Found this old speech from the 2001 Forrester Forum. Interesting to contrast, and see how far the industry has come, yet still the big banks have a long way to go.
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Let me thank Forrester Research for helping investors to understand the New Economy and the fact that a company can be a winner even if it happens to make money.
I appreciate the opportunity to show how a Fortune 50 financial services company like Fannie Mae can harness the technology of the New Economy to be a leader in what we call the Permanent Economy. In fact, let me report today that Internet Week magazine has just named Fannie Mae their “E-Business of the Year in Financial Services.” As the magazine said, “Fannie Mae has almost overnight become one of the nation’s premier e-businesses.” If you’re wondering how a 63-year-old company in the secondary mortgage market became an E-Business success, we did it by embracing two key trends.
First we fully embraced what Forrester calls “open finance.” As Forrester has pointed out, the trend in financial services is that large-scale, strongly branded firms will collect and offer their consumers the best financial products available anywhere in the market — the best credit card, the best insurance, the best mutual fund, the best mortgage. Not just the in-house brand, but the best product available. And the winners in this trend will be financial companies that specialize either in making the products, or distributing them. They won’t try to do it all.
Fannie Mae specializes in making products. We offer the best, lowest-cost, consumer-friendly mortgages. We also offer the most investor-friendly investment products, which we sell to fund those mortgages. And rather than try to provide these products to consumers and investors ourselves, we team up with aggregators or distributors that want to offer our products — both new entrants, and traditional partners.
So open finance plays to our strength.
The second trend we fully embraced is e-commerce. Over the past year, we’ve nearly doubled our Internet business volumes, going from $450 billion to over $800 billion. And we’ve seized on technology to lower our costs, treat our customers uniquely and create customized mortgage products for consumers.
Let me describe how we’ve taken advantage of these two trends.
A year ago, we set out a new model for how e-commerce is transforming the mortgage industry into a vastly simplified value chain with distinct, specialized segments.
At one end of this value chain is consumer aggregation — what some call “collecting eyeballs” or “creating brands” — where mortgages are originated with home buyers.
We’ve seen an explosion of mortgage originators, first because the mortgage market is strong, but also because the cost of entering the business is quite low. And because the underwriting is embedded in the technology, it’s a relatively easier business to get into. You no longer need to be an expert.
Next on the value chain is the fulfillment function, where mortgages are processed and serviced. Here, we’re seeing a consolidation of the business into a few large entities, because success in this business depends on high volumes and low cost, which raises the bar to entry. E-commerce is accelerating this trend by allowing the best and biggest players to become even better and more efficient.
Finally, you have the product segment, which is where Fannie Mae does business. Again, we create mortgage products that consumers want. We fund those mortgages by creating investment products that investors want. And then we manage the credit and interest-rate risk on the mortgages.
How we do this is fairly straightforward.
First we have a credit guaranty business. Mortgage lenders originate and close loans with consumers. Lenders take those loans and swap them with us for a mortgage-backed security, and we guarantee the timely payment of principle and interest. The lender then holds the mortgage-backed security, or sells it to investors.
We also have a portfolio business. When Fannie Mae sells our debt securities to investors, we use the proceeds to purchase mortgages and mortgage-backed securities. We hold these assets in portfolio, and then manage the interest-rate risk of our portfolio by matching and re-balancing the duration of our assets and liabilities.
As you see, our business model is mono-line — we focus on creating and managing one product – U.S. residential mortgages. Having a mono-line business is a great advantage in the New Economy – it helps to focus our e-commerce strategy and technology investments on doing our one business better.
Technology Keeps Our Costs Low
We start with a very low-cost business model. Unlike the large banks, for example, we don’t have all the costs of running multiple lines of business. All we do is mortgages, we do them in greater volumes than anyone else does, and that gives us great economies of scale.
We spend only 11 percent of revenues on operations compared to 50-60 percent for large banks.
Our low costs help to explain why a Fannie Mae mortgage is anywhere from $22,000 to $200,000 cheaper than a similar jumbo or subprime mortgage over the loan term.
It is Fannie Mae’s job to lower the cost of homeownership, and technology allows us to bring our affordable mortgages to more home buyers, and expand our market share, without expanding our costs.
For example, one of our largest costs is associated with risk sharing. Bear in mind, we don’t simply take mortgage risk. We manage mortgage risk by sharing it with others in the market. Credit risk we share mostly with mortgage insurance companies. And we share interest-rate risk with investors who purchase our callable debt securities, or with our derivative counterparties.
That’s why, of the $42 billion of revenue on our mortgages available for managing mortgage risk last year, $1.8 billion went to mortgage insurers and others to share the credit risk and $33.8 billion went to investors to fund the loans and share the interest-rate risk.
Technology is a powerful tool to reduce these risk management costs.
With our Desktop Underwriter® system, we can apply our massive loan performance data to assess the credit risk on each loan precisely, control our credit risk exposure, and lower our credit losses. And because we can assess our credit risk precisely, we can make sure we don’t over-insure or under-insure.
Our loss mitigation technology also helps. Lenders can use our Risk ProfilerSM system to analyze the loans we guarantee, identify borrowers who may be at risk of default, and then we help them stay in their homes. As a result, we now do more workouts than foreclosures, where in the past, three out of four troubled loans foreclosed.
Altogether, Desktop Underwriter and related applications help to lower both our risk-sharing costs and the cost of credit losses. The results are unparalleled. Since 1997, our book of business has grown about 75 percent, from $800 billion to $1.4 trillion. But our credit loss rate has declined from about 4 basis points to under 1 basis point.
That’s not just because the economy was strong. During the same period, bank credit losses on the same kind of mortgages we guarantee increased from about 10 basis points to about 12 basis points.
Our credit risk exposure is so low that our revenue-to-credit losses in the last two quarters of 2000 was about 100:1. So even if credit losses were to increase and we expect they will those losses will have little impact on our earnings growth.
Another way technology lowers our costs is by allowing us to increase our business volumes efficiently.
During the refinancing boom in 1993, for instance, we had over 500 employees in mortgage operations to process the flow of business. In today’s boom, we’re processing even more volume with only 300 people.
And this spring, in the middle of the refinance boom, Desktop Underwriter hit a new milestone for volumes — 100,000 mortgage applications came through in a single day, which was over twice the average daily flow last year. We doubled our business volume through Desktop Underwriter in six weeks, without adding a single new employee.
Finally, with our Desktop Underwriter system on the Internet, we can distribute our mortgage products much more efficiently. With Desktop Underwriter we can roll out our new products to hundreds of customers and thousands of underwriters in a matter of weeks.
Technology also helps to lower costs in our portfolio business.
Over the past two years, we’ve begun to issue our debt securities through the Internet, including our weekly $8-$9 billion Benchmark Bill auctions, and even our Investment Notes for retail investors. Using the Internet allows us to streamline our processes and interact with our dealers and investors more efficiently, and sell larger volumes at lower transaction costs.
Altogether, technology has made our business of guaranteeing, funding and managing the risk on mortgages much more efficient. But in some ways, the efficiency of our customers is more important. Without mortgage lenders doing a healthy business and sending us their loans, we would have no business at all.
So we have a vested interest in helping mortgage lenders to expand their business, cut costs and serve consumers better. There is no question that automated underwriting technology has revolutionized the mortgage process, or that it cuts costs for lenders, even if the actual savings are difficult to quantify precisely.
We’re happy that Fannie Mae’s underwriting technology leads the market, with nearly 1,300 lenders and 12,000 brokers using Desktop Originator® and Desktop Underwriter every day. But these systems are just part of how we’re using technology to help lenders thrive in a competitive market. Because:
Technology Helps Us Treat Customers Uniquely
As the mortgage industry has moved into the Internet Age, Fannie Mae has transformed the whole concept of our customer service into an effort we call “E-Solutions.” We now custom-tailor our Internet-based products and services to lenders’ individual needs, whether they are large, small or in between.
And they’re all different. For instance, large lenders have less need for Desktop Underwriter because many have their own underwriting systems. What they want are other mortgage services — streamlined appraisals, for instance — or new ways of reaching consumers.
So for example, we’ve helped to link Cendant Mortgage and Homeside Lending with new distribution channels — new “eyeball catchers” — such as BET.com, the Internet arm of Black Entertainment Television, so these lenders could tap the growth market for minority home buyers.
Mid-sized lenders want help to increase efficiency, cut costs, offer more loan products and improve their service. Mike Williams, the president of our e-business unit, talks about how we linked up with Ohio Savings Bank to package mortgage products and technology services. As a result, the bank increased its volumes by 16 percent — or $154 million — even while the rest of the market was shrinking last year.
But where technology can really make a difference is when it comes to smaller financial institutions such as community banks, credit unions, thrifts and others that have modest assets and simpler business models.
Most are too small to have a mortgage operation of any kind. If they make home loans, they have to lend from deposits, hold the loan and assume most of the risk. Thus, they tend not to offer long-term, fixed-rate mortgages — mostly short-term adjustable-rate, or home equity. When they do offer long-term loans they require a very high down payment.
E-commerce is changing all of that.
For example, Nevada Bank and Trust serves 11 small, rural towns several hours north of Las Vegas. Until recently, if a customer wanted to borrow $100,000 in a standard long-term fixed-rate mortgage, she had to provide at least $30,000 in cash. And the loan approval took a little while, because the bank filled out the mortgage application by hand and mailed it to New Jersey for approval. Like many small banks, it didn’t have much of a mortgage business.
To solve their problem, we created a customized technology package that hooked them up with Cendant Mortgage through the Internet, and now Nevada Bank and Trust can offer the same full plate of Fannie Mae low-cost, consumer-friendly mortgages as the largest metropolitan banks in America. And we fund the loans and manage the risk, so they can focus on making more of them.
Finally,
Technology Helps Us Create Customized Products for Consumers
I mentioned earlier how Fannie Mae specializes in providing the best-in-breed mortgage products in the marketplace — the lowest-cost, the most consumer-friendly. But now we’re using e-commerce to transform the whole concept of mortgages.
People talk about mortgages as commodities. But let me tell you a story.
If you’re a gardener, especially in the Midwest, you might know about a product called Milorganite. It is a leading organic fertilizer, the final byproduct after the Milwaukee sewer system has processed sewage.
Milorganite is thought to have special properties because of all the waste products from the breweries in Milwaukee. However, all but one of the large breweries in Milwaukee are closed. Nevertheless, Milorganite is still considered special.
If you can create a brand name for the waste product of sewage systems, nothing has to be a commodity. Not even mortgages.
Indeed, our strategy is to transform mortgages from commodities into customized products that meet the specialized needs of home buyers. And we are not talking about mere branding, we mean creating real differentiation that consumers value.
We’re already on the way. Right now, about 20 percent of the mortgages in our guaranty business have customized features.
These include Alt-A mortgages, where borrowers with good credit can avoid a lot of the normal paperwork and hassles of getting a mortgage.
We also have a new “Interest First” mortgage, where the borrower pays only the interest for the first 15 years and the loan amortizes over the remaining 15 years. This lowers the monthly payment in the early years, and has tax benefits.
Another example is our Timely Payment Rewards MortgageSM, which allows borrowers with slightly impaired credit to get a much better deal than with a subprime loan. If they make their payments on time for 24 months, their rate drops automatically because they’ll have demonstrated that they are a better credit risk.
We’re just scratching the surface.
The teacher who gets paid nine months a year could make payments just during those nine months.
If a borrower is going to retire in 17½ years, he could get a 17½-year mortgage and make the last payment with his last paycheck.
If a home buyer says, “I don’t know whether interest rates are going up or going down,” a lender can say, “Fine, have half your mortgage be fixed-rate and have half your mortgage be adjustable-rate. Have your own internal hedge.”
Now these are complicated mortgages to underwrite. But thanks to Desktop Underwriter, we don’t have to train thousands of mortgage lenders in how to underwrite each new product. It’s built into the technology. And these are hard loans to service. So we are investing in a mass customization infrastructure.
Conclusion
We believe that Forrester is right — we are heading toward a world of open finance. There will be specialists in brand and distribution, and specialists in products. Fannie Mae is the low-cost specialist in mortgage products. And e-commerce lowers our costs even further and enables us to do more business.
But the real test of any e-commerce strategy is what happens on the bottom line. For a while, the business strategy of some of these dot-coms sounded like the plot line from the Broadway musical The Producers – no matter how hard they tried to fail, they still attracted investors. Those days couldn’t last very long.
Fannie Mae’s experience demonstrates how an Old Economy company can apply New Economy strategies to be a winner in the Permanent Economy. We have delivered 14 consecutive years, 53 straight quarters, of double-digit growth in operating earnings, something only four other companies in the S&P 500 have done. And in 1999 Fannie Mae set as a stretch goal that in five year’s time, we would double our earnings per share. We are well on our way.
We’ve all had high hopes for e-commerce technology. In my view, technology can be used to expand access to the American Dream of homeownership; it will make life better for families, for communities, for the economy and for the nation as a whole; and that is what Fannie Mae is all about.
Thank you.
©1998-2006 Fannie Mae
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