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| Douglas G. Duncan is chief economist and senior vice president at the Mortgage Bankers Association (MBA). As leader of MBA's Research and Business Development Group, Duncan is responsible for providing economic and policy analysis services in the areas of real estate finance, legislative and regulatory proposals and industry trends for MBA and its members. He also oversees the education products and services of the association as well as its Industry technology committees and standards efforts. He has oversight responsibility for the Research Institute for Housing America (RIHA), the Mortgage Industry Standards Maintenance Organization, the Secure Identity Standards Accreditation Corporation (SISAC), and Lender Technologies Corporation (MISMO). Duncan received his doctorate from Texas A&M University, B.S. and M.S. degrees from North Dakota State University and A.A. degree from Fergus Falls Community College. |
| Equinox : The U.S. economy has bounced back so strongly from a slow period late last; the IMF forecast the U.S. economy would grow 3.4 percent this year but inflationary pressures guides for higher interest rates. So, how do you translate these macro economic indicators in perspective of Mortgage Industry? Douglas G. Duncan : Economy is very strong, first quarter results are stronger than expected, which will ease the pressure on federal reserve to continue pushing the interest rates up. There is a debate as to how much further the rates will go, but our current modeling does not show that it will make any further move. Our current expectation is that rate will be stable for some time. There will be next move in mid to late 2007. Lets suppose we are wrong and there is a raise of another quarter, we will adjust our forecast accordingly. But it seems it will be flat for the year. In the present scenario, the fixed rate products will be around 6.9% to 7.0% by the end of the year, which will have some slowing impact on the housing market but the word which we are using for this phenomenon is “Normalizing”. The reason to use this word is because there is so much hype about the home prices. There will be few markets where the prices will fall, so you are going to hear bunch of stories that price bubble blew up but the normal state of US housing market will witness prices falling in few markets and in most market the prices will rise. But unusually for last four & a half years when the prices were falling the average increase has been high as negative markets holding the average down. That’s why we used the word normalizing. I think the first priority of the fed will be to keep the long term inflation expectation low. Macro environment has lot of uncertainty in regard to how far the fed will go with respect to interest rates. Nonetheless we are of the view that in worst case the interest rates will be not pushed to beyond 7.5%. |
| Equinox : I understand the long term rates are very much dependant on the bond market. Douglas G. Duncan : Absolutely, you can look at the U curve and if you look at the 10 years treasury which is the base price for fixed rate products, so 30 years fixed rate product reaches price after 10 years treasury because people in US stay in a house on an average 7-9 years. At present time the spread of the mortgage outset over 10 years treasury is that’s set at about 5.1 and with adding 150 basis point the mortgage rate comes at around 6.6%. We believe 10 years is not going to go far from what it is but the spread is going to widen out little bit at close to 170 basis points by the end of the year, which will translate to 6.8% - 7% by year end. If Fed goes by another quarter add up 15 to 20 basis points. This will reflect in the decline of 8%to 10% range. Our survey which is a very accurate predictor for new homes put the decline at 10%. For the existing loans first quarter compared to last year same quarter is down by 2% and new homes by 8%, so we are pretty close to where market is going. |
| Equinox : What about the builders, we talk to some builders and the trends we see is that there is lot of activity in the building space. Why is building new homes is high against the stated trends by you? Douglas G. Duncan : It’s true. When a builder starts a property they tend to take it through completion. We really need to see the number of permits obtained on which the property is not started is at record levels, that very consistent with the decline in new home sales. Secondly the properties will are sold but not yet started is also at the record levels. So, both is the buffer on the supply side of the larger builders. If you look at the reports you will see cancellations and concessions are up in general for them. All of this to us is an orderly slowing in the housing market. On Refi side, refi is stronger than the interest rates, interestingly the sales market is not sensitive to the interest rates as lot of people think. We will se 30% decline in the refi volumes this year. In some market the prices will fall steeply. Markets will be heavily affected by condos as the prices of condos will fall sharply. Supply of condos is at about 7 months compared to 3 months (twenty months ago), so supply has risen very rapidly. Interestingly the higher percentage of condo owner do not live in the primary residence, so the condos tends to be more price sensitive to short term market movements and prices are more vulnerable, so we watch condo markets as the leading indicator. |
| Equinox : In terms of refi mortgage lenders, in last few years many brokers counted into banker and major growth has come from refi boom that pool is fast drying up. What will be its impact on mortgage lenders? Douglas G. Duncan : Bread & butter of the mortgage market in long run is home sales, if you look at the finance of home sales, it’s very steady. The option to repay from the customer side increases the volatility in the business. In 2003, there was $2.5 trillion of refi in addition to $1.4 trillion of the home purchase loans (the total of $3.9 trillion). In 2004 and 2005 the loan origination volumes were in range of $2.8 -$2.9 trillion, this year we think the volume will further drop down to $2.4 trillion. The dollar value of the homes sales will drop only couple of percentage points because even though the number of home sales will drop by 8% to 10% but the average price will still rise. So the dollar value will not fall as much the unit value. There is no question that refi is coming down and all of this is having significant impact on the production margin. This has translated to close to 80% decline in margins. Other structural thing that’s taking place is on securitization front. Significant shift in private label securitization market happened because of the development of vertical columns from consumer directly to investors through secondary market execution. So you have companies like Merill Lynch, Bear Sterns and Lehman who are buying mortgage origination operations and driving the product through their own securitization structure into investor community. This is fairly recent phenomenon and if you take in context with what Wachovia did in its acquisition of Golden West, Wachovia has column within the holding company. A year ago they bought American Network Mortgage which is a broker operations, but they didn’t integrate it with their mortgage retail operations but have integrated it with their capital market group. So you have got some interesting structural changes taking place. It is beginning that’s focused on capital management and capital market execution as opposed to sales culture that was ten years ago. |
| Equinox : So what you are saying is that there has been 80% decline in the margins and it will make lending operations more sensitive to cost. I keep on getting diverse numbers from various lenders on the cost of loan per unit. I have read MBAA 2004 cost study; I would like to know what is included in the unit cost and what is the unit cost of originating a loan? Douglas G. Duncan : All the firms that operate in one or four more channels i.e retail, broker, correspondent or direct marketing. Direct marketing includes telephone and internet. You have to sort the cost vis-à-vis channel and also have to sort out by cost to create servicing and investor relations is the second aspect of the operations but firms doesn’t have that, large diversified companies certainly have it. You have to look at servicing cost per loan and secondary market execution including hedging cost and servicing rate amortization. |
| Equinox : Two years back the cost of production was not an issue when companies were enjoying the margins. But today it’s becoming very critical so how do you see mortgage bankers looking at core vs non core, fixed cost to variable cost regime& also how they are looking at offshoring? Douglas G. Duncan : Definitely, I see a trend there but from mortgage market perspective it’s a unit labor cost issue adjusted for productivity differences, wage rage advantages and efficient execution than they make a switch. Most companies are doing it but for some of them tried and they were not successful but part of it has to do with the scale of the operation. Some points are critical- are they narrowly focused or broad based, are they national, regional or local. But its an industry where the rule of competition applies and in pure competition cost minimization is profit maximization in long run. So, the trick is going to be the firms which have more than broker operations will have to invest in technology to survive and lot of them are making significant investments. |
| Equinox : The increased compliance burden like Sarbox, DoNotCall, Basel II, HMDA, RESPA, TILA will surely increase the cost of operations, with excess industry capacity and loan volumes declining by 20%. How do you see the industry responding to these external challenges to maintain their profitability? Douglas G. Duncan : Underline themes of all these is transparency, transparency means data availability and purity. There is no question that firms with the larger database will be unable to atleast in short run can afford the investments in technology and tools to help them meet the compliance requirement. It’s a challenge as industry is not accustomed to refined consistent data reporting, there is no question that some smaller firms will deploy the capital elsewhere. Most will go for readily available off the shelf compliance tools which will immediately import the efficiency that come with those. |
| Equinox : In mortgage life cycle from origination to servicing, how do you see the role of IT outsourcing and BPO strengthening their competitive advantage in a cutthroat market? Douglas G. Duncan : The industry has been outsourcing for years, things like tax and insurance which require highly narrow and specialized capabilities, where there can be economies of scale. If you look at technology solutions anything that is narrowly defined and replica table will atleast be exposed to whether or not it can be conducted efficiently again on a unit labor cost basis internally or externally. Today in mortgage industry there will be no company which can say that they can do every step in mortgage process by them selves. Now for outsourcing and offshoring each company should plan their ability to execute. |
| Equinox : There is a new breed of outsourcing companies which are extending end to end solution for loan processing. What are your thoughts on that? Douglas G. Duncan : I have tracked the structural changes in manufacturing like automobiles & airlines, mortgage industry processes other than loan contract portion with customers is essentially manufacturing process. There are great efficiencies that can be imported into processes but the main concern is of quality control. The way I look at the end game is electronic mortgage, which means customer sits at computer and applies the request and doesn’t have to act on it until such time when they have to lock in the interest rate and to electronically sign the closing documents. The information that’s external passes the system supplemented by information that service providers supply upon the queries by and from the production manager. It is imported into the same file with quality control run. This file is automatically transferred to the investor who is agreed to purchase it in electronic format. Though we are long way from that but since it is the production process and you have to see the pressure points to find out the error rates and attack those points and then look at each entry point at the production process and see whether or not it’s adding any value. If it’s not cut it off or find possibilities for re-engineering. |
| Equinox : Offshoring is in nascent & experimental stage in Mortgage ecosystem, there is a need to educate banks with both the risks and advantages. What role MBAA can play in facilitating the same? Do you plan to create a team which can develop standards in offshoring (same as MISMO for information technology)? Douglas G. Duncan : Standardization is the objective of MISMO. MISMO is a two phase process, firstly its data definition & structure and that’s what has been focused on for last five years of its existence. MISMO is a interface between lenders and vendors. One thing that MISMO has not done is process re-engineering and in eMortgage context there is lot more to discuss. The second phase if MISMO activity will be data purity. Data flow has become very smooth, hardware and software can talk to each other because they are using the same language. This doesn’t translate that data is of good quality. There has to be lot of efforts to standardize the data purity which is what SOX and other compliances are targeted at. |
