How to build mortgage banking business.

Although some financial institutions have always been heavily involved with mortgage banking, today we are seeing banks entering, re-entering, or enhancing their mortgage banking operations. They are doing so through de novo growth, expansion of existing operations, or, most commonly, through

The field is open to the aggressive. The mortgage banking industry is relatively fragmented and therefore provides many opportunities for growth through gains in market share. The top producer of residential mortgages, based on 1992 dollar volume, has less than 4% of the total market share. The top ten producers in 1992 collectively had 21% of total market share versus 16% for the top ten producers in 1991.

Three sources of profit

The mortgage banking business provides opportunities for profit in each of its three main disciplines; origination, secondary marketing, and servicing. Overall, this represents a good way to earn fee income without putting assets on the balance sheet (unless servicing is purchased or acquired through a merger.

The greatest profits generally result from servicing, once a critical mass is achieved and economies of scale realized. Additionally, in this steep-yield-curve environment, there are profits to be made from the interest spread between mortgage loans held for sale and the debt to finance those loans for the 30 to 90 days the loans are held. And, with the exception of certain state requirements to pay interest on them, escrow accounts are a low-cost deposit source.

Mortgage banking activities, such as new loan originations, loan purchases, and servicing purchases provide new customers--and cross-selling opportunities--to a bank.

One possible drawback of mortgage banking to most financial institutions is the volatility of earnings, especially resulting from production operations. A further source of volatile earnings is the amortization of purchased mortgage servicing rights. in periods of high mortgage refinancing, this asset is subject to accelerated amortization due to prepayments.

What factors to weigh

There are pros and cons to each of the three routes to mortgage banking growth--establishing a de novo effort; expanding an existing operation; or acquiring someone else's shop.

The main advantage of starting a mortgage operation from scratch is that it allows an organization to develop the operation in its own image. This method would allow, for example, creation of a "state-of-the-art" shop, integrating production, secondary marketing, and servicing.

This method would also allow the bank to more easily implement non-traditional business practices and processes. For example, a bank may want its mortgage operation to rely on non-commissioned employees to originate loans. Because many mortgage companies have long paid commissions to loan officers, acquiring one of these companies would make implementing the desired business practice difficult.

The primary disadvantages of going de novo are a long start-up period, with significant personnel, facilities, and systems costs and minimal revenues in the beginning--as well as the possibility that there will be no core of experienced mortgage employees from which to build.

Expanding an existing operation of your own has the advantages of leveraging your bank's culture and business process and may require fewer resources than starting from scratch or acquiring another operation. However, this is much slower than acquiring another operation and may make it harder to crack new markets.

Acquisition provides the most immediate act in terms of entering or expanding in the mortgage business. Disadvantages of acquisition include a significant commitment of resources and capital, cultural changes, and posibly unforeseen or undiscovered problems in the target's operations. Because acquisition provides the most immediate impact, the following and the box above discuss acquisition.

Due diligence measures

Due diligence helps mitigate one of the major disadvantages of acquisition--buying someone else's problems without realizing it. Due diligence allows the buyer to meet its potential new employees; inspect operations; identify, confirm, and quantify risks; and confirm pricing and operating information.

The process can generally be divided into three broad areas:

Financial review covers the balance sheet, income statement, cash flows and routines, post-acquisition projections, and other items that may impact the purchase price.

Of particular concern on the balance sheet of a target mortgage company are the valuation and aging of mortgages held for sale and associated hedging instruments; the recoverability and valuation of servicing advances (principal, interest, escrow, and fore-closure); and the valuation of real estate owned and the reserves associated with any credit recourse relating to balance sheet assets, the servicing portfolio, and loan and servicing sales.

Although they are large assets on the balance sheet, purchased and excess servicing are generally ignored at this stage, because their worth is weighed in the valuation of the company's servicing portfolio. Because the value of the servicing portfolio is a key component of a mortgage company's value, a thorough review of the data used to value the portfolio, and the servicing agreements, is critical.

Servicing agreements must be reviewed for transfer provisions, termination clauses, credit recourse provisions, confirmation of fees, and other impacts on servicing value.

The income statement must be scrutinized to confirm the company's base profitability, the profitability of its lines of business, and nonrecurring and related-party transactions, all of which are critical to the development of the post-acquisition projections that drive the purchase price.

Mortgage companies historically haven't had sophisticated management information about line-of-business profitability. As a result, the bidder needs to make allocations and assumptions in developing projections

Operations review includes examination of production, secondary marketing, servicing, and support areas.

Servicing generally requires the greatest due diligence, with the emphasis on the completeness and quality of loan files; proper reconciliation, control, and maintenance of mortgagor escrow custodial cash accounts; accurate and timely investor reports; accurate delinquency reports; proper cash processing; and proper collection and foreclosure management.

Another step we strongly recommend is the verification of the data on the tape used to value the servicing. The tape must be checked against the source documents that created it.

Due diligence in the production area may have greater importance than the other operating areas depending on an acquiror's reasons for doing the deal. Established production networks are in demand and command premiums. Areas of importance include reviewing and verifying historical production levels by branch, loan officer, and loan type; reviewing pricing philosophy and its impact on loan production; reviewing underwriting and quality control practices; reviewing instances of fraud and the causes thereof; and reviewing origination systems.

Due diligence in the secondary marketing area should focus on hedging and risk management practices, historical pipeline close rates, and the quality and functionality of the secondary marketing system.

Corporate review includes legal, human resources, facilities, and other similar areas. Particular emphasis must be paid to the company's compliance with investor and regulatory requirements. Potential liabilities relating to employee and facility matters must be considered in pricing the acquisition.

Successful acquisitions

Over the last year most major acquisitions of mortgage companies were either consummated by or given strong consideration by banks. For example, ample, in May of this year, it was announced that PNC Bank Corp. would purchase Sears Mortgage. PNC viewed the acquisition of a mortgage operation as a way to expand income from fees, to compensate for slow loan growth. Further, it would allow PNC to quickly be a high-volume servicer in an industry where economics of scale are realizable and significant. The combined entity would service approximately $36 billion of residential mortgages.

Other mortgage acquisition opportunities include entities in the control of the Resolution Trust Corp.

Another possible source of opportunities is sales of excess mortgage operations by banks in connection with mergers.

Why have banks been successful in these transactions?

First, overall banks are cash rich, thereby providing ample funding. Second, banks provide the prime investment vehicle for borrowers' principal, interest, tax, and insurance escrow deposits, because they are FDIC-insured and therefore can take maximum advantage of these deposits.

Third, the diversity of large banks' operations allows them to absorb components of mortgage companies that may not be as attractive to other buyers. Finally, banks' return on investment requirements may not be as stringent as those required by investor groups, venture firms, and other buyers.

Mortgage bank acquisition, step by step

Once bank management determines that acquisition is a viable alternative, how should it proceed? The following provides an overview of the acquisition process:

(1) Define strategic objectives for acquisition--The bank must determine its business needs to find a target that fits them well.

(2) Identify opportunities--Ongoing contacts with other bankers, accounting firms, investment bankers, and others can reveal acquisition candidates that haven't been "shopped around" already.

(3) Obtain target financial and operational information--Long before due diligence begins, the acquiror must get a view of the target detailed enough to determine if it's worth going forward. Key data to get hold of includes any offering memoranda that may have been produced, as well as overview figures concerning the target's balance sheet, income statement, and servicing portfolio.

(4) Perform company and portfolio valuation--The acquiror must determine what the target is worth and how sensitive the target is to such variables as the interest-rate environment.

(5) Submit initial bid or letter of intent--This is where things begin to come down to price.

(6) Perform initial due diligence--Issues flagged at stage 3 must be explored further. Risks must be weighed to make sure the acquiror will be comfortable with them and able to come down to a purchase price.

(7) Submit the revised bid--Having performed initial due diligence and had the company valued, the acquiror can make a firm offer.

(8) Negotiate the definitive agreement--This entails structuring the deal to meet the needs and objectives of buyer and seller.

(9) Develop the transition and integration plan--To maximize profitability, the groundwork must be done for a smooth handoff.

(10) Closing--At this stage, the deal is completed, the transfer made, and a final audit of the acquisition is completed. Typical elapsed time: four to six months.

Mr. Oliver and Mr. Hisey are partners in the Mortgage Banking Group of KPMG-Peat Marwick's Washington, D. C., office. They provide financial advisory services to the mortgage banking industry.