First of Two Parts

If you think restructuring of the mortgage industry is moving quickly, just wait. Fundamental economic forces will drive change even faster.

In the past, the industry's least efficient players could count on accounting rules and the slow pace of the business to keep competitors from pulling too far ahead. Those days are gone.

Technological innovations, accounting changes, increased market volatility, and competition are all reshaping the industry. Yet the long- term implications are not well understood. The key is to understand cost differences among the competitors.

These differences are much larger than most people realize and are driving a dramatic restructuring of the industry.

Many mortgage lenders compare their origination and servicing costs to the averages that are published in industry surveys.

Unfortunately, dramatic cost disparities have emerged between the average and the best-in-class institutions, differences that will put immense pressure on those that are slow to achieve excellent performance.

Our work with major mortgage institutions shows that differences in cost between best-in-class and average performers is roughly 50% in both origination and in servicing. Gaps of this size cannot continue for long without having a profound effect on the industry. When the shakeout comes, the players with the lowest costs will survive, not the average ones.

What accounts for the deviation? Size is one element. Several institutions, such as Norwest and Countrywide, have grown dramatically in recent years, gaining advantages in addition to economies of scale.

This edge includes lower-cost funds and lower capital requirements; cost advantages in hedging; bargaining power with secondary-market providers; and greater ability to make investments in technology.

In addition, leading institutions have been able to control costs. The techniques include locating in low-cost areas; creating innovative compensation schemes; and tailoring staff levels to the business cycles.

Cost differences translate into price and service advantages that enable the efficient companies to expand their market share. For example, top servicers are able to buy up volume in the wholesale market because their lower-cost position enables them to realize greater value from the servicing rights.

Similarly, institutions that are efficient in both origination and servicing are growing large, integrated retail and wholesale businesses that fuel the growth of their servicing portfolios.

Smaller players that are efficient only in originations continue to take advantage of their local presence, flexibility, and consumer access. To maximize returns and remain competitive, these players are slowly being forced to sell their servicing rights.

This explains the significant growth of the broker and correspondent wholesale businesses, which now account for a large percentage of national mortgage volume. As a result, we are seeing the beginnings of consolidation.

Next: What lenders can do to survive

Mr. Bucca is a principal in the financial services practice at Booz, Allen & Hamilton, New York. Mr. Jewett is a senior vice president who has been involved in developing business strategies for lenders.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.