Ratings

The following are key industry risk factors that Standard & Poor's Ratings Services 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 with consolidation in the industry up dramatically; 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 FHLMC's 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 rights (MSRs) 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 strips and other retained interests resulting from mortgage securitizations.
• For conventional mortgage loans, the developed secondary market for MSRs has benefited the valuation of these assets; in contrast, the secondary markets for subprime mortgage MSRs is not as highly developed and fluid market.
• Accounting standards: In the U.S., valuation and impairment standards under FAS 140, FAS 149, FAS 133, and related Emerging Issues Task Force interpretative guidance regarding the sale and servicing of mortgage assets. FAS 140 tends 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.

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.

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 or the Internet.
• 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 versus 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 versus prime/conventional mortgages).
• Does the company provide ancillary services and/or own businesses related to the mortgage origination process?

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 140, FAS 149, and FAS 133) provide a challenge in evaluating mortgage banks' profitability. Several factors influence reported gain on sale and mortgage servicing amortization and impairment levels, including product mix, discount rates, credit quality, prepayment, 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 companies other mortgage banking activities; in a stable or rising rate environment, this gets afforded a higher-quality revenue, as the company will benefit from an "annuity-like" flow of servicing revenue as mortgage prepayments decline. Also, servicing impairment reserves can be recovered based on lower of cost or market of the underlying servicing rights.
• 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 + depreciation + amortization/term debt (nonwarehouse debt).
• Operating expenses relative to total revenues and growth trends.

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 versus adjustable-rate mortgages,
• Percentage conforming loans (FNMA & FHLMC),
• Percentage jumbo loans (loans over the conforming loan limit (FNMA and Freddie Mac limit)),
• 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,
• Quarterly servicing impairment charges,
• 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.
• Servicing portfolio growth derived from the company's own production versus purchased mortgage servicing.

• 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.
• Type and size of retained interests held to support securitization of mortgage loans.

• Liquidity
• 1. Level of unencumbered assets.
• 2. Quality of earning assets; liquidity within the loan and investment portfolio.
• 3. Negative or positive cash flow position.
• Funding
• 1. Diversity of funding sources; mix of long-term versus short-term funds.
• 2. Number and size of mortgage warehouse lines: maturity schedule of warehouse and nonwarehouse lines; committed versus uncommitted lines; advance rates under warehouse lines per eligible assets, including restrictive covenants, if any.
• 3. Composition of funding sources: warehouse versus nonwarehouse lines.
• 4. Restrictive bank loan covenants.
• 5. Leveraging of the servicing portfolio.
• 6. Average escrow balances retained.
• 7. Structure of securitizations utilized.
• Frequency of securitization activity and securitization structures.
• 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.
• 3. Strength of the macrohedge; the balance and scale of mortgage production income versus loan servicing income.

• 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
• Off-balance-sheet risk factors.