Why Some Banks Are Measuring Mortgages Wrong

Late last year, I wrote a column about why I believe that regional and community banks have the potential to be big players in the mortgage market in the coming years. I argued that a bank should be able to cross-sell new mortgages to 1-2% of its existing banking households. A bank with 100,000 households should be able to generate $3 million to $6 million annually in mortgage pretax net income, driven by origination profits.

The column received lot of feedback from bankers. The most striking information, from my perspective, is not how various banks are performing in the mortgage arena but that banks themselves often do not know how they are performing.

Many banks seem to approach and account for mortgages as they would any deposit or consumer loan product. Just as they would with loans, banks separate the ongoing income produced by the product (the loan yield and fee income) from the expenses associated with its origination.

This may make sense from a traditional banking perspective, in which all originated loans and new deposits become part of the bank’s balance sheet. But it creates some real challenges in measuring the comprehensive performance of mortgage activity, in which some mortgages become portfolio assets but others are originated and sold.

There are several reasons why mortgages should be treated differently from deposit products as well as loans.

First, banks have an array of offerings for consumers who are seeking a deposit relationship. A customer may want a highly liquid checking account, a safe savings account, a longer-term certificate of deposit or a more aggressive mutual fund. Each of those account types, with the exception of the mutual fund, becomes a part of the bank’s deposit base. While each of these products has its own cost and revenue components, they are often delivered through a similar sales process and the same delivery channel.

Customers frequently migrate through these products: they begin with a checking account, then move to savings accounts and certificates of deposits as their accounts grow. This means that a bank can make money on the overall deposit relationship while not necessarily making money on any one particular account. Each product is a ready substitute for the other, or better yet, complementary. Because of these traits, the revenue and expense associated with any given deposit transaction is not critical to overall profitability measurement.

Mortgages are an entirely different matter. A consumer who is shopping for a mortgage typically has a pressing need for a home purchase or for the cash from a refinance. And the mortgage customer keeps that one product for a long time, since most consumers retain that mortgage until they refinance it or sell the home. Use of a specialist is often required to assist the consumer in selecting from a variety of loan types--each with its own down payment, credit, fee and structural characteristics. And although some banks are not yet involved with selling any of their mortgage originations into the secondary market, many are. For all these reasons, unlike deposits, the measurement of the income stream for the mortgage transaction itself becomes very important to understanding overall mortgage profitability.

Because of these complexities, most banks don’t measure the results from their mortgage origination operations correctly. They tend to view mortgage origination as a low-risk, low-return business that invests in mortgage loans rather than as a higher-risk, high-return fee business that creates loan and servicing assets for investors both internal (the bank itself) and external (such as Fannie Mae and Freddie Mac).

Setting up the proper accounting for mortgage activity, in which origination net revenue is measured separately from the bank’s decision about whether to invest in the originated loan, is a key ingredient on the road to generating additional mortgage-related income for the bank.

In future articles, I will discuss how decisions about product offerings, pricing, approach to secondary marketing, staffing levels, marketing activities and servicing can unleash mortgage profitability potential for banks.

In the meantime, I would encourage banks to sharpen their focus on the direct costs and revenues associated with the origination of mortgages in their institutions today in order to lay that foundation. It’s worth taking another look.