Forging wholesale's future.

Author:Lamalfa, Tom

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.


Rapid and profound shifts are occurring. The whos, whets and wheres fill the trade journals. You talk about them with each other and customers--hear them discussed on CNBC and at conferences. Change is omnipresent.

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...

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