Surviving Changing Markets Mission Impossible?

Mission Impossible

Your Assignment Manage Your Mortgage Company Through Changing Markets: Minimize Product Risk Avoid Repurchase Requests Reduce Overhead at the Right Time Keep your Warehouse Lender Happy Goal: Survive with Your Net Worth and your Warehouse Line Intact!

Causes of Changes in Mortgage Industry Interest Rate Cycles Graph of Interest Rates from 1980 to 2003 –Includes Mortgage Origination Volume –Employment in the Mortgage Industry Change in Products Acceptable to Investors –The primary cause of the current downturn is the use of stated income to “qualify” borrowers for loans they cannot afford to pay

Mortgage Industry Cycles Source: Mortgage Bankers Association of America

Risks Faced in this Market Repurchase requests Unsaleable loans Lack of liquidity Lack of Net Worth Excess Overhead Changing Loan Guidelines Loss of Warehouse lines

The Survival Solution: PLANNING “Success is not an accident—it is always accompanied by a plan.” --(Dave Hershman in Mortgage Daily, 5/25/04)

Planning and Evaluating Options Defend Against Repurchase Requests Sell Loans PRIOR to Funding Get Additional Liquidity if Needed Know Your Breakeven Point Make Cost Cuts Until You are Profitable Avoid Warehouse Default by Keeping Covenants

Defend Against Repurchase Requests Get servicing records from investor Contact borrower to determine whether payments were made Bring borrower current through direct contact or broker Go after brokers & borrowers for fraud Hire a good advisor and/or attorney Re-negotiate Sale Contracts to reduce repurchase risk: EPD periods and Reps & warrants

Sell Loans PRIOR to Funding Changing Guidelines are the Number One reason that mortgage companies have been failing Forward Commitments do not typically guard against guideline changes Bulk selling presents an unacceptable risk at this time for even largest sellers Flow selling to trusted investors on a prior-approved basis is least risky

Lack of Liquidity Liquidity is your cash and assets easily converted to cash Allows the company to make haircuts and margin calls required by lenders The resource used to negotiate on repurchase requests The life-blood of your business Can be added through equity, lines of credit or subordinated debt

Know Your Breakeven Point: In order to plan your success, you need to know your breakeven point. –Must be able to split fixed versus variable costs –Formula: Indirect Expenses divided by Net Revenue Percentage

Breakeven Calculation 1.Calculate Indirect Expenses (total expenses less commissions and loan- related costs) 2.Calculate Net Production Revenue as a percent of Indirect Expenses 3.Divide Indirect Expenses by the percentage derived in #2

Breakeven Example Monthly Production of $30MM Revenue of $300,000 Total Expenses of $225,000 include: –Commissions of $100,000 –Direct Loan Expenses (appraisals, credit reports, underwriting fees, Etc) of $50,000

Breakeven Example Revenue as a percent of production: Assumptions:Calculate Net Revenues: Production $30,000,000Gross Revenue $ 300,000 Less Direct Expenses: Total Revenue $ 300,000 Commissions $ (100,000) Expenses: Other Direct Costs $ (50,000) Commissions $ 100,000Net Revenues $ 150,000 Direct Loan Costs $ 50,000Divided by Production $ 30,000,000 Other (Indirect) $ 75,000Net Revenue as % of Production0.50% Total Expenses $ 225,000Indirect Expenses: $ 75,000 Divided by Net % Revenue0.50% BREAKEVEN $ 15,000,000

Project Your Staffing Needs: Calculate number of loans each type of employee can handle in a month Create spreadsheet with various monthly volumes as the column heading and each type of employee as a row heading Plot out the number of each type of staff needed for each level of volume considered likely

Make Cuts When Production Falls The best way to preserve capital is to reduce staff as quickly as possible Don’t wait until you see losses to cut staff—use your projections to determine timing

Warehouse Line Default Risk Major Covenants include: Minimum Net Worth Covenant Maximum Leverage Minimum Liquidity Restriction on Losses Restriction on Distributions

Covenant Formulas: Adjusted Net Worth: GAAP Net Worth less officer receivables, illiquid assets (real estate, stock); plus subordinated debt and servicing portfolio Leverage: Total liabilities divided by Adjusted Net Worth Liquidity or Current Ratio: Current Assets divided by Current Liabilities

Keys to Avoiding Covenant Violations Use your projections to cut costs before you incur losses Use your breakeven analysis to plan your overall approach—adding new products, moving into new geographic areas, etc. Use off-balance sheet financing to avoid leverage and current ratio problems

Summary This is a cyclical business-plan early and often! Pre-sell all loans prior to funding to avoid guideline shifts Vigorously defend against existing and future repurchase requests Don’t wait to cut costs-when you see losses on your financial statements, it’s too late! Manage your capital and leverage to avoid covenant violations Look into off-balance sheet financing to provide flexibility Keep your capital intact and get to Mission accomplished!