The following are key industry risk factors that Standard & Poor's considers in its review of mortgage banks.
Residential mortgage markets are highly cyclical; highly sensitive to changing interest rate cycles and the strength/weakness of regional housing markets; also identify other external factors that affect local/regional housing market.
Highly competitive market; large number of players, and large players are in the market; low barriers to entry.
Commoditization of the mortgage market has affected profitability of conventional loan sales, given the highly developed secondary market and FNMA and FHLMCs position in the market.
The secondary market has eliminated geographical differences in interest rates, allowing for national competitive rates; the secondary market also allows for geographic diversification in mortgage portfolio.
Monoline business risk.
Asset valuation risk: mortgage servicing assets (MSAs) are a major earning asset for mortgage banks active in servicing. The valuation of this asset is an estimate of value based on several key assumptions (the valuation of behavioral risk of the mortgagor is one of the key assumptions—e.g., prepayment rates, credit quality, interest rates, etc.). This is also true for the valuation of I/O strip.
For conventional mortgage loans, the developed secondary market for MSAs has benefited the valuation of these assets; in contrast, the secondary markets for subprime mortgage MSAs is not a highly developed and fluid market.
Accounting standards: In the U.S., valuation and impairment standards under FAS 122 and 125 regarding the sale and servicing of mortgage assets. FAS 122 and 125 tend to front-load the origination costs and GAAP reported earnings for servicing and gain on sale as a present value calculation (based on several assumptions), which may or may not be realized.
Management and Corporate Strategy
Mortgage banks are characterized by the scope of their business, targeted customer base, and mortgage products offered. There are three distinct business profiles that mortgage banks typify:
Mortgage banks that are involved in mortgage production through retail and wholesale channels and building/retaining a mortgage servicing portfolio.
Mortgage banks that are only mortgage producers/originator.
Wholesalers/conduit mortgage banks.
Once the business profile is identified, evaluate management's execution of its business strategies and overall corporate practices:
Credibility of management and its track record.
Ability to expand and contract business in light of changing market conditions.
Acquisition strategy for mortgage production, mortgage servicing, or franchise expansion.
Servicing innovation/technology.
Hedging strategies.
Competitive position and market position.
Compensation practices used for loan underwriters and loan originators.
Franchise/Business Overview
Identify primary loan origination and production channels and their volume relative to total production:
Wholesale production. Typically from two sources:
1. Percentage from correspondents: The buying of closed loans from mortgage brokers, commercial banks/thrifts, and other financial intermediaries.
2. Percentage from mortgage brokers: Loans delivered to the company from mortgage brokers and other financial advisors.
Retail production. Percentage of total production of loans funded through retail branch offices or loans funded through "retail" telemarket/call centers.
Loan production/total servicing portfolio: Gives an indication of the company's capacity to replace servicing in a refinance market.
Loan production by state: Geographic concentrations (top state percentage and top five states' percentage of total loan production).
Purchase mortgage volume vs. refinance mortgage volume.
Types of loan products originated and serviced:
Variety of loan products offered.
Targeted customer profile for each loan product (subprime loan products vs. prime/conventional mortgages).
Does the company provide ancillary services and/or own businesses related to the mortgage origination process?
Profitability
The inherent vagaries of the residential mortgage markets can lead to volatile profitability measures for mortgage banks. Loan volume directly impacts profitability. In a rising-rate environment, mortgage volumes decline, and in a declining-rate environment, mortgage volumes increase significantly, fueled by higher refinance activity. Also, GAAP accounting issues (FAS 125) provide a challenge in evaluating mortgage banks' profitability. Several factors influence reported gain on sale and mortgage servicing amortization levels, including product mix, discount rates, credit quality, and duration estimates.
Revenues are primarily derived from origination fees, warehouse spread, secondary market sales, and service fees. Companies that also provide ancillary services to the mortgage process will add another fee-based revenue source to overall profitability.
Diversity of earnings:
Interest income (usually a small component of revenue).
Noninterest income:
1. Loan servicing revenue. Loan servicing/total revenues. The higher the % the larger the servicing portfolio relative to the company's other mortgage banking activities; in a stable or rising rate environment, this contributes an "annuity-like" flow of servicing revenue.
2. Loan production revenue. Loan origination fees/total revenues; gain (loss) on the sale of warehouse loans/total revenues; gain (loss) on the sale of mortgage servicing rights as a percentage of total revenues.
Frequency of whole loan sales and the gains realized relative to total revenues. Evaluate this by product type (prime, subprime, etc.).
Profitability measures. ROA (earnings power is a reflection of the quality of the underlying assets); coverage of fixed financial charges by cash flow; (net income + deprec. + amortization/term debt (nonwarehouse debt).
Operating expenses relative to total revenues and growth trends.
Servicing Evaluation
Stratify the mortgage loans serviced by risk category and identify the key characteristics of the underlying loans in the servicing portfolio. Including:
Total size of portfolio, in dollars,
Percentage fixed rate vs. ARMs,
Percentage conforming loans (FNMA & FHLMC),
Percentage jumbo loans (over $227,000 in 1997 and over $240,000 in 1998),
Percentage GNMA (FHA and VA loans),
Weighted-average coupon rate,
Weighted-average servicing fee,
Weighted-average contractual maturity,
Projected weighted-average life,
Servicing portfolio runoff rate,
Projected servicing amortization rate,
Percentage of loans 90 days past due, and
Geographic concentration: top state percentage, and top five states' percentage.
The degree of centralization of servicing activities and number of servicing centers.
nServicing portfolio growth derived from the company's own production vs purchased mortgage servicing.
Asset Quality
Mortgage originations. Concentration of mortgage product: underwriting guidelines followed for each mortgage product; delinquency levels (% past due and trends); % loans in foreclosure.
Accounting issues. Capitalization of mortgage servicing rights and I/O strips for prime mortgages and valuation of excess servicing rights and I/O strips for subprime mortgages (assumptions utilized, size of the asset relative to capital and total assets; frequency and degree of write-downs/impairment charges).
The level of recourse exposure in the loan servicing portfolio or loan sale activities.
Asset-Liability Management
Liquidity
Level of unencumbered assets.
Negative or positive cash flow position.
Funding
Diversity of funding sources.
Number and size of mortgage warehouse lines: maturity schedule of warehouse and nonwarehouse lines; committed vs. uncommitted lines; advance rates under warehouse lines per eligible assets, including restrictive covenants, if any.
3. Composition of funding sources: warehouse vs nonwarehouse lines.
Restrictive bank loan covenants.
Leveraging of the servicing portfolio.
Average escrow balances retained.
7. Structure of securitizations utilized. frequency of securitization activity.
Interest rate risk management
1. Type of hedges used on the servicing portfolio and on the mortgage warehouse; net gains (losses) realized.
2. Overall management of prepayment risk in servicing portfolios and securitizations.
Capitalization
Capital composition,
Total equity/total assets,
Leverage guidelines: the level of nonwarehouse debt to equity,
Mark-to-market value of assets and subsequent capital levels,
Financial flexibility; ability to tap external sources of capital, and
