Mortgage banking can be a great business for a community bank. The transactional nature of the revenues can lead to a high return on assets, and the customer-retention aspects are invaluable.
The business involves high levels of financial leverage. When rates are dropping, this leverage can generate outsize gains - and the past several years were like the proverbial 100-year storm, with purchase activity strong and refinancing even stronger.
But when rates rise - as they are likely to do sometime in the next several quarters - mortgage banking can generate monstrous losses.
That makes hedging controls and pipeline management crucial.
The right hedge ratio - the percentage of the pipeline that is hedged - is crucial to preventing secondary marketing blowups. No matter how small the operation, directors must set policy on that ratio and monitor compliance with that policy.
The board might simply set a maximum and a minimum - for example, directing senior management to target 70% of the pipeline but never to hedge less than 50% or more than 90%. (If rates appear to be dropping, a ratio as low as 50% might be appropriate. If rates are rising, senior management should accept the pipeline's being 80% hedged.)
This approach is probably too simple, but it has one special strength: Management can get reports every day showing what the percentage is. That is the ultimate early warning system.
Many, many subtleties go into this ratio, but it is not my intent to go into these here. Let's just say that at a minimum, banks must set and enforce these ratios.
And because the directors are ultimately responsible, it is not enough that they learn what the ratio was on the last day of the month, or what it averaged during the month. They should demand to see what it was on each day of the month, or at least what its high and low points were.
Of equal importance is management oversight of the rate-lock desk.
Not centralizing this function is a recipe for disaster. How can the secondary department follow hedging policies if it does not know what's in the pipeline?
I have seen lenders that allow localized rate-lock extensions. But though loan officers insist that this is necessary to provide superior service, it can lead to catastrophe.
Policies must dictate who can extend rate locks and when. Extending a 30-day rate lock for 10 days when rates are stable or falling can actually increase margins. But what about when rates are rising? Such extensions can lead to losses.
In my 25 years in and around mortgage banking, virtually every blowup has to do with inadequate hedge ratios, lousy data about the pipeline, or both. And that data must include rate-lock extensions, rolldowns, and borrowers who are declined or withdraw their loans.
Mr. Garrett is a partner in Garrett, Watts & Co., a Berkeley, Calif., firm offering advisory services to banks and other lenders involved in mortgage banking.
