Generation Of Mortgage Lending Rates

The determination of mortgage lending rates is a complex interplay between levels in the secondary market for MBS, the value of servicing, the pricing of credit enhancement, and the costs associated with generating the loan. In this process, the pricing of different MBS (quoted directly and through the mechanism of intercoupon spreads) is very important in determining the eventual disposition of loans because the MBS market allows providers of funds (investors) and users of funds (lenders) to interact at the national level. Using the MBS market, lenders make loans, package them into securities, sell them into the capital markets, and use the proceeds to make new loans. While certain lenders may hold some loans and products in portfolio, the bulk of production (especially in fixed-rate products) is securitized and sold into the capital markets.

While a complete discussion of the MBS market is beyond the scope of this chapter, it is instructive to review the process involved in securitizing loans because of the importance of this process in the determination of lending rates. For the sake of simplicity, the following discussion focuses on fixed-rate conforming loans securitized under the aegis of the GSE programs. The coupons on such pools (or pass-throughs, since they pass principal and interest through to the investor) generally are created in V2 percentage point increments, e.g., 5.5%, 6.0%, etc. Loans, by contrast, generally are issued in V8 percentage point increments. The creation of pools to be traded as MBS involves the aggregation of loans with similar characteristics, including note rates (which are a proscribed minimum and maximum amount over the coupon rate, depending on the agency and program) and remaining term. Pooling nomenclature includes weighted-average coupon (WAC), which refers to the pool's weighted-average rate paid at the borrower level,9 and the weighted-average maturity (WAM), which measures the remaining term of the loans in the pool.

At the loan level, the spread between the loan's note rate and the coupon rate (or pass-through rate) of the associated pool is allocated to three sources:

  • Required or base servicing, which refers to a portion of the loan's note rate that is required to be held by the servicer of the loan. As noted previously, the servicer collects payments from mortgagors, makes tax and insurance payments for the borrowers, and remits payments to investors. The amount of base servicing required differs depending on the agency and program.
  • Guaranty fees (or g-fees) are fees paid to the agencies to insure the loan. Since these fees essentially represent the price of credit risk insurance, fees vary across loan programs. Generally, loans that are perceived to be riskier typically require a higher g-fee for securitization; at the same time, g-fees are negotiated between the GSEs and lenders, and those lenders with higher volumes may be able to negotiate lower g-fees. For GNMA pools, the g-fee is almost always 6 basis points. Note that for FNMA and FHLMC securities, g-fees can be capitalized and paid as an upfront fee in order to facilitate certain execution options.
  • Excess servicing is the remaining amount of the note rate that would reduce the interest rate of the loan to the desired coupon. This asset generally is capitalized and held by the servicer. Nonetheless, secondary markets exist for trading servicing either in the form of raw mortgage servicing rights or securities created from excess servicing.

Note that the distribution of cash flows within the pool is done at the loan level, subject to the GSEs' guidelines. A simplified schematic illustrating how two loans might be securitized into a hypothetical GSE pool is shown in Exhibit 1-5.

The actual process of determining lending rates involves the calculation of discount points necessary for a range of rate levels and for rate levels associated with both positive and negative points. Points are fees paid at loan closing; negative points can be thought of as a rebate to the borrower in exchange for paying a higher rate. In this discussion, it is assumed that the loans in question will be

9. The term is technically a misnomer; coupon generally describes the interest rate paid to holders of a security, whereas the rate of interest paid on a loan by an obligor is referenced by lenders as the note rate.

EXHIBIT 1-5

Cash-Flow Allocation for a 5.5% GSE Pass-Through Pool for Multiple Loans

Loans (Note Rate)

Base (Required) Servicing

Guaranty Fee (Assume 20 Basis Points)

Passthrough Pool (Investor receives 5.50% on unpaid principal balance)

Excess Servicing (Remaining Interest)

5.5% Passthrough

Excess Servicing

Excess Servicing

securitized in fixed-rate pools issued by one of the GSEs. The process for other products is similar in concept, if not identical in process. Exhibit 1-6 shows a sample matrix of rates and points for 30-year conforming fixed-rate loans.

Given existing market conditions, the process of generating points involves two steps:

  • Determination of the optimal execution for each note rate
  • Calculation of the appropriate amount of points for each note rate

Loans can be securitized in pools with a wide range of coupons. The maximum spread between a loan's note rate and the coupon of the pool into which it is securitized is 250 basis points (e.g., a conventional loan with a 6.5% note rate can be securitized in Fannie Mae or Freddie Mac pools that have coupons as low as 4.0%). To maximize securitization proceeds, optimal execution for a range of note rates is calculated regularly by originators. For each note rate strata, optimal execution is a function of the levels of pass-through prices, servicing valuations, and guaranty fee buydown proceeds.10 Exhibit 1-7 shows two possible execution scenarios for a loan with a 6.25% note rate. Note that execution economics generally

10. G-fee buydowns are the monetized value of the g-fee and are paid by the originator as a fee at the time of funding. As noted, they are used to facilitate execution options.

EXHIBIT 1-6

Hypothetical Rate/Point Matrix for 30-Year Conforming Fixed-Rate Loans

EXHIBIT 1-6

Hypothetical Rate/Point Matrix for 30-Year Conforming Fixed-Rate Loans

Rate

Points

Rate

Points

4.750%

6.625

6.000%

0.125

4.875%

5.750

6.125%

-0.250

5.000%

5.125

6.250%

-0.625

5.125%

4.625

6.375%

-1.000

5.250%

3.500

6.500%

-1.500

5.375%

2.750

6.625%

-1.625

5.500%

2.250

6.750%

-1.875

5.625%

1.750

6.875%

-2.250

5.750%

1.250

7.000%

-2.250

5.875%

0.500

7.125%

-2.250

7.250%

-2.625

7.375%

-2.875

7.500%

-3.000

dictate that loans are pooled with coupons between 25 and 75 basis points lower than the note rates because creating a larger spread between note rate and coupon normally is not economical. In the example, securitizing the loan in the 6.0% pool is the best execution option because it provides the greatest proceeds to the lender.

Once the optimal execution is determined for each note-rate strata, the associated points then are calculated. As with the execution optimization, the calculation of points is based on market prices for pass-throughs and prevailing valuations for servicing and g-fee buydowns. Exhibit 1-8 shows a hypothetical calculation of points for loans with 6.25% and 6.625% note rates, assuming that the best execution for both rate levels would be within pools with a 6.0% coupon rate. The calculated points are shown at the bottom as the difference between the net value of the loan after pricing all components and its par value. While the example does not show it, points generally are rounded to the nearest one-eighth. In practice, points would be calculated simultaneously for many rate levels and subsequently would be posted in a rates/point matrix used by direct lenders and loan brokers to quote rates.

There are a few additional noteworthy points with respect to Exhibit 1-8:

• As mentioned previously, the examples show the calculation for a loan that is eligible to be securitized in a pool issued by one of the GSEs. If a loan is ineligible for such securitization (or other options offer better execution), the cost of the g-fee is replaced in the calculation by the cost of alternative credit enhancement needed to securitize the loan.

EXHIBIT 1-7

Pooling Options for a 6.25% Note Rate Loan Using Hypothetical Prices and Levels

6.0% MBS

TBA Prices for Forward Settlement

MBS Passthrough Price

101

Excess Servicing: Amount in basis points

0

30

25 bps in both cases— assumes 4x multiple*

Excess Servicing Value

0

1.2

4x multiple for 30 bps for 5.5s*

Guarantee Fee Buyup/ Buydown: G-fee Buyup/(down) in basis points1" G-Fee Buydown Value

(20) (0.60)

0 0.00

Assumes 3x multiple for Buydown

Proceeds

101.4

101.2

Total Origination Costs (includes allocation of G&A, hedging, and origination costs)

Net Proceeds

-1.65 99.8

-1.65 99.6

Assumed same in both cases

*For simplicity's sake, the multiples for Base and Excess Servicing are assumed to be the same in this example. In addition, the value placed on servicing is a function of the different remittance styles utilized by Freddie Mac and Fannie Mae. As a result, the choice of remittance method may also affect the optimal pooling decision.

tThe example assumes a 20 bp. g-fee. Note that the g-fee buydown is paid to the GSE, and is therefore treated as a negative value.

*For simplicity's sake, the multiples for Base and Excess Servicing are assumed to be the same in this example. In addition, the value placed on servicing is a function of the different remittance styles utilized by Freddie Mac and Fannie Mae. As a result, the choice of remittance method may also affect the optimal pooling decision.

tThe example assumes a 20 bp. g-fee. Note that the g-fee buydown is paid to the GSE, and is therefore treated as a negative value.

• The targeted profit margin of the lender is included in the cost of the loan. Margins vary by product and change in line with market conditions, specifically levels of lending volumes and the price competitiveness of the industry at that time.

Risk-Based Pricing

The term risk-based pricing describes a paradigm where loans' rates are generated by the valuation of the incremental riskiness of specific obligor attributes.

EXHIBIT 1-8

Sample Calculation of Points Given a Lending Rate (All Levels Hypothetical)

Note Rate

6.25

6.625

Comments

Optimal Passthrough Coupon*

6.0

6.0

MBS Passthrough Price

101

101

Servicing Values:

Base Servicing1"

1.0

1.0

25 basis points, assuming a 4x multiple

Excess Servicing

0.0

0.7

Assuming 20 basis points of guaranty fee, there is no excess servicing

(net of Guaranty Fee)1"

for the 6.25% note rate, and 17.5 basis points for the 6.625% note

rate—example assumes 4x multiple

Guaranty Fee Buydown

-0.6

0

For 6.25% note rate, 20 basis points of g-fee must be bought down.

No buydown is required for 6.625% note rate, since 20 basis

point g-fee can be paid out of the note rate after base servicing

Total Value of

Servicing and Buydowns

0.4

1.7

Gross Value

101.4000

102.7000

MBS Price plus Servicing Value plus Origination Income

Total Costs (Including Origination,

2.0

2.0

Administrative, and Hedging Costs,

as well as an allocation for a targeted

profit margin)

Net Value

99.4000

100.7000

Gross Value less Costs

Gross Points

0.6000

-0.7000

100.00 less Net Value

^Determined by the methodology described in Exhibit 1-7.

tFor this example, the assumed multiples are the same for both note rates. In practice, the multiples might be different, due to different valuations placed on the servicing of the two note rates.

^Determined by the methodology described in Exhibit 1-7.

tFor this example, the assumed multiples are the same for both note rates. In practice, the multiples might be different, due to different valuations placed on the servicing of the two note rates.

Additionally, the lending schematic also serves to trade off higher values of desirable loan parameters with lower levels of less desirable attributes in assessing the aggregate riskiness of the loan. Such attributes include credit score, documentation style, loan size, LTV ratio, and various combinations of these different characteristics. The paradigm suggests, for example, that a loan with reduced documentation is riskier than one with full documentation. This loan becomes significantly riskier when the borrower also has a low credit score. Another example uses the metric of LTV ratio. As noted, high-LTV-ratio loans have elevated riskiness because the delinquency and default rates are higher and postdefault recoveries generally are lower. However, the incremental risk of a high-LTV-ratio loan increases for very large loans owing to limited liquidity in some higher-priced real estate markets.

Pricing the risk of individual attributes is accomplished through two primary methods. One methodology is based on creating multiple loan programs that reflect a variety of different attributes and pricing the loans based on different g-fees or credit enhancement costs. This is reflected by the proliferation of lending programs that take into account credit histories, documentation, loan size, and LTV ratio. Each program has an associated g-fee or (in the case of loans ineligible for agency securitization) credit enhancement cost.

There are many cases, however, where it is not efficient to create separate loan programs. In this case, attributes are priced using add-ons, or points added to the discount points calculated in the manner previously described. Add-ons are fees calculated to account for the incremental cost of credit enhancement for a loan. Such fees are quoted as percentage points of the loan's face value in the same manner as discount points. As an example, consider a 30-year fixed-rate conforming-bal-ance loan with a 6.0% note rate that is associated with lh point. However, a borrower seeks a NINA loan with an LTV ratio that is higher than that specified by the program's guidelines. If the add-on in this case is IV2 points, the loan then becomes a 6.0% loan with 2 points.

However, the disinclination of many borrowers to pay higher closing costs necessitates a recalculation of the rate, given some targeted amount of points and the rate/point structure prevailing at that time. In the preceding example, assume that the borrower prefers to pay only V2 point after the effect of the add-ons. Referring to Exhibit 1-6, note that a loan with V2 point is associated with a 5.875% note rate, whereas a loan with negative 1 point has a note rate of 6.375%. Therefore, the borrower in the example could obtain a loan with 1/2 point at a rate of 6.375%.

This methodology accounts for the higher rates observed for loans with "alternative" characteristics in comparison with generic loans. Note that add-ons differ across loan programs and types, as does the relationship between rates and points. The execution and pricing calculations described in Exhibits 1-7 and 1-8 are strongly affected by the pricing of securities. Moreover, servicing and (where appropriate) g-fee buydowns affect the pricing of points. Therefore, the relationship of rates and points illustrated in Exhibit 1-6 is highly product-specific.

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Responses

  • dora
    How are mortgage excess servicing fees calculated?
    6 years ago
  • yerusalem
    How do higher g fees affect mbs?
    5 years ago
  • ursula
    How the g fee affects mortgage rates?
    5 years ago
  • jana theissen
    Why is there a different between the gfee and the rate priced by originators?
    5 years ago
  • Ilario
    What g fees are associated with ginnie bonds?
    5 years ago

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