Printer Friendly

In search of real mortgage bankers.

Has a herd mentality toward wholesale and correspondent loan originations trampled the traditional structure of mortgage banking?

It is no secret that the strategies for loan origination have changed. Any number of companies have turned the corner from retail to wholesale originations or purchased servicing. Thus, the question begs to be asked: "Are there any |real' mortgage bankers left?"

The term "mortgage banker" has, until recent years, referred to a company with limited capital, external warehouse relationships, internal originations and retained or released servicing rights; in short, a fully integrated loan origination company. The focus of the firm was to originate, process, fund, market and service mortgage loans. Competition came primarily from the savings and loan industry. There were few bank-owned mortgage companies or mortgage conduits. The domain of the mortgage banker was the government loan and the conforming conventional loan. Portfolio lending was done by local savings and loans. The main disadvantage for mortgage bankers was the need to have an investor for every loan produced, while the local savings and loan could hold the loan for investment in its own portfolio - and most did. Mortgage loan conduit companies did not exist because there was no secondary market vehicle for them.

This scenario sounds like ancient history today, what with the dramatic demise of the portfolio lender, the influence of bank-owned mortgage companies, the emphasis on wholesale and correspondent lending and the mortgage loan conduits. Loan origination has shifted to the small mortgage company or loan brokerage. Many of today's major industry participants did not "grow up" in the industry. Most are "johnnie-come-lately" entrants, enticed by accounting considerations and loan servicing trading below its economic value. Many CEOS of major mortgage banking firms have never originated, marketed or serviced a loan in their mortgage banking career. They have been promoted from a financial company parent or even a nonfinancial company parent.

This is not to say these executives are not suited for their roles; however, it points to their lack of firm roots in this industry. They cannot possibly understand the nuances or practical problems that are faced daily by those employees who work under them, several management levels down. These CEOS look at servicing growth as just a "make or buy" decision, and many are erroneously concluding that buying is better.

Moving away from self-origination to other channels of loan acquisition seems to be the strategic direction for the large mortgage company that wishes to service mortgage loans. The common reasons for leaving the retail origination arena point to the demise of the "real" mortgage banker - the entrepreneur that forged this industry and made it the vital business it is today.

Disadvantages of retail originations

A number of mortgage bankers that have had active origination branches have closed or sold their operations. They say they are pursuing "a new strategy." What they really mean is that they cannot figure out how to make loan originations work in a cost-effective way.

The reasons commonly cited for this shift in strategy away from retail originations toward other forms of loan acquisition are because: * it requires a large investment in

fixed assets and human assets; * building significant volume takes

time; * retail requires more hands-on

management; * the costs associated with retail production

must be expensed monthly; * the net cost to produce often exceeds

the servicing-release value of

the loan.

Many of these objections to retail loan production have merit, but the "real" mortgage banker knows that the advantages far overshadow the disadvantages, and several of the disadvantages can be managed, such as the high net costs to produce. Furthermore, one must remember that all loans are originated at the retail level by someone.

Advantages of retail originations

The real mortgage banker knows that there are more advantages to retail loan production than disadvantages. The real mortgage banker is an entrepreneur and has developed the expertise to make the business of loan origination a profitable one. Several of the advantages for originating loans are: * the cost to produce can be significantly

lower than the servicing release

value of the loan; * the quality of the loan is typically

better than purchased loans; * the yes/no decision is made on

every loan before it is closed; * the flow of business is steady and

more predictable; * pricing considerations and concessions

are made at the point-of-sale

not at a more general level (i.e. the

price sheet level); * hedging costs are lower, due to

more predictable fallout; * company employees perform all

functions, not just a few (lessening

the likelihood of fraud); * agencies are biased in favor of self-originations

and against third-party


Loan acquisition

Once a lender makes its exit, it is difficult and expensive to re-enter the retail origination arena. If all mortgage lenders decide to "buy" their loan production rather than originate it, the point-of-sale will be surrendered to others. To be able to control the cost of acquiring high-quality mortgage servicing, it is mandatory that a lender maintains control over the cost of the loan from the beginning of the lending process. The loan acquisition arena is a crowded one and continues to gain participants. Who will be left to originate the loans? At some point, those that originate the mortgages will be able to command higher and higher servicing-release premiums, as loan purchasers "bid up" the price to get the product and to achieve their budgeted volumes.

There are several methods of acquiring mortgage servicing: wholesale, correspondent, assignment-of-trade (flow) and concurrent transfers, to name a few of the most common. Assignment-of-trade and concurrent transfers are really "buying servicing," not loan originations. It is ludicrous to even mention them as mortgage banking activities - somewhat analogous to calling someone that buys a new home a builder.

Acquisition channels

We will now examine the motivation for acquiring loans through either a wholesale or correspondent channel. For discussion purposes and to clear-up different understandings that exist from region to region, for the purposes of this article, "wholesale originations" will mean loans acquired with no servicing-release premium and closed in the servicer's name. "Correspondent lending" will refer to buying closed loans and paying a servicing-release premium, whether buying one loan at a time or by commitment.

Of the alternative origination methods, wholesale lending is the closest to retail originations. The only elements missing are the application and processing phases. While it has been stated that this is a no-servicing-release-premium business, there is, however, one implied most times when pricing the loan at the "price-sheet" level. This is caused by competitive forces requiring pricing below cost. A problem with this type of loan origination is that there is limited income, because the originator keeps the loan origination fee. Any pricing concessions, which are really implied premiums, cannot be capitalized but must be expensed. Only well-managed and properly scaled operations can produce wholesale loans efficiently and below their economic value. Next to retail originations, this activity is most like mortgage banking.

Correspondent lending (premiums paid) makes the least sense of all. Why would anyone who wishes to make a profit from servicing loans pay close to, or the full economic value for, a loan to acquire it? The servicing-release premiums being paid today by the largest of the correspondent lenders approach, and may exceed in the case of conventional loans, the economic value of the loan being purchased. (Would anyone several years ago have believed that a 10 percent loan would be refinancing two years later?) The justification for these premiums is often a result of using a marginal costing analysis for modeling the servicing returns. Certainly it is appropriate to use marginal costs, if excess capacity exists in the servicing function, but there are step-cost functions that must be considered. Often those modeling the acquired loan are also the ones being compensated for acquiring them. Therefore, it may be compensation considerations influencing the pricing scheme.

When asked, most correspondent lenders cite the low cost of origination as the reason they are in this line of business. If one were to isolate only the costs associated with the acquisition activity, this would be true. However, the servicing-release premium must also be considered. When you add the servicing-release premium to the "hard" costs of operating the loan purchasing business unit, the resulting all-in costs make realizing a profit margin less likely. Only the least efficient of retail originators have higher costs.

The fact that the premium cost of acquiring a loan can be capitalized on the balance sheet, and need not be expensed when paid, is what drives this business. Rarely are decisions made for tax avoidance or current book earnings economically correct ones. The reasons driving the decision to be in the correspondent lending business are often not related to being in the loan servicing business at all, but are rather to exploit a large interest margin due to cheap sources of funds, or cross-selling opportunities, or free escrow deposits and the like. These are all valid and good reasons to be a mortgage servicer, but they should be synergistic benefits, and not sole reasons for entering the industry.

Another reason often cited for paying high servicing-released premiums, is "economies of scale." This is a tired excuse. In fact, there are fewer economies once a company is servicing more than 100,000 loans. The greatest impact to servicing efficiencies, which in turn, creates greater spreads, is higher quality loans. Lower delinquencies rather than higher volumes of loans serviced create higher earnings. Once again, originating your own loans leads to higher loan quality, and thus, higher profitability.

Efficient retail loan originations

The economic reasons for self-origination are powerful. Ignoring accounting considerations and the present value of the cash flows, a cash-on-cash analysis shows quite dramatically the economic advantages for originated versus purchased loans. A retail loan can be the most cost-effective and the highest quality loan one can put into the servicing portfolio. It is hard work creating a low-cost production operation, but the returns are much higher than the thin margins associated with purchasing loans servicing-released through a correspondent lending operation. The entities best suited for a purchase program are those with a very low cost-of-funds so that there are ancillary benefits aside from those generated by net servicing revenues.

Let us look at the payback or breakeven point for two identical loans; one, originated at the retail level at a cost of 75 basis points; another, purchased for a servicing-release premium of 125 basis points, with a cost of acquisition of 25 basis points. We will ignore the present valuing of the cash flows for this analysis. The other assumptions are rather simple non-esoteric ones: the loan is a conventional, fixed-rate $100,000 mortgage, with no escrows and 25 basis points of net service fee. The cost to service this theoretical loan is $65, with the costs escalating $1 per year. Given these assumptions, it takes three years to recover the cost of originating this loan (See Figure 1), while it takes eight years with the purchased loan (See Figure 2). Whether the assumed cost to originate is higher or lower for your company, and whether the cost to service this loan is higher or lower than shown, the net effect is going to be the same. The payback will always be better with loans produced from an efficient origination operation than from loans purchased paying a servicing-release premium.

The keys to effective and low-cost retail loan originations are: * maintaining few layers of production

management; * getting branch managers involved

in cost control; * setting up performance-based compensation

plans; * making sure branches have scales

of operation appropriate for their

markets; * having short-term leases, to ensure

flexibility; * training all branch employees to be

involved in originating, processing

or closing loans.

The zeitgeist of mortgage banking

With the reduction in competition for the residential loan caused by the drastic decline in savings and loan's involvement, the future for the mortgage banker has never looked brighter. In 1991, mortgage bankers emerged as the dominant home mortgage lender. Buried in this phenomenon is the dynamic of a changing mortgage banking industry. The mortgage banker of today and tomorrow may be primarily a buyer of mortgage servicing, having surrendered the origination arena to the servicing-release originator and the loan broker.

Retail originations is still a viable method of acquiring and building a high-quality, profitable servicing portfolio. It would be a sad day for this industry, if one day we look around and wonder, "Where have all the |real' mortgage bankers gone?" Their entrepreneurial spirit must have been trampled by the herd mentality of becoming a buyer of servicing and not an originator.

John J. Jacobs IV, CMB, is executive vice president of production and risk management of BancPLUS Mortgage Corporation in San Antonio, Texas.
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.

Article Details
Printer friendly Cite/link Email Feedback
Author:Jacobs, John J., IV
Publication:Mortgage Banking
Date:Jun 1, 1992
Previous Article:A balancing act.
Next Article:Here and now high-tech.

Related Articles
Stocking a full line.
Better boards.
From waiter to rainmaker. set to launch.
Attract more money for mortgages: establish your own trust company--operate like a bank--raise substantial funds to originate and purchase mortgages.
Secured Funding integrates VMP fraud solution.
A rising tide?
Optimal Blue, Ellie Mae form strategic partnership.

Terms of use | Copyright © 2016 Farlex, Inc. | Feedback | For webmasters