Opportunities for Action in Financial Services. Making the Most of Mortgage Markets

Transcription

1 Mortgage Apr 03 4/23/03 8:44 AM Page 1 Opportunities for Action in Financial Services Making the Most of Mortgage Markets

2 Making the Most of Mortgage Markets In much of the industrialized world, mortgage volumes have been high in recent years, driven by falling interest rates and in some countries by widespread refinancing. Lenders have profited considerably from this bonanza. The United States, for example, saw record origination volumes of $2.1 trillion in 2001 and $2.5 trillion in 2002, thanks to increased refinancing business. The boom in Western Europe arrived even sooner, with the mortgage market there growing at an annual rate of more than 9 percent from 1995 through These good times may continue for a while, especially in the United States, where interest rates recently dropped to 45-year lows. However, there are longterm structural forces eating into the industry s profitability that will become more apparent if the economy slows further. Competitors need to prepare for these more difficult times by reviewing their strategies and economics to find methods of improving and sustaining their profitability. Market Changes Erode Profits Two fundamental changes in the structure of the mortgage industry will put downward pressure on profits. First, mortgage businesses such as origination and servicing are consolidating. In many markets, large players derive significant benefits from scale and can more readily afford the increased investment in technology and marketing required to stay competitive. In most Western European countries, the five largest local players now generate more than 50 percent of mortgages a big change from the early

3 1990s. Germany continues to be an exception because of the highly fragmented nature of its banking business. In the United States, the top ten financial institutions now account for more than 55 percent of the market, compared with just 16 percent in And in Australia, the four major national banks account for 60 percent of the market. Such consolidation makes business much more competitive for all but the largest players. The second event transforming the mortgage landscape is deregulation, which has heightened competition and increased the pressure to consolidate. In North America, ambitious new entrants such as Merrill Lynch, American Express, and Charles Schwab are aggressively seeking to expand their mortgage businesses, at the expense of traditional midsize competitors. Even some leading retailers, such as Tesco in the United Kingdom, are entering the mortgage business. In Australia, the last five years have seen the emergence of independent nonbank originators and a proliferation of third-party brokers. The highly cyclical nature of the business in many countries exacerbates these trends, requiring competitors to adjust capacity constantly to rising and falling volumes. Mortgage players that prosper during boom times often do not survive downturns. Every downturn sweeps away some competitors as the industry adjusts to overcapacity. An assessment of the U.S. mortgage industry, for example, shows that weak business environments have forced a surprisingly large number of leading players to exit the industry. (See Exhibit 1.) Faced with these trends, which make it increasingly difficult to generate consistent returns, financial institutions can always quit the field. But we believe mortgages are integral to retail financial-services offerings.

4 Exhibit 1. The Mortgage Industry Continues to Be Highly Cyclical U.S. Mortgage Competitors Exiting or Outsourcing During Down Cycles Mortgage origination volume ($billions) 2,500 2,000 1,500 Prudential Financial North American Mortgage Directors Mortgage American Residential Mortgage Plaza Home Mortgage First Interstate Bank Crestar Mortgage AccuBanc Mortgage Headlands Mortgage Source One Mortgage Mellon Financial U.S. Bank Merrill Lynch 1, Refinancings First mortgages SOURCE: BCG analysis. NOTE: In 2003, continuing low interest rates are generating a high volume of mortgage refinancings despite the slow economy. Volume shown for 2003 is an estimate; volume shown for 2004 is a projection. Since many consumers look to their primary financial institution for a mortgage, turning them away would be an opportunity lost. Competitors would be only too happy to pick them up, as a mortgage relationship can be an effective platform for cross-selling a variety of related products. Strategic Responses for Lenders So what should mortgage providers do? We suggest four strategies they can use to differentiate their businesses and improve their economics:

5 Deliver product innovations and enhanced value Strengthen and customize the brand Outsource the mortgage-processing business Insource the mortgage business when there are clear advantages of scale Of course, a player s existing competitive position and capabilities determine which of these approaches are most appropriate. Deliver product innovations and enhanced value. While customer demand has been high, many lenders have continued to rely on plain vanilla mortgage products, but that strategy won t work for long. Recognizing that the good times can t last forever, more and more players have successfully introduced innovations intended to give consumers increased flexibility. These include portable mortgages that move with their owners; blend-and-extend options that allow borrowers to alter the mix of principal and interest payments and to stretch obligations over more years; skip-a-payment and other unconventional payment options; and adjustments to accommodate changing financial burdens. Some players, such as American Express, now offer their cardholders additional reward points as an incentive to originate mortgages with them. One of the newest concepts, which has been popular in Australia and the United Kingdom, is bundling mortgages with savings and checking accounts. Customers like these products, which also offer lines of credit, for their flexibility and potential as wealthbuilding tools. Bundled, or offset, accounts also provide tax advantages in some markets. In Australia, for

6 example, they enable customers effectively to earn interest on their savings at the same rate that they would pay for their home loans; interest that would normally be taxable is deducted from the interest payable on mortgages, giving customers a tax benefit. These bundled products give traditional banks an edge over mortgage monolines, which have proliferated in Australia, the United Kingdom, and the United States in recent years. Monolines find it difficult to compete in this area because their underlying funding structures are incompatible with such flexible products. Strengthen and customize the brand. Although mortgages are often regarded as commodities, a strong brand can help a company preserve and build its business, even in bad times. Washington Mutual in the United States has made a substantial investment in advertising around its key theme, The Power of Yes. Some institutions have gone further and invested in a multibranding strategy. HBOS in the United Kingdom uses five different brands to target particular segments and channels, thereby maximizing its reach and making itself the leader in the U.K. mortgage market. One of its brands, Intelligent Finance, for example, appeals to financially sophisticated young consumers, who prefer remote channels like the Internet. HBOS keeps its costs down by using common selling and processing platforms for its various brands. Outsource the mortgage-processing business. Many small and midsize competitors, which lack scale and the resulting cost advantages, may wish to consider outsourcing their mortgage-processing businesses. The Boston Consulting Group s analysis of several U.S. competitors suggests that outsourcing can reduce

7 the earnings volatility associated with the business and can increase real earnings throughout the interest rate cycle. (See Exhibit 2.) If an institution believes that the industry s long-term future belongs to competitors with a low unit-cost position, or if its strategy is to focus on mortgage distribution instead of mortgage production, then it should consider outsourcing. There are two main approaches to outsourcing the business. The first is to combine back offices and infrastructure with those of other players. Commerzbank, Deutsche Bank, and Dresdner Bank in Germany, for example, have merged their mortgage subsidiaries to achieve economies of scale. Likewise, savings banks in the eastern part of the country have built a mortgage production facility to attain greater scale and efficiency in their middle- and back-office functions. It also sometimes makes sense to outsource selectively, retaining in-house the more strategic functions that involve personal business matters. Abbey National in the United Kingdom has outsourced Exhibit 2. Outsourcing Can Increase Earnings and Reduce Volatility Earnings of a Typical Midsize U.S. Mortgage Competitor Earnings 70 before tax ($millions) Outsourcing Keeping the business 10 in-house SOURCE: BCG analysis. NOTE: Earnings shown for 2003 are estimated; earnings shown for 2004 are projected.

8 much of its mortgage processing but has retained credit assessment, security documentation, and collection in-house because of the high touch nature of these functions. The second approach is to outsource the business on a private-label basis. This tactic can dramatically improve the economics of the business for large and midsize players, and allow them to focus on developing and managing customer relationships. Although revenues may drop, profits often rise owing to lower costs. In the United States, many institutions including FleetBoston Financial, Merrill Lynch, and American Express have chosen this route, relying on companies such as Cendant Mortgage to process their mortgage businesses. Thus, by leveraging the capabilities of larger and more efficient players, these companies have continued to own the customer relationship even as they have significantly reduced head count, capital, and high-fixed-cost infrastructure. Whichever way it s done, outsourcing must be carefully managed. The first priority should be to ensure that an institution s brand is not compromised and that its customers expectations are met. Companies that outsource to competitors also have to guard against those competitors efforts to cross-sell other financial products and services to their customers. Those considering outsourcing also need to be mindful of hidden costs. In some countries, such as Germany and Australia, value-added tax has to be paid to companies for services provided, making it harder to realize economic benefits from outsourcing. Germany is also one of several countries with relatively strict labor laws that make it difficult to reduce staff to achieve benefits from outsourcing. Furthermore, while standard prices may decline, businessprocessing companies may exact heavy charges for

9 any changes in processes, products, or promotions, for example that the outsourcing companies require. Finally, the mortgage provider must carefully evaluate the risks of ceding control over reinvestment and new-product development in the mortgage business. Insource the mortgage business when there are clear advantages of scale. Just as there may be an opportunity for midsize players in some markets to outsource, large players with advantageous cost structures may be able to increase market share through insourcing: operating another company s mortgage business or portions of it. Washington Mutual has sought to capitalize on this opportunity by providing mortgage origination and servicing for smaller competitors. Insourcers, however, face several challenges. First, these companies, which are likely to have dealt primarily with retail clients and mortgage brokers, must develop capabilities to work with other financial institutions. Second, they need to build production and processing platforms that are flexible enough to accommodate private-label programs with different requirements. Third, they need to figure out how to share the benefits they derive from scale with outsourcing companies. Fourth, they have to address the outsourcers confidentiality concerns. And last, insourcers must ensure that their own retail businesses do not compete with their private-label clients for the same customers. Move Before It s Too Late Players need to act now, while the mortgage business is still healthy, by taking a dispassionate view of their

10 businesses to determine how competitive they are and how they can improve their positions. Their options include product innovation and enhancement, brand strengthening, outsourcing, and insourcing. Companies that move expeditiously are less likely to end up on the long list of competitors that don t survive the next down cycle. Monish Kumar Michael Krupp David Pitman Monish Kumar is a manager in the New York office of The Boston Consulting Group. Michael Krupp is a vice president and director in the firm s Frankfurt office. David Pitman is a manager in BCG s Sydney office. You may contact the authors by at: kumar.monish@bcg.com krupp.michael@bcg.com pitman.david@bcg.com The Boston Consulting Group, Inc All rights reserved.

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