Although banks have many logical reasons to expand their involvement in mortgage banking, the business has certain risks and challenges that bankers must be made wary of.
There is a fundamental cultural difference between the way that a mortgage banking enterprise and the traditional commercial banking organization operates.
Mortgage banking enterprises tend to be more of an entrepreneurial-type business with a heavy sales emphasis. The industry is price competitive, and production people must generate new loans to be compensated and cover operating costs.
Production-Based Pay
The compensation structure has historically been in the form of commissions ranging from 35 to 50 basis points of each loan originated. This will often result in a situation where loan production personnel can make significant sums of money equal to (or in excess of) salaries received by key executives of the bank.
The banking industry is becoming more comfortable with the concept of production-based compensation. However, banking organizations have historically been reluctant to pay personnel based on production because it is difficult to measure quantifiable results, and the overall culture does not support this form of compensation.
Mortgage banking enterprises tend to be thin-margin businesses that require high levels of production and servicing. Therefore, the organization may be run in a fashion to maximize volume.
However, banks manage their businesses to balance out their assets and liabilities and earn a return based on the interest rate spread.
A key objective of banks has been to match the maturity and repricing of assets and liabilities to provide the highest possible return and minimize interest rate risk.
The mortgage banker's objective is to match off the pricing of the current production against commitments, and to deliver this production to institutional investors or the secondary market within a short period.
Differing Points of View
The mortgage banker wants to keep the process as short as possible so that funding sources in the form of warehouse lines of credit can be continually reused.
Historically, the spread has been the primary source of earnings for a bank, but for the mortgage banker it is a small element of revenue and can be negative based on product mix or during periods of an inverted yield curve.
While many bankers have routinely sold certain forms of mortgage loans, others have traditionally held originated loans as part of their lending portfolios on a long-term basis.
This is more prevalent with adjustable rate loans and is consistent with the concept of providing full services to the banking customer. The mortgage banker, on the other hand, will originate and sell loans and may or may not retain the servicing that would be a link to the customer on a long-term basis.
The concept of originating loans for resale also results in different risk characteristics than the normal interest rate risk that the bank is accustomed to. The risk involves the market risk while the loan is committed and while it is sold.
Market risk can be managed to some extent, but the movement of interest rates during this period of time can result in additional exposure to the institution. The risk arises:
* When unclosed committed loans, because of upward movements in interest rates, close at a rate higher than anticipated; or
* When there is a downward movement of interest rates, which results in a higher fallout rate, and customers walk away from existing commitments and obtain a loan commitment from another source.
This leaves the bank in an exposed position, particularly if the institution has already committed to sell these loans. In periods of erratic rates, the risk is magnified because movement up or down in rates substantially increases the exposure.
Because of numerous risks associated with mortgage banking activities, mortgage bankers must have the proper systems to monitor risk.
Additionally, if a banker is going to have a large mortgage banking operation, the company needs the proper systems to monitor and control costs and determine the profitability for a variety of mortgage loan products.
Because of the thin margins available in an increasingly competitive market, only the low-cost mortgage loan producers and servicers will survive.
