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A windfall year; mortgage executives concede that last year's business environment made everybody look good.

Mortgage executives concede that last year's business environment made everybody look good. Record origination volume and a steep yield curve made it very hard to lose money. But many see a price war looming, as companies hunker down for the post-refi, leaner times ahead.

Record volume in 1992 helped bring profits to companies ranging from national mortgage lenders to one-office mortgage brokers. In addition, some firms gained even more cash by issuing shares of public stock during the year. Although profits arrived because of economic forces felt by all, subsequent choices regarding how these funds will be put to work will have a large bearing on how individual lenders seek business in the future.

Common components

A steep yield curve in 1992 meant that rates on short-term warehouse funds were well below mortgage rates, thus producing "record spreads"' says Walter C. "Terry" Klein Jr., chairman and president of Sears Mortgage Corporation in Vernon Hills, Illinois. Klein says warehouse spreads rose about 20 percent last year. When combined with record volumes going through warehouse lines, it was a major source of profits for many lenders. Warehouse spreads quoted by mortgage bankers for 1992 ranged from 2.5 percent to 4.5 percent.

Net interest income at Columbia, South Carolina's Fleet Mortgage Group, Inc. increased 79 percent, or more than $20 million, during the first nine months of 1992 when compared to the same period in 1991, according to statements issued by the company. Originations during that period were $13.3 billion for the company, a 58 percent rise from a year earlier. But that was partially offset as servicing runoff more than doubled, reaching an annualized rate of 20 percent. Warehouse income grew more than net loan servicing revenue did at Fleet.

Besides encouraging refis, lower rates throughout the year meant that secondary marketing gains kept improving, says Albert C. Kocourek, president and chief executive officer of First Advantage Mortgage Corporation in Columbia, Maryland. Current production had less likelihood to prepay at the lower rates, and thus prices kept going up, Kocourek explains.

Unprecedented gains

Fleet Mortgage reported a rise in mortgage production revenue of $74 million during 1992's first three quarters, when compared with the previous year. More than half of that increase was due to secondary marketing gains, and the rest came from loan origination fees according to Fleet's most recent 10-Q statement.

Profits rose because expenses went up by smaller amounts. Fleet's personnel costs increased by less than $40 million during the first three quarters of 1992, while office and operational expenses rose by $12 million. Taxes went up by $40 million, canceling out the increased revenue from servicing income and warehouse spreads. After removing these major cost factors, Fleet wound up with net earnings that were $25 million greater than the firm's results through September 30, 1991.

Remake, grow or stay put

During 1992, some lenders opted to expand their production operations, while others disciplined themselves and imposed limits on the refinancing volume they would take. Only when the market changes will these various companies see the consequences of their different strategic choices. Will those who went into new areas gain market share or be saddled with excess capacity? Will companies that kept an emphasis on calling on Realtors during the refi boom enjoy more business when the purchase market comes back? And did volume mask the effect of certain origination strategies that otherwise would have been quickly seen as unprofitable in a normal market?

Pasadena's Countrywide Funding Corporation was one of the companies that opted for expansion, and as a result it leapfrogged to being the nation's top provider of home loans, according to SMR Research Corp., Budd Lake, New Jersey. Yet personnel expenses were held in check, as Figure 1 shows.
FIGURE 1
Countrywide Funding Corporation
 Total Production No. of Workers
June 1991 $763 million 1,217
June 1992 $2.48 billion 2,279


Although Countrywide's monthly production rose by 325 percent in 12 months, the number of employees required to bring in those loans didn't even double. Jonathan Gray, senior research analyst at New York's Sanford C. Bernstein & Co., Inc. estimates that Countrywide will dose 118 loans per employee in fiscal 1993 - up from 60 per worker two years ago.

Smaller firms - such as First Mortgage Corporation in Diamond Bar, California - also enjoyed the profits, produced by the banner year in originations. For the six months ending September 30, 1992, total revenues at First Mortgage were up 66 percent from the same period the previous year. But total expenses went up just 35 percent during that time. As a result, First Mortgage's net income in these two six-month periods went from $1 million to $2.7 million.

"We make a profit on retail" says Executive Vice President Bruce G. Norman. Costs are controlled by placing all nonservicing workers on incentives and lower salaries. Even clerical and back office staff have one-fourth of their compensation based on production. "When production is down, our payroll drops very quickly"' adds Norman.

During slow periods Norman says he doesn't lose many workers, because few companies are recruiting then. And when the job market heats up during times of high production, his employees are happily earning bonuses. First Mortgage President and Chief Executive Officer Clem Ziroli reportedly receives no salary - only "an annual bonus that is approximately equal to 15 percent of First Mortgage's pretax profits," according to stock analyst Allen N. Strand of Crowell, Weedon & Co., in Los Angeles.

Origination growth plans also are not confined to any set regions. Indianapolis-based Banc One Mortgage Corporation is expanding in the normally conservative Midwest. President J. Albert Smith Jr., notes that originations by dollar volume tripled in the first nine months of 1992, compared with 1991.

Slow growth

But not all companies grew in origination volume as dramatically in 1992. Some were constrained by warehouse credit limits, while others pursued a policy of limiting refinance business. Klein says Sears Mortgage "restricted loan officers. We told them the percentage of their pipelines that could be in refis." He hopes that Sears will improve its market share when home purchases increase, because the firm kept good relationships with Realtors by requiring "the discipline of time and territory management from loan officers."

Sears' refinance business came from real estate agent referrals and from attempting to refinance existing customers who called to determine their existing balances. By sticking to its traditional business - purchase money lending - Sears Mortgage probably gave up some potential profits in 1992. Yet Klein sees "the total capacity of the industry reducing" in coming years. "The challenge is delivering service as your costs go up - or down," he notes. Other observers note that the mortgage industry was consolidating before the refinance boom hit, and that as refinancing slows, those firms with overcapacity could see expenses taking a big chunk out of their earnings.

Changing focus

"We had record profits last year," notes David Frank, president of Margaretten & Co., Inc. in Perth Amboy, New Jersey. Revenue from originations and corporate profits both rose 80 percent over the first nine months of 1992, when compared with the same period in 1991. It's rare for a mature company to see such rapid growth.

Yet, when Margaretten officials look back at 1992, the volume might not be as important as other changes that took place within the company. Production records only helped Margaretten to make some basic changes in its approach to the business. Although the market provided opportunities for expansion, management decisions and capital also were necessary.

Increased industry profits helped spark a market for stock offerings by mortgage companies. On February 5, 1992, Margaretten made an initial public offering of common stock that raised more than $50 million in capital for the firm. Seven months later, the company purchased NationsBanc Mortgage Corp. of Virginia for $136.8 million.

Shortly after the NationsBanc purchase, Margaretten's servicing portfolio totaled $13.1 billion, compared with $3.3 billion just 12 months earlier. Higher income from servicing - as well as from warehouse spreads and secondary marketing - means that a much-smaller percentage of Margaretten production now is sold servicing-released. According to the firm's 10-Q statement, third quarter 1992 mortgage origination revenue was more than twice as high as it was during the same period a year earlier. But income from the sale of servicing rights dropped by more than 40 percent during that time. Because of this, the servicing portfolio can grow faster than before and provide more income during times of slow originations.

Additionally, Margaretten has actively been purchasing wholesale loans to increase its production. Wholesale volume more than doubled in 1992 from 1991, reaching more than $1 billion.

David Frank notes that a number of executives - including himself - came to margaretten from nonmortgage backgrounds. Bringing "new disciplines" to the firm meant these managers "can ask basic questions," he explains. "Yesterday's answers are not adequate for today in terms of technology, management and the use of capital."

Newcomer expansion

If this proves a trend at other established mortgage companies, then it would seem reasonable that some relatively new firms are not necessarily at a disadvantage, because they have no vested interest in operating traditionaly. Seven-year-old Plaza Funding used the 1992 market to issue its first public stock offering and expand into new markets. Jack French, board chairman and chief executive officer of the Santa Ana, California-based lender, notes that originations went from $1.9 billion in 1990 to $5.2 billion in 1992.

His expansion strategy involves "doing your homework, finding the right players and going in on a wholesale basis first an then filling in with retail where appropriate."

French noted that in the first quarter of 1992, Plaza opened an office in Portland, Oregon. By the end of the year, it was "one of the top six or seven lenders in that market." In the third quarter, Plaza went into Arizona and Florida and has plans to open branches in six more states in 1993.

Mortgage broker profits

Plaza and many other mortgage lenders got much of their production last year from mortgage brokers. Jean Alperstein, a cofounder of A.S.K Mortgage Corp., a mortgage broker firm in Denver, notes that volume increased 60 percent last year. No new people were required to handle that production, which went from $6.5 million in 1991 to $10 million last year, in A.S.K.'s four-person office, although they replaced their manual system with a computer.

Alperstein was a senior vice president in the mortgage subsidiary of a large regional bank when her division was sold almost half a dozen years ago. "They put all of us out on the street" during the height of Denver's economic doldrums, says Alperstein. With her sister and two former colleagues, she started brokering loans.

Keeping expenses low helps mortgage brokers "ride out slow times," Alperstein explains. "We've avoided the temptation, when business has been good, to expand." Although her business is quite successful, Alperstein adds that "we'd all make a lot more money" working for a big lender. "We don't make six figures," she notes.

Going public

"Capital is going to be king in the mortgage business in the next few years," says W. Gene Ross, chairman and chief executive officer of Paragon Mortgage Corporation in Smyrna, Georgia.

Having capital helps mortgage firms in several ways, adds Terry Hodel, president and chief operating officer of North American Mortgage Company in Santa Rosa, California. North American was known as IMCO Realty Services before going public last year. Hodel notes that additional capital makes "it easier to get warehouse lines," because most warehouse lenders provide credit up a specific multiple of a mortgage banker's net worth. Capital also is being used by many lenders to reduce their warehouse borrowings. More can be saved in interest costs than could be earned by investing that cash in short-term financial instruments. Because warehouse credit lines cost more than the prime rate, while savings earn under prime, it's to a lender's advantage to fund some of their warehouse needs with spare cash, instead of putting that money in a savings account.

Capital also is necessary when purchasing servicing rights and when acquiring or opening branch offices, Hodel adds. Having cash thus should increase economies of scale for mortgage lenders both in the production and servicing side of the business.

Paragon Mortgage went public when it was formed in 1989. Ross says $1.5 million was raised at that time, and another $5 million has been invested since the first offering. Investors as far away as Japan have been attracted to this traditional mortgage lender, which is seeking to originate mainly through retail outlets and to build up its $250 million servicing portfolio.

Capital advantages

Larger wholesale lenders have helped Paragon by providing warehouse funds, as well as good pricing and specific products, Ross adds. Having a net worth of more than $4 million means that lenders "can look at us in a different light than they would a small broker," he explains. Ross sees "tremendous consolidation" in the business, and he notes that mortgage brokers continually approach him wanting to merge or be acquired. Some of his branch offices used to be mortgage brokerage firms, Ross adds.

Paragon operated at a loss for two-and-a-half years - as was expected. But its stock price has risen more than 50 percent since the initial offering. Originations were expected to reach $600 million in 1992, and Ross expects them to reach $1 billion this year. Eighty percent of Paragon's production is retad and comes out of a dozen offices in six states.

Other medium-sized firms also have found new capital in the stock markets. In April 1992, First Mortgage Corporation sold 20 percent of its stock to the public and raised $5 million, says Executive Vice President Norman. First Mortgage used the cash to reduce its borrowings of warehouse credit and to open four branches, giving the firm a total of 14 offices, which should originate $450 million this fiscal year, which ends March 3 1.

Strategies for success

Operating strategies also helped foster profits in 1992. Throughout the year, First Advantage's Kocourek hedged his pipeline with "a combination of mandatory commitments and put options. We stuck by our hedging game plan no matter which way the short-term market went." He notes that refinancers would lock in a rate, but then fall out if interest rates fell 25 basis points. First Advantage decided to charge borrowers 50 basis points to apply and the same amount to lock a rate, up to a total of $1,000. This practice reduced the number of locked loans, and with it, the need to hedge.

On the bright side, Kocourek says that high volume led to "less price competition on refis. They were priced at what you could sell them for." He notes that "everybody looks like a hero this year. People who managed properly did very well. But we can't all think we're geniuses because of what happened."

One motto that First Advantage lived by in 1992 was the saying: "Don't try to steal more than you can carry. You tend to drop things," says Kocourek. First Advantage "turned business away so we wouldn't embarrass ourselves" or increase the likelihood of making a mistake in underwriting or processing.

Prepayments hurt profits

Yet prepayments reduced profits for most firms. Although "1992 was a good year, it was not an excellent year" for profits, says Arthur Harreld, president and chief executive officer of Lincoln Service Corporation in Owensboro, Kentucky. "It costs to produce loans," he notes. "The more you produce, the more you lose." Origination losses were offset by warehouse spreads and servicing income, he adds. However, Lincoln still needed to sell some servicing to boost earnings. Yet overall the portfolio grew by $250 million, for a total of $6.2 billion.

Both retail and wholesale operations expanded for Lincoln Service in 1992, with a greater emphasis on bringing retail originations above their current level of 25 percent of the total. In 1989, only 2 percent of Lincoln's production was due to retail originations. "We want to control [thel production of servicing," Harreld adds.

Harder times ahead

Lincoln Service had $2 billion in 1992 originations - nearly double its 1991 volume - yet Harreld sees harder times ahead. When rates increase, lenders will have "to cut costs as opportunities to produce evaporate," he says. "Who is going to have the foresight and the will to eliminate expenses?" He adds that "the industry has cut its own throat in pricing wars" in 1992. "What will we do if rates rise and there is less production? It will take discipline by management to not just price for market share."

Stephen Ashley, MBA president-elect and chairman and chief executive officer of Sibley Mortgage Corporation in Rochester, New York, adds that "higher costs associated with higher production are hopefully not fixed costs." Although increased volume lowered unit costs in 1992, the question that remains is, "Can we wring those costs out when volume drops? Managing is the key." Ashley also expressed concern about how the lingering domestic recession is affecting delinquency and foreclosure costs for lenders.

Finding solutions

Volume nearly doubled from 1991 to 1992 at American Residential Mortgage Corporation in La Jolla, California - reaching $5.5 billion - notes Chief Financial Officer Judith Berry. But most of the physical expansion that accompanied this production growth occurred in low-cost "satellite offices", she explains.

American Residential had 20 hub offices and 18 satellites in the first quarter of 1992. By the end of the year, it had added two hub offices and 10 satellite branches.

Costs for the satellites are kept low by having monthly leases. Loan officers drawn from the hub offices staff these branches. If volume drops at the satellite, the loan officers can return to the hub, Berry notes. Receptionists and processors supporting the loan officers are retained only if volume levels justify that expense. "Our costs haven't kept up with the increase in production revenues," Berry adds.

American Residential also went public last year and found that it was able to increase its warehouse lending lines by more than 100 percent - to $700 million - as the company's net worth grew. Capital also was used to purchase servicing portfolios and expand the correspondent purchase program - which Berry sees as a means of increasing volume without adding significantly to committed overhead. American Residential is considering purchasing a servicing operation for a second platform, she adds.

Because of warehouse spreads and secondary marketing gains, plus the economies of scale that volume brought, "fully loaded" 1992 originations were profitable at American Residential, Berry says. She added that, by comparison, low volume two years earlier meant originations were costing the industry 90 to 100 basis points. With production profitability potentially fluctuating between these extremes, American Residential's policy is to have flexible expenses and to cut costs as volume drops, Berry notes. "We expect overall market volume to be down in 1993," she says. Yet Berry predicts that correspondent lending and expansion into new regions will cause American Residential's market share to increase.

Cost cutting

California-based North American Mortgage tabulates per-loan expenses for every office on a monthly basis. All expense items also are figured in terms of basis points of cost they add to the process. In this way managers can isolate the branches that are doing different aspects of the business best and talk with them to get suggestions for running more efficiently. Hodel says the firm analyzes new locations to make sure it has a long-term commitment to them before ever opening a branch. He then puts "professional managers, not salesmen/managers" in each location. "Their job is to keep providing quality service and to control costs."

Sharing expenses also reduces costs. American Residential runs wholesale and retail operations out of most of its branches, according to Berry. In addition to being able to use the same operations staff, "typically one production source is stronger than the other at any given time," she explains.

Efficient operations don't develop immediately. John Kuczwanski, president of Loan America Financial Corporation in Miami Lakes, Florida, says starting a wholesale lending division took two years from initial planning to having a mature program. "You must have a properly developed combination of sales and operations."

Loan America kept its costs low, while originating $3 billion in 1992, by working out of just four wholesale production offices. When refinancing business fades, the company will draw business from a wider region around each of those production branches in order to maintain overall volume, explains Kuczwanski. Loan America let go some business during the boom times so that it won't have overcapacity in the future. "Because the offices don't abut each other, they are less sensitive to volume swings," he notes. "We could have doubled production, but [that] would have had consequences later."

Niche strategies

Platte Valley Funding, L. P. in Scottskbluff, Nebraska, is offering borrowers in its servicing portfolio the option of a bi-weekly payment plan. President and Chief Executive Officer Terry Malone says that 5 percent of customers who are contacted agree to the $390 application fee. "It's a virtually untapped market," notes Malone, who envisions homeowners paying off their mortgages quickly with lower out-of-pocket expenses than refinancing requires.

Platte Valley also specializes in government loan servicing. While other servicers see difficulties, "we proactively create solutions" for these loans, he says. "We're going to make a lot of lemonade out of this VA no-bid problem." Malone adds that Platte Valley is getting back into correspondent lending.

But 25 percent of the firm's 1992 earnings came from selling an interest rate hedge early in the year. It was a financial instrument that they bought as a hedge in 1991 and sold profitably in 1992. It had been recommended by one of Platte Valley's investors, and "My only regret is that we didn't buy four times the amount we bought," says Malone. "It was an insurance policy - but it turned out to be more than we dreamed it would be."

Wholesaler and servicing firm - Lomas Mortgage USA in Dallas - also is reactivating its wholesale table-funding subsidiary, says President Michael E. Patrick. A "major negative hit" last year was a reduction of investment income from escrow funds, as short-term interest rates fell, he said. High prepayment volume also increased the amount of paid-in-full interest required by mortgage-backed securities.

On the positive side, Patrick says mortgage servicing saw "a fall in price due to the amount available." If refinancing volume falls and less servicing is produced in the future, acquisition costs could rise.

Paragon's Ross suggests that wholesale firms with large appetites will bid up loan prices when production contracts. A price war" is likely if business falls off, Hodel agrees.

Last year the mortgage lending business proved that there are many ways to make money in a year of record originations. But it also showed there are many different business responses to any given situation. By choosing to expand, stand pat or adopt new strategies, what mortgage companies did last year reflected not just their vision of that year, but also of the future.

Howard Schneider is a freelance writer based in Ojai, California. He writes frequently for Mortgage Banking.
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Date:Jan 1, 1993
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