Mortgage finance companies are focusing on higher profitability at acceptable risk levels.

The critical risks in loan origination relate to operational and creditor underwriting risk.

Higher interest rates reduce volume, and low volume in turn decreases profitability because fixed costs are spread across a smaller number of mortgages,

In an effort to increase profits, mortgage companies are focusing on market share, competitive pricing, and expanded loan products and services. Many are originating B and C mortgages and adjustables with very low teaser rates.

Furthermore, mortgage companies are offering products at very competitive prices and guaranteeing quick credit decisions.

As a result, evaluating the impact of new products on operations is critical, as are monitoring and controlling underwriting risk.

One key control over the underwriting process is maim raining an effective quality control program over documentation and underwriting of loans and utilizing the results of quality control to evaluate originator and underwriter performance.

Last year, interest rates were declining and many mortgage companies made significant profits in secondary marketing. With interest rates increasing and uncertainty as to the day-to-day movements of interest rates many companies are taking significant losses instead.

Mortgage companies need to focus on secondary-market strategies, critical secondary risks (such as pricing, hedging and fallout risk), and operating system controls.

One of the major pitfalls creating significant losses for mortgage companies is failing to adjust the fallout rates for the pipeline in a volatile interest rate environment.

Another pitfall commonly found m secondary marketing is failing to receive complete and accurate information on the pipeline.

The critical risk of servicing in the past two years has been prepayment risk. As rates declined, mortgagors found it advantageous to refinance. As a result, mortgage companies took significant writedowns on their servicing assets. They have renewed their search for hedging instruments to offset potential declines in servicing values.

Another risk associated with servicing is related to increase in the variety of loan products. Some of these products will require a greater servicing effort, and operating systems may not be up to speed. Mortgage companies need to perform regular reviews of ARM loan portfolios. In addition, many of the ARMs offered have low teaser rates that generally result in higher delinquencies as monthly payments increase. Higher delinquencies may also be in store because of the increase in loans with high loan-to-value ratios and the increase in loans to marginally qualified borrowers.

Regulators are continuing to turn up the heat on fair lending. Specifically, mortgage operations need to focus on the various fair-lending laws such as the Fair Housing Act, which prohibits discrimination in lending and servicing; the Home Mortgage Disclosure Act, which seeks to prevent lending discrimination and redlining by requiring disclosure of information about mortgage loan applications; and the Community Reinvestment Act, which seeks to encourage institutions to meet the credit needs of the entire community served by each institution.

Mortgage companies need to increase the time and attention they devote to preparing for exams and examining their data (particularly Home Mortgage Disclosure Act data). Companies should regularly implement selftesting programs to ensure compliance with all regulations. Furthermore, regulatory agencies are cracking down on mortgage companies in regard to fair lending and are utilizing HMDA data to detect lending discrimination by mortgage companies.

For strategic purchasers of mortgage operations, the acquisition risks can be separated into two categories: valuation and integration.

From an acquisition valuation perspective there are generally four elements of

value that you need be concerned about: servicing portfolio value, net asset value, production network value, and strategic value. All can be addressed through due diligence.

Valuing the servicing portfolio is certainly complex, with prepayment rates, servicing costs, investment rates, and discount rates representing significant assumptions. Of these, the foreclosure cost component of servicing cost seems to have been particularly troublesome to purchasers, many of whom found themselves paying several years down the mad for the poor lending practices of the seller. To avoid this, buyers should review average foreclosure losses as part of due diligence and negotiate some foreclosure loss cap in the form of a holdback. Base prepayment rates on historical information, but do sensitivity analysis to determine the level of risk assumed.

Loan production networks are typically valued based on some multiple of annual production. The key is to focus on what is the sustainable production versus the record volume achieved last year.

A buyer should be cautious of producers with high percentages of refinances or wholesale purchases from fluctuating sources, as these sources of loan volume are less likely to be sustainable. Instead, during due diligence, look for reliable correspondent networks based on service level more than pricing, strong relationships with builders or other loan sources, and established branches with proven originators.

If the seller insists that a certain production level can be achieved, try an earn-out structure in the contract (with controls to ensure that loan quality does not decrease) that rewards them if the promised production levels are profitably achieved.

The last element of value in a mortgage company is strategic value. Items attributed value in transactions are platform value, especially by banks with an interstate banking strategy, and market share value in competitive areas where additional market share is expensive and difficult to develop. Avoid backing into the synergy value based upon what you think is a winning bid. Instead, focus on valuing the synergies that can reasonably be obtained.

The next issue is how to integrate the acquisition into your organization. This is especially true if you are a financial rather than a strategic buyer, since the cost savings achieved through integration probably represent a larger part of your valuation. Strategic planning for the combined entity will help identify and mitigate the risks of common problems like incompatible systems.

The most prevalent integration problem is culture clash, especially when you combine an entrepreneurial mortgage originator with a traditional bank. This clash can push critical employees out the door, some of whom you are counting on to achieve increased performance levels.

To avoid culture clash, many companies proceed with integration slowly, especially in the area of originator compensation The downside is that integration savings come more slowly.

One problem best dealt with quickly, however, is the reduction of redundant staff. Our advice is to identify redundant personnel during due diligence, remove them quickly after closing, and move forward with the remaining group.

Next: How mortgage ban kers can increase their profitability.

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