making the most of mortgage markets - bcg · making the most of mortgage markets in much of the...

Opportunities for Action in Financial Services

Making the Most of Mortgage Markets

Mortgage Apr 03 4/23/03 8:44 AM

Making the Most of Mortgage Markets

In much of the industrialized world, mortgage vol-umes have been high in recent years, driven by fallinginterest rates and—in some countries—by widespreadrefinancing. Lenders have profited considerably fromthis bonanza. The United States, for example, sawrecord origination volumes of $2.1 trillion in 2001and $2.5 trillion in 2002, thanks to increased refi-nancing business. The boom in Western Europearrived even sooner, with the mortgage market theregrowing at an annual rate of more than 9 percentfrom 1995 through 2000.

These good times may continue for a while, especiallyin the United States, where interest rates recentlydropped to 45-year lows. However, there are long-term structural forces eating into the industry’s prof-itability that will become more apparent if the econ-omy slows further. Competitors need to prepare forthese more difficult times by reviewing their strategiesand economics to find methods of improving and sus-taining their profitability.

Market Changes Erode Profits

Two fundamental changes in the structure of themortgage industry will put downward pressure onprofits. First, mortgage businesses such as originationand servicing are consolidating. In many markets,large players derive significant benefits from scale andcan more readily afford the increased investment intechnology and marketing required to stay competi-tive. In most Western European countries, the fivelargest local players now generate more than 50 per-cent of mortgages—a big change from the early

Mortgage Apr 03 4/23/03 8:44 AM Page 3

1990s. Germany continues to be an exception becauseof the highly fragmented nature of its banking busi-ness. In the United States, the top ten financial insti-tutions now account for more than 55 percent of themarket, compared with just 16 percent in 1990. Andin Australia, the four major national banks accountfor 60 percent of the market. Such consolidationmakes business much more competitive for all but thelargest players.

The second event transforming the mortgage land-scape is deregulation, which has heightened competi-tion and increased the pressure to consolidate. InNorth America, ambitious new entrants such asMerrill Lynch, American Express, and CharlesSchwab are aggressively seeking to expand their mort-gage businesses, at the expense of traditional midsizecompetitors. Even some leading retailers, such asTesco in the United Kingdom, are entering the mort-gage business. In Australia, the last five years haveseen the emergence of independent nonbank origina-tors and a proliferation of third-party brokers.

The highly cyclical nature of the business in manycountries exacerbates these trends, requiring com-petitors to adjust capacity constantly to rising andfalling volumes. Mortgage players that prosper duringboom times often do not survive downturns. Everydownturn sweeps away some competitors as the indus-try adjusts to overcapacity. An assessment of the U.S.mortgage industry, for example, shows that weak busi-ness environments have forced a surprisingly largenumber of leading players to exit the industry. (SeeExhibit 1.)

Faced with these trends, which make it increasinglydifficult to generate consistent returns, financial insti-tutions can always quit the field. But we believe mort-gages are integral to retail financial-services offerings.


0

500

Refinancings First mortgages

1,000

1,500

2,000

2,500

’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04

Mortgage origination volume ($billions)

Prudential Financial

North AmericanMortgage

Directors Mortgage

American ResidentialMortgage

Plaza Home Mortgage

First Interstate Bank

Crestar Mortgage

AccuBanc Mortgage

Headlands Mortgage

Source One Mortgage

Mellon Financial

U.S. Bank

Merrill Lynch

U.S. Mortgage Competitors Exiting or Outsourcing During Down Cycles

SOURCE: BCG analysis.NOTE: In 2003, continuing low interest rates are generating a high vol-ume of mortgage refinancings despite the slow economy. Volumeshown for 2003 is an estimate; volume shown for 2004 is a projection.

Exhibit 1. The Mortgage Industry Continues to Be Highly Cyclical

Since many consumers look to their primary financialinstitution for a mortgage, turning them away wouldbe an opportunity lost. Competitors would be onlytoo happy to pick them up, as a mortgage relation-ship can be an effective platform for cross-selling avariety of related products.

Strategic Responses for Lenders

So what should mortgage providers do? We suggestfour strategies they can use to differentiate their busi-nesses and improve their economics:


• Deliver product innovations and enhanced value

• Strengthen and customize the brand

• Outsource the mortgage-processing business

• Insource the mortgage business when there areclear advantages of scale

Of course, a player’s existing competitive position andcapabilities determine which of these approaches aremost appropriate.

Deliver product innovations and enhanced value.While customer demand has been high, many lendershave continued to rely on “plain vanilla” mortgageproducts, but that strategy won’t work for long.Recognizing that the good times can’t last forever,more and more players have successfully introducedinnovations intended to give consumers increasedflexibility. These include portable mortgages thatmove with their owners; blend-and-extend optionsthat allow borrowers to alter the mix of principal andinterest payments and to stretch obligations overmore years; skip-a-payment and other unconventionalpayment options; and adjustments to accommodatechanging financial burdens. Some players, such asAmerican Express, now offer their cardholders addi-tional reward points as an incentive to originate mort-gages with them.

One of the newest concepts, which has been popularin Australia and the United Kingdom, is bundlingmortgages with savings and checking accounts.Customers like these products, which also offer linesof credit, for their flexibility and potential as wealth-building tools. Bundled, or “offset,” accounts also pro-vide tax advantages in some markets. In Australia, for


example, they enable customers effectively to earninterest on their savings at the same rate that theywould pay for their home loans; interest that wouldnormally be taxable is deducted from the interestpayable on mortgages, giving customers a tax benefit.

These bundled products give traditional banks anedge over mortgage “monolines,” which have prolifer-ated in Australia, the United Kingdom, and theUnited States in recent years. Monolines find it diffi-cult to compete in this area because their underlyingfunding structures are incompatible with such flexibleproducts.

Strengthen and customize the brand. Although mort-gages are often regarded as commodities, a strongbrand can help a company preserve and build its busi-ness, even in bad times. Washington Mutual in theUnited States has made a substantial investment inadvertising around its key theme, “The Power of Yes.”Some institutions have gone further and invested in amultibranding strategy. HBOS in the UnitedKingdom uses five different brands to target particu-lar segments and channels, thereby maximizing itsreach and making itself the leader in the U.K. mort-gage market. One of its brands, Intelligent Finance,for example, appeals to financially sophisticatedyoung consumers, who prefer remote channels likethe Internet. HBOS keeps its costs down by usingcommon selling and processing platforms for its vari-ous brands.

Outsource the mortgage-processing business. Manysmall and midsize competitors, which lack scale andthe resulting cost advantages, may wish to consideroutsourcing their mortgage-processing businesses.The Boston Consulting Group’s analysis of severalU.S. competitors suggests that outsourcing can reduce


the earnings volatility associated with the business andcan increase real earnings throughout the interestrate cycle. (See Exhibit 2.) If an institution believesthat the industry’s long-term future belongs to com-petitors with a low unit-cost position, or if its strategyis to focus on mortgage distribution instead of mort-gage production, then it should consider outsourcing.

There are two main approaches to outsourcing thebusiness. The first is to combine back offices andinfrastructure with those of other players. Commerz-bank, Deutsche Bank, and Dresdner Bank in Ger-many, for example, have merged their mortgage sub-sidiaries to achieve economies of scale. Likewise,savings banks in the eastern part of the country havebuilt a mortgage production facility to attain greaterscale and efficiency in their middle- and back-officefunctions. It also sometimes makes sense to outsourceselectively, retaining in-house the more strategic func-tions that involve personal business matters. AbbeyNational in the United Kingdom has outsourced

0

Earnings before tax ($millions)

Outsourcing

Keeping the business in-house

1997 1998 1999 2000 2001 2002 2003 2004

70

60

50

40

30

20

10

–10

Earnings of a Typical Midsize U.S. Mortgage Competitor

SOURCE: BCG analysis.NOTE: Earnings shown for 2003 are estimated; earnings shown for 2004are projected.

Exhibit 2. Outsourcing Can Increase Earnings and Reduce Volatility


much of its mortgage processing but has retainedcredit assessment, security documentation, and collec-tion in-house because of the “high touch” nature ofthese functions.

The second approach is to outsource the business ona private-label basis. This tactic can dramaticallyimprove the economics of the business for large andmidsize players, and allow them to focus on develop-ing and managing customer relationships. Althoughrevenues may drop, profits often rise owing to lowercosts. In the United States, many institutions—in-cluding FleetBoston Financial, Merrill Lynch, andAmerican Express—have chosen this route, relying oncompanies such as Cendant Mortgage to process theirmortgage businesses. Thus, by leveraging the capabili-ties of larger and more efficient players, these compa-nies have continued to own the customer relationshipeven as they have significantly reduced head count,capital, and high-fixed-cost infrastructure.

Whichever way it’s done, outsourcing must be care-fully managed. The first priority should be to ensurethat an institution’s brand is not compromised andthat its customers’ expectations are met. Companiesthat outsource to competitors also have to guardagainst those competitors’ efforts to cross-sell otherfinancial products and services to their customers.

Those considering outsourcing also need to be mind-ful of hidden costs. In some countries, such as Ger-many and Australia, value-added tax has to be paid tocompanies for services provided, making it harder to realize economic benefits from outsourcing. Ger-many is also one of several countries with relativelystrict labor laws that make it difficult to reduce staff to achieve benefits from outsourcing. Further-more, while standard prices may decline, business-processing companies may exact heavy charges for


any changes—in processes, products, or promotions,for example—that the outsourcing companiesrequire.

Finally, the mortgage provider must carefully evaluatethe risks of ceding control over reinvestment andnew-product development in the mortgage business.

Insource the mortgage business when there are clearadvantages of scale. Just as there may be an opportu-nity for midsize players in some markets to outsource,large players with advantageous cost structures may beable to increase market share through insourcing:operating another company’s mortgage business orportions of it. Washington Mutual has sought to capi-talize on this opportunity by providing mortgage orig-ination and servicing for smaller competitors.

Insourcers, however, face several challenges. First,these companies, which are likely to have dealt pri-marily with retail clients and mortgage brokers, mustdevelop capabilities to work with other financial insti-tutions. Second, they need to build production andprocessing platforms that are flexible enough toaccommodate private-label programs with differentrequirements. Third, they need to figure out how toshare the benefits they derive from scale with out-sourcing companies. Fourth, they have to address theoutsourcers’ confidentiality concerns. And last,insourcers must ensure that their own retail busi-nesses do not compete with their private-label clientsfor the same customers.

Move Before It’s Too Late

Players need to act now, while the mortgage businessis still healthy, by taking a dispassionate view of their


businesses to determine how competitive they are andhow they can improve their positions. Their optionsinclude product innovation and enhancement, brandstrengthening, outsourcing, and insourcing. Com-panies that move expeditiously are less likely to endup on the long list of competitors that don’t survivethe next down cycle.

Monish Kumar Michael Krupp

David Pitman

Monish Kumar is a manager in the New York office of TheBoston Consulting Group. Michael Krupp is a vice presidentand director in the firm’s Frankfurt office. David Pitman isa manager in BCG’s Sydney office.

You may contact the authors by e-mail at:

[email protected]

[email protected]

[email protected]

© The Boston Consulting Group, Inc. 2003. All rights reserved.


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