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Compensation strategies.

Commercial mortgage banking industry executives must design compensation programs that complement their firms' overall strategic plan.

Effective compensation programs must be an integral part of achieving competitive advantage for a commercial mortgage company in today's difficult environment. The proper compensation program can retain and motivate top performers while also ensuring the efficient production of net income to the bottom line of the business. Compensation is one of the most critical organizational elements that propels a commercial mortgage banking firm to success. In light of dramatic reductions in loan production volume as well as new demands placed on mortgage banking firms for additional services by traditional life insurance company clients, a re-evaluation of compensation programs is in order.

Sensitivity to market conditions

Most commercial mortgage banking executives believe the industry will experience reduced production throughout this year and next. Today's commercial mortgage lenders are either extremely conservative or they are leaving the market altogether. While many mortgage executives believe institutional investors are now in a better position to solve their commercial mortgage problems, the industry will continue to experience difficult times for the foreseeable future. However, the long-term future for real estate will depend on how insurance company executives manage their total investment portfolio.

Investment in real estate, relative to other investments such as equities and fixed-income instruments, is undergoing redefinition. The changing product mix of insurance companies is creating a need for liability matching with vehicles more liquid than real estate. This suggests that the role played by real estate may be diminished within the total portfolio of invested assets for insurance companies. The most active sector of the mortgage business will be the rollover of existing mortgages. There will be minimal construction lending over the next few years due to overbuilding in most major markets.

There are several critical issues facing the commercial mortgage banking industry that should be factored into a review of current compensation programs. First, loan production volume will likely remain at far lower levels than in previous years. Smaller loans will dominate the business. There will be fewer large transactions, therefore CEOs for mortgage banking firms must restructure their operations to become more efficient in handling a greater volume of smaller transactions. These smaller transactions will require equal or more time and resources to originate and close relative to larger deals. This suggests that greater resources will be required to handle business that will produce less revenue.

Second, the correspondent system is still viable and essential for the business, particularly for smaller insurance companies that understand and appreciate the need to have field representation. While many large insurance companies are out of the market, smaller insurance firms, many of them based in the Midwest or Canada, continue to make small loans and spread their risk in the process. Maintaining excellent relationships with these organizations will be critical for commercial mortgage bankers, and compensation programs should be structured to promote a relationship approach to the business.

Also, mortgage bankers are looking to expand their capital relationships beyond the life insurance industry, to focus on other long-term sources of capital such as pension funds, foreign investors, mutual funds and securitized pools of capital. This suggests a future environment where relationships with entities outside the life insurance industry will be of paramount importance, as mortgage bankers seek to diversify their capital sources. Compensation programs should be designed to promote the development of relationships with these new sources of capital.

Another critical issue is that mortgage bankers must present their investors with transactions of the absolute highest quality, which are supported by a tremendous amount of up-to-date market information. The analysis of property values is of primary importance of the investor, and mortgage bankers provide an essential service in this regard. This does, however, require a certain skill set that compensation programs must accurately reflect.

Further, according to a recent Ferguson Partners survey, a majority of mortgage banking executives believe that the correspondent/servicing relationship is out of balance relative to the current fees for the work required. Many executives in the industry, including representatives from insurance companies, suggest that some additional compensation might be structured for property inspections, appraisals, valuations and document reviews that are required to maintain control over both performing and troubled loans. A few executives proposed the idea of offering insurance companies "cafeteria-style" service, where fees would be charged for additional activities above and beyond the traditional servicing relationship. While this aspect of compensating mortgage banking firms is in a transition phase, a long-term emphasis can be placed on this topic, as compensation programs are redesigned for the industry.

Strategic responses

In the current environment, a majority of mortgage banking executives are focused on sticking to their knitting; remaining a classic mortgage banker. According to our research, many top executives in the business continue to focus their organizations on insurance companies and are giving maximum effort of expanding their existing relationships, while making sure no surprises occur in their correspondent portfolios. With this approach, mortgage bankers are configuring themselves to provide their correspondents with exactly what they need. Therefore, production staff must be extremely precise in providing the right kind of product and services to life companies, and compensation programs must be designed to ensure this responsive behavior.

While mortgage banking executives are concentrating on enhancing their existing relationships with correspondents, diversifying to provide new sources of revenue will be essential for long-term growth. Diversification will enable mortgage bankers to provide complementary operations to their corre- spondent relationships. Under serious consideration by many industry CEOs are these commonly considered diversification alternatives: pension fund advisories, equity placements, asset management, foreign client advisory, workout services and consulting. As diversification is analyzed, compensation programs can play an important role in promoting cross selling and developing business from a multitude of capital sources.

Compensation's role in the corporate strategy

It is important to understand that compensation programs alone cannot ensure a firm's success. From a business policy perspective, the commercial mortgage banking firm must have an effective strategic plan coupled with the right organizational design. Compensation programs are but one component that make a firm successful.

To deal with the challenges of the current marketplace, the mortgage banking firm must revisit its current strategy. A formal strategic planning process is often helpful in this regard. The result of a strategic planning program will ensure that the CEO and senior management team are equipped with a mission statement for the firm, the company's long-term objectives and an action plan for the company that can be communicated throughout the entire organization. It is critical that the formulation of the firm's strategy precede all discussion about organization--including compensation.

To properly execute a strategic plan, the right organizational elements must be put in place. The most critical organizational elements for a commercial mortgage banking firm include: defining job roles for production staff, senior management and administration groups. It is also important to have appropriate reporting systems, information systems, financial controls, recruiting policies, managerial development systems and compensation programs in place, all of which should follow the overall strategic corporate objectives. Within this framework, compensation system play a critical role in determining the success of a commercial mortgage banking operation.

Designing a compensation system

Modifying a compensation program within a commercial mortgage banking operation is a highly sensitive issue. CEOs must be prepared for the reactions they may receive in implementing compensation changes, given that the prime assets of the organization are predominantly its own people. With this in mind, the following basic steps can be followed in reviewing and modifying a firm's compensation system:

Organizational structure--The successful implementation of a mortgage banking business strategy requires the appropriate organizational framework to execute the plan. The organizational design of the company must reflect and support the basic strategy for the firm. Reporting relationships, feedback mechanisms and managerial control systems must be designed to configure and direct the mortgage banking staff. Additionally, the functions of servicing, asset management and administration must be structured within the framework of the overall organization.

Job definitions--Once the commercial banking firm has totally defined its strategic business plan and organizational structure, this will drive the job design for certain roles within the company. For most mortgage banking firms, typically this involves delineating responsibilities for production staff in three basic levels: trainee, junior producer, and senior producer (See Figure 1).

Administrative functions for jobs involving servicing are defined separately, as are other support roles within the firm. Once a basic identification of each important function within the company is made, detailed job descriptions can be written which define the responsibilities, qualifications, and experience levels required for each position. Thereafter, job levels can be structured for certain job functions, thereby creating a career ladder for positions within the firm.

Base salary versus commission--A decision to implement base-salary programs versus straight-commission programs will generally be determined by the firm's chosen business strategy. Given the most mortgage banking operations are committed to a relationship approach to servicing institutional investors, base-salary programs are essential to encouraging the right type of production. Straight-commission system may encourage production staff to work independently, and with less objectivity, given the need to earn ongoing income to support one's lifestyle. While this approach is consistent with keeping salary levels at a minimum, there are detrimental aspects to such a system for servicing long-term relationships with institutional clients. Therefore, base salaries remain a favorite approach to compensating the work force.

Salary determination--For each defined job description within the firm, a median salary should be formulated to serve as a midpoint for a range that provides salary boundaries for the position. Prior to determining salary midpoints and ranges, a market study should be undertaken to determine compensation levels for the position relative to industry trends and variations in job responsibilities. Once market levels are established for these positions, median salary ranges can be determined specifically for the firm. For example, the role of junior producer may be determined to have a median base salary of $40,000. Once this median is established for the position, a range can be structured around this midpoint figure. Typically, salary ranges should not exceed 50 percent of the salary median. Using our example, this would create a maximum salary of $50,000 for the junior producer, and a minimum salary of $30,000. This provides certain flexibility for structuring the salary for incoming production staffs, such that the base salary can be adjusted according to the experience level and production capabilities of candidates for the position.

Incentive programs--A recent survey by Ferguson Partners indicated there is a tremendous variety in the specific features of incentive programs among commercial mortgage banking firms. This variety is found in the calculation of threshold levels for mortgage production staff, the timing of incentive payments, the availability of subjective bonuses and compensation for the production servicing income.

While there is tremendous variety in these incentive elements, the mortgage banking industry remains committed to structures in which base salaries are multiplied by factors in the range of two times, or two-and-a-half times, to determine a threshold level, beyond which incentive compensation is paid to the producer. The key question regarding these formulas is whether they sufficiently cover the cost of operations and profit requirements of the firm. The concept behind establishing threshold levels is to achieve a level of basic cost coverage for the mortgage banking entity, while providing meaningful hurdles beyond which production staff can participate in pay-out levels.

An analysis of cost structures suggests that the 2.5 multiple adequately covers the more direct costs of production. Pay-out levels themselves are also subject to a great deal of variety across the industry. Initial pay-out to producers who have exceeded their threshold level typically begin in the 20-percent- to 25-percent-of-fees-collected range, scaling upwards to a 40-percent to 50-percent payout, once the producer achieves production volume upwards of $300,000.

Changing to straight commissions

Across the mortgage banking industry, many senior executives are asking themselves whether this is an appropriate time to change to a straight-commission system. Based on our research, we believe the chosen strategy of most mortgage banking firms is best served by continuing with a base salary/incentive program, in order to appropriately serve the ongoing needs of institutional investors. The institution using a straight-commission system has several disadvantages, including the fact that many important employees might be lost when the conversion occurs.

Second, the ability to control the production sales force toward predetermined objectives--typically designed to ensure institutional investors' needs are being met by the firm--tend to become more difficult as commission-based producers act independently to achieve their highest levels of personal earnings. We believe other cost-cutting measures are more appropriate, such as freezing salaries, or reducing salaries to a certain extent, to ensure the retention of key employees, while maintaining cost control of salaries. Other cost-saving measures may be implemented, such as renegotiating rent, downscaling perquisites or arranging for sharing the cost of employee benefits. Relative to other cost-cutting measures, the CEO of a mortgage banking industry may critically review the number of producers required by the firm and may elect to reduce the production workforce or reallocate production staff to other salaried positions such as asset management or property management until the market rebounds.

New compensation systems

Once the CEO has established job descriptions, salary midpoints and salary ranges for each position within the company, often changes must be implemented to update the current compensation program for production staff.

In some cases, production staff may currently be receiving base salaries that are deemed to be in excess of the defined ranges for the position, while in other cases the employee might be undercompensated. Basic decisions need to be made in adjusting these salary levels, but immediate adjustments could result in employee defections for those producers being downgraded. Rather than cut the salary immediately, the CEO may elect to "redline" the employee, thereby freezing the salary until such time as it falls within the salary range. Or, alternatively, the salary can be gradually adjusted upward or downward over, say, a three-year time frame.

Subjective bonus systems

While most mortgage banking firms are committed to incentive programs that are entirely objective in nature, many firms are establishing systems whereby bonus pools are created from teamwork activities. These bonus pools can then be distributed on the basis of both objective and subjective determinations. This encourages cooperation and joint effort among the sales force to create revenues that are then shared at year-end on a subjective basis.

The determination of bonus amounts for each employee is typically the decision of an executive committee. The committee awards each employee a bonus based on merit and overall contribution to the team effort. This type of compensation system will likely grow in the future, as the needs of the clients of the mortgage banking firm grow in complexity, requiring team-based solutions. A few mortgage banking companies have established incentive systems that are partially based on objective bonus calculations, with the remaining component determined by subjective bonus awards.

Senior management compensation

Depending on the job structure for the senior management position, base-salary levels tend to be augmented by incentive systems that are based on group performance and branch or unit profitability. This ensures that the senior executive is motivated to generate increasing amounts of revenue, while also focusing on the bottom line of the operation. Seldom do senior managers participate directly in transaction revenues, because this may tend to create a competitive environment in which the senior sales staff limit its reliance on upper management. In fact, this relationship should be fostered to better service institution clients. Generally speaking, compensation systems for senior managers should be oriented toward developing new business and pursuing new capital sources for the firm.

Supporting the corporate strategy

As CEOs of mortgage banking firms review their compensation programs, they must ensure that such programs are entirely supportive of their corporate strategy. Given that most CEOs are committed to maintaining and expanding their key relationships with the lending community, base-salary systems appear to be an essential component of future compensation programs. While commission systems may result in cost savings, they may prove detrimental to achieving corporate objectives. Of course, certain cost-cutting measures can be undertaken to freeze or marginally reduce base-salary levels, as can reducing the size of the production workforce. However, the basic system of base salary and incentive formulas should remain in place.

Changes to compensation programs must be carefully thought out to avoid drastic modification which will encourage defection of key employees. CEOs should begin with a complete understanding of the corporate strategy and organizational structure before commencing with modifications to their compensation programs. When properly designed, a compensation program will ensure a profitable future for the organization, a happy workforce and the attainment of predefined corporate objectives. It will enable the organization to withstand current pressures, while positioning for long-term relationships with key clients. William J. Ferguson is chairman and John F.C. Parsons is managing director of research for Ferguson Partners, Ltd. based in Chicago.
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:Corporate Management
Author:Ferguson, William J.; Parsons, John F.C.
Publication:Mortgage Banking
Date:May 1, 1992
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