Forging wholesale's future.

Six forces converged to spawn the growth of wholesale mortgage banking in the 1980s. Today things have changed, and future prospects for this market are in question.

CHANGE IS IN THE AIR IN THE MORTGAGE BUSINESS.

Rapid and profound shifts are occurring. The whos, whets and wheres fill

Beyond all these new developments and reports is their ripple effects on the people and structure of the mortgage delivery system. Employees names, hats, companies and hat racks soar through the night sky like so many meteorites.

People in the business are uniformly stressed: too many hours, meetings, hats to wear, roles to play. Too many altered assignments and too many handcuffs. It's almost an uphill struggle to stand still, we hear over and over.

Chief financial officers come and go today like marketing directors once did. Presidents too. On a recent assignment, we discovered that five of 26 mortgage banks we talked to had new CFOs this year; two others had new presidents. These are different CFOs than the ones who attended MBA's annual convention in Boston just last October. There's not a lot of continuity.

The primary reason for this state of affairs is the financial trauma the mortgage banking industry has experienced these past 18 months. It's been a long hard road. Profits have been virtually nonexistent. Revenues have tumbled. Hardly anyone but Fannie Mae and Freddie Mac is making money. Cash flow is often coming from sales of servicing. Earnings are frequently from asset dispositions. Net income isn't the true, purer form that results from growth or widening margins. This business is experiencing negative growth.

Technology gets more than its share of blame for these forlorn signs. Though culpable, because it adds uncertainty to the very challenging mortgage banking environment, technology is being made more of a scapegoat than it deserves. The travails are really economic and structural; more like the airline industry, unfortunately. Higher long-term mortgage rates beginning in February 1994 caused a sharp deceleration in lending as refinancing activity collapsed.

Although the increase in mortgage rates proved remarkably modest given historical precedent, residential origination activity fell 25 percent, 30 percent, even 40 percent in various markets nationwide. The falloff was still greater for some others, especially the big jumbo lenders. Conduit activity fell approximately 70 percent. Overall, the quarterly pace of originations dropped from around $250 billion to the $150 billion to $160 billion range.

Unfortunately, mortgage banks aren't built to withstand such large and sudden drops in market activity--not easily anyway. Production capacity is carefully established based on real and projected volumes. Companies staff to a level of activity. As volume declines, staffing shifts downward.

To survive, firms reestablished their equilibrium point last Year: individual functions, such as underwriting, finance, marketing and sales--to cite several--were hollowed out. Departmental teams were stripped to the bone: three underwriters succeeded 10; two regional sales managers replaced seven; the finance department was reduced from seven to five employees; 50 branch offices were shut down; groups totaling 1,500 to 2,000 employees were let go--usually in two or three waves--from the giants in the business. In total, there are 75,000 fewer mortgage banking employees in the economy today than at the peak in early 1994, according to the Commerce Department. When supply isn't in balance with demand, cutbacks become mandatory as every economics student knows.

Wall Street analysts uniformly believe and write that mortgage production has little market value. Earlier this year, a report prepared by CS First Boston titled Mortgage Banking, Approaching an Inflection Point, contained this statement: "pricing has softened to the point where a potential acquirer will pay only for the adjusted book of a company, with no additional production premium. We expect this `buyer's market' to continue until production capacity is brought into line with mortgage demand." Hard to argue with that. And that sentiment appears still right on the money. So absent a rise in demand, capacity must adjust further downward to remove the excess.

In the interim, many mortgage companies have merged, been acquired, closed down or been put up for sale. Prudential Home Mortgage Company, Inc., Clayton, Missouri, consistently one of the nation's largest mortgage companies, is notable among them. As of early September, Prudential had been. on the sales block for six months and Goldman Sachs & Co., New York, its investment broker, hadn't yet found a buyer, according to industry reports. Other major mortgage banking operations that have been available in recent months include: Source One Mortgage Services Corporation, Farmington Hills, Michigan; Empire of America Realty Credit Corp., Buffalo, New York; J.I. Kislak Mortgage Corporation, Miami Lakes, Florida; and The Leader Mortgage Company, Cleveland, to list a few. Some companies have been for sale for the past year. Other companies have been pulled from the market because bids were inadequate. Since precious few have been sold, it would appear there's a dearth of buyers.

Servicing is quickly selling in today's market. Portfolio runoff and lower production keep this sector's activity brisk. Thanks to demand, the price of servicing remains near record highs.

Disappointed parents

The mortgage banking business is largely owned by parent companies (chiefly banks and insurance companies) that allocate capital based on financial performance. Like parents paying their kids for good grades, payments cease when adequate grades aren't attained. So the allocation of funds slows or stops altogether for mortgage subsidiaries when performance targets aren't achieved.

Parents traditionally expect a return on equity (ROE) of around 15 percent. But the best-managed companies in the business today are returning only 5 to 7 percent. Most are breaking even, and for too many firms, the returns are negative. Not surprisingly, virtually all owners are reviewing their options. Accordingly, CFOs come and go, layoffs strike again and again, and more companies get listed for sale.

It is against this backdrop of profitability struggles, pink slips, right-sizing, mergers and reorganizations that the mortgage delivery system must be assessed today. Specifically, we want to examine wholesaling by looking at the six factors--the determinants and drivers--that have propelled its growth in recent years. The goal is to determine whether and how each of these factors has changed due to industry developments. This article will examine each of the factors that drove the rise of wholesale to see how each is being affected by change. From there we will attempt to assess what this implies for the future of the business.

Six years ago we penned an article ("What's Driving Wholesale?" Wholesale Access: A Journal of Wholesale Mortgage Banking, Spring 1989) that examined these six factors. We thought they were chiefly responsible for driving the growth of wholesale mortgage banking. The term "wholesale" was defined to mean all purchased production whether acquired from mortgage brokers through table-funding or from mortgage bankers with warehouse lines. Our definition excluded all loans coming from a traditional retail or direct production channel.

The six factors

Indirect or wholesale production is defined to include all origination activity that resulted from acquiring closed loans individually or in bulk from correspondents (mortgage bankers) who close and fund loans with warehouse lines; or acquiring loans from brokerage companies that originate and process but rely on their wholesalers to table fund (concurrent fund in California) the settlements. In the years immediately preceding the article mentioned earlier, the volume of activity in these two branches of the wholesale business was growing sharply. We wrote that various economic, financial and "political" factors were converging to make the wholesale channels--not traditional retail--the production channel of choice.

These favorable factors were these: lower fixed costs; a more favorable accounting treatment; perceptions of improved risk-management and quality control capabilities, the anticipation that it was a better, more efficient way to build a loan servicing portfolio; the ripple effect of federal legislative and regulatory requirements, and the advent of mortgage brokers in the major urban areas of America.

Our research led us to conclude then that mortgage brokers were likely to be the big beneficiaries of this convergence of forces. This was the case because it meant that more mortgage banks would be allocating capital to these two less-expensive ways to produce loans. Wholesalers could benefit too from lower production costs.

In 1989, when we wrote the first article, the thrift industry was waning in importance in mortgage lending. The Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) passed in August of 1989, and other regulatory and financial concerns were commanding all of the thrift industry's attention. Commercial banks and insurance companies acquired or set up mortgage banking companies to fill the void. They were bringing more money, technology, resources and capacity to the business at a time when many thrifts were retracting.

Moreover, the cylical nature of industry earnings was pushing mortgage bankers to find lower-cost alternatives to traditional retail origination. Production never was a consistent money maker, year in and year out. The money came later from servicing the loans.

In any case, these new entrants to mortgage banking were more profit driven than their predecessors had been. Savings and loans and savings banks had a more benign approach to profitability in mortgage lending than today's players. Thrift institutions regarded residential mortgage finance as their inheritance, their tradition and their essence. It was an industry legislatively created to encourage thrift and promote home-ownership. It was an outgrowth of the Great Depression. For a generation it operated with ups and downs in earnings. Thrifts got through bad years with thin profits because of management belief that the industry was performing its preordained role. It was widely believed that good years always offset weak ones. This sense of harmonious cyclicality is gone in the 1990s.

When we review the infrastructure of the wholesale delivery system, we discover that several of the six factors that drove its formation are tottering. Let's review why some of these factors are less supportive of the current wholesale delivery system than before and why two production channels that accounted for between two-thirds to three-fourths of total origination volume in 1993 are today in decline.

Lower fixed costs

The first factor that helped launch wholesaling was its lower fixed-cost structure. Six years ago we could write that it was less expensive for Country-wide Funding Corporation, Chemical Mortgage Company and Chase Home Mortgage Corporation, for example, to buy mortgages from brokers and other sellers. They could buy loans for less then they could produce them through retail--unequivocally.

Wholesalers maintained lower fixed expenses because they didn't need branch offices everywhere in the country to be large national players. They didn't need to lease, rent or own an office; hire a manager to oversee the operation; employ a clerical staff to keep the business organized; or hire a sales force to bring in the business. Having processors, underwriters, closers and shippers at every office location was costly--and, by the late 1980s, it became unnecessary.

Instead of carrying all that overhead, wholesalers could merely staff a centralized operations center or several regional operating centers. Either allowed lower fixed costs. In lieu of hundreds of employees, maybe two to five underwriters, five to 10 wholesale account executives and a manager might fill the bill. And if they were really good producers, they might do many times more volume than their retail counterparts. Their overhead, the cost of doing business, and total direct fixed expenses would be millions of dollars cheaper with wholesale.

Salaries and benefits are approximately 65 percent of aggregate operating costs in mortgage banking. With wholesale, staffing was reduced to a fraction (generally one-quarter to one-tenth) of the retail expense structure, and was deemed a more cost-effective alternative. Because fixed costs were lower and variable costs essentially the same, wholesaling grew while retail output shrank. In a decade's time, purchased production grew from 5 percent to about 70 percent of aggregate origination activity.

Today it's much harder to make and support the argument that fixed costs are lower in purchased production channels. Although direct expenses are still less than in retail--a finding confirmed by a recently completed study for the whole--sale giants--indirect expenses have increased dramatically. Competition for purchased production has sent prices soaring "through the screen" by a point or more. Fierce competition means pricing concessions and market subsidies. Wholesalers pay servicing-release premiums that they pray will produce projected revenues. Retailers subsidize their prices to compete. Big price concessions make the cost of wholesale production rise and profits fall.

Accounting rules

A second factor encouraging the rise of the wholesale delivery system was the more favorable accounting treatment given expenses on purchased production. Specifically, Financial Accounting Standard 65 allowed for expenses incurred in acquiring a mortgage to be capitalized. The cost of acquiring the asset (servicing) could be deferred and amortized over the expected life of the mortgage--traditionally five to seven years. Three-fourths to one and one-quarter points or more would be expensed and capitalized by some wholesalers.

In this way the wholesaler--but not his retail counterpart--could say, "No, it didn't cost me $2,000 to originate that mortgage. It cost me $400 this year, and $400 a year in each of the succeeding four years." Retailers correctly argued that the economics of the transaction were not materially different. Critics bemoaned that the accounting treatment was a "gimmick." Surely, both production mechanisms resulted in the creation of an identical asset--servicing. Yet, accounting differences made the playing field unlevel, tilting it in favor of wholesalers, who could use the deferred expenses to subsidize the price, thereby bidding it still higher.

As the years passed, it became increasingly evident that more and more of the capitalized cost was being put back into the prices paid for purchased production. This has seriously hurt industry profitability. In 1991, 1992 and 1993, profit margins were 15, 12 and 15 basis points, respectively, according to the Mortgage Bankers Association (MBA) figures. Earnings evaporated as activity ebbed and margins shrank last year. Preliminary reports estimate the industry's profit margin hit 6 basis points in 1994.

After years of discussion about the accounting situation, the Financial Accounting Standards Board (FASB), the Zeus of the accounting world, moved to permit retailers to defer expenses on direct originations. FAS 122 made accounting a neutral factor: wholesalers and retailers alike now can capitalize origination expenses. A second leg supporting and benefiting wholesaling was eliminated.

Quality and risk

The third factor nourishing the rise of wholesaling was visions of better quality and improved risk management. The premise was that higher-quality loans would result.

Retail loan officers depended largely on Realtors to bring them financing opportunities. However, the more deals that arrived, the more beholden the loan officer was to his customers. And the more important Realtors' customers became, the better they could leverage the loan officer and the mortgage company. "Take these two mediocre deals, and you'll get five more sweethearts this month." You would hear it over and again. Loan officers were being pressured to compromise quality more and more; or so the thought went in many senior management circles.

Wholesale production offered a way to ameliorate this situation, if only psychologically, since it moved the decision making away from transactions that were more difficult to be objective about. It made perfect sense: Wholesaling made the lending business more of an arm's-length transaction. Now it was the broker's customer, not the loan officer's. Surely it was easier for the whole-saler's underwriter to say "no" to the broker's customer. The broker couldn't beat up on the underwriter.

Contrast this with retail where the loan officer could moan about underwriters being too restrictive, too capricious, too inconsistent and lacking in common sense. During staff meetings, over breaks and at lunch, a chaffing often went on between production and underwriting personnel. It was commonplace for all of a loan officer's originations to go to one designated underwriter. Some loan officers might boycott all others. Since the underwriter had to work with the retail loan officer every day, peaceful coexistence was a worthy goal.

Back in the real world, fraud and duplicity were commonplace enough that they were hurting lenders financially. Meanwhile, mortgages were rapidly becoming commodities as the value of the service component--the customer service differential--was losing importance. The importance of price grew relative to the value of the financial service rendered. And enough junk was being submitted that quality-control expenses remained high. More resources needed to be put into quality assurance: due diligence, underwriting and auditing. That all created layers of expense. Wholesaling's cost was rising.

So too with risk management. Take geographic dispersion for instance. In theory, a great concept; spread the eggs around in many baskets so that if a basket gets bumped, only some of the eggs will break. But risk management can have side effects, as many wholesalers learned.

One negative effect of wholesaling is fallout, or the risk of losing loans in a pipeline that are already hedged. These days wholesalers are having a dickens of a time trying to determine what percentage of registered loans will close. Always difficult, the task is especially trying during periods of declining interest rates. Will the "pull-through" rate on the $100 million pipeline of locked loans for, say, 45-day delivery be $60 million or $75 million? If a lender sold short a $75 million position but only $60 million was delivered, the difference, $15 million, comes at a sizable cost. Depending on the specific type of hedge, that $15 million "error" translates to a loss of $1 50,000 to $450,000.

For medium-sized wholesalers, multiply these numbers by 10, or by 100 for the giants. That gives you a sense of the exposure to loss that is confronting wholesalers in declining-rate environments. They must produce much gold to offset the expenses incurred pairing off short positions. But the precious metal isn't there to be mined.

A friend who manages secondary marketing for a midsized bank-owned mortgage company lost $1.2 million in May due to the collapse of his pipeline. One might conclude this risk alone offsets all of the benefits of geographic dispersion. What distresses wholesalers most is that retail fallout is usually much lower than that on broker table-funded business. Retail pipelines close better. Wholesale fallout has two sources. Double "apping" (putting in applications with more than one wholesale lender) and multiple lock-ins are a big-time problem for the industry. A solution is needed.

So the third factor on which the wholesale market was built, better risk management and loan quality, also shows signs of wear.

Building servicing

The fourth influence driving wholesale between the late 1980s and early 1990s was the supposition that it was a better way to accumulate a servicing portfolio. Cheaper, faster and more efficient went the argument. And so it was. Wholesalers were only limited by their pocketbooks. Many were very big, like GE, Westinghouse, Merrill Lynch and GMAC. "Switch hitters" would produce all the servicing they could in-house (retail) and then buy billions more if they had the cash to do so. If price was the control knob for the production spigot, and if capital was deep, the amount of new servicing to be added could be increased from $10 million per month to $100 million a month through wholesale. Why not $1 billion per month? Countrywide Funding was adding $5 billion or $6 billion per month in 1993. After all, it was servicing that these firms really wanted. It's the prize in mortgage banking.

The remark that "maybe wholesale isn't the surest way to add servicing" started to be heard in 1992. Concern mounted throughout 1993. Runoff from servicing portfolios was heavy. Refinancing, thanks to sharply lower interest rates, became a fashionable way for college-educated borrowers to increase their disposable income--arguably at no cost.

The market and brokers aided and abetted borrowers. Why not? Brokers could save their customers a buck and make themselves one too. No fees or points deals were readily available thanks to the secondary market. Closing costs could even be folded into the financed amount. Cash out too, for those who wanted it.

Wholesalers discovered that brokers weren't passive refi participants like retail loan officers. Their survival-tactic, enterprising side appeared. Brokers were found lacking interest in their wholesalers' welfare. Retail loan officers who called their customers with 10 percent note rates and said--"Hey, why don't you refinance? Rates are 8 percent. You'll save $167 per month"--in all likelihood wouldn't have a job after three to five such refinancings. Not so with the brokers; their livelihood wasn't threatened because of capitalizing on refinance business. Likewise, they could shift their business to another wholesaler if others cut them off for breaking locks. Brokers knew plenty of wholesalers that offered good prices and service and wanted their business.

Wholesalers concluded from the experience that too many brokers had only a minimal interest in their success. The broker-wholesaler partnerships promoted by some were found lacking. An industry that many hoped would prove relationship-driven proved transaction-oriented instead.

This experience with brokers has raised concerns and disquieted wholesalers. Eyebrows are raised; eyes are fixed on the industry. Will interest rates fall enough this year or next to usher in "Refi-Mania 3"? Will $200 billion be refinanced or $500 billion? What role will brokers play? Will they take care to get the mortgage back to the same servicer who paid one, two or more points for it? Or will the preponderance of the evidence tip in favor of concluding wholesale is "not a good way to build servicing?"

Washington inputs

The fifth catalyst for the rapid growth of wholesaling during the past five-plus years involved an array of legislative and regulatory issues. FIRREA, the Real Estate Settlement Procedures Act (RESPA) and the Community Reinvestment Act (CRA) are among them.

FIRREA affected the market largely due to the fact that it tied the thrift industry into regulatory knots for five years. The act forced thrifts to focus on compliance, capital adequacy and regulatory requirements--not mortgage lending--from 1989 to 1994. New capital rules for financial institutions heightened commercial banks' interest in mortgages. Their more-favored, less-risky investment status permitted less capital to be held in reserve against home mortgage portfolios. That made mortgages attractive.

RESPA revisions authorizing controlled business arrangements (CBAs) and computerized loan originations (CLOs) are beginning to have an effect on wholesale as well. This promises to alter the existing delivery system. In Chicago, for example, about a dozen joint ventures between real estate and mortgage companies have debuted since January 1994. Several others between builders and mortgage companies also have appeared. These arrangements basically exist to capture business for financially related entities. This development has prompted many whole-salers to initiate similar programs giving them direct access to Realtors and builders--if only for defensive purposes, we're told.

CRA has affected wholesaling by expanding the size of the market. It has increased the number of affordable housing programs and prompted Fannie Mae and Freddie Mac to develop initiatives to grow this market sector. Along with the Home Mortgage Disclosure Act (HMDA), the Truth in Lending Act, Equal Credit Opportunity Act and fair lending enforcement initiatives, regulatory compliance has affected product mixes and business tactics.

On balance, this has been the least influential of the six factors that grew wholesale. Nonetheless, it carries an effect that varies from legislative to legislative development, from regulatory to regulatory initiative. If either causes mortgage banking strategies to be altered, product mix to shift, or markets served to change, it affects wholesaling.

Mortgage brokers

The sixth and final factor supporting wholesaling these past years was the evolution of a large, well-trained entrepreneurial group of origination specialists to produce the loans. They gathered the harvest for the wholesalers.

What makes the brokers important is the market share they have cultivated during the past 10 years. Our firm's studies on the industry--three substantial studies during the past four years--indicate that brokers at times have accounted for 50 percent of all residential originations nationwide. Though some observers think this figure is too high, we know it's fairly near the target.

We estimate there are about 16,500 mortgage brokerages across the country. Their strength has grown in all the major urban areas but varies from one market to another. For instance, in Los Angeles, Chicago and New York City, they originate 50 to 65 percent of all originations, but in Cleveland, Houston and Atlanta, brokers generate 30 to 45 percent of residential originations.

Brokers have been successful in general because they are hard working and enterprising. They put in the time to succeed--long hours on weekends and in the evenings. They learned the products and developed the networks.

Forecast

This review of the factors that in recent years converged to drive the growth of wholesaling shows that four of the factors are now less-supportive factors for wholesalers than in bygone days. The four are these: the cost structure of wholesale production; the accounting treatment; the issue of loan quality/risk management; and wholesale's servicing growth capabilities.

Three of them--cost structure, quality/risk management and servicing growth capability--must become more supportive of wholesaling if the existing purchased production system is to remain intact. Indirect expenses must be brought under control if the number of wholesalers is to stabilize or rise. Likewise, an embracing technology that improves risk management is sorely needed to reduce pipeline fallout expenses. And, of course, solutions for the servicing runoff problem must be found. Prepayment penalties could go a long way here. Unless improvements come in all three areas, we would expect more banks to follow the lead of First Union, Keycorp, FBS, Wells Fargo, First Interstate and others who have left the purchased production business.

Two chief concerns remain: First, that wholesalers will not quickly return to a policy of pricing their products to make a profit; second, that the parent companies of mortgage bankers will shift their capital from mortgages to more-profitable subsidiaries. Either action will be detrimental to the current wholesale delivery system.

Accounting, in the wake of FAS 122, is at best a neutral factor and probably really more supportive of retail production.

Although the future is always hard to predict, our bet is that the pendulum that carried wholesale to its former highs in the originations business has swung as far as it will. We would conclude that wholesaling as a production outlet has peaked in volume and popularity. How much market position it sheds in the next three to 18 months will be determined by the strength of its economics and the resolution of its problems.

In the interim, brokers and wholesalers must sit down together and work to resolve the loan quality, risk management and servicing problems. New policies and procedures are needed. A failure to do so will further dim wholesaling's promise.

Tom LaMalfa and David Olson are the managing partners of Wholesale Access, a research, consulting and publishing company with offices in Shaker Heights, Ohio, and Columbia, Maryland. Wholesale Access monitors the: wholesale mortgage banking and home equity businesses, and provides specialized services to lenders in these fields.