Ins and outs of mortgage subservicing for big and small banks

No more than a very small percentage of community banks outsource their servicing work-and that doesn't appear likely to change anytime soon. Despite the argument that servicing is a scale business that makes economic sense only if a lender has many loans in portfolio, community bankers continue to

Above all, community bankers fear that sending their loan servicing work to the big companies that dominate subservicing will hurt customer relationships.

Those few smaller banks that are venturing into subservicing, or at least considering it, differ from their community bank peers only in their attitude about this new way of doing business. Basically, they have decided the proponents of subservicing are, or may be, right.

Subservicers contend that servicing mortgage loans in-house is expensive and complicated, making it a perfect function to outsource. These servicing vendors say they can service the loan for less than the lender. Cenlar FSB charges between $70 and $100 for subservicing a loan for a year, versus the $150 to $200 Cenlar says it costs a bank to do the work itself.

Cenlar contends that it takes about as much investment in technology, staff, and general infrastructure to service 5,000 loans as it does to service 50,000 loans.

The Mortgage Bankers Association did a cost study a few years ago to confirm the obvious, which is that the smaller the number of loans being serviced, the higher the cost per loan.

"The economics of the situation is that a pure subservicer can control costs better," said Douglas Duncan, MBAs chief economist.

The decision to use a subservicer depends on a bank's philosophy, according to Kevin Dunne, senior vice president at $12 billion-asset Roslyn Savings Bank in Jericho, N.Y.

Subservicing proponents say most lenders lack a clear picture of how much their servicing operations cost. Community banks "of all sizes don't truly recognize what they are spending on their servicing operations since it's spread around," said David Miller, senior vice president and business development director at Ewing, N.J.-based Cenlar.

This makes sense to Roslyn, which has $1 billion in servicing with Cenlar. Until 1995, the thrift did its servicing in-house. But ACB-member Roslyn could not do that work as efficiently as it wanted, given the small scale of its servicing operation, Dunne said.

Why did Roslyn, which Dunne describes as "a traditional thrift," decide to farm out its servicing? "Subservicing takes away headaches like payroll and taxes," Dunne said.

This speaks to one of the selling points of subservicing, which is that by outsourcing the servicing function, bank management can focus on the income-generating job of producing loans. These vendors note that the refinance boom has put a lot of stress on the mortgage loan operations of banks, sometimes turning servicing into a distraction.

Dunne said it was important to the bank that its subservicer operate in a "private label environment; customers don't like to think they are dealing with someone other than their bank."

The subservicer provides a few more options, he said. "They have the expertise to sell the loans to just about anybody, such as Fannie or Freddie," Dunne said.

Because the government-sponsored enterprises demand more of their servicers, some banks that want to sell loans into the secondary market are outsourcing the servicing function.

Roslyn is one of about 20 community banks that use Cenlar, which is the third largest subservicer in the nation.

Community banks overwhelmingly prefer to do their own servicing. As bank managers see it, they are already paying employees to handle servicing and are not prepared to fire those workers, only to then start paying someone else to do their work. Subservicing doesn't even appear on the radar screen of these banks.

"We operate in a very simple fashion; we hold all our loans in portfolio and do the servicing," said Theresa Phalon, chief loan officer at $206 million-asset ACB-member North Country Savings Bank in Canton, N.Y. "It's just part of our business plan to do it that way."

Subservicing, Phalon said, "just isn't a business strategy I would opt for at this time."

Community lenders are, of course, loath to lose personal contact with their mortgage borrowers, who they see as prime candidates for cross-selling. "We are a small community bank and pride ourselves on being able to service our customers in a personal manner," Phalon said.

Servicing vendors note, though, that with private label servicing, the lender need never lose that personal touch, or at least the appearance of it.

With Cenlar, Miller said, "the customer sees the community bank's name and logo on every piece of correspondence, and the customer makes his check out to the community bank." If customers want to make their mortgage payments at the bank branch, they can.

Anytime the mortgage borrower calls the subservicer, a rep answers the phone in the name of the community bank. "We will even transfer a live caller to the banks retail sales center," Miller said. "Our private label is deep down. Everything the customer touches has the bank's name on it."

The subservicers also say the bank has the same opportunity to cross-sell the customer that it would have if it were doing the servicing itself. The servicing vendor will put inserts into mailings to the customer, offering everything from auto loans to life insurance policies.

These arguments fail to impress Dennis Doll, senior vice president in sales and lending at ACB-member Reliance Savings Bank in Altoona, Pa., even though he said the mortgage loan is overrated as the linch-pin in maintaining customer relationships.

The $248 million-asset Reliance Bank retains about 90 percent of its servicing, but "it's more an economic issue than a customer relationship issue," Doll said. Reliance is as interested in the customer retention and cross-selling value of savings accounts and home equity loans as it is in that of mortgage loans, he said.

"Mortgage servicing is important, but it's not the only way to maintain the relationship," Doll said.

Reliance, which each year originates between $80 million and $100 million in home loans, "has never investigated the option of subservicing," he added.

It is shifting its strategy on servicing, though. A couple of years ago, Reliance held onto all servicing. Now it sells 10 percent. This "represents a big change," Doll said. He predicts servicing sales will increase. Previously, the policy of retaining servicing and doing it in-house was set in stone, he said. Now its board of directors has directed Reliance to review its servicing operations.

But would the bank ever consider subservicing? "Everything is on the table," Doll said. However, he said that "there probably aren't a lot of people in the industry who understand the subservicing piece."

Despite record-breaking originations the past two years, subservicing volume is stagnant. At yearend 2002, the top 20 mortgage subservicers had a total of $215 billion in loans they serviced, according to figures from National Mortgage News. That is only a half a percentage point more than it was a year earlier.

Dovenmuehle Mortgage in Schaumburg, Ill., with a subservicing portfolio of $44 billion, is the country's biggest vendor among companies servicing mostly prime quality mortgage loans. Wells Fargo Home Mortgage located in Des Moines, was second with a $36 billion portfolio, and Cenlar was third with a $30 billion portfolio. Washington Mutual, an ACB member based in Seattle, the biggest servicer in the nation with about three quarters of a trillion dollars in volume, has only $191 million in subservicing.

It's very difficult to say how much of that servicing volume comes from community banks. "There's no way of knowing, really," said Miller of Cenlar.

According to Ron Haynie, a senior vice president in mortgage solutions at ACB Business Partners Inc., an affiliate of America's Community Bankers, "there are no stats like that. Because the servicing asset doesn't actually change hands, there are no records, so it can't be tracked."

A Wells Fargo spokesman said the bank "cannot provide this information," while a spokesman for Washington Mutual said "it does not disclose that information."

Ed Burger, the president of the subservicer Midwest Loan Services in Houghton, Mich., said, "I don't even have a guess as to the community banks using subservicers." Midwest Loan subservices $1.4 billion in loans.

Dovenmuehle did not respond to several phone calls seeking comment about its subservicing business.

The fastest growing major subservicer is GMAC Mortgage based in Horsham, Pa., which last year increased its volume of loans subserviced to $8 billion from $5 billion. According to Ken Perkins, senior vice president of business development, "we believe we have a unique combination of being a low-cost provider able to offer high quality service at very competitive pricing."

GMAC, Perkins said, sees subservicing as a way to increase profits for the company "with little associated investment. We have the infrastructure in place for servicing. Subservicing is another way for us to feed our scale."

GMAC offers what it calls "complete private labeling at all the customer touch points, while offering cross-sell opportunities."

Perkins said GMAC would never cross-sell a community bank's customer anything the bank hasn't approved. His point touches on a concern of lenders that the subservicer could become a competitor.

When asked why GMAC is suddenly interested in subservicing, Perkins said, "a couple of years ago there were questions about the subservicing marketplace. For some it was just a place to park their loans. Some of the shops offering subservicing were not doing what we would call a quality job."

"Countrywide is clearly a competitor. We think they are looking at it the way we are. They have scale, know-how and a name, just as GMAC does," Perkins said.

Lee Wardlow, head of national sales and marketing for the subservicing program of Countrywide Home Loans, said the company is "actively pursuing subservicing relationships." The greatest obstacle to selling a lender on the value of subservicing is control, Wardlow said. Lenders want to be sure "Countrywide will do a good job with their customers." They want private label capability, cross-selling opportunities, and for the subservicer to act as the banks back office. But, he said, "I would guess that community banks make up a very small percentage of our business. They are really not on our radar screen, though that's subject to change."

Countrywide, an ACB partner, has only about $11 billion in subservicing volume, out of a total servicing portfolio of more than $500 billion. "A boom in originations does not a boom in subservicing make," Wardlow said.

The larger world of servicing has been roiled by loan prepayments that have devastated servicing values. Calabasas, Calif.-based Countrywide, for instance, lost $554 million in its servicing business in the first quarter. The reason is ever-lower mortgage interest rates, which have fallen steadily for three years. In the week ending May 16, mortgage interest rates averaged 5.45 percent for 30-year fixed-rate loans, according to Freddie Mac. In May 2000, the average 30-year loan rate was 8.52 percent.

Greg Bennett, president of Hamilton, Carter, Smith & Co., a financial advisory firm in Beverly Hills, Calif., makes the point that a customer can refinance more easily than ever before. With improved loan technology paving the way for a well-informed borrower, mortgage rates need drop by only 40 basis points to make a refinancing likely, he said.

According to Haynie of ACB Business Partners, "servicing is a volatile asset, especially now with prepays." he said that ACB members are "reporting record runoff rates."

Many lenders, including some community lenders, have decided to bail out of servicing altogether.

"We looked at subservicing and decided it wasn't for us," said Chris Reichert, executive vice president at Pulaski Bank in St. Louis, Mo. The $430 million-asset community bank makes about $120 million to $140 million each month in home loans and sells 90 percent to 95 percent of them servicing released.

"Interest rate risk-the prepay risk-is the main reason we get rid of servicing," Reichert said. "Our mortgage business is good, but it would be catastrophic to our bank to see interest rates fall 50 basis points and have our servicing rights run off."

Pulaskis mortgage operation, he said, is "big and robust," while its servicing capability is much smaller.

The ACB-member bank, he said, simply "doesn't have the portfolio appetite, given our $400 million-asset size."

Reichert also makes the point that selling the servicing "locks in all the gain from a loan sale into the current quarter, so we get all the earnings without the risk."

Holding on to the servicing for an annuity-like stream of income may be a sound policy in theory, but if a bank needs funds immediately, then selling the servicing rights may make sense. With home loan originations proceeding at record-breaking rates, lenders are hungry for income to fuel that end of the business.

Perkins of GMAC notes that "lack of financing can limit a lender's ability to originate loans. The banks make money originating loans and then selling them along with the servicing. They don't want to be bothered with servicing."

But some observers say with interest rates so low, now is a good time to retain servicing rights. The idea is that prepay and runoff risk on current servicing would be minimal. To this, Perkins said, "wheres the bottom? People made the same argument when rates were two points higher than today."

A good subservicer, though, will be alert to loans likely to refinance and will approach the customer on behalf of the community bank to offer a modification or refinance. This way the lender gets to keep the customers business.

For lenders who want to retain servicing while selling their loans into the secondary market, Fannie Mae and Freddie Mac have programs with America's Community Bankers to make the outsourcing of servicing easier. The programs are designed to help smaller lenders operate more efficiently and competitively in the secondary market. ACB members are able to get better pricing for the loans they sell to the GSEs, with access to private label subservicing through Cenlar.

As Miller of Cenlar put it, the community bank "will get a better execution with an able subservicer, since the GSEs require special reporting methods and accounting requirements."

If subservicers ever get a foothold in community banking, it will probably be among those lenders that want to sell into the secondary market. Servicing for investors like Fannie Mae and Freddie Mac creates a whole new set of challenges, such as separate loan tracking and reporting requirements. "Fannie and Freddie have strict follow-up procedures, for instance, if a loan goes delinquent," said Haynie of ACB Business Partners.

The government-sponsored agencies require servicers to remit by a certain date, among other rules. There are steep penalties for infractions. "Fannie and Freddie have rigorous requirements for servicing loans," said Haynie. "This may not be easy for community bankers used to doing things one way to then find they have to follow someone elses rules," he said.

For these banks, a subservicer may be the answer. Wardlow of Countrywide suggested the GSEs are concerned about the extraordinary consolidation in the servicing world and want to encourage diversification. "Fannie and Freddie see that all their loans are with 10 to 15 companies. They are investors and have to be careful."

But Douglas Robinson, a spokesman at Freddie Mac, said, "we are not encouraging servicing, we are encouraging mortgage lending. This program lets a lender do more mortgages, makes it a more efficient lender."

Jeffrey Hayward, a senior vice president in single-family business at Fannie Mae, said, "our interest is to make sure the local lender has options. The typical community bank doesn't want to have to figure out the secondary market."

Thrivent Financial Bank, a unit of the $60 billion-asset financial services firm Thrivent for Lutherans, is selling its loans into the secondary market and letting Cenlar do the servicing.

It's "a cheaper proposition doing that," said Joel Sherwood, chief lending officer of the $344 million-asset ACB-member bank. He said the Appleton, Wis.-based bank did a lot of research before choosing a subservicer. "There's lots of anxiety in choosing the vendor to send your servicing to. If it gets botched, it can affect the business relationships our parent has with its customers on products like annuities and life insurance," he said.

Thrivent for Lutherans is a fraternal organization. "To sell servicing would defeat the purpose of deepening the relationship with our customers. We never considered selling the servicing," Sherwood said.

Another reason Thrivent chose Cenlar is because that vendor is national, and Thrivent lends in 12 states. The bank, he said, can make a wider range of loans if it has a good subservicer doing the servicing, loans like a bi-weekly mortgage or an ARM.

Subservicers also offer their services as suitable for any occasion a bank might want to get its loans off its computers for a while, such as when it's doing a system conversion. And when one bank buys another, it might decide to use a subservicer for a while until it's comfortable putting those new loans on its system.

Perkins of GMAC said he believes there is the potential for many companies to consider outsourcing their servicing functions. "We anticipate an increase in the subservicing market, though the increase is difficult to quantify," he said.

The community banker, though, is likely to remain a hard sell to subservicers.