Margin Management Best Practices for Mortgage Lenders

In this article, we will discuss top-level margin management strategies including 6 business intelligence inputs that are helpful for making educated margin management decisions.

Table of Contents

 

When is Margin Management Important in the Mortgage Market?

There is a great history of value and theory behind margin management within the mortgage industry.

One example of the importance of margin management was what happened in the United States mortgage market from 2020 through the start of 2021.

During decreased rates during the COVID-19 pandemic, there was a combination of staggering volumes and exploding margins that made it nearly impossible for lenders not to post record profits.

At that time, most lenders were so preoccupied with how they were going to turn their inadequate warehouse lines or maximize funded loans through exhausted operations teams, that the last thing on their mind was margin management.

Soon after the economy emerged from this once in a 25-year boom, the industry witnessed a significant contraction in mortgage lenders’ pipelines.

The average MCT client as of May 2021 was down 30% from market highs and some of the larger refinance shops were faring even worse.

When each basis point makes an impact on the bottom line, a prudent, well-thought-out, and disciplined margin management strategy is an invaluable pillar of any successful lending company that wishes to stand out amongst its peers.

While margin management best practices are based on common sense, we all could use a refresher every now and again.

 

Problems with an Unmanaged Profit Margin

With the advent of the pricing engine and, along with it the functionality that allows lenders to institute a spread in between the investor’s published price and the lender’s street-facing price, it became easy to simply establish a pass-through strategy that fixed the lender’s anticipated profit margin.

The problem with this “set it and forget it” margin management approach is twofold.

 

First, the unmanaged profit margin fails to optimize that lender’s opportunities for profit gain when the market allows. By constantly testing the pricing elasticity through adjusting margins and watching the subsequent following lock volumes, a company can pick up basis points that might otherwise have been unnecessarily passed through.

 

Second, an unmanaged profit margin ignores the lender’s need to regulate volume against the company’s internal resource capacities. If, for example, resources are being stretched to the point that the service levels are compromised, an increase of the margin can actually solve the problem while making up the revenue lost on the conceded volume with the larger gains of the loans that do fund.

 

When a company holds a static margin on the pricing engine, it’s essentially tethering its pricing decisions to those of the targeted investor.

 

It is guaranteed that major investors are actively managing their own margin changes based upon their own particular circumstances and a lot of times those margin changes can be significant.

In the scenario of an unmanaged profit margin, the lender’s margin and profit are along for the ride. For example, a lender could have tied their margin to price the day before then later realized that they were “over the skis” in terms of volume. When the investor throws another 25 basis points into pricing to slow things down, the lender then inadvertently widens their price by 25 due to an unmanaged profit margin.

 

Establishing a Proactive Margin Management Strategy

In the following section, we will answer the question, “What should a lender consider in a margin management decision?”

It is important to remember that margin management doesn’t happen in a vacuum. The following recommendations and examples highlight the necessity for regular analysis of the decision-making margin management process.

 

Strategy 1: Consider How Margins are Affected by Competition

For example, if a lender’s low FICO government production is spiking (it can happen even in a scenario where that lender might not have made any changes to its margin or pricing hits), a competitor could be making an active change to margins and influence the lender’s profitability.

If the lender is not paying attention to their production mix, that lender might become victim to adverse selection in the market and have a problem – even if the lender itself did not make any active changes.

 

Strategy 2: Use Margin Management to Steer Volume & Production Mix

Reviewing a P&L to see how a company is faring against financial goals is a good exercise but it is a different exercise than a tactical analysis required to adjust pricing mid-flight toward optimal levels.

In other words, hitting targeted profitability goals does not necessarily mean you achieved maximum profitability or appropriate pricing objectives.

When we say “pricing objectives” outside the context of actual profitability we mean that lending firms should be thinking of pricing not only as a means to bottom-line growth but also as one of its most effective tools to manage other flows in the business.

An obvious example of this strategy in place is that, instead of using pricing to increase volume, you can use price to push volume away. Price and margin management can act as a throttle used to slow the machine down when volumes are compromising the service levels.

Margin management strategy is not just crucial in terms of managing total volume, it can also be used in the context of managing production mix.

For example, a lender could also use margins to steer the production of purchase versus refinance volume or to free up underwriting space for more profitable loans such as non-QM or Jumbo. There are different scenarios where pricing can be adjusted to adjust the production mix.

Another scenario might be when lenders might try to clean up their performance based on investor or Agency scrutiny. Your production of low FICO might have you on the radar with one of the entities that are buying your loans.

 

 

6 Suggested Inputs for a Robust Margin Management Analysis

In this section, we will detail various analyses that would be helpful in a robust margin management analysis to inform the two strategies listed above.

 

1. Volume vs. Capacity Analysis

A firm should have a grasp of its FDE requirements for producing a loan. Then, they should be measuring that capacity against actual production.

This is done not only to determine the appropriate headcount in the long run but also for a short-term basis.

As mentioned earlier, in the time that it would take a lender to lay off part of their workforce, they could instead use price to adjust volumes to bring the firm back to an off optimal capacity.

 

2. Competitive Rate Comparisons

There are many well-known rate comparison tools that are useful in margin management, such as the Icon Survey.

At MCT, within our suite of business intelligence offerings, we anticipate the rollout of another option. This competitive rate comparison tool will allow our users to gauge their price against the price of their peers.

A competitive rate comparison tool is important for margin management because you can compare your street price to the street prices of other lenders.

This is not necessarily a margin management tool, though it does inform margin management decisions as discussed in the strategy section above.

When you utilize a competitive rate comparison tool, we recommend that you restrict parameters in the system to give you greater insight such as filtering to your specific geographical market, channels, and products.

As your trusted capital markets partner, MCT has found that it’s much more actionable to look at price than margin because when analyzing margins, there’s too much noise when it comes down to comparing one lender’s margin against another.

Whereas margin to margin comparison becomes very challenging, looking at the street price allows each lender to “back into” their implied margin off of the comparison.

 

3. Market Share Analysis

Within the MCT Business Intelligence Platform, a lender can monitor locked volume versus peers to inform their margin decisions. Market share indicators are more telling than an actual volume analysis in a vacuum.

A market share analysis allows the lender to determine if the increases or decreases in the volume are simply market-driven or if those movements are the result of their price competitiveness or any of the changes they have made in their pricing.

 

4. Pricing Elasticity Testing

It is recommended that lenders test the elasticity of their pricing in small but regular increments. This is to ensure that margin isn’t just being given away without an appropriate pickup in volume to merit the thinner margin.

 

5. Day One vs. Final Execution Analysis

A Day One vs. Final Execution Analysis is a report that is more important for mandatory than best efforts lenders. With mandatory execution, there will be a little bit of a disparity between the day one assumption on what you’re going to exit at (which is what you use to establish your price) versus your final execution. Once you run this analysis, you can ask yourself “what action am I going to take with this potential differential or lift?”

The lift between day one and final execution can be much more significant depending on how you establish that day-one price. A lot of lenders are using the best efforts price basis to come up with the rate sheet, so this will be less important as the loan pricing is fluctuating less.

MCT’s Business Intelligence Platform contains a feature that allows lenders to compare their up-front pricing basis to their final execution when the loans are committed out of the price. The basis identified by this report is essentially the sell-side price assumption used to come up with the upfront pricing.

A lender can use this analysis to establish front-end pricing by running the upfront price basis as of the time that the loan is actually sold, then capturing the spread of that basis to the committed price. The reporting is dynamic and it can be manipulated for different views, depending on your business needs.

 

6. Best Effort Execution Max Investor View

One very helpful iteration shown in the Day One vs. Final Execution analysis is over a time series that displays that day-over-day spread. There is lots of functionality that this tool accommodates but you have to restrict the bid value filters to best effort execution max investor.

When you do that, the tool is comparing the committed price on loans to the max investor as of the day the loan was committed on a best effort basis.

For example, a lender who is using best efforts upfront pricing shows a delta over a recent prior period of time that is 78.4 basis points. This is a pretty good indication of what their lift over best efforts is (and of course you have to take into account your hedge cost).

When you have an accurate analysis of the recent context of that spread you are no longer guessing and it helps the lender become firm in their decisions of what portion of that gain passed through into their pricing.

If the lender is confident in that lift then they can choose to let it bleed back into their pricing if they deem it to be appropriate (after considering all other analyses) in order to drive additional value.

At that point, the lender will want to come back to their pricing elasticity testing and ask themselves “does it make sense to pass out extra basis points to borrowers or should we be keeping them for ourselves?”

 

 

Seeking Rate Sheet and Margin Management Expertise

After reviewing this article, you should feel confident as a lender about margin management strategy overall.

In conclusion, nothing about margin management is mind blowing. Margin management is more about oversight and provoking critical thoughts on how to refocus a margin as it passes through your pipeline.

When you roll into a market environment well-prepared with margin management strategies you will know how to manage your lending business so you can come out on top.

 

 

Manage Your Margins with MCT

It’s in the lenders’ best interest to be focused on common-sense tactics to manage their own margins.

To prepare for market scenarios that require robust margin management, contact MCT today. We would love to help in any way we can by having a one-on-one conversation about your business needs.

Interested to learn more about market volatility best practices? Explore our market volatility guidance for lenders or find related articles below.

 

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