the time and costs associated with making the transition and establishing an internal operation add up to a greater cost than working with a third-party vendor. Also, with a hedge advisory firm, lenders can lean on the expertise of the entire firm rather than a handful of internal resources. 

Myth: It Will Take Too Long to Get Started

An experienced hedge advisory firm can normally have lenders up and running with a mandatory execution strategy within one month. This includes the forming of systems and hedge models, approvals to sell using mandatory commitments and having broker-dealer relationships in place. A hedge advisory firm will help lenders identify best-fit broker-dealer relationships for their balance sheet size and execution strategies. 

Myth: There’s Too Much Risk

There is not more risk than what is generally already related to mortgage lending. There is always risk that some loans will not close on time, or at all. Moving from best efforts commitments to advanced execution deliveries shift that risk from an investor to the lender. However, using proper pipeline analytics to establish an individualized hedge model allows lenders to commit/sell loans AFTER they have closed and funded. These closed loans are sold using a short delivery period and for the best pricing available at that time.

Myth: There’s No Risk Using Forward Block Mandatory Commitments For Loan Sales

Forward commitments that are taken down in lump sum dollars then later filled with loans after they close can result in tail pieces, causing either over- or under-delivery amounts that must be dealt with usually at a cost. If single-loan forward commitments are used rather than the lump sum variety, should the loan not close on time, or not at all, extension fees and pair-offs may be assessed.

Furthermore, by committing loans into forward bulks, lenders lose the ability to take advantage of pay-ups that exist. Investors are often willing to pay more for pools of loans that share similar characteristics, such as low-balance loans, because pre-payment risk is much lower for these groups, and investor pay-ups for these pools can range from 25 basis points (bps) to more than six points.

In mortgage lending, risk always exists, and a proper hedging strategy is an important part of managing those risks as a financial firm. Much like with mortgage lending, the benefits of using advanced executions far outweigh the perceived risks. Once myths surrounding mandatory execution are busted, the decision to move from best effort to mandatory becomes much easier.

This article originally appeared in MortgageOrb.

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