Can community banks and thrifts still compete in the mortgage business? That is a critical strategic question that many of the nation's small and midsize depository institutions are asking themselves.

Mortgage banking is fast becoming a technologically intensive industry driven by scale and cutthroat pricing. Many community banks and thrifts are unknowingly destroying shareholder value as they move to expand their mortgage activity without a clear strategy or realistic measurements of profitability.

At this point in the mortgage industry's evolution, community banks, especially midsize institutions with more than $500 million in assets, should be formally evaluating whether their mortgage business is adding to or destroying shareholder value. A formal assessment of the mortgage operation should provide the chief executive and board with answers to the following key questions:

*What are the economic values of our origination and servicing functions?

*Is our mortgage business consistent with the overall strategy of the bank?

*What is our average cost to originate and service a mortgage loan, and how do these measurements compare with those of industry leaders?

*How do staffing levels and our organizational structure compare with industry benchmarks?

*Is our secondary marketing process effectively mitigating all pipeline risk?

*How effectively is the mortgage operation cross-selling other banking products?

*Do we have a comprehensive marketing plan to effectively compete in the mortgage business?

Community banks will have the opportunity to fill narrow product niches and serve a small portion of mortgage customers inside a "relationship banking" context. We see many community banks surviving in the mortgage business by playing one of the three distinct roles:

Role No. 1: The relationship-based originator. Under this structure, community banks originate loans for local customers and sell the assets into the secondary market. The value added under this strategy amounts to a small origination fee and the opportunity to broaden this relationship by cross-selling other financial products. If origination costs are not kept to a bare minimum and cross-sell efforts do not pan out, the relationship- based origination strategy adds little to a community bank's franchise value.

Role No. 2: The niche server. The typical full-service mortgage company loses money in the origination process, breaks even in the secondary market, and produces a narrow profit margin in the servicing function. Under the niche servicing structure, the community bank focuses its expertise on servicing and tries to fill niches where efficiencies can be achieved that are competitive with the industries' largest players.

Some small and midsize banks have been able to achieve dramatic servicing efficiencies by bucking the strategy and organizational structure of large servicing players. Instead of organizing themselves functionally, these niche players utilize the "case manager" approach, where each servicing employee can complete all of the loan servicing functions from a single workstation.

Under this scenario, efficiency and increased revenue are achieved by operating with fewer, but more highly skilled and trained loan servicing generalists.

Role No. 3: The niche portfolio lender. Under this structure, the community bank focuses on the origination and investment in loans that are less salable than the standard conventional mortgage. A portfolio lending niche must focus on areas where the bank believes the secondary markets are inefficient. Construction lending, jumbo mortgages, self-employed borrowers, and discounted low loan-to-value loans are examples of portfolio lending niches.

Should management decide to continue competing in the mortgage business, the following strategies should be considered:

*Rethink point of sale to increase convenience and drive down costs. Consumers will be demanding much higher levels of convenience and speed in the mortgage process. The telephone, the PC, and the laptop-equipped agent will all become more popular channels of mortgage origination.

In addition to improving speed and convenience, mortgage originators will have to aggressively drive down their unit origination costs by as much as 50%.

*Actively solicit mortgage business from your banking customers. Community banks should position themselves as the first place customers come to discuss mortgage needs, primarily because they can connect their customers with a loan counselor who offers honest comparisons of market rates and options.

*Reengineer servicing. Adopting the case management structure, increasing training, and offering quality, productivity, and sales incentives for employees will allow community banks to build productive servicing environments that are consistent with their relationship banking strategies.

*Improve customer service and focus on retention. Community banks will only carve a niche in the mortgage market if their responsiveness on both the origination and servicing sides is truly different.

Before a competitor steals their relationship, banks should proactively communicate with their customers regarding refinance opportunities. Active sales calling to customers included in a servicing portfolio can improve retention from 15% to 40% during a heavy refinance period.

*Identify portfolio lending niches based upon market needs. Community banks must analyze their market to determine opportunities where the institution can be confidently constrained to the underwriting, information requirements, and terms of the secondary markets.

*Develop a strong, profit-based Community Reinvestment Act lending business. Select community banks and thrifts have been very successful in identifying under-served portions of their market in which alternative credit policies - focused on varying patterns of behavior among different ethnic groups - allowed the bank to book profitable loans while better providing credit to the ethnic groups.

Profitable CRA lending is typically driven by marketing and commonsense underwriting strategies versus a regulatory compliance mentality.

The days of me-too competition by community banks in the mortgage market are over. In this highly competitive industry, the most effective way for community banks to reduce costs and capture market share is to capitalize on providing value, convenience, and honest mortgage advice to the bank's existing customer base.

Mr. Horner is president at R.D. Horner and Associates. Mr. Williams is managing director of M One Inc.

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