Copyright 漏 2004. BenchMark Consulting International, NA, Inc. All Rights Reserved.
BenchMark Consulting International
Rod Arends & Jim Leath
In today's lending environment, the inevitable
Federal Reserve rate increases will force banks
and mortgage companies to seek alternative
sources of revenue enhancement. As interest
rates begin to increase, the demand for first
mortgages and refinancing will drop from the
recent historical highs. To offset this decline in
the revenue associated with these products, many
lenders are looking to the home equity lending
arena.
Home equity lending volumes are trending
upward and this is expected to continue through
2004. According to Keefe, Bruyette & Woods
Inc.'s 2004 earnings outlook report, analysts wrote
that home equity loans are expected to be a
product of choice. The report went on to say that
demand for these products could easily match the
20% growth rate of 2003. The 2003 CBA Home
Equity Study conducted by BenchMark shows a
home equity net portfolio change reported by
participating banks of 29% from June 2002 to
June 2003. This figure combines total Home
Equity portfolio growth with an adjustment for
portfolio runoff.
This article explores the revenue and risk, process,
marketing and pending legislative reform
differences between mortgage companies and
banks in the home equity arena. For the purposes
of this article, mortgage companies are defined as
institutions originating home equity loans or lines
of credit, bundling them into pools, and selling
these pools of receivables and servicing to
investors in the secondary market. Traditional
banks are defined as institutions originating the
home equity loan or line, holding these loans or
lines in their portfolio, and servicing them for the
full term.
Revenue and Risk
Mortgage companies rely on the yield spread
premium (or the spread between the customer's
interest rate and the wholesale interest rate) to
provide fee income from each mortgage loan. By
operating as a mortgage company that sells off
receivables along with servicing (i.e., servicing
released), the only risk to be managed is market
risk (or interest rate risk) that ultimately
determines the yield spread premium. Because of
the 'single' risk management aspect of a mortgage
company, it can operate on a significantly lower
cost structure as compared to a bank.
Banks rely on the revenue stream from interest
income, net of cost of funds and servicing costs
during the life of the loan. A bank must manage
not only market risk but operational risk, as well.
Operational risk is process-oriented and involves
the control of servicing costs and effective
leveraging of technology for the life of the loan.
Home Equity Lending - Originations
Comparing Mortgage Companies to Banks
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Home Equity Originations -- June 2004
A revenue differentiator between mortgage
companies and banks is higher loan officer or
broker commissions paid by mortgage companies
on a per loan basis. These commissions put
additional pressure on mortgage companies to
achieve a sufficient spread to reach profitability
goals. Banks usually have an incentive plan in
place, but these plans are not generally based on a
per loan method and do not impact the per loan
revenue as significantly. The bank's loan officer
compensation model can also incorporate loss or
delinquency rates since they retain the servicing of
the assets.
Turnaround Time
Turnaround time is defined as the elapsed time
from application submission to boarding or
booking the receivable to the host computer
system. When comparing origination turnaround
time between mortgage companies and banks, it
has historically been the banks that have provided
a more consistent, and overall shorter, turnaround
time for credit approvals and closings.
For mortgage companies, turnaround time will be
adversely affected by the somewhat volatile nature
of the origination volume. Since the mortgage
company revenue model relies on meeting
delivery deadlines for inclusion in a given pool of
loans for sale, the overall turnaround time may be
impacted by swings in origination volume as the
deadline draws near.
Banks generate home equity transactions that will
be held for the life of the loan or line. As stated
earlier, the major source of revenue comes from
the interest revenue stream over the life of the
asset. As such, the focus for banks is the efficient
and effective processing of the loan application
through closing, and the ultimate servicing. Once
again, this effort combines the market (interest
rate) risk with the operational risk.
Banks are also better capitalized to be able to
pursue and implement leading edge technologies
that will assist in decreasing and stabilizing
turnaround times. Since the data entered during
application processing will ultimately become the
basis for the loan accounting system and servicing
system, automation and accuracy play a more
significant role, and IT investment (to achieve
these goals) can be more easily justified. In
contrast, the mortgage company's transaction-
based income is based on an asset where the
receivable and servicing will be quickly sold with
no future use of the application data. Therefore,
investment in technologies that will ensure
efficient and effective data capture are not as
easily justified.
Underwriting
The underwriting process involves rendering a
credit decision based on the borrower application
and credit information. In addition, the value of
the underlying collateral must be reviewed to
determine if sufficient equity exists in order to
approve the requested loan amount.
For mortgage companies, the underwriting
process is normally dictated by investor
expectations. Investors will generally have certain
covenants in their financing agreements that
define items that must be verified and may define
certain credit score guidelines that must be met.
In addition, the loan-to-value guidelines may
require more robust appraisal methods to ensure
the accuracy of the collateral risk level. These
attributes combine to make the underwriting
process within mortgage companies less flexible
and more rigorous than the underwriting process
within a traditional bank. The mortgage company
must render a credit decision based on strict
investor guidelines that define the salability of the
asset, secondary market servicing, and price.
The underwriting guidelines for banks are
generally more flexible. Since the bank is
assuming the full risk of the loan for its duration,
the underwriting guidelines can be driven by
historical loss experience, efficiencies within their
own servicing department, and local economic
conditions. A borrower's prior experience with
the bank may also factor into the underwriting
criteria. While a customer may not meet the
stringent guidelines of a mortgage company
underwriter, the same customer may have a long,
satisfactory history with the bank and be a good
candidate for the bank to fund.
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Home Equity Originations -- June 2004
Data Verification
Data verification typically includes any activities
associated with the review or verification of data
elements or supporting documentation within the
application package. The amount of data
verification necessary to complete the review of a
credit application or collateral will also drive
turnaround time.
Mortgage companies tend to derive their data
verification guidelines based on the underlying
investor covenants or expectations in order to
ultimately place the asset and its servicing into a
saleable pool. These guidelines tend to be based
on a formulaic approach where the FICO score
of the applicant will dictate fields that must be
verified.
In the banking environment, there tends to be
more flexibility built into the data verification
process. The customer's existing or prior
relationship with the bank may be acceptable as
partial verification and alleviate some verification
requirements. The type of product that the
customer is applying for, in terms of loan-to-value
ratios, may also provide more flexibility. For
example, some banks may only require evidence
of the local government tax assessment of the
collateral and then apply a multiple to the assessed
value to determine the collateral value. This is
done in lieu of a full or partial appraisal. Local
knowledge of economic conditions and/or the
local housing market may also impact the bank's
verification guidelines. All of these aspects of
data verification allow a bank to be more flexible
in their approach and to devote less time and
resources to the verification process, yet still be in
a comfortable position from a collateral valuation
and risk assessment standpoint.
Appraisal Method
The appraisal method utilized by a lending
institution is an area where leading edge
technology and system architecture, in terms of
accepting and processing third party data, can lead
to great increases in efficiencies and effectiveness.
The mortgage company appraisal method is
usually dictated by investor guidelines. The
methods are usually either a full appraisal or, at
the very least, an Automated Valuation Model
(AVM) based on an automated retrieval and
comparison of comparable property sales data in
the local area. These methods involve a greater
commitment of either human resources to order,
track, and process the full appraisals; or advanced
system architecture coupled with a vendor
relationship to process the AVMs. There will also
be a necessary vendor management aspect of the
AVM process to ensure consistency and quality of
results.
For banks, there is more latitude in determining
the appropriate appraisal method. The ultimate
method will be driven by the bank's risk
tolerance, their knowledge of the local housing
and real estate markets, and their commitment to
technology investment. Usually, a bank will be in
a better position, from a capital expenditure and
budget standpoint, to make the investment in
leading edge technology to provide a fully
compatible third party data channel. Banks are
also able to provide the resources necessary for an
efficient vendor management process. However,
because the loans are not subject to any investor
guidelines, the chosen appraisal method becomes
more of a risk tolerance issue. The bank has
more flexibility in determining which loan
applications need which appraisal method, rather
than prescribing the same method for all
applications of a similar credit score and/or loan-
to-value. This scenario provides significant
opportunities for revenue enhancement as the
bank can better control the ancillary costs
associated with the origination of the loan.
Title Reports
For the mortgage company or broker, the
underlying investor will likely have more stringent
title insurance requirements in order to make the
loan available for sale in the secondary market.
Some investors will require a 'bringdown
endorsement' that will allow transfer of the title
insurance benefits from the initial lender to the
ultimate investor. This type of title insurance will
require more effort and time on the part of the
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Home Equity Originations -- June 2004
mortgage company and will likely have an
increased cost.
For banks, the titling requirements are established
based on the policy within the lending institution.
Since the loans will be held and serviced by the
lending institution, the ability to determine the
most appropriate title insurance requirements
results in more flexible titling guidelines. More
flexible titling guidelines result in fewer FTE
devoted to the process, thus reducing costs, and
possibly decreasing the overall turnaround time
from application to closing.
Generally, a bank that originates loans within a
specific geographic region will likely be more
familiar with the local governing offices title
procurement procedures. This knowledge may
aid in the bank's overall title policy decisions as
well as decrease overall turnaround time!
Flow of Origination Volume
For mortgage companies, the flow of origination
volume tends to fluctuate due to the deadlines for
inclusion in pools for sale. The fluctuation in the
flow of origination volume is a function of the
revenue model for a mortgage loan company as a
per transaction fee-based income model. The
more loans that are fed into the pipeline, the more
income that can be earned. Because of this
model, origination volumes will tend to increase
as the sale deadlines approach, which may
produce a load management environment that
challenges staffing levels. The response may be to
utilize temporary staff or increase the hours per
day for existing staff. In either scenario, it is likely
that accuracy and turnaround time will both be
adversely affected. In the temporary staffing case,
training becomes an issue. For the increased
hours scenario, staff may become less efficient
and less accurate as they work longer hours to
address the increased volume. The error rate is
likely to increase, thus increasing the turnaround
times as the errors are detected and corrected as a
part of the workflow.
Banks do not rely on a transaction-based revenue
model since the loan will be originated and owned
by the lending institution. As such, monthly
volume targets have a less important role in the
overall revenue model. The more important
aspects of the revenue model become the
efficiencies in the servicing of the loans and the
effectiveness of the collection process.
Marketing Strategies
The marketing strategies and methods vary widely
between mortgage companies and banks.
Primarily, these differences are driven by the
inherent differences in whether a lending
institution retains the loan and the servicing or
sells on the secondary market.
For mortgage companies, the most prevalent
methods of origination volume generation are
media outlets (TV / radio / newspaper), direct
mail, and telemarketing. These avenues are fairly
costly, and the response rate cannot always be
counted on to drive the volume needed to
support the profitability targets.
Because the mortgage company has a very limited
opportunity for interaction with the customer
beyond the initial application and closing
functions, there is little opportunity to continually
make contact to take advantage of additional
financing needs.
There is significant opportunity for banks to
cross-sell an existing bank customer on any of the
products offered by the bank. The most
prevalent channel of volume tends to come from
existing first mortgage customers who may have a
desire to utilize the equity in their home for a
financing need. It is likely that one of the first
sources these mortgage customers will consider is
their bank.
Because of the existing relationship with
customers, banks also have a distinct advantage
over mortgage companies by data mining their
CIF system for pre-approval, targeted direct
mailing campaigns, and a traditional source of
origination volume.
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Home Equity Originations -- June 2004
The Future of Home Equity Originations
Another consideration for the future of the home
equity and mortgage lending markets is the
pending Real Estate Settlement Procedures Act
(RESPA) reform. Once enacted, it is likely to
place more stringent disclosure requirements on
mortgage brokers, as related to home equity loans.
Brokers would be required to disclose the full
APR for a home equity loan, which would include
the yield spread premium. The yield spread
premium represents the difference between the
customer's mortgage rate in the contract and the
wholesale rate paid by the originator. The
requirement to disclose the full APR, including
the yield spread premium, would have the impact
of classifying many home equity loans within the
high interest rate category according to the Home
Ownership and Equity Protection Act of 1994,
triggering additional disclosure requirements. The
additional disclosure requirement would spell
opportunity for banks. Since they would not be
bound to the same APR disclosure requirements,
they would not be reselling the loan on the
secondary market.
RESPA reform is also likely to bring about
Guaranteed Mortgage Packages. Guaranteed
Mortgage Packages will force all mortgage lenders
to disclose an up-front cost for completing the
mortgage transaction with a relatively small
tolerance for differences in the final costs. The
Guaranteed Mortgage Package requirement will
force lenders to invest in technologies to lower
origination costs. Lenders who have fully
embraced the latest efficiencies to be gained
through technology investment will become the
low cost providers of mortgage loans and will
likely reap the benefits through increased market
share. Some of the technologies would include
automated property valuation, interfacing
application processing systems to document
preparation systems and loan accounting systems,
and automated retrieval and population to host
system of third-party vendor data.
It is likely that there will be some consolidation
within the home equity lending arena, as scale will
become a more important factor in justifying the
increased investment in technology. The increase
in scale is also likely to justify investment in single
platform systems, which would provide additional
cross-sell opportunities for banks. All customer
information and relationships could be housed on
one platform, providing seamless servicing and
data exchange between unique product lines.
As RESPA reform combines with the decreased
demand for first mortgages and refinances, it is
likely that banks will continue to realize a
significant demand for home equity products.
Those lenders who have made the appropriate
technology investments will be poised to gain
significant market share along with the resulting
increased revenue.
Summary
Mortgages companies and banks must find an
alternative means of revenue generation as the
demand for first mortgages and refinances begins
to decrease due to the impending rise in interest
rates. Home equity lending appears to provide
the perfect alternative as the origination and
delivery channels utilized for first mortgages and
refinances can now be leveraged for the home
equity volumes.
Advantages exist in the approach taken by both
mortgage companies and banks in home equity
lending. From a process, marketing, and
impending legislation perspective - banks appear
to have an edge.
Rod Arends is a consultant at BenchMark International with over 14 years of experience in indirect auto
finance and consumer lending. Arends specializes in Indirect Lending and Consumer Finance and
associated business process design.
Jim Leath is the Mortgage and Consumer Lending practice manager at BenchMark Consulting
International. He has extensive background in mortgage and consumer lending, strategic planning,
consolidations and corporate restructuring.
BenchMark Consulting International has specialized in improving the financial services industry since
1988. The company is a management consulting firm that improves the profitability of its financial services
clients through the delivery of management decision making information and change management services
to realize the benefits of business process changes. BenchMark Consulting International's expertise is in the
designing, managing and measuring of operational processes.
As of 2004, the firm has worked with 20 of the top 25 (in asset size) commercial banks, all 14 automobile
captive finance corporations, several of the largest consumer finance corporations and many regional banks
throughout the United States. Internationally, BenchMark Consulting International has worked with the
five largest Canadian commercial banks, more than 20 European organizations in eight different countries,
in addition to financial institutions in Latin America and Asia.
The company is a wholly owned subsidiary of Fidelity Information Services, Inc., with clients in more than
50 countries and territories, provides application software, information processing management, outsourcing
services and professional IT consulting to the financial services and mortgage industries. BenchMark
Consulting International has dual headquarters in Atlanta, Georgia, and Munich, Germany.
For more information about the company, visit the Web site at: www.benchmarkinternational.com
BenchMark Consulting International
3535 Piedmont Road, Suite 950
Atlanta, Georgia 30305
(404) 442-4100
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