The year 2014 has been on the minds of mortgage bankers since the implementation dates for Dodd-Frank regulatory reform from the CFPB were announced. We all knew that some of the most extensive mortgage banking rules were changing for 2014 and would require the industry to be even more cautious in its origination process and increase the magnification on the lens of the due diligence microscope.
What was unclear was what the housing financing market would look like as these rules took effect. It should be no surprise to anyone reading this that mortgage volumes have been in steady decline over the past nine months. And lower origination activity coupled with increased regulatory burden is the perfect recipe for a sharp decline in residential financing profitability.
But there are ways mortgage bankers can maintain reasonable profit margins while facing rapid volume changes, new mortgage rules and increasing investor requirements.
INSIDE THE NUMBERS
The Mortgage Bankers Association (MBA) does a great job tracking industry numbers and providing excellent commentary on the market.
After breaking the $2 trillion dollar mark in 2001 for 1-4 family home mortgages, and nearly $3 trillion in 2006, the housing financing market fell fast in 2008 and then had mediocre activity in 2009, 2010 and 2011. 2012 was a good year, with volumes steadily increasing quarter to quarter, and 2013 started out strong with over $1 trillion in loan originations through the first six months of the year. Then loan rates started to creep up, refinance volume began to dry up and the purchase market did not come back at the vigorous pace we all hoped. It looks like the fourth quarter of 2013 did not reach $300 billion and could end up being the worst quarter since the so-called mortgage meltdown.
It is also no surprise that profitability has dropped during the same period. The MBA surveys independent mortgage banks and mortgage subsidiaries to gauge loan profitability. In Q2 of 2013, respondents reported an average of $1,528 of profit for each loan originated. This dramatically declined by over 50% in Q3 to $743 of profit per home mortgage loan. While the numbers are not out yet for Q4, the expectations are low for any positive development to be revealed.
Servicing income is also on the downswing. At this year’s MBA National Mortgage Servicing Conference, economists showed the slow decline in per-loan revenue from $726 in 2007 to $512 in 2013. To make matters worse, expenses in servicing rose from $203 per loan in 2007 up to $357 in 2013. Not much margin left for servicers.
You do not have to be an economist to figure out that as business revenue declines, profits tend to go down with it. Certain fixed costs are difficult to modify quickly enough to make up for decreasing sales. At the same time, you need to be cautious to not adjust too much based on forecasts.
“PREDICTION IS VERY DIFFICULT, ESPECIALLY IF IT’S ABOUT THE FUTURE”
That sounds like a quote from the great philosopher Yogi Berra but actually comes from Nobel-Prize-winning physicist Niels Bohr. We love to criticize economists and meteorologists for the lack of accuracy in forecasting. “An economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today” – that’s from Laurence J. Peter, The Peter Principle guy.
While easy to laugh about, predicting future economic outcomes is extremely difficult with so many variables to take into account. The MBA does a solid job of forecasting and is not afraid to share their predictions with actual results. For example, in October 2010 the MBA Mortgage Finance Forecast pegged 2011 to be the year where volumes fell below $1 trillion and believed 2012 would be just a tad above $1 trillion. The reality is that those years, due to continued economic stimulus and low rates from the Fed, came in at $1.26 and $1.75 trillion respectively.
The point is that while the forecasts for 2014 continue to look dark, you don’t want to be caught unprepared if economic conditions strengthen and volumes begin to rise.
TURNING FIXED COSTS INTO VARIABLE EXPENSES
One way to guard against the ebb and flow of the mortgage banking business is to look for ways to better match expenditures to actual closed loan and servicing volume. A couple of ways to do that are through strategic outsourcing and transaction-based technology.
Much of the shrinking ROI in both originations and servicing come from increasing costs in labor, benefits, training, facilities and technology. And the productivity per employee is going down as transaction complexity increases. National averages for underwriting are down to 2.5 files daily per underwriter. Loans serviced per employee are down from 1,863 in 2007 to an estimated 748 in 2013. With numbers like these, there’s a strong business case for operational outsourcing of processing, underwriting and servicing.
Outsourcing is a good idea, not just to handle overflow capacity, but as a long-term strategy to directly match certain expenses with volumes. Just about every step of the mortgage banking process can be outsourced. There are a number of service providers that provide origination, processing, underwriting, closing, document generation, secondary marketing, post-closing, quality control, compliance and servicing activities on a per-loan basis.
Besides the ability to match costs to volumes, outsourcing takes a lot of the training burden of new regulatory and investor rules off the lender. The right outsourcing partner will be well-versed in the changing rules environment and provide safety and the assurance of compliance.
A popular function to outsource is quality control. QC of files at origination/prefund helps prevent default loans, which eat at profits, but does require default prevention and specialty servicing skills. The strategy is continuing to shift to using vetted QC partners who can help manage the files with the necessary skill sets and alleviate overhead burdens to lenders.
Another case for strategic outsourcing is that anticipated growth in the market will be in “higher-end” loans, i.e. >$417/K. That means the Jumbo ARM market and many origination organizations do not have the capability to correctly underwrite, QC and service this client. A proficient Jumbo ARM underwriter is uncommon, so a partner with that skill set can greatly increase market share and profit without the risk of loss through default or regulatory fines.
A great way to ensure you only pay for technology you use is to work with vendors that offer a transaction-cost model. From loan origination software to secondary marketing tools to servicing systems, having a payment model that is based on closed loan or serviced loan volume is advantageous.
Most vendors offer this payment structure as an option with their technology; especially if the systems are being run as SaaS and hosted by the vendor. While many vendors require minimum usage fees, those numbers are negotiable, so make sure you are committing to a volume that you can manage even with the most pessimistic industry projections.
SaaS-based software is also the best way to ensure loans are being produced that meet new regulatory rules and investor guidelines. The right technology partner will maintain regulator- and investor-compliant software and reduce the burden on the mortgage lender and servicer. While ultimately the compliance burden falls to the lenders and servicers, maintenance of core rules by a systems vendor makes the task more manageable.
PICKING THE RIGHT PARTNERS
Many lenders are apprehensive to use SaaS or outsource major parts of their operation for fear that vendor mistakes will ultimately be their responsibility. The loss of direct control can be a turnoff to many business leaders. While there is a risk to SaaS and outsourcing, it is a risk that can be managed if the right service provider is engaged. With so many service providers in the mortgage market today, how do you find a strategic partner that will provide the organization a positive ROI with low risk?
The key is thorough due-diligence. A search for a service provider needs to be comprehensive. Things you need to look at: how long the vendor has been in business, where their service is being provided from, and what types of lenders they service. You should also know: if they are dealing with borrower data are they SSAE- 16 compliant? Do they have robust policies and procedures? Other good questions: how is technology utilized, what reporting will you receive and how can a positive ROI be determined?
And vendor due-diligence should not be a one-time occurrence. Ongoing comprehensive vendor management is key to prevent operational problems. Keep in mind that as your loan volumes decrease, industry vendors also have revenues declining. You need to ensure that service provider has the capability to maintain a productive and compliant operation during periods of loss revenues. Look at financial statements, staffing patterns and the company’s continuity of business and disaster recovery plans. Most importantly look at how the vendor reacted in the past to periods of fluctuating volumes.
With the right business partner, the rewards of outsourcing and transaction technology can greatly outweigh the risks.
A WINNING STRATEGY
Just because loan volumes may be down 40% and profits may be off 50% in 2014 does not mean your firm cannot stay above the curve.
A few things to help ensure success: Get a thorough understanding of the costs associated with your operation; look at areas that can be successfully outsourced and produce a positive ROI; ensure your technology is compliant, running efficiently and look to move as many systems as possible to a SaaS and transaction-based model; develop and maintain a strong vendor management program to ensure your partners remain viable, can meet volume demands (both high and low) and continue to offer new services to help you meet the challenges of a post-Dodd- Frank mortgage banking entity.