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Rosy results in servicing.

Higher productivity, lower direct costs and higher per loan profits made 1995 a good year for many servicers. A new study shows average profit was $225 per loan last year versus $175 in 1994.

The debate continues inside companies today about whether they should stay in or leave the mortgage servicing business. As in the past, many believe that if they cannot be top industry players, then they shouldn't be playing the game.

The year 1995 was a relatively quiet one for mortgage servicing operations - at least compared with 1992, 1993 and the beginning of 1994. Many companies finally had the opportunity to manage their servicing operations proactively rather than resort to the reactionary management used in the previous three years.

Proactive strategic decisions have led to the emergence of a new class of mega-servicers with portfolios of more than 1 million loans. At the same time this proactive decision making has led many companies to exit the mortgage business entirely. These departures and looming competition with huge servicers have led many in the mortgage finance industry to ask, "Is it still profitable to service mortgage loans?" And if it is, "Is there more than one way to be a profitable mortgage servicer?"

These were two of many questions KPMG Peat Marwick LLP (KPMG) focused on in its 1995 annual mortgage servicing performance study, MorServ. This was the 10th year of KPMG's MorServ study. MorServ's objective has been to produce meaningful performance measurements for the mortgage finance industry. The study provides performance measurements that allow mortgage finance companies to compare themselves on an "apples-to-apples" basis with other mortgage servicers in the industry.

To achieve comparability, the participants' data is subjected to thorough data validation by KPMG to ensure that it is presented consistently and accurately. It is crucial that revenues, costs and personnel data is classified and categorized consistently despite the differences among mortgage servicers' internal reporting measurements.

MorServ focuses on single-family mortgage servicing data compiled of both quantitative and qualitative information. Factors such as portfolio characteristics, use of technology, management structure and compensation structure are analyzed against the profitability of the servicers to identify best practices within the industry.

As every mortgage servicer knows, no two portfolios are exactly alike. They differ in such respects as average loan size, portfolio size, investor mix and geographic locations of the underlying mortgages. It is important to understand how these differences affect the profitability, cost and productivity of each organization before any meaningful performance comparisons can be drawn.

KPMG concluded that companies with higher profitability were profitable because of the characteristics of their portfolio more than because of the number of loans in their portfolio. Many times a mortgage company considers its competition based on a rival's portfolio size, thus ignoring many of its actual competitors.

Also, many servicers do not consider companies that perform servicing activities differently than they do as competitors, yet they compete for loan servicing in some of the same markets. So the moral of the story, from MorServ findings and analysis of the industry, is that something can be learned from all of a company's competitors, regardless of size or business strategy.

Changes in classifications

KPMG's servicer classifications have evolved along with the industry. The first MorServ study compared all participants on a toe-to-toe basis, focusing primarily on the cost to service. As a class of large servicers began to emerge, KPMG provided a separate analysis for the major- and middle-market servicer participants. Major-market participants were defined as those servicing more than 100,000 loans. Major-market servicers were viewed differently because of their economies of scale and their investments in leading-edge technologies, such as voice-response units.

In 1994, KPMG realized that the major-/middle-market segmentation of the findings was not considering other important factors to mortgage servicing. As the industry continued to consolidate, two distinct groups of servicers emerged: national companies that serviced more than 300,000 loans and niche, smaller servicers that focused on a smaller geographic area or a particular product type.

As technology became more affordable and more evenly distributed among servicers of various sizes, many of the benefits from economies of scale that favored major-market servicers diminished. Both the national and niche groups realized advantages from creating experts rather than generalists in specific areas of the servicing operation.

National servicers continue to derive benefits from economies of scale that accompanied their portfolio growth. But they also have become burdened with extra layers of management and less accountability in sensitive areas such as investor reporting and default management.

The niche servicers have been able to gain economies from specialization. By specializing, niche servicers master nuances of investor reporting and default management and can react quicker to changes in their portfolio.

Those servicers who did not fall into either one of these two groups face the decision of growing quickly, specializing in a product and/or geographic region (and possibly shrinking in size), or leaving the servicing business entirely.

As costs continue to decline, their importance to overall profitability also has declined. In the 10 years that the study has been done, direct servicing costs per loan have gone from $80 in 1986 to a peak of $109 in 1990, plummeting to $63 in 1991 and then hovering before dropping considerably to the $47 per loan last year.

The industry consolidation of recent years has narrowed the range of direct servicing costs that are acceptable for viable long-term survival. The industry appeared to be identifying the base cost of the mortgage loan servicing business with relentless efforts to drive down costs in recent years.

The more profitable servicers identified by KPMG realized reductions in direct cost per loan. The direct costs for the more profitable class of companies were within $8 per loan of each other and ranged from $39 to $47 per loan. Those servicers that have not reached the average cost of $47 per loan still have opportunities to improve through technology enhancements and process streamlining.

The only major technology enhancements that remain to become consistently used throughout the industry are workstations and imaging. Debate continues among companies as to whether the increased efficiencies of imaging in the servicing operation merit the substantial cost entailed in acquiring that technology.

1998 MorServ

In producing this year's MorServ study, KPMG studied data for the 12 months ending December 31, 1995. Participants responded to an in-depth questionnaire focused on profitability, cost and productivity, including questions regarding activity levels (such as number of calls per operator per day and number of tax payments per FTE), quality, operational processes and statistics, technology and portfolio composition.

As a result of this approach, some of the better existing and emerging mortgage servicing practices could be identified. The analyses encompassed each of the functional areas identified in MorServ, which were the following: customer service (customer inquiry, taxes, insurance, escrow analyses, payoffs and assumptions); investor services (investor accounting and reporting, cashiering and cash management); default management (collections, workouts, bankruptcies, foreclosures and REOs); new loan setup, servicing acquisition and indirect. The indirect function includes general and administrative, data processing and record retention activities.

This year's MorServ study included data for mortgage servicing operations with a combined servicing volume of nearly $400 billion, with portfolios ranging from 25,000 loans to 1 million loans. Participants include eight of the top 25 mortgage servicers. Portfolio composition ranged from 85 percent GNMA servicing with an average loan balance of $47,000 to 91 percent Fannie Mae/Freddie Mac servicing with an average loan balance of $110,000. While the servicers in MorServ do not represent the industry as a whole, they do represent a broad cross section of the industry. Bank-owned mortgage companies represent 65 percent, non-bank owned mortgage companies 30 percent and independent mortgage companies represent 5 percent.

MorServ trends

While mortgage banking is a cyclical business, and the participant mix in MorServ changes from year to year, KPMG has noted trends in the industry during the 10 years of the study [ILLUSTRATION FOR FIGURE 1 OMITTED!. One of the most identifiable trends has been that during the past 10 years direct costs have decreased while productivity increased. The overall average direct servicing cost per loan declined from $67 in 1993 to $57 in 1994 to $47 dollars per loan in 1995 [ILLUSTRATION FOR FIGURE 2 OMITTED].

KPMG's 1986 MorServ study concluded that the competitive range of direct servicing cost per loan appeared to be between $70 and $90. Companies today incurring direct costs at what was considered acceptable levels in 1986 should be assessing the strategic issues of whether to get out of the servicing business entirely, subservice the portfolio or invest in process changes and technology to drive costs down to competitive levels.

Productivity also has dramatically improved during the last 10 years. Only a few years ago, servicing productivity of 1,000 loans per direct full-time equivalent employee (FTE) was considered a goal to aim for, even though it seemed potentially out of reach for many. This year's average direct productivity of 1,100 loans per FTE shattered that concept. The best performer and most profitable companies surpassed 2,000 loans per direct FTE. The progress made in recent years in servicing productivity is remarkable. As recently as 1993 the average direct productivity for survey participants was 690 loans per direct FTE. That jumped to 901 in 1994 and then crossed the 1,100 barrier last year as automation fueled substantial gains in servicing productivity.

Characteristics of profitable servicers

In light of new financial accounting standards requiring the capitalization of both purchased and originated mortgage servicing rights, this year's MorServ analyses focused more heavily on profitability than ever before. In determining profit, KPMG considered total revenues less total expenses, not just direct expenses.

Gains related to the sale of servicing were excluded from this profit analysis since they were generated outside of the normal operational activities. Companies whose profits are substantially affected by gains from servicing sales tended to sell servicing primarily for that reason and not necessarily to alter their portfolio characteristics for strategic reasons.

Also, the accounting impact of purchased and originated mortgage servicing rights (which includes capitalization, amortization and impairment adjustments associated with mortgage servicing rights) was excluded from profit for purposes of this study because of the different timing used by companies for implementation of this accounting standard during 1995. Some of the participants implemented at the beginning of 1995, some throughout 1995, and some waited until 1996 to implement Financial Accounting Standard 122.

The 1995 MorServ average profit was $225 per loan compared with $175 in 1994. The better performer's profits were $375 per loan compared with the lowest profit of $91 per loan.

KPMG identified a class of participants whose profit was better than the average and who were considered top performers based on profitability. To identify the factors driving profitability, KPMG analyzed those companies exhibiting higher than average profitability. These top performers showed average profit per loan of $350 in 1995 compared with slightly more than $200 per loan on average for the remaining participants in the study [ILLUSTRATION FOR FIGURE 3 OMITTED]. That represents a difference of roughly $150 per loan in profits.

One interesting fact to note was that the major-market (or largest) servicers' average profitability was $216 per loan compared with the middle-market servicers' profitability of $204 per loan. This challenges the industry's mind-set that bigger is always better in the servicing business. A single dominant type of servicer did not emerge among the companies making up the more profitable grouping, rather it was a combination of national and niche-type servicers.

National servicers were defined as companies considered the industry players or the top 25 companies ranked in terms of portfolio size. Their geographic portfolio distribution was national, and they serviced primarily for the secondary market agencies (Fannie Mae, Freddie Mac and GNMA). Niche servicers had smaller portfolios (usually fewer than 100,000 loans) and were concentrated geographically and/or by loan type.

The largest insight gained from the performance and characteristics of the more profitable servicers was that several ingredients contributed to their profitability. In addition, size plays a different role than many previously thought. Many companies and analysts believed that direct cost was the most important factor to consider in evaluating a mortgage servicer's performance. KPMG found that revenues were an equally important source of profitability.

The industry has focused heavily on the size of the servicing portfolio and the opportunities to lower costs through economies of scale and the ability to segment the portfolio because of size alone. However, the opportunities to lower costs in areas such as indirect expenses and investor reporting and accounting activities did not exist as many in the industry would have expected. For example, the larger servicers' data processing costs averaged $13 per loan compared with $11 per loan for the smaller servicers. Similarly, the investor reporting and accounting costs averaged $3.25 for the larger servicers compared with $3.70 for the smaller servicers.

Higher revenues

The higher profit servicers proved that higher revenues had a greater impact on profit than did lower cost. Total cost per loan (calculated as direct and indirect costs plus foreclosure losses and nonoperating interest expenses) for the more profitable servicers of $105 was only $10 per loan less than the average of $115.

Net servicing fees (excluding amortization of mortgage servicing rights) and float income were the two largest contributors to increased revenue. Net servicing fees were nearly $120 per loan, or 5 basis points, higher than the average for the more profitable servicers. Net servicing fees in 1994 for the more profitable servicers was nearly $200, or 15 basis points, higher than the average.

The higher servicing fees were a result of higher average loan balances, $95,000 for more profitable servicers compared with $75,000 for the remaining data base, and the investor mix. The more profitable servicers tended to service primarily for each of the three major agencies (Fannie Mae, Freddie Mac and Ginnie Mae). Loans being serviced for the agencies made up 85 percent of the more profitable servicers' portfolios, compared with an average of 76 percent for the data base as a whole.

Float benefit was another large contributor to higher profits. The more profitable servicers had $30 per loan more float income than the average participant. The MorServ study presented float income based on what was received by the mortgage servicer - not an imputed value.

The ownership structure of the servicer affects the amount of float income received. This income was allocated to mortgage companies using a variety of methods. Some companies, recognized no float benefit in the servicing operation's profitability. Others had various relationships related to direct interest earnings and credit allocations related to benefits from compensating balances. Various participants had sophisticated means of investing their escrow and principal and interest balances in order to receive maximum benefit while still complying with industry regulations.

Direct cost components

Although the more profitable servicers' cost per loan of $45 was only slightly less than the data base average of $47 per loan, the components of direct costs were different for the more profitable servicers than for the average servicer. The more profitable servicers tended to incur higher "other" operating expenses than the rest of the participants because of outsourcing. Personnel cost made up 59 percent of the direct cost on average but only 54 percent for the more profitable servicers.

In recent years, KPMG has identified an increasing number of participants that outsource their tax and insurance payment processing activities. Some companies were exploring outsourcing other areas of their operations such as some default management activities. All of the participants who out-source their insurance payment processing were among the more profitable servicers.

Personnel cost per employee

Paying fewer people higher salaries was another strategy used by some of the more profitable companies. Personnel cost per FTE was $10,000 higher for the more profitable servicers than the average servicers. Personnel costs per FTE (which includes benefits, incentives and so on) ranged from $25,000 to $48,000 and averaged $32,000. While the amounts shown are not adjusted for a cost of living factor, the higher paid employees were not in an area requiring higher salaries.

The dual forces of having personnel cost be a lower percentage of direct costs and having a higher personnel cost per FTE led to 20 percent higher productivity for the more profitable servicers compared with the average study participant. Productivity for the more profitable servicers was 1,600 loans serviced per direct FTE, which includes the customer service, investor services, default management, new loan set up and servicing acquisition activities. This number was significantly higher than the average participant's number of loans serviced per direct FTE of 975.

Which products were least costly to service?

Another focus of the 1995 MorServ study was to compare the direct cost to service the various types of loans. The direct cost per loan was analyzed by product classifications such as government (FHA and VA loans), conventional conforming agency loans (Fannie Mae and Freddie Mac), portfolio loans (owned by the mortgage company or its parent) and private investor loans [ILLUSTRATION FOR FIGURE 4 OMITTED]. This year's results confirmed and expanded on observations from last year's MorServ analysis. The 1995 study found the most expensive type of portfolio to service on a direct cost basis was portfolio loans. The direct cost for this product type was $87 per loan. The next most costly type portfolio was private investor servicing at $74 per loan in direct costs. This was followed by government mortgage portfolios at $55 per loan in direct costs. Finally, conventional servicing portfolios showed the lowest direct cost per loan at $45 for study participants.

The servicing cost comparison between government and conventional agency servicing highlighted some interesting observations. As expected, both had similar costs except for the default management function where the conventional agency servicing's cost of $11 per loan was nearly half of the government servicing's cost of $20 per loan. Delinquency rates behaved similarly at 7 percent for government servicers compared with 2.3 percent for conventional agency servicers. The overall direct cost for government products in 1995 was $55, while conventional servicing direct costs were $10 cheaper on a per-loan basis. The relationship was consistent with 1994 findings, which found government servicing's direct cost to be $62 versus $54 for the conventional agency product costs.

KPMG's analysis of government servicing operations found some positive factors. The government portfolios had lower payoff rates of 8 percent versus 10 percent for the conventional agency servicing portfolios. Comparing direct profits (net servicing fee less direct and indirect cost excluding loan losses) revealed that the government servicing was more profitable at $155 per loan than conventional agency servicing at $125 per loan. Even though the government loan portfolios had higher direct cost and a lower average loan balance ($56,000 versus $82,000 for the conventional agency), the higher servicing fee paid to servicers for government servicing more than compensated for this difference.

Portfolio loans exhibited the highest direct servicing cost per loan at $87 in 1995 (the costs were similar in 1994). The high cost was due to their default management costs. Even though the portfolio loans had lower delinquency rates than government loans, their cost was high due to the additional exposure on foreclosure losses. In addition, portfolio loans had the highest payoff rate at 13 percent.

Private investor loan products had the next highest direct cost per loan of $74 in 1995, compared with $86 in 1994. The fluctuations between years occurred in the investor services (investor accounting/reporting and cashiering/cash management activities) and default management functions. Typically the cost associated with private investors differs from the agencies because of the number of loans included in pools. Most of the participants' number of loans per private investor in 1995 ranged from 400 to 800, which is less than the number of loans in each agency pool. Different remittance methods and timing for each private investor and different collection, workout and floreclosure terms as loans migrate into the default management area between each private investor all contribute to the higher costs for these loans.

What the numbers show

While the industry historically has not dwelled on servicing profitability at the product level, the capitalization of originated mortgage servicing rights has forced companies to begin to evaluate their performance differently. Intuitively, the industry knows that servicing government loans is more costly, which is evident from a pure analysis of direct cost, yet the industry has ignored the profitability of these products.

KPMG evaluated the return on investment for the more profitable, the average major-market and the average middle-market servicers. On a pretax basis, the return on investment was 19 percent for the most profitable companies and 11 percent and 12 percent for the middle-market and major-market companies, respectively. Clearly, the industry should focus more heavily on what drives overall servicing profitability rather than simply direct cost to service.

Companies are now forced to accept the discipline of managing an on-balance-sheet asset because of the increased awareness of stockholders, Wall Street and senior management. The servicing asset today is more volatile than many are willing to accept, and management must assess their tolerance of the impact this asset has on the income statement. However, without the appropriate data, this analysis cannot be performed accurately and completely.

Not only does the accounting impact of servicing rights need to be addressed and managed more closely in 1996, but the economic impact of servicing rights also must be closely managed in order to compete in the industry. These two concepts, accounting and economic analysis, are not the same. The accounting impact focuses on the market values of servicing rights. The economic impact considers the company's profitability by risk characteristics of the servicing portfolio. These risk characteristics may be more detailed for the economic analysis than the accounting analysis. To properly manage the asset, profitability data such as net servicing fees, float income, ancillary income and direct cost to service must be available to management at product-level and, in many cases, loan-level detail.

This year will prove a year of enlightenment for senior management about the servicing divisions of their mortgage companies. New opportunities will arise, such as joint ventures between companies, to maximize companies' investments in technologies and infrastructure. The ability to negotiate with outside vendors for services through larger portfolios will provide the opportunity to bring down the cost of servicing further. Companies should not forget, however, the impact revenues have on profitability and the ability to increase servicing revenues.

Geoffrey Oliver is a partner and co-director of KPMG Peat Marwick LLP's Mortgage and Structured Finance Group, headquartered in Washington, D.C. Laura McDonald is a senior manager and Neil Kennedy is a senior associate with the Washington, D.C., group.
COPYRIGHT 1996 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1996 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Servicing; mortgage servicing
Author:Oliver, Geoffrey; McDonald, Laura; Kennedy, Neil
Publication:Mortgage Banking
Date:Jun 1, 1996
Previous Article:Guarding against risk.
Next Article:The dawning of a new era.

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