30 December 2013

Top (10) Mortgage Industry Beliefs

The following lists what we discern to be the top ten (10) beliefs governing mortgage businesses today, and are likely to be the cornerstone of many business plans for 2014 within the Industry and worthy of some discussion:

Top Ten Beliefs in the Mortgage Industry
1 The more volume the better
2 Economies of scale are a key to profits
3 Cross selling is a key to profits
4 Synergism works in financial services
5 Centralisation beats decentralisation
6 Wholesale funds providers are brokers' friends
7 Credit risk is not a concern: pass it on
8 Housing is a major market, . . . the capital markets and government support will always be there
9 Technology will favour large players and consolidate the industry
10 In the mortgage business, the SHORT RUN is all that matters

Beliefs 1 & 2 - 'Bigger is Better' - Size and Economies of Scale fix everything

Mortgage industry participants worship size and volume, and believe firmly in the magical powers of economies of scale; a genuine fallacy of the more volume the better. Research on financial institutions shows economies of scale are neither automatic nor continuous with size. In fact, except in narrow operational fields, the most efficient financial institutions in a field are not the biggest companies. The largest banks, non-banks and broking firms are not the low cost producers. Furthermore, where scale economies are gained through re-engineered operations, in large organisations they are often lost to higher bureaucratic costs and in poor communications and response times up and down the chain of command. Boutique operations on the other hand with a specialised approach and high customer focus are often small, but highly profitable as they command a specialist price for their unique services.

This "Bigger is Better" fixation is no more evident than in mergers and take overs which the industry has coined "consolidation". In almost every instance of a take over activity seen to date, promises are made about the cost savings to be achieved through size, and new and improved service levels for consumers. Regrettably in practice the real economic synergies in the deal are the potential for staff redundancies rather than eliminating duplicated IT or improving other systems and processes. But consolidations do eliminate competitors. The bad news is that in every instance the remaining competition got bigger and more price oriented.

Beliefs 3 & 4 - Cross-Selling and Synergism

As a collorary to the "bigger is better" belief, the financial shores are littered with dreams of well intended bank and non-bank organisations who believed consumers wanted a one stop shop for financial services. The casual observer may not recognise the truth of that statement because of the many major companies who bought that thesis - many have entered and left the field. They entered with great fanfare and strong publicity; but when the strategy did not work, they put the concept to bed as quietly as possible.

Consumers, no longer babes in the woods, are increasingly taking the lead in selecting their home loan provider. Some players are now consumed with joint ventures or strategic partnerships, and large corporations like American Express, QANTAS, and BMW are offering mortgages to their members as a value added perk.

Examples of cross selling failures, however, abound; how about Sears with its socks and stocks and real estate and banking theme (late 1980s), Wingspan an IBM-Bank Boston joint venture of 1998 and others. Operating efficiently a multi-channel, multi-product, multi-discipline business is capital and labour intensive, and consumers in fact may not wish to place "all" their business with one provider. This is the equivalent of a "one size fits all" or attempting to "be all things to all people" approach which has always proven not to be a sustainable business proposition.

Valuable lessons can be learned from studying other commodity type consumer businesses - the grocery business, department stores, beverage companies and fast food companies. All use price and specials as a competitive weapon. They also use loss leaders, vigorous cost control, but significantly they focus on niche marketing and brand management. They seek to recoup their costs on the commodity business, while making their profits on the niche products, exclusive brands and special services.

Mortgage brokers might be well advised to seek out proprietary niche values as specialists in holiday home loans, immigrant loans, affinity group loans, renovation loans, impaired credit/sub prime loans (loans with previous repayment delinquencies), home computer shoppers, small town residents, refinance mortgages, bridging loans, farm or rural loans or low rate high fee loans. Any one of these could produce 5 percent of volume but 15 percent of profits. McDonald's is said to make more money on french fries and drinks than on hamburgers. Many movie theatres make more money on popcorn than films.

In tomorrow's world one could see two competing mortgage brokers with the same origination volume and the same cost structure, yet one is highly profitable and the other operates at a loss. Why? Because one believes all home loans are created equal as far as profitability is concerned. The other knows better and markets for profits.

Belief 5 - Centralisation Beats Decentralisation

Neither centralisation nor decentralisation is the winner in business organisation for financial services. Both have advantages and disadvantages. Central control can get too tight and stultify an organisation's responsiveness to consumers, and then too loose and drain profits. Decentralisation can lead to lack of harmonised standards operating throughout the company, as different staff interpret company policy and procedures differently. This has some significant implications for bankers, broker intermediaries, and other players in the industry in how best to serve the customer via their chosen distribution channels and networks and/or respective business structures (e.g. retail direct, wholesale path, broker only, franchise, . . . etc.).

Beliefs 6 & 7 - Wholesale Funders are the Broker's friend, and Credit Risk is not our concern - Pass it on

The Banks are the mortgage purchasing giants in Australia and their predominance will continue. That means they are the principal direct and also indirect (through capital market securitisation programs) suppliers of funds to housing and industry players. This has been good for housing and home ownership but now has a downside risk for brokers. The bankers currently encourage loan broking as a source of replacement distribution resulting from branch closures, and have significant trail commission exposures to brokers' groups. Should any significant losses arise from this distribution channel then the bankers will either close it down or perhaps be forced to adopt the "full recourse" model of the US which makes the broker responsible to buy back bad loans.

In competitive markets, credit risk will stick to banks and the investors of securitisation issues and can materially affect profits. In commodity markets with razor thin operating margins, mortgage players are well advised to be sensitive to any increase in delinquencies or defaults. Remember the business cycle is not dead, and when an international credit crisis hits, it can turn already thin profits into gnawing and life threatening losses quickly; bankers however are very adept at recouping their losses.

Housing finance will be commodity business for years to come, and the entry price for any operator's viability will be operational efficiency, low costs and controlled growth.

Belief 8 - Politics of Housing - Government support will always be there

The commonly held political belief of mortgage operators is that housing will always get the equivalent of most favored nation status from government. The words may continue to be there, but the economic arguments are beginning to wear thin. The current thrust of governments around the globe has always been to regulate and push to balance budget deficits and once the regulators perceive a need to protect consumers from bad practices the only question is when will regulation be implemented? This could mean matters such as negative gearing, capital gains discounts, or first home owners grants come under increasing scrutiny.

Moreover the advent of the modern multi-channel broker offering a wide range of home loans from multiple bank and non bank suppliers, has resulted in the ability to offer convenience to many customers - who have a limited time to visit banks themselves and work their way through various products, (a panel of 20 lenders is average in the broker industry), which in itself builds a "know your product, know your client" principle, where the broker recommends a suitable product for the client from a range of choices. This is clearly a regulatory matter for the future including the vexed issue of trail commissions under FOFA.

Belief 9 - Technology favours the Big

Technology investment should be selective. Experience in Australia and overseas repeatedly shows with technology you are either:

  • Pioneer [the "bleeding edge"];
  • Fast Follower; or
  • Road Kill.

Current model computers we have now are 2000-3000 times faster than the first personal computers in 1984. Within the next three to five years they will be 2000-3000 times faster again. This obsolescence can be punishing to any business continuously reinvesting to stay on top.

Whilst it is interesting to see automated loan underwriting and loan credit scoring, the difficulty with technology is that it does not apply to all demographics (that is the online community have vastly different expectations to the off-line community as to service speeds) and users must be educated to it. Issues are not technical, they are human behavioural and legislative (privacy and security).

Also technology generally will work against margins, that is reduce them over time. As an example, it is our view that in markets such as the refinance market, plain vanilla loans will eventually go to the competitor which can produce the fastest outcome.

Belief 10 - Short Run Vs Long Run ("Brand") Strategy

A short-term strategic focus has served mortgage operators well in the past. It kept them at the cutting edge of financial, credit and housing markets. It invited confidence that perhaps 'King of the Hill' (Biggest is the Best Strategy) could be played after all. Yet evidence from other competitive industries puts a lie to this premise. The winners in the grocery, department store, fast food and beverage fields, and even among securities firms, are those with a long-range plan.

... That's Lending

Best regards,
Paul Wells, Chief Investment Officer
La Trobe Financial Asset Management Limited

La Trobe Financial is one of Australia's leading independent credit specialist Fund Managers. Its business includes residential mortgages, commercial mortgages, and investment services operating one of Australia's largest Mortgage Funds under AFSL 222213. It employs over 123 staff and has managed over AUD$10Billion covering over 100,000 investment grade assets since inception in 1952.

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