February 27, 2003

Internet technology and RESPA reform will change the way banks conduct mortgage business

The Bank of the West (TBW), a $92 million community bank with four branches in Oklahoma, started late last year to originate residential mortgages in direct competition with established mortgage brokers and other retail outlets.

The early results?

"We're killin' 'em," said Channing Graft, president of TBW parent BancWest Financial, Oklahoma City. "We're just killin' 'em. They just can't compete."

The reason for TBW's success: its use of a white-label online mortgage fulfillment service provided by ABN AMRO Mortgage Group. Now when a customer with good credit walks into a TBW branch, the bank can provide both a guaranteed rate and a guaranteed closing cost, making simplicity a formidable competitive weapon. "I can tell the customer, 'It's not going to cost you any more than that, period,'" said Graft.

Meanwhile, TBW's competitors continue to rely on traditional mortgage processes and practices, such as passing additional fees and charges beyond the written estimate to consumers-and continue to lose business to TBW.

"They build additional costs into the good faith estimate via processing fees, or they're making it on the back on the mortgage service release premium," said Graft. "It gets really camouflaged."

REFORM MINDED

In addition to capturing market share, TBW's adoption of online lending processing technology also prepares it for a potentially dramatic regulatory change in mortgage lending law. Indeed, in some respects, The Bank of the West is a paradigm of how the government would like the mortgage settlement process to work under changes proposed by the U.S. Department of Housing and Urban Development to the Real Estate Settlement Procedures Act, or RESPA.

RESPA reform would heighten disclosure requirements by mortgage brokers. Furthermore, mortgage originators would have to either commit to their Good Faith Estimates (GFEs) within a prescribed tolerance, or instead provide Guaranteed Mortgage Packages (GMPs) that reduce the complexities of closing costs into a single, guaranteed, up-front fee. "Our economic analysis tells us that consumers will save approximately $8 billion per year as a result of our proposed reform," said Brian Sullivan, spokesman for HUD. "That's approximately $700 per settlement."

TBW's simple solution comes courtesy of ABN AMRO Mortgage Group's Interfirst Wholesale division. Interfirstlink.com, designed for community bankers to use together with their customers, takes loan application information via the Internet. While the banker prints and describes the initial application disclosure, Interfirst automatically pulls a credit report and runs the information through its automated underwriting engine.

Once filed, the application becomes Interfirst's responsibility. "We take over the whole back-room fulfillment," said Fran Clemens, senior group vice president, financial institutions, at Interfirst Wholesale. "The whole process is private-labeled for the bank, and so any involvement that AAMG has is basically generic."

The customer still belongs to the bank, which can remain involved to the extent it sees fit. For instance, when an area cardiologist used TBW to originate a mortgage, Graft indicated that he would personally handle all customer contacts. "He doesn't need to be in open heart surgery and get a call from the call center wondering where his tax return is," added Graft. "I'll take care of that."

The application process provided Graft with valuable insights about his high-profile customer. "It gives me a financial snapshot," said Graft. "He's given me his tax returns, and he's given me a 1003 residential loan application."

Indeed, after examining his customer's financial statements, Graft picked up a pretty hefty sum in outstanding car loans "I said, 'Hey, that's with Chase Manhattan-I'm your local banker, why don't you let me take care of that?'" he said. "You can just kind of cherry-pick stuff from them."

That type of cross-sell gain, along with the ability to use existing staff and facilities, makes private-labeled mortgages an attractive proposition for a bank. It's also a big win for ABN AMRO, which gets to expand its scope and scale through such ventures. Along with Interfirstlink.com, AAMG also operates a site for mortgage brokers called MOAI, and a retail online channel, Mortgage.com.

All of these channels employ statistical techniques to estimate closing costs. Just as automated underwriting has made it possible for originators to quote accurate mortgage rates at the point-of-sale, automated fee estimation engines have the potential to present a complete mortgage package at the point-of-sale. Indeed, AAMG's fee pricing engine operates at the Zip-code level for the entire country, and provides a guaranteed amount for title, appraisal and the other assorted line items that beleaguer homebuyers.

Traditionally, borrowers have had to bear the entire risk of inaccurate estimates. "The customer has a lot of risk in that scenario," said Garth Graham, senior vice president, consumer e-commerce, at ABN AMRO Mortgage Group. "If you're a little off on closing costs, the customer's going to pay your final number, not what your estimate was. "

Adoption of the HUD proposal would spur innovation in the settlement process. "In the current environment, there's not really a huge incentive to reduce those costs," Graham said. "The cost is simply passed onto the consumer."

That dynamic makes it difficult for mortgage servicers to justify investments in technology to connect with their settlement partners. "Right now, say you spend a lot of money on technology to build a very efficient platform to reduce your title insurance expenses," said Graham. "The customer may end up getting a better deal at closing, but it doesn't necessarily help you capture market share."

"The customer can't figure out what the closing costs are up front, anyhow," he added.

In contrast, the HUD proposal envisions that customers will be able to compare Guaranteed Mortgage Packages from multiple lenders, creating the competitive impetus to lower the settlement costs driving the total package cost.

Shifting the estimation risk to the banks makes perfect sense, according to Graham. "Can lenders manage the risk associated with higher or lower fees?" he asked. "Well, we manage billion-dollar pipelines of loans in a rapidly-moving rate environment, and we manage tens of billions of servicing assets which can run off with adjustments and interest rates."

"We're in the risk management business," he added. "We can manage this risk, too."

DETAILS, DETAILS

That's not to say everyone's happy with the RESPA rules as originally proposed.

For one, interest rate guarantees lacked a time limit. "While interest rate locks commonly provide between a 30-, 45-, and in some instances a 60-day window, the regulation as written really had an open-ended timeframe," said Ted Parker, mortgage practice manager at BenchMark Consulting, an independent subsidiary of Alltel. "You have to have some reasonable time constraints imposed or it just doesn't become manageable for all parties concerned."

Another critique centers on the disclosure requirements. Mortgage brokers typically receive a yield-spread premium, essentially a markup of the wholesale interest rate. Under RESPA reform, the effective annual percentage rate, or APR, for the yield spread premium would have to be disclosed under Truth in Lending guidelines. As a result, more borrowers would end up in the "high interest rate loan" category and trigger the restrictions of the Home Ownership and Equity Protection Act. "Because of the way they wanted it structured, it was going to cause that APR number to appear much larger," said Parker. "The change to the yield spread premium, how it would have to be disclosed, would cause more loans to come under the strictures of that HOEPA legislation than less."

But in the patchwork world of mortgage regulation and oversight, virtually any change carries the risk of unintended consequences. "RESPA has to take precedence over all fifty states in order for them to really do a good job," said Anthony Hsieh, founder and CEO of Home Loan Center, Irvine, Calif. "In every state there are all different kinds of governing bodies-nobody really has a clear distinction on who manages a mortgage company, or who manages a bank or who manages a mortgage broker."

"When the government comes out with rules, I'm all in favor for it," added Hsieh. "But because the mortgage industry and process is so complex, often the rules are generated in good faith but they actually hurt the consumer."

Hsieh's prior company, LoansDirect, was sold to E*TRADE and now operates as E*TRADE Mortgage. Now, he's focusing on the risky borrower through the Internet channel. After customers enter their personal data and loan criteria online, HLC's pricing engine instantly pulls a credit report. "It allows us to give that person an interest rate quote based on his credit criteria rather than quoting somebody on a paper rate, and then checking their credit and marking up the interest rate later," said Hsieh. "It's a dynamic rate quote rather than a static rate quote."

For the most part, Home Loan Center does not compete directly with banks. "Most banks specialize in good-to-perfect credit borrowers," said Hseih. "Home Loan Center was created to serve borrowers of all credit spectrum, regardless of your credit background, your documentation, or your credit history."

TURNING UP THE VOLUME

However, big banks that hold mortgages and package them for investors can also take on the full range of borrowers, especially in a high-volume, low interest rate environment. "It's been a crazy two years," said Jim Gallant, senior vice president at Chase Manhattan Mortgage. "And it doesn't show much sign of lightening up in the immediate future."

Gallant manages a division called Home Loan Direct, an 800-person inside sales organization that handles entire mortgage transactions over the telephone and by mail. But sometimes, even 800 people can't keep up with the volume, and so Chase has established alternative channels for that traffic, including 25,000 loan officers across the country.

The high volume comes with a caveat: a substantial portion represents churn and early payoff. "For every 10 new customers that you get, there's probably anywhere from seven to 10 that are leaving you," said Gallant. "The customer base remains fairly constant in the industry-it just keeps moving from institution to institution."

That's why Chase has focused intently on customer retention. Using a predictive modeling system honed through decades of data and experience, the bank can identify customers most likely to leave. "We try to identify customers that have a need for refinancing, and get those customers' names and phone numbers in front of salespeople that can contact them," said Gallant. "That may be the inside sales force that I've got, it may be the loan officers off the street."

However, it's one thing to create a list of hot prospects, and quite another to bring them to the closing table. "You'd distribute these lists, and you'd never know if any attempts had been made to contact the customer," said Gallant. "There was little or no incentive to provide any feedback."

To help create the proper incentives, Gallant brought in Connextions, Orlando, Fla., to develop a Web-based system that distributes and track leads. "They wrote the program that allows the loan officers to access the system and get their leads, and then come back and periodically post the status on the progress of those leads," said Gallant. "Their ability to access those leads from anyplace, over the Internet, was a significant contributor to their success."

"It really has built a new model among the field sales force," he added.

SECONDARY EFFECTS

Compared to big banks and specialty mortgage companies, regional and community banks tend to tread more carefully. Many originate conforming mortgages that end up with Fannie Mae and Freddie Mac, government-sponsored entities, or GSEs, that purchase and repackage the bulk of consumer mortgages in the U.S. Indeed, the GSEs' automated underwriting engines-Desktop Underwriter from Fannie Mae and Loan Prospector from Freddie Mac-undergird many of the industry's leading origination platforms. For instance, when a community bank connects through Fiserv origination software to Mortgagebot's online loan platform, it's Freddie Mac's Loan Prospector supplying those systems with rate information.

Although RESPA reform has a direct impact farther down the food chain from the GSEs, the primacy of the GSEs in the mortgage market extends to their impact on mortgage technology. "We're bringing technology to the market that really helps to streamline the origination process, removing a lot of barriers with that process for consumers and lenders alike," said Patricia McClung, vice president of Loan Prospector for Freddie Mac, McLean, Va. "It's technology that will eventually span all processes, from getting that original pre-approval that you're going to give to the borrower, all the way through to funding the loan."

From Freddie Mac's perspective, it all starts with automated underwriting. "The first thing is getting borrowers accepted and approved in a product that's going to make the most sense for them," said McClung. "Then, as you move into the processing of that loan, now you're moving into some new areas of technology that are helping to bring all of the third parties involved in a loan transaction together through electronic means."

The third parties, which together form a rather large party, include appraisers, title insurers, lawyers, closing agents and flood assessors. Bringing these people together has become an important initiative for the mortgage settlement industry. For its part, Freddie Mac has started on that path with Vendor Services Exchange, developed with BCE Emergis, Vienna, Va. "It can enable you to move all of that data and not pay all of the courier fees that you used to pay," said McClung. "It also allows the lender to get this information much earlier in the process, and hopefully better communicate with the consumer about what their closing experience is going to be like, with fewer surprises at the closing table."

No matter how RESPA reform divides the risk of cost overruns in settlement between borrower and lender, it's likely that the closing table itself will end up in cyberspace. In fact, it's already on the way.

Freddie Mac is extending the Vendor Services Exchange concept in a pilot program called e-Close, designed to "bring a closing package to the borrower that they could view ahead of time, and see all of their closing documents prepared online," said McClung. "And then, as e-signature continues to evolve, eventually you would actually be able to sign them online."

From there, expect to see an online document archive, similar in ways to an inter-bank electronic check archive. "It'll be a full electronic repository, and it'll replace the vaults that hold loans today and make it actually an electronic registry of those loans," said McClung. "That will even make the world that much easier as loans move between lenders."

"It's just a simple assignment change versus all kinds of paper," added McClung.

But getting the industry and the various regulators ready for such a world may take a while. "We're trying to get everyone on a common standard such that we're not putting a lot of investment into different technology, so if you sell to one agency versus another, you have to do things differently," said McClung. "We're certainly trying to avoid that."

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