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Winds of change.

Winds of Change

The business of mortgage banking will be done differently in the future. Not much time is left to change the sails, but here's a look at which way the wind is blowing.

The marketplace is lecturing to those of us left in the mortgage business. If you were to pause and take a moment to listen, this is what you would hear: "Say hello to the person on your left and your right. At the end of the year, two of you will be gone."

I wonder if the marketplace's lecture to us has our full attention?

The mortgage banking industry is undergoing the same permanent structural change as the rest of the financial service business. And as we already know, bankers and thrift managers are seeing the competitors on their right and on their left--or themselves--disappear.

Consolidation is one of the inevitable results of the rationalization of any fragmented business. But consolidation and the elimination of weaker firms is not the only structural change being faced today in mortgage banking. A few other key issues are exacerbating the pressures of this transition. These other issues include price erosion, unchecked cost escalation, meager investment in technology and inadequate management capabilities.

The inevitable companion to industry consolidation is intensified price competition. The traditionally high margins of the industry attracted numerous additional competitors in the 1980s. This additional competition, plus the end of the 1980s demand bubble caused by refinancings, has resulted in a marketshare struggle carried out at least in significant part through price competition. The net result is likely to be a permanent reduction in effective prices.

In terms of the issue of unchecked cost escalation, historically we have not been a cost-conscious industry, but rather volume-conscious. As a result, unit costs have continued to escalate, even in the face of declining demand. We haven't succeeded in adjusting our operations quickly enough to the new realities of production.

To further try the hand of the industry's leaders, this business has not made the most of available technology. Historically, we have spent little money on technology, or worse--where we have spent lavishly, the results have been dismal. We are an industry crying out for help in improving productivity, yet have little positive experience in applying the tools of technology to assist us.

Finally, industries in transition demand much deeper and broader management capabilities than do stable industries. The breadth of management capabilities in mortgage banking is thin relative to the current challenges being faced.

Furthermore, the transition from a fragmented industry is being abetted by pressures from regulators and the banking and thrift industries' performance. These pressures will further alter the competitive landscape.

The impact of the changing roles of thrifts and banks in the competitive landscape is significant. On balance, the mortgage industry is trading out one substantial competitor--thrifts--for another--banks. This new competitor, however, is better capitalized, managerially deeper, and technologically more resourceful. There is no question that thrifts must change their posture toward mortgage lending/banking. Growth constraints created by tougher capital requirements are dampening the often irrational pricing practices of the past, and, therefore, throttling unbridled production strategies. Rules relative to capitalized servicing are reducing thrifts' aggressiveness toward purchased servicing.

As thrifts reduce their aggressiveness, commercial banks have compelling reasons to accelerate their mortgage banking strategies. The new risk-based capital regulations encourage banks to hold residential mortgage assets. In addition, there is generally a scarcity of other attractive lending opportunities currently available. Finally, banks are believers in building retail relationships, with mortgage lending providing a key vehicle for doing that. It is true that, as with thrifts, the new capital regulations discourage purchased servicing by banks, but only in extreme capital situations. Most large banks have significant room for additional goodwill in the form of purchased servicing.

The entry of major new competitors during any wide industry structural transition usually results in permanent changes to the competitive environment or, in other words, how the business is actually done. Although slow to evolve, this is also happening in mortgage banking.

The entry of heavily capitalized competitors such as Sears Mortgage Corporation, Citicorp Mortgage, Inc. and Prudential Home Mortgage accelerated the development of private securitization, which in turn redefined the pricing and documentation requirements for the largest segment of the industry--low-LTV, conventional lending. Technology investment has accelerated, resulting, for example, in 15-minute loan approvals (using artificial intelligence), effective remote processing and, perhaps, significant changes in the scale economics in servicing.

Another way the competitive environment has changed is that new delivery channels have been developed. Retail branch production is but one way to reach consumers, and is probably not the most efficient in many cases. Direct mail/telemarketing is proving viable, Realtor-builder/lending partnerships have flourished and the wholesaler-broker distribution combination has become a dominant force in several of the largest markets.

So, without a doubt, the way we conduct the business is changing. And it will continue to change, pressured by the new competitors with new ideas and a lack of historical bias and culture to overcome.

Transitions are painful

Make no mistake about it, structural transitions are not fun for most people in any endeavor. A whole way of working and living is being upset. Uncertainty is heightened, positions and, indeed, self-esteem and confidence are threatened. Resistance is the first and natural response.

Unfortunately, the characteristics of our industry are not well suited to ease the transition and the attendant natural threats to its work force. Mortgage banking is not a business with high research and development (R & D) expenditures. Typically, we do not invest a lot in new ideas. As a result, we are not accustomed to regularly trying new ideas. Any expenditures in R & D are an incremental cost to us, at a time when cost pressures are already substantial.

Existing mortgage banking management teams have little experience in testing or implementing alternative solutions. Merely learning how to go about investigating new alternatives, while still managing current business, is a significant challenge; one which typically results in pushing the whole issue of addressing needed changes down the priority ladder.

The key resources present within the industry today are not the right ones to lead the changes. Real consumer marketing talent is very thin within the industry and deep, practical technology and process-management talent has not been acquired. As a result, the two key areas of expertise--marketing and technology--are not available in quantity to provide the conceptual leadership necessary for the current industry-wide transition.

The net result is regrettable, but predictable. There is a strong, natural resistance to change and a lack of clarity about the solutions or how to get them implemented. The actions taken, therefore, tend to be traditional, short-sighted, short-lived solutions to the issues--cut staff, shave commissions, price competitively and pray for greater volume, or hire consultants and relinquish responsibility for the problems to them. However, this structural transition is a strategic issue we cannot run or hide from. It must be met head-on, with an open mind and a commitment to change

Learning from other industries

If mortgage banking's managers can't hide, then where can we look to gain perspective on the challenges they now face and, more importantly, find the logical solutions? Surely, mortgage banking, and financial services in general, are not the only fragmented industries that have undergone structural change. Several industries have, in fact, experienced similar changes during the past two decades that mortgage banking is now facing. Those industries include airlines, trucking, investment banking and the grocery business.

While the exact nature and results of each of these industry-wide consolidations was different, there are some critical similarities that provide relatively unambiguous insights into what we should expect in the mortgage banking industry.

The outcomes of those other industry transitions produced fewer competitors. Not just a handful of competitors resulted, but it typically produced a bifurcation of the business between a few, very large, competitors and many very small players, with a dwindling of mid-sized competition. This is understandable, as the two groups select the specific basis on which they will compete. Big players capitalize on scale economics and technological and marketing sophistication to differentiate themselves, while small players focus on speed, flexibility and an absence of overhead. Mid-sized players tend not to be able to win against either of the strategies, with the marketplace becoming less and less tolerant of simple "me-too" competition.

As these other industries have shown, transitions also produce better cost economics. It is axiomatic that cost structures change, that is, improve, dramatically as industries consolidate. The cause of the improvement, however, is not just size. In fact, it rarely is. But rather it is usually fundamental changes in the entire delivery system for the product. Fresh eyes, not blinded by history, literally dismantle the parts of the business and then reconstruct them, using superior marketing, technology and process management skills. But, however obtained, unit costs are improved significantly through the structural consolidation of the industry.

Another side effect of these industry-wide transitions is a crisper focus--"All things to all people," and "volume of any kind from any price" are no longer valid management principles. The winners clearly and carefully select what product, geography and type of distribution segments in the business that they want to compete. They also decide specifically how they will compete. The focused competition stands a chance of winning, the non-focused competitor almost surely vanishes.

The final by-product yielded by the structural change that reshaped those other industries was frequently different management. Over time, any industry attracts, develops and maintains the kind of managers needed to be successful. As the rules of the game change, so do the management requirements. Structural consolidations fundamentally change the rules of the game and the concomitant managerial requirements. More often than not, the existing managements find it difficult or impossible to learn or adjust. The necessary knowledge must be imported from outside the industry, and the existing culture must be modified to assimilate effectively this new perspective and style.

The sky isn't falling

The message for our industry is not that the sky is falling, or that all is lost. There will continue to be a very viable mortgage banking industry. Demand for mortgage loans will continue, albeit subject to cyclical pressures. Therefore, there must be someone to deliver the service. And if demand is present, the economics of the business will adjust over time to be acceptable for the better competitors.

Clearly the business must change to remain viable. One undebatable conclusion is that unit costs of production must be reduced. Price increases aren't likely and increased volumes can't be depended on to bail the industry out. The profit margin structure of mortgage production has worsened intolerably for the average production operation.

Fifteen years ago, production overages were normal, one could reasonably bank on marketing profits, and the value of servicing was not yet recognized in the marketplace. Some 300 basis points in total revenues were reasonable to expect (See Chart 1). Costs were contained, principally by a lack of intensive competition. The net results were often branches with direct production profits and very strong "full economic" profit margins.

Now that is no longer the case. For the typical firm, production is a net cost and a substantial one. It is not unusual to see a 70 basis point net direct cost of production. Marketing profits have disappeared (unless the company manages its pipeline uncovered), and despite an increase in the value of servicing, the typical firm is fortunate to break even on a full economic basis. Moreover, in the current environment with servicing values temporarily depressed, the full economic value of production may even be negative. Firms must either adapt in various ways to reduce their unit costs or suffer a gradual liquidation of their equity bases.

Another way that the business must adapt is by finding a way to reach the consumer more efficiently and effectively. The historic, ubiquitous, branch-based delivery system, with essentially no formal consumer marketing support, must give way to more and better ways to reach the consumer. Two hundred basis points to produce a loan in a branch is not tolerable.

Depending upon an intermediary, such as a builder or Realtor, to generate every piece of business almost guarantees a price-based, high cost-of-acquisition production approach. As more home buyers in the 1990s move-up and become more knowledgeable borrowers, the need to deal through an intermediary diminishes. Efficient direct marketing becomes a viable alternative to a singular reliance on branch-based production.

Today's mortgage lenders must also rationalize their documentation standards. Documentation requirements in large measure dictate not only the cost structure of the business, but also relative access to major segments of local markets. Consequently, this aspect of production influences unit costs from two perspectives--branch scale and individual functional costs.

Traditionally, mortgage bankers adhered to the documentation requirements of their principal investors--the agencies--accepting the requirements as merely a cost of doing business. Now, however, it is a cost that must be challenged at every turn. Alternative investors with documentation levels better rationalized by quality of credit and borrower, permit streamlined cost of production and greater customer service. Failure to challenge documentation requirements reasonably, and make active trade-offs between the depth of documentation and its cost, ultimately will take its toll on individual competitors in terms of cost and marketshare positions, thus almost guaranteeing weak or non-existent profitability.

Documentation standards should be completely adjusted to meet the varied risks posed by product and type of customer segment, rather than blindly applied across the business.

If there is one key to future success that all mortgage bankers can act on relatively quickly, it is the concept of focus. Understanding what customers, geographic markets and what specific products the firm has, and then structuring the entire firm to focus on these areas, is critical to succeeding in a consolidating industry.

It requires thinking and courage to make tough personnel decisions, but it doesn't usually require extensive investment. Most mortgage bankers know "where their bread is buttered." Getting rid of areas that do not contribute to the overall success of the firm is not is a major step toward survival.

Another principle that needs to be embraced by managers that want to prosper in the new competitive environment is the co-equal management of all pieces of the business. Mortgage banks are typically production-driven companies. Sales management dominates. If we are to survive, operations and secondary marketing must assume co-equal influence and attention. Integrated mortgage bankers will not survive without secondary marketing capabilities that are well beyond merely being able to sell product to the agencies or conduits. Nor will they be able to turn sales into profits without skills in the operations area.

Change creates opportunities

Change is not necessarily bad. Change always creates as many opportunities as threats. The rules for success are merely altered. The seemingly paradoxical behavior of individual mortgage banks in recent times reinforces the dual-edge condition present in today's mortgage lending business environment.

In the area of retail production, for example, we have seen Lomas Mortgage USA, Dallas, close or sell off its retail branch network, concluding that it cannot make the business adequately profitable. The industry has also witnessed numerous other mortgage banks either leave the retail business completely, reduce their networks, or switch to wholesale production due to the apparent high cost of retail production. Yet other competitors, such as Norwest Mortgage, Inc., Des Moines and Countrywide Funding Corporation, Pasadena, are aggressively, or at least selectively, expanding their retail networks. Why? How can the business look so bad to some competitors and so good to others?

A second paradox in retail production is the simultaneous exodus of firms with large branch networks and the tremendous expansion of mortgage brokerage operations. What is it in the economics of the production business that makes the origination business attractive to prospective brokers and yet negative to branch network-based competitors?

In another aspect of the business, servicing values are down, markedly. Therefore, servicing is not attractive, or is it? Obviously, it depends on whether you are selling or buying. For the firms with a large servicing portfolios that are neither buying or selling in significant quantities, the situation is neutral. The real economic value of servicing has not changed appreciably.

For the originator who must rely upon servicing-released sales to cover production costs, the changes taking place are a catastrophe. The cash value of his product has declined as much as 30 percent in recent months. However, for the firm considering building or expanding its servicing business, the situation is perhaps singularly attractive. Potential returns on new servicing acquisitions are the highest they have been for more than 10 years. This is a situation that may not be repeated for some time. It is a critical period for building market position in the servicing business.

Is this paradoxical competitive behavior? Absolutely. But it is entirely rational. The structural dynamics are creating enormous opportunities as well as hardships. The competitive dynamics at work here will help explain the paradoxical behavior.

Traditional branch operations are indeed largely unprofitable. Such operations typically entail small average-branch size, low productivity and products sold at razor-thin commodity-like margins. Lomas and Nettleton, to use that example, was unable to change its equation sufficiently to make a difference. It validated the unacceptable profit dynamics of the traditional branch. There is a need to change the delivery system to make retail branch unit costs acceptable.

Presumably, Norwest, a company that is pursuing a branch building strategy, will do so by concentrating on high-balance or at least low-documentation credits, enabling its branches to build larger volumes with lower unit costs, fundamentally altering the branch economics. It is the same strategy the major thrifts have deployed successfully for years.

Countrywide has chosen a different, yet apparently successful strategy. It has focused on the high cost of originators, reducing or eliminating this cost, accepting lower average-branch volume, but producing this volume at a lower cost. They have also substituted direct mail marketing for the loan originator. Whether this combination of strategies is defendable over the long term is not clear, but it has helped Countrywide bridge a perilous period in the business.

How can mortgage brokers make it when branch networks can't? Relative cost advantage is not the answer. The combined cost of the wholesaler and mortgage broker or correspondent is almost certainly greater than that of the branch network. Then what is fueling this transition from retail branch networks to mortgage brokers?

One answer is a willingness by brokers and wholesalers to squeeze more of the profit margin out of the business to win production. Branch network-based competitors still largely price their products directly off the secondary market, without adjusting prices for servicing value. Wholesalers readily price their product to their customers with either an explicit or implicit servicing-release fee. It is implicit if it shows up as a lower net price to mortgage brokers or explicit if servicing-release fees are quoted separately. In either case, the net result is a lower "street" price for the originator than that which the typical branch network can quote. Business looks good to the wholesale originator, terrible to the branch network.

The other answer is probably just as important. Mortgage brokers tend to win in head-to-head competition with branch originators because they are better and more seasoned marketers. Typically, they have established clientele who come to them because of service as much as price. Despite the focus on price competition, mortgage production is still as much service-based as it is price-based. The proliferation of mortgage brokers reinforces the importance of customer service in the equation for successful retail production.

Finally, in the area of servicing the dynamics are reasonably clear. The following configuration of: excess supply in the form of RTC-controlled servicing, which ultimately will be placed back in private hands; plus the loss of traditional competitors (the thrifts); and the change in capital regulations that dissuade purchased servicing; has resulted in a temporary buyers' market. Clearly, the situation is temporary, since the true economic value of servicing hasn't changed materially.

The ultimate winners and losers in the servicing business are beginning to emerge. However, some of the more logical long-term winners have yet to buy into the business. Some of the logical candidates to emerge as buyers of servicing and potential buyers with special reasons not to buy into the servicing business, warrant a brief discussion.

Public companies are disadvantaged. Servicing is a wonderful cash flow business. It is only a fair reported earnings business under typical purchased servicing prices. Mutual insurance companies are naturals, given the lack of focus on reported earnings, cash reserve buildup opportunity, plus the opportunity to acquire attractive assets in large quantities and control the quality of asset servicing. Private ventures to buy servicing rights are attractive. Tax-sheltered investments are possible. Banks should be willing to provide the necessary leverage, having a predictable cash flow as collateral.

Scale economics may ultimately prove a significant differentiator among competitors. But to date, that has not been the case. Therefore, it's not likely that a handful of firms will control a majority of the servicing. For portfolios larger than say $4 to $5 billion, servicing unit costs have been largely a function of servicing location (labor costs/quality), portfolio mix and operational management skill, not size.

Sidestepping the threats

The structural pressures in the industry will continue for some time. The restructuring of the industry is nowhere near completion. In order to transform threats into potential opportunities, there are several critical issues that each firm must sort out and incorporate explicitly into its strategy.

The starting point to develop a viable survival strategy is understanding clearly the competitive environment. Banks, thrifts, independent mortgage banks and mortgage brokers are all in a state of flux. Each has some relative strengths it can exploit, as well as some particular vulnerabilities. Since it is no longer feasible to be all things to all people, it is critical to determine explicitly the answers to three specific questions.

What are your comparative strenghts--and weaknesses--relative to each type of competitor? Which market segments are ones where you can have a relative advantage or the places where your relative advantages can be best applied? How best can you apply your relative advantages to win and defend marketshare?

Much is written about competitive strategies, and most of it is conceptually correct. Unfortunately, in the press of daily management, most of it is forgotten or ignored. Ignoring the incisive development of a competitive strategy now may be tantamount to failure.

Theorists would lead us to believe that, as a paper intensive business and, therefore, subject to scale economics and technology, servicing increasingly will become concentrated in the hands of a few "megaplayers." Clearly, some very large servicers are emerging. But it is doubtful that they will become so efficient as to make the business uneconomic for others.

It is important, however, for each mortgage banker to understand and come to terms with the amount of continuing investment that will be required to stay competitive in terms of servicing costs, particularly as cash flow demands cause more churning of servicing portfolios. Each competitor must determine whether it is in the production or servicing business, or both. The skills to manage both businesses are significantly different, with a marketplace now much less tolerant of mediocre management in either business.

Finally, to prosper in the new marketplace, production costs must come down substantially. But how? Retail branch production will continue to be the primary distribution channel. It is not something most firms can abandon. Solutions must be found to reduce branch costs permanently.

Increased average-branch size is clearly one answer. There are pronounced scale economies in retail branches. According to the latest survey by ICM Consultants, Bala Cynwd, Pennsylvania, direct unit cost (in basis points) of mortgage originations fall dramatically as branch size increases. The unit production costs dropped from 200+ basis points for branches under $25 million in production volume to almost 100 basis points for branches over $125 million in volume, according to the survey.

Cost-effective production translates into the challenge of winning a major share of any market in which the company competes, not a small share of numerous markets.

But size alone is not the answer. Few individual communities will support single branch production of more than $100 million. To realize these scale advantages, which are primarily processing rather than sales-related, a crucial part of retail strategy must be to find ways to concentrate processing without diminishing customer service. That is a tough order, but not impossible.

Branch costs also are not influenced simply by size alone. Size alone does not overcome poor productivity management. The branch is an information factory, one in which information must be processed efficiently and quickly. Very few mortgage banks have yet made much headway in turning their branches into such operations.

The use of technology will help in the battle of scale and efficiency. Yet it cannot be blindly or carelessly applied. Making major inroads into cutting branch costs means fundamentally redesigning the branch distribution system, with technology as the catalyst allowing this to happen.

A critical question in making the future a place where we cash in on opportunities is this one: How do we kill the paper?

Mortgage banking is among the most egregiously paper-laden businesses ever created. We are on the verge of becoming overwhelmed by the paper deemed necessary to produce quality loans. Or are we? We are actually in an information management business--gathering, processing and disseminating information. The technology now exists to eliminate most of the paper we create. How well we address this issue over the coming years will play a central role in keeping individual firms competitive, as the required level of sophistication--that is, the cost of entry into the game--escalates.

On the issue of quality versus cost, experts tell us we do not face a trade-off between quality of production and cost. They maintain that, in fact, quality and cost go hand-in-hand. Conceptually, this is correct. Firms noted for high quality performance also tend to be lower cost firms. However, we cannot continue to add complexity to our production process where it is not needed. Consumers will reject our demands and go to competitors who have simpler loan application processes. We must individually, and as an industry, better address the balance between reasonable assurance of the quality of the assets being generated and the cost of producing this level of assurance. It cannot remain a relatively one-sided issue.

Finally, speed is increasingly becoming an important solution to several key survival issues: production differentiation; processing costs; and pipeline exposure and risk.

The winners will manage very aggressively the time it takes to approve the typical loan application. Speed is, and will grow in importance as, a competitive weapon. This will require, in many cases, fundamentally changing attitudes in individual companies--shaking up complacency regarding the time it takes to accomplish individual production tasks and eliminating excuses as to why things can't be done more quickly.

Even though we don't control others that must supply us with information in the production process, we can manage much more effectively the timeliness of information we receive from others. Speed may, in fact, become the best attack weapon we possess against competition, cost and risk.

The successful solutions for each company may vary, but the specific challenges they face are essentially the same. There are five common challenges we must all address:

Develop a clear conceptual perspective--No simplistic solutions are likely to be adequate. We are not facing normal industry cyclical changes, but fundamental changes in the way our business is conducted. Each management must have a clear conceptual understanding of what is happening and why, before developing effective responses.

Proper strategic positioning--Each firm must select a specific strategy that is correct for its resources and competitive environment. Unrealistic strategies from either a competitive or internal resource perspective will lead to failure. The margin for error that existed historically is no longer present.

Commitment to change--It's easy to talk about and plan change, but it's painful to develop and maintain a commitment to change. This is particularly so when it involves, as it inevitably must, difficult people and culture decisions. Good planning will accomplish little if the intestinal fortitude to execute the plan is not present.

Intensive effort--This is not business as usual. It will take extraordinary energy both to implement a new order of things while managing effectively the current business. Without properly channeled intensity, it will not get done.

Supplementing the management teams--Reconstituting the management team to supplement it with additional talents is a difficult task, requiring tremendous executive courage. But the changes we face require perspectives and expertise not present in the typical mortgage bank. They must be imported and assimilated effectively to make a difference.

The world our industry faces is not hospitable. There are, to be sure, very significant threats to the survival of each of our firms. But just as certainly, there are substantial opportunities for those competitors that seize them. Mastering the changes required can lead not only to survival but prosperity. Continuing to manage the business as usual will almost certainly lead to extinction. [Chart 1 Omitted]

Fred Portner is executive vice president of Directors Mortgage Loan Corporation, Riverside, California.
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Title Annotation:mortgage banking in the future
Author:Portner, Fred
Publication:Mortgage Banking
Article Type:Cover Story
Date:Oct 1, 1990
Previous Article:Economic trends.
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