Building more profitable portfolios.

Mortgage companies should think strategically before they blindly sell off excess servicing.

Maximizing profitability. Those two words have taken on great meaning in today's mortgage banking industry.

To maximize profits, mortgage bankers are following several strategies that include reengineering entire operations to eliminate costs; investing in technology to capitalize on economies of scale that may be reached in loan servicing; and purchasing or originating servicing rights in an attempt to replace runoff-prone higher coupon product with today's attractive low-coupon servicing.

This article offers insight into how mortgage bankers may build a more profitable servicing portfolio for the future through the use of agency buy-up and buy-down programs.

Many organizations use agency buy-up options to eliminate excess service fees. The desire to eliminate excess service fees stems largely from the prepayment risk associated with the excess servicing asset.

While the excess servicing asset must be prudently managed, there may be interest rate environments where old strategies about eliminating excess service fees through buyups may no longer apply and where pursuing such strategies is contrary to a company's overall strategic goals.

Loan servicing departments are generally handed loans with fixed revenue streams and must focus on managing costs to meet profitability goals. The revenue side (service fee) is determined in the secondary marketing area and is a function of the individual characteristics of the loans held for sale, as well as the available agency programs and the views and objectives of the secondary marketing manger.

The secondary marketing area plays a critical role in determining a company's future servicing performance. In order to maximize future servicing income, mortgage banking firms need a full understanding of the true economics of agency and investor programs in the secondary marketing area. As a result, management is challenged to formulate company-wide strategic goals and develop procedures to ensure that overall profitability is encouraged, while at the same time dispelling some old fears regarding excess servicing.

Past experience

Excess servicing was more prevalent in the late 1980s than it is today, by virtually any measure. Several mortgage bankers experienced significant excess servicing asset write-downs in the mid to late 1980s. As a result, some have stopped recording excess servicing altogether, while others employ more conservative assumptions. In many instances, excess servicing has been partially or completely eliminated thanks to the advent of what are known as buy-up and buy-down programs offered by the secondary market agencies.

Buy-up options, which have been available for several years, allow sellers of mortgage loans to "buy up" guarantee fees on security sales to reduce or eliminate excess service fees. In return for higher guarantee fees during the life of the security, the seller of the loans receives more cash at the time of the sale. The essence of this transaction is that the seller has sold excess servicing to the investor.

This type of transaction (a buyup) allows the seller to transfer some of the prepayment risk associated with the loans being sold to the agency. Before the advent of the buy-up option, the seller had little choice but to record the excess service fee as an excess servicing asset and only hope that the underlying loans did not prepay faster than expected at the time the asset was recorded.

Charges to excess servicing assets in the mid to late 1980s made buy-up options an attractive means of managing prepayment risk. But prepayments are a function of interest rates, among other things. As prepayment risk changes with the various interest rate environments, so should buy-up strategies.

Using buyups and buydowns wisely

Entering into a buy-up transaction is a sound decision--some of the time. If one believes that prepayments will be "high" over the course of a loan's life, a buyup may make sense because the agency will pay current period cash in return for a higher guarantee fee over the life of the loan. If, however, one believes that prepayments over the course of a loan's life will be "low," a buy-up transaction may not make sense. The following illustration highlights this point:

* Assume monthly loan sales of $10,000,000;

* Assume an average excess service fee spread of 10 basis points;

* Assume a standard guarantee fee of 15 basis points;

* Assume an investor buy-up ratio at time of sale of 4.15 for 1 basis point.

The buy-up ratio means that for the 10 basis points of excess service fee spread, the investor will pay the seller .415 percent of the outstanding principal amount in cash or $41,500. In return, the seller promises to pay not only the 15 basis point standard guarantee fee each month of the loan's life, but 10 additional basis points as guarantee fee as well.

If the seller believes that the loans are likely to last less than four years, the price received is economically advantageous. This is so because the cash that would be generated from the 10-basis point excess service fee spread yearly is $10,000 (excluding principal amortization). If, however, the seller believes that the loans will last more than four and a half years, the transaction might not make economic sense.

It should be understood that this example is somewhat simplified as she excess service fee cash flows should be discounted at an appropriate market rate to fairly evaluate whether or not the transaction makes sense.

Organizational consistency

Does this mean that mortgage banking entities should immediately stop using buy-up options? To answer that question, each company must make its own decision as to the risks it is willing to accept. Furthermore, secondary marketing strategies need to be dynamic and not set in stone. A decision to stop using buy-up options today may not be appropriate in a different interest rate environment.

For example, those who used these options over the past several years, generally made sound business decisions, as loans originated during that time period have experienced heavy prepayments due largely to falling interest rates and the proliferation of the no-point/no closing cost loan. If, however, a company believes that prepayments have slowed or the firm is currently purchasing servicing rights, it might not only want to stop using buy-up options, but also may want to consider using buy-down options to truly maximize future servicing fee revenue.

The following example illustrates how buy-down options can be used to increase service fee revenue.

Assume the same facts as before, except the buy-down ratio at sale date is 4.5 for 1 basis point.

If a mortgage lender opted to enter into a buydown using these facts, it could promise to pay only 5 basis points of guarantee fee over the life of the loan, as opposed to the typical 15. If electing this option, the seller/servicer would sell the loan into the same coupon security, thereby keeping the prepayment risk the same as if a buydown were not used. In this scenario, the seller would receive $45,000 less in cash at the time of loan's sale, but would pay only 5 basis points of guarantee fee each month. The mortgage lender's net book profit from the sale of the loan would remain the same as if the guarantee fee had not been bought down. The net effect is the mortgage banker has merely forgone current period cash of $45,000 and instead recorded an excess servicing asset and related gain of $45,000.

When does this type of transaction make sense? When the mortgage banker anticipates that the lives of the underlying loans being sold will extend beyond 4.5 years, then this transaction makes economic sense. In essence, the mortgage banker is buying servicing from the secondary market agency for which the pay-back period is 4.5 years.

The creation of excess servicing undoubtedly subjects a company to prepayment risks. These prepayment risks, however, are similar to those associated with purchased servicing rights on the same loan. A company that eliminates excess servicing through buyups on wholesale loans where servicing rights are purchased, may be acting inconsistently. After all, why would a company purchase a loan's servicing rights if it expected the loan to prepay prior to recouping their investment? The buyup is essentially the sale of servicing to the investor. If a buyup occurs on a loan where the company has purchased servicing rights, companies may want to consider, instead, using buy-down options as a means of enhancing the company's future servicing revenue.

Clearly, excess and purchased servicing rights are not exactly alike, even though they're similar in several respects. Excess servicing carries with it no escrow or ancillary revenue. However, it should be noted that there is no incremental cost of servicing associated with excess servicing. The accounting treatment of excess servicing is currently more conservative than the accounting for purchased servicing rights. But purchased servicing rights are afforded less favorable treatment for regulatory capital purposes than excess servicing.

Despite these differences, excess and purchased servicing assets bear similar economic prepayment risks. Therefore, the prepayment risks associated with buydowns and the purchase of servicing rights on individual loans may be viewed similarly.

Maximizing overall profitability

The essential message here is that mortgage banking companies need to think through what they are doing in their day-to-day operations and understand the implications of all their actions. Today's strategies should not be built solely around yesterday's problems.

While the prepayment risk associated with the excess servicing asset is undeniable, companies must employ procedures to ensure they are not routinely selling an asset (excess servicing) for less than it is actually worth, simply out of fear.

Prior to selling into the secondary market, secondary marketing personnel should perform a best execution analysis of the economic benefits that could be derived from buy-up and buy-down transactions. Such analyses should be geared toward overall company profitability. The strategies pursued should be consistent with those throughout the company. Furthermore, companies must ensure that secondary marketing strategies are flexible and that they change with, among other things, the interest rate environment.

Secondary marketing personnel are responsible for developing a complete understanding of each agency program. This understanding should then be communicated to top management so they are educated as to the economics of each agency program. Executive management is then responsible for choosing the alternatives that make the most sense for their company.

In mortgage banking today, cost cutting, reengineering and technology initiatives all have their place in maximizing profitability, however, in order to implement these initiatives, a quality servicing portfolio must be in place generating acceptable revenues. The record loan production of the past several years has already begun its decline. The successful mortgage companies of tomorrow will be those with the foresight to take advantage of today's opportunities wherever they exist. Effective use of buy-up and buy-down options is one way to take advantage of such opportunities.

Tim Ryan is a manager in Price Waterhouse's Financial Services. Industry Practice in Boston. He specializes in consulting with mortgage banking entities. Ryan recently authored Price Waterhouse's report entitled "Managing Interest Rate Risk in the Mortgage Banking Environment" based on a survey of 125 mortgage banking firms.