During the intermittent refinance waves, the mortgage industry is lulled into a sense that all is right in the world.

Volumes are high, and falling rates generate attractive gains on loan sales. Though portfolio runoff is a concern, record closings keep the portfolio replenished.

But as surely as these waves occur every four or five years, they also end.

At this point mortgage lenders start complaining about heightened competition and low margins. Inevitably, the discussion leads to how Fannie Mae and Freddie Mac have squeezed the margin and the profits out of the business.

As long as mortgage lenders complain about margin compression, they have conceded defeat. The war over margin is not one they can win. It does not matter if they are mortgage bankers or portfolio lenders. The war has been won by Fannie Mae and Freddie Mac. It is futile to fight them; they are too large, and their cost of capital is too cheap. To fight them is to take on a losing battle.

Let's look at some numbers. Freddie Mac generates a 21% return on equity with a net interest margin of only 80 basis points. Fannie Mae's margin is a still-slender 102 basis points but generates a 24% ROE. If these companies were savings & loans or banks, they would have long ago gone under. Even the most poorly operated depository earns a spread of at least 200 to 225 basis points.

How can the agencies be so profitable holding mortgages at such a slim margin? First, they let the rest of the mortgage finance industry do all the expensive work, such as originations, selling, shipping, and servicing.

Let's look at efficiency ratios, the measurement of how many cents an institution spends to generate one dollar of revenue. Golden West (the parent of World Savings) is at 34%. Washington Mutual comes in around 45%.

Freddie Mac's efficiency ratio is around 15%, and Fannie Mae's is 12%. No matter how much you watch your overhead, you just are not going to compete.

Second, the agencies have much more leverage on their balance sheet. Because of their status as government-sponsored enterprises, they are both able to employ leverage of 33 to 1. Washington Mutual has a 20 to 1 leverage ratio. World Savings is leveraged 12 to 1.

How can mortgage lenders possibly compete with these giants? The answer is to stop fighting the old war. As with all military strategy, the key is to define the battle in your own terms. You can't beat the agencies on their overhead or their leverage. Stop trying!

How can you redefine the terms of the debate, the lines of battle? How can you take on the agencies on a terrain where you have all the advantage? The answer, I believe, is to use mortgage lending not as an end but as a means to aggregate large numbers of customers about whom you have a great deal of information. With these customers, you can then sell them additional financial products, something Fannie and Freddie cannot do.

When a financial institution takes a mortgage application, it learns more about that customer than is obtainable through most other bank products. Think of all you learn when you take a mortgage application.

Does a borrowing couple have a one-year-old child? What if both husband and wife list themselves as having college degrees? Isn't this a couple absolutely ripe to be solicited for a college savings plan for their one-year-old?

What if someone's loan application shows lots of cash in the bank? Isn't this a wonderful opportunity to cross-sell savings or investment programs? If the borrowers also list other properties shouldn't they be solicited for refinances on those properties as well? What if the borrower drives a 1983 car? On the chance that the car might be on its last legs, why not contact the borrower with a special on auto loans?

The days are long past when it was sufficient to stuff a Visa card solicitation into every monthly statement. Nor is it acceptable to gather data on bank customers and never use it. One key, I believe, is the mortgage application. Banks that can capture it in a customer-oriented database can then offer that borrower only those products that are relevant.

Bank customers deserve customized offerings. Banks that can do this will start to solve the mystery of cross-selling. This is territory that rightfully belongs to the banks, and it is terrain on which Fannie Mae and Freddie Mac cannot compete.

Mr. Garrett is president of Sequoia National Bank in San Francisco.

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