Forget Economies of Scale, Dominate Your Market (1995)

Has mortgage lending operation failed because it couldn't we adequate economies of scale? For that matter, how many have succeeded solely because they could? Economies of scale is a principle relating to the cost of manufacturing goods and services. In theory, a firm can lower unit costs by making more of what it makes with the same facilities. For mortgage lending this means some large-volume levels may exist where lenders can produce the lowest cost loans and loan servicers can perform the lowest-cost loan servicing. Firms with these optimal scale advantages should be able to create sustainable advantages. Ask any five mortgage bankers to identify the volumes at which optimal economies of scale are achieved. A spirited discussion will follow--but no firm answers. Economies of scale have always been the much talked about, but incredibly elusive, Holy Grail of the industry. Let's look at the record. Mortgage operations flop because they: * Overpay for servicing and then experience dramatic runoff. * Can't reduce their cost structure quickly enough in response to plummeting volumes. * Don't hedge their pipelines against rate changes. * Experience excessive loan defaults and run out of cash. * Rely on only one type of customer-- for example, the refinance customer when rates move away from that market. Lots of ways to fail--but none involve economies of scale. So can the principle really matter so much? Bad design for the task By and large, the real estate finance industry is not designed to exploit economies of scale. Mortgage lending is a fragmented business made up of thousands of competitors. One-person mortgage brokerage firms compete with national giants, and everything in between. In 1995, they will be fighting over 5,332,000 customers--that's the number of new 1-4 family mortgages the Mortgage Bankers Association estimates will originate in the U.S. In 1994, according to National Mortgage News, the largest mortgage originator, Countrywide Funding Corp., held only a 4.1% market share, based upon an estimated $774 billion market. The newspaper reported that the top four companies held only a 12.7% market share and the top 20 companies a 29.9% market share. Mortgage servicing was slightly more consolidated. Now consider a local market--Massachusetts. Total mortgage originations, as compiled by Banker & Tradesman, illustrate an increasingly fragmented industry. The top 25 lenders in the state lost ground in 1994, dropping to a 33.7% market share, from 37%. Meanwhile the number of active lenders grew from more than 318, in 1993, to more than 354, in 1994. Lending is still a local activity for thousands of banks, mortgage brokers, and credit unions. These firms don't focus on economies of scale for success in other lines--why should they consider it critical in mortgage lending? I contend that only the giants of the industry--less than one-third of one percent of all mortgage lenders--should even consider economies of scale in their strategic thinking. And even they should be concerned about the answer to a critical question: How do you know when you have arrived? What works? Dominance If the economies of scale concept is not a meaningful factor for over 99.7% of mortgage lenders, who are niche lenders, and is only one of many important factors for the largest lenders, what will produce success ? Regardless of size, successful lenders exhibit one common trait--dominance. Here is how to achieve it: 1. Catering to the consumer--Mortgage borrowers require seven things: speed, affordability, simplicity, security, reliability, convenience, and competitive pricing. The mortgage loan, for consumers, represents one of three things: owning a home (purchase-money); building assets (investor); and freeing up money for other purposes (refinance). Successful niche and national lenders focus on meeting a combination of these core consumer needs with their products. …