Handbook of Secondary Marketing

Question 1

What does locking an applicant’s rate do?

Answer 1

Locking establishes a firm rate and discount at which the applicant will close if the application is approved. 1

Question 2

What is a discount?

Answer 2

The discount is a charge the lender collects from the borrower (or a third party such as a home seller) in exchange for offering a lower interest rate.

Question 3

What is a negative discount?

Answer 3

A negative discount is where the lender absorbs certain closing costs on behalf of the borrower in exchange for the borrower accepting a higher interest rate. 1

Question 4

What else is a negative discount called?

Answer 4

Premium pricing is another name for a negative discount. 1

Question 5

What are the two kinds of risk a lender exposes itself to by locking in the application?

Answer 5

By locking an application, the lender exposes itself to interest rate risk and fallout risk. 1

Question 6

What is the interest rate risk in a rising rate situation?

Answer 6

If the loan is unhedged in a rising rate situation, the lender will incur a loss on the sale of the loan. 1

Question 7

What is fallout risk?

Answer 7

Fallout occurs when a locked application fails to close. 1

Question 8

What happens when selling forward on a mandatory basis and there is fallout?

Answer 8

If a lender hedges a locked application by selling forward on a mandatory basis and the application fails to close in a falling interest rate environment, the lender incurs a loss. 2

Question 9

What is the purpose of pipeline hedging?

Answer 9

The purpose of pipeline hedging is to mitigate the interest rate risk and fallout risk during the period of time between when a loan locks in and the time that it either falls out or is finally sold. 2

Question 10

Draw graph of fully hedged

Answer 10

x 3

Question 11

When is a long position profitable?

Answer 11

Given an initial purchase price of 100, a long-asset position is profitable when the market price increases above 100. At market prices below 100 the long position is unprofitable. This would mean that market rates are falling. 2

Question 12

When is a short position profitable?

Answer 12

Given a short-sale position with an initial sales price of 100, the short position is unprofitable if the market price increases above 100. At market prices below 100, the short position is profitable. This would mean rates are rising. 2

Question 13

What is the difference between a speculative position and a fully hedged position?

Answer 13

A speculative position can be profitable or unprofitable depending upon post-transaction market price movements. A fully hedged position is protected from adverse price changes, but it also gives up the benefit from positive market price movements. 3

Question 14

What is an ideal pipeline hedge?

Answer 14

An ideal pipeline hedge preserves asset value over a wide range of market fluctuations. 4

Question 15

Why would a lender engage in disguised speculation?

Answer 15

Intentionally disguised speculation usually results from a lender’s desire to follow a speculative strategy while placating bank or investor requirements to be fully hedged. 4

Question 16

Why are mortgage backed securities so complex from a fixed income perspective?

Answer 16

While mortgages are “callable” by a prepaying borrower, the exercise of this embedded option is sometimes based on unpredictable and seemingly irrational factors. Whereas market interest rates dictate other security prepayments, mortgages are subject to the whims of homeowners. 5

Question 17

What single characteristic makes a mortgage backed security less attractive than a T-note?

Answer 17

The mortgage’s call feature makes its price-rate relationship less attractive than that of the T-note. 5