Expect yet another round of consolidation in the mortgage servicing industry in the months ahead.

Further consolidation will almost certainly be a result if the Federal Reserve Board cuts interest rates, bankers and economists agree. If that happens, that means that the industry's top 25 servicers will control close to 60% of this nations' $4 trillion-plus annual servicing business, now handled by about 1,500 servicing specialists.

"As of this year, the top 25 servicers by volume control over 50% of the servicing rights for the first time ever," notes Doug Duncan, director of research and senior economist at the Mortgage Bankers Association of America, Washington. "Ten years ago they controlled roughly half that volume, and that's going up about 2 to 3% annually."

Since the mid-1980s, mortgage servicing has gone through a successive number of consolidations. "In 1985, Lomas Mortgage was probably the largest servicer with 100,000 to 200,000 loans," says Paul Colombe, senior vice president of mortgage servicing at Old Kent Mortgage Services Inc., Grand Rapids, Mich. "Now you've got companies than have up to two million loans."

How much more consolidation is possible? "Practically speaking, you could have one firm servicing everyone," notes Mr. Duncan. "The consolidation will continue for awhile; I'm not sure what the magic number for the top 25 will be, but you're going to see one or two mergers a month, with no start-ups."

The coming consolidation will occur not only because of lower interest rates but because mortgage servicers have been investing heavily in technology with little thought of a rate cut's impact

"It looks like, between this year and next, we'll have the best two back-to-back years in mortgage servicing ever," says Ed Elanjian, managing director at Cohane Rafferty Securities Inc., New York. "There is going to be between $1.2 trillion and $1.3 trillion in originations this year, and based on what has been happening with rates in the last 30 to 60 days, it looks like 1999 will be a trillion-plus year.

"For people who have a large origination presence relative to their servicing portfolio, that's great, they're gaining strength," he says. "On the other hand, when you're refinancing as an industry, you're cannibalizing one another: Someone gets a new loan to service, someone loses one.

"This is forcing consolidation," he adds. "Those companies heavily oriented toward servicing are seeing a third of their portfolio run off each year and if they can't replace that through originations then the only thing they can do is purchase replacement servicing," he adds. "Meanwhile, they've got a major investment in technology, which is a fixed cost, of course. When you're growing, your marginal costs are low, but when you're shrinking because your loans are paying off, the reverse happens and your cost structure implodes.

"So the servicing-heavy companies are coming under tremendous pressure," he says."As their portfolios are shrinking they're running into diseconomies of scale; your fixed costs begin to eat you alive. That's what's driving the next wave of consolidations."

New consolidations aside, there's plenty of evidence that mortgage servicers are pushing hard to continue lowering the cost of servicing.

"If your servicing costs are in the range of $40 to $50 a loan, you're considered to be one of the best," says Old Kent's Mr. Colombe. "To be able to cut much more, you'd have to be able to make a quantum leap in technology. There's a certain point where you can't reduce costs any more and you need to focus on increasing revenues instead."

Nevertheless, the mortgage servicing industry is determined to push the envelope. About 18 months ago, the MBA decided to broadly expand the type of information it captures in its annual survey of loan servicing costs. Among the issues it is looking at-results have yet to be released-are costs department by department.

Says Old Kent's Mr. Colombe: "We're starting to look at servicing costs by function so we can compare apples to apples. The statistics have yet to be released, but this is all part of an effort to get to the bottom of what our true costs really are."

The new study divides servicing into 16 functional areas. Among the departments where the MBA hopes to gather more information: default administration, escrow, and investor reporting.

"This will allow us to compare ourselves to our peers," says Mr. Colombe, "for instance in insurance processing. The survey will also feature companies that outsource processing of certain information. One reason that they may have a cost advantage is that they have outsourced certain work."

Bankers do emphasize quality considerations. "In terms of quality, if you are right the first time, that eliminates rework," says Mr. Colombe.

Adds the MBA's Mr. Duncan: "We want to identify more closely where there are economies of scale and where there are not. The opportunities for cost reductions are in escrow, real estate taxes, and insurance. Another primary area is in defaults. It's very expensive to service delinquent loans."

The association is digging deeper than that, however. One of the industry's main benchmark related to productivity is the number of loans serviced by employee

"This is a productivity measure," says Mr. Colombe.

Adds Duncan: "If you're outsourcing half of your operation, you should be more efficient, but on a cost-adjusted basis you may be less efficient. So what we're doing is gathering both outsourcing and personnel information to control productivity measures for outsourcing."

Whatever progress mortgage servicers have made in reducing their costs, it's clear that the industry faces at least one crucial test. "There's one caveat," said Mr. Duncan. "We haven't had a significant recession since 1981 and 1982, when the largest servicer had about $40 billion in business. Now we have six servicers with over $100 billion in business and two servicers with over $200 billion. The single most expensive process in servicing is loan delinquency and default.

"The problem is that foreclosed property is a local market," said Mr. Duncan. "If you have a recession, you have to have outsourcers in all of those local markets to manage all of those properties and we haven't tested whether it can be done efficiently. There's some question as to whether economies of scale have been achieved in this part of the business.

"The servicers say it's no problem," he adds. "On the one hand, they say they have relationships with all the locals. On the other hand, they say that the refinancings already done have improved the overall financial health of those borrowers, so they're better able to withstand a recession than they would have been if they hadn't refinanced."

Meanwhile, the servicing giants are taking steps on their own both to identify potential defaults as early as possible and reduce costs as well.

"Even if the quality of a portfolio is a factor, you can, though automation and technology, reduce the cost of servicing those delinquent loans," said Mr. Colombe. "For instance, Freddie Mac and others have software available where you can target customers who are more likely to foreclose. With that, you can target those customers as opposed to taking a shotgun approach to everyone."

For those who want to survive the next consolidation round, having a strategic plan in place will be crucial, bankers and analysts agree. For instance, there still is money to be made in specific niches-for instances, reverse mortgages. "There's no question that some in the business now are definite acquisition candidates," says Mr. Colombe. "Others may want to refocus their lines of business so that they're more profitable. Whatever they decide to do, strategic thinking is imperative."

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