NEWS ANALYSIS: Mortgage Banking Remains A Slippery Slope for Most,

"Every time we make a sale, we lose money. But we can make it up on volume."

That's an old joke. It's also a good description of what's happening in the mortgage business today.

Mortgage bankers can be out of pocket by as much as $2,000 after they have originated and sold a conventional loan. They could then take in perhaps $1,500 by selling the servicing rights on a $100,000 loan. Or they could hold onto the rights and hope to take in some $2,500 to $3,000 in fees over the probable life of the loan. But the cost of performing the servicing can range from $60 to more than $300 a year.

Actual costs range widely from company to company, but the arithmetic is simple and stark. If you are a high-cost originator and a high-cost servicer, you're dead or dying. But many a moribund company still sees more volume as the panacea.

If, on the other hand, you're a low-cost originator and low-cost servicer, you can survive and prosper as others leave the business.

Indeed, new figures from the Mortgage Bankers Association for 1996, a year of good market conditions, indicate that the gulf between profitable and unprofitable originators has been growing wider. The success of the best performers, most of them large, has tended to obscure the tenuous state of the rest of the industry.

With origination volume down in the first half of this year, the gap between the haves and have nots has likely grown larger.

Richard Kovacevich, chairman and chief executive of Norwest Inc., Des Moines which has become the No. 1 originator and servicer of mortgages, put it this way: "You have to be big. God help you if you're not-you're dead."

As a result, he and many others in the industry are expecting a major consolidation. "There will be blood all over the streets," Mr. Kovacevich said in an interview earlier this year.

But to paraphrase John Templeton, the investment guru, blood in the streets is a signal to buy. And presumably companies like Norwest will be among the opportunistic acquirers.

Indeed, Norwest has already been a big buyer, pushing itself to the top by acquiring in the last two years most of the business of Prudential Home Mortgage Co. and the servicing portfolio of Directors Mortgage Loan Corp. It also operates the mortgage program for Wells Fargo & Co.

Banking companies are expected to be the big acquirers of mortgage companies in the next few years, as they have been in the last few. While banks, like some thrifts, have been losing enthusiasm for mortgage investment, they are eager for fee revenues and will be functioning primarily as mortgage banks, selling most of their loans in the secondary market and holding only those loans that happen to fit well with their overall strategies for balancing assets and liabilities.

Bigness alone is no guarantee of survival or prosperity. Prudential threw in the towel with its mortgage business last year; Lomas Financial Corp., once the No. 1 company in the industry, has been sold off in pieces after going bankrupt; and GE Capital Mortgage Corp. has sharply reduced its lending business, finishing as No. 26 and No. 17 among originators nationally the last two years after consistently being in the top 10.

What has happened to divide the business so dramatically into predators and prey?

To some extent, the industry is a victim of its own success. The secondary market, which has facilitated the growth of the business, has become so enormously efficient that it has pushed interest rates down to rock bottom for borrowers but squeezed lenders in the process.

Lenders are divided over the role of the secondary-market agencies in the profit squeeze. Fannie Mae and Freddie Mac continue to rack up record profits even as many lenders struggle.

One prominent mortgage executive said, "We're seeing a major shift in wealth to the agencies and away from the lenders." He requested anonymity, saying he did not want to anger the two housing finance enterprises, with which he does a large amount of business.

Indeed, Fannie and Freddie together earned $3.2 billion after taxes in 1995, compared with $1.2 billion pretax for mortgage companies, including those owned by thrifts and banks, according to a computation by the MBA.

Last year, Fannie and Freddie together earned $3.9 billion after taxes, while mortgage banking companies showed improvement, earning $1.6 billion pretax. But Douglas Duncan, senior economist for the MBA, pointed out that the variability of earnings widened in 1996-the leaders' results got stronger, while others weakened.

Other observers see the matter of agency-vs.-industry earnings differently. Gregory Barmore, who recently retired as chairman of GE Capital Mortgage Corp., says the profits at Fannie and Freddie fairly reflect the degree of risk they are assuming.

And Laura McDonald, senior manager of the mortgage and structured finance group at KPMG Peat Marwick, says the real culprits are the lenders themselves. She says they have driven down margins in their scramble for business in the face of industrywide overcapacity.

But the highly competitive pricing isn't necessarily irrational. Mr. Duncan of the MBA says, "Some of the most efficient servicers have been using their cost advantage to cut their rates." In effect, they are subsidizing production with profits from servicing.

Fannie and Freddie, meanwhile, say they have been offering lenders some powerful ways to reduce their origination costs and thus increase their profits. The tools include automated underwriting, streamlined appraisals, and other technological services.

Roger Conley, vice president for technology marketing at Fannie Mae, says the average loan origination costs the lender $2,400 and involves another $800 in expenses that are passed through to the borrower. Mr. Conley believes lenders can now cut the combined tab of $3,200 by about a third.

A Fannie Mae spokesman said his company was offering a wide variety of loan products that are solidly profitable for lenders., "Fannie Mae is part of the solution, not part of the problem," he said.

Mortgage insurers have also continued to thrive even as their best customers are scrambling for profits. The growing prevalence of loans with small down payments has been a bonanza.

"There is a real imbalance in the marketplace," said Jerome J. Selitto, an executive vice president with Amerin Guaranty Corp., Chicago. "The question is when, not if, the lenders recognize the vendor is making more money."

Residential lending has also gone the way of many other high-volume processing businesses operated by banks. The banks have been caught in a vicious cycle: they must cut costs, and that takes big technology investments. To make the investments pay, they must have volume.

Many companies simply can't see fit to lay out the money for automation because the payoff is so far down the road and so uncertain. The graveyard humor is that technology will help them lose money faster. So consolidation proceeds, with the most efficient institutions sopping up volume as others throw in the towel.

Yet another factor is the cyclicality of the mortgage business. Lending volume increases sharply as interest rates fall but drops off quickly as rates rise. The most recent refinancing wave, for example, carried volume to $1 trillion in 1993 as rates plunged to 25-year lows.

Volume soared to a record $292 billion in the fourth quarter. But in the quarter a year later, with rates up sharply, it was an anemic $136 billion.

According to figures from the Mortgage Bankers Association, profit margins actually shrank slightly in 1993 to 7.9%, from 10% in 1992, not including any gains from servicing sales.

A big reason was that the massive loan prepayments that accompanied the refinancing wave forced large writedowns in the value of servicing. Consequently, net servicing income almost disappeared.

Lenders were slow to adjust to the slump. Eager to keep their loan officers busy, they engaged in a wave of price competition that quickly squeezed profits out of the business even as servicing income rebounded.

As a result, the industry showed a negative profit margin of 2.7% in 1994. And Mr. Duncan points out that the figures only include surviving companies and thus overstate the margins.

Mr. Duncan added that new asccounting rules have also pushed reported earnings higher.

While pricing has shown signs of improvement from time to time, it has never fully recovered, and experts say that the industry remains overstaffed on the loan production side. So further consolidation could significantly improve the profit picture.

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