Given the unprecedented changes in mortgage lending, it's reasonable, prudent and essential for all mortgage lenders to examine their business plans; joining a branching mortgage bank warrants consideration. For some brokers, the goal could be to just focus on sales and hope that the world we’ve all known will continue. This would be to not worry about the changes in U.S. Department of Housing & Urban Development (HUD) net worth requirements, HUD’s potential elimination of the loan correspondent category, or the potential regulatory issues facing the disclosure and limitation on yield spread premiums (YSP). It sounds preposterous to comment about this strategy like this, but the reality is, we see people do it. This is also known as the Ostrich Effect: To avoid apparently risky financial situations by pretending they do not exist.
For most, the goal could be to adjust their businesses strategy to cope with the regulatory issues landing on wholesale originators.
In evaluating their futures, some brokers might decide to keep their businesses essentially unchanged, while others might choose to become independent mortgage bankers, or a third option is to align with a branching organization.
Join as a branch
In the past, there were many variations on the branch concept, some of which didn't follow HUD requirements. This led to a negative connotation to the term “net branch.” Many firms now use the terms “partner branch” or “affiliate branch” instead. Whatever you call it, the net branch structure can be implemented in a format that meets regulatory requirements.
As per HUD, all branch employees must be classified as W-2 employees of the main office. In the past, many companies have disregarded this rule, but the requirement is clear. All uniform residential loan applications to be insured by the Federal Housing Administration (FHA) must be conducted by an employee of a company holding a HUD approval.
Brokers who decide to go the branching route typically choose a branching company that operates as a mortgage bank. There are branching companies that themselves are brokers acting as wholesale aggregators. In both cases, brokers can benefit from the power of the unified volume when negotiating favorable pricing and terms with investors. The banking structure likely provides protection from regulatory assault on the YSP.
Typically, the home office of the partner branch manages payroll, payables, human resources compliance, state licensing and all regulatory compliance issues. In this structure, the branch manager gets the net earning from the branch's activity after paying a cost-per-file for delivery support, as needed. Thus, the term “net branch” relates to the compensation structure for the branch manager. They could be called “profit participation branches” rather than “net branches.”
In a broker aggregator wholesale branching company, brokers send processed files directly to the investor. When the loans close, the investor sends the YSP to the home office, where the payment is processed and operational deductions are made before the net funds are deposited into the branch account.
When the branching company is a mortgage bank, the broker sends the file to the home office for underwriting, closing and post-closing. Typically, the branch will receive a portion of the loan gain on sale after the loan is sold with the proceeds deposited into the branch cash account for payment via the next payroll.
In both cases, all branch employees are W-2 employees of the home office and are subject to the home office’s policies. HUD also requires that the branch lease be in the name of the home office with a comparable lease liability. The lease/sublet issue gets complicated and should be addressed by an attorney.
Under any branch structure, it is important for branch managers to consider the deep operational ties they will have with the home office and to evaluate the steps necessary to separate from the company, if needed.
The decision to move from operating as an independent broker to joining a branch organization requires a complete assessment of business objectives. It's wise to consider the following:
►Philosophical alignment: If the group doesn't share the same business philosophy as the mortgage broker, a long-term alignment isn't probable.
►Product suite and pricing standards: Brokers should study each of these for several weeks before making a decision. Compare possible future branching companies to assess potential profitability.
►Financial condition: Is the company stable? A third-party or certified public accountant (CPA) can help determine this.
►Operational support services: Brokers should understand all the offered services and their fees.
►Cash commitment: The company should hold several months of operating cash in an account for each branch. New branches will be expected to fund and maintain a minimum balance in this account.
►Protocol for relationship termination: It's best to plan a well-designed exit before the relationship begins. The process of separation should be described in a termination or revision agreement. It can be a simple or complex process, depending on the affiliation structure.
Before diving in to a branch arrangement, it's also imperative for brokers to consider other available paths.
Remain an independent broker
Independent brokers must focus on capital preservation, operational efficiency, monthly profitability, and rapid adoption of regulatory modifications, including new YSP disclosure requirements. It’s also important to have continuing relationships with several warehouse investors by delivering quality files and preserving a strong capital base. Independent brokers should avoiding churning customers or locking loans with more than one wholesale investor. Pushing the limits with investors isn't a good plan in today's market.
Become a mortgage bank
Becoming a mortgage bank begins the path to true independence. As a banker, you can control the timing of closing. As a banker, you can hedge to improve pricing. And only as a banker can you sell loans to Ginnie Mae, Fannie Mae or Freddie Mac (actually, the loans are securitized with the servicing separated and the newly formed security delivered into a TBA security). Despite the formality of the process, getting on the path to mortgage banking leads to this new level of freedom. The key to this path of mortgage banking is capital and the new levels of capital begin at $1 million and rise to $2.5 million.
How can a small lender even think of reaching this level? The first path already discussed is to join a branching company that has already achieved these levels. The other two choices are to raise capital or to pool capital.
Raising capital sounds complicated and it is complicated, but there are billions of dollars looking for good returns and most well run mortgage banks generate return-on-investments (ROI) north of 20 percent. This is a strong return in any market. The key is putting together a professional presentation with an accurate financial forecast. Don’t short change getting this information prepared correctly. We are helping companies across the country implement capital formation strategies.
The other choice is to merge companies with one or even several other companies. If a company with $250,000 in capital joins with three like companies and another company with $1.5MM, the new whole company has capital of $2.5MM and is ready for the future. Merging together is more complicated than simply joining as a branch. This is a viable solution, but a difficult transition. Get help from a firm that specializes in mortgage bank mergers and acquisitions activity.
Before making any transition, it's essential for brokers to have a clear vision and a plan for implementation. Whatever you decide, you must make money to remain successful. Having a solid business plan can help as noted below. Most important, brokers should remain aware of industry changes and always be on the lookout for new opportunities.
Mortgage banking basics
Before joining a branching company or before converting to a mortgage bank, it is important to understand a few basics. The key issues to all mortgage banks are pricing, warehouse funding, risk management, strong accounting and good financial management.
Pricing is a function of investor delivery options and hedging strategies. The secondary marketing department manages pricing and lock registration. The companies with the best prices are typically mortgage banks that have a hedging strategy, provided it is managed well. A mortgage bank that is hedging, but has an inefficient operation, could have less favorable pricing than a best efforts company. Either way, look at their pricing for an extended period of time to see how they compare to the market.
A warehouse line is the funding source to close loans. Obviously, having several stable warehouse lines is essential for a mortgage bank. Find out how the branching company gets the money to fund a loan.
Risk management sometimes refers to secondary marketing. In this case, I am referring to operation risk management deep within a mortgage bank. Many of the failures that occurred during 2007 and 2008 resulted from mortgage banks engaging in high risk behavior that often included suspension of risk management practices. The key risk management areas include:
►Operational risk (disaster recovery plan);
►Compliance risk (disclosures and fraud prevention);
►Counterparty risk (assessment of business partners);
►Reputation risk (what others think of the company); and
►Financial risk (did the company make money).
Make sure a company has the tools to address these risks.
A good accounting system, along with loan level accounting procedures, is essential for accurate financial reports. Otherwise, the branch profits could be distorted. Many mortgage banks do not record loan level activity. Make sure you check.
The federal agency that helps small business says that 95 percent of all new businesses fail in the first three to five years due to poor planning and poor financial management. This is not just new business but also business that grow quickly like a branching company. Out of 1,000 people who started a new business, people who took all of their savings to start the business, people who were all 100 percent confident in their future success, 950 out of 1,000 of them have failed and lost everything. They lost everything because they didn’t have proper financial planning with proper controls over money. So, why didn’t they have a good system to control financial results? Maybe they didn’t know how to build one. Maybe they didn’t have access to a mortgage certified public accountant (CPA). The unfortunate reality is that almost all of them didn’t know what they needed to know. Make sure any branching company has a strong accounting system with a good chief financial officer (CFO) who is also a CPA.
Business plan basics
Mortgage brokers can help keep their businesses get on track by following these planning tips published by the U.S. Small Business Administration (SBA). A key element of success is a business plan that addresses strengths, weaknesses, opportunities and threats. This plan should answer several important questions, including:
►What is the business's financial forecast?
►Which funding sources are in place or anticipated?
►How will you incentivize your sales team?
►What technology platforms will you use?
►How will you measure success?
To learn more about running a successful business, visit the SBA's planning page at www.sba.gov/smallbusinessplanner.
Do not wait to find success
Everyone wants to be successful, but the desire to be successful is not enough. It takes discipline, planning and a combination of skills to achieve financial success. Mortgage products today are relatively simple, but the complexity of achieving success is more challenging than ever. Do not underestimate the challenges of 2010. A Chinese proverb states, "He who asks a question is a fool for five minutes; he who does not ask a question remains a fool forever." It is better to ask a question and get help finding your way, than to not ask for help and fail.
Andrew J. Schell, CPA, CMB, CFF is managing partner for Mortgage Banking Solutions and president of CFO2Go, as well as the MBS outsourced bookkeeping service. Mortgage Banking Solutions is a national advisory firm based in Austin, Texas with offices from coast to coast. Schell’s experience over the past 30 years with both small and large organizations, including Bank of America in San Francisco, has distinguished him as a results oriented leader who quickly implements creative solutions to enhance profitability. He is both a CPA (Certified Public Accountant), a CMB (Certified Mortgage Banker) and a CFF (Certified in Financial Forensics), who is often published in national circulations discussing risk management, accounting, and secondary marketing issues.