Reengineering the Residential Lending and Secondary Marketing Process MBAs 90th Convention

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Reengineering the Residential Lending and
Secondary Marketing ProcessMBAs 90th
Convention ExpoSan Diego, CAOctober 20,
2003Marito DomingoExecutive Vice President
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Mortgage Industry A Case for Change in the
Primary and Secondary Markets
Todays Reality

• Continued growth is projected at a steady rate
• Consolidation has created an impactful few
• MSRs will challenge the growth of the industry
• The secondary market has an opportunity to lead
  real change

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State of the Nations Housing
Steady Projected Growth

• Harvard Housing Center reported that U.S.
  households will increase 22.6 to 129 million in
  the next 20 years or 1.19 million new households
  per year
• It is clear that the underlying demographics
  will (drive) the housing market - Nicolas
  Retsinas

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Drivers of Growth Projected Single-Family
Mortgage Debt Outstanding
Steady Projected Growth
Annual Growth Rate

• Actual(a) Forecast Range(b)
• 1980s 1990s 2000s
• Households 1.5 1.4 1.3 - 1.4
• Homeownership Rate (0.2) 0.5 0.5 - 0.6
• Average Home Price Gains 7.3 3.6 5.0 - 6.5
• SF Residential Investment 8.6 5.5 6.8 - 8.5
  
• Debt-to-Value Ratio 2.0 1.6 1.3 - 1.7
• SF Mortgage Debt Outstanding 10.6
  7.0 8.1 - 10.2

(a) Bureau of the Census, Federal Reserve Board,
Office of Federal Housing Enterprise Oversight
and National Association of Realtors, as of
period presented (b) Fannie Mae Forecast, October
2002
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Mortgage Servicing Market Trends
Steady Projected Growth
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Mortgage Origination Market Trends
Steady Projected Growth
3.2
9.6 Purchase Market CAGR
2.5
2.0
1.5
1.5
1.3
1.0
1.0
0.8
0.8
0.8
0.6
Source Mortgage Bankers Association, Mortgage
Finance Forecast, September 2003
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Accelerating Consolidation in the Mortgage
Industry
Impact of Consolidation
Top 10 Market Share
Source Inside Mortgage Finance July 25, 2003
(Originators) and August 1, 2003 (Servicers).
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Threats
Key Threats in the Industry

• Predatory Lending
• Credit
• Mortgage Servicing Rights

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Mortgage Servicing RightsA Case for Change in
the Primary and Secondary Markets
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Mortgage Origination Business Strong GAAP
Earnings, Cash Loss
Key Threat - MSR

• The 90s saw a lot of changes that have left
  mortgage lenders/servicers with an unfavorable
  financial structure
• Moodys called it Mortgage Origination Cash
  Loss, Strong GAAP Earnings and tells Mortgage
  Banks Innovate or Be Consolidated (1)
• Its a capital-intensive business and the
  Capital have-nots will lose . . .

(1) Moodys December 2001
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What Happened? How Did We Get Here?
Key Threat - MSR

• Borrowers receive a free prepay option plus
• Lenders are required to finance a larger
  portion of closing costs plus
• No viable secondary market outlet for additional
  premium created plus
• Technology and scale have driven servicing costs
  lower
• Result Lenders hold on to more servicing than
  needed in order to fund premium - accounting
  rules require recognition of income, but lender
  ends up cash poor holding I/O investment risk
  that should be left to more sophisticated
  investors

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The Borrowers Free Option
How Did We Get Here?

• GSE reluctance to support pre-pay penalties
• Predatory lending concerns
• Proliferation of no-cost loans
• Result Some borrowers game the system

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Servicing is an Operating Business - Not a
Derivative Investment
How Did We Get Here?

• Base service fee in current operating environment
  is too high
• Unit costs have decreased with scale and
  technology
• Expenses are based on units
• Revenue has increased
• Based on loan size
• Contribution of non-service fee income -
  ancillary float
• Result Margin between revenue and expenses has
  created a larger absolute MSR value, and has
  expanded the role of servicers to investors in
  I/Os

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No Viable Secondary Market Outlet for
Additional Premium
How Did We Get Here?

• Agency MBS market is the only fixed-income market
  that trades in 1/2 coupons
• As a result, the bulk of the market for the past
  two years is in 6s and 6.5s the most recent refi
  boom has produced 5s and 5.5s
• In fact, Current Coupon is not a real security
  - its interpolated - decimalization would get us
  there
• Result Lenders are forced to create excess
  (I/Os) and capitalize and hold

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Capital Have-Nots?
What Does This Mean?

• All lenders are impacted at some point
• Consolidation only increases the gravity of
  issues for larger mortgage banks, even if part of
  a strong capital-rich group of companies
• Result With expected growth, there is not
  enough capital to support the growth of consumer
  mortgage debt over the next decade

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Is Risk Manageable?
What Does This Mean?

• Strategic advantage of certain players
• Transactions in market to sell excess servicing
  (Countrywide/ WaMu)
• Bifurcation of MSR asset into Base and I/O
• Long Run Primary and secondary markets must
  migrate toward a solution for excess servicing

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What must Market Participants do? Reengineer the
process!
Opportunity

• Provide a mechanism to reduce the amount of
  servicing that is capitalized and bring the
  business back to cash neutral/positive
• Institute prepayment penalties in return for
  advancing closing costs
• Add closing-cost advances to principal balance
• Sell excess servicing to MBS investors
• Continue efficient securitization of excess
  servicing (e.g.. FN Trust 309, 325, 330, 331, 335
  and 336)
• Create secondary market that trades in smaller
  fractions

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Rethink Prepayment Penalties and Advancing
Closing Costs
Solution

• Structure as a fair deal - not punitive
• Strike a balance by charging appropriate
  prepayment fee commensurate with the risk of
  advancing the origination costs collected over
  time as a result, the consumer should also be
  charged a lower rate
• - or -
• Advance closing costs as part of principal
  without triggering the marginal LTV thresholds
• Educate borrowers, regulators and investors

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Reduce Base Servicing Fee
Solution

• Align servicing fee with the operational
  infrastructure necessary to support it
• Strike a balance between risk/reward and market
  requirements - the lenders skin in the game
• Recent moves
• GNMA II from 44 bp to 19 bp
• Fannie Hybrid _at_ 12.5 bp
• Freddie Hybrid _at_ 10 bp
• The time is right for a thorough review of the
  merits

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Trading MBS in 1/8s (or at least 1/4s)
Solution

• Mortgage originators price their loans to
  consumers in 1/8s
• An MBS market that traded in 1/4s or 1/8s would
  allow originators to sell their excess
  servicing and book cash gains
• Ultimately move the market toward decimalization
• Issue perceived liquidity risk
• The industry can create this reality

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What must the industry do?
Solution

• Overcome hurdles
• Liquidity premium
• Lenders can provide the necessary supply
• In a 3T market - Top 10 will issue over 2T in
  securities
• CMO bid a natural buyer

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Investor Transparency
Value Proposition 1

• Tighter WAC dispersion
• Current 75 bp
• Proposed 25 bp
• Prepayment performance
• Could you ask for anything more?

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Lender Transparency
Value Proposition 2

• Excess MSRs are minimized Lenders can focus on
  operating the business and making more loans
• The value of excess MSRs becomes transparent
  addresses the lack of benchmarks for valuing
  servicing due to lack of a liquid market for MSRs

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Why Change? Our Future Depends on It.
Conclusion

• We need to create a primary and secondary
  marketing solution to the MSR issue
• We are better off defining how to change the
  industry than having it dictated to us through a
  large upheaval of the primary markets

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Reengineering the Residential Lending and
Secondary Marketing ProcessMBAs 90th
Convention ExpoSan Diego, CAOctober 20,
2003Marito DomingoExecutive Vice President