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An operational redesign.

The financial services industry is evolving at dizzying pace. Driven by computer and communications technology, as well as regulatory, legal and economic pressures, what once was a monolith is quickly becoming segmented. There has been a transformation of old "duties" into new products. Indeed, the monolithic thinking that once characterized the industry has correspondingly become "niche" thinking.

Within this sea of flux, the retail mortgage industry may seem like an island of stability. The reality is that even the mortgage industry is feeling the pressure, and those firms that continue to operate with a business-asusual mentality have become more and more vulnerable to market fluctuations, regulatory changes and competition. The mortgage industry has resisted change because the day-today operations of the typical organization have already become too complex and segmented to be managed effectively. Many of the operating assumptions on which the industry has been based are no longer valid and have little connection to the current and future industry. Nowhere is this more true than in retail originations.

This article will focus on how mortgage lenders can reduce the costs of retail originations while also offering more responsive and flexible service to the customer. To do this, mortgage lenders must "rethink" their operations and manage this cost center as a profit center.

I contend that by rethinking the entire process in the context of today's market dynamics, profitability from originations will be the rule rather than the exception. Because per-loan origination income is essentially fixed, profits can only be achieved by dramatically reducing costs. The costs per loan can only be reduced by increasing productivity.

Clearly, where cost savings, rather than profitability, is the motive, there remains much pressure to improve operating efficiencies. Firms that are more cautious about "adjusting" their costs more aggressively may want to consider many opportunities available today, such as new outsourcing services. These services can not only reduce exposure to direct costs but can also increase productivity without capital investment.

Changing conventional wisdom

The conventional wisdom in the mortgage business is that servicing earns profits, while retail originations results in losses. Those who draw a distinction about losses from originations differ only in whether to assign those losses to cost of operations or cost of sales. Indeed, many mortgage lenders are so enured to losses from loan originations that some lenders now construe it to be a cost of sales necessary for capturing the servicing. In fact, this mindset is so ingrained that, for some mortgage firms, the logical solution to a short-term cash problem has been to reduce origination activity; without even attempting to reduce the origination losses to a more manageable level.

This conventional wisdom is evident by examining The Mortgage Bankers Association of America's (MBA) 1989 Cost Study. According to the study, the typical mortgage banking organization earns revenue of about 134 basis points per loan while spending an average of 266 basis points per loan on retail originating activity. Compare this to earnings of about 42 basis points per loan while spending only 16 basis points per loan on direct servicing cost.

It would seem, then, that mortgage organizations are increasingly devoting more human, technical and financial resources to servicing than to retail originations. Arguably, that may be the only rational management decision in the offing. On the face of it, it certainly appears that servicing should be at the fulcrum of leveraging a profitable mortgage strategy.

The fundamental question: Why are so many mortgage companies spending more than two times the income on a retail loan origination, while they are capable of servicing at costs of less than one-half of direct servicing revenue? Some suggest it is because it is impossible to earn a profit on retail originations. Others suggest that it is simply because losses from retail originations are both accepted and expected - falling in the same category as death and taxes. Others write it off as the result of inflexible accounting rules that do not allow lenders to reflect the true value of originating income received.

These are all common observations by those in the business. The truth is that mortgage lenders lose money on originations because the mortgage industry was originally designed to operate in a labor-intensive environment. Today, evolving automation makes it possible to redesign mortgage operations to profitably process more loans with fewer people.

Breaking traditions

Mortgage managers have been taught to think of the steps in the mortgage process as integral - flowing in a linear fashion from origination, to processing, underwriting, closing, warehousing, shipping and delivery and finally to loan administration. This rootbound philosophy has been an industry cornerstone for decades, established in the days when only thrifts made mortgages and commercial banks did everything else.

In today's market, there is little resemblance to the market of the "good old days." Money is lost on retail originations because retail originations continue to be seen as the "front end" of an integrated and linear mortgage process. However, the forces that drive demand for mortgage originations are no longer the same forces that drive demand for servicing. Even though neither loan origination nor servicing can wholly exist without the other, they are no longer the same business.

For example, servicing is driven entirely by investor demand at two levels. First, most of this country's mortgages are originated with the intent to sell the payment streams into the secondary markets. Investors, who focus on the cash, and not the administration of it, need some entity to collect and administer their cash and security. Mortgage companies have done an excellent job of filling this niche and have created a highly profitable segment of the mortgage process around this investor-driven servicing activity. This administrative function, therefore, represents an attractive opportunity for investment when viewed in isolation from the rest of the organization.

Retail originations, on the other hand, are driven and fueled by consumer demand. Consumers view a mortgage in the simplest terms: it is the mechanism that enables them to fulfill the dream of homeownership. Consumers do not stop and think about whether or not an investor will perceive the right mix of risk and return in the cash flows that result from the mortgage obligation. Nor do they care how lenders will be affected by the latest ivory-tower pronouncement from the Financial Accounting Standards Board (FASB), or Fannie Mae's or Freddie Mac's myopic view of third-party originators.

If running a profitable business demands structuring that business around the wants, needs and motivations of the customer, it follows that the way to run a profitable retail origination operation is to structure that business around the wants, needs and motivations of the homebuyer - just as factoring in the needs of the investor is the logical way to run a profitable servicing operation.

Finding a profitable strategy

Because the market demands of homebuyers and investors are completely unrelated, a mortgage business strategy that compromises these two positions may be doomed to fail. Compromise strategies, even if unintentional, are the inevitable result of the standard linear process flow, in which a full-spectrum mortgage organization attempts to bridge an imagined gap between the homebuyer and the secondary market investor. However, because these two parties have absolutely no relationship, there is no bridge to be built. To serve both areas well is possible - but only when separate processes are designed that address each on its own terms.

To begin the task of redesigning the processes, the long-outdated integrated linear process must be entirely abandoned. A properly designed mortgage business strategy begins with the idea that at least three separate businesses exist: loan origination, origination operations and loan servicing.

Economies of scale are both possible and practical in retail originations. Among those lenders who have a contemporary view of retail origination strategies and are enjoying economies of scale - it is evident that building a profitable retail origination business requires treating retail as two core businesses: loan origination and origination operations.

The most compelling reason to design the retail origination business around the concept of two separate profit centers is because the objective of loan origination is to take applications, while the objective of origination operations is to close loans that investors will buy. These objectives are not compatible.

A second reason to treat these two parts of the retail origination area as separate cores is because loan origination may be managed around either dollar volume (although it is less and less useful to do so) or units originated. Origination operations, like servicing, concerns itself with units, not dollars.

Third, the productivity (based on loans per employee per day, week, month or year) performance of origination operations versus loan origination is radically different when each is measured in isolation from the other.

The conventional wisdom that no opportunity exists to achieve economies of scale in retail may be true for loan originations. However, this is definitely false when it comes to origination operations. A 1991 internal management study conducted by Citicorp Mortgage, St. Louis, found that its centralized operations environments were capable of performance rates of 122.45 loans per employee per year. Most of the performance increase over the industry average of 35 loans per retail origination employee/per year, (MBA 1989 Cost Study) results from a myriad of benefits created by economies of scale. In fact, if viewed as unrelated to the loan origination area, origination operations can be run at the same levels of productivity now commonly achieved in servicing operations.

From the origination operations perspective, a loan is a loan is a loan. For processing and underwriting functions, it doesn't matter at all if the loan was originated in New York City or Nome, Alaska, or if the loan amount is $25,000 or $500,000, or if the loan was originated by an employee loan officer or by a third party. As a result, it makes absolutely no sense to process or underwrite from every location that originates loans.

The one area of origination operations that is location-sensitive is closing - but only at the level of closing documents and the settlement itself, not closing coordination. From the closing coordination perspective, loan size or application source is again irrelevant.

Processing: at home or afar?

The debate about whether to have centralized, regionalized or localized processing occurs frequently at virtually all mortgage companies today. Loan originators who persist in the belief that "having local processing is important to their customers" are likely to be guilty of spending insufficient time building relationships and taking applications or wasting time with poor applications. Mortgage brokers, once the sole source of so-called third-party originations, cannot determine where origination functions are handled because they do not perform most of those tasks themselves.

Loan officers' concerns about where, or by whom, originations are handled, also comes from a lack of understanding of origination operations functions. The basics of processing and underwriting are concerned with verifications, credit reports and appraisals. In fact, verifications are obtained by mail and telephone regardless of where processors are physically located. Credit reports, no matter which bureaus are used, are accessed by data-link terminals, telephone or mail - no matter where processors are physically located. Appraisals are performed at the subject property by an appraiser familiar with the local market and never in the offices of a lender.

Even in the closing process, the lender relies on telephone, mail and courier services except for the actual production of closing documents and the formal settlement. Indeed, insofar as the borrower, loan officer or average Realtor knows, the loan closing process is always performed by a settlement agent domiciled in the jurisdiction in which the loan was originated. And when a settlement agent is involved, it is most often one who was not selected by the lender. For borrowers, it is immaterial whether originations operations are centralized, so long as the approval for the loan on their dream house comes though.

Forging a new path

To take control, a good first step is to centralize originations in one physical location - just as most retail enterprises handle servicing operations. Once centralized, originations must be re-oriented, not just to take full advantage of economies of scale but also to reflect that the loan closing is the real center of gravity for all other aspects of the mortgage business. Rather than following the old linear path, mortgage bankers who are open to a new way of thinking can establish a pre-closing and post-closing phase - each a discrete, closed loop with separate goals.

The goal of the pre-closing loop is to efficiently identify applications that fit investor standards, so that those loans can close quickly. The goal of the post-closing loop is to efficiently and quickly move closed and funded loans out of the warehouse line and into the hands of investors and their servicers.

To attain these origination operations goals, pre-closing and post-closing must be viewed as communication and information-management processes that use quality control as a benchmark. These steps are not simply the paperwork exercises that mortgage companies have persisted in making them. Paperwork exercises are inherently labor-intensive, and consequently, are less productive than information- and communication-management functions. From the standpoint of a rationally configured origination operation, the paper drill is necessary only to document the actual event or task. The point of all pre-closing and post-closing activity is not how much or how quickly paper is shuffled; rather it is how efficiently and professionally information is communicated and managed.

In fact, labor-intensive paper or database-dependent functions such as credit reports, appraisals, closing-document preparation and settlements can be handled by third-party contractors. Use internal staff to manage and coordinate those contractors.

Most mortgage lenders already use third-party contractors or vendors to "outsource" credit reports, appraisals and settlements. Increasingly, many are also outsourcing document preparation. Typically, an outsource vendor's fee is passed along directly to borrowers and sellers, rarely raising an objection on the part of borrowers because the work is actually performed by this third party. Objections to fees assessed for document preparation, credit reporting, appraisal or inspection, closing review and the like, are raised only when the lender views it as an opportunity to increase operating revenues, or in circumstances where there actually is no third party performing the task.

Productivity gains

As with outsourcing appraisals, the real beauty of outsourcing closing-document preparation is in making it a "value-added" service that is reimbursed directly by the borrower. Handled this way, the lender is totally and entirely liberated from all the costs associated with mustering internal resources to perform the function. In these areas, an origination operation gets both relief from direct costs and collateral savings through productivity increases (which will reduce the 266 basis point per loan average cost while boosting that 35 loans per employee per year productivity rate).

Having outsourced eligible functions, staff who used to handle originations as "extra duties" are free to concentrate on important tasks associated with collection, review and communication. Moreover, once the operation has been centralized, automated processes can be set up at a far lower cost.

Interestingly, those who sought to automate without reorganizing have become "computer-bound," with productivity gains offset by direct equipment and software costs, training expense and the distraction of staff from revenue-generating activity. While automating a properly sorted-out process is critical to productivity, automating an outdated and inefficient process is an exercise in futility.

By combining the elements of outsourcing, process redesign, centralization and effective automation, productivity per employee in origination operations can be set and managed around 360 to 420 loans per employee per year as an initial base to build upon.

Around the next bend

To be an effective, efficient and profitable industry in the next century, the mortgage business must recognize and yield to the pressures of today's investor and consumer marketplaces. The mortgage industry must also recognize that specialization of tasks and functions are a natural and exorable consequence of an economy driven by service and information needs.

In a changing mortgage business where specialization is increasingly commonplace, companies that use centralized origination operations are now a reality. Often, subservicers, foreclosure specialists and other servicing outsource organizations can further reduce the costs of managing the servicing portfolio.

Because warehouse line providers and secondary market conduits control the dollars anyway, all the other players in today's mortgage industry are, in a sense,outsource vendors of some sort. Just as the secret to cost control in any business is improving productivity, the secret to profitability is being able to concentrate on delivering what the customer really needs.

Mark J. Muratore is managing director and corporate secretary of F&M Docset, Inc., a provider of operations services based in Fairfax, Virginia.
COPYRIGHT 1992 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Title Annotation:mode of operation in today's mortgage industry
Author:Muratore, Mark J.
Publication:Mortgage Banking
Date:Jun 1, 1992
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