Via the systematic study of competitive pricing position and price elasticity of customer demand, margins and revenues can be optimized in challenging circumstances.
Mortgage lenders are facing serious questions about how to drive revenue growth and profitability, suffering from both an excess capacity overhang and new layers of compliance-related expenses. For many, it is time to consider a performance tool widely used elsewhere but underutilized in mortgage origination — demand-side pricing.
Across the industry and within individual network footprints, price sensitivity varies measurably among mortgage applicants: by geography, type of product, borrower purpose and loan amount. Through a careful analytical understanding of such differences, a lender can learn to tap select pockets of opportunity in the overall market, either to enhance margins or to capture additional origination on favorable terms.
By contrast, mortgage pricing traditionally has focused heavily on cost-plus considerations, reflecting the complexities of hold-vs.-sell decisions, secondary market pricing, managing interest rate risk, etc. And market fluctuations have tossed lenders between all-consuming extremes. Thus there has been little time or attention devoted to demand-side pricing. But now there is a clear call to action.
Following a 60% plunge in origination volume between 2003 and 2008, the U.S. mortgage market got a lift as homeowners took advantage of low rates to refinance. Mortgage lenders beefed up sales and distribution capacity to capitalize on the surge.
But with prolonged rock-bottom interest rates, refinancing burned through all possible volume and has slumped in the past two years, and it likely will remain low if rates climb. While purchase origination will rise in a recovering economy and housing market, it likely will not be enough to offset the refinance slide (Figure 1: Mortgage Origination Trends & Outlook).
Banks are left to face a stagnant market for some time to come. Not only does a shrinking market produce an overhang of fixed costs to deal with, but ongoing struggles with TILA-RESPA Integrated Disclosure rules and other compliance-related expenses are further pinching margins.
An analytic understanding of customer demand differences, to identify where additional margin can be realized, will be critical in producing the most possible revenue under these challenging circumstances. Lenders will want to take three steps:
1) Determine competitive pricing position. Mortgage units need a market-by-market understanding of how competitive standing influences customer purchase decisions.
2) Develop a feedback loop with local sales leadership. To effectively deploy a new pricing framework and control exceptions at the point of sale, the bank needs strong coordination with the field.
3) Optimize margin enhancement and balance formation. Using price elasticity of demand as a guidepost, the goal is to fine-tune mortgage pricing for profitable growth.
Drawbacks of “Cost-Plus” Pricing
Today’s dominant mortgage pricing approach considers only supply-side loan economics. Under the typical cost-plus formula, baseline pricing is derived either from capital markets dynamics for loans to be sold off, or from cash flow valuations on loans to be held on the bank’s balance sheet. From there, the bank establishes a target spread, adjusted for risk and prepayment, which will provide a necessary return on equity, with some margin for origination expenses.
This approach establishes guardrails for minimum required returns, but falls short in its ability to maximize revenue. It does not consider the borrower’s price sensitivity relative to the circumstances of the decision. Nor does it rigorously consider variations in local market dynamics and the lender’s competitive position (Sidebar: What Drives Local Market Pricing Variation?). It also seriously degrades as price concessions are offered by mortgage loan officers to close deals in the field.
What Drives Local Market Pricing Variation?
The capital markets determine the value of a mortgage-backed security through efficient trading activity. For loans held on the balance sheet, banks use cash-flow and risk evaluations that are consistently applied to all loans booked system-wide.
But these powerful top-down influences do not homogenize regional competition. Much depends on the mortgage origination operation, where expenses can differ significantly among competitors.
Size. The size of an origination operation is often correlated with how a lender executes in the secondary market, e.g., cash window or MBS. Among other execution options and MSR valuations, this can lead to differing base values for loans depending on the lender.
Composition. Bank expense structures vary considerably, both fixed costs for physical presence, and variable costs, such as for loan officer compensation plans.
Now drill down into a specific region, where these influences play out among the various competitors including large national banks, regional banks, mortgage banks, community lenders, correspondent lenders, and, more recently, marketplace lenders. Clearly pricing varies from lender to lender. And the differences can be pronounced, depending on the region in question
As an originator trying to profitably serve each region, these local differences should not be ignored when deciding how much margin should go on top
— Zach Wise and Andrew Frisbie
The end result is imbalanced pricing strategy. Mortgage offer rates reflect intensive efforts to fully account for supply-side factors, yet only loosely account for variations in customer demand in varied competitive settings.
As an example of market variation that commonly is overlooked today, a Novantas analysis of data provided by Informa Research Services shows that on rate sheets for February 1, 2016, lenders in California were charging a weighted average of 0.90 discount points to obtain a 3.875% conforming 30-year refinancing mortgage, whereas the comparable price in Texas was only 0.32 points.
In another snapshot of competition in Texas last October through December, pricing variations among four of the largest bank competitors in the market ranged from 27 to 38 basis points (Figure 2: Significant Price Dispersion in Local Mortgage Markets).
If a central pricing team tries to deploy “standard” prices in these varied settings, it inevitably leaves money on the table. Either the bank sacrifices margin that could have been captured via judicious upward margin adjustments, or it sacrifices balance growth that could have been captured via modest downward revisions.
Often geographically-tailored pricing is the first place the bank should look for pricing-related mortgage performance improvement within a large network footprint. But as teams get better grounded in demand-side pricing, a suite of applications comes into view (Figure 3: Evolution of Mortgage Pricing).
Many originators have anecdotal experience with demand-side reactions when market rates temporarily plunge and borrowers rush to refinance. To mitigate a flood of applications, one tactic is a blanket price bump to dampen demand. In the future, leading originators can ensure they approach such pricing actions surgically, to maximize margin gains by specific segment. There are three major keys to progress:
Relative Competitive Position (RCP). For a robust view of demand side impacts, originators need a solid grasp of each product’s price position against the market.
The important first step is to establish a robust benchmark metric, customized for each market. Novantas research shows that a 3-D input stream works best, not only daily rates posted by competitors, but also customer note rate selections relative to par, plus a weighting of competitor influence as reflected in origination market share. The resulting mathematical simplification yields a weighted average “price vs. competition” metric, allowing the originator to quickly understand the current position and respond.
A tandem requirement is to establish a technology and analytics platform that manages the voluminous data needed to support RCP — numerous competitors, multiple mortgage products, a significant number of pricing scenarios, etc. — and can provide continuously refreshed output for daily decision-making.
Local Sales Dynamics. Each competitor in a given region has its own expense structure, loan officer compensation framework, purchase money or relationship banking strategy, cash flow valuations and secondary market execution. These variations can produce different market pricing dynamics from region to region.
The inelegant coping mechanism, widely used today, is the use of price exceptions at the point of sale. Under the banner of a “competitive price match,” loan officers are authorized to make on-the-spot rate concessions to close business at the point of sale. Even though these negotiations are supposed to be bounded by specific policy guidelines, a significant amount of authority is moved away from the centralized pricing desk, complicating the effort to meet top-of-house targets.
This is a specific setting where a competitive position metric can be put to good use. Working hand-in-hand with price exception policy, it optimizes baseline pricing in the field while improving the ability to forecast usage and make quick corrections. Sales feedback is essential for adoption of these analytical approaches and ensuring that pricing managers have the most accurate real-time information available.
Revenue Optimization Framework. Having developed both a competitive position metric and a sales feedback process, the next step is to build demand elasticity curves that correlate local market share with RCP. A full understanding of demand elasticity allows the pricing manager to execute tailored strategies for different markets, products and borrowing purposes. Margins on portfolio and securitized originations can be optimized without putting volume requirements at risk, or vice versa.
Putting Concepts to Work
The accepted wisdom about mortgage pricing is that rates are inevitably controlled by two forces — capital markets and internal profit calculations — with a clumsy demand-side safety valve in the form of price concessions at the point of sale. But given the outlook for a stagnant market, it is self-defeating to omit possibilities based on a systematic study of competitive pricing position and price elasticity of customer demand.
In putting these concepts to work, often the best approach is to begin with test-and-learn programs — a series of controlled experiments that allow the bank to validate assumptions in the models and refine the data requirements. Pilot programs also allow pricing managers and loan officers to get more comfortable with this revenue optimization framework prior to full rollout.
A few first movers have already set a course to improve annual revenues in select aspects of mortgage origination, for example, within certain risk tiers and priority metropolitan markets. Far more of this progress will be needed across the industry as banks gear up for the coming battle for profitable market share in mortgage origination.
Zach Wise is a Principal in the Charlotte, N.C. office and Andrew Frisbie is a Managing Director in the New York office of Novantas Inc. They can be reached at firstname.lastname@example.org and email@example.com.