What a difference a year makes. In mid-2021, most mortgage companies enjoyed strong origination volume and were hiring additional staff in response. But as we begin the third quarter of 2022, the landscape has changed drastically and multiple challenges face the industry. Rates are now reaching almost 6% for a 30-year fixed mortgage, while the Federal Reserve has enacted substantial interest rate hikes and further increases are likely on the horizon.
These developments have essentially brought refinance originations to a screeching halt. In just one quarter, from March to June, the Federal National Mortgage Association refinance forecast decreased 23%. Meanwhile, products like adjustable-rate mortgages and home equity lines of credit are being reintroduced.
There are now fewer possible borrowers considering refinances due to the increased interest rates, while most potential purchasers are encountering low inventory that has led to multiple bids on properties, cash offers and ongoing searches.
Additionally, originators continue to see challenges to gain on sale, and mortgage servicing rights prepayment speeds have reached or are nearing a floor, resulting in smaller MSR pickup.
As revenue challenges persist because of compressed margins in traditional agency products, we’re also coming off a period of heavy refinancing where many mortgage companies added significant headcount and costs to their business.
A fresh approach is needed to combat this combination of issues. Amid relatively high expenses and reduced revenue, what steps should you take to navigate the current circumstances and position your business for success in the future?
The answer is to focus on driving efficiency and effectiveness. This concept is exemplified by a Japanese management practice called “kaizen,” which emphasizes continuously eliminating waste and reducing inefficiency.
It’s natural to pay less attention to these aspects when times are great. As the old adage says, “Revenue forgives all sins.” But the reality is that businesses should always emphasize efficiency, and that consideration is only heightened in times like these. A lack of available revenue will help separate companies that excel in execution from those whose success has derived mostly from a favorable market.
Mortgage lenders can benefit by adopting kaizen principles. While there are many areas of your business that kaizen could apply to, one particularly important aspect is understanding cost structure — not only in general terms, but with sufficient granularity to help you make appropriate decisions.
Inspiration from manufacturing
Having spent about 10 years of my early career in manufacturing, I’ve found applying this perspective to mortgage lending helps me view creating a loan as manufacturing a product. When evaluating your cost structure efficiency, simply taking a P&L number and dividing it by your volume doesn’t really allow you to understand the true impact of costs.
Rather, I suggest the approach employed by many manufacturing firms, which tend to do a good job of understanding their overall cost to produce by breaking it down into constituent parts, including inputs (raw materials), direct labor and fixed costs.
For example, a furniture manufacturer would want to know the cost of its wood, varnish, nails, glue and other supplies, as well as labor expenses and any additional costs related to factory production. The same concept can also apply to mortgage lending:
- Inputs: These include per-unit charges for origination and flow registration software, credit reports, 4506-T forms, and various other services or data used to originate a loan.
- Direct labor: The cost of operations should be broken down into granular components such as cost by department, including separate categories for closing, loan setup, processing, underwriting, etc., as well as management overhead and variable sales costs.
- Fixed costs: These include labor costs not associated with direct labor (management, support functions, etc.), as well as rent, depreciation, general & administrative, marketing and other fixed expenses.
Adding up the inputs and direct labor categories will provide an accurate overall cost to originate. Using fixed costs, it would be easy to determine breakeven volumes. This data trended over specific time periods should provide a clear indication of inefficiencies and where efforts to increase efficiency would be best directed.
Is there a way to ensure that you can be competitive from a price standpoint, that your loan officers are making sufficient commissions to earn a living, and that you make enough margin to keep the business afloat? Understanding fixed costs will provide a clearer understanding of breakeven and the relative impact of adjusting fixed expenses.
Better positioning for future success
In the current market, because volume has declined, you probably don’t have a growth problem to solve. The benefit of that is you should have sufficient time and capacity to develop a strong understanding of your cost structure and any potential inefficiencies.
If the predictions turn out to be true that we’ll have some type of recession by 2023, you’ll need to build a bridge from here to the other side of that recessionary impact, when your business will likely see improved outcomes as rates drop again.
Companies that position themselves better from a price and cost perspective should be able to at least hold their own until then. I believe that incorporating the kaizen concept of continuous improvement can help ensure that a business stays focused, efficient and successful both in difficult market circumstances and over the long term.
Ravi Correa is Chief Financial Officer at Angel Oak Lending.