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The factors driving wholesale.


Wholesale purchasing has quadrupled since 1987, and many signs indicate that the wholesale business may be the best way to go.

Wholesale mortgage banking's popularity has grown at a torrid pace in recent years as the number of companies engaged in the business has increased at least threefold to more than 100 since 1987. Purchase activity has more than quadrupled to more than $100 billion in the same period. Why is this part of the business attracting so many new players? What is driving this expansive volume?

This article examines the engines causing wholesaling to expand. The authors hope to provide some new insights into a sector of the mortgage market that is growing faster than origination volume, agency purchase activity or securitization. The authors share some credentials that together give them a unique perspective on the rise of the wholesale business. Recently purchased by Prudential Home Mortgage Company, Inc., the Springfield, Illinois-based operations of America's Home Mortgage Company, headed by Phillip Bracken, purchased $2.8 billion last year, has been a wholesaler since 1981. Thomas LaMalfa, a long-time observer of the mortgage market, spent much of the past two years tracking the wholesale business.


Wholesaling is a method of production. Rather than originating loans through the efforts of an in-house staff, whole loans are purchased servicing-released from correspondents, mostly mortgage bankers and mortgage brokers. Acquisitions, consisting of closed or new originations, are made on either a bulk or flow basis. Bulk transactions typically range in size from $500,000 to $50 million or more and involve closed loans; flow sales encompass closed or new loans sold one at a time or in small groups. Many wholesalers use both acquisition methods.

The authors' first exposure to wholesaling occurred in the late 1970s when George Greenwell, then president of Lincoln Service Corporation, Owensboro, Kentucky, adopted this production method as an alternative to direct or retail originations. Greenwell, wanting to produce loans as inexpensively as possible, bought whole loans servicing-released and sold participations to Fannie Mae and Freddie Mac, or pooled the loans for Ginnie Mae securities. Like traditional mortgage bankers, Greenwell and his company wanted the servicing.

By the early 1980s, a handful of other companies began wholesale operations. Many initially limited acquisitions to FHA-insured and VA-guaranteed mortgages; most were supplementing retail production to take advantage of the economies of scale available to larger producers.

As origination activity rebounded after the 1980-1982 recession, wholesalers' ranks began growing gradually. In 1985, LaMalfa was asked to survey the market to determine how widespread wholesaling was. Working through the large private mortgage insurer--MGIC's national secondary market network, he had access to people who were knowledgeable about lenders based in various sales regions. From what could be gleaned, 12 to 15 companies were active participants; aggregate production totaled approximately $2 billion at that time.

Two years later the same questions arose: Who were the wholesalers and how much business were they doing? The response was that in 1987 there were 30 to 35 wholesalers collectively producing $15 to $20 billion of business. Clearly wholesale's appeal was growing, and activity was expanding.

Earlier this year, another survey was taken. However, unlike previous efforts, it was taken after closely studying the wholesale industry for almost two years: the players and their operations, programs, products, markets, approval requirements and so forth were now well known. Such familiarity provided an opportunity to ascertain how much business each company did in 1990 and how much was expected this year. (A sequel to "Who's Who in Wholesale," an article that appeared in the April 1990 issue of Mortgage Banking, is currently being drafted.)

Except for a few companies that preferred anonymity, the 1990 survey indicated that 73 major wholesalers purchased approximately $90 billion. From 1989 to 1990, the number of major wholesalers had increased by 15, and total purchase volume had risen by nearly $40 billion, up 78 percent from the prior year. Wholesaling was continuing to attract new entrants, and volume was climbing.

Seven reasons help explain why the wholesale mortgage banking business is attractive: 1) lower fixed costs, 2) more favorable accounting treatment, 3) increased efficiency in building a servicing portfolio, 4) scale economies and the economics of size, 5) regulatory and legislative developments, 6) improved risk management and quality control standards, and 7) structural changes in the mortgage market. No attempt was made to prioritize these factors based on their importance; likewise, every factor cited may not have applied to each company's decision to enter wholesaling.

Lower fixed costs

Greenwell's objective at Lincoln Service Corporation was to build a servicing portfolio and to increase profitability by reducing production costs. Wholesaling accomplished this: it reduced personnel costs, limited the number of branch offices needed to produce loans and helped control general and administrative expenses.

Historically, mortgage companies generated capital for expansion through retained earnings. After capital was created, an office was established, employees were hired and the lending operation was begun. Although this process was repeated successfully throughout the post-World War II period, the high inflation rate of the late 1970s and the competitive environment of the 1980s raised serious questions about the operating strategy's financial viability. Profits proved too thin for most companies to generate capital internally via this means.

Establishing a production facility could be expensive. Once a decision was made about where to locate, the office had to be leased, a staff hired, equipment purchased and so on. Generally, the sequence went like this: a branch manager was hired and he or she brought on board the back office and sales teams. Because getting production going quickly was important, experienced employees were sought and top dollars were paid to secure such a team.

Because office expansions typically occur simultaneously throughout the industry, many branch managers were hiring staff at the same time as their competitors.

To attract the best-qualified, most-experienced staff, ever-larger compensation packages were extended, ensuring that the company's financial break-even point rose with each new employee.

Salaries were not the only item adding substantial costs; so were rents. Following the real estate maxim that price is determined by "location, location, location," lenders established offices at pricey addresses, and production costs rose accordingly.

By comparison, wholesale costs less to operate because fewer offices and employees are needed. If one central facility does not suffice, a central locale with a few regional offices usually does. Fewer offices mean less overhead. Moreover, wholesale offices can be relatively spartan. They are visited infrequently by correspondents and never by Realtors, builders and borrowers. In wholesale, cost control exceeds location in importance. As one pundit observed, "You can run wholesale from the basement of a gym."

Staffing efficiency is also improved: centralization eliminates duplicate management; salaried loan officers are unnecessary and job responsibilities are frequently narrower. For example, the wholesale underwriter can perform his or her tasks faster and more efficiently on closed loans than the retail underwriter who frequently must wait for the documents to be assembled. Similarly, the wholesale processor does not assemble the documents, a step required of the retail processor. The wholesale processor's task is to verify the facts and figures provided by the originator. This improves efficiency. Smaller staffs, fewer salaries and lower rents mean less overhead, lower production costs, better profitability and greater efficiency.

Accounting treatment

The accounting rules give wholesalers greater profit opportunities by allowing the cost of the service-released premium--the big expense item for most wholesalers--to be capitalized and amortized, rather than treated as an intermediate-period expense. By booking servicing as an asset, and writing it off over the mortgage's estimated life, revenues and expenses can more easily be matched.

Because the retailer is producing--not purchasing--an asset, the more favorable accounting treatment is not available. Under FASB 65, only purchased assets can be amortized. Moreover, the retailer must take the difference between the fee income received from the loan and the cost of production and treat it as an immediate-period income or expense. For instance, if the all-in cost of production is 2 percent, the industry average per data gathered by the Mortgage Bankers Association of America (MBA), and 1.5 percent is received in origination-fee income, then a 0.5 percent loss must be recognized. The retailer cannot treat the shortfall as an expense and amortize it.

Building a servicing portfolio

Because servicing generates large revenue and income streams, investor demand for it is strong. The real question that confronts the industry is: "What is the best way to build a profitable servicing portfolio?"

Investors have one retail and two wholesale routes to choose from when acquiring servicing: they can originate loans one at a time; they can buy bulk servicing; or they can purchase loans servicing released on a flow basis from multiple sellers. The first and second options have drawbacks not found in the third.

Retail production's biggest disadvantage is that it takes weeks to originate, process and close a mortgage. A second drawback is competition: it is keenest in the primary market where dozens of lenders vie for every loan; even the largest companies command only small market shares. Third, a loss is incurred on nearly every origination, as the total cost of producing a loan is seldom completely covered by the fees received.

Bulk acquisitions allow servicing to be accumulated quickly, but these purchases are not without disadvantages. First, bulk transactions are large--typically $50 million or more in size--and because packages generally cannot be split apart, buyers are exposed to loans in markets they may not know or want to enter. A second shortcoming is that the loans cannot be underwritten individually. The general rule is, if you take one, you take them all. Another drawback is quality; as sales accelerated in recent years, quality declined as sellers often sold parts of their portfolios that cost the most to service and retained their best. A fourth disadvantage is the difficulty of digesting a bulk acquisition: each loan must be integrated into the buyer's servicing system correctly without disrupting the operation or adding unnecessary costs. Finally, bulk prices are frequently higher than flow prices, because a combination of strong investor demand, excess industry capacity and high yields together produce aggressive bids.

Building a servicing portfolio through wholesale flow production offers these advantages: 1) loans can be purchased from select markets and specific originators; 2) loans can be underwritten prior to purchase; 3) prices are lower than bulk prices; 4) buyers have greater latitude in what they will pay; and 5) purchase volume can be adjusted to meet capital and back-office demands.

Size and economies of scale

Economies of scale, though difficult to measure, are as important in mortgage banking as in manufacturing. The more widgets or mortgages produced, serviced and sold, the more efficiencies are attained, especially if state-of-the-art technology can be applied, and if size offers advantages not available to every competitor. Size and scale economies offer cost savings in four areas: hedging, securities issuance, servicing and marketing.

Most wholesalers offer best-efforts commitments to eliminate their correspondents' exposure to interest-rates. Using futures and options markets to offset interest-rate risk is effective, but it is expensive and requires careful attention and considerable sophistication. Large-scale use of hedging allows reductions in per-unit costs.

Securities issuance provides economies of scale because issuance costs decline as the size of the security increases. For example, with the cost of issuing a double-A rated pass-through security being about $250,000, the cost is 100 basis points if spread over a $25 million security but only 25 basis points on a $100 million security. Larger securities also command higher prices.

Computers create efficiencies in servicing that reduce expenses. All else being equal, the greater the number of loans serviced, the lower the per-unit cost. In servicing, where the same tasks are repeated, automation has lowered personnel costs. This is best seen in the steady increase in the industry figures showing the number of loans serviced per employee.

A fourth economy of scale is available in marketing. National and regional wholesalers market their programs to hundreds or even thousands of correspondents from centralized, single-location facilities. America's Mortgage Company, a division of Prudential Home Mortgage, has more than 300 correspondents from 30-plus states and operates from Springfield, Illinois, while Countrywide Funding Corporation, which has thousands of correspondents, reaches them through its headquarters in Pasadena, California. Higher costs are incurred reaching large numbers of correspondents, but the costs are variable and thus are more controllable.

Finally, size itself begets various advantages. First, large players ordinarily have access to cheaper funding sources, such as commercial paper, which gives them a cost advantage over smaller producers. Second, big players can negotiate better terms from vendors, the agencies, bankers and others because they too benefit from economies of scale. For instance, the agencies extend lower guarantor fees to larger sellers because it costs them less to negotiate and execute one $1 billion commitment than one hundred $10 million commitments.

Regulatory and legislative issues

Various regulations and legislation also have favorably impacted wholesaling, including the risk-based capital requirements, the Federal Deposit Insurance Corporation's (FDIC) rule governing purchased servicing, the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA), state-licensing rules for originators and sundry federal laws, such as the Community Reinvestment Act (CRA).

The risk-based capital rules aid wholesalers through their financially advantageous treatment of residential, first mortgages. These rules allow regulated institutions to retain less capital to hold these assets than for most other alternatives. Although this incentive may be consummated through direct investment, such as in Ginnie Maes, bigger profits can be reaped by purchasing and securitizing whole loans. Moreover, the banking industry's poor track record with higher yielding investments--commercial real estate, leveraged buyouts and third-world debt and so forth--fosters greater interest in lower risk assets. Current difficulties raising capital further tilts the table toward conservative, non-capital-consumptive strategies.

The FDIC rule permitting 50 percent of purchased mortgage servicing rights to apply toward meeting the core-capital requirement of affected institutions is another blessing for wholesalers. Though many had hoped for an even more liberal limit, the adopted rule was less onerous than the version originally proposed. Some wholesalers, particularly those who traditionally set high net-worth requirements for correspondents, are considering setting up mortgage broker programs; loans closed in the wholesaler's name do not fall into the category of "purchased servicing."

FIRREA promotes wholesaling in two ways: first, it increases the supply of mortgages and servicing available for sale; second, it decreases competition for purchased mortgages and servicing from thrifts. By imposing higher capital requirements--especially against a backdrop in which most thrifts cannot raise capital--the regulators are forcing the industry to downsize. Longer term, the qualified thrift-lender test, which raises the floor to 70 percent on the percentage of thrift assets that must be held in mortgage investments, portends greater involvement by thrifts in wholesaling.

State efforts to regulate originators are considered constructive because the resulting requirements, such as net worth and educational standards, make it easier for wholesalers to evaluate and monitor current and prospective correspondents and enforce minimum standards.

Certain other federal statutes that apply directly to retail lenders have less, if any, applicability to wholesalers. Moreover, some retailers with wholesale departments find that purchasing loans is the best way to comply with the CRA.

Risk management and quality control

The burdens of risk management and quality control are somewhat lighter for wholesalers because they have a wider range of choices in markets, products, procedures, correspondents, requirements and the like. Not physically tied to a specific locale, they can scour the country looking for strong markets from which to purchase loans. When a market softens, production can be redirected to areas where origination activity is better, growth more robust and property values are rising.

Consider the widely discussed cut-backs in military spending and the Department of Defense's decision to shutdown or scale back at least 30 military bases. When a specific base closing is announced, the wholesaler would have the option of ceasing business in that market virtually on the spot, after honoring the pipeline. The retailer, whose pipeline is in most instances considerably longer, can do likewise, but then must address the problems of what to do with the lease on that local office and the staff.

Wholesalers are better able to deal with a soft market because prices can be adjusted to be slightly less competitive, the product menu can be pruned to direct traffic toward less-risky instruments, fees can be increased and other techniques can be used to redirect demand and more accurately price the risk. To manage price risk in a soft market, fees can be imposed to offset potential losses, just as a security issuer might subordinate a portion of a pool to serve as credit enhancement. Employing such concepts is impractical for most retailers who would fear criticism from competitors, customers and possibly the local media.

A commitment to staff, customers and location gives retailers in soft markets fewer choices: they can exit a market, scale back or shut their eyes and pray that the problem--be it a downturn in the market or a crazy competitor--will prove ephemeral. However, these options have a cost, economic and otherwise.

Taking actions similar to those just cited are possible, but they run the risk of alienating the builders and Realtors the retailer works so hard to woo. And, of course, shutting an office requires providing severance pay and making good on the lease. Scaling back in a soft market increases the likelihood that top income producers will depart.

There are three basic reasons why the wholesaler can exercise better quality control: financial goals need not be achieved from a specific market; the wholesaler is one step removed from the originator and the borrower; and managers are usually not compensated for individual loans.

Retailers must be more circumspect about rejecting loans for fear customers will slow the flow of business; it also usually means no commission for the loan officer and no override for the branch manager. Also, retail managers' compensation packages are tied to the profitability of the branches, and profits typically are tied to quantitative not qualitative measures. For wholesale managers, the trend in compensation has shifted toward greater balance between volume and quality. Performance-based criteria are increasingly being used to compensate the wholesale manager.

Yet another advantage concerns the representations and warranties used to force repurchase: correspondents can be required to buy back a loan but a retail branch cannot. Standard correspondent contracts (similar to agency agreements) have a 12-month repurchase window. It can be used in the event of early delinquencies, foreclosures, document deficiencies, fraud or any severe adverse change in the correspondent's financial or legal status. No similar safeguards exist for retailers. Ever heard of a branch buying back a loan because of missing documentation? Wholesalers can and do demand repurchase for exactly that.

Retail lenders like to point out that an originator with a net worth of $50,000 cannot repurchase a $100,000 loan in foreclosure. Besides neglecting the fact that neither can the branch office, such statements overlook the correspondent's ability and proclivity to assist the wholesaler by absorbing the $2,000 to $5,000 shortfall for unreimbursed foreclosure expenses. Such an assist is not possible from a branch office.

Another major advantage for wholesalers involves underwriting: decisions are made away from the playing field by wholesalers whereas retailers make them on-the-field. This is most evident in compensation and proximity to customers, such as Realtors and builders. Obviously, off-the-field decisions help increase underwriting objectivity.

In light of the rolling recessions that have struck various regions and economic sectors during the past decade-and-a-half, geographic risk dispersion should be considered in the context of quality control and risk management. Not surprisingly, wholesalers benefit more from risk dispersion than retailers. Many lenders who made no more grievous error than to be located in Texas, Arizona or Colorado were ruined financially when the bottom fell out of those state economies a few years ago. Smaller losses were suffered by wholesalers who diversified their exposure geographically.

The absence of a fixed location, better-balanced compensation programs, and greater distance from the borrower creates an environment where quality control and risk management procedures can be better carried out by wholesalers.

Structural changes

Three changes in the structure of the mortgage market also have worked to the benefit of wholesalers: the growth of the secondary market; the decline in the profitability of mortgage banking and the collapse of the thrift industry; and the move to restore industry profitability through specialization.

The maturation of the secondary market has had a direct effect on wholesaling because it fostered a large, liquid aftermarket where firms could buy and sell loans and securities. Without it, wholesalers could not perform routine functions like hedging or offer an array of products and commitment options. An expanded variety of mortgage securities, especially second-generation varieties like collateralized mortgage obligations (CMOs), created an environment where wholesaling could thrive. Fannie Mae, Freddie Mac and GNMA share credit for developing this market.

According to industry cost studies published by the MBA, average returns on revenue have tumbled in the mortgage banking business. In 1987 and 1988, the most recent years for which data has been published, profit margins averaged 1.2 percent compared to returns of between 15 percent and 25 percent in the prior five years. With profits virtually nonexistent, lenders have focused on unbundling services. Several years ago, companies performed all of the activities, from origination through servicing. Today, some participants only originate, others only subservice, some only do wholesale, others only gather deposits and make investments and still others only perform due diligence or offer investment banking services. Specialization is expected to counteract the decline in profitability by controlling costs, increasing productivity and taking advantage of economies of scale.

Lower profitability, in combination with the disintegration of the thrift industry--more than half of the 4,000 thrifts that existed in 1980 are gone--sharply increased unemployment among mortgage professionals. Rather than abandon the business, thousands of them decided to originate and broker loans. In many cities, such as Chicago, New York, San Diego, Seattle and Houston, to name but five, mortgage brokers account for a majority of originations. Their trade association, the National Association of Mortgage Brokers, Phoenix, estimates there are 10,000 brokers nationwide; mortgage broker organizations in California and Florida by themselves boast thousands of members. Significantly, the advent of the mortgage broker has given wholesalers the means to grow; an opportunity they did not have before there were enough originators seeking to sell loans servicing released.

The confluence of these seven factors is arguably making wholesale mortgage banking the best production mechanism available today. Assuming the reasons for being a wholesaler remain intact, its popularity is likely to grow in coming years. The challenge will be for wholesalers to realize all of the benefits this production arrangement offers. As this is recognized, wholesaling will flourish.

Commercial banks are likely to be chief among the new entrants in this arena. One catalyst likely to pique their interest is the risk-based capital rules. The wholesale business allows regulated financial institutions to optimize the value of their capital.

On another level, the advent of wholesaling reflects the trend toward the unbundling of services that is restructuring the financial service business. Specialization is one method of improving profits in a mature industry.

There certainly are challenges aplenty ahead for wholesalers. Freddie Mac's new policy on third-party originations, the taxation of servicing issue, accounting considerations for broker programs and a myriad of other issues must be resolved. But even with the caveat that no one can predict the future course of events, wholesaling is very likely the best road to take today to get from here to there in residential finance.

Thomas S. LaMalfa is president of Wholesaling Inc., a mortgage consulting firm in Shaker Heights, Ohio. Phillip Bracken is executive vice president of Gaithersburg, Maryland-based Prudential Home Mortgage Company, Inc., and senior executive officer of America's Mortgage Group located in Springfield, Illinois.
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Title Annotation:wholesale mortgage banking
Author:LaMalfa, Thomas S.; Bracken, Phillip
Publication:Mortgage Banking
Date:Aug 1, 1991
Previous Article:Crossing the rubicon.
Next Article:Adjusting to the perils of ARMS.

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