SELLING HOMES ISN'T THE only way big builders have been churning out profits in recent years. Increasingly, they've developed their own mortgage operations, in one form or another, reaping additional profits from a mortgage market on fire with the lowest interest rates in decades.

Not this year, however. Or next year. Or perhaps for several years to come. Sales and revenues at many builder-owned mortgage companies are down sharply.

As the refinancing business plummets from outer orbits back into more traditional atmosphere, the mortgage industry is adjusting to abundant overcapacity. There's far more intense competition for far fewer loans. With long-term interest rates rising, many more homeowners now choose less-costly adjustable rate mortgages (ARMs) that are also less profitable for lenders. Few doubt there will be a shakeout in the industry. Although builders' mortgage operations are in better positions than many competitors, the next few years pose challenges.

Those challenges come at a time when more and more builders were coming to depend on their mortgage businesses for incremental cash flow. Builder-owned mortgage companies and their business cycles certainly aren't new. KB Home Mortgage of Los Angeles, perhaps the first of its kind, dates back to 1965. But the number of captive mortgage operations has grown quickly in the past several years, industry participants say.

Homebuilders Financial Network (HFN) of Miami Lakes, Fla., a company that creates and manages builder-owned mortgage companies, has seen its customer base grow from some 20 customers five years ago to 37 today, says its president, Thomas Meyer. When the business got started in 1993, “it was rare to find builders with in-house mortgage operations,” Meyer recalls. “Today, virtually every large production builder has some kind of mortgage operation, and the number has certainly accelerated in the past several years,” he adds.

That's not surprising. The mortgage business until recently has rarely been more lucrative. The past three years set volume records in the mortgage business overall. “It was raining loans. All you needed was a bucket and you could price accordingly,” says Joel Van Ryckeghen, president of Shea Financial Services in Aliso Viejo, Calif. The company expects to write about 4,500 loans for approximately $1.4 billion this year.

Average per-loan (gross) profits climbed from less than $1,900 in 2001 to some $2,550 last year for builder-owned mortgage companies, notes Christine Clifford, vice president of Wholesale Access in Columbia, Md., a mortgage research and consulting firm that conducts benchmarking studies for a number of builder-owned mortgage companies. Builders in the HFN network earn, “about $2,500 per loan pretax profit after all expenses,” says Meyer.

But that's over now. After jumping by more than 50 percent to $3.9 trillion last year, total mortgage originations in 2004 are now forecast to drop by $1.4 trillion. “The phenomena you get is too many lenders chasing too few deals,” Van Ryckeghen says.

Naturally, that has depressed margins. “Last year, most people were so swamped that to control the amount of business they were marking the price up a lot,” Clifford explains. “In the first half of this year, all that margin has disappeared.” Van Ryckeghen concurs: “The price competition today is much tougher than even six months ago,” he says.

Arm Twisting Competitive pricing is not the only factor. Added pressure comes from the sharply increased number of borrowers opting for lower-margin ARMs. “Just in the past six months we've seen a stampede to ARMs,” Van Ryckeghen says. “Our percentage last year was in the 30 [percent] to 35 percent range. Now it is in the 60 percent range.” The same was true for many public builders. For Beazer, ARMs doubled year-over-year in the second quarter, for example, and tripled at MDC Holdings for the same period, according to company quarterly reports.

Builder capture rates also have tumbled as the absence of last year's massive refinancing rush has resulted in more lenders turning their attention to new home buyers. KB, M/I Homes, Standard Pacific, and other public builders reported lower capture rates for the second quarter. Private builders have seen similar declines. At John Laing Homes, for example, where mortgages are written through joint ventures with Countrywide and Wells Fargo, the capture rate is currently in the “mid-to-high 50 percent range,” according to Wayne Stelmar, CFO. The target is about 70 percent, he adds.

Altered mortgage market conditions show up on the balance sheets of many publicly owned builders. For the quarter ending in June, for example, at least 10 public builders reported year-over-year revenue declines in their mortgage or broader financial services operations.

Yet some smaller builders serving fewer markets say their rates remain high and unchanged. Reed Porter, president of Trend Homes in Phoenix, says his firm's 90 percent capture rate is unchanged from a year ago. The company will write about 900 loans this year through a company created by HFN. At Somerset Homes in Bell Alton, Md., president Allen West says the capture rate remains at 98 percent on some 200 projected closings for the year. Somerset financing is handled by a joint venture with Charter One Mortgage.

Renewed Commitment Despite a more competitive, less profitable climate—and perhaps because of it—many builders are putting more effort and resources into their mortgage operations. Although profits are important, more important are the tighter business control and improved customer service a dedicated mortgage operation can provide, they say.

“I think the top reasons to have your own mortgage company are backlog management and control over the customer experience,” says Clifford. She stresses, as do many builders, that “dedicated' mortgage personnel almost certainly can provide better service to both builders and customers than can an outside lender.

The benefits are readily apparent for large builders. Shea gets “control and predictability,” says Van Ryckeghen. “If this company didn't exist, our divisions could be dealing with 20 or 30 or 40 lenders. We take that burden from them,” he adds.

Smaller builders benefit as well. “When 70 [percent] to 80 percent of a builder's closings are being handled by one mortgage company, it dramatically reduces the logistics of the closing process,” says Bill Orosz, president of Cambridge Homes USA in Altamonte Springs, Fla.

Builders also find that many more closings take place as scheduled. West says he saw on-time closings jump from 65 percent to 95 percent when he formed a mortgage joint venture three years ago. “The dates are more predictable, more on time, [and there's] less hassle,” he says. Porter says all closings handled by his mortgage company take place on time versus—depending on the lender—“as many as 50 percent that don't. They may be late by only a day or two, or it can be as much as a month,” he adds.

Improved customer service and satisfaction are at the heart of what's motivating most builders to maintain their mortgage businesses, even if profit margins might normally dictate otherwise. “The No. 1 goal is that we have to provide a profoundly positive experience to our home buyers. That's what we are all about,” says Richard Powers, president of KB Home Mortgage. “To the degree that we can complement that home buyer's positive experience getting the home loan, we can help drive higher scores there,” he adds.

“Managed correctly, the mortgage company can significantly reduce the stress of the customer through one of the more difficult processes in the home buying experience,” says Orosz. “It also lends great professionalism to our organization when the entire transaction occurs flawlessly.”

But the mortgage business isn't easy. Interest rates change constantly.

Economies of scale are critical to holding down the cost of processing the necessary documents, an area in which few can compete with the industry's giants. (Through June, the top five mortgage lenders held 46 percent of the market, the top 25 held 81 percent, according to John Bancroft, managing editor of Inside Mortgage Finance.) New products and consumer preferences evolve and change quickly. You have to know the secondary market or assume huge risks.

“We're in a totally different environment than we were 10 years ago,” says Jack L. Haynes, executive vice president of the National Builder division of Countrywide Mortgage. There is a dizzying array of new products and new types of products: hybrid ARMs, fixed-period ARMs, interest-only products. “These aren't as simple to work with as the fixed-rate product, and the expertise of the loan originator or loan officer has to be greater,” he says. There are also technology issues making the mortgage market a tougher place to operate in, Haynes adds.

Although some of the largest builders have the resources and loan volume to justify going it alone, the preferred choice for many is the joint venture. Joining with a knowledgeable partner enables them to sidestep some of the challenges. HFN, with its so-called “mortgage in a box” approach, plays up not only its turnkey back-office infrastructure for builders' mortgage businesses, but also its ongoing management expertise in the mortgage marketplace. Mortgage lending giants such as Countrywide and Wells Fargo, meanwhile, offer joint ventures as one of several ways in which they work with home builders.

Integrated Systems No matter what the form, builders agree that integration with home building operations is essential for making the venture successful. With home prices escalating, homeownership becoming more challenging for first-time buyers, and creative mortgage products enabling lenders to, “reach deeper into the credit spectrum,” according to Van Ryckeghen, it's more important than ever to make the components work well together.

Builders such as Shea and KB are physically moving mortgage company personnel to their home building operations to enhance integration. “We are fully decentralized in our branches so that our branch system has sales, loan officers, processors, underwriters, and closers, and many times they are in the same building,” Van Ryckeghen says. By year's end, KB will have loan personnel in all divisions, Powers says. “By having our folks in local sales management, they become essentially an integral part of the home building team in each of the divisions.”

KB is also investing in technology to enhance integration, striving to mesh the components of mortgage origination, processing, and closing and make it easier for both the people and the computers to communicate. KB is currently upgrading an aging integrated “legacy” system. One benefit will be to improve customer service and enhance the predictability and control builders want. “It will push our ability to approve the loan even earlier in the process,” Powers explains, so that for a “significant subset of our borrowers,” the company will be able to approve financing when they sign the sales contract.

Shea Mortgage is also in the midst of upgrading its mortgage technology. Separate systems currently handle origination, underwriting, closing documents, and accounting. “Our challenge is either to get all those systems to talk to one another and eliminate multiple input, or replace them with one system that works end to end,” Van Ryckeghen explains.

Side By Side John Laing Homes tries to integrate thoroughly on many levels. Loan officers and sales personnel are side by side in its sales offices, explains Wayne Stelmar, CFO, and both groups receive the same training. Additionally, “the collateral material we use for the joint venture looks identical to the material we use with John Laing Homes. The mortgage company is integrated with the John Laing Web site. It has to appear seamless to the buyer, and we want the experience to be seamless,” he adds.

Good integration relies on “consistent communication” throughout the process, both internally and with the customer, Orosz asserts. “We work very hard to make sure the customer ‘handoffs' from one discipline to the next are well scripted [in order] to set the proper expectations throughout the process,” he adds.

“It's important that everyone sing from the same songbook,” Orosz says. “Our mortgage company personnel meet on a weekly basis with our sales associates to make sure everyone is current on programs offered and current rate sheets.” At Trend Homes, everyone works from the same Microsoft Excel spreadsheet showing the status of all the homes under construction. “Every week the mortgage company gets an update so they are continually appraised,” Porter explains.

The challenges are formidable. And they aren't likely to lessen anytime soon. There's a general agreement that a mortgage industry shakeout is on the way, precipitated in part by a rush of players into the market during the recent golden years and by longer-term industry consolidation. The industry has to work through its current overcapacity, Clifford says. Margins can virtually disappear as foundering companies try to save themselves. Builder-owned mortgage companies are bound to be affected, but less so than others.

“Because we have essentially one client, we are pretty well-insulated,” explains Powers. “It does mean that the competition for our financing will be more and more confined to just a few names as the industry consolidates,” he adds.

The greatest challenges, however, likely remain with the builder, where smart management can have an impact.

“We have to make sure that our sales-people are educated about the products and capabilities of the mortgage company in servicing our home buyers,” Van Ryckeghen says. “And that we continue to provide a customer experience that is as good as or better than those [mortgage companies] that are huge and that are spending big dollars on it.”

Learn more about markets featured in this article: Los Angeles, CA.