Secondary Market Policy – Part One

By: Paul Pouliot

Introduction

Today there are many financial institutions that, in order to provide the opportunity for borrowers to seek fixed rate mortgages, have ventured into participating in the Secondary Market. I acknowledge that there are many ways for a financial institution to participate in this industry and I will address it in later parts.

The focus of this article is to understand what risks are involved in participating in the Secondary Market and how a financial institution can identify those risks and address them.

Secondary Market Policy

In todays’ environment, meeting the needs of the borrower while earning a respectable rate of return usually falls under the domain of the Asset/Liability Committee of the Board of Directors with input and direction from the Senior Management of the institution.

When participating in the Secondary Market there are several items which need to be fluid and readily adjusted. The first item is the expected reasonable rate of return for the sale of loans. Understand that this amount cannot be cast in stone but, rather, management should be provided with the flexibility to adjust within a range.

Once the financial institution has established this benchmark then the daily rate can be issued to all employees of the financial institution.

The policy should identify who is responsible to ALCO to provide reports reflecting the mortgage activity for the secondary market. The policy should also address what type of investors the institution should consider and the requirements necessary to seek approval.

The selection of investors should be able to provide the products your institution wants to be able to offer to prospective borrowers. Some institutions will look to the GSEs to satisfy their conforming fixed rate mortgage products. Other investors may be selected for “Jumbo loan requests”, while other investors may be selected for a variety of adjustable-rate mortgages.

The reason behind requiring management to seek approval for each investor is the risk of default on commitments. You want to review the financial strength of each investor, the products they will purchase and the type of commitments they will issue to you.

The policy should identify who will be responsible for the daily commitments from the approved investors. The policy should specify what type of commitments would be used such as mandatory or best effort transactions.

All activity should be reported to the Board monthly, especially if each loan application is not being covered with a commitment from the investor. Understand that if your institution is not matching off each loan application you are assuming risk. Some institutions have told me over the years that if the loans were not able to be sold then it would become a portfolio. This is a reason why you need to identify those loans and the possible impact it might have on your portfolio and yield within a report to ALCO.

For each rate lock loan, a policy should be created that indicates when it is committed to an investor. Any period of time between the rate lock and the delivery commitment is an exposure to changing rates and therefore a risk that needs to be addressed.

Therefore, you should identify your institution’s level of risk and then write your policy to tie all the elements together.

Once a secondary market policy is created and approved by the Board it should be viewed as a living document. As the institution changes over time or seeks new direction, the policy should be revisited for updates. An annual review should be mandatory.

At SCA we can help with the drafting of this policy to fit the desires of your institution based upon the level of risk aversion your institution wishes to accept.