Understanding Builder Forward Commitments in Today's Market | Feb. 18, 2025

Jim Glennon: 00:00:02

Welcome to Optimal Insights, your weekly source for real time rate data and expert capital markets commentary brought to you by Optimal Blue. Let's dive in and help you maximize your profitability this week.

Welcome to Optimal Insights, your weekly source for timely market analysis and expert commentary from Optimal Blue. I'm your host, Jim Glennon, Vice president of hedging and Trading client services at Optimal Blue.

Our clients and industry partners have long relied on Optimal Blue for trusted insights and commentary. And these podcasts are an evolution of our commitment to keeping the industry informed. Let's dive into today's episode. Hello. Welcome everybody.

Today's Friday. We're going to be recording this on a Friday due to the President's Day holiday next week, but you'll be hopefully seeing this Tuesday.

A lot going on. We've got a great show today. We will of course talk to Ben about some econ and some current event stuff.

And then right after that, Ben and I will talk with Jeff Casella, one of the team managers on our desk, who you may know. We're going to talk a bit about builder forward commitments. So we'll get into exactly what that means.

But a lot of you probably are aware that, that a lot of new homes or a lot of homes that are being sold in this current crazy market tend to be new homes sold directly by builders to, to borrowers.

And in order to keep those homes, you know, very affordable in this higher interest rate market, you're seeing builders spend a lot of money buying down rates significantly for borrowers. So we'll, we'll talk about what that means and how that's done and what we're seeing on the, on the trade desk.

And then in terms of data and volume and rates, just some high level numbers. Even though we've had, you know, we had some pretty gnarly inflation numbers this week, which we'll talk to Ben about.

But as people have dug deeper into those numbers, actually seeing rates rally again, having a rally again today. On Friday. We had a rally yesterday. So rates are dipping back down to some of the lowest levels we've seen this year. So that's good news.

And then volume is still really steady in January.

levels near where we were in: 2019

Welcome back to the podcast, Ben. How's everything going?

Ben Larcombe: 00:02:36

Good, good. Yeah.

It's been an exciting week in markets and we've kind of gotten back to the same place we started, which honestly we'll take after some not so great inflation news.

Jim Glennon: 00:02:49

Yeah, the inflation saga continues or even kind of retraces or backtracks a little bit. What's the latest? What happened this week?

Ben Larcombe: 00:02:57

Yeah, so we had the big CPI release on Wednesday. That headline number came out quite hot. 0.5% month over month.

I don't even want to calculate what that number looks like if you were to annualize it out, but you know, 6%, right? Yeah. If not more if you compound that. So, yeah, that's kind of a scary number.

Digging a little deeper, the core component was up 0.4%, so a little bit better. And 3.3% on the year over year. Core component. So still quite hot. Market did not like it, understandably. Solidly above expectations.

Higher than the December year over year rate, which was at 3.2%. So really nothing from that CPI report that was good or a source of optimism? Unfortunately.

Yeah, I think we're all kind of familiar with egg prices at this point. They were up 15%. Yeah, definitely some, some issues there with food and energy as evidenced by those egg prices.

But even digging down into the core component where we throw out food and energy, which tend to be more volatile, shelter just remains a problem at 0.4% month over month. It's been that same story for years now. And that should come down.

We know about the lags in CPI and their measurement techniques and that should continue to come lower. But it doesn't mean we're not going to still see some bumps in the road like. Like we saw this month.

Jim Glennon: 00:04:28

Agreed. Yeah. It just feels like that graph, you know, if you look at a inflation graph, we almost made it. You know, we got to two and a half, 2.6%.

We did not quite get to two, and we're starting to come. Starting to edge back up, which is, I think troubling. But the market seems to still be okay with it, as if some of that was already priced in.

Ben Larcombe: 00:04:45

Right. And it's just one report. And even Powell in his testimony to Congress this week, downplayed its impact a little bit.

You know, saying the Fed's not going to react to one or two bad readings or good readings. He didn't seem too concerned about it. It definitely reiterated the focus on the core PCE reading, which we'll get later this month.

But it definitely puts the next rate cut or talk of the next rate cut very much in doubt. And we're basically just fully in wait and see. And we might not even see a rate cut in the foreseeable future, which is not great.

But that's not necessarily the end of the world for the mortgage market. Right. Like we're definitely tending to look longer out on, on the yield curve.

We still could see longer term rates rally before we see another rate cut. So not the end all be all but definitely certainly some cause for concern.

Jim Glennon: 00:05:40

Yeah, I mean we're still, I feel like at this point it was priced in like one cut, maybe zero cuts. And like you said, it's short term. But longer term there's pressure pushing the other way on rates, meaning pushing them down.

The unemployment report wasn't great. The debt cycle does seem to be kicking up. Reading more articles about folks getting in over their head or going delinquent even on non housing debt.

So that's going to start pushing rates the other way as well.

So yeah, it just feels like there's a good balance there that's still at least going to keep rates in the 6 to 7 range, if not maybe a little bit lower if we get, if we see the labor market really start to tick down. Right.

Ben Larcombe: 00:06:17

And it's possible, you know, everyone I think has an opinion on some of the, the Department of Government efficiency cuts we're seeing and it remains to be seen like whether that's going to make a significant impact on the deficit for now. But it's possible the bond market likes some of those activities regardless of maybe the method it's being handled.

Less spending I think would be a great thing for the bond market.

And just getting better to a better fiscal position might give the 10 year a little bit of breathing room and some room to rally regardless of what the Fed does. So that's something to keep an eye on and there's definitely some optimism out there.

We did, we also got PPI yesterday which kind of came out seemingly bad, but if you dig down deeper, the core was as expected and there were a couple components. It was airfares and physician costs actually in those producer prices that directly feed into the Fed's preferred core PCE gauge.

They both dropped outright dropped on the month I think kind of surprising markets a little bit and we've kind of rallied off of that. So some signs that we might actually get a core PCE reading later this month that's at 0.3% or even a touch lower, which would be Good news.

Jim Glennon: 00:07:34

Yeah, that's a good point.

Some of those, those wholesale numbers are starting to drop and those are really going to feed into that that when you triangulate that PCE number that the Fed looks at so, so closely. And then something I noticed yesterday that I, we used to talk about it a lot on the desk and in certain markets it has more, it holds more weight.

I feel like it might be coming back and some, some of it's just kind of stuff I like to nerd out about and that's, that's treasury auctions. There was a 30 year auction, it was yesterday or Wednesday, I can't remember.

And the, the demand for that auction looked really strong relative to, to previous auctions into what expectations were.

So it had a pretty low yield on it to anyway, we'll do a whole podcast on, on treasury auctions at some point but that can be a good gauge of as we've always said, follow the money. Right. What are people investing in?

And to Invest in a 30 year treasury is a pretty, is a pretty big commitment to whether you think rates are going to be low or high. Right. When you make those bids.

Ben Larcombe: 00:08:33

Exactly.

Jeff Casella: 00:08:34

Yeah.

Ben Larcombe: 00:08:34

We, when you get yields kind of approaching 5%, I think that kind of becomes an enticing level. Right. Like you could lock your money in what is now still perceived to be a risk free bet, at least in terms of credit risk.

There's plenty of duration or other interest rate risk, whatever you want to call it. But if you can lock in close to a 5% gain, that's a pretty attractive bet.

And even just looking at what stocks have done, maybe some people are eager to step in and buy Treasuries. And obviously they're not the people buying at treasury auctions. Those are large institutional players, broker dealers.

But definitely at some point when yields get high enough, they become really attractive, especially when it's US Government debt, which is still the kind of the king of the castle in the debt world for now at least. So yeah, definitely some, maybe yields are somewhat capped around this 5% level.

We might not see a ton of relief in terms of yields going lower, but maybe there's not really that much more upside risk too, which would be great.

Jim Glennon: 00:09:41

Right. The week coming up, it's a short week with President's Day, but there's a few numbers coming out a little bit thin in terms of data.

But what are we, what are we going to see Tuesday through Friday?

Ben Larcombe: 00:09:53

Yeah, so we, we have January's FOMC minutes. Those come out on Wednesday at noon. Mountain 2 Eastern. So definitely keep an eye on those. I wouldn't expect anything earth shattering.

It was kind of a ho hum Fed meeting anyway I believe so look for any surprising commentary out of there. We do have a few Fed speakers next week, but mostly it's just going to be housing market data.

Kind of the typical slate we get where we get homebuilder confidence I believe on Tuesday and then housing starts and building permits following up. So we'll get kind of an idea on what, what home buildings pace is at right now.

And then we have existing home sales on Friday, another gig gauge of how the housing market is holding up and what potential future MBS supply could look like.

Jim Glennon: 00:10:41

All right, so still some good numbers coming out in the Fed minutes. Yeah, probably nothing to fret about there but something we'll keep an eye on and talk about in the next podcast.

One thing I wanted to come back to real quick because we're still watching the screens right now and we were still rallying a bit today on Friday. I think a lot of times retail sales numbers don't seem to have a big impact on the market.

But could that be part of the reason that we're seeing green on the screen today?

Ben Larcombe: 00:11:06

Yeah, yeah for sure. I think this morning a lot of the move is kind of looking at that retail sales dropping.

It dropped 0.9% on the month, so a pretty significant miss there.

Sometimes we see that with retail sales where it can beat or miss by a seemingly large amount or you know, if you, if CPI comes in a half a percent low or half a percent high that would be a major, a major shock. But that happens with retail sales. So missed this morning which I think the bond market likes.

Some of this could be weather and fires impacting things in January. So tough to say some of those impacts but it could also be a sign that the US consumer is weakening a little bit. So yeah, just kind of tough to say.

But I think the bond market likes that sign that maybe things are cooling a little bit in the economy and with the consumer which, which drives a lot of that economy.

Jim Glennon: 00:12:01

Right. We've been looking for cracks there for a while, right with the, the doom.

Spending was a thing for many years after Covid and it's been leading to a lot of this excess debt, you know, non housing debt, whether it's automobile or credit card and maybe some folks are finally feeling the pressure of that and slowing down. I don't know what they're spending money on for.

Uncertainty sometimes can just drive you to be a little Bit tighter with your wallet because you don't know what you're going to be spending money on second half of this year and what your taxes are going to look like and what hopefully not more inflation. But you could be a little bit worried about that too. All right, good. Thank you, Ben. Appreciate the color.

Ben Larcombe: 00:12:39

You bet.

Jim Glennon: 00:12:40

As promised, let's talk a little bit about builder forward commitments. Ben and Jeff.

So just in the way of background, for anyone who's not familiar, you know, whether I'm on a capital markets desk or I'm a builder or I'm an originator, I may be aware of this program or maybe not really. What we're talking about here is it's no secret that over the last couple of years a majority of homes that are sold are new homes, new builds. Right.

There's the lock in effect that is keeping existing homes supply very low because folks just aren't willing to move out of their homes that have 3% or sub 3% interest rates. So they are, builders are churning homes out, building them and selling them to two borrowers.

And a lot of those borrowers tend to be new borrowers or they tend to be borrowers.

Especially with housing prices where they are, they tend to be a little bit marginal in terms of affordability because rates are so high and prices are so high. So one of the tools that builders have employed is putting money towards buying the rate down on behalf of the borrower.

So when rates right now are 6 and a half ish percent, builders are willing to buy down that rate for you to, we've seen on the desk as, as low as four, four and a half percent, which obviously takes a ton of points to do. And it's a little bit of a risk for the lender as well.

Whether the lenders within the, the builder or the builder has a relationship with a lender, it's way below market rate. So there's a little bit of an issue with liquidity.

So typically what will happen is the builder will enter into a forward commitment with the lender to say, okay, the lender will secure $10 million worth of financing at four and a half percent and the builder will sign a, basically sign a short contract that says we will deliver that 10 million over the next whatever, 30, 60, 90 days at this given rate. And that rate will cost us X number of dollars to buy down for every single borrower that falls into that commitment.

Saw a lot of this during the run up in rates in, in 22 and then we, it really got popular in early 23 kind of waned a little bit, I would say, going into 24.

But now with rates pretty stagnant at these higher levels or even a little bit of uncertainty where rates will go from here and a little bit more worry that they could go up a bit with, with tariffs and with inflation and with some of the other policies of the new administration seeing more interest on the desk from our clients and certainly hearing more out in the industry about, about new interest in these builder Fords.

So gentlemen, what are some considerations right now about these forwards and what are you hearing or what are some things you think that lenders should be worried about? And Jeff, you're, you're, you're a manager on the desk. You talk to, you know, 50, 100 clients a week.

What's, what's the, what's the chatter right now?

Jeff Casella: 00:15:39

Yeah, it's kind of a resurgence.

So like you mentioned, we heard that last year as rates were heading higher and then as they kind of peaked, I think into the summer, early fall, I think most were thinking rates were going to start heading lower. So kind of that chatter died down.

But now all of a sudden we're in the new year and I think everybody's kind of assessing the likelihood that we're just going to trade flat. So this is certainly, you know, one of the bag of tricks that a builder has.

So traditionally I think they try to pay closing costs, something along those lines.

But given where rates are, this is a way for them to, you know, I think a little more bang for their buck in terms of that's something that's going to grab a potential buyer's attention with, you know, a little bit lower of an interest rate, especially if they're in that range where 4 and a half, 5% is just a lot more palatable than Isix, almost 7%. So that's the one thing. And in conversations with our clients, some are just kind of exploring the topic.

I think they tend to begin to say the automatic assumption is anytime you hear builder or forward commitment is that is this a long term lock? And I think there's a lot of reluctance on long term locks and a lot more risk.

Where this is a program tends to be like you mentioned, 30, 60, maybe 90 days out and it's inventory that a builder has available that now they're saying, I think it's typically like spec homes or something where they're saying how do we get these loans or these homes sold quicker and attract the buyers.

Jim Glennon: 00:17:23

So yeah, that's a good clarification. You're Right.

I think pre Covid when you would say builder, people would think about more of a, like a construction loader construction to perm, which is this could be six months out, a year out. Right. Which could be really risky lock, really expensive lock to hedge or to protect.

Whereas we're really talking about just a commitment to guarantee rates that are well below market for a relatively short period of time. Because it is, yeah, it is current inventory.

But builders want some certainty of what the rate is going to cost and how much it's going to cost to buy it down.

Jeff Casella: 00:18:00

Yeah, exactly.

I think just from a lender's perspective, if you're able to quote, let's say a four and a half or five, well below market, much easier scenario than trying to predict out, okay. Where rate's going to be in 180 or 360 days.

And especially, you know, there's, there's, I don't want to get into the whole long term lock discussion, but you just don't know where the market is going to be at that point versus this type of product, which is, you know, a short term horizon.

Jim Glennon: 00:18:29

So yeah, it's really meant to create some sort of affordability. It's really one of the only levers that's available.

I think builders would rather throw 15, 20, 30, even 40 grand at buying down a rate versus reducing the price of the home by six figures.

Jeff Casella: 00:18:46

Right, right.

Jim Glennon: 00:18:47

I think it's probably a better investment over time.

Jeff Casella: 00:18:49

And you know, as soon as you print a reduction in a loan sale like the price of the house, you're sort of locking that in. Now appraisers are going to look at that, other people that are going to look at the historical sales.

So if you can do it with a rate, it achieves the same thing but in a much better fashion for a builder.

Jim Glennon: 00:19:11

Great. But yeah, you're not bringing down the real estate market value, which is essentially what you would do if you lowered the house.

Lower the price of the home versus just the affordability of the monthly payment. You seen anything additional or different? So Ben is a team lead on our desk.

I know when on this podcast we often talk econ with Ben as our econ expert. But he's also a team lead on our desk. And what are you seeing from clients?

Ben Larcombe: 00:19:36

Yeah, yeah, I would just say important to especially if you're like an IMB or a bank could be as well working with a builder client and you're not part of the builder.

A really important piece of this is having a rock solid agreement with the builder and having, you know, you want something in writing, something if you have a legal department probably good to get them involved and not, you know, not that things are necessarily good going to get there but I think it needs to be really clear like you know, how much is the builder going to pay to buy down the rate and also are they going to be on the hook for any kind of pair off cost if they are unable to deliver that volume? Like say we get in a rallying market, all of a sudden your hedge is way underwater.

The builder says, hey, we actually don't want to fill this, we just want to go maybe do a different builder forward at a much lower cost or rate somewhere else or just the borrower, you know, somehow go more towards current market. Well, you don't want to be stuck on the hook with a, a big loss and that the builder's not willing to play ball.

So definitely a word of caution there. Make sure you have a rock solid agreement.

If you're an in house lender of a builder, that's not generally a problem like you're, it's all coming from the parent company's bottom line one way or another. So it's much less of an issue.

But we have seen that where some predicaments have arisen where maybe a written agreement wasn't even entered into upfront and it kind of becomes a difficult situation. But definitely a lot of value for the relationship too.

If you can get a solid relationship with a builder and everyone can benefit, that can be a great source of volume for time to come as well. Whether that's via builder forward or just more traditional volume as well.

Jim Glennon: 00:21:29

So right message there. Big messages are have some, the builder needs to have some skin in the game.

You don't want to have one of this because the builders will shop around for some of these arrangements.

You don't want to have one of the softer arrangements where if rates do move lower, you get left holding that commitment because you will, you will end up that's not free. That could cost a lot of money on the capital markets side of this equation.

So you want to have some teeth in it so that if the builder walks away or is unable to deliver that they're directly paying for any sort of cost that you're going to incur on the capital market.

Jeff Casella: 00:22:05

Yeah, we've, we've seen some kind of boilerplate templates and things but there isn't one size fits all with those.

And you know, I think it's a great point that you need some sort of Agreement, definitely from a legal perspective, you know, depending on the state and what you can keep and everything along those lines. And so that's one of the two main challenges when you talk to a lender for the first time.

Like how do I structure this is one piece and then the other piece is how do I hedge it? Am I looking at let's say a best efforts?

You know, there are certain investors out there, correspondent investors that have programs available so you can go through that, that channel or I think ultimately probably the best way to handle it though is with either a forward commitment, whether it's a cash commitment or a mbs. But in those you typically have something in place with the builder that says there's a mandatory commitment.

So if you don't fill it here is what the pair off costs would be and you can even kind of lay out the, the calculation to say I'm going to put on this Ford TBA or you know, cash commitment. And you know, this is how we will calculate the pair off cost. So it's, it's pretty transparent.

Jim Glennon: 00:23:17

It's in stone. Yeah, yeah, it needs to be. You need to have some solid math behind it. So there's no.

Because it could be a big number and you don't want to have that discussion after the fact.

Ben Larcombe: 00:23:26

Yeah.

So along those lines, you kind of have a set like you should pull these through at a hundred percent so you don't have to worry about pull through calculations. So that's kind of one. That's actually a simpler part of the, the game there.

If they have to, if it's mandatory, they're going to deliver those and pay a pair off if not. And the other thing too is you're kind of.

These are usually well below par rates and you are likely to have a higher servicing value depending on what you're doing on that side and also probably a more stable servicing value. You're kind of so far in the money there that you're not kind of in right around par where servicing values can fluctuate.

So some of that can be kind of a positive of builder forwards. So it's not all difficult parts.

There are some kind of some interesting things and that's definitely more on the, the hedging valuation side of things.

Jim Glennon: 00:24:19

ime machine and going back to: 2021

That's never going to pay off. If I'm a borrower and I get a 4%, 4 1/2% rate. Right now, nobody's projections have rates going lower than that in the next decade.

So that becomes super valuable to whoever buys that loan or whoever owns the servicing of it or both.

Jeff Casella: 00:24:43

Yeah, and I think, you know, one of the other things from a legal perspective, it's, you know, compliance, you know, make sure these loans are not, you know, breaking any rules in terms of amount you can buy down. So it's typically a structured program for the builder pays the fee to buy down a group of loans. It's not on a specific loan fashion.

So that's just one of the things you definitely want to make sure you're working with your legal team and compliance. Just make sure it's structured correctly and you're not going to find yourself in hot water.

Jim Glennon: 00:25:16

Yeah. Good disclaimer. We are not lawyers. We're not giving advice here. We're just telling you what we see.

But we do know that our clients work very closely with their compliance and legal folks to design these documents and design these programs because there's definitely some compliance considerations that you can certainly work through it. Just you need to be aware of them.

Jeff Casella: 00:25:35

Yeah, but, you know, we. We have clients that really have significant volume flowing through these products.

So, I mean, you know, right now, everybody's looking at the next year and saying, how do we increase market share? You know, make sure where volumes are either maintaining or going up. So this could be a potential.

Jim Glennon: 00:25:54

Absolutely. Yeah. Certainly, if it's likely, many of you out there are already involved in these programs, if you're able to be.

If not, it's something to look into or something to talk to us about.

Ben Larcombe: 00:26:03

It kind of seems like we're like, new home sales are probably going to be kind of the hotter thing here for a while. I mean, we'll see what. How existing home sales play out.

But this is likely to be a conversation that's going to continue for the foreseeable future, it seems like.

Jim Glennon: 00:26:20

So.

Jeff Casella: 00:26:22

Yeah, the only way to get more supply is to build more homes is to create it.

Jim Glennon: 00:26:26

Yeah. Good discussion. I guess.

Last thing I would say we talked a little bit about the super bowl last week, but if you know Jeff, you know, Jeff's a Philly guy. South Jersey. Go Birds.

Jeff Casella: 00:26:37

Yeah, that was. That was quite a thrashing.

Jim Glennon: 00:26:41

So it was.

Jeff Casella: 00:26:42

Sorry. All those. Sorry. All you Casey fans. But.

Jim Glennon: 00:26:47

But also not. Sorry. It's been a good few years for Casey.

Jeff Casella: 00:26:50

Exactly. And. And anybody that's a Penn State fan. So Saquon Barkley, easy guy to root for like, just awesome guy.

And so it's nice to see him get that super bowl, too.

Jim Glennon: 00:27:03

Definitely. All right, thanks again, gentlemen.

Jeff Casella: 00:27:06

All right.

Jim Glennon: 00:27:07

Thank you.

Jeff Casella: 00:27:07

Appreciate it.

Jim Glennon: 00:27:08

All right, let's wrap this thing up. Big thanks to Jeff and Ben for the conversation today. Everybody have a good long weekend. That's it for today.

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