A battle plan for the price war.

Most lenders will tell you a price war has already begun. So here are some tips on how not to become a casualty, when the skirmishes break out into a full-fledged war.

If all the lenders today were to debrief their front-line troops, I'm sure they would find employees already battle weary from the refi wars they just fought. Now there's a possibility of an escalation in the price war. That's a message the industry's troops probably don't want to hear. They just barely survived the refi wars, and now an even more heated contest has begun. Led by a dramatic fall in rates to their lowest levels in 20 years, the industry's regulars experienced wave after wave of refi assaults, battering their front lines and taxing already beleaguered operations. Through it all, they never broke ranks and ran. Well, maybe a few went AWOL, but most held their positions and got the job done. At times, we wondered how the seemingly endless waves of refinancing borrowers were being constantly reinforced. It became clearer when we started seeing the same faces over and over again. It was then that we knew we were fighting a losing battle. Our servicing portfolios were deserting us, and it was only through constant replenishment that we were able to keep our ranks intact. But not without great cost. Some of our servicing became impaired and had to be written off. Portfolio lives were shortened by the overwhelming flood of no-cost, no-prepayment-penalty loans. And all the costs of recruiting, training, equipping and processing were lost. The servicing that remained was diminished in value and caused us to wonder when these servicing rights would desert us. Amazingly, most companies' bottom lines came through the refi campaign relatively unscathed, thanks only to great support from the secondary gain and warehouse income contingents. True, there were a few casualties, but although there were losses, most of us survived.

So now that we survived the onslaught of refi business, what can we expect should a full-scale price war actually materialize? To answer that, I'd like to take you through some of the events leading up to what might become the next big pricing war.

Here's what we're going to cover:

* Factors fanning the flames of a price war;

* Offsetting factors tempering the war's full impact;

* How in a real war everyone loses;

* How to keep from becoming a casualty; and

* Survival tactics.

This debriefing will be successful if you come away from it with a firm opinion about whether or not the industry is likely to have a full-scale price war, or ongoing skirmishes, and what impact these events might have on you. Let's examine these factors in greater detail so we can scope out the size and strength of the enemy's position.

Fanning the flames of war 

Just as the world sees evidence of arms escalation before a real war, this industry has seen a significant volume escalation leading up to this pricing war.

The following points offer some background explanation as to why a pricing war may be escalating in today's market.

During the last several years, our industry has been on an unsustainable binge with production capacity growing oversized to accommodate huge volumes. Very soon we will have to bite the bullet and decrease our production overhead or face the high-cost consequences.

The refinancing hordes are finally running lower and lower on fresh new recruits. Even the refi junkies are getting tired of charging the same old hill. But the damage has already been done. Our servicing portfolios may never recover the values we once enjoyed.

In 1994, total origination volume is expected to fall by roughly $220 billion from the unbelievably high volume posted in 1993--approximately $1.1 trillion. As time rolls on, pricing margins will be pressured as fewer and fewer loans become available for production.

Last year was the first time ever that refinance volume surpassed purchase volume. To put things in perspective, think about this: refi origination volume alone in 1993 was greater than total origination volume in any year prior to 1992.

Refis represented about 55 percent of total volume in 1993. As refis return to a more normal 15 percent to 20 percent level, lenders will face a cost squeeze as volume drops and old processes and new people stay in place. Inefficient lenders will be at a real competitive disadvantage due to their higher cost structure.

Portfolio lenders may sound the battle cry as they try and take away some of mortgage bankers' market share when rates rise and ARMs increase in popularity. Part of their funding to compete on price could come from portfolio income.

In our highly fragmented industry, with cutthroat competition and imminent volume declines, prices and profit margins may be driven down to levels that just sustain our existence. Insignificant barriers to entry permit almost anyone to play in this industry. New originators further fan the competitive flames.

The growth in mortgage broker ranks from roughly 7,500 to more than 18,000 from 1987 to 1993 speaks to this point. These niche specialists with low costs continue to enter and carve the industry up into cost-efficient segments.

One final factor that could fan the flames of a price war is a pending change in accounting rules for mortgage banking. Under accounting rules now in place, we must capitalize our investment in wholesale purchased servicing and yet expense our investment in retail-originated servicing in the current accounting period. If the Financial Accounting Standards Board (FASB) revises accounting rules to allow the deferral of costs incurred in the origination of loans sold and serviced, all retail mortgage bankers will see current earnings improve.

While this accounting revision would not change the long-term economic value of the servicing produced, it would allow all of us to capture current earnings, as well as level out the playing field between wholesale and retail originations. This FASB change, however, might encourage the onset of a price war, as banks and thrifts may elect to recapture market share in what will appear to be a more profitable business.

Tempering factors

Let's examine now some of the battles we won in the refi wars and some we may win in the future. It's also worth noting that some significant ammunition was stockpiled to help endure the next big competitive siege.

Although refinance volume will steadily decline, greater purchase volume will help take up some of the slack. In fact, purchase originations will rise to their highest level ever--about $530 billion in 1994, according to Joseph Hu, director of mortgage research with Oppenheimer & Co., Inc., New York.

With roughly $1 trillion in 1993 originations, now almost one-third of all outstanding mortgages carry interest rates right around 20-year lows.

These low-rate loans are unlikely to prepay before we get a chance to realize some value from them. The rapid runoff of servicing portfolios witnessed during the past two years will slow down measurably. The lengthened average life of servicing portfolios will be one very welcome side benefit of shrinking volume.

The overall performance of servicing portfolios has improved as seasonally adjusted delinquencies on 1-to 4-unit residential properties fell in the third quarter of 1993 to 4.21 percent, their lowest level since 1974 according to the Mortgage Bankers Association's National Delinquency Survey.

We've already mentioned this next point, but it is worth repeating. Accounting inconsistencies where the same servicing asset is treated differently depending on the origination method (retail or wholesale) may go away. From a short-term, bottom-line perspective, this is good news. In the long run, who knows? Financial institutions may shoot us and themselves in the foot if they price too aggressively to recapture market share.

Everyone loses

Whoever fires the first volley in a price war may win a short-term market share battle, but we'd all lose the pricing margin war.

"We've met the enemy and it is us." Some wholesalers have already lost the "no-cost" refi war. And the shelling continues among wholesalers who accommodate brokers with above-par pricing. If wholesalers don't cap premiums and compress prices as premiums increase, they build considerable prepayment risk into these no-cost time bombs.

Some of these bombs have already exploded in wholesalers' faces, and there are quite a few live ones still ticking. Hopefully, rising rates will defuse some of those.

Nonetheless, all of these bombs have negatively affected the value of servicing rights as servicing buyers aren't about to pay up for cash flow streams that aren't likely to be there for very long.

Therefore, we've all seen the value of our servicing portfolios drop. Even worse, some portfolios have accelerated runoffs to where values are impaired (i.e., purchased mortgage servicing rights are greater than present value cash flows).

As a result, servicing is a lot more option-like than it used to be. Remember the "good old days" when we could count on servicing a loan for 8 to 10 years? Now that asset can disappear because of a 50-basis point drop in interest rates. The old rule-of-thumb of a 2 percent spread before a refi made sense is totally obsolete. A fundamental change has occurred in our industry, and the real casualty is servicing.

Last year we survived the refi wars because large secondary profits and decent warehouse earnings offset the erosion in servicing values. However, if we have a full-scale pricing war coupled with depressed servicing values, a flatter yield curve and little secondary gains, the battlefield will be littered with casualties.

After the refi boom of 1986, which pales in significance to 1993, profit margins eroded from 19.6 percent in 1986 to 0.7 percent in 1987, according to the 1992 Annual Mortgage Banking Performance Report. If anything, competition for originations has increased since then. In our highly fragmented and segmented market, profit margins could be driven down to survival levels when volume drops precipitously and price wars ensue.

To keep from becoming a casualty in any price war that might heat up, it goes without saying that you should never, ever use credit concessions as a market-place differentiator. Anyone who's ever tried, no matter how big soon lost superpower status, and some even became credit quality casualties.

Take the offensive in the secondary

Another, more proactive way to keep from becoming a casualty is to take the secondary offensive. Use Fannie Mae's Flash program and Freddie Mac's Gold Rush to price to the near month.

Reduce the number of days in your pricing formula to hedge to the near month quicker. For example, traditionally you would take a 15-year loan where settlement of the pool is on the 20th of the month and count forward, say 20 days, to get a cut-off date on the first of the month.

Now we have the potential to cut those 20 days down to 15 and if you want to be superaggressive, down to 10. The rationale supporting the superaggressive position is that with longer lock-ins, the average loan doesn't close on the last possible day of the lock.

So someone who is using a traditional pricing method and figuring a 60-day lock might be priced to May, while you're still priced to April. The 9/32nds or 10/32nds price advantage you enjoy will go a long way to preserving profit margins in a price war and keep you from becoming a casualty.

In order to pull this off, you must be or become very efficient in your back room. In addition you need excellent arrangements with closing agents and correspondents to make sure that all loans are promptly delivered to you. These efficiencies will allow you to turn loans around fasten. This speed, in addition to the Gold Rush and Flash programs, will enable you to price to the nearer month. If you're priced to the wrong month, you're going to have to use a price subsidy to keep up with the competition.

Negotiate low guaranty fees

You are going to have to negotiate hard with the agencies to get the lowest guaranty fees possible. At times, the agencies will also distribute special grids where they pay bigger buy-ups than standard. You need to at least be aware of when this is happening, so you can use this as a point of negotiation. However, unless you produce huge volumes, you're unlikely to be offered this extra ammunition.

Another important piece of survival advice is that you need to perform best-execution analysis on each new hedge, existing hedges and actual deliveries to improve your secondary results without taking any additional risks. The following three points will help you follow this bit of advice:

* Run the analysis at the point of pooling to determine if your original hedge still represents best delivery.

* Maintain active master agreements and master commitments with both Fannie Mae and Freddie Mac in order to maximize your number of possible delivery choices.

* Understand thoroughly the use of buy-ups and buydowns.

It also will help you avoid casualty status if you routinely perform delivery variance analysis.

If you take the offensive on all of these secondary techniques, you could produce additional risk-free profits of about $1 million for each $1 billion of conventional loan volume. The 10 basis points you pick up can go a long way in helping to maintain profit margins.

Reengineering can help

Reengineering is nothing more than process redesign that incorporates the best of what technology has to offer, applied to operations that are as streamlined and seamless as we can devise. The gap between what's possible with existing technology and how we operate today is enormous.

Where the industry is today technologically, bears no resemblance to where we could be.

High volumes, inadequate use of existing technology and antiquated processes that haven't changed measurably since World War II have led to built-in inefficiencies. Operations personnel have struggled to process the huge influx of volume using inadequate tools and redundant, outmoded processes. It's now time to look at the inefficiencies we've created and reengineer our back rooms to increase productivity and lower costs. The dual pressures from leaders in the industry who have a technological head start and our potentially shrinking profit margins leave us no choice.

There are a few additional words of advice I would offer to those wishing to survive a possible price war.

* Diversify your originations base. You can no longer depend on just retail or just wholesale to see you through an industry that has changed so fundamentally.

* Do not price to a loss. With what could be a permanent reduction in the value of servicing, pricing to a loss is like going on a kamikaze mission. Don't do it if you want to survive.

* Hedge your servicing portfolio. Recognize the fact that servicing is a lot more option-like than in the past.

* Don't acquire above-par bulk servicing. Stay away from the acquisition of servicing packages where a significant number of loans have been originated above par.

* Actively manage customer relationships. There are battles that will be won in the trenches of your customers' offices. Train and educate your front-line people as to what mortgage banking is all about. Teach them to manage relationships that contribute long term to your bottom line, and then nurture those long-term relationships with all of the service components you can deliver.

Finally, if you think that you're out-gunned, outmanned and outmaneuvered, get out of the war. I could use a little less competition. Just kidding. I hope this article helps you reinforce your battle lines and be prepared for the next serious price skirmish. Then, when the heavy guns do start firing and profit margins become serious casualties, at least you'll survive and live to fight another day. If not, "c'est la guerre."

Paul Neal is president of Washington Square Mortgage Company, Des Moines.