Counter to the industry trend-and despite rising interest rates-loan applications increased last month at First Nationwide Mortgage, a subsidiary of Golden State Bancorp's California Federal Bank.

Walter C. "Terry" Klein, the mortgage unit's chief executive officer, attributes this to a strategy it has employed since late 1996: offer loans with lower rates but steep prepayment penalties. The penalties are enforced strictly unless the borrower sells the house.

These loans now make up some 65% of First Nationwide's production. In an interview at its Frederick, Md., headquarters, Mr. Klein outlined the strategy.

What is the appeal to borrowers of the prepayment-penalty option?

If rates go up they win - they've got a lower rate. If rates stay the same they win-they've got a lower rate. If rates go down a little bit they're probably even, because it probably wouldn't be worth refinancing. And if rates go down a lot they can refinance, but they have to give us our investment back.

The keys to the product are:

One, we have to price it better than non-prepay. They're giving something up to get something. We have to make it attractive, the way adjustable rate mortgages have to be priced below fixed-rate.

Two, we don't waive the penalty, which gives us integrity with our investors.

The fear on Wall Street when we started this was that mortgage bankers traditionally, when they get their own refinance back, will waive the fee. Well, even the bank customer who knows the president and wants to refinance the loan, and they're not selling their home-we charge the penalty. We have only waived it in one or two circumstances.

It's not intended to be an anti-consumer product. Once our sales force understood it, and the pricing advantage it gave us, it tended to sell itself.

How has this strategy benefited First Nationwide?

It gave us protection on a portion of our portfolio we didn't have to hedge as rates came down. We have had prepayments, (but) the prepayment experience is between one-third and one-half of (the prepayment speed of) nonprepayment protected (loans).

We've done it for high-Fico-score borrowers who are sophisticated enough to understand the transaction they're entering into. And we hope they'll stick around, won't encounter financial problems or go to foreclosure, and they're going to be on our books for a while.

How has the prepayment-penalty option affected your production numbers?

Our best month for applications was October, the low point of rates in the refi boom. March was our second-best month, which is, I think, consistent with what the market may have seen. And May was our third-best month, which I think is a little counterintuitive.

Brokers do a large part of the business in refi. But (First Nationwide's) wholesale (division) had its second-best month in spite of what is, in May, a drop in refi.

First Nationwide recently purchased BankAtlantic's $3 billion servicing portfolio, bringing its total book to $90 billion. How important is it for a servicer to be big?

There are no golf-course bragging rights. First Nationwide and Cal Fed aren't competing for a ranking. We believe we have built capacity for 1.1 million to 1.2 million loans in here. Therefore, it is more efficient to achieve and keep that level than to let it run off.

This year, with BankAtlantic coming, we sold $1.7 billion of under- $40,000 Ginnies and got rid of 10% of my delinquents but only 3% of my loans.

The price was less relevant than the fact it made us a better servicer than fighting 10-year-old stuff that we didn't originate, doesn't have much identity with us, and has been worked over and not refinanced over the last 10 years.

My philosophy is: It isn't worth doing if it's for the sake of volume; it's only worth doing if you do it right. If you put junky loans on the book and service them badly, in the long run - if there's a recession - it's going to cost a lot of money.

It dictates our strategy: Put good loans on the books; keep them there. No fuss, it lowers servicing costs, you don't have a big foreclosure department.

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