This article is adapted from a talk by Mr. O'Donnell delivered last month at the senior executives conference of the Mortgage Bankers Association.

The challenges mortgage bankers face will be very much like the challenges the industry has faced in the past. But a stronger, smarter, more efficient mortgage banking industry will be far better able to cope with them.

The No. 1 challenge is, of course, interest rates. Mortgage banking has been, is now, and, at least for the foreseeable future, will continue to be a cyclical business.

As everyone in this room knows, low rates lead to refinancing booms and very high levels of originations. We saw this in 1993, that wonderful year that seems so long ago.

But after low rates inevitably come high rates. This change sharply - and suddenly - reduces originations, generating a huge overcapacity problem for all mortgage lenders, including portfolio lenders.

This is what we saw in 1994, and it's what we are still seeing today.

The truth is, the "protective devices" that mortgage bankers supposedly had this time around did not work.

The most ballyhooed protective device is the servicing portfolio. The "portfolio protection theory," a major selling point for the shares of mortgage bankers in 1992 and 1993, is simply overstated - overblown, if you will.

This is the theory that earnings would be protected by a servicing portfolio that becomes more profitable as rates rise and originations decline.

A servicing portfolio does provide protection, but only to a limited degree - nowhere near enough to offset the decline in origination revenue - as the (relatively low) share prices of all publicly traded mortgage banks currently indicate.

After interest rates, the next challenge for the iudustry is cost control.

This time around, that too was supposed to be different. By the way, these are perhaps the most dangerous words in the investment business: "This time it's different".

Mortgage bankers, on the retail side, were very zealous about cost control in 1993, mainly through the use of temporary employees. Also, wherever possible, they used mortgage brokers and correspondents as origination sources.

These are less profitable origination sources, but, on the other hand, do not require much overhead.

However, despite trying mightily to keep up during the past year, the industry has been cutting costs more slowly than the drop-off in originations.

The third challenge facing the industry is capital. This is especially severe now that the public equity market has become very cool to mortgage bankers.

The year 1992, though only three years ago, seems like an ancient time of innocence. That was the year when more than a dozen companies tapped the equity markets by selling their shares to the public.

The fourth challenge is technology. Mortgage lending remains the people- intensive, paper-intensive business it has always been. But going forward, technology, particularly the use of artificial intelligence in underwriting, is certain to reduce both paperwork and head count.

The winners in such a scenario are going to be mortgage bankers at the cutting edge of new technologies.

The fifth and final major challenge is competition. In 1993, mortgage bankers accounted for more than 50% of the $1.1 trillion in mortgage originations.

Last year's rise in rates cut both the overall level of originations, and the share accounted for by mortgage bankers even more deeply as portfolio lenders gained.

Next: A closer look at the challenges to the mortgage business and their possible responses.

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