Marketing to today's borrower.
Mortgage banking industry journals have been bemoaning the absence of healthy profits since the end of the 1993 refinance boom. The problems - predatory pricing, portfolio fallout, excess capacity, high overhead, low productivity - have been documented enough to satisfy even the most disbelieving skeptics. Yet very few solutions have been offered as a map for guiding mortgage bankers out of the profitless plains.
Leon Kendall, Northwestern University professor and retired Mortgage Guaranty Insurance Corporation chairman, and William Dallas, president and CEO of First Franklin Financial, San Jose, California, very convincingly describe the plight of lenders in the October 1996 issue of Banking. These gentlemen leave little doubt that profitability is a concern and only radical changes will improve operating revenues. Both authors illustrate a residential lending market where supply exceeds demand, lenders are competing "solely on price," and margins are "driven down to a level that will barely sustain existence."
This isn't news to most residential lenders. Seeing these realities documented by the findings in MBA's annual cost study increases the impact and validity of Kendall and Dallas' calls for operational reengineering.
Excluding gains on servicing sales, the average company in the 1995 MBA Cost Study generated a before-tax profit margin of 4.5 percent. This is far better than 1994's -4 percent profit margin, but the improved results were not generated by the core functions of origination and servicing. In fact, the largest contributor to income was net marketing, which benefited from both falling mortgage rates and the implementation of the Financial Accounting Standards Board's Financial Accounting Standard (FAS) 122. The second-largest income contributing category was "other."
If you are willing to rely on a continuing favorable rate environment, new accounting rules and "other" to generate profit margins comparable to money market returns, then 1995 is a good model to follow. If you are not willing to bank on interest rate cycles, industry accounting trends and obtuse subsidiary contributions for future profitability, you will have to look for answers elsewhere.
Tradition in the face of reality
Today's industry experts and consultants are overly enamored with the acronyms that abound in today's mortgage business: CLO (computerized loan origination), CBA (controlled business arrangement), EDI (electronic data interchange) AIU (artificial intelligence underwriting). Their attention is further distracted by the promise of technological salvation: credit scoring, and a seamless lending process resulting in an efficient "score it, price it, close it" marketplace.
Granted, the toys of 21st-century lending are attractive and promising. They can be applied, however, only after you have a borrower committed to a loan containing a profit margin sufficient to sustain existence. It's like putting all your research and development and capital expenditures into equipment for extracting gold from ore. Now, all you need to do is find the gold. (Of course, that's the hard part.)
Mortgage originators traditionally worked with real estate sales agents to get borrower referrals; staking their claims, working the ore, extracting the gold. Unfortunately, many of today's Realtors seem stripped of the once-profitable referrals that made them acceptable marketing targets for originators.
Consumers are increasingly selecting their own home loan provider, which dramatically limits the influence and value of the Realtor as a referral source. In fact, an estimate of the number of borrower referrals controlled by the average Realtor in 1994 is an appallingly low 1.82. That's right, 1.82 deals - and that was in the third-largest real estate year in history. Don't believe me? Let's run the math.
In 1994, the third-best real estate year in history, 4.62 million units were sold (new and existing). Of those 4.62 million housing units, nearly 30 percent sold without the services of a real estate sales agent, according to the U.S. Department of Commerce. Industry studies by HomeSide Lending, Jacksonville, Florida, and Countrywide Home Loans, Inc., Pasadena, California, have determined that Realtors influence significantly less than half of lender decisions; 40 percent is a generous estimate.
Lastly, the U.S. Statistical Abstract shows the total number of licensed real estate sales agents exceeds 710,000. So, that's 4.62 million housing units sold, minus 30 percent, divided by 710,000 Realtors who control 40 percent of the lender decisions made by homebuyers. That comes out to 1.82 borrowers. It's not a pretty exercise, but one that lenders must endure in an effort to justify the radical changes required for extracting more gold.
When you consider the increasingly limited referral potential represented by the average Realtor (even if I'm wrong by tenfold), it is difficult to justify any marketing efforts - whether originator sales calls, controlled business arrangements, computerized loan origination systems or anything else - aimed solely at their business, in my view. Whether marketing to Realtors can or cannot be justified, it consumes the vast majority of resources dedicated to originations by the vast majority of residential lenders today.
When you point the lending industry's attention and resources directly at a referral source whose ability to influence borrower choices is shrinking, what is the result? The answer is a marketplace dominated by price competition that exemplifies the theory of supply and demand. Is it any wonder that lenders, according to Kendall and Dallas, are increasingly competing on price alone and that margins are "shrinking down to a level that will barely sustain existence?"
New mines filled with gold
Residential lending in this country, as measured by current originations and outstanding housing debt, may well represent the world's largest retail market. For originators, virtually everyone they meet is or will be a mortgage borrower. Few industries can claim such universal product appeal. When you consider that for most Americans, their house, and mortgage, are their largest asset and monthly obligation, you can see how this industry holds a unique position.
Further, the residential lending industry is a dynamic one, with projections of 59 percent growth in total outstanding housing debt from the end of 1993 through the year 2000, according to KPMG/Peat Marwick. The market is offering lenders ample opportunity for success. But I believe we need to reexamine to whom we market, how our product is used and where profitable borrowers can be found.
Let's start by taking a few steps back and examining the U.S. population that we are serving. Consumers are becoming increasingly sophisticated and demanding. They are bombarded with mass-marketing efforts and, quite frankly, have heard it all. Their attention span for any marketing message is understandably short. In an effort to capture the audience's attention, lenders have screamed "discounts!" So, this industry's own mass-media marketing efforts have created a rate-conscious, price-driven monster.
The need for the mortgage industry's services is greater now than at any time in history. The 1996 elections focused attention on our government's shrinking ability to maintain the social support programs for working class, average Americans created by the New Deal and Great Society. This isn't news; it's just that the majority of voters now recognize it to be true. The public is on its own financially now more than ever, in this climate of government downsizing.
Faith that Social Security will be there as a supplement to retirement income is nonexistent among wage earners young enough to have worn tie-dyed shirts and bell-bottoms the first time they were popular. This same demographic group, however, has done an extremely poor job of preparing their personal finances for the future absence of government largess. The really bad news is they are running out of time.
President Clinton's 50th birthday helped punctuate the fact that baby boomers are aging. Thoughts of retirement are stirring in their heads, and the imagined future is not what most anticipated. Of the 76 million baby boomers, 83 percent have a net worth of less than $100,000, according to Michael Levine, author of Lessons at the Halfway Point.
In fact, nearly half of that 83 percent (about 40 percent of all baby boomers) owe more than they own, and it's getting worse, Levine says. Revolving consumer debt is at an all-time high; more than $460 billion, as of this writing. The average American spends more than 10 percent of his or her discretionary income on monthly interest payments, and that excludes mortgages and car leases, according to a column by Susan Tompor that appeared in The Detroit News. Worse yet, a third of the 76 million baby boomers saved absolutely nothing in 1995, according to USA Today.
We can talk about the 46 million Generation Xers (age 19 to 30), 47 percent of whom saved zero dollars in 1995. We can look at the 51-and-older wage earners, where the typical white household has assets of $17,300; the typical African-American and Hispanic households have assets of less than $500, and four out of 10 of those have nothing at all, according to a Rand Corporation study on "U.S. Wealth Distribution," covered in a news story by Reuters in July 1995.
To say the least, a huge, almost limitless number of households need immediate financial planning help.
Okay, so tens of millions of wage-earning Americans have too much bad debt (i.e., high interest rate, nondeductible, leveraged against a depreciating asset) and not enough working capital (i.e., present value dollars exposed to compounding interest). How does that affect the mortgage industry and its sagging margins? Bear with me for a little while and I'll explain.
Supply and demand
The concept of supply and demand is probably the most basic and easily understood economic truth. When the local department store has a supply of dickeys that grossly exceeds the demand for them by shoppers, it's time for a clearance sale. When Realtors have a supply of residential lenders that grossly exceeds their demand for residential loans, goodbye margins, hello discounts.
Depending on where you live and whom you ask, the average American moves every five to seven years. If we can agree upon the number six, that means in any given year approximately one-sixth, or 16.66 percent, of homeowners in America are in the real estate market. One-sixth of American households will be set upon by 710,000 real estate sales agents (one for every 300 or so people) followed by a horde of rate-sheet-waving loan officers.
In a strong year for housing, 1994, all this activity resulted in about 4.5 million homes trading hands. Compare 4.5 million new purchase mortgages with a market made up of the 63 million baby boomers who have little or no net worth to invest toward retirement. Do you see a large and profitable opportunity beginning to open up before your eyes?
A wealth-creation strategy
A properly structured mortgage is the cornerstone of any successful wealth-creation strategy. American homeowners can borrow money cheaper than any Fortune 1000 corporation and the interest rate is subsidized by Uncle Sam. Mortgages represent "good debt" (i.e., low interest, tax-deductible, leveraged against an appreciating asset) and an invaluable tool for creating wealth.
How much time, creativity and investment does your mortgage operation devote to creating demand for cash-out mortgages? For most lenders the concept of creating rather than chasing demand is foreign. And the notion of positioning residential mortgages as a wealth-creation tool is well beyond our galaxy. I know that a strategy that promotes prepayments in your portfolio is not going to win any immediate nods around the boardroom. But bear with me on this while I lay out the rationale.
An entirely different supply-and-demand environment exists for those few lenders that do understand demand management and commodity arbitrage - profiting from the simultaneous purchase and sale of a commodity at unequal prices, i.e., purchasing mortgage dollars at 7 percent, investing same at 10 percent or more.
Right now, the average homeowner can acquire long-term residential debt (i.e., good debt) at after-tax rates in the low-to-mid-single digits. The same borrower can acquire long-term wealth-creation products (i.e., stocks) that deliver average annualized returns in the low double digits (the experience historically since 1926). That's an arbitrage position if I've ever seen one.
So, why don't more homeowners take advantage of this wonderful disparity in the costs of money? Why don't they borrow cheap (against their home equity) and invest for double-digit returns in, for example, today's stock market? (How much time did you say your mortgage operation devotes to creating cash-out demand?)
Before we go any further, let's first dispel some current myths about homeownership. Buying a house is not like buying an investment. Buying a house allows you to convert tax and rental dollars into real property. Paying extra each month or year toward your mortgage principal is, generally, very bad advice. If borrowers want to pay off their mortgages as quickly as possible, they should have as much of their capital working for them as possible.
Everyone that advocates saving money in a cookie jar, raise your hand. The idea of storing money in nonincome-generating instruments is universally rejected. Now, what's the difference between storing your money in a cookie jar and storing your money in your house? Yes, your house does appreciate in value (hopefully).
Let's imagine that our cookie jar was part of the JFK estate, and it, too, is increasing in value. Does that make it a good place to store $100 bills?
Webster defines "invest" as: "put [money] to profitable use." If you buy a $200,000 house with 50 percent down and sell that house 12 years later for $300,000, what was the return on your initial investment? What would be your rate of return if you purchased that same house with just 10 percent down? OK, it's a trick question. The rate of return on both down payments is zero. The house is what's appreciating, not the capital stored in the form of home equity.
But let's look at a scenario where we leverage the smaller down payment to purchase the desired property and invest the remaining $80,000 (the difference between a 50 percent down payment and 10 percent down in the example) in a long-term growth fund. After 12 years, which buyer is better off financially?
The fastest way to pay off your mortgage is to have as little equity in your home as possible and instead grow your capital by making investments in assets with stronger returns. As that capital stockpiles, it can be used to pay off the mortgage sooner. Investors (our borrowers) understand the advantages of pre-sent-value dollars, compounding interest and liquidity. Home equity enjoys none of those advantages sought by successful investors.
The single-greatest obstacle faced by investors is access to capital; incremental monthly cash flow and lump-sum disbursements. What if our 10 percent-down borrower regularly (any time the borrower can qualify for a 75 percent LTV cash-out loan; no points, no costs) withdrew his or her home equity via cash-out refinancing and invested the money along with the original $80,000 deposit? How would that affect the velocity of the compounding interest or the accumulation of capital or the liquidity of the investment? How would this investor's asset manager react to this strategy? Would the asset manager introduce this strategy to other investors/clients?
In the origination business, you create demand by supplying value-added services for borrowers and referral sources. Helping your clients and referral sources maximize their returns and grow their businesses will result in profitable borrowers pursuing financial objectives.
Wise investors don't choose a professional asset manager on the basis of price. Wise investors, likewise, will choose their mortgage supplier using the same criteria: greatest return on investment; best progress toward financial goals. If the returns and progress toward goals are the same with every lender - which they tend to be today - the wise investor then begins price shopping.
Residential mortgages and wealth creation
As mentioned earlier, a properly structured mortgage is the cornerstone of any wealth-creation strategy. The ability to borrow money at advantageous rates that are subsidized through tax deductions to purchase an appreciating asset is clearly a good thing. Over time, the outstanding loan balance goes down and the value of the appreciating asset goes up. This equity gain, however, exists only on paper, will be paid in future-value dollars (less valuable than present value dollars), generates no income (who pays interest or dividends on your home equity?) and is not available (liquidity) to the homeowner for more lucrative investment (compounding interest). Again, the mortgaged property is appreciating in value, but this appreciation occurs with or without an outstanding loan balance and is not compounding in its effect on the paper profits frozen in home equity.
This, you say, sounds well and good for consumers, but what about its effect on mortgage servicers? If mortgage lenders and servicers don't provide value-added services that are good for consumers, how are they going to continue in business at a profit? Look at the huge sums of dollars that have flowed out of banks and into mutual funds under the management of the big investment houses (see Mortgage Banking, November 1996). The national investment houses have provided more value-added services for depositors than banks and thrifts.
All of these investment houses are looking for new financial products to sell, and mortgages look like a winner, i.e., Merrill Lynch, State Farm, PaineWebber and so on. Mortgage strategies have to be good for consumers or consumers will stop buying. Then the lenders and servicers will have no one to lend to - nothing to service.
Home-equity loans are increasingly popular for debt consolidation, home improvements and purchasing automobiles. But home-equity loans are less advantageous than cash-out refinancing, in my view. Here's why: The higher interest rates and shorter amortization of home-equity loans significantly reduces the arbitrage relationship - profit generated by buying and selling a commodity at unequal prices in different markets - that we discussed earlier. Explain why a borrower would want to do that.
One of the biggest complaints among portfolio lenders today is the absence of borrower loyalty. During the mini-boom in the summer of 1995, many lenders experienced 30 percent or more portfolio run-off 50 percent reductions in just a matter of weeks was not unheard of. If lenders keep focusing upon portfolio management at the expense of their borrowers' best interests, they'll create a market opportunity for a sharper competitor, and they'll be out of business (see "The Brave New World of Banking," Mortgage Banking, November 1996).
I understand the advantages of home equity loans for the lender, but after all, whom are we serving? The borrower's best interests may, at times, run contrary to those of the portfolio manager. If we, as lenders, choose to protect our interests over our customers' interests, we have no right to complain about a lack of loyalty. Further, in the eyes of our borrowers, we become indistinguishable from one another.
To prove the point, ask yourself this: How easily are my company's services and products replaced? If you can't be in the business of representing your customers' best interests and maintaining a profitable loan portfolio, let one or the other go.
Large insurance companies can underwrite the risk of loss more cost-effectively than most companies or individuals can self-insure. It would be great to keep all those premium dollars, but one big loss and you're broke. The insurance industry giants have the law of large numbers working for them. The risk is spread over a huge pool of insured accounts, reducing the impact of an excessive loss and creating an insurable average exposure. Large servicing portfolios enjoy the same benefit.
If keeping loans in your portfolio to recoup origination losses is more important than serving the unmet economic needs of your borrowers, then I believe you are living on borrowed time. Rate and term and cash-out refinancing are growing in acceptance. Borrowers are increasingly understanding the role they plan in personal financial plans. Prepays will become more common, not less, in my view. Borrowers will eventually realize the need to convert debt that doesn't work for you to good debt, nonworking home equity to working capital, and future-value paper profits to current-value dollars. Borrowers will eventually realize the need to manage their mortgages, just as insurance coverages and investment portfolios are regularly monitored.
The average person in this country is born and bred to pursue two American dreams: homeownership and financial security. The mortgage is the single most effective vehicle for achieving both.
There is a huge, untapped and under-served market willing to pay a premium for superior financial results delivered by strategies built around their needs and objectives. Insurance companies, investment houses and accounting firms are all opening mortgage operations to meet this market opportunity. Today's lenders must reengineer their origination marketing strategies, reconsider their positions as originators or portfolio managers, or watch what remains of their profitability shrink below the "level that will sustain existence."
For those lenders that decide to reengineer, creative expertise will be needed to design and execute the necessary changes. Many that provide such expertise today are adept at using new technology to squeeze incremental basis points from the process once a borrower has applied and is approved. Yet, the biggest challenges remain: finding profitable borrowers, tapping into niche markets with value-added services and insulating origination efforts from direct-price competition. Until you can create and secure long-term strategic alliances with your customers and own their point of sale, predatory pricing, portfolio losses and adverse supply and demand conditions will be your never-ending concerns.
Bill Early is president and chief executive officer and Mark A. Tisdel is director of marketing at The Morlend Group, mortgage lending specialists in Southfield, Michigan.
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|Title Annotation:||mortgage banks|
|Author:||Early, Bill; Tisdel, Mark A.|
|Date:||Apr 1, 1997|
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