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Building business.

Through strategic planning, commercial banks can use their full-scale mortgage lending department as a profitable means to cross-sell products and help meet community reinvestment obligations.

Most commercial banks have a mortgage loan department. They see it as a part of their business and offer at least some mortgage financing for their customers. But this department should not be taken lightly.

The mortgage loan department can be a critical element to the success of a bank. It can draw in new customers, make profits and support community needs. Mortgage financing programs can go a long way toward fulfilling community service obligations now mandated by the Community Reinvestment Act. Cross-selling of mortgage loan products can greatly enhance a bank's strategic marketing plan as well. For commercial bankers who have considered setting up a full-scale mortgage banking operation, this article gives some hints on operating this department to take advantage of these opportunities.

New customers

When new customers move into town, they usually need to establish a new banking relationship. In addition, they are often looking to purchase a new home. The lender that can provide mortgage financing for them has an inside shot at their other banking business such as deposit accounts, credit cards, installment loans, commercial loans and so on. The lender that is not competitive with mortgage loan products not only loses that mortgage loan, but the customer as well.

Profitability

Unquestionably, mortgage lending has become more complex over the last five years, as many articles in industry publications have attested. This complexity causes the lender to incur more up-front costs to originate a mortgage loan.

Mortgages are a relatively homogeneous product. As a result, margins are slim for these types of loans. If a bank's overall net interest margin is around 4 percent, the margin on mortgages for in-portfolio loans can be expected to be around 2 percent (if pricing is competitive). Those loans sold on the secondary market net the lender only an origination fee and a service release premium (if the servicing is sold) or a servicing fee ranging from 1/4 to 1/2 percent if the bank continues to service the loan. This compares poorly to normal net interest margin spreads.

In addition, new accounting rules have reduced the impact of origination fees collected on mortgage loans. The majority of origination fees and other points collected for loans retained in portfolio must be amortized over the life of the loan. This reduces immediate accounting profits on mortgage loans originated.

Many mortgage loan industry experts argue that it takes at least 1 1/4 to 1 1/2 points in origination fees to cover the cost to originate a mortgage loan. Given the competitive pricing in the market today, it may be difficult to obtain this level of fees up front and remain competitive.

However, the profitability picture for mortgage loans may be much rosier than some in the industry say. Mortgages do have a narrower profit margin; however, the risk for a mortgage portfolio does not compare at all to the risk with higher margin portfolios, such as commercial lending. At Marine Bank, Springfield, Illinois, our net charge-offs have averaged less than 100th of 1 percent of the portfolio. Compare this with an average year for commercial loan write-offs.

Mortgage loans that are sold with servicing retained typically yield only servicing fees of 1/4 to 1/2 percent. The lender in most cases, however, has eliminated all credit risk, capital requirements and interest rate risk on this portfolio. Clearly, eliminating these risks has some value.

Similarly, because accounting rules concerning the amortization of origination fees and other points collected have changed, the economics have not. Origination fee and point cash flows continue to be a good, steady source of cash flow, if not accounting profits.

Finally, as to the argument concerning the cost to originate a mortgage loan, I am sure that if you were to establish a completely separate origination office for mortgage loans that was required to pay its own way for loan servicing, the sale and funding of loans, mail services, telephone systems, utilities and rent, a 1 1/4 to 1 1/2 percent origination cost would be reasonable. For most commercial lenders, however, a mortgage loan department already exists, or space is available for mortgage loan operations. The incremental costs to originate an additional mortgage loan is much less than 1 1/2 percent.

Community Reinvestment Act

Recent changes in the Community Reinvestment Act require lenders to take steps to solicit input from the community and find ways to support community needs. CRA examiners will look to see whether loans made by institutions in specific areas are proportionate to their populations of those areas. For those low- to moderate-income areas that appear deficient, the regulators will want to know what steps the bank has taken to remedy this problem.

Mortgage financing is a key component in meeting community needs. The consequences for noncompliance or halfhearted compliance with the Community Reinvestment Act are much more severe in 1991 than in years past. Home Mortgage Disclosure Act data list residential loans originated or declined and segregates these data by sex, race and income. These data for any bank are now available to the public. Lenders without a good track record for community reinvestment may find themselves unable to acquire additional institutions, receive charters for new lines of business or even close facilities or branches. They will also need to deal with adverse public opinion.

It is in a bank's best interest to make sure the mortgage loan department not only meets general housing needs but also targets the needs of low- and moderate-income groups and other disadvantaged minority groups.

The housing sector is one important part of the economy in which a bank operates. The availability of permanent financing for development and new construction, with a careful watch on the risks inherent in this type of lending, can also have a broad impact on the economic outlook for your community.

Running a mortgage operation

Now that we have established that a full-service mortgage loan department is important to a commercial bank, here are some basic points concerning mortgage loan operations. This section contains ideas based on real life experiences.

Make sure that mortgage loan officers want the client as a bank customer, not just as a mortgage loan customer. This is one advantage commercial banks have over nonbank competitors. They are able to provide additional services to customer beyond mortgage loans. As a consequence, commercial banks take a longer-term interest in their customers.

In Marine Bank's mortgage loan department, cross sales are measured for all loan officers. In addition to noting the loan volume for each mortgage loan officer, we also track and reward the sale of additional bank products. This is critical given the aggressive pricing that is sometimes required to attract mortgage loan business. It's a terrible mistake to work hard to bring a customer into the bank with a low-rate mortgage and not sell him or her additional products and services.

Another point to remember: you don't have to have the lowest rate in town to do business. At Marine Bank, we consistently hear complaints from Realtors and others that our rates are not competitive. At the same time, the bank continues to command a leading market share, with loan volumes 50 percent higher than the second-place lender.

It is important to have a broad array of products. In Marine Bank's mortgage loan department, the following types of loans are offered: construction loans, interim financing, fixed-rate mortgages (with terms from 10 to 30 years), adjustable-rate mortgages, balloon loans, biweekly mortgages, FHA/VA loans and community homebuyer programs (such as state housing development authority loan programs).

FHA/VA financing has also been added to our portfolio of products only recently. This type of financing is less profitable and much more time consuming than conventional financing. However, an important segment of the market was being overlooked. By providing FHA/VA loans in 1989, not only did the FHA/VA financing take off, but conventional volume increased as well.

When looking to take on new lines of business, it is important to invest in expertise. Marine Bank tried to learn the business of FHA/VA financing on its own. However, there is never an adequate substitute for experience. It was not until a qualified originator/-manager and processor/-closer for FHA/VA financing was added that we started to do business. There is nothing worse than making mistakes that hurt the customer when beginning a new kind of business.

Marketing mortgages

There is no simple way to market mortgage loans. Many banks have tended to mind the store and wait for business to come in to them. Bankers can no longer afford this luxury. The mortgage market is much more competitive now than in the past. It is, therefore, important to agressively market mortgage loans and pursue customers.

When deciding who the best candidates are, call on those who count. Perhaps the most important part of a marketing program is to call on spheres of influence, such as Realtors and contractors. There are some drawbacks to this approach, to be sure. Realtors no longer control a large portion of their customers for lending institutions. However, they are still the primary source of referals for new home purchases. The same can be said for contractors.

It may also be practical to offer incentives to loan officers. It is important to have some form of incentive in place, particularly when members of the department exceed a threshold level. This helps us in busy times as well slow times, because in slow times loan officers are more actively looking for additional business, and in busy times they are more likely to take a positive approach to the last customer at the end of the day.

Get referrals. It is wise to use referral sources in your bank. New customers coming to town often establish account relationships and then look to purchase their new home. New business customers that come to a commercial loan department may also have home financing needs. It is important to find a way to cull your in-bank prospects on a regular basis. Other employees in the bank may not be thinking in terms of these customer's mortgage loan needs. Also, construction loans are often overlooked for further financing opportunities. Loan officers should be following up on construction loans for permanent financing.

Despite all of the opportunity that lies within the bank, loan officers should be encouraged to make calls outside of the bank on a regular basis. Similarly, community involvement is important, such a participating in local real estate and home builder organizations. These and many other community events give your lenders good exposure.

Customer service

Another key component of a good mortgage loan operation is customer service. If at all possible, a bank should service its own loans, even those that are sold. It is frustrating to sell a loan servicing-released and have the customer contact you with problems that you have no power to resolve. We hear all too often the horror stories of customers: payment processing being transferred from one toll-free number to another, taxes being sold for nonpayment when the customer is escrowing and so on. A bank that services loans itself can control these problems.

For those loans that must be sold servicing-released, know the investor that you are dealinbg with. The best price is not always best for you and your customer. With successful cross-selling, customers will continue to do business with the bank for a long time after the original mortgage. Remember, they will hold you accountable for servicing problems whether or not servicing is under your control.

Risks in mortgage financing

Along with the opportunities of mortgage financing, there are some risks. One example is low-doc and nodoc loans. Though previously the industry had accepted certain types of loans with little or no documentation concerning the customer's employment or credit, these have proven to be a disaster in the secondary market for purchasers of loans such as Fannie Mae and Freddie Mac. Recently, however, both of these agencies have discontinued or curtailed the purchase of no-doc and low-doc loans. If your customer is not willing to share this information with you, you should think twice about originating the loan.

Providing mortgage financing for a self-employed borrower can also produce a good prosepect for commercial bankers; however, there are much higher risks in financing a self-employed borrower than someone with a standard salary. MGIC, an industry leader in private mortgage insurance, reports a claim rate (defaulted and insured loss) five times greter for self-employed borrowers than salaried borrowers. This has to do not only with the adequacy but also the timing of cash flow for small businesses. Another important predictor of mortgage loan defaults for self-employed borrowers has to do with time in business. Individuals who have been in business for less than two years should be viewed with a great deal of caution.

It is important to get adequate documentation from self-employed borrowers. At Marine Bank, we like to see tax returns on their business as well as accountant-prepared financial statements. It's ironic that in the mortgage loan department, we can sometimes obtain much more detailed and current financial information than the commercial lender's department does. With your customer's permission, you can share this new financial data with your commercial lenders. Just because the customer is being referred by a commercial loan officer, this is not reason not to check credit. This is a critical part of the process.

Community lending program risks

A community lending program is critical for your institution, given the changes in the Community Reinvestment Act. Prior to establishing a community lending program, bankers should identify and attempt to quantify the risks that they are taking on.

The programs that seem to work best in terms of borrowers stability, low default and low deliquencies are those where a community organization maintains regular contact with the borrower. For example, if the community organization has provided low interest, second mortgage financing, it may actually collect the payments and provide counselling for the borrowers. Because these borrowers probably have limited experience in financing of any kind, therefore, many community home-buying customers need to be educated, not only in budgeting for and maintaining a household.

Down payment requirements are less stringent for community lending than they are for conventional financing. It many cases the borrower obtains the down payment needed from the community or some non-for-profit organization. Bankers should make sure that the customer has some investment in the property--in the form of cash of sweat equity.

Another important component of the risk of any mortgage loan is the amount and type of equity injected into the property. At Marine Bank, we are more careful when someone else is supplhing the down payment, unless it's a family member. If a junior mortgage is used or a seller take-back is the down payment, the buyer may feel no real ties to the property. Studies have shown that the riks of default increases dramatically when the market value of the property is less than the loan balance. MGIC reports a claim rate for 95 percent loans that is three time greater than for loan to values of 90 percent or less. However, some industry experts believe that borrowers tend to hold onto a property longer if their actual cash equity in a property is substantial. For those loans that have a less-than-normal down payment, private mortgage insurance or government loan programs should be used.

Construction loans

Contruction loans are profitable mortgage financing for any lender. However, they do carry a considerable amount of risk. There are a number of areas to carefully consider, such as the expertise and reputation of the builder, and the fact that the builder and borrower should have a complete understanding of what the borrower wants in the home. We have had a number of high-dollar loans with considerable cost overruns based on changes made by borrowers during the construction process. For the lender, this may mean being forced into a permanent mortgage with higher loan-to-value than originally anticipated.

During construction, it is important to have a total cost breakdown from the borrower in advance. Insist that it be adhered to. Because of the problem of cost overruns, Marine Bank limits the loan amount on most construction financing to 75 percent or less rather than 80 percent. This give room to advance an additional 5 percent on the permanent mortgage without needing additional cash on the part of the borrower.

An important point to remember about a construction is that once you have committed to make a construction loan, you need to finance the completion of the project. There is far less risk in agreeing to lend additional dollars to get the house complete and providing permanent financing than there is in calling the project to a halt. This may not be true with commercial construction, but it's certainly true with residential financing. There are all kinds of potential problems, including lender liability, if borrowers are cut off in the middle of constructing their new home.

Investment properties

The subject of financing investment properties could fill several textbooks. Here are a couple of points that are of primary importance.

Cash equity is extremely important in invesment properties. While there may be some compassion involved in getting a buyer into a new home. Marine Bank is inflexible when it comes to cash investment in rental properties. This is a primary predictor of whether an investor walks away from a troubled property.

It is important to analyze cash flows on the property. Not only should one have a good feel for a projected operating income statement based on current rent rolls, it is just as important to get historical financial information on the subject property. Ask the seller or the borrower to provide the Schedule E for the subject property from the tax return. Large discrepancies on older properties will often be found between projected cash flow based on a rent roll and historical cash flow. This difference can only be accounted for as increases in rent over the previous period and vacancy. We have found a our market that a number of older properties appear to have excellent cash flow, but don't show up nearly as well on a tax return. This points to a problem with vacancies in these type of units and underestimated expenses for maintenance for these units.

The loan officer should go take a look at the property's condition, be aware of potential environmental hazards and look for deferred maintenance (evidence that the current or previous owners skimmed cash flow from the property). Further, assess the experience level of the person who is looking to borrow for the rental property. This is true especially for individuals who are building or buying a new rental property. Many times assumptions are quire rosy concerning occupancy, rents and expenses with first-time investment property owners.

We look for a sense of balance between the financial capacity of the borrower and the financial requirements of the project. For example, an individual earning $40,000 per year with a net worth of $30,000 consisting primarily of an IRA and equity in his residence has no business financing a $500,000 apartment project. His ability to carry the project in leaner times is very limited. You are in essence making a loan to the project.

We look to the customer's ability to service debt under distressed economic conditions for rental properties. Special consideration should be given to an individual with a strong net worth that is tied up primarily in rental properties. All of the person's eggs are in one basket. A local economic downturn can affect his or her ability to service all of his or her debt, not just yours. It is important to get a feel for the amount of leverage that this type of borrower is carrying on his or her properties and to do a break-even analysis. At what level of occupancy and rents will the investor's properties still be able to service debt?

We strongly resist any requests for cash out refinances of investment properties. Our loans are typically limited to the purchase or refinance of existing debt on investment properties only. If you do provide cash out refinancing for an investment property, be careful that you are not lending all of the borrower's cash investment out of the property. This refers primarily to small, residential income properties.

Finally, with the new FIRREA requirements for appraisals, it is clear that everyone will be receiving appraisals for mortgage financing. However, just as important as receiving the appraisal is taking the time to review it. The biggest problem that we have seen at Marine Bank in the appraisal area is in comparables. Would a potential buyer of the subject property also be willing to consider the comparable sales for purchase? If not, the comparables may not be adequate.

Environmental concerns

With the CERCLA and Sharp amendments to the Superfund, environmental concerns are on the minds of most lenders concerning commercial real estate. These concerns are usually less relevant to residential one- to four-family financing. However, some circumstances may arise that require attention. These include evidence of asbestos residences, radon levels or the possibility of leaking underground storage tanks such as old home heating oil tanks.

Summary

Mortgage loans are critical to the success of any bank. The mortgage loan department can be an excellent source for cross-selling other bank products and services. Mortgage loan financing is profitable for the bank and fills an important part in the asset liability picture. With an increased focus on community reinvestment and more stringent CRA requirements, a well-rounded mortgage loan financing program is essential in today's competitive marketplace.
COPYRIGHT 1991 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

Article Details
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Title Annotation:mortgage lending of commercial banks
Author:Hixon, Richard M.
Publication:Mortgage Banking
Article Type:Cover Story
Date:May 1, 1991
Words:3645
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