The following is an excerpt from Chapter 4 of Volume III of The Mortgage Professional's Handbook:
BEST EXECUTION
Philip Rasori, Chief Operating Officer
Mortgage Capital Trading
PERFORMING BEST EXECUTION ANALYSIS
Any robust best-execution analysis must incorporate all execution outlets available to the seller. While this would seem to be a self-evident realization for any seller, in practice many executions are routinely left out of the best execution analysis. Although there are some legitimate operational reasons to omit certain outlets, the majority of these issues can be quantified within the best execution analysis by adjusting the respective net execution level accordingly.
In order to arrive at an accurate cash to acquire servicing value, the best executable aggregator price is normally the first to be calculated in a best-execution analysis. Although there is some variation in formats, the general components of an aggregator price are Base Price, Loan Level Price Adjustments (LLPA) and Servicing Release Premium (SRP). Any seller-specific LOA incentive agreement will be added to these figures as well. The aggregator that has the largest sum of these values will possess the best executable aggregator price. A hard guideline eligibility analysis will be performed for all aggregators on each loan and any ineligible executions will be removed from the analysis.
The next step will be to calculate the best executable agency retained value and the best executable agency released value. For Fannie Mae and Freddie Mac there will be Base Price and LLPA components, whereas with Ginnie Mae there will only be a security price which will be the effective Base Price. From the detailed released versus retained discussion above, it’s clear that the retained value will include an MSR component and the released value will have some flow servicing execution value associated with it.
Two Oft-Neglected Variables for Accurate Best-Ex Decisions
At this point in the analysis, we have calculated the primary components that are needed for an execution comparison. With that said, there are two more factors that are invariably forgotten about in the best-execution process. One of most neglected components of a best execution analysis are aggregator file fees. There can be as much as a $400 difference per file charge between aggregators. It’s mathematically obvious that this becomes a larger factor for small loans. Using a $50,000 loan as an example, a $400 difference in a file fee would adjust the execution comparison by 80 bps. This is an important factor in ensuring an accurate retain versus released analysis, due to the fact that a robust MSR valuation model will automatically draw down its value as the loan size begins to rapidly decrease. This is due to the fact that the fixed fee associated with servicing low loan amounts will cost more to service as a percentage of the loan amount and thus eat away at a larger percentage of the revenue generated by servicing the loan. As such, the release execution will need to be reduced by its file fee basis point equivalent in order to prevent it from being unfairly advantaged.
The other often neglected factor in the best-execution analysis is warehouse carry. Each note rate must be constantly compared to the seller’s borrowing costs. Negative carry will obviously advantage the rapid purchase execution of the agencies. However, in the case of substantial positive carry, this pickup must be compared to the price deterioration of longer term locks in order to analyze whether or not some form of a “hold in funding” strategy is warranted.
Comparing Results
Once all net economic seller values have been calculated, the executions can be compared. This execution comparison will produce three essential values for each loan: Economic Best Execution, Cash Best Execution and Cash to Acquire Servicing. The Economic Best Execution will be the overall best net value inclusive of the MSR forecast. The Cash Best Execution will be the best net execution without including the MSR valuation. The Cash to Acquire Servicing value will be the difference between the highest released execution and the highest retained execution prior to adding the MSR value. This will provide information on whether or not the seller can afford to retain servicing from a cash perspective.
In general, a seller will look to the Economic Best Execution analysis for decisions on where and how to sell their loan production. When this analysis points to a servicing retained execution, the seller will then consult the Cash to Acquire Servicing analysis to decide if they can afford the cash opportunity cost that is required to acquire the servicing. In an environment where the seller has no cash constraints, the results of the economic best execution should always prevail. With that said, anyone with experience in the mortgage industry knows that this is not always the case.
COMMON MISTAKES COMMITTED IN BEST-EXECUTION ANALYSIS
In the preceding section we mentioned the necessity for including aggregator file fees in the best execution analysis. As stated above, delegated file funding or admin fees can range by as much as $400 between aggregators. While neglecting to include file fees in the analysis can distort the picture of which aggregator is truly the best execution, it can dramatically affect the retain versus release analysis. The file fee will generally have the greatest effect on loans where the MSR valuation model has substantially reduced the forecasted retained value due to a small loan size. In some cases, valuation models will actually drop the Net Present Value of the MSR below zero. A negative MSR value means that retaining the servicing asset is not only worthless to the seller, it will actually have a net cost impact to the organization over the expected life of the loan.
Negative MSR values bring us to another mistake that can be made during the servicing retain versus released decision portion of the Best-Execution Analysis. As discussed above, in a normal environment the total servicing released execution to an aggregator will generally be greater than the asset value of the retained execution with including the value of the MSR. Aggregators are generally paying a positive value for servicing and thus the Cash to Acquire Servicing analysis will generally show positive values. This means that the seller will have to give up current cash in order to get the future income stream from servicing the loan. However, in some cases the cash asset price from the agency will actually exceed the best available servicing released outlet. This would be the case in Loan B of our example grid above. In secondary marketing, this is generally referred to as an “economic no-brainer” since the servicing value is simply added to the higher cash value of the agency execution, thus making for an even a stronger economic reason to sell to the agency instead of the aggregator. With that said, a stronger cash price does not automatically mean that the best execution will be to sell to the agency and retain the servicing asset. This is due to the fact servicing value can actually be negative in certain cases and thus holding the servicing of the loan is a cost to the organization. If the negative forecasted servicing value brings the total value below that of the aggregator, the best execution will be to sell the servicing and loan asset to the aggregator. While this is in an uncommon occurrence, it is a good illustration of why it is essential that all components of loan value are closely examined during the best-execution process.
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