Study: Nontraditional Loans Responsible for 85% of Profits

A new analysis of the industry's profitability sheds some light on why lenders are rushing into the nonconforming market: because that's where the money is.

The study, by the international consulting firm of Mercer Oliver Wyman, concludes that while nonconforming and home-equity loans account for less than half of mortgage lending volume, they generate 85% of the industry's profits from loan origination and servicing. And that means mortgage servicers had better be prepared to manage more "weird" loans.

For purposes of the study, banks and mortgage lenders reaped an estimated profit of $29 billion to $32 billion in 2003 from home loan origination, servicing activities and related activities. Of that, the profit attributed to "conventional, conforming" lending was estimated at just $3 billion to $5 billion.

By contrast, the subprime, first-lien market accounted for an estimated $8 billion to $10 billion in industry profits, the jumbo market for an estimated $6 billion to $7 billion in profits, alt-A for $2 billion to $3 billion, and FHA/VA for $500 million to $1 billion. Home-equity lending also grabbed a big share of the industry's profits, with prime and near-prime home equity lending accounting for $5 billion to $7 billion of profits and subprime home-equity accounting for $1 billion to $2 billion.

The segments in some cases overlap, with "other prime" and "jumbo" being an example, according to Mercer Oliver Wyman, because explicit data sources are not always available.

But the authors say their segmentation "reflects the underlying business logic better than an artificially tidy segmentation with no overlaps."

The study groups the eight segments into four clusters: conventional conforming; jumbo, other prime and alt-A; subprime; and home equity.

The jumbo, other prime and alt-A cluster accounts for about one-third of the industry's profitability. Subprime accounts for 30% of the total mortgage banking profits.

Michael Poulos, managing director and head of the North American retail and business banking practice at Mercer Oliver Wyman, noted that the study excludes profits made by Fannie Mae, Freddie Mac and secondary market investors in MBS.

He told Mortgage Servicing News that the profitability of the nonconforming sector is related to its differentiation.

"Basically, the further you get away from the conventional, conforming space, by definition you are talking about loans where there is less commoditization," he said.

Other factors, such as shorter terms that reduce rate risk and hedging costs, also may enhance the profitability of nonconforming loan products, he said.

"There is also more opportunity to make a margin from credit risk as you get away from the sterling credits," he said.

Mercer Oliver Wyman has advised clients to consider moving into the nonconforming business, but Mr. Poulos cautioned that being successful in the nonconforming business often requires a different set of competencies from the conforming market.

"If you are primarily a conventional, conforming player, you really ought not to go stampeding into the nonconforming sectors of the market without gaining a full appreciation of what you are getting into," he said.

Success in nonconforming niches requires a more "granular" understanding of the profitability associated with individual loans and borrowers, the authors said. That means understanding borrower characteristics like employment, home-equity line utilization, and a host of secondary market factors for lenders that sell their loans.

"All of those factors cause the value of the loan to differ," said Piyush Tantia, a director in the North American retail and business banking practice. "People need to understand that the mortgage business is not monolithic. There are many different segments that people can play in."

Mr. Poulos said banks are eager to refine their real estate and mortgage lending businesses because of the size of the market, noting that there is about $8 trillion of mortgage debt outstanding. That's about 10 times the size of the credit-card market.

Mr. Tantia said that it is difficult to break down the division of profits attributable to loan origination and loan servicing because the profitability of each sector differs depending on market conditions such as interest rates. Accounting practices also can affect where profits are recognized. The transfer pricing of different activities is also difficult to establish in vertically integrated shops.

But in general, assuming a "normalized" environment and using "some simplifying assumptions," the profitability breaks down roughly as 20% from origination, 70% from holding loans in portfolio and 10% from servicing.

The study notes that in the conventional, conforming loan market, very little differentiation is possible through risk-based pricing or product innovation. Origination is dictated by underwriting and documentation requirements. Servicing costs are already low and hold little potential to further influence the bottom line. Mercer Oliver Wyman estimates that a 10% reduction in servicing costs would translate into less than $20 million of pretax profit gain for the industry.

However, the study also suggests that lenders with good refinance-recapture rates can mitigate rate and prepayment risk in the conforming sector and provide low-cost origination volume.

"The upside of commoditization in the conventional, conforming world is that it can be very inexpensive to process an application," Mr. Poulos said.

Their study says that already, some lenders can originate a loan for half of the industry's typical processing cost of about $750 per loan.

The study's authors say their results hold several lessons for mortgage lenders, urging industry players to pick their segments carefully.

The report urges lenders to develop "micro-valuation" models to drive their origination mix and secondary marketing and funding decisions. Those micro-valuation techniques help identify the specific profit prospects for different borrowers and loan products, a key element of alt-A, subprime and jumbo lending.

SNAPSHOT: Estimated 2003 mortgage debt outstanding

Total $7.2-$7.4 Trillion

Conv. Conforming $3.25 Trillion

FHA/VA $475 Billion

B&C First Liens $650 Billion

Alt-A $400 Billion

Jumbo $1.470 Trillion

Note: Table does not include "other prime," home equity and second-lien volume.

Source: Mercer Oliver Wyman

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