Balancing act: SunTrust Mortgage Inc., Richmond, Virginia, keeps most of the servicing it originates. The mortgage company's president and CEO, Sterling Edmunds Jr., sees servicing as the perfect natural hedge to its origination business.

Author:Milligan, Jack

STERLING EDMUNDS JR., CMB, IS BEING PRESSED TO explain the important role that mortgage servicing plays at Richmond, Virginia-based SunTrust Mortgage Inc. Sitting in his sun-drenched office one January afternoon, Edmunds grabs a sheet of paper and quickly draws a seesaw. A work of art it's not, but his stick-like rendering serves as a useful metaphor for how SunTrust manages its residential mortgage business.

The industry is highly cyclical, and no one knows this better than Edmunds, SunTrust Mortgage's president and chief executive officer. On one end of the seesaw Edmunds places SunTrust's various origination channels. Perched on the opposite end is its servicing operation, along with certain ancillary businesses. But the keys here are origination and servicing, which tend to be countercyclical--when the fortunes of one are down, the other's are usually up.

The swings never match up perfectly, but Edmunds believes SunTrust's servicing portfolio provides a "natural hedge" that keeps that seesaw more or less even by smoothing out his unit's earnings.

"We've managed this risk pretty good, and entirely different than everybody else in the industry," says Edmunds.

And it's a darn good thing, because SunTrust Mortgage is a wholly owned subsidiary of Atlanta-based SunTrust Banks Inc.--and institutional investors take a decidedly dim view of earnings volatility when it comes to bank stocks. In fact, stocks of commercial banks and thrifts that derive a significant percentage of their revenue from mortgage origination and servicing often trade at lower price/earnings ratios than other institutions of similar size.

It's difficult to deliver steady earnings in the mortgage business--in part because mortgage servicing rights (MSRs) are so difficult to hedge, and also because sudden changes in interest rates can have a whipsaw effect on origination volume.

"Having a mortgage operation is a good way of reducing your [stock] valuation," says bank stock analyst Michael McMahon at Sandler O'Neill & Partners, New York.

The trick is managing the mortgage industry's inherent volatility, which SunTrust does largely by balancing its servicing portfolio and origination volume--which tend to be countercyclical--as a natural hedge, one against the other.

"We think servicing is so important because it balances [loan] production," says Edmunds. "We sell very little servicing, so growing production will automatically grow servicing. But if we were to go out and sell half the servicing portfolio, for whatever reason, we'd be out of whack and the numbers wouldn't work." In other words, that metaphorical seesaw would no longer be level, and SunTrust's investors would be very unhappy.

Through the third quarter of 2004, SunTrust Mortgage was the 15th-largest servicer--and 21st-largest originator with $16.4 billion in residential loans--in the United States, according to National Mortgage News. According to SunTrust, it finished out the year with origination volume of $22.26 billion (plus an additional $7.99 billion in purchased loans, for total production of $30.25 billion) and a servicing portfolio of $77.7 billion.

The mortgage company gets about 40 percent of its annual origination volume from its own sales force in SunTrust Banks' retail footprint of Virginia and the District of Columbia, Maryland, Georgia, Alabama, Tennessee and Florida. The remaining production is split about evenly among approximately 850 correspondents and 3,250 brokers, although it does originate a small percentage of loans over the telephone and through the Internet.

Like many large mortgage companies, SunTrust has beefed up its production capabilities in anticipation of a secular shift from refinancings to purchase loans as interest rates rise. "We have dramatically increased the size of our sales force--particularly on the retail side of the business, where we've gone from about 400 loan...

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