Retention Strategies Need Attention
by Steve Kropper
Mortgage Servicing News, October 2001

Two numbers leapt off the page at me on a recent morning. First, there was the Mortgage Bankers Association of America estimation that refinancing will constitute 43% of all loan origination in 2001. I know the mortgage industry is cyclical, but 43% represents a 180-degree turn back to 1998, when refinancing was 50% of all origination. Second, there was the $288 million after-tax write-down of mortgage servicing rights (MSRs) at HomeSide Lending, a top 10 mortgage company (6th in servicing and 7th in origination).

HomeSide's parent, National Australia Bank (NAB), is widely rumored to be considering the sale of HomeSide to stem the damage. In their press release announcing the HomeSide debacle, NAB cited three factors that led to the write-down:

*Unprecedented refinancing activity in the United States mortgage market following six rate cuts in six months that reduced the future income from the mortgage servicing portfolio.

*Extreme volatility in U.S. interest rate markets that had adversely impacted HomeSide's United States hedging positions.

*And changes to industry and market forces following new accounting standards in the United States (i.e., FAS 133, requiring servicers to book MSRs at market value).

Those three factors are hardly unique to HomeSide, which suggests that other banks, lenders and mortgage servicers will be reporting write-downs in their MSRs in the near future, probably when Q3 results come out in early October.

How could these write-downs occur in the middle of a refinancing boom? Because of the ugly little secret of the mortgage business, namely the loan churn, short loan lengths and portfolio runoff that are the soft underbelly of this spring's refinancing boom. As homeowners moved to refinance, they typically left one mortgage servicer's portfolio for another. The banks are losing mortgages from their portfolio quicker than they can originate new ones. The result is that big banks and mortgage servicers are seeing the value of their MSRs decline by 10 to 15% or more.

HomeSide's problems were compounded by inadequate hedging strategies, which failed to protect the lender from interest rate cuts. Some of HomeSide's peers will hedge better than others, but all of them are fighting portfolio runoff.

To understand why the mortgage industry is in this predicament, let's step back and look at the origins of the problem, and outline some solutions.

"OK, here's the plan: we acquire customers for $1500. We will lose a little money on the customer acquisition, but we will make it up over the lifetime of the customer." Does this sound like your nephew's dot.com? No it's how the mortgage servicers operate. Their business model is to buy a borrower's loan with big costs up front, hold on to the borrower for 6-7 years, generate a stream of servicing revenue from them to cover their acquisition costs and make a profit. Sounds like eToys.com. What do you do when your loan life assumptions are very wrong?

That model is out of date, and in many cases, rotting on the shelf due to portfolio runoff. First, there are too many lenders chasing too few loans, resulting in hence the high prices extracted by mortgage brokers. Lenders treat mortgages like financial commodities to be bundled, packaged and sold. Thus it should be no surprise that there is zero brand loyalty. Consumers now treat their mortgages like commodities too, and will refinance based solely on price. Astute consumers are churning more frequently; also, cash-out refis have become really popular as record-high consumer debt burdens force consumers to take action to make ends meet. The net impact of all this is that portfolios are churning faster than expected, leaving servicers exposed to write-downs. Equally glum is the fact that 93% of borrowers choose a new lender when they refinance. Or to put it another way, the mortgage industry's customer retention average is an anemic 7%, or almost non-existent. Do you know any other industry with a lower customer retention rate? Goodbye long-term, profitable servicing rights.

Steven Kropper is co-founder and CEO of Domania, Inc. (www.domania.com), a Boston-based financial and marketing services software company that provides customer acquisition and retention products to banks, mortgage lenders and Realtors.