A CRE technology primer: the commercial lending and servicing business would benefit greatly from some of the latest technology. This high-level discussion offers food for thought.

According to almost everyone you talk to, the commercial mortgage industry is in need of an overhaul--technology-wise. Technology continues to be underutilized, and too many decisions are still made through the use of glorified Excel[R] spreadsheets--the key remnant of the industry's last major "innovation." [??] Not to mention the fact that too many lenders continue to use a hodgepodge of poorly documented, home-grown and antiquated applications. In addition to problems associated with inflexibility, older technologies are costly to maintain and less efficient than the newer platforms now available. [??] According to the Mortgage Bankers Association (MBA), there was $2.845 trillion in commercial/multifamily mortgage debt outstanding at the end of the third quarter of 2006. To help manage and service those loans, the industry as a whole is spending about $3.5 billion a year on mortgage technology, according to Needham, Massachusetts-based Tower-Group, a research and consulting firm.

As for the top-100 loan servicing organizations, they spend millions, or, based on my analysis, an estimated $650 per loan, on information technology (IT)--which is also about what they generate in net profit. That is a major investment. But are companies spending it on the right things?

Unfortunately, most technology industry assessments show the average organization spends up to 80 percent of its budget on maintaining existing applications and infrastructure, and these costs show no sign of declining. It's not hard to imagine the value of a more optimized IT infrastructure.

If the top 100 servicing firms could move to an IT budget more balanced between maintenance costs and new development/software, it could free up almost $40 million, or $150 per loan, to invest in reducing operational costs and/or in new services and capabilities, by my estimates.

Over the past few years, there has been an increasing level of pressure placed on the management of all types of financial institutions to get all possible efficiencies out of their existing systems. Virtually every major commercial servicer has implemented, with varying degrees of success, initiatives to keep costs under tighter control and to reduce those costs wherever possible.

In the next one to two years, they will find that few opportunities to cut costs remain within existing technology and people infrastructures, and that further reductions in expenses are not really feasible without seriously undermining and endangering their ongoing operations--which are already showing signs of strain.

While the complex and often unique nature of individual commercial mortgage transactions limit the perceived potential for high levels of business-process automation, there are several areas in which organizations could improve communication, data integrity and overall efficiency. This article examines the trends that are driving commercial lenders and servicers to confront their historic resistance to change, as well as why the traditional software vendors have been slow to respond. It also looks at the new enabling technologies that can significantly reduce the industry's operating costs and compliance risks, and improve customer service and satisfaction levels.

Global trends in technology

Let's begin by looking at the trends that are driving the need to change.

The global financial services industry is transforming how it applies technology to support its business needs at the enterprise level. In the opening address to more than 600 financial services executives attending the 2005 TowerGroup Financial Services Business & Technology Conference in Boston, Karen Cone, TowerGroup's president and chief executive officer, mapped this transformation starting in the mid-1990s--and identified the financial services mega-trends she expects to dominate the industry through 2010.

"The initial vision behind the business/IT governance models and the customer relationship management [CRM] and data-warehousing infrastructures first built in the mid-1990s focused on technology serving financial institutions at a truly enterprise level," said Cone. "In the 10 years since, we've experienced the peaks and valleys of economic upturn, downturn and recovery, regulatory emphasis, new technologies and processes, and an increasingly global market. But in spite of shifts in-business focus and other interruptions, the transformation sparked a decade ago has continued. We believe that forces are now converging to bring long-discussed trends to fruition, where financial institutions are able to fully leverage the enterprise vision."

The following is a brief summary of those major trends.

MEGA-BRAND POWER

Consolidations will continue, with mega-brand survivors assembling, cross-selling and delivering to customers globally a value chain of products and services sourced through the most efficient internal or external channels.

Several global banking institutions have already taken important steps in this direction by consolidating technology platforms and initiating targeted entry into new markets through acquisition or branding plays. By 2010, TowerGroup expects the global banking scene to be dominated by fewer than a dozen of these mega-players that have the power to rapidly and dynamically deploy resources to shifting high-growth markets.

NICHE PLAYERS ALSO WIN

Beyond the mega-brands, a wide range of niche-focused players of varying sizes will thrive by specializing and providing superior customer value to captive or highly targeted markets. Many will be large players that select multiple specialties. This holds true for firms that have migrated to a business model that favors specialization in targeted segments, such as loan origination, servicing or securitization.

REGULATION RULES

Regulatory compliance remains mandatory, and becomes accepted as an inherent cost of doing business. It will be leveraged by successful financial institutions as an important means to gain and maintain customer trust. In addition, winning financial institutions will build more efficient enterprisewide infrastructures to address regulatory requirements, and leverage these enhanced capabilities as a competitive weapon to create differentiating offerings with improved price and performance (see my two-part article, "Making Compliance Pay for Itself" in the June/July 2006 issue of Commercial Mortgage Insight).

FROM DATA TO PREDICTIVE INFORMATION

Winners in the financial services industry will take advantage of better predictive analytics and automated decision-support tools to manage their business more effectively and deliver higher customer value. For example, initiatives such as risk-based pricing will spread in response to commercial lenders' ability to increase profitability. And industry standards initiatives such as MBA's MISMO[R] Commercial Working Group will make it easier to share and integrate data across companies and software applications.

TECHNOLOGY BECOMES AN ENTERPRISE DIFFERENTIATOR

IT spending across all financial services vertical sectors reached about US$361 billion globally in 2005, and will grow to close to US$450 billion by 2010. The context around this compound annual growth rate of more than 4.2 percent includes declining maintenance expenditures on in-house IT and, as a result, additional spending directed to new, differentiating IT platforms.

By 2010, those institutions that have created interoperable infrastructures based on service-oriented architecture (SOA), internally as well as externally with third parties, will be the clear leaders in their industry.

In the coming years, differentiation and competitive advantage from technology will be gained not from the tools themselves, but rather from how an institution leverages them on an enterprise level. The emphasis will be on spending money smarter--which means less investment in point solutions and "siloed" business processes and greater investment in building the intelligent, event-driven enterprise. Recent initiatives that I am aware of at several financial institutions integrate loan origination workflows that span lines of business, data-warehouse improvements to get more visibility across the enterprise for pricing and risk management, and the desire to consolidate the hundreds of platforms that most banks operate into fewer moving parts.

Now, let's look at what's happening on the technology front.

According to Harvard Business School professor Clayton Christensen's seminal work, The Innovator's Dilemma: When New Technologies Cause Great Firms to Fail, despite most established vendors' technological prowess in leading sustaining innovations, from the simplest to the most radical, the firms that led the industry in every instance of developing and adopting disruptive technologies were new entrants to the industry--not its incumbent leaders.

Christensen's research showed why the emphasis on creating better, more expensive products; earning higher profits and margins; and expanding market reach--the guiding principles of technology industry leadership--dictate against investing aggressively in disruptive technologies. Why? Because they are generally cheaper and simpler; are initially commercialized in emerging or insignificant markets; and are rejected by their most profitable customers, who are unable or unwilling to adopt unconventional products.

That doesn't sound too promising for many of the existing software vendors and their customers. So, how can companies win in the long run without neglecting the realities of their day-to-day operating demands and the immediate needs of their customers?

One of the toughest jobs for managers today is keeping up with the rapid changes in technology, and keeping an eye out for the firm that can help them take advantage of these changes.

The advent of Web services and straight-through-processing-based (STP-based) platforms makes this more important, because these technologies are fundamentally changing the need to build in-house systems and how we support our businesses--as well as how these internal systems interact with external systems. Unfortunately, these new technologies are also not the core competencies of most of the vendors the CRE industry deals with--however they are available.

So many new business demands and technologies have never really converged at the same time before in the software industry. We are on the cusp of having integrated, vertically focused software components that will reduce the costs of our software systems, while at the same time increasing the capabilities of the systems.

Sure, you have heard that promise in one form or another more than once before. And more than once, the delivery fell short of the promise. But, as the software industry's capabilities and tools mature, and the next generation of applications takes hold, we are closer than ever to making these promises come true.

Like the Y2K issue, there is just too much money that is going to be spent over the next few years to stay competitive, compliant and profitable not to attract better solutions. Necessity has always been the mother of invention, and in the past the need was just not as clearly defined--or, more important, felt--as it is today.

OK, then what technology should you encourage with your investments?

Whether the initiative is called or modeled after the lending value chain or life of loan, or straight-through processing, the goal is a solution that automates the end-to-end processing of transactions for all financial instruments, including CRE loans, from origination to disposition.

STP actually began as a securities industry initiative to address the manual processes, risks and time delays around stock trades and settlements more than 10 years ago. While it had a rocky start, like all major new innovations, according to the Securities Industry Association, New York, it has since reduced settlement times from seven days to three days, with the goal of reducing it to one day.

At the time, competition drove the need to streamline back-office activities while also leading to reduced trade failures, more transparency, lower risks and significantly lower costs per transaction. It encompasses a set of applications, business processes and standards that are redefining the settlement and processing paradigm within the capital markets industry. Given its success on Wall Street, the next stop for STP is banking systems in general, and in particular the outdated patchwork of siloed commercial mortgage lending and servicing applications.

Just like the similarly initialed automobile oil additive that promises to keep your engine properly lubricated to reduce friction, heat buildup and wear, the technology-based STP provides a number of benefits to keep the lifeblood of your organization--data--running smoothly through it. These benefits include the following:

* Better electronic connectivity among different entities involved in the origination, lending, servicing and disposition cycle;

* Integration of front-, middle- and back-office applications, based on standards that allow easier interoperability between organizations and applications;

* Elimination of a lot of manual activities and redundant processes in the end-to-end processing of loans;

* Higher accuracy of servicing and surveillance activities;

* Reduced operational costs; and

* More-efficient and accurate loan-boarding and servicing-transfer processes.

According to a recent book by Gunjan Samtani, divisional vice president of information technology with UBS PaineWebber Inc., New York, Web Services Architectures and Business Strategies, STP has the same significance to the financial industry as supply-chain management (SCM) has to the manufacturing industry and CRM has to the service industry.

If you can improve the efficiency of your operations, you can save on costs--which will improve both your pricing to the markets and your service to customers. That gives the companies that figure out how to effectively bring STP into their operations an advantage over their competitors.

The critical parameters of STP that determine its success or failure across the entire commercial mortgage lending and servicing industry include the following:

* High availability and scalability to be able to support increased global origination and servicing volume;

* High security as the data exchanged among multiple entities are confidential loan and collateral-related data;

* Robust business services that can be plugged into any internal or external loan processing or servicing application; and

* Guaranteed messaging to ensure that each and every message from borrower, investor or lender reaches its appropriate destination.

And despite the promise of standards, they would only address a subset of functional requirements the industry needs now. The truth is, beneath the corporate veneer, even large global participants draw on a disintegrated collection of stovepipe applications--some only as sophisticated as desktop spreadsheets--to handle various product and operational requirements. Operating cost, risk management and compliance, to name a few, ultimately have suffered.

For example, can any one of the major servicers truly claim that its existing core loan accounting and servicing application is its system of record, when in fact it spends four to five times as much money on the 10, 20, 30 or even 40 side systems it built to respond to the market and run its operations? Not to mention the data warehousing and compliance nightmare it created for itself because its vendors couldn't respond to its needs.

Some of the toughest STP challenges involve risk management, portfolio management and data integration. These are all activities that typically reside in the middle and back office. With STP, the concept of a back office goes away and is replaced by real-time support systems.

The key to financial services is exchanging transactions, which means the industry can learn from all the work that has been done on the manufacturing value chain, including how best to deal with its unique constraints and bottlenecks. The business challenge is to introduce new products and services when and where the customer wants them. The IT challenge is to achieve operational efficiency by optimizing the use of existing computing resources and delivering on internal and external service-level agreements (SLAs) with a lower cost per transaction.

There are a number of benefits of an STP-based platform that delivers the power of customizable workflows with proven core loan accounting and transaction processing capabilities. These include the following:

ADOPTION OF OPEN STANDARDS 

As the financial supply chain expands globally, a properly constructed and supported STP-based platform will allow integration of business processes across corporate boundaries. The need to exchange documents or communicate between different systems requires supporting different industry messaging standards.

Web services fully leverage open standards, including hypertext transfer protocol (HTTP) and extensible markup language (XML). Application-centric Web services enable companies to integrate business processes despite the constraints of proprietary internal infrastructures, platforms and varying operating systems.

EASIER BUSINESS PROCESS MANAGEMENT

Web services help to clearly separate business process logic and the participating business services for both internal and external STP, thereby making the development, execution and management of these services much easier. The main advantage of Web services is that companies can use Web services interfaces for process management, logic transformation and integration between core and packaged applications, instead of writing non-standards-based custom code for each application.

EASIER INTEGRATION

A typical business process related to STP may be supported by multiple diverse applications such as C++, Java-based front-end systems; Java, C, C++ based middle-office systems; and AS400 or other mainframe-based legacy systems. It is virtually impossible to cost-effectively manage a workflow and execute the different tasks associated with it, which may require using application programming interfaces (APIs) of other systems or exchanging messages with them, unless the underlying technology provides easy integration facilities.

This is made even more difficult by the general lack of data dictionaries and standards--not only for some core applications that you would expect would have them, but also for the internally developed systems. Nobody likes or seems to have the time or budget to document what they have built, making it extremely costly and risky just to upgrade to a new release, not to mention convert to a new platform.

BETTER AND CHEAPER CUSTOMER SERVICE

Both user-centric and application-centric Web services can play a major role in customizing a range of financial and non-financial product packages suited for each customer's specifications, and making it cheaper and faster to deliver. This can be achieved by assembling workflows targeted for each such product and bundling them together. Of course, the assumption here is that there will be servers and tools available that will make this orchestration of Web services possible.

For years, commercial servicing organizations have debated and gone back and forth on whether to make or buy software. For those customers that find ways to take advantage of newer, STP-based platforms, they will not only be able to more cost-effectively plug in the software they buy, but will also more efficiently deploy those solutions they need to remain competitive.

Shaun M. Brady is managing director, global real estate solutions, with Automated Financial Systems Inc. (AFS), Exton, Pennsylvania. AFS is a provider of commercial lending software, services and management information reporting to top-tier U.S. financial institutions. Brady can be reached at [e-mail].