A wave of mortgage servicing deals in recent weeks has raised expectations that a major shakeout, much like the one that reshaped the custody business, will narrow the field to just a small handful of powerhouses.

There are plenty of reasons to buy the consolidation argument. Like custody, servicing is a scale business, one that rewards the efficiencies of size.

Even where the businesses differ, size brings benefits. Custody is a fairly straightforward, noncyclical fee business; mortgage origination and servicing are extremely sensitive to the rate cycle (inversely, providing a built-in hedge to those in both businesses). Larger institutions tend to hold an advantage both in their capacity to financially hedge portfolios and their ability to ramp up mortgage production, themselves or through third parties.

But even as the top tier in the servicing industry marches toward $500 billion portfolios, industry insiders say it is extremely unlikely that consolidation will push smaller participants out of the competition.

What stands in the way? Several factors.

One obstacle is that the market is still extremely fragmented. Even if the top three servicers were to combine their portfolios into a nearly $1 trillion behemoth (see chart), the resulting operation would represent only about one-fifth of the market.

Also, there is value to be tapped in a mortgage portfolio above and beyond the fee income it generates. Cross-selling opportunities are one such area.

Hamilton, Carter Smith & Co., a brokerage in Beverly Hills, Calif., is auctioning a portfolio of servicing rights on $2 billion of 30-year fixed-rate conventional loans for an undisclosed, privately held mortgage bank in northern California. A selling point, said Gregory J. Bennett, president of the brokerage, is that the seller is a monoline mortgage company that is not in any other financial services, so the borrowers in the portfolio have never been solicited for cross-selling - at least not by their mortgage provider.

If the market stays true to recent form, there will be plenty of bidding interest from the leaders. But for smaller portfolios, the ones that pop up in the $500 million range, the dynamic may soon change, at least in terms of who does the bidding.

With volumes at the servicing industry's top four ranging between $250 billion and nearly $350 billion for Wells (including the recent First Union purchase), some deal advisers openly wonder if larger servicers will invest the effort needed to bid on smaller portfolios. Their standing aside would open the door for smaller companies looking to aggregate their way into servicing's middle class.

Another argument against the demise of small servicers is the Fannie/Freddie factor.

By striking guaranty fee discounts with the largest mortgage companies, Fannie Mae and Freddie Mac have contributed in at least some way to the market concentration.

In theory, if the big became too large for their tastes, they could choose to even out the pricing scheme. That would remove the incentive for smaller companies to sell their rights to the larger ones rather than deal directly with Fannie and Freddie.

Where does it all lead?

Given the aggressive run by Wells Fargo & Co. - followed up a $52 billion First Union Corp. deal with a $7.5 billion portfolio purchase last week from a FleetBoston Financial Corp. unit - it almost certainly leads to a world populated by a handful of companies holding sway over huge servicing portfolios.

But just as likely it will produce a parallel world in which small and midsize companies can thrive, in part by focusing on niches where they enjoy unique opportunities to cross-sell.

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