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King of the Hill.

Top originators and servicers can't stay on top for long in the wide-open competitive world of mortgage banking today. Industry rankings show what the topsy-turvy world of mortgage banking does to those pursing aggressively competitive strategies.

MOST READERS WILL REMEMBER THE CHILDHOOD GAME, King of the Hill. One youngster would capture the top of a rise and defend it against all comers. He or she would not remain "King" for long, however. Someone would come up from behind, or a pack would attack all at once, and a new king would be crowned to take on the next surge of would-be royalty.

Since 1980 and the deregulation of mortgage finance, that little game aptly describes the financial services businesses--particularly residential lending. Prove it to yourself by examining the rankings accompanying this article. Figure 1 shows the top mortgage originators during the 1980s and the 1990s. Note the new names and changes in rankings from year to year. More significantly, formerly prominent organizations drop completely from the list. Firms like CityFed Mortgage, Goldome and Weyerhaeuser--industry leaders in the 1980s--are not to be found on the leader board in the 1990s. With different leaders every few years, you can see why King of the Hill is the name of the game.

Although we do not have rankings of mortgage originators from 1970, those of us who worked in these markets back then knew the leaders year after year to include Lomas and Nettleton, Advance, Colonial, Kissell. They were the firms that hosted the grandest dinner parties during the Mortgage Bankers Association's conventions.

Data on mortgage servicing does exist for the 1970s and appears in Figure 2. You will find many of the same firms staying in the top 10 during the 1970s. But, by the 1990s, change rather than stability seems to be the order of the day. And this is true despite the existence of economies of scale and the aggressive drive for size and market presence that has prevailed in the servicing area.

Reading the corporate goals announced by fast-growing firms in the trade press, one can expect companies such as American Residential, Capstead and Plaza Mortgage to challenge today's Kings of the Hill--as change in the top ranks of the industry seems to have become a given.

Patterns in other deregulated businesses

Inspection of top 10 lists for both thrifts and commercial hanks, by asset size, shows a remarkably similar pattern. The stability in industry leadership that marked the 1960s and 1970s was replaced by major changes in the composition and rankings on the industry leader boards during the 1980s. For example, among thrifts, in 1986, American Savings, Meritor, Goldome and Great American of San Diego were in the top 10. By 1989, all were gone.

Among commercial banks ranked by assets, the top five historically were Bank of America, Citibank, Chase Manhatten, Manufacturers Hanover and Morgan Guaranty. By the 1990s, Chemical Bank and NationsBank were in the top five, and the earlier order was reshuffled. The airline and trucking industries, along with other deregulated fields, show similar competitive patterns.

One final figure before exploring the forces behind this phenomenon. Figure 3, compiled from data taken from the industry newsletter Inside Mortgage Finance, lists all the residential loan originators that appeared in its top 25 rankings in any year between 1986 and 1992. (The rankings on this table differ significantly from those in Figure 1 because one is based only on production volume by mortgage banking entities while the other includes originations by banks, thrifts and mortgage banking firms.)

Nevertheless, if you just compare the yearly change in rankings for companies using only Inside Mortgage Finance numbers, you can quickly see how many of these companies bounced around in the production rankings. Note how many "OFFs" appear on the sheet. "OFF" means the firm tumbled down the leadership hill (coming in under the top 25 originators).

The conclusion: The competitive pattern in the mortgage lending business has changed dramatically since 1980. Mortgage banking is a tough business. Leadership is fraught with new perils. What once was a business where the ranks of industry leaders stayed relatively stable, has become a business where change is the only constant. Newcomers vault into top production positions virtually overnight, and traditional leaders can find themselves quickly eclipsed.

Managers and capital contributors would do well to understand the forces that are creating these volatile patterns in mortgage lending. Those seeking steady growth and stability have some work cut out for them.

The new competitive patterns

Some may believe that the volatility is temporary, that we are merely in a transition period from the competitive equilibrium experienced in the 1970s to a new order likely to appear in the late 1990s. The evidence from formerly regulated industries puts a lie to that thesis.

Others may believe that banking and finance will be reregulated. This also is highly unlikely. Deregulation is now global, and the United States could not return to regulated financial markets without other major nations doing the same thing. Globalization and securitization are here to stay.

Besides, consumers love the benefits of competition. See how readily they exercise their option to refinance home loans. And politicians are not likely to lead the way back to regulated markets where they are held responsible for government failures like FSLIC (the now-defunct Federal Savings and Loan Insurance Corporation).

Some owners and managers of mortgage banking firms may like, even enjoy, the new competitive forces in their industry. They should, however, understand where freely competitive markets lead. The new forces can make long-term investment in mortgage banking less rewarding. The price-to-earnings ratio is low rather than high for public companies in commodity industries that demonstrate relatively short life cycles, and volatility. The ability to build reserves in the best of times, for safety in the worst of times, is jeopardized when profit margins are narrowed.

In a state of unlimited competition, prices and profit margins are driven down to a level that will just sustain the existence of those who produce the product. In the textbook example, more and more farmers will plant wheat until the price per bushel is just enough to provide a normal profit for the efficient producer. "Normal profit" is one dollar more than it takes to cause you to leave the industry or go broke.

New entrants can enter the residential lending business faster than farmers can plant new wheat crops. And mortgage lenders don't have to wait until next spring to enter a market. So a steady stream of new entrants will only further fan the competitive flames already affecting mortgage lending.

The why

How can one explain the patterns of mortgage industry competition just noted?

Mortgage finance entered a new era in 1980. During the 1960s and 1970s, consumer finance--that is banks and thrifts--operated under essentially a cartel form of competition. There were strict limits on price, product competition, new entrants and innovation.

Mortgage bankers played at the edges of these cartel markets and competed through their superior market information and selling skills and by identifying pools of capital (e.g., life insurance funds) they could bring to local markets at differing prices and terms. There was stability in industry leadership in all parts of finance. With limits on entry, price and product competition, market position was relatively easy to maintain. Remember, after its experiences during the 1930s, society wanted a financial system with no failures. Cartels provide that assurance. Many will recall that the rates on FHA and VA loans were controlled, usually fixed below market. And, after the invention of points, points were controlled as well.

Today's pricing and competitive systems are more like those of the 1920s than of the 50 intervening years. Unregulated pricing, free entry and innovation in real estate finance are the order of the day. The mortgage lending business, instead of concentrating, has segmented and atomized. Where one organization used to carry a home loan transaction from origination through underwriting, closing, funding, servicing, marketing and a capital link to an investor, now the process is likely to have 8 or 10 individually owned points of entry, all striving to be profit centers.

Customers, that is, borrowers, who used to choose a lender based on service competition and convenience, and rarely aggressively shopped prices, during the 1970s, now choose a lender based on price (which changes daily), product (a buffet of loans) and a growing array of services. Markets are being segmented, and brand loyalty is weak--rare is the borrower today who automatically seeks a mortgage from the bank holding the family's savings account. Increased consumer education about home loans, and borrower experiences with refis is adding materially to this, and it makes the market even more competitive.

Lenders used to have similar costs and little incentive to innovate, thereby leading them to a public utility-type management style. Now, they are faced with a marketplace where competitors have varying cost structures, legal powers, ownership forms, competitive motives and technological capabilities, and where entry is relatively easy.

The substitution of free-market competition for cartel-type competition in mortgage lending is having powerful consequences. This is what we see reflected by the turnover in the rankings of the industry's top performers.

What did not work in the 1980s

Evidence from experience in banking and other deregulated industries during the 1980s strongly suggests that a number of strategies do not work in a competitive world. These include bigness, as a stand-alone strategy, financial one-stop shopping, attempts at preemptive technological innovation and supergrowth.

The benefits of economies of scale have proved fleeting in my view. And, except in mortgage servicing with its heavy reliance on electronics and volume, they simply do not exist. The mortgage business over the past decade has segmented rather than concentrated. The growth in mortgage brokers from roughly 7,500 to more than 14,000 between 1987 and 1993 speaks to the issue. Niche specialists, with low costs, continue to enter and carve the industry up into cost-efficient segments. The fact that large institutions have encountered TABULAR DATA OMITTED difficulties competing, along with the small, provides further evidence that bigness is not a passport to profits. The histories of Lomas, CityFed and Citicorp, among others, demonstrates that size will not keep you King of the Hill.

A number of industry supergiants tried synergy. Sears (although the mortgage operation did well), American Express Company and Merrill Lynch & Co., Inc. all wound up with little profit and much in the way of excessive cost by pursuing financial supermarket strategies. One by one, each abandoned the losing strategy.

As to technological innovation, the no-doc loan systems and Realtor links, such as those tried by Century 21, Merrill, Dean Witter Financial Services Group, Inc. and ERA, did not work. The efforts fell on the swords of high cost, high losses and minimal consumer (and Realtor) acceptance. Another effect of such efforts was to cause traditional competitors to sharpen their pricing and services and to raise the hurdle that any new system would have to overcome.

Finally, supergrowth. In a sentence, "Supergrowth is fool's gold." In my view, a large organization that tries to grow at twice the rate of its competitors in commodity-type financial services markets can do so only by taking excessive credit risks, sacrificing the quality of its originations, and paying up for market share in today's high-volume, hot markets (tomorrow's Houston?). Like Jack's beanstalk, growth can't reach heaven.

So given that the marketplace has changed dramatically, the obvious question that emerges is, what will work?:

* Being a low-cost producer in commodity markets.

* Being disciplined in your competitive responses--manage your markets; do not let your markets manage you.

* Developing profitable niches where monopoly profits exist.

* Preserving quality and productivity in operations.

It's a mortgage banker's world

The cartel era favored thrifts. They were kings of the mortgage hill. In the free-market era, mortgage bankers will be favored. The reason is that mortgage bankers have always been market-focused middlemen. The traits of the great ones have been superior market knowledge, superior salesmanship, adherence to competitive pricing (they never said to borrowers, "Buy my ARM loans; they are good for me," as the California thrifts did), flexibility (they follow, not lead, markets) and a short-term focus. As to the latter point, this can be a fault, but it can be overcome by adopting a long-term strategy that encompasses a short-term operating focus.

The market share performance of mortgage bankers during the past 5 to 10 years testifies to the feasibility of assigning them the leadership role in the decades ahead. Their share of residential home loans during the past decade has grown to more than 50 percent from 25 percent. The fact that they originate more than 65 percent of the commodity-type, securitized loans today indicates that as securitization becomes even more widespread, their share may rise further.

If the industry leaders can develop an appropriate longer-term strategy to accompany their successful short-term market tactics, they will be able to convert more of their competitively earned volume into dependable profits. In my view, that should enable them to grow, and stop playing that King of the Hill game.

What must be done?

Recognizing that competitive markets, by their nature, are an interactive game, mortgage bankers should seek fuller understanding of the new world in which they are operating. Deregulated, freely competitive markets are here to stay for the business lifetime of most readers of this article.

Business history books are likely to report that the first generation of managers in every one of the deregulated industries--from airlines to trucking to financial services--reacted poorly and inappropriately to the new models of competition. Because of the misfortunes of thrifts and banks, mortgage bankers, as middlemen, have proven to be beneficiaries. Now that they are poised at the top of the hill, the question is can they keep it?

A lot will depend on the ability of top managers to adapt to the new competitive landscape. There are some steps that can be taken to acquire the crucial survival skills needed in the new marketplace. First, senior managers of mortgage banking organizations would do well to analyze business sectors that have operated in competitive markets for a generation or more. I suggest they study the grocery and department store businesses, and any other businesses dominated by quality middlemen. Put folks from these industries on your boards of directors. Learn how competitors position themselves in these markets, how they price products and services, how they control costs and how they react to market thrusts by competitors.

Second, focus on gaining monopoly profits. Seek out a few isolated niche products and markets insulated in part from the direct competitive fires. Focus corporate development plans on monopoly profits. And, if you find them, do not publicize your successes.

Third, and perhaps most importantly, invest heavily in risk management. Bad loans proved to be the Achilles' heel of many of the former occupants of the hilltop. Mortgage risk requires more than credit and appraisal proficiency. Former Kings of the Hill, afflicted with the supergrowth virus in their quest for market share, would offer increasingly liberal loan terms in regional markets that went from good to bad--based in part on their overlending. The introduction of unique loan contracts and "streamlined" lending procedures, like CityFed's CAMP loan and the no-doc loans of others, were instrumental in causing financial trauma to even experienced institutions.

Looking ahead, the price the investor market and the rating agencies will assess for above-average delinquencies and foreclosures is likely to rise and, in fact, put firms out of business.

What can the industry expect down the road now that the rules of the game have changed and the industry's smartest competitors are playing them to their advantage. Following are my thoughts on what's ahead for the industry.

A look over the horizon

America is a relatively well-housed nation. Thanks to deregulation and securitization, ample funds are available for home lending and refinancing, and the diversity and price of private funds is acceptable and, indeed, often more favorable than government money. The federal government is likely to pay less and less attention to housing for the upper and middle classes, except as it seeks ways to raise tax revenues. To the degree that Congress allocates funds or guarantees to housing, it will be targeted to the homeless, new immigrants and very low-income groups. Short of resources, HUD will focus on those niche markets.

Fannie Mae and Freddie Mac will be subject to more and more social costs and indirect taxes. Their shareholders and managers in the next 10 years, may find ways to cut completely their ties to government. It's my view that full privatization will occur as they seek to expand powers, lessen the emphasis on low-income housing, and get their stock prices up.

Private conduits will proliferate as mortgage market practitioners seek out more and more high-profit niches. Investment bankers, using their "rocket scientists," will continue to slice and dice cash flows into increasingly refined investment products. Securitization is, at best, in its teen-age stage.

The arbiters of how mortgage lending is done will pass from government to private agencies. The Federal Home Loan Bank Board and FHA of the cartel era and the quasi-governmental Fannie Mae and Freddie Mac of more recent years will no longer set the terms of secondary market trading. They will be supplanted by the private rating agencies (Moody's and S&P), the secondary market conduits, credit-enhancers (including mortgage insurers) and institutional investors as the new standard-makers.

In mortgage banking, pressure to eliminate middlemen will be continuous. Securities firms, after focusing on growth, along with growth in managerial salaries, during the 1980s, will direct themselves to capital returns. As a consequence, they will not be in the market for synergistic empire building. But other financial firms, yet to learn the lessons of the 1980s, are likely to see mortgage lending as an attractive diversification and will enter the fray. In free markets, new entrants are the threat to any profit centers.

Other changes are coming in the way the business is managed internally. There is an excess supply of resources--capital, labor and management--seeking positions in financial services. As the refi boom cools, supply excesses will be even more evident. As a consequence, the owners or private investors will seek to shift more risk onto labor in mortgage companies. Compensation systems, emphasizing commission and bonus techniques, will be designed to shift the seasonal and cyclical risks in volume to labor. Benefit and retirement costs and even training costs will be managed closely.

Finally, free markets are more volatile and messy, and hold much more risk than cartel markets. Society will become more willing to let firms fail. Prior to 1929, more than 5,000 banks failed because they could not compete. Depositors and stockholders lost, but commerce continued and the world moved on. In the 1980s, when the members of the insured bank and thrift cartel failed, we were all shook up because our taxes had to pay the socialized FSLIC and FDIC (Federal Deposit Insurance Corporation) losses.

There will be many more bankruptcies and more catastrophic losses during the free-market era. Reserves must be built for these, and risk management must always be near the top of any senior management strategy.

The game of King of the Hill is an exciting one. It includes the joy of victory and generates a great deal of press coverage. Unfortunately, it also promises the anguish of defeat--and rather abruptly. King of the Hill is an unsatisfactory game for management and shareholders of any financial services firm. For industries that play it, the price/earnings ratio on shares will be permanently low, credit ratings will be weak and access to new capital through initial public offerings and the capital markets will be limited.

Mortgage banking can do better. The new free-market era in finance is made for the traditional skills its professionals bring to the marketplace. Industry leaders already know that the final years of the 20th century have ushered in a new era to real estate finance and that this era requires changes in long-term competitive strategy. By emphasizing skillful marketing and a heavy measure of market discipline regarding both growth and the management of risk, the new breed of industry leaders will move from playing King of the Hill to the more-enduring game of monopoly profits. That is a game worthy of all mortgage bankers and financial service providers.


Top Mortgage Bankers Based on Originations


1) Norwest 2) Lomas & Nettleton 3) First Interstate 4) Alliance Mortgage 5) Security Pacific 6) Goldome Realty 7) Kissell Co.


1) Citicorp Mortgage 2) CityFed Mortgage 3) Sears Mortgage 4) Goldome Realty 5) GMAC Mortgage 6) Lomas & Nettleton 7) Commonwealth Mortgage 8) Fireman's Fund 9) BancBoston Mortgage 10) Weyerhaeuser Mortgage


1) Citicorp Mortgage 2) CityFed Mortgage 3) Sears Mortgage 4) Countrywide Funding 5) Goldome Realty 6) Weyerhaeuser Mortgage 7) GMAC Mortgage 8) Margaretten 9) ICA Mortgage 10) First Union


1) Fleet/Norstar 2) Citicorp Mortgage 3) Norwest 4) Prudential Home Mortgage 5) BancBoston Mortgage 6) Chemical 7) Countrywide Funding 8) Chase 9) IMCO Realty 10) Sears Mortgage


1) Norwest 2) Fleet/Norstar 3) Prudential Home Mortgage 4) Countrywide Funding 5) Citicorp Mortgage 6) Sears Mortgage 7) Chemical 8) Chase 9) IMCO Realty 10) Margaretten


1) Countrywide Funding 2) Prudential Home Mortgage 3) Norwest Mortgage 4) Fleet/Norstar 5) Chemical Mortgage 6) North America (IMCO) 7) Sears Mortgage 8) NationsBank 9) BancBoston Mortgage 10) Margaretten

Source: American Banker, Inside Mortgage Finance

Figure 2

Top Mortgage Bankers Based on Servicing


1) Lomas & Nettleton 2) Western Mortgage 3) Associates Mortgage 4) Advance Mortgage 5) Collwell Company 6) Colonial Mortgage 7) Kissell 8) National Homes Accept. Corp. 9) Bankers Mortgage 10) James W. Rouse & Co.


1) Lomas & Nettleton 2) Advance Mortgage 3) Union America 4) Colonial Mortgage 5) Pennamco 6) Kissell 7) Cameron-Brown 8) National Homes Accept. Corp. 9) Stockton, Whatley, Davin & Co. 10) James T. Barnes


1) Lomas & Nettleton 2) Colonial Mortgage-Philadelphia 3) Banco Mortgage 4) Weyerhaeuser Mortgage 5) Wells Fargo Mortgage 6) Advance Mortgage 7) Mason-McDuffie 8) Kissell 9) Suburban Coastal 10) Cameron-Brown


1) GMAC Mortgage 2) Lomas & Nettleton 3) Citicorp Homeowners Services 4) Fireman's Fund Mortgage 5) Metmor Financial 6) Commonwealth Mortgage 7) Weyerhaeuser Mortgage 8) First Interstate Mortgage 9) Cameron-Brown 10) Fleet Mortgage


1) Citicorp Mortgage 2) Fireman's Fund Mortgage 3) GMAC Mortgage 4) Chase Home Mortgage 5) Fleet Mortgage 6) Lomas Mortgage 7) Fleet Real Estate 8) Prudential Home Mortgage 9) Barclays American 10) First Union


1) Fleet/Norstar 2) Citicorp Mortgage 3) Countrywide Funding 4) GMAC Mortgage 5) Prudential Home Mortgage 6) Source One (Fireman's Fund) 7) GE Capital Mortgage 8) Chase Home Mortgage 9) Lomas Mortgage 10) Chemical Mortgage

Source: American Banker, Inside Mortgage Finance

Leon T. Kendall is a professor of finance and real estate at the J.L. Kellogg Graduate School of Management at Northwestern University, Evanston, Illinois. Paul Webster, MGIC vice president, and his associates in MGIC's National Accounts Division assisted in researching industry rankings for this article.
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Title Annotation:Cover Report: State of the Industry; mortgage banking
Author:Kendall, Leon T.
Publication:Mortgage Banking
Date:Oct 1, 1993
Previous Article:Unusual times.
Next Article:Cutting back.

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