Our analysis of the mortgage banking industry has revealed the following fundamental trends:

* Consolidation, which has begun to occur in the mortgage banking industry is likely to continue, initiated by players both inside and outside the mortgage banking market. Driving this expected consolidation is commercial banks' and thrifts' desire to increase the contribution of fee income to the bottom line, their need for new asset-generating capabilities, and the opportunity for commercial banks to cross-sell products. For mortgage banks, the motivation is to gain market share and create synergies.

Deal Activity Heats Up

Over the past six months, four mortgage banking companies with originations in 1993 and yearend servicing portfolios greater than $3 billion have been acquired and an additional two companies have placed themselves on the block - compared with the two acquisitions in all of 1992 and four in 1993.

We expect this trend of increased merger and acquisition activity to continue throughout 1994 as excess origination capacity is squeezed out of the market and smaller inefficient players either close shop or are purchased by larger financial players.

* Market share among the top companies continues to consolidate. The top 10 mortgage bankers, both independent and subsidiaries of larger companies, originated 25% of the new mortgages in the first quarter, up from a market share of 15% in 1991.

In the servicing market the top 10 mortgage servicers commanded market share of 18% at March, up from 15% in 1991. The three mortgage bankers under coverage also have realized strong market share, which has increased to 8.3% and 5.4% of the origination and servicing markets, respectively, from 4.3% and 3.0% in 1991.

* As refinance volume contracts in 1994, share gains in the purchase market likely will play a strong role in the level of earnings growth realized by mortgage bankers. The mortgage banks that can realize market share growth and limit origination margin compression over 1994-95 will likely benefit from the industry's expected recovery in servicing profitability.

* Pending accounting changes likely will narrow the gap between reported income and economic value for originators, affecting the industry in a number of ways.

First, retail mortgage banks likely will decrease the level of servicing sales. Second, investors will be able to better analyze mortgage companies. Third, the level of competition within the industry likely will increase because companies will compete based on their individual cost structures, not accounting advantages.

These changes are expected to increase tangible book values by an average of 40% for the group by yearend 1995. We estimate 1995 book values follows: American Residential, $17.66 per share; Countrywide Credit, $14.84 per share; and Fleet Mortgage, $11.80 per share.

* Servicing margins likely will rebound over the next two years as heavy amortization expense and lost interest float begins to decline along with the decline in refinance activity. According to the latest industry data for calendar year 1992, servicing income as a percentage of the unpaid principal balance in a company's servicing' portfolio fell by 50% in 1992 to 6 basis points from its five-year average of 11 basis points because of heavy refinancing volume.

We suspect that margins fell further in 1993 for the total industry as refinancings increased, further increasing turnover inservicing portfolios.

We expect this decline in servicing margins to reverse as refinancings decrease. The industry continues to realize the strong economies of scale inherent in loan servicing. In 1992, direct servicing expenses - personnel costs, data processing and occupancy expenses - declined to 50% of total expenses, from 70% in 1985.

* Because of these expected improvements in servicing margins, growth in servicing portfolio balances likely will drive earnings appreciation in 1994 and 1995. We expect servicing revenues as a percentage of total pretax income to reach each Company's historical level in 1995, muting the earnings volatility experienced over the past two years.

* As a result of the decline in origination volume, economic and market values for servicing rights - which are countercyclical to origination volume - are expected to improve throughout 1994. Because of the increased level of servicing sales during the first quarter of 1994, there has been a disparity between market values for servicing rights and their corresponding economic values.

This article was excerpted from a recent report titled "Mortgage Banking - Beyond the Refinance Wave."

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