The broker brand: in hindsight, brokers have been singled out for blame for the subprime lending bust. But can they restore their industry once we get past all the finger-pointing?
Inventories of unsold new and existing homes also declined through all of 2009. From its peak in July 2006, the number of new homes for sale has dropped by 54 percent--reaching its lowest level since November 1992, according to MBA. There was about a seven-month supply of new houses available for sale--which is only a little over the traditional average of six months--and MBA was expecting residential housing investment to increase in the third quarter of this year for the first time since late 2005.
"Recent trends in home sales and single-family housing starts confirm a gradual recovery in residential investment," concluded an MBA Mortgage Finance Commentary in mid-October.
Slumping origination volume
The bad news is that origination volume for one-to-four-family mortgage loans has fallen off sharply from the market's peak in the third quarter of 2005--although origination volume did spike to $626 billion in the second quarter of this year due to a surge in refinancing activity, according to MBA. As of mid-October, MBA was forecasting that total origination volume, including both purchase loans and refinancings, would total about $1.96 trillion for 2009--a healthy 30 percent increase over 2008's total of $1.51 trillion.
But for 2010, MBA expects that a sharp drop in refinancing activity will pull total originations back down to about $1,556 trillion. And this would be less than half of what the market did in 2005, when total originations exceeded $2.912 trillion.
The decline in origination volume alone would have had a significant impact on the mortgage brokerage industry, but the residential mortgage business has changed in other ways that place even more pressure on the brokers.
Tom LaMalfa, president of TSL Consulting, Shaker Heights, Ohio, points out that the origination market has tightened due to credit concerns by lenders, and that historically brokers have had a disproportionately higher share of first-time homebuyers and buyers with lower credit scores--the very people who are finding it more difficult now than a few years ago to obtain a mortgage.
"It's going to be a long and difficult period for the mortgage broker," LaMalfa says. "This business is going to be very difficult for the next couple of years."
Another challenge is that the industry's profitability dynamics have also changed. "We've moved to a plain-vanilla product market," says Matthew Lind, a Hingham, Massachusetts-based managing director for consulting and investment banking firm STRATMOR Group Inc. "The exotic products that used to pay a lot of money are gone, and brokers participated disproportionately in those. [Origination] volumes are down and [profit] margins on those products are tighter," says Lind.
The dominance of big banks
A significant factor in the brokerage industry's shrinkage is the fact that the home mortgage market is now dominated by the four largest U.S. commercial banks, three of which--Bank of America Corporation, Charlotte, North Carolina; JP Morgan Chase & Co., New York; and Wells Fargo & Co., San Francisco--have extensive retail branch networks that operate in most major metropolitan markets across the country.
According to LaMalfa, Bank of America and Chase have closed down their broker channels, while Wells Fargo and the fourth major bank player--New York-based Citigroup Inc.--have cut back drastically on their broker production. This has hurt the brokerage industry, because in recent years brokers were an important origination source for the big banks--especially during the boom years in the early part of this decade, when they enabled the banks to rapidly and efficiently expand when the mortgage market exploded.
But over the last year, many commercial banks saw both their profitability and capital come under intense pressure when the U.S. economy slid into a deep recession. "The capital crunch has led banks to focus on their own retail networks," says Lind. "The brokerage industry has also suffered reputational damage, and a lot of banks don't want to deal with them."
The combined pressures of a smaller, less-profitable mortgage market and the decision by the big banks to de-emphasize the broker channel or abandon it altogether have driven a large number of brokers out of business.
In May 2007, Access Mortgage Research--then known as Wholesale Access--released a survey of the mortgage brokerage industry that estimated there were approximately 54,000 firms in the business. "If there are 20,000 firms now, that would probably be a conservative number," says LaMalfa, a co-founder of Wholesale Access who was still affiliated with the firm at the time.
Guilt by association
As if all the economic challenges weren't enough, brokers are also operating under the stigma of having been significant participants in the subprime mortgage crisis--an event of seismic proportions that reverberated throughout the global financial system.
The mortgage brokerage industry has traditionally been regulated at the state level, and state licensing requirements have varied widely, which allowed many originators with varying degrees of oversight to participate in the mortgage market. Mortgage brokers ended up originating a large share of subprime loans because many of the largest subprime lenders operated using a wholesale production model.
Since subprime loans are inherently more risky, many of those loans later went into default, including the infamous option-adjustable-rate mortgage (ARM), which typically started out with a below-market interest rate that gave the borrower the option of varying the monthly repayment amount and enabled many people to buy homes they couldn't afford at the housing market's peak.
But there were other parties who played an equally important role in the market's collapse, including mortgage companies and commercial banks that underwrote and funded the subprime loans; Wall Street investment banks that bought the loans and combined them with other types of mortgages to make complex securities known as collateralized debt obligations (CDOs); credit-rating agencies that gave the securities their blessing; and yield-hungry institutional investors around the world who eagerly snapped them up, even though they knew little or nothing about the U.S. mortgage market.
"Brokers never underwrote a loan and never paid themselves a commission," says LaMalfa. "The only way they were able to do what they did was that they had willing accomplices."
The widespread perception that mortgage brokers were the primary cause of the subprime crisis resulted in a variety of legislative initiatives that have impacted brokers directly, either by raising their costs or making it more difficult for them to do business. NAMB did support passage of the Secure and Fair Enforcement for Mortgage Licensing Act (known as the SAFE Act), which was signed into law in July 2008 and established uniform licensing standards for state-licensed mortgage originators. Still, the new mandates do require a commitment of both time and money from brokers that remain in the industry, and have increased their compliance costs during a period when profits are down.
"It's a short-term inconvenience, but long term it's a good thing," says LaMalfa. "It will keep fly-by-night firms from coming into the business."
Walling off brokers from appraisers
Another regulatory change that is intended to create a stronger mortgage industry, but has negatively impacted the broker, is the Home Valuation Code of Conduct (HVCC), which took effect in May 2009. Developed jointly by the Federal Housing Finance Agency (FHFA), Fannie Mae, Freddie Mac and the New York State Attorney Generals Office, the rules have brought about significant changes in how the home-appraisal process works.
For example, brokers are no longer permitted to order home appraisals themselves, and originators--regardless of whether they work for a brokerage firm or a bank--are not allowed to have any communication with the appraisal firm. Retail originators may order an appraisal, but the appraisal firm cannot be a subsidiary of the bank.
The HVCC was intended to prevent appraisers from feeling pressured by origination staff to inflate an appraisal to make it more likely that a loan application would be approved. But the new rules seem to have created a lot of dissatisfaction throughout the industry. In a July 2009 survey by the National Association of Realtors[R] (NAR), Chicago, 76 percent of the respondents said the loan application process had been lengthened by the HVCC requirement, and one-third of the respondents said they had lost at least one sale because of a delay in the appraisal process.
NAMB President Jim Pair claims that the new HVCC rules can add anywhere from three to seven days to the amount of time it takes to get a mortgage, and hurts brokers since they can no longer order an appraisal directly. "It places us at a competitive disadvantage compared to the retail [originator] because they can do some things faster than we can," says Pair.
Brokers are also concerned about a proposed change by the Federal Reserve Board to Regulation Z of the Truth in Lending Act (TILA) that would place restrictions on the payment of a yield-spread premium (YSP) by a lender to a broker. A yield-spread premium is essentially a rebate that a lender gives to a broker for originating a higher interest rate on a mortgage loan. Brokers would sometimes share a portion of this rebate with the borrower to help him or her offset some of the closing costs, but it also provided added compensation to the broker.
"If we can't get indirect compensation, that could put a lot of brokers out of business and also hurt the wholesale lender, who often relies solely on the broker," says NAMB's Pair.
However, the proposed change would not ban all YSP payments to brokers, but would stipulate that any such payments must be fully disclosed to the borrower and cannot vary based on the terms and conditions of the loan. In other words, a broker could not offer a YSP on just certain loans that the broker might offer to a potential borrower, or vary the spread from one loan to another. The intent, according to Steve O'Connor, senior vice president of government affairs at MBA, is to prevent brokers from steering borrowers into higher-cost loans through the use of a YSP.
"[The Fed] is trying to reduce the incentive to put people into disadvantageous products," O'Connor explains.
It is not an exaggeration to say that the mortgage brokerage industry has entered a Darwinian period where only the strongest firms will survive. Because they can no longer rely on a booming mortgage market to carry them along, they will have to work harder than ever before.
Hard work ahead
Frommeyer, whose company has nine employees and focuses primarily on the Federal Housing Administration (FHA) market, says nowadays he often spends two or three months cultivating a potential mortgage customer before finally making a sale, and he has to work harder to find good leads. "The days of the phone ringing off the hook are gone," he says.
The survivors will also have to work smarter. "There's a premium now on brokerage shops that are professionally run and managed," says STRATMOR Group's Lind. "That has never been the broker's strong suit. When money is flowing like water, there are a lot of things you don't need to do well. Only the best broker shops will be able to stay in business."
The skills needed today to stay in business include making better use of point-of-sale technology to take control of the origination process.
By LaMalfa's reckoning, the brokers with the best prospects for the future are the ones who have been in business for 10 years or more and have a strong performance record with the wholesale lenders with whom they have been doing business. All lenders have tightened their credit criteria and are examining very closely the quality of mortgage applications their originators are bringing them, paying more attention to such things as FICO[R] scores and loan-to-value (LTV) ratios than in the past.
The SAFE Act also requires that all originators' loan performance be tracked over time, with the clear inference that those with sub-par performance could have their licenses revoked. Individual lenders are also very interested in the credit quality of their originators' loan production.
"Most lenders have the ability to tie loans in the servicing portfolio back to the brokers," says Olson.
Wholesale lenders also expect their brokers to have high pull-through rates in the 70 percent to 80 percent category, according to Olson. (The pull-through rate is the percentage of mortgage applications from an originator that end up getting funded by a lender.) And lenders are looking closely at the quality of mortgage applications they receive from their originators.
"They want good and complete documentation in hand," says Olson. "They don't want documents coming in after the fact. Things got very loosey-goosey there for a while. Now we have to get back to having very strong standards."
Brokers have the reputation of being resourceful, and that ability will be especially important in today's market. "They're going to need networks--Realtors[R] that they're comfortable working with," says LaMalfa. Realtors are a crucial source of leads, which is extremely important in a tight market. "Without that, they're screwed," adds LaMalfa.
Some brokers have also been setting up alliances with mortgage lenders other than their traditional wholesale lenders. Pair, who owns Mortgage Associates Corpus Christi, a small brokerage firm with three originators in Corpus Christi, Texas, has teamed up with a local credit union that does some mortgage lending in its service area. Pair originates the loans, and the credit union closes them and keeps them in portfolio. Pair has heard of other brokers who have struck similar arrangements with other credit unions or who, in the case of one individual, work with a local bank to originate construction loans.
"These are the kinds of things you're seeing mortgage brokers across the country doing," Pair says.
Although the mortgage brokerage industry's reputation was tarnished by the subprime crisis, brokers will have to concentrate on providing superior service to their customers.
"The customer likes having that contact with someone," says Pair. "They get a lot more attention from the broker than from a retail establishment, and that's why we're still in business."
STRATMOR Group's Lind believes there will also be room for service-oriented people in the home lending business. But whether it's fair or not, the mortgage brokerage industry has been stigmatized by the abuses that occurred during the subprime boom and by the market's eventual collapse.
Lind says brokers will have to work hard over the next few years to regain the trust of their customers. "If they can't rebuild their reputation at the local level or as an industry, they'll be in trouble," he says. "Can brokers build a trusted brand?"
Jack Milligan is a freelance writer based in Charlottesville. Virginia, and the former editor-in-chief of U.S. Banker. He can be reached at email@example.com.
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|Title Annotation:||Cover Report: Wholesale / Retail|
|Comment:||The broker brand: in hindsight, brokers have been singled out for blame for the subprime lending bust.|
|Date:||Dec 1, 2009|
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