A WHITE PAPER _COMMISSIONED BY LOANLOGICS

BY_JEFF LEBOWITZ_MORTECH_LLC

We are working in a time of unprecedented technological change. Compounding technology

change is an historically disruptive regulatory environment. It is reasonable to conclude that change today is truly different than what we as individuals and as managers have ever known. Some say that the change we now experience

can only lead to a process of creative destruction that will change the structure of the industry and upend

lenders traditional business models. (See Exhibit 1)

Creative destruction is a concept related to economic innovation, but few pay attention to what it means for a company. The term describes change as incessantly revolutionizing commerce and market structure, incessantly destroying traditional approaches to business, and incessantly creating new business models appropriate to coping with changing business conditions.

In mortgage, there has been a change in the world view of who makes the rules determining product definitions and market behavior. Regulators have forced

a rethinking of how managers define and deal with underwriting models, the definition and management of risk, how to recognize a qualified borrower, what rules govern the relationship between primary and secondary markets, and what data is valuable and what uses are to be made of the data. Large-scale regulatory intervention is an external shock to traditional business models. It is difficult to interpret and respond to, and it causes disruption in the normal working of markets mortgage markets in this case.

Mortgage bankers are suffering the consequences of the early stages of a paradigm shift. Mortgage banks and mortgage subsidiaries of chartered banks made an average profit of $743 on each loan they originated, down from $1,528 per loan in the second quarter, according to MBA data for the third quarter of 2013. In the same MBA report, average production volume was $391 million per company, down from $439 million per company in the second quarter. The volume by count per company averaged 1,788 loans, down from 1,921 in the second quarter. (See Exhibit 2)

EXHIBIT 1: MORTGAGE ORIGINATIONS IN 12 YEAR DECLINE IN VOLUME LENDERS IN A BATTLE FOR MARKET SHARE

Source: MBA February 2014 Mortgage Finance Forecast

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EXHIBIT 2: LENDERS DEALING WITH PROFOUND CHALLENGES

Source: MORTECH, LLC

Unlike past episodes of profit decline, it is conceivable that bankers are experiencing something worse than a typical business cycle. Mortgage companies reflexively turn their focus to cost management. However, if we are in something more than a cyclical downturn, cost reduction alone will not be enough to compensate for shrinking volume. Traditional business methods will need to change.

The fact is that information has become more valuable to business owners than all other commodities. With the explosion in mobile and wearable devices, the amount of data captured and data reported grows exponentially. Connectivity to streams of data has become pervasive. The intelligence mined from ubiquitous connectivity and massive data underlies the next wave of innovation in computing and will persist for decades to come.

Among lenders there is a growing interest in addressing and resolving highly inconsistent and fragmented data and transaction flows. In fact, data generated worldwide likely will overwhelm IT infrastructures and will challenge the ability to use data profitably. According to International Data Corporation of Framingham, MA, in 2011 one point

After the financial crisis of 2007-2008, government has intervened in all levels of mortgage operations. The federalization of the secondary market has caused a true, dyed-in-the-wool paradigm shift. Neither the government nor the industry have yet to reach a consensus on what will be the effective governing policies or business models appropriate to the incoming paradigm. Will it be run with private market funding? Can populist policies that subsidize mortgages

eight zettabytes (or 1.8 trillion GBs) of information were created. In 2012, data creating reached 2.8 zettabytes. IDC now forecasts 40 zettabytes (ZB) created by 2020. A zettabyte is equal to 1,000,000,000,000,000,000,000 bytes.

Industry regulators as well are obsessed with data, data quality, data standards and data use. They are pushing lenders to standardize the types and formats of data collected and reported.

The 2007-2008 financial meltdown created a universal awareness of reference data1 and helped elevate it from a back office concern to a critical business function. Regulators see this as a key foundational component in any effort to manage systemic transactional risk.

to maximize home ownership re-emerge? Will the industry restructure into an oligopoly with a small number of large lenders determining the rules of trade in the mortgage industry?

No matter the outcome, successful market participants will embrace and integrate new technologies, alternative distribution channels and fact-based strategies formed around good data and analytics that describe and more importantly predict optimal firm behavior.

Lenders are engulfed in regulatory reform and struggling with evolving rule sets. They are faced with integrating new state regulation, new investor rules, and CFPB reform regulations such as Ability-to-Repay, Qualified Mortgage rules, and so forth. These changes add cost and complexity to efforts to comply. Reconciling regulatory incongruences is difficult and adds legal and operational risk for lenders.

In 2010, the Federal Housing Finance Agency (FHFA) insinuated itself into the inner depths of lender operations with The Uniform Mortgage Data Program (UMDP). Consistent and accurate data is the root of informed decision-making throughout the mortgage origination and secondary sales processes. Fannie Mae and Freddie Mac are working together under the direction of their regulator,

GOOD DATA AND WINNING STRATEGY

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the Federal Housing Finance Agency, to implement UMDP. Their overarching goal is to put in place single-family data standards that will improve the quality of data and provide consistency of definition throughout the mortgage industry.

FHFA mandates what lenders have voluntarily pursued since 1999 with MISMO. It is MISMO that initiated a standard approach for two business-related firms to streamline shared data contained in forms or reports. Government mandate and industry forces have laid the ground work for digitizing mortgage operations.

The value of data has appreciated further as the U.S. Congress and

the Obama Administration propose expansion of risk-management requirements. High demand for data forces new automated applications which can raise technological risk. (See Exhibit 3)

Changing technology platforms represent one dimension of technological risk, and brings with it uncertainties and potential failure. No change comes without risk. There is always risk, no matter how small.

Requirements for a new system change as the business changes.

Users have limited input in selecting the new system.

Staff does not expect the new system to change workflows.

Users resist a new system when they have to be retrained and change their traditional way of working.

Ultimately, users do not want to be accountable for whether or not investments in new systems payoff as expected.

Projects do not end with installing the new system. To actualize the potential of a new technology application, business processes have to be reengineered.

Converting data from old to new systems is risky and more difficult than planned for.

Many of the systems and technology changes being required today have no obvious payback.

EXHIBIT 3: DATA CHALLENGES: DATA IS IMPORTANT TO SENIOR MANAGERS IMPLEMENTATION HAS ITS CHALLENGES

Source: KPMG, CFO-CIO Survey Aug. 2013

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Compliance with rapidly escalat-ing rules generation does not enrich lenders and requires smart choices to avoid punitive penalties and increased operations risk. As a result, regulated firms have adapted existing information technology systems created originally for internal management purposes, and now are developing new ones intended specifically to satisfy government mandates. This creates a proliferation of systems that also raises technological risk.

Lenders who emphasize decision making based on data and business

In our world, the critical variable is the time it takes company management to sort through the many permutations of new technologies and adapt to regulatory change that creates government priorities that supplant management priorities. Remaining viable and being competitive depends more than ever on being continuously innovative. In todays world, that means digitizing operations.

Digitizing operations is sometimes called the fourth industrial revolution. Industry 4.0 promises to turn the business world on its head. Classic operating organization and techniques will be displaced by cyber-physical production systems.

analytics (data driven decision-making) show higher performance results. Value is created from reliable information flows. Revenue and efficiency gains derive from processing verified electronic transactions.

Business applications must have access to data that has been integrated from a wide variety of sources, in-house or externally sourced. Data frequently are loaded into separate systems. This makes obtaining a complete, efficient, accurate data set elusive.

In the age of digitization, managers have new ways to manage business relationships.

Digitization refers to the process of making information, business activities (e.g., origination), and offerings digital. Thus, business relationships can be defined as the process of making information, business activities, and offerings related to exchanges between two organizations digital. Value is created from reliable information flows. Revenue and efficiency gains derive from processing verified electronic transactions.

Fully digital business relationships can be performed without human intervention. This is made possible if the product, process, and

Operations performed efficiently and effectively require the relevant data to be received, formatted, sorted, validated and readily accessible.

The increasingly pervasive reliance on technology comes in the form of information-technology and decision-automation system software and analytics. These are the core capabilities to assess and control risk, and to comply with government regulation mandating its management.

operators are digital. Furthermore, as the systems of two companies are integrated, data transmissions and transactions can be automated, and information can be exchanged dynamically.

The heightened scope, speed, and interdependence of business transactions, market behaviors, and the lender technologies that enable them have become sources of contemporary riskfrom financial, to operational, to informational.

As lenders move through the phases of digitizing operations, they have to deal with both technological risk and transactional risk. Transactional risk mainly refers to the uncertainties and potential negative outcomes caused by the strategic behaviors

NEW DATA-DRIVEN OPERATING MODEL

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of supply chain partners in misusing digital linkages and exploiting the inter-firm relationships. The concern over these risks often discourages lenders from adopting digital operations to support their inter-organizational operations. Effectively selecting the right business relationships to be digitized brings flexibility, reliability, and lower cost to various activities.

Managing data and data exchange recognizes that lenders operate in what academics now are calling a business ecosystem. A business ecosystem is simply a lenders network of investors, correspon-dents, technology/service providers, referring realtors, and warehouse lenders. Applying the principles of an ecosystem helps to manage loan creation and delivery effectively.

In fact, basic mortgage banking business models are built on managing a network of business relationships, more so than most other types of businesses. More than ever, lenders must plan and manage their strategic relationships, how they are connected, and the quality and currency of data exchanged among members of that network. Contemporary jargon designates this network and its information exchanges as an ecosystem. (See Exhibit 4)

Technological change leaves behind some people, perhaps even a lot of people, who avoid this change to their detriment. Faster response times to imminent change are essential to improving business performance and avoiding obsolescence. Information deficits and delays in getting information promptly offset technological risk and support adoption of digital operating processes.

Industry leaders create and nurture their ecosystems by coordinating and harnessing the collective power of developers, partners, and others integral to their shared success.

What is distinctive about viewing business as an ecosystem is that management focuses on more than a

Lending executives increasingly will find appreciation for and use of their data. Focusing on data will lead to new ways to collect the data, utility in using data, and will develop technology applications driven by data. By necessity, lending executives will become technically savvy. They will collaborate directly with IT to build competitive digitized companies.

single function and works to make the business entire ecosystem more effective. Focusing primarily on which players in the ecosystem brings new advantage to the business. Successful management of relationships within a lenders ecosystem has become a core competency for senior management.

DATA EXCHANGE ACROSS THE BUSINESS ECOSYSTEM

EXHIBIT 4: MANAGING LENDERS ECOSYSTEM NOW A CORE COMPETENCY

Source: MORTECH, LLC

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A growing number of organizations are adhering to the mandate to make more decisions based on data or facts. The demand for better analytics is shifting how some companies view the value of their data. Many companies are making the effort to use their own data to become more effective producers and marketers.

Exhibit 5 shows how important it is to use data to locate better performing markets in this case higher- end property buyers and owners. While data used well can have great value, often enough there is a mismatch in the data required and data available. (See Exhibit 5)

In a recent research by MIT Sloan Management Review and SAS Institute2, 60% of respondents agreed that senior managers are pressuring the organization to become more data-driven and analytical. In contrast, only 42% of respondents said they frequently or always have all the data they need to make key business decisions.

On top of the intrinsic value of data, industry regulators are compelling lenders to use information generated from corporate operations in ways for which many were not prepared. Regulator-mandated risk controls cannot function without the data

collection, data analysis, and monitoring facilitated by integrated computer technology. Government regulators have corralled lenders and are forcing them to comply by standardizing behavior and investing in automated compliance technology.

The difference between being a winner and being a lagging firm in IT-intensive industries is very large and growing. Using technology effectively matters more now than ever before. Firms that adopt data-driven decisions have output and productivity that is 5-6% higher than what would be expected given their other investments and information technology usage.

OPERATIONS PROVIDE A WEALTH OF DECISION DATA

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EXHIBIT 5: DATA REVEALS INNER WORKINGS OF MORTGAGE MARKETS HIGH END SEGMENT OUTPERFORMS LOWER END

Source: Mortgage Bankers Association Weekly Application Survey

Changing capabilities and technology investments of firms within a lenders ecosystem influences the nature and timing of its own investment in operations and technology. Increased levels of IT adoption by interacting partners motivate all firms to digitize transactions. As the number of possible partners increase, so do transaction costs.

Integrating data technology into existing systems and/or business models can help control these costs, but can also be one of the biggest challenges facing these companies. That is why platform technologies have increasingly become the center of ecosystems and provide strong network effects among members of the ecosystem. (See Exhibit 6)

Platforms are defined by degree of usefulness (standards) and value derived (business benefits). In Exhibit 6 we refer to four technology-based business platforms:

1. Internal (single user, limited functionality);

2. Utility platform (wider access, limited functionality);

3. Value net (limited access, broad functionality);

4. Industry platform (wide access, broad functionality.)

Establishing and maintaining the interfaces among members of a lenders ecosystem creates efficient transactions across the network of relationships and among operational systems. The interfaces create the boundaries of connected

elementscomponents of a system. The ecosystem interfaces reduce both coordination and transaction costs across operating and corporate boundaries.

Digitization is essential to exploiting the ecosystem and is valuable in reducing costs, reducing operations risk and increasing revenues. Management benefits include reduction in labor use, decreased error rates, and growing and managing increases in the volume of business. The objective of technology investment and cross-company collaboration is to make informational and transactional activities more accurate and still have faster turnaround times. This is possible with automatic and dynamic updates to databases and Web pages.

SUBSCRIBING TO A TECHNOLOGY PLATFORM

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Source: Using Platforms, IBM Corporation 2012

EXHIBIT 6: CONNECTIVITY DEFINES BUSINESS PLATFORM

The prerequisite for successful digiti-zation is the identification of the key relationships in a lenders ecosystem including vendors of technology managed processes. Operations and financial risk are reduced with the choice of a ready-to-use integrated systems or a best-of-breed offering. The ideal technology partner is one known to innovate and facilitate a flow of products and services com-plementary to its core capabilities.

All lenders now are operating under strict and often arcane regulatory and investor requirements. Investments that once were made to improve and expand businesses now are used to stay in compliance with government rules. At one time, the lenders end game was to build volume. Now it is to maximize the usefulness of lenders internal data and reference data from the mortgage marketplace.

Lender search for a vendor partner to help them compete in the new regulatory paradigm mostly uses the conventional screening criteria. These include:

Knowledge of mortgage industry

Functionality of technical solution

Total solution cost

Technology competence

Financial strength

This type of vendor builds services on a technology platform optimized to each lenders ecosystem.

Screening for a vendor appropriate to a lenders requirements is different in the digital world than it was in the world of licensed and installed tech-nology. Winners in a platform market generally have the best platform strategy, not necessarily the best product. A best standalone value proposition is a good starting point,

Customer reference sites

In the modern era of computing, lenders need to add one more consideration when evaluating a new technology investment: does the vendor build their capabilities on a platform-architecture?

The platform-architecture may be a more complete solution when aligned with particular workflows in a lenders operation. Vendors with services built on a consistent and reusable technology platform can network complementary services into their service packages. Complementary services may be developed by the vendor or attached from a specialized supplier (e.g., risk analytics). Having access to a menu of complementary services from one processing platform allows a lender to customize a solution through one vendor, the vendor that best fits

but it is usually not sufficient to win in a business being transformed by platform-based ecosystems.

All lenders are now living under regu-latory and investor requirements that are not an option. Investments must be made to comply, but now there are real opportunities to realize posi-tive returns from those investments. The end game is to maximize use of lenders internal data and reference data from the mortgage marketplace.

the lenders operating and financial needs.

Lenders benefit from the fact that the platform-architectures inherently run with economies of scale. The archi-tecture reduces a technology buyers costs of searching for a complete solution, offers a more efficient imple-mentation of a solution, and lowers coordination and support costs. Finally, the flexibility of a platform-architecture reduces technology risks for vendors and their clients alike.

Connection to essential technology solutions that hang off a platform is the key to compliance, data integrity, and risk management. Platform-ori-ented technology is the new driver of innovation and growth. Aligning with vendors operating from a common platform will assure lenders are able to adapt to the uncertainties that are the future of mortgage banking.

LENDERS ECOSYSTEM

CONNECTING WITH THE PLATFORM-ORIENTED VENDOR

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Jeff Lebowitz, MORTECH, LLC

Jeff@mortech-llc.com

1. Reference data: data that describes financial transactions and helps identify the participants in those transactions.

Jeff Lebowitz is widely recognized as a thought leader in mortgage banking. For twenty five years, he has written and consulted on the application of technology to change the competitive dynamics in the mortgage industry. Mr. Lebowitz began his mortgage career as the head of Strategic Planning for Fannie Mae. Mr. Lebowitz then founded and has been chief researcher and strategist for the mortgage indus-try research and consulting firm, MORTECH, LLC. He long has promoted the importance of fact-based decisions made on data from original scientific research.

2. 2013 Data & Analytics Global Executive Study

For his accomplishments, Mr. Lebowitz was awarded the 2013 Source Media/Mortgage Technology Magazines Steve Fraser life-time achievement trophy. In 2002, Lebowitz was named to Mortgage Banking Magazines technology all-star roster.

ABOUT THE AUTHOR:

FOOTNOTES:

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