The best efforts to mandatory spread is a measurement the industry monitors to assess the risk/reward of employing a mandatory delivery strategy and an accompanying pipeline hedging strategy. While there are many factors to consider when deciding whether selling best efforts or mandatory is right for your company, the best efforts versus mandatory spread is the baseline that allows you to determine the risk/reward associated with pipeline hedging. It is also used to determine return on investment with greater precision.
As you consider a move to mandatory delivery, it is important to understand the principles of the best efforts to mandatory spread.
- Let’s start by considering reasons why the spread exists and fluctuates over time. Lack of full details for aggregator at time of best efforts lock – Best efforts pricing is a grid-based approach, which is inherently imprecise, and much can change between initial lock and final loan closing. When aggregators bid on closed loans for mandatory delivery, they have more loan-level details, thus they are able to fine tune their pricing. Generally, this results in better pricing.
- Risk premium associated with hedging – There are risks associated with hedging a pipeline. When the seller (originator) is hedging, the buyer (aggregator) is relieved of that particular risk and therefore can improve the price they pay for those loans. At Optimal Blue, our hedging advisory and platforms are designed to manage this risk at the originator level.
- Optionality of delivery – A best efforts investor gives the seller a penalty-free option to not deliver the loan, with the cost of potential fallout built into their pricing model. A mandatory investor, on the other hand, does not provide this option (aka “free put”) and will charge the seller a pair-off fee if they fail to deliver the committed loan(s) amount. Removing this delivery uncertainty allows the mandatory investor to improve the price they will pay relative to a best efforts price.
- Offset unexpected fallout – Even loans that are expected to close at time of lock may experience unforeseen issues that can cause the loan to fallout. Predicting fallout using sophisticated modeling is a key driver of maintaining an effective hedge position, and the loan seller is closer to the pipeline and therefore in a better position to monitor and manage fallout risk than the aggregator/buyer. This also contributes to the spread the mandatory buyer is willing to pay above a best efforts price.
- Aggregator offsets hedge cost – An aggregator will pay more for a loan that has already closed or where a locked loan in the pipeline is subject to a potential pair-off fee. Under both cases, they will see this as a risk-free loan in their hedge because any fallout cost would be passed on to the seller.
Now, let’s look at what causes the index to move.
- Market volatility – This can cause many disruptions to the key components for pricing, which are your benchmarked source, and the mortgage servicing rights (MSR) that are associated with that loan. Pricing uncertainty will always cause a buyer to err on the side of caution. As a result, best efforts pricing will be priced accordingly.
- Time for aggregators to recalibrate – The MSR is a big component to pricing and is often what separates the competitive positioning of the aggregator’s price. However, the MSR strip is a moving target, especially during big market swings. As a result, aggregators often need time to recalibrate the value of the MSR, judge if the market move is in a new trading range or just a knee-jerk reaction to a news event, and price to prepare for a possible refinance event. This will cause best efforts pricing to suffer.
- Investor capacity – Investors have capacity restraints just like originators. While most can scale quickly, it still takes some time to implement and, in those cases, the best efforts price tends to be the first to feel that impact. However, the opposite happens when volume is below capacity, which will narrow the best efforts to mandatory spread.
- Price discovery – As we’ve seen over the last few years, there are times where bond prices move so much that illiquid coupons suddenly become the benchmark security. When this happens, it takes time to establish a liquid market. This will result in the best efforts to mandatory spread widening.
So, why should you trust the accuracy of the Optimal Blue best efforts to mandatory spread?
With access to the deepest data set in the industry, Optimal Blue has been providing this much-monitored spread for years, and we believe it is the most accurate measurement of the best efforts versus mandatory spread that the mortgage industry has to offer. This metric is just one of many charts published in our widely popular Daily Market Briefing, which is free to all subscribers.
We start by taking a deep look into all the loan sales by our hedging clients. As the market-leading hedge provider, Optimal Blue has access to the largest sample of active hedge clients within the industry. We then take the first-ranked best efforts price versus the first-ranked mandatory price at time of commitment.
Optimal Blue’s hedge platforms are the only ones in the mortgage business that are fully integrated with the Optimal Blue product, pricing, and eligibility (PPE) engine, which is how we know that the source for best efforts pricing is 100% reliable. This is because of the unparalleled accuracy of the Optimal Blue PPE, which not only provides our hedging platforms with the most current best efforts price of all configured PPE investors, but it also scrubs those investors for product eligibility. This eliminates any benchmark pricing from an unsalable source.
There are many factors to consider when looking to transition from best efforts to mandatory, and Optimal Blue has been successfully helping clients evaluate them for almost 20 years. If you’re ready to begin exploring how mandatory delivery could benefit your business, contact Optimal Blue today.