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Lessons learned.

A look back over recent industry history reveals that major changes made the business landscape rocky in the 1980s. The secret for success during the decade proved to be perfecting the art of survival.

WHEN I ENTERED THE BUSINESS OF MORTGAGE finance, in 1980, it didn't take long to master the tools of the trade. Thirty-year, fixed-rate mortgages were the norm. Mortgage bankers had only recently begun venturing beyond government lending into conventional production, and jumbo lending was tried only by a daring few.

Because of the rapid home price appreciation experienced during the late 1970s, credit risk was considered an oxymoron. In fact, the mortgage insurance company I worked for was embarrassed to report a 5 percent loss ratio for the previous year, and several executives wished for just a few more loans to go bad so our clients would better appreciate the value of our service.

The typical mortgage banker was a small, independent, retail originator that packaged FHA/VA loans into Ginnie Maes or sold whole loans to thrifts. Pricing was based on a 12-year prepay assumption, and cash flow yield was only a glint in Dexter Senft's eye. The Fannie Mae MBS did not yet exist, while private mortgage-backed issues were rarer than sightings of Elvis.

Because interest rates had been on a steady uptrend for years, pipeline fallout and negative convexity were merely academic concepts. Servicing traded infrequently, and when it did, valuation was simple: it was worth 1 percent.

I produced my first financial forecast with a pencil, a hand-held calculator and a large green accounting pad. Later that year, when we bought personal computers and I transferred my numbers to a Visicalc spreadsheet, that was considered state-of-the-art.

How times have changed.

The 1980s

In retrospect, the 1980s was a transitionary decade, a time of unprecedented challenges, of experimentation and consolidation. The smartest and toughest players learned quickly and adapted to the new environment, while the rest were casualties that shrunk or sold out or simply closed shop.

The first great challenge was the high level of interest rates that all but shut down origination volume. Creative lenders took advantage of liberalized lending regulations, and the result was a vast expansion in the menu of mortgage products. The new product list included more than 200 types of adjustable-rate mortgages (it took several years for the industry to decide between ARM and AML as the preferred acronym) and a sometimes bewildering profusion of graduated payment, growing equity, shared equity, wrap and second mortgage loans. I remember long debates with colleagues about which of these loans would survive.

As so often happens, the wishes of consumers and investors were diametrically opposed: investors demanded loans that would adjust immediately to market, while consumers sought out loans that looked as fixed as possible--only with lower interest rates. For a long while, mortgage bankers despaired as thrifts dominated the origination market with teaser-rate ARMs (loans with starting rates well below the fully indexed accrual rate); getting a whole loan standby to sell such ARMs to a thrift investor was often the difference between sitting on the sidelines and being a player on the street.

The marketplace eventually winnowed the product menu down to a manageable few choices, and the lower interest rates of the later 1980s brought back the popularity of fixed-rate loans. The competitiveness of mortgage bankers was enhanced not only by the return of a fixed-rate environment, but also by two other factors that dramatically changed the industry: the demise of the thrifts and the rise to dominance of the mortgage-backed security.

The decline of thrifts

The thrift industry was at once a blessing and a bane: while thrift investors were a primary outlet for whole loan product, thrift originators were frequently unbeatable competitors. But the same shortsighted impulse that led thrifts to aggressively market teaser-rate ARMs (some of which actually had lifetime caps below the prevailing level of fixed rates) led to a multitude of other dubious business decisions that sealed their fate.

Fortunately, at the same time that thrifts were diminishing in importance as investors, the MBS was coming into its own. By the late 1980s, even ARMs and jumbo loans were being packaged into generic MBS and resold through Wall Street to a wide variety of institutional investors, many of whom would never dream of investing in whole loan product. Early fears that the thrift investor base could never be replaced proved groundless: Mortgage-backed securities are distributed internationally at prices that translate into competitive rates on the street. These developments helped mortgage bankers, because the industry excels at competing on a level playing field in a market-rate environment.

By mid-decade, it had become painfully clear that the lax underwriting standards and some of the more questionable of the early 1980s' new products (such as the 95 loan-to-value negatively amortizing GPM, also known as "the loan that ate Texas") were producing catastrophic results. Lenders had blithely passed on risks to mortgage insurers, and mortgage insurers had become so dominated by their sales and marketing departments that few even bothered to employ actuaries. As losses mounted, insurers had to move fast, and action--sometimes Draconian--often preceded analysis.

One of the great debates of the mid-1980s was whether payment shock or equity erosion was the more significant contributor to default risk. Eventually it became evident that equity is the single most important determinant of credit risk. As underwriting ratios were tightened and LTV limits were cut back, many lenders complained bitterly that they were punished unfairly for the "other guy's" sins. Gradually, however, insurers analyzed the delinquency and default experience of millions of loans and arrived at sensible standards that protect the interests of borrowers, lenders, insurers and investors.

Just as the early 1980s were dominated by the effects of high interest rates, the second half of the decade was strongly colored by declining interest rates. This had several profound effects. Origination and refinance volume soared, opening up many profit opportunities for mortgage bankers, as long as they weren't overwhelmed by volume pouring into back offices that were often understaffed as a result of layoffs during the lean years.

But there was a darker side to these years as well. Old-fashioned secondary marketing officers, who had often been hired for their skill at cultivating thrift investors, were ill prepared to deal with the volatility in both interest rates and pipeline fallout ratios. The new secondary marketing manager had to be adept at analyzing pipeline behavior and using the full array of futures, forwards and options to hedge interest rate and fallout risk.

The MBS market felt the effects of the refinance boom also, as outstanding pass-through issues experienced the full meaning of negative convexity and MBS-Treasury yield spreads soared. (Negative convexity, for those unfamiliar with the term, is the shortening of expected average life of mortgage-backed securities as interest rates decline, which causes MBS prices to stall out--or even decrease--as rates drop below certain threshold levels.)

But the outcome of this experience was ultimately very positive: a profusion of new products that have increased the investor base for mortgage loans and helped to dampen the volatility of every mortgage banker's bottom line. Multiclass REMICs (real estate mortgage investment conduits), often featuring 20 or more tranches, became the standard way of selling MBS to institutional investors. The elegance and complexity of these mature instruments made the initial three- and four-class issues of the early 1980s seem like Stone Age instruments. Short-term floating-rate classes tied to LIBOR (London Interbank Offered Rate) were sold to money managers from Hong Kong to Hamburg. Long-term classes protected from prepayment risk were sold to pension funds, and a multitude of other classes were developed to meet every conceivable investor need.

As a result, the investor base for MBS dramatically increased. Although the small player selling off his or her originations loan-by-loan may not realize it, access to this enormous, worldwide pool of capital at the most competitive rates possible has helped dampen the volatility of every mortgage banker's bottom line.

Does bigger mean better?

The stress and strain of the 1980s led to an unprecedented shakeout among mortgage lenders, and the number of players today is far smaller than only a few years ago. Thrifts have lost considerable market share, and larger commercial banks have emerged as significant players, often through mortgage banking subsidiaries, which benefit from cross-selling opportunities and access to their parents' credit facilities.

While the cost of entry into loan origination continues to be low, the financial resources necessary to compete and succeed as a full-service mortgage banker have increased severalfold. As a result, the industry is increasingly dominated by the largest players, behemoths with servicing portfolios of $30 billion or more that often obtain a considerable portion of volume from wholesale, rather than retail, production.

Does bigger mean better? Is this a long-term trend, or will future market developments lead to the dismantling of today's giants? Let's break these questions down.

Although it is not clear that there are economies of scale in loan origination, there is no doubt that larger origination volume can increase marketing profits while decreasing secondary marketing volatility. This is because larger producers can negotiate better pricing in the secondary market, and because (all other things being equal) a larger pipeline is more predictable and thus easier to hedge. On the other hand, wholesalers are one (or in some cases, two) steps removed from the origination process, and this means that enforcing credit quality is that much more difficult. Thus, greater marketing profits today could be offset by servicing losses down the road, unless a substantial investment is made in quality control.

Economies of scale in loan servicing are well documented, but the question remains: what is the point of diminishing returns? Some have argued that, above a certain portfolio size, marginal servicing costs may actually increase.

Although it is likely that the largest players will continue to dominate the business, there always will be a profitable niche for small originators. In recent years, that niche has been in mortgage brokerage, and the recent refinance boom has led to an unprecedented increase in the number of "mom and pop" mortgage brokerage companies.

Even though it is safe to say that when the boom subsides, there will be some consolidation in the brokerage sector, the important point is that, in general, success will likely result from following one of two clearly defined strategies. If a mortgage banking firm wants to take secondary market risk and service loans, it had better plan on being large enough to compete. The alternative is to stay lean and mean and to concentrate solely on origination. While medium-sized mortgage banking firms that service their own loans are currently profiting from the refi boom like everyone else, their long-term outlook is uncertain. Many of them will undoubtedly be forced to either shrink or expand.

Surviving the capital crisis and runoff

A number of the largest mortgage bankers grew very quickly in the past several years through bulk purchases of servicing portfolios. The secondary market for mortgage loan servicing has grown twelvefold in the past ten years, far outpacing the growth in origination volume. The valuation of servicing, which was still in its infancy as recently as the mid-1980s, is now as sophisticated as the analysis of MBS.

In the early 1990s, the demise of the thrifts, combined with new bank capital requirements, put enormous pressure on the servicing market, and the resulting mismatch between the number of buyers and sellers led to required yields that sometimes exceeded 20 percent. In a perfect example of how the market tends to return to equilibrium, these yields attracted new investors into the mortgage banking business, helping to offset the loss of thrift capital.

In the 1980s, almost all the efforts to combat interest rate risk focused on secondary marketing. But interest rate volatility also affects servicing portfolio runoff. During the past two years, the historic increase in prepayment rates led to significant write offs by many large servicers. Mortgage bankers, who would never dream of leaving a pipeline uncovered, were routinely leaving their largest asset--servicing--unhedged. Of course, the tools to hedge prepayment risk have only recently become available through Wall Street.

The ability to hedge both servicing and pipeline risk means that larger mortgage bankers are becoming less and less volatile, which will decrease their cost of capital and further increase their competitive edge.

Affordable housing: The new frontier

The 1980s saw the development of new origination and securitization programs for jumbo loans, second mortgage loans, B-quality loans and manufactured housing loans. In the 1990s, the new frontier is affordable housing loans. Prodded by Congress, Fannie Mae and Freddie Mac have already stepped up their affordable housing initiatives. Programs that allow borrower down payments as low as 3 percent or that provide subsidized second mortgages are becoming commonplace.

Low- and moderate-income lending will prove to be a profitable niche for many mortgage bankers. By pursuing this business, lenders will be helping to strengthen the social fabric of this country (increasing homeownership will mean a more stable, more prosperous nation).

Many mortgage bankers are under the impression that affordable lending is only for nonprofit institutions. This is simply not true. Several for-profit organizations that have studied affordable lending and devoted the necessary resources to it have been very successful in the field. In general, these organizations have succeeded through the application of enlightened underwriting standards that remove "suburban blinders" and take into account the realities of urban environments. Although many of their programs allow for lower down payments and higher debt ratios, their delinquency and default experience is equal to, or better than, conventional portfolio experience. This isn't really surprising; it simply underscores how important homeownership is to low-income Americans.

The involvement of Fannie Mae and Freddie Mac in affordable housing is very important, but it isn't the whole story. During the next few years, there will undoubtedly be important private-sector initiatives, particularly in the area of mortgage-backed securities. The problems that Wall Street has had to solve in order to gain acceptance for MBS are very similar to the problems we face in affordable housing--and suggest that many of the cutting-edge techniques developed in the past few years can be applied to dramatically increase the availability of funding for our inner cities and rural poor.

Using MBS technology, affordable financing programs of the future will divorce the design of the mortgage product from the design of the bonds. First, originators will design the product that the borrower really needs. Then Wall Street will create multiclass bonds that isolate subsidy features in a limited number of tranches.

For example, consider a case where we want to create mortgage loans that start out at 4 percent and then graduate up over a number of years to a fixed market rate. A subsidy organization (such as a state housing agency or a charity organization) might invest in a subordinate class that absorbs first-loss default risk and diverts cash flow to the senior classes. This would allow the senior classes to receive investment grade ratings and attract full market rates. The subordinate class might be further subdivided, allowing the sale of BBB-rated market rate bonds to high-yield investors who have done their homework and recognize the excellent credit quality of most affordable housing loans.

Technology: The competitive edge

Perhaps the single most important factor affecting mortgage banking in the 1990s has been--and will continue to be--advancements in technology. Mortgage banking operations in the 1980s were generally paper intensive, time consuming, costly and error prone. Thanks to technological developments such as electronic data interchange (EDI), artificial intelligence, imaging and optical character recognition, mortgage bankers will be able to operate faster, cheaper and with higher quality than ever before.

Technology is affecting every aspect of the business, often in multiple ways. For example, automated origination systems not only reduce costs, but also open up entire new origination channels, such as computerized loan origination networks (CLOs). Automated expert systems will handle routine underwriting, freeing up underwriters to focus on the most difficult loans. State-of-the-art technology is helping mortgage bankers to analyze and manage pipeline risk, which will stabilize earnings and attract more capital into the business. Technology is reducing servicing costs, maximizing loan workout opportunities and minimizing foreclosure losses.

Technology will undoubtedly give certain companies a decisive competitive edge. Not every technical innovation will prove fruitful, but it is probably safe to say that the leading mortgage bankers in the year 2000 will be using new technologies undreamed of today.

The caveat in the last sentence is worth exploring. Simply because an innovation is introduced under the banner of "faster and more efficient" doesn't mean that it's a good idea. A good example would the no-doc underwriting that began to proliferate in the late 1980s, as lenders sought to streamline the underwriting process and eliminate unnecessary, time-consuming requirements. Limited documentation lending was a great idea, but no-doc was taking a good idea too far. (I remember being shown one file where a pizza parlor employee reported an annual income of $250,000.)

Experimentation with such programs illustrates a frequently occurring phenomenon in the mortgage banking business: a good idea is introduced; enthusiastic lenders (some well meaning, some with questionable motives), take it to dangerous extremes; losses ensue, and programs are restructured to achieve the necessary balance between risk and return.

The secret of success

A few months into my first job with a mortgage insurance firm, I was invited to attend the company's national sales conference, where an outside consultant--a famous inspirational speaker--was going to be giving a lecture to the sales force entitled, "The Secret of Success." What a break. I wasn't going to have to discover the secret by trial-and-error over many long years. I was going to find out right away. When the great day arrived, I showed up an hour early to get a front-row seat and sat there, pencil poised, ready to take notes.

I still have my notes from that lecture. They consist of three words: Just show up.

(Well, there was an advanced version of this lecture where two additional words were added: on time.)

At first, I was pretty disillusioned by this lecture. What kind of recipe for success is "Just show up?" I wanted my money back. But over the years, the more I thought about it (and the more sales calls I made), the more I appreciated the consultant's words. The best secrets of success, whether in sales or anything else, are simple. People are always looking for complicated ways to get ahead, but that's not usually the way things work.

During the 1980s, a lot of us had a very simple secret indeed: Just survive.

As it turned out, it took a lot of patience to follow this rule. When thrifts were offering teaser-rate ARMs, the temptation to compete by gambling on rates or relaxing underwriting standards was awfully high. But when the smoke cleared, the mortgage bankers who kept their heads down and played for the long haul came out on top.

In the 1990s, I think we can expand the rules just a bit. Here are my revised secrets of success, good to the year 2000 or $25 billion origination volume, whichever comes first.

Learn the lessons of the past--Mortgage bankers who have entered the business after the mid-1980s are unfamiliar with what it takes to compete in a high interest rate environment. There is a natural tendency to assume that current conditions will continue in perpetuity, but that of course is not the case. Rates one day will return to unaffordable levels, and it is important to remember what worked and what didn't work in the early 1980s.

Similarly, it is not hard to imagine a young mortgage banking executive in the year 2000 who has never gone through a period of high defaults or volatile interest rates. If we don't learn from history, we are doomed to repeat it.

Analyze the risks of the present--As we learned in the 1980s, if you want to succeed, the first thing is to survive. The environment for mortgage bankers is still filled with risks. Every innovation usually introduces new risks. The popular strategy of emphasizing growth and diversification can often lead to unanticipated management problems and higher, rather than lower, costs. New legal and regulatory risks abound. And the very pace of change poses the risk that your competitors will find a way to take away your client base. The most successful mortgage bankers in 2000 will undoubtedly have adopted a meaningful strategic planning process that places a high priority on identifying and planning for risks.

Master the tools of the trade--Not every new tool makes sense for every mortgage banker. But if you don't take advantage of the latest products, marketing strategies and technological developments that might benefit your business, you may not only have given up a potential competitive advantage, but you may also find yourself at a marked competitive disadvantage--or out of business entirely.

Identify the opportunities of the future--If you've learned the lessons of the past, survived by avoiding the risks of the present and mastered the tools of the trade, you are poised for success. All that remains is to remember that the markets are in a constant state of flux. The winners of tomorrow tend to be companies that are always looking forward, anticipating new market developments and their clients' changing needs.

Jess Lederman is a private investor and writer based in Driggs, Idaho.
COPYRIGHT 1993 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Cover Report: State of the Industry; mortgage banking
Author:Lederman, Jess
Publication:Mortgage Banking
Date:Oct 1, 1993
Previous Article:A balanced response.
Next Article:The need for new money.

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