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What drives servicing profits?

A servicing cost study shows that profitability doesn't always track with size of the servicing portfolio. But on the servicing cost side there are definite advantages to being big. The largest servicers squeezed down their direct costs per loan to $43 last year; medium-size servicers whittled it down to just $49.

One cannot begin writing about mortgage servicing without commenting on the impact of the recent banking mergers. With NationsBanc Mortgage and BankAmerica Mortgage combining to form the largest mortgage servicing portfolio and one of the largest consumer customer base, the gap between the medium-sized mortgage servicer and the mega-mortgage servicer has widened greatly. But sheer portfolio size is just one consideration when analyzing potential performance of these merged institutions, as this article will show.

Of the top-seven servicers, all of whom service more than $100 billion in loans after their acquisitions, only two service from one location. The remaining servicers have between two and seven servicing sites. This is an important consideration when evaluating the economies of scale and the mortgage servicer's financial performance.

The continued concern over replenishment (adding new loans to offset those paying off) is more profound with the megaservicers. To mitigate the need to purchase servicing in bulk packages, which continues to be more costly, there should be a balance between the mortgage production and mortgage servicing operations.

The industry continues to believe that bigger is better for mortgage loan servicing. KPMG Peat Marwick LLP (KPMG) agrees with this hypothesis when averaging results. However, we have consistently identified companies in our database with fewer than 150,000 loans in their portfolios that exhibit "best-in-class" profitability. Likewise, KPMG has identified companies with more than 500,000 loans that did not meet average profitability standards. Thus, our historical comments of considering more than size should be evaluated at the company-specific level to understand how smaller to medium-sized companies can realize best-in-class profit levels.

The 1997 weighted-average operational profitability for servicers with more than 500,000 loans in their portfolios (large servicers) was $337 per loan compared with the medium-sized servicers (those with less than 500,000 loans) of $153 per loan [ILLUSTRATION FOR FIGURE 1 OMITTED]. Operational profitability excluded the amortization of mortgage servicing rights and the gains from bulk servicing sales.

There was an increase in the gap of the direct cost to service between the medium and large servicers from 1996 to 1997. Our data has shown that the weighted-average direct cost to service for large servicers was $43 per loan in 1997, compared with $42 in 1996. The medium servicers' weighted-average direct cost to service a loan in 1997 was $49, compared with $47 in 1996 [ILLUSTRATION FOR FIGURE 2 OMITTED].

1997 MorServ

This was the 12th year of KPMG's mortgage servicing performance study - MorServ. Throughout the years, MorServ's objective has been to produce meaningful performance measurements for the mortgage finance industry. MorServ 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 equal comparability, KPMG gathered the data at the participant company to ensure that the data was presented consistently and accurately. The participants must be confident that revenues, costs and personnel data were being classified and categorized consistently despite the differences that exist among the mortgage servicers' internal reporting measurements.

MorServ focused on both quantitative and qualitative data in its assessment of participants' single-family mortgage servicing operational performance. Factors such as portfolio characteristics, technology use, management structure and compensation structure, to name a few, were compared against the profitability of the servicers to identify best practices within the industry.

Although no two portfolios were exactly alike, they differed in such areas as average loan size, portfolio size, investor mix and geographic locations of the underlying mortgages and so forth - it was important to understand how these differences affected the profitability, cost and productivity of each organization.

KPMG concludes that companies with higher profitability were profitable because of the characteristics of their portfolio more so than because of the number of loans in their portfolio. Often a mortgage company considers its competition based on its rival's portfolio size, while ignoring many of its other competitors. Also, many servicers do not consider companies that perform servicing activities differently as competition, although they compete for loan servicing in some of the same markets. Lessons can be learned from each of a company's competitors, regardless of their size or business strategy.

In producing this year's MorServ study, KPMG studied the data for the 12 months ending December 31, 1997. This year's MorServ study included data for mortgage servicing operations with a combined servicing volume of more than $486 billion. The aggregate number of loans serviced in the MorServ study was more than 5.5 million. The portfolio composition averaged 53 percent conventional agency, 14 percent government, 22 percent parent/own, and 11 percent private investors.

The ownership structure of the participant group was substantially bank-owned institutions. Of the top 25 mortgage servicers, 65 percent were bank-owned. While the servicers in MorServ did not represent the industry as a whole, they did represent a broad cross-section of the large and medium mortgage servicers.

MorServ included questions regarding activity levels, quality, operational processes and statistics, technology, and portfolio composition. KPMG's analyses encompassed each of the critical functional areas identified in MorServ:

* customer service (customer inquiry, taxes, insurance, escrow analyses, payoffs, assumptions and special loans)

* investor services (investor accounting/reporting and cashiering/cash management)

* default management (collections, workouts, bankruptcies, foreclosures and REOs)

* new loan set-up (electronically transferring or manually inputting borrower information into the servicing system)

* servicing acquisition (due diligence activities associated with acquiring loans via bulk servicing purchases)

* indirect (including general and administrative, data processing, and record retention activities).

MorServ historical trends

While mortgage banking is a cyclical business and the participants in MorServ change from year to year, KPMG has continued to note the trends in the industry apparent during the 12 years of the MorServ study. Subsequent to the refinance activities in 1993 and 1994, direct costs have shown little significant change [ILLUSTRATION FOR FIGURE 3 OMITTED]. The 1995 average direct cost of $47 shows little change from the 548 average direct cost in 1996 and 547 in 1997. Productivity has shown improvements because companies continue to migrate toward outsourcing the tax, insurance and foreclosure processes. In 1995, the number of loans per direct full-time equivalent employee was 1,106 compared with 1,044 in 1996 and 1,247 in 1997 [ILLUSTRATION FOR FIGURE 4 OMITTED].

Operational profitability, which excluded the impact of the amortization and impairment of mortgage servicing rights and gains on bulk servicing portfolio sales, improved significantly from 1992 to 1997, with a 9 percent improvement between 1996 and 1997. In 1996, per-loan operational profit was $222, compared to 1997 profit per loan of $243 [ILLUSTRATION FOR FIGURE 5 OMITTED].

1997 MorServ analysis - Most profitable companies

For the past several years, KPMG has computed a classification of companies that were considered the most profitable based on their operational profitability (excluding the impact of mortgage servicing rights and bulk servicing sale gains). In 1997, the most profitable companies realized $353 per loan in operational profits compared with their counterparts in 1996, which realized $288 per loan. The improvement was attributed primarily to higher float income of 531 per loan.

Analyzing the difference in the 1997 data, KPMG found that the portfolio characteristics of the most profitable servicers were 27 percent government, 49 percent agency conforming, 10 percent parent/own and 14 percent private investors. The average classification excluding the most profitable performers in 1997 consisted of 7 percent government, 56 percent agency conforming, 30 percent parent/own, and 7 percent private investors. The higher float income realized by the most profitable servicers resulted from the volume of government investor loans, which require escrows.

1997 MorServ analysis - Customer service

Direct costs continued to be heavily weighted toward customer service, which accounted for 44 percent of the total direct costs [ILLUSTRATION FOR FIGURE 6 OMITTED]. Economies of scale did not appear to provide a benefit in the customer service departments, where 50 percent of the cost of customer service consisted of customer inquiry activities. KPMG analyzed the customer inquiry costs, which should be heavily automated by using a voice response unit (VRU), and found the range of costs to be from less than $7.50 per loan to a high of more than $14 per loan. The company with the highest cost had more than 500,000 loans in its portfolio, and the company with the lowest cost had less than 500,000 loans in its portfolio. This, again, dispels the argument that size is the primary indicator of "best-in-class" performance.

To identify a company's action plan to achieve the lowest cost and highest productivity in the customer inquiry area requires analysis of several pieces of information. KPMG looked at the following information in its MorServ database to determine the drivers of customer inquiry cost for each company:

* Number of calls per loan per year

* Reasons for the calls

* Time to resolution (amount of time an operator spends on the telephone)

* Voice response unit utilization

* Operator productivity

* System data readily available

* Number of written inquiries

* Monthly statements versus coupon books.

Intuitively, utilization of the VRU is the most significant indicator of low cost, yet the average VRU utilization was 39 percent in 1997, compared with 38 percent in 1996. Surprisingly, the size of the company did not affect this analysis. Approximately 56 percent of the calls focused on standard questions, which should be easily answered by the VRU but apparently are not, based on the VRU usage rate [ILLUSTRATION FOR FIGURE 7 OMITTED]. A primary opportunity for improvement is the mortgage servicers were unable to identify the reason for nearly 20 percent of the calls received. Call identification must be used to make substantive process changes to reduce customer inquiry costs.

Another indicator of low cost was the number of calls per loan serviced per year. The average number of calls per loan per year continued to be around four. There was virtually no change from 1996. KPMG also analyzed the impact of sending monthly statements vs. annual coupon books to determine the impact on the number of calls received. We found that in 1997 the average number of calls for companies using statements was virtually the same, at 4.2 calls per loan per year, compared with 4.1 for annual coupon books.

1997 MorServ analysis - Default management

The default management department contributed 33 percent of the total direct costs, excluding loan losses on foreclosures and real estate-owned properties, as shown in Figure 6. Forty percent of those default costs were in collections. The nature of the default department was such that some companies actually realized a profit because of the ability to effectively manage late-charge collections.

Average default management department profitability - considering the impact of late fees collected and loan loss expense in addition to the direct cost of the department - was about $7 per loan in 1997. The larger servicers had similar weighted-average profitability, at about $8 per loan, compared with the medium-size servicer's weighted-average profit of slightly more than $8 per loan [ILLUSTRATION FOR FIGURE 8 OMITTED]. However, the delinquency rates for these groups differed significantly from those of the larger servicers, which incurred average delinquency rates in 1997 of slightly less than 5 percent, compared with slightly more than 2 percent for the medium servicers.

Companies that collected payments using monthly statements collected an average of $11 per loan per year more in late fees than companies that used coupon books. It should be noted that the delinquency rate in 1997 for servicers using coupon books averaged slightly more than 3 percent. Those sending monthly statements averaged 3.5 percent [ILLUSTRATION FOR FIGURE 9 OMITTED].

While call center management is not a new concept, the mortgage companies that are focused on reducing their direct costs of business must evaluate the impact this has on their profitability. Servicers also should consider training their customers in the technology to boost usage and thus allow greater realization of the benefits of this technology. One way to maximize the impact of call center technology is to consider combining the mortgage operation's default management and customer inquiry departments. Because a majority of the larger mortgage companies are owned by banks, the opportunities to leverage platforms exists, yet has been ignored historically because of the organizational structure of the entity.

Next steps for mortgage companies

How does the fact that a mortgage - treated by most as a commodity - fit into a business strategy touting superior customer service and delivery? This question is more significant in light of the consolidation in the industry - nearly 53 percent of mortgage servicers' market share was owned by the top-25 mortgage servicers as of the end of 1997 per the latest National Mortgage News data when you factor in the impact of the recent mergers. Of these top-25 mortgage servicers, 85 percent of the mortgage servicing market share was owned by banks, all of which focus on delivering superior customer service. Despite the focus on service delivery, it is interesting that the mortgage industry, especially those companies owned by banks, did not examine its profitability based on products and customers to support its business decisions to cross-sell and provide "superior customer service."

Understandably, reporting customer and product profitability data on an historical basis does not consider the customer's behavior given certain future external and life-cycle events. However, the industry must begin to understand how to align its business strategies to enhance profitability and contribution to shareholder value for the institution as a whole, not just for the mortgage product.

The mortgage company's link to its bank owners must be integrated into its business strategies to provide the opportunity to enhance the bank's overall shareholder value and consequently the mortgage company's profitability. This change should translate to a win/win scenario for all involved: the customer benefits through a true service relationship (not a commodity), the shareholder through enhanced stock value and the company's employees through increased compensation and job security.

In the banking sector, market share and margins are declining as increasing competition presents customers with more choices for consumer loans and mortgages. Similarly, with attractive mutual fund and stock market returns, the frequency of bank deposits is declining. Mutual funds have grown from $57 billion to $1,583 billion while bank deposits have grown an average of 4 percent during the last 15 years per the Federal Reserve Board, Flow of Funds Accounts of the United States. This growth has put increasing pressure on profitability at a time when lower cost channels, such as online banking and the Internet, are gaining in popularity. However, despite the expansion of product lines and the addition of new channels, cross-sell ratios have declined. From 1993 to 1996, the number of bank products per household has slipped from 2.30 to 2.18.

Many of the largest mortgage companies are in the early stages of managing their businesses in a way that allows for stronger customer relationships. Success will be driven by the ability to manage customer behavior and build long-term, profitable relationships.

Determining customer profitability

Of particular concern to institutions should be customer profitability or the lack thereof. For a typical multiproduct, multichannel retail financial institution, a small percentage of customers provides the vast majority of profits. KPMG studies have found that approximately 140 percent to 170 percent of profits can come from only 20 percent of customers. This presents another interesting twist on the 80/20 rule: 20 percent of customers typically generate 80 percent of losses, while the majority of customers, approximately 60 percent, range from mildly profitable to unprofitable [ILLUSTRATION FOR FIGURE 10 OMITTED].

To support this skewed cost-revenue equation, most multiproduct, multichannel retail financial institutions have built large, complex cost bases and expansive multilayered organizational structures. In contrast, single-product competitors with much leaner cost and support structures attract the most profitable customers. As a result, institutions need to identify the bottom 20 percent that account for 70 percent of the losses to determine whether they can be converted to profitable customers. In addition, institutions need to identify and retain the profit-generating top categories of customers. This can only be achieved through greater insight and understanding of the customer and by delivering much better service.

Improving customer service

KPMG studies have shown that consumer dissatisfaction with customer service is widespread at the financial institution level. However, even though the level of service that customers expect is fairly rudimentary, the vast majority of institutions are still falling short. Typical complaints consist of incorrect information in correspondence, irrelevant telemarketing and direct mail efforts (offering customers products they already have, for example) and never being able to speak to the same person twice at call centers. However, in considering current operating structures and practices, these problems are not surprising.

Currently, internal procedures and technology are both driven by transactions, products or geography. This must change. Without a holistic view of the customer and the ability to understand their wants and needs, service will continue to be mediocre at best. What's more, while the traditional top-down approach to product sales management is ideal for reaching short-term internal sales objectives, it runs contrary to building long-term customer relationships. By focusing on pushing individual products through product-specific distribution channels - a process akin to internal wholesaling - customer needs are not satisfied and revenue generating opportunities are lost. Not surprisingly, a product manager who is evaluated only on the sales of his or her individual product has no vested interest in ensuring that the organization as a whole is meeting the individual needs of each customer.

To maximize profitability and remain competitive, financial institutions will have to align people, processes and technology in the search for innovative, cost-effective ways to retain and deepen the lifetime economic value of customer relationships. This requires widespread availability of and instant access to detailed information - often at the point-of-sale - including:

* Accurate customer profitability

* Product ownership and balance information

* Delivery channel usage and preference

* Overall understanding of product usage (including at other institutions).

Unlike a packaged goods product where profitability is unaffected by whether a product is used once it has been purchased, profitability for financial-service providers is determined by subsequent events. For financial institutions, the key to success is to predict customer behavior/usage correctly and to manage it in the most profitable manner over time. The most effective way to do this is by adopting a strategy of customer centric management[SM] (CCM).

By adopting a CCM-based strategy, financial institutions can build profitable relationships that customers value. Customers are likely to show more allegiance due to value-added pricing, convenience and the interrelationship of products, even though individual products may not be best-of-breed. This loyalty will halt the erosion of profitable customers and address the skewed cost-revenue curve that defines the industry.

Research by Bank Marketing International has shown that retaining 5 percent of customers can boost profits by 100 percent. In short, CCM provides the strategy and the implementation support needed to deliver the right products at the right time - and for the right price.

Through CCM, financial institutions can also begin to address the challenge of realigning business process and technology to build and retain profitable customer relationships. However, the transition from a product or geographic-oriented organization to a customer-centric one requires an organization to rethink customer and product strategy, reengineer the supporting financial management systems and develop entirely new business scorecards to measure and reward performance. For example, staff that has customer contact must be financially measured and rewarded to encourage a long-term view of the customer.

Knowing the customer

To maintain competitiveness and maximize profitability, financial institutions will have to gain an understanding of their customers like never before - their behavior, actions, desires, preferences, likes and dislikes. Once implemented, an approach like CCM will enable financial institutions to:

* Understand and predict customer needs.

* Build valued, long-term relationships.

* Manage profitability at the customer level.

* Contain delivery costs.

* Improve branding and customer allegiance.

* Implement cost-effective and efficient management and operational processes.

* Collect and effectively use information to achieve a more holistic view of the customer.

Narrow profit margins and unrelenting competitive conditions make it now imperative that institutions transition to a more customer/relationship-oriented strategy. To continue operating business as usual will leave institutions with an increasing percentage of unprofitable customers and an inflexible cost structure that will erode profits and reduce competitiveness.

Laura McDonald is a senior manager and Geoffrey Oliver is the partner in charge of KPMG Peat Marwick LLP's Mortgage and Asset Finance Group, headquartered in Washington, D.C.
COPYRIGHT 1998 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1998 Gale, Cengage Learning. All rights reserved.

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Author:McDonald, Laura; Oliver, Geoffrey
Publication:Mortgage Banking
Date:Jun 1, 1998
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