What a difference a year makes. In mid-2021, most mortgage lenders saw strong lending and hired additional staff in response. But as we enter the third quarter of 2022, the landscape has changed drastically and the industry faces numerous challenges. Interest rates are now approaching 6% for a 30-year fixed-rate mortgage, while the Federal Reserve has announced significant rate hikes and more hikes are likely on the horizon.
These developments have essentially brought the initiation of refinancing to a standstill. In just one quarter, from March to June, the State Mortgage Association Funding guidance down 23%. Meanwhile, products like adjustable rate mortgages and home equity lines of credit are being reintroduced.
Due to increased interest rates, there are now fewer potential borrowers considering refinancing, while most potential buyers are encountering low inventory which has resulted in multiple property bids, cash offers and ongoing searches.
Additionally, originators continue to see challenges to make a profit on sales and mortgage servicing rights prepayment speeds have hit or are nearing a floor, resulting in lower MSR pickup.
As low margin revenue issues remain with traditional agency products, we have also come through a period of heavy refinancing where many mortgage lenders added significant headcount and costs to their businesses.
A new approach is required to combat this combination of problems. In the face of relatively high expenses and lower revenues, what steps should you take to navigate the current circumstances and set your business up for success in the future?
The answer is to focus on increasing efficiency and effectiveness. This concept is exemplified by a Japanese management practice called “Kaizen,” which emphasizes the continuous elimination of waste and the reduction of inefficiency.
In good times, it is natural to pay less attention to these aspects. As the old adage goes, “Sales forgives all sins.” But the reality is, businesses should always value efficiency, and these considerations are only reinforced at times like these. A lack of available revenue will help separate companies that excel at execution from those whose success relies primarily on a favorable market.
Mortgage lenders can benefit from adopting Kaizen principles. While there are many areas of your business that Kaizen could be applied to, one particularly important aspect is understanding the cost structure – not just in general, but with enough granularity to help you make appropriate decisions.
After spending about 10 years of my early career in manufacturing, I’ve found that applying this perspective to mortgage lending helps me think of making a loan as making a product. When evaluating your cost structure efficiency, if you simply take an P&L number and divide it by your volume, you can’t really understand the true impact of costs.
Rather, I propose the approach used by many manufacturing companies, who tend to have a good understanding of their total production costs by breaking them down into components, including inputs (raw materials), direct labor, and fixed costs.
For example, a furniture maker would want to know the cost of wood, varnish, nails, glue, and other consumables, as well as labor costs and any additional costs associated with factory production. The same concept can also apply to mortgage loans:
- Inputs: This includes per-unit fees for lending and power registration software, credit reports, 4506-T forms, and various other services or data used to originate a loan.
- Direct working: Operating costs should be broken down into granular components such as costs by department, including separate categories for closing, credit establishment, processing, underwriting, etc., as well as administrative overhead and variable selling expenses.
- Fixed costs: This includes labor costs not directly related to work (management, support functions, etc.), as well as rent, depreciation, general and administrative expenses, marketing, and other fixed costs.
The addition of the inputs and direct labor categories gives exact total costs for the creation. Using fixed costs, it would be easy to determine break-even volume. This trending data over specific time periods should provide a clear indication of inefficiencies and where best to direct efforts to improve efficiency.
Is there a way to ensure that you are price competitive, that your loan officers are making enough commissions to make a living, and that you are making enough margin to keep the business afloat? Understanding fixed costs will lead to a clearer understanding of breakeven and the relative impact of adjusting fixed costs.
Better positioning for future success
Since volume has decreased in the current market, you probably don’t have a growth problem to solve. The benefit of this is that you should have the time and capacity to develop a thorough understanding of your cost structure and potential inefficiencies.
If predictions hold true that we’ll have some kind of recession by 2023, you need to build a bridge to the other side of that recessionary impact from here, when your business is likely to do better when interest rates come down again.
Companies that are better positioned in terms of price and costs should at least be able to hold their own until then. I believe that incorporating the Kaizen concept of continuous improvement can help a company remain focused, efficient and successful both in challenging market conditions and over the long term.
Ravi Correa is Chief Financial Officer at Angel Oak Lending.