Predicting the future of any industry, especially one as complex as mortgage banking, can be challenging. So let's start with one of the most fundamental concepts related to the economics and backbone of any economy and industry: the law of supply and demand.Â
As long as the American dream of homeownership exists, so does the demand for residential real estate financing. But this crisis has forced us to painfully discover that homeownership is at the DNA level of our economy – if the housing market fails, so too does the rest of the economy. Therefore, the ‘supply’ component is less certain than the ‘demand’ component.
Most recognize that the core of the problem is not a lack of capital, but rather a lack of willingness to deploy/invest the capital. The return on investment analysis of those with capital has shifted to a return of investment. There's little concern that investors will eventually return to investing in our industry. The unanswered question is when – there is evidence that this has already begun, but it is a fragile recovery, at best.Â
In the big scheme of things, few question the future existence of our industry; however, most question what the future holds. The following is a review of some areas in question and some predictions.  Â
Warehouse woes
The main concern regarding the industry's future is the ongoing and unprecedented liquidity crisis. Nowhere is this more evident than in the area of warehouse financing.
Just a few years ago, there were more than 120 warehouse lenders pursuing every mortgage banker they could find. It didn't matter if the mortgage banker had any experience or how well capitalized they were. Today, that has all changed – the number of warehouse lenders has shrunk by approximately 90%, and approximately 12 lenders exist today to meet the critical warehouse financing needs of the entire independent banking community. Â
One of two things will happen. Either new lenders will come in and fill the void left by those that exited warehouse lending, or we can expect to see Fannie Mae, Freddie Mac or Ginnie Mae – or possibly all three – get involved by providing warehouse financing on a secondary basis.Â
But the secondary markets provide another headache. Two of our industry's largest institutions, Fannie Mae and Freddie Mac, were taken over by the Fed and placed into conservatorship a year ago. These two too-big-to-fail behemoths were originally established to make sure we always had liquidity in the secondary markets. But they are now on federal life support, with billions of dollars being fed to them until their futures can be determined.Â
The ability to sell directly into these agencies is going to be critical to independent mortgage bankers' survival. This is especially the case if the mortgage banker is a wholesaler who is funding third-party originations.Â
We should be encouraged to see a new crop of investors entering the market. While a few of these will be regulated financial institutions, the majority of new investors will probably come from the non-regulated world. These investors will be extremely well capitalized and will have well-established access to international markets.Â
As for margins between best efforts and mandatory, they will remain wide and give significant pricing advantages to those that sell their loans on a mandatory basis, hedging the rate volatility risk. Making the move to sell on a mandatory basis will make the difference between being competitive or not, which could make the difference between success or failure.Â
Capital requirements
One of the easiest predictions anyone could make is that capital requirements will be going up. What will drive this is aggregated contingent liability. As an industry, we failed to consider the ever-increasing contingent liability each mortgage banker was taking on each month and each year as they funded more and more production.Â
Correspondent lenders happily approved thousands of thinly capitalized mortgage bankers. Conversely, most mortgage bankers happily signed these purchase-and-sale (P&S) agreements, unaware that they were sealing their fates. Both seemed content with brushing aside the growing contingent liability in favor of focusing on producing more product and volume, exacerbating the problem.Â
Intoxicated by their own success, many blindly failed to recognize the strong contractual language that many of these P&S agreements contained – until it was too late. Then, in 2006 and 2007, an avalanche of repurchases (buybacks) – the result of early payment defaults (EPDs) – buried many mortgage bankers. Compounding the problem of signing P&S agreements with onerous repurchase language was the fact that many of them were selling some of the craziest high-risk loan products that had increased EPD risk written all over them. The loan products were void of any rational underwriting logic.
We experienced systemic failures across many of the supposedly fail-safe systems that were in place to prevent a meltdown. As a result, we have already seen capital requirements dramatically increase in recent months.Â
A year ago, the only thing that was needed to be an approved seller or servicer of Fannie Mae and Freddie Mac was a mere $250,000. That has now increased tenfold to $2.5 million, effective Jan. 1, 2010.
Furthermore, it is anticipated that regulated correspondent lenders are going to have at least two levels of approval, based upon the level of capitalization – one for higher net-worth companies that have the ability to carry the ongoing contingent liability, and another for those capitalized with $1 million or less. They will have pricing that effectively buys out any repurchase risk, except for fraud.Â
Beyond the agencies and correspondent investors, other key participants – such as warehouse lenders – are requiring higher minimum capitalization. For a more traditional warehouse line facility, you would do well to have at least $3 million liquid net worth.
However, in the current highly competitive world where so many are competing for so few warehouse lines, it is better if the lenders' net worth exceeds $5 million.
The higher the capitalization requirements, the higher the barrier of entry will be for future participants. But we can expect a good number of very well-capitalized mortgage companies entering the market or moving up from lower net worth levels.Â
Regulations galore
No other single development in our industry will have a greater impact on our future than the tsunami of new rules and regulations coming out of Washington, D.C., and from many states. The general public and most regulators commonly believed that it was an out-of-control and unregulated mortgage industry that plunged our nation into the worst economic mess since the 1930s.Â
But brace yourselves, because we are going from a time of ‘irrational exuberance’ – to borrow an Alan Greenspan line – to a time of irrational regulation, the likes of which this industry has never seen or could imagine. It will be the mission of seemingly every state and federal legislator to do something to make sure this train wreck never happens again.
At a minimum, we can anticipate an increase in cost of doing business that will have the unintended consequence of higher rates and fees to the consumer.Â
For the first time, loan originator compensation will be regulated. The proposed Regulation Z rule changes, over 600 pages long, have already been written and are scheduled to go into effect immediately after the 120-day review period that concludes Dec. 27. Based on the minimal response to date, it is anticipated that these new rules will take effect relatively uncontested.Â
It is almost impossible to stay on top of all the regulatory developments by virtue of the volume being put forth and the thousands upon thousands of pages related to each proposed rule and regulation. Even worse, many executives are either unaware of what is happening or there is little they can do about it.Â
Technology issues
Generally speaking, the mortgage industry has not been known for its quick adoption of technology. Perhaps it is because of the conservative nature of mortgage bankers – they have a tendency to go with the technology that is tried and proven, rather than experimenting with new solutions.Â
It is probable that we are entering a season in which fewer dollars will be invested in developing new technologies than in the recent past – or at least until things stabilize economically. At the same time, there exists a rich and rare opportunity for well-established, existing technology companies to grow their market share.Â
But technology isn't always the solution – it can be a problem, if misused. One area related to the future of technology has to do with our previous mistakes in using automated underwriting systems (AUS).
In the last business cycle, AUS technology was the be-all and end-all solution to underwriting. We lost sight of the partnership that needed to exist between AUS technologies and humans. I heard one speaker at a conference a number of years ago warn our industry to ‘not lose sight of the importance of involvement of 'carbon-based systems' (humans) as we increase our dependence on 'silicon-based systems' (computer technology).’ Regrettably, that warning fell on deaf ears.Â
Our industry crashed and burned, as we let the autopilot of AUS technology drive our credit quality off a cliff. Innovation can never replace the intuition of an experienced underwriter. But technology can powerfully enable humans to do substantially more and, therefore, drive down cost. That was the original design of technology in our industry, and it is one that the industry will return to in the coming years.
Sales and marketing
The public-opinion pendulum is swinging far to the right as it relates to sales and loan production. This is apparent when talking with many warehouse lenders and correspondent investors who view wholesale originations more negatively.
Capital requirements are going up for those who exclusively originate on a wholesale basis, and an increasing number of warehouse lenders and correspondent investors will not even consider a new application from a company that is predominately wholesale. As evidenced by the new regulation, many regulators have made the mortgage originator the icon of everything that went wrong in the last business cycle.
Going forward, new regulation will make the playing field precariously uneven for almost any mortgage broker. We may never again see – at least in our lifetime – independent mortgage brokers ever regaining the market share they enjoyed in this last business cycle.Â
Everyone who is exclusively in the wholesale channel needs to adapt, or they will not make it. As business owners, it is critical to adjust the thought process from arguing the point to determining how to adapt and take advantage of this situation for our own betterment and the betterment our of broker base.Â
But circling back to the beginning, the objective of our industry should still be the ability to facilitate the American dream of homeownership by providing reasonably affordable financing for consumers with products and programs designed to promote sensible, long-term homeownership. It will be a challenge, but the industry will persevere – and go on to greater bottom-line success than previously achieved.
David Lykken is managing partner at Mortgage Banking Solutions in Austin, Texas. He can be reached at dlykken@mbs-team.com.
