(Re)inventing mortgage banking.

Technology is driving changes in the marketplace that are rewriting the profit equations for the business--both in production and servicing. To survive, the business must be rebuilt on a radically different foundation.

This year technology surged forcefully to the forefront of the business world. Everywhere we turn we find evidence of the influence of technology on the minds of businessmen. It's as if we collectively just realized the pervasive impact technology will have on all businesses during the next few years.

The technology revolution is undeniably upon us. It threatens to question every aspect of how any business is run. What's even more disconcerting is how compressed the time frame is for remolding our businesses to respond to these technology-induced changes.

Historically, structural changes in industries evolved over several years. This is no longer the case. The pace and degree of change made possible by today's technology is so rapid we no longer have the luxury of time. During the next three years, the mortgage business will undergo more change as a result of technology than it has in its entire history.

Every industry is facing daunting challenges from technology-induced change. In consumer(hard goods) and industrial firms, however, there is some insulation in that the products themselves are not usually significantly affected, only the manufacturing, delivery, and/or geographical structures around these products.

In financial services, though, we are not so lucky. The product itself is information, however packaged. As one prominent consultant, Ed Furash of Furash and Associates in Washington has observed, "In financial services, the customer does not distinguish between the product and the delivery system that delivers the product; the delivery system is part of the product."

As a result, the technology revolution will dramatically affect every aspect of the mortgage banking business--how we define the product; how, where, when we deliver it; how we manage the business; the skills required to operate successfully; and, of course, the overall economics of the business.

Writers are always tempted to stretch reality to make their point passionately enough. However, the overwhelming evidence of what can be done with even today's technology--let alone what's around the corner--strongly suggests we are not overstating the circumstances facing this industry. Consider, for example:

* Completely paperless processing systems are possible and cost-effective today. Imagine how differently a servicing or production operation would look if no paper moved inside the shop.

* Real-time credit approvals are possible today--that is, with current technology we can provide credit approvals to a significant percentage of applicants at the interview table.

* Video teleconferencing has the potential to greatly change the traditional originator economics.

* Effective cross-selling of multiple products is possible with current technology and substantially changes the individual customer economics.

* Aggressive, proactive management of servicing assets greatly reduces the exposure to purchased mortgage servicing write-offs, with advanced technology and reengineered organizational structures.

The only limiting factor in realizing these improvements is management's willingness and capability to deal with technology-induced change.

Predictions

What impact will these dramatic changes have on the measures of performance in the mortgage business during the next three to five years?

* At least 50 percent of new loans will be credit-approved in less than one hour from the time the applicant sits down at the interview table.

* The gross direct cost of origination will be reduced from the current 1.5 percent to 2 percent range, to less than 100 basis points.

* Loans serviced per employee for the best firms will increase from less than 1,000 to more than 1,500.

* Unfortunately, the average life of loans will decline to two to three years because of the ease of refinancing (unless we have a prolonged run-up in rates and/or investors impose an effective prepayment penalty). This will significantly reduce the value of servicing and cause the whole economics of mortgage banking to be rethought.

Radical? Not possible? Actually, it's not only possible, but technologically very realistic.

Clean sheet of paper

The process of making change happen is usually incremental. We start with where we are, identify individual incremental changes that are needed and proceed to systematically change how we do things. This system of change management has carried American business forward for decades. It is what we're taught in business school and how our management processes are geared to operate.

It's an acceptable system in a relatively stable world where significant change is not necessary or possible. But it will fail utterly to get us from the traditional mortgage business to the operating world of the future. Only if we implement a whole new approach to change management will the needed technology-induced changes occur in a competitive time frame. We must start with a clean sheet of paper.

In a case where dramatic change is necessary, it is essential to design the solution starting without preconceived notions. Ignore the current operation, culture and policies. Instead, design the ideal solution to serve the customer relying on what is possible through available or expected technology.

This is not as esoteric as it sounds. In most situations, it's actually far easier to visualize and design the ideal solution than make incremental improvements. A small team of seasoned line managers and staff, technologists, and consultants/facilitators can actually design very elegant, viable visions of how the business needs to be run in the space of a few weeks.

Once, the design is done, the logical steps to get the firm from where it is to where it needs to be can be identified. This "clean-sheet-of-paper" approach to managing change is the primary vehicle for dealing with the magnitude and speed of change facing the mortgage banking industry.

Key results of redesigning the business

What happens to the business if we in fact redesign it starting from a blank sheet of paper? Several fundamental changes emerge:

* Death of the stand-alone branch. Local branches are a pre-technology creation. They have no economic or service rationale in today's world--let alone tomorrow's world. In fact, stand-alone branches inhibit providing consistently high-quality service at low cost across an entire retail network. With today's technology, closeness to the customer has nothing to do with physical closeness; it has to do with the proper enabling technology and customer-focused organizational structures and practices.

* Paperless processing. Paper is the enemy of any high-performance organization. Fortunately, we now have the cost-effective tools to make paper superfluous, both in origination and servicing. The best firms will drive as hard and fast as they can to eliminate the need for producing and handling paper. Paperless processing systems are actually in use today. Individual firms will not be able to position themselves as low-cost/high-quality competitors without moving to paperless processing.

* Real-time approvals. Why the focus on immediate approvals? Loan closings will surely not become real time, so why the urgency for immediate approvals? There are three basic reasons, and they work in concert to make real-time approvals the future service standard.

First, no one likes uncertainty. The faster the uncertainty of approval is removed, the better all parties to the mortgage transaction feel--Realtor/builder, borrower and lender. Second, the faster the approval, the easier the transaction is for everyone--the whole process is simplified. Third, and most important to the mortgage lender, collapsing the time in the pipeline greatly reduces loan fall-out risk, with its attendant hedging cost.

* Realtors/builders as integral players. Well over 50 percent of the larger Realtors are already participating in the mortgage business in one fashion or another. Realtors and builders have a strong economic rationale for wanting to extend their role with homebuyers. Now technology makes it much easier to do so.

Realtors and builders, as always, will control the point of sale. But increasingly they will move to initiate the mortgage transaction through in-house capabilities rather than through outside originators. By doing so they share in the revenue generated. They will initiate the origination process in one of two ways--either actually taking the application or participating through teleconferencing capabilities set up in the Realtors' offices and connected to centralized mortgage representatives. In either case, the day of the door-to-door originator appears to be numbered.

* Move from long-term asset management to dynamic asset management. Short of imposing significant prepayment penalties, the industry can do little about the loss of stability of servicing assets on the books. Technology has made it easy to refinance loans, and aggressive competition will ensure that customers take advantage of every opportunity to lower their payments, even if ever so modestly.

What this seemingly simple issue means structurally, however, is very significant. The whole business management process in mortgage banking is geared toward originating loans at a loss in order to put a long-term asset on the books. In fact, our operations also are geared toward managing this servicing asset as if it were a long-term asset. If it's no longer a long-term asset, the economics of this business must be entirely rethought.

If servicing becomes a month-to-month asset, one that has a high probability of disappearing whenever rates move downward by a half to 1 percent, then the management approach must change. It must switch from static management to dynamic--that is, the mortgage services will evaluate each of its servicing assets monthly for vulnerability to rate changes and act dynamically to manage the refinance risk. This can be done by either the servicer initiating the refinance, or selling the asset if the market's valuation of the asset is materially higher than the value assigned using internal models. Or the servicer can decide to hold the asset if the other two actions aren't justified.

The critical point is that managing the actual servicing of the loan will no longer be the focal point of servicing. The focus of servicing management will be on aggressively managing an asset with volatile value.

The implications for the overall mortgage business are fundamental. If the expected life of a servicing asset is substantially reduced, how much should a servicer be willing to pay for this asset? Some might say not much.

As uncertainty about the value of servicing increases, the whole economics of the mortgage banking business are laid open to question. Pressure on servicing values only heightens the pressure on the origination business to dramatically improve its economics.

* Move from being organized along functional lines to cross-functional teams. Both production and servicing personnel will be reorganized into cross-functional teams that serve an identified set of clients or customers. Functional organizations are an anachronism of pretechnology-dominated, hierarchically managed business. They tend to become inwardly focused, inefficient and slow to change with age. The mortgage banking organization of the very near future can't tolerate the limitations of the functionally based organization and thrive. Thus successful firms will reorganize into cross-functional teams in both servicing and production.

Fortunately, the technology available today readily facilitates this fundamental shift. However, making this transition may be the singularly most difficult change behaviorally that survivors in this business will undertake. The necessary redefinition of roles and redistribution of authority and power could meet with significant resistance by middle management, if senior management doesn't provide aggressive, consistent leadership during the transition.

* Proliferation of distribution channels. Significant expansion of the channels of production has already taken place. Clearly, as business increases its use of the Internet, this embryonic channel of communication and commerce will explode. However, few firms will thrive over the long term by putting a primary focus on the Internet. The real action will continue to be at the point of sale with the client, whether it is a Realtor, builder, banker or CPA. The redefined mortgage company must be able to provide immediate, user-friendly access to someone who can execute most, if not all, of the mortgage origination process at the first encounter.

Other industries have already mastered the organizational and technological challenges and are delivering this level of service. It is essential that mortgage bankers do so as well.

* Cross-selling and relationship-building. Nothing has received more lip service and achieved less success in mortgage banking than effective cross-selling of mortgage customers. Despite having customers' full attention during one of the most important transactions of their lives, mortgage banks, whether they are independent or owned by a financial institution, have simply not found the key to leveraging the mortgage sale into a multiple-sales relationship.

The redefined successful mortgage bank will be proficient at cross-selling. The changing economics of the business will demand it, and the available technology will enable it to happen much more easily than in the past.

Cost-effective cross-selling will change mortgage lending from a mediocre business in terms of its returns to a solid, core business because of the relatively low incremental acquisition cost of the cross-sold products and the ability to solidify customer relationships. This will be the case particularly as the largest banks truly become national in their retail operations.

Sophisticated data base management enables the mortgage company to integrate additional product sales specialists into the mortgage process at the right time and in the right way, while ensuring that all contact is effectively coordinated with the mortgage origination process.

There are, to be sure, other major characteristics of the redefined mortgage business, but these provide a good sampling of how much our business will change.

Changing economics of the business

The redefined mortgage business carries with it a greatly redefined set of economics as well. So different, potentially, will be the economics of production and servicing that it may be impossible for many current competitors to change enough to achieve the redefined economics. A traditional retail mortgage company's production economics typically might look like the numbers outlined in Figure 1 (with revenues/expenses expressed as a percent of production).

FIGURE 1
Traditional Retail Production Economics

Origination fees           1.10% (modest overages)
Processing fees             .25
Total Revenues             1.35%
Origination expenses       2.00% (including corp. O/H)
Net production loss       (0.65%)
Secondary marketing       (0.50%)
Warehouse profits          0.15
Total production profit   (1.00)%
Value of Servicing         1.25%

The production economics of various firms vary greatly, but the data in Figure 1 is fairly representative. A typical mortgage company works for maybe 25 basis points profit--including the value of the servicing. Of course, secondary marketing's impact varies dramatically, depending on the movement in interest rates and the depth of price competition. Increasingly, however, it seems that firms are prepared to price about one-half point "through the secondary market curve" to get business. Therefore, an explicit cost of 50 basis points is included in the current production economics profile.

The new economics of production

How does this profitability profile change in the future when the business has been radically redefined? Fundamentally. Basic origination fees may be retained for a while, but third-party fees, such as credit bureau, appraisal, and title insurance fees, will plummet. Moreover, firms will need to make a profit on origination itself, not depend on the servicing value to cover production losses. The reason: Servicing value will be heavily discounted as uncertainty increases about the economic life of loan assets. Therefore, fewer firms will be willing to speculate very far into the future on the probability of loans staying on their books. As a result, servicing values will become more of a earn-as-you-go proposition.

The good news is that for those firms that are able to redefine themselves, the expected profitability actually looks better than it did using the approach of a traditional mortgage company (see Figure 2).

FIGURE 2
Comparison of Traditional and Redefined Production Economics

                          Traditional     Redefined
                          Company         Business
Origination fees           1.10%          1.10
Processing fees             .25            .25
Origination revenue        1.35%          1.35
Expenses                   2.00            100
Net production profit     (0.65%)         0.35
Secondary marketing       (0.50)         (0.25)
Warehouse profits          0.15           0.05
Total production profit   (1.00)%         0.15%
Cross-selling profit       ---            0.20
                          (1.00)%         0.35%
Value of servicing        (1.25)          0.50
Net value of production    0.25%          0.85%

Employing my model for a newly designed origination firm, production expenses can be cut dramatically. To realize these reductions, branch offices will be eliminated and roving originators transformed into centralized telephone representatives at a significantly lower unit cost. (Although, total income for the good reps may actually increase.) Additionally, a substantial amount of the processing and underwriting work is eliminated, and what's left is made much more productive by using teams and technology.

Secondary marketing costs are reduced because of a faster origination process, which collapses the pipeline in the process and reduces hedging costs. Warehousing profits are reduced simply because the whole securitization/loan sale process is accelerated.

The good mortgage companies will realize at least another 20 basis points ($250) in incremental net revenue from cross-selling other products, with the real potential for significantly more revenue than this.

Finally, in my view of the future, the value of servicing declines to, say, two years' worth of servicing fees, from a typical four-times to six-times servicing fee prevalent today. For those mortgage companies that actually institute effective, dynamic, servicing asset management, the changing value of servicing will prove a real boon to them. Through their dynamic asset management, they will be able to preserve their servicing assets by aggressively refinancing their own loans. (Investors may well become unhappy, but the reality is that the mortgage asset is a one-way option for borrowers; it's not a true fixed-interest contract.)

A healthier business foreseen 

For the redefined mortgage companies, the end result is very healthy. Some of the outcomes of this redefinition build value into aspects of the business that have been chronically weak and unviable. The positive changes I envision ahead are:

* Production becomes a business that stands on its own; it does not need to depend upon an uncertain future stream of payments to justify the business. The successful firms will restructure their production channels sufficiently to make them profitable on a stand-alone basis.

* The risk in speculating on servicing values is reduced.

* The exposure in secondary marketing is reduced.

* Continuing, multiple-product relationships are established with customers.

Orchestrating the changes

The mortgage industry was built by originators--salespeople. We built processing operations because we had to. But we never did it very well. Nor did we typically hire professional, highly skilled processing environment managers. Similarly, many in the business did not invest aggressively in highly trained technologists, instead mostly relying on outside software vendors. The neglect of these two competencies has now caught up to us.

Mortgage banking is at its core a data base management business, requiring the same kind of highly skilled, technology-smart process managers one finds in the best industrial firms. Unfortunately, few mortgage companies have these skills abundantly in place. This will prove a limiting factor in how fast and how successfully mortgage bankers are able to redefine their businesses.

As a result, look for new players that have developed these skills in other businesses to perform a major role in the redefined industry. The largest firms will gradually develop the skills necessary and will be able to defend their positions as fully vertically integrated players.

However, most midsized firms increasingly will need to look to outside parties to outsource the critical technology and process management of the business, much the same way as it is done today in credit cards and mutual funds. Those outsourcing options, interestingly, are already beginning to show up on the competitive landscape. They are technology-rich companies with deep skills at processing paper or data (actually doing away with paper) and with total real-time command of the process.

My sense of the future incorporates the view that the change in roles at the point of sale will greatly diminish opportunities for mortgage brokers and small production organizations. Admittedly, it will take some time for the technology delivery systems to be wide-spread enough to obviate the need for face-to-face originators. However, the handwriting is on the wall. The redefined mortgage business simply will need fewer middlemen. In place of the highly fragmented production business we have now will be an increasing number of joint ventures. And these alliances will be between increasingly large mortgage lenders and a consolidating real estate brokerage industry, technologically "joined at the hip."

A caution

The recent implementation of the Financial Accounting Standards Board's Financial Accounting Statement (FAS) 122 provides a vehicle for mortgage companies to avoid fully facing reality for some time if they so choose. By permitting firms to capitalize internal production costs and amortize them over time, FAS 122 reduces the financial urgency to redefine and restructure the business. Yet, given the state of the business and pace of technological development, a deep sense of urgency is needed within the management of today's mortgage companies if they are to emerge as eventual survivors.

Redefining the business from scratch is relatively easy. Actually making it happen is incredibly difficult. Nothing short of a siege mentality is needed to reconstruct most current mortgage companies into effective players for the future.

Getting from here to there

If the goal is to be an effective player in the future mortgage banking business, several critical steps must be taken to put the firm in a position to succeed.

* Thoroughly prepare your management team and staff for the changes they are about to experience and why.

* Develop a clear, detailed clean-sheet-of-paper-based vision of the way the business will be run in the future. Fill in all the details down through each process step.

* Supplement your management team with a few top-quality technology and production process-managers from outside the industry. They will bring the necessary fresh perspectives and understanding of how these new organizations must work.

* Redesign the organization into cross-functional teams and roll it out slowly, giving the structure enough time to prove itself before broadly implementing the team approach.

* Seriously consider partnering with one of several imaging and workflow software firms that can provide the necessary software foundation for the newly formulated business.

* Work diligently at developing your fair share of strategic partnerships with Realtors, building critical positioning at the point of sale.

* Develop a steering committee to drive all the changes. Have it meet at least monthly to retain the intensity necessary to complete the job and complete it quickly enough to survive.

Keep up the courage of both the management and staff--don't let the organization become discouraged by the inevitable setbacks that will be encountered. At the end of this transition lies a better business with greater stability, job satisfaction and profit margins for those that can persevere.

Fred Portner is president of Portner Consulting Associates in Alexandria, Virginia.