The combination of weak short-term mortgage loan demand, heightened price competition, and the secularly increasing importance of scale promises continued dislocation in the mortgage banking business. To survive in this environment, industry leaders must thoroughly understand the determinants of shareholder value.

Maximizing shareholder value added - defined as the present value of the income derived from a mortgage applicant after the appropriate charge is made for the needed risk capital - requires an appreciation of the interdependence among a number of variables, including price (i.e., gross mortgage coupon), volume, loan size, the capture of escrow balances, pipeline fallout rate, prepayment propensity, delinquency likelihood, and the costs of origination and servicing.

How does one rank the relative importance of these value levers? Answering this question requires the building of an imformation-based strategy that uses models to reveal the impact of product, customer, and competitive dynamics on the bottom line.

Assessing Sensitivity

Mortgage bankers-who employ such models can assess the sensitivity of shareholder value added to discrete changes in each of these variables. (We also have developed models that measure the value contribution of the on-balance-sheet funding of various types of mortgage product.)

For example, although many bankers stress the need to cut costs, especially in origination (which is sometimes erroneously viewed as a loss-leader business), the normally attainable level of expense reduction can prove less significant than manipulating other levers of mortgage value.

A 10% reduction in the cost of originating a $100,000 conforming mortgage adds only $95 to per-loan shareholder value for the average originator/servicer. By contrast, if the originator/servicer is able to get an extra 10 basis points in mortgage coupon, the value of the mortgage will increase by some $375.

Cutting servicing costs, although obviously quite desirable, also has less impact than many believe. A 10% reduction-in core servicing expenses yields a $25 increment to per-loan shareholder value, or about one-eighth the increase that would have resulted from success in obtaining a mortgage applicant's escrow balances.

Overemphasizing Delinquency

Interestingly, although the bulk of the underwriting effort is expended to minimize delinquency risk, reductions in the average delinquency rate often have less effect on shareholder value than reductions in the prepayment propensity that are just as easily attained.

A two-percentage-point reduction in the expected delinquency rate (say, from 4% to 2% of the portfolio) raises typical per-loan values by just $20 for the originator/servicer. But identifying customers with a 20% lower prepayment propensity at any given level of interest rates can increase per-loan values by about $100.

This finding argues for more balance in the underwriting process - that is, relatively more emphasis on understanding the prepayment propensity through the use of progressively more sophisticated models.

Avoiding Ginnies

Improvements in most of the value levers mentioned above generally come about through changes from one customer type to another. For example, shifting from, say, a $70,000 Ginnie Mae adjustable-rate mortgage applicant to a $100,000 conforming fixed-rate mortgage, one can increase shareholder value by $1,000.

Not only does loan size go up, which adds $200 to the bottom line, but origination and servicing costs as well as the fallout rate are lowered. That's because, relative to applicants for conventional loans, those who apply for government mortgages take up more underwriting time, have higher delinquency rates (which inflate servicing costs) and tend to shop prices and terms more actively (which increases their propensity to "fall out" of the pipeline). On the positive side, Ginnies have a lower likelihood of prepayment.

Referrals Are Best

Accordingly, mortgage bankers should strive to identify the marketing approaches and delivery channels that consistently provide a superior quality of mortgage applicant.

Often, the ideal applicant is already, say, a depositor at an affiliated commercial bank. In fact, at one institution we studied, the equity returns earned form the referral of current banking customers were nearly 40% greater than those earned from customers coming through retail-mortgage hank channels and more than three times greater than returns garnered from customers supplied by brokers.

Thus, the prerequisites for surviving in today's mortgage banking environment are relatively simple. Mortgage bankers need high-value customers who will buy high-value products.

Scarce But Obtainable

These are scarce but obtainable in sufficient numbers provided the banker (1) develops the information needed to understand the relative impact of each lever of mortgage value and (2) measures rigorously the capacity of existing and alternative channels of mortgage delivery to produce customers with the greatest likelihood of activating the right levers - i.e., those with the most attractive value-creating attributes.

Bankers who can fill this prescription should be able to continue earning risk-adjusted ROEs in mortgage origination and servicing that are at least 30% and 20% respectively.

Mr. Toevs and Mr. Zika are managing vice presidents of First Manhattan Consulting Group in New York.

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