Channels and strategies. (Origination Strategies).

Four very different mortgage companies are preparing for the certain future of a steep falloff in refi business. E*TRADE, First Horizon Home Loans, Homestar Mortgage Services and InterFirst have different channel strengths, and all believe they will use those strengths to weather the coming downturn.

A RECORD-SETTING MORTGAGE REFINANCING boom that began in first-quarter 2001 and is still going strong no doubt has harried and overworked loan originators wondering if their lives will ever return to normal. Working nights and weekends, missing dinner and Saturday afternoon soccer games, it's the price you pay when--as was the case in the first quarter of this year--your industry wrote $655 billion in one-to-four-family loans, 68 percent of which were refinancings.

"It's really like a freight train coming right at you, says Peter Norden, president and chief executive officer at Paramus, New Jersey--based Homestar Mortgage Services LLC, which originates loans about equally through brokers and its own retail sales force.

The good news is there's light at the end of the tunnel. The bad news is that it's another, entirely different sort of freight train bearing down in the distance. This time it's a forecasted decline in mortgage loan volume--and particularly the red-hot refinancing sector--that will force originators to refocus their attention on the purchase market.

For some, it will be a time of getting back to the basics of sourcing new loans while developing new product lines or market niches. For others, it may be a time of testing whether their business model can function just as effectively in a post-refinancing environment where consumers are no longer so highly motivated to seek out mortgage companies. It will be a market that separates the racehorses from the nags and reminds everyone of what it really takes to be successful in this business.

The refi bonanza started in the first quarter of 2001. It has continued unabated except for a brief pause in the third quarter of 2001, and again in the second quarter of 2002, based on quarterly data compiled by the Mortgage Bankers Association of America (MBA). But the party may be coming to an end if a slowly growing economy starts to pick up steam.

The U.S. economy grew at a modest 1.4 percent annual rate in the fourth quarter of 2002, according to the U.S. Department of Commerce's Bureau of Economic Analysis. MBA expects this tepid performance--which will probably continue through the second quarter of 2003--to gradually improve as the year unfolds. A successful conclusion to the war in Iraq, combined with monetary and economic policies coming out of Washington that are "strongly stimulative," should lead to a boost in consumer and business confidence, according to MBA's most recent economic analysis, released in April. MBA is forecasting the U.S. economy to grow 4 percent in the fourth quarter.

The most likely scenario for later this year anticipates an increase in interest rates and lower refinancing demand, while also dampening somewhat the appetite for purchase loans. Indeed, MBA expects origination volume to drop off to just $335 billion by the fourth quarter of 2003--with refis accounting for just 33 percent of that total. This compares with mortgage loan originations in fourth-quarter 2002 of $774 billion--69 percent of which were refinancings.

"I think we definitely anticipate a dropoff in refi volume," says Norden. "You're asking someone who thought it would end six months ago, but I certainly don't believe that the Federal Reserve is going to drop rates any further."

William A. Newman, president of Ann Arbor, Michigan-based InterFirst Wholesale Mortgage Lending, a unit of ABN AMRO Mortgage Group Inc., concurs--and worries that the present refi boom has extended for so long the correction may be especially sharp this time.

One would normally expect refis to drop back to about 30 percent of total volume after a boom, but Newman says refis could drop as low as 10 percent to 15 percent.

"This one's going to be more drastic than any other change we've ever seen," he says.

The wildcard in this economic forecast could turn out to be the war in Iraq, which seemed well in hand at press time. But a continuation of hostilities deep into 2003 could result in even slower economic growth and lower interest rates--which, perversely, might actually keep the refi boom going for a while longer.

MBA Chief Economist Doug Duncan believes there's less than a 20 percent chance that the U.S. economy will end up in another recession.

Duncan also expects the mortgage industry to undergo a significant contraction in origination capacity as many originators are forced to scale back their operations to meet the slackened demand. He also expects to see further industry consolidation as some mortgage companies try to offs declining origination volume through acquisitions.

Duncan says when the refi market contracted sharply in early 1994 after running strongly for more than a year, originators were able to make up some of the lost volume in the subprime market. "Subprime won't be the savior this time, so some of the capacity has to go away, he says.

But these are macro changes, and each mortgage company will react to the market's changes a little differently. One thing they're all likely to do is get their originators refocused in a kind of back-to-basics approach.

"The challenge is always that when loan officers are in the midst of a refi boom, they're not thinking enough about other things," says Jerry Baker, president and chief executive officer of Irving, Texas--based First Horizon Home Loans, a subsidiary of First Tennessee National Corporation. First Horizon originates most of its loans through a large branch network.

Refinancing activity has been heavy in recent years that "the industry hasn't had time to think ab** referrals" or any of the other basics ** the purchase mortgage business, s* Baker. "You almost have to go ba** remedial training."

In Baker's view, the first th** many mortgage companies should ** is get their loan production tea** prepared for a market in which re**nancing volume will be way do** and they will be forced to make ** that business on the purchase si** When it comes to the purchase market, "You need to have a strategy, ar** setting goals for branches and ** region is very important," says Baker.

Referrals are also key on the purchase side of the business, and loan officers and brokers need to make sure their referral sources haven't been ignored. "You need to make sure they are really servicing their clients," says Norden. "If you neglected Realtors or builders during the refinancing boom, they're not going to give you the business when you come back to them."

How individual companies react to a decline in origination volume and the need to place greater emphasis on purchase loans will depend largely on their business model.

Retail channel

First Horizon originates about 65 percent of its one-to-four-family mortgage loans through a network of 1,300 loan officers and 198 branches in 38 states. So it comes as no surprise that Baker sees that retail origination capability as an asset that should be exploited as much as possible.

"One way to deal with an increase in [interest] rates and decline in volume is to grow your sales force," says Baker. For its part, First Horizon has hired some 600 loan officers in the last 15 months in expectation that the refi market would eventually burn itself out. "You need to make sure you're adding loan officers, because as overall volume declines one strategy is to try to gain market share," says Baker.

But growing share in a declining market by definition means taking it away from someone else--and this is an undertaking many mortgage companies simply won't be able to accomplish. Ironically, even while he has been expanding First Horizon's retail sales force, Baker expects many of his competitors will have to cut their networks back as volume declines. The problem is many of the loan officers hired during the refinancing boom have never had to rely on the purchase market for most of their volume. Also, declining volumes overall will mean less to go around for everyone.

"They didn't have to fight for the business--it just came through the door," Baker says. "I think that 10 [percent] to 20 percent of the industry's loan officers won't be able to survive." According to Baker, the top 25 percent of a typical mortgage company's loan officers write about 50 percent of the business, "while the bottom 25 percent don't do much." If the mortgage market contracts as expected, many companies may have little choice but to jettison their stragglers.

Baker also says that as refi volume wanes, it will be important for mortgage lenders to expand their origination channels in an effort to reach out to additional sources of purchase loans. For example, First Horizon recently hired a number of specialists to concentrate on the builder market. And the company has been reaching out to "emerging markets," including such groups as Asian Americans and Hispanics, and recently placed Executive Vice President Nancy Mercer in charge of that initiative throughout the company. "In our case, we thought it was important to hire someone just to handle that effort," Baker says.

Wholesale channel

Leading wholesale lenders like InterFirst probably face a more difficult challenge when the mortgage market goes through one of its cyclical corrections. This is so because, unlike lenders with predominantly retail sales forces, they have less control over the brokers who originate most of their loans.

"In the wholesale environment, you have to make sure you're dealing with the right partners," Newman says. "Will their business model be successful in a down market?"

In contrast to First Horizon's decision to expand its retail lending capability, InterFirst has modestly reduced the number of brokers it originates through. InterFirst currently has about 7,000 broker partners, and according to Newman has "deactivated" about 1,400 relationships in the last year while simultaneously adding new ones. All told, he figures InterFirst is still down "several hundred" brokers from its recent high-water mark.

"It's an evolutionary process to see who matches up well with us," Newman explains. "We're trying to get ahead of the curve a little bit."

Going forward, InterFirst wants to make sure it's dealing with brokers who are interested in working with a small number of lenders rather than spreading their business around. This is key during a down market because wholesalers can be subject to pricing pressure by brokers who aggressively shop business around to a large number of lenders. InterFirst also looks for brokers who place an emphasis on processing loan applications as efficiently as possible and who have strong referral sources. "They have to be effective at bringing in clients," Newman says.

Newman also has focused on enhancing or expanding his product line. Recently he re-engineered InterFirst's second-mortgage product to make the origination process more efficient for brokers. He also has been staffing up an operation to focus on construction lending. "It's important to squirrel away enough resources to prepare for the future," he says.

Builder business

Launched in late 1999 by Norden and Chief Operating Officer Martin J. Levine, Homestar got an important boost from a strong refi market that tended to lift everyone's boat. But Norden says he has always been "a little uncomfortable" with being so reliant on refinancings, because there's limited opportunity to build a strong referral business.

"Our plan has always been to go after the purchase business," Norden says. "Refis come and go, and you don't really build a relationship." Homestar currently has 19 offices in nine states throughout the Southeast and is licensed to do business in 33 states overall.

One approach that many lenders are taking in anticipation of a market correction is to emphasize specialized sources of purchase loan production. Through its National Builder Division, which has 55 builder clients in Atlanta and three in Florida, Homestead has made the home-builders market a major part of its origination strategy.

Vice President Kelly Allison, who once headed up sales and marketing for a large Atlanta home-builder and runs Homestar's builder division, says the two parties--builder and lender--"should be the perfect partnership."

Allison spent more than nine years in the building industry and got to experience the loan origination process from a different perspective. "I was never completely satisfied with how my loans were handled start to finish," she says.

Allison says one common flaw of many lenders is a "lack of urgency," and for this reason Homestar processes all loan approvals in 72 hours or less. The company also offers builders a guarantee--which it claims is unique to the mortgage industry--to close its loans on time, or it will fund the interest charges until it does.

Homestar uses a single software platform for both origination and processing. Allison believes this gives it some important advantages, with quick turnaround time being just one. The system also provides builders with direct, around-the- clock access to Homestar's pipeline so they can check on the progress of an individual loan. "They can go in at 9 a.m. and again at 10 p.m., and that loan can look completely different," Allison says. "That is extremely unique in the builder's world."

Homestar also picks up a portion of the marketing costs with its builder partners, which includes direct mail, billboards, and radio and television advertising. And it provides feasibility studies--which can be extremely valuable to smaller builders that lack the resources to provide these for themselves. "We're always trying to find ways of providing value to our builders," Allison says.

Online channel

As the mortgage market gradually returns to a more normal configuration, the biggest challenge may lie with online lenders that were an easy channel option for rate-sensitive consumers looking to refinance. E*TRADE Bank, a subsidiary of Menlo Park, California--based E*TRADE Group Inc., is the third-largest online mortgage lender, according to National Mortgage News. It trailed only Countrywide Financial Corporation, Calabasas, California, and Washington Mutual Inc., Seattle. But unlike those companies, E*TRADE does not enjoy the benefits of a huge network of branch offices, and thus must prove its Internet-based business model can work just as successfully in a market where refi activity no longer dominates.

E*TRADE entered the mortgage business in February 2001 with the acquisition of LoansDirect Inc., which already had built a strong position in the online mortgage market. The deal occurred just as the refi market was taking off in the first quarter of that year, and Rob Bernabe, the company's director of retail mortgage lending, admits the timing turned E*TRADE into a refi shop.

Over an eight-quarter period ending in the fourth quarter of 2002, refis never accounted for less than 64 percent of E*TRADE's total fundings--and in some quarters that percentage was in the low 905.

"Consumers have reacted to declining interest rates, and E*TRADE reacted to consumers," Bernabe says.

Bernabe explains that E*TRADE's value proposition in the mortgage space is built around pricing and how the product is offered. Thanks to an automated underwriting system, mortgage applicants receive an answer--and a call from an E*TRADE loan representative--in 60 minutes or less, and there is no fee to apply. Once approved, the customer is given a guaranteed rate and closing cost that won't change. Bernabe says that one problem with how mortgage loans have typically been made is that customers are never sure of exactly how much the process will cost.

"Customers end up with a price down the road that's different from what they thought they were getting," he says. An important element in E*TRADE's strategy has been an effort to simplify--and demystify--the application process as much as possible.

"The consumer gets clear, no-hassle, easy-to-understand prices," Bernabe adds. And the company backs that all up with several guarantees, including $100 if a loan representative doesn't call within 60 minutes of submitting a completed application, and $500 if the loan doesn't close on time.

While he does not disagree that E*TRADE will have a tougher time in a market where purchase loans will be the main volume driver, Bernabe believes the company's value proposition can be effective in all kinds of markets. For those customers who are predisposed to look at the online channel, "We don't believe it's that much more difficult to do a purchase deal than a refi deal," he says. "Certainly the process isn't any harder."

Instead, the challenge is to find ways of herding potential applicants to the E*TRADE Web site. The typical E*TRADE mortgage customer is an early adopter who's comfortable doing a complicated transaction in an online environment. The customers also tend to be very cost-conscious and see the Internet as a quick and effective way of shopping around for the best deal.

"Generally the customer comes to us first," Bernabe says. But waiting for Internet-savvy rate shoppers to find you might be more problematic when it comes to purchase loans, and E*TRADE is looking to build the same kind of alliances and referral relationships that traditional lenders rely on. For example, the company is reaching out to the Realtor community and trying to educate Realtors about E*TRADE's mortgage offering. It is doing this by attending industry conferences and developing collateral material that explains its mortgage process and introduces the E*TRADE team assigned to a particular loan.

And of course, E*TRADE will continue to educate consumers--including all those people who are not early adopters--about the advantages of doing business online. "It's a challenge, but we know we can deliver on it," says Bernabe. "We believe we'll be fine.

Perhaps the most effective strategic hedge against a sharp decline in refi volume is some element of diversification. In addition to its mortgage lending activities, First Horizon focuses on the home-equity, construction and sub-prime markets, so it's not completely reliant on the one-to-four-family mortgage sector.

"As a shareholder, you better sit back and say that I better not be in just the mortgage business," says Baker.

Homestar also has been constructed as a diversified mortgage company with more than 200 different loan programs aimed at borrowers in the A, alternate-A, B and C-credit categories. Norden expects that a decline in refi activity because of rising interest rates will have the greatest impact on loan volume in the A-paper category, but he believes the other categories are much less rate-sensitive.

And while Bernabe's mortgage unit does not enjoy as much customer or product diversification as First Horizon and Homestar, E*TRADE does have one compelling advantage to fall back on--its association with a successful online brokerage operation, E*TRADE Financial.

Bernabe says he cross-sells mortgages to approximately 25 percent of the brokerage firm's 4 million customers, and that operation continues to be a vital source of referrals. "That strategy has really grown this company, he says. "The E*TRADE name has a lot of brand equity."

Jack Milligan is a freelance writer based in Charlottesville, Virginia, and the former editor-in-chief of U.S. Banker.

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