Top 5 in '05

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The Top Five in 05
MBA Servicing ConferenceFebruary 21, 2005
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Speakers

• Tony Ebers IndyMac Bank
• Martin Touhey PricewaterhouseCoopers
• Matthew Cosman - PricewaterhouseCoopers

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The Top 5 in 05

• Cost and Capacity Management
• Cash Flow Management
• Maximizing Customer Value
• Operational Risk Management Sarbanes-Oxley 404
  Basel II
• Repurchase Risk Management

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Industry Conditions Where Have We Come From?

• Interest rates dropped to historical lows before
  increasing to levels that remain below historical
  averages
• Unprecedented refinance volumes came to an end
• Refinance market that favored TPOs and
  originators gave way to a greater focus on
  servicing portfolios
• Operational risk became a greater compliance risk
  with the introduction of Sarbanes-Oxley

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Industry Conditions The Present

• Servicing will be the major driver of revenues
  float, ancillary income, cross-sell, etc.
• Relatively stable servicing portfolios given most
  customers have refinanced at low interest rates
• Interest rates relatively stable although
  continued upward bias
• Focus on purchase market
• Focus on cost management

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Industry Conditions The Present

• Development of new products ARMs, Treasury
  Index, Interest-Only Loans, introducing
  additional servicing complexities
• Increased focus on home equity and sub-prime
  markets
• Customers will use home equity products in order
  to avoid losing low interest rates on first
  mortgages
• Sub-prime customers fully leveraged
• Highly leveraged customers and properties require
  robust portfolio management in order to monitor
  risk
• Local housing bubbles and over concentration
• Monitoring of CLTV and FICO scores

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• Cost and Capacity Management

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Effective Cost and Capacity Management

• Why is it important?
• Servicing is a low margin business
• Excess or over capacity can adversely impact
  profitability and customer retention
• Some servicing initiatives that focus on cost
  improvement and/or customer service could in fact
  be damaging the cash flow economics to the
  business
• Ability to understand cost components fixed vs.
  variable, and marginal costs is required in order
  to make sound strategic decisions

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Strategies to Manage Capacity

• What is your capacity?
• Cost of excess capacity
• Impact of over capacity
• Outsourcing / Insourcing
• When does it make sense?
• Non-core process typically back-office
  functions
• Non-preferred customers
• Strategies to mitigate risk
• Rigorous vendor management process and controls
• 404 compliance issues
• Sub-servicing
• When is it advantageous to outsource servicing

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Economics of Sub-Servicing

• Failure to understand the true economics can
  adversely impact the business

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Strategies to Manage Capacity

• Consider combining HE and first mortgage
  servicing
• Cost and service advantages to doing so
• Have a capacity plan in place
• Linked to a robust forecast model
• Segmentation of portfolio is critical varying
  service levels

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Managing Costs Effectively

• Avoid blanket cost reductions slash and burn
  is detrimental in the long run
• Understand your cost drivers imperative to
  making correct decisions
• Identify value added vs. non-value added
  activities and target the high cost / low value
  activities for reengineering
• Understand channel costs and correctly align
  customers with appropriate channels (requires
  segmentation)

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Opportunity Matrix - Cost vs. Value-Added
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Managing Costs Effectively

• Measure and understand the costs of excess
  capacity and allocate appropriately
• Recognize the difference between cost development
  and cost transfer
• Understand the difference between fixed and
  variable cost components to determine the true
  savings of any planned initiatives
• Understand and measure marginal costs

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• Cash Flow Management

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Cash Flow Management Performance Measurement

• Historic Industry Practices
• Business line priorities are often not aligned
  with maximizing cash flows
• Capital Markets functions that value the MSR
  asset are run distinctly from the Servicing
  operations that generate the cash flows intrinsic
  in those asset values
• Customer related initiatives often do not include
  a genuine understanding of the real cash value to
  the servicer (e.g., payment campaigns such as
  bi-saver) but are instead focused on marginal
  cost reductions and customer service values that
  are not quantified
• Little understanding of actual cash flow
  performance

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Cash Flow Management Performance Measurement

• THE SERVICERS WHO WILL PERFORM THE BEST IN THE
  COMING YEARS ARE THOSE WHO CAN RECOGNIZE WHEN A
  COST MANAGEMENT INITIATIVE WILL BE A DETRIMENT TO
  OPERATIONAL CASH FLOWS, THIS REQUIRES
• Detailed understanding of costs
• Detailed understanding of operational cash flows
  such as float, corporate advances, fee income,
  etc.
• Performance measures that are balanced between
  cost management and revenue maximization

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Cash Flow Management Effective Performance
Measurement

• Building the Right Framework
• Track actual cash flows at a loan level
• Align servicing performance measures with actual
  cash flow performance of the MSR asset
• Vendor performance measurement includes cash flow
  targets and significant controls over cash flow
  component
• Actual cash flow performance data linked to
  pricing models
• Actual cash flow data linked to TPO scorecards

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Cash Flow Management Effective Performance
Measurement

• A detailed knowledge of the cash economics of
  mortgage servicing is imperative to performing
  effective process improvement analysis
• Real dollar operational benefits arise as a
  result of measuring actual cash flows against
  projected and investigating variances and making
  operational changes
• Not only will it help deliver value to the
  company, it will also help meet investor, state,
  federal and other requirements for servicing
  customer mortgages
• Excessive focus on cost ignores the fact that
  float revenues often far outstrip costs to service

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Improving Cash Flows Best Practices

• Escrow
• PI Float
• Payoffs and Lien Releases
• Interest Lost on Payoffs
• Ancillary Income
• Service Fees
• Corporate Advances
• Cost to Service

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• Maximizing Customer Value

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Customer Value Industry Conditions

• Industry Conditions
• General move from looking at the business as a
  transaction / loan based business to more of a
  customer based business
• Servicing portfolios are more stable presenting
  greater cross sell opportunities
• Many servicers have implemented streamline
  refinance products to reduce expensive
  acquisition costs
• Home equity loans are a key area of focus
• Increased focus on up-front data capture to
  support retention and marketing efforts

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Customer Value Lifecycle Approach

• It is important to understand the needs of your
  many different customers What are the
  attributes of your most profitable customers?

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Understanding Customer Value

• The Spectrum

• Transaction / Loan view
• Minimal customer level data
• Inability to track multiple products
• Little understanding of profitability

• Customer level view
• Customer data collected but not integrated across
  all platforms
• Ability to track multiple products
• Basic understanding of customer profitability
• Customer retention programs in place

• Customer centric view
• Customer data collected and integrated across all
  platforms
• Complete customer / product level view
• Detailed understanding of customer profitability
• Segment / customer level service and pricing

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Benefits of Understanding Customer Value

• The goal of understanding customer value is to
  measure the total profitability of your
  relationship with customers across all products
  as well as customers loan level profitability.
  This will help you determine campaigns, pricing
  incentives, refinance channel direction, and loan
  servicing fee waivers.
• Benefits
• Reduced hedging costs on CRM campaigns
• Marketing campaigns to profile of profitable
  customers
• Modification vs. Refinance offers based on
  profitability
• Fair and consistent fee waiver policy
• Pricing incentives based on total profitability
• Provides customer benefit for an increased number
  of relationships

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Strategies to Harvesting Customer Value

• Have a market strategy
• Which part of the pie do you want to eat?
• If not defined you will be left with bottom of
  the barrel
• Understand your customer base
• Requires ability to segment your portfolio
• Assess customer / segment level profitability
• Develop your customer strategies
• Targeted retention campaigns
• Targeted offers for home equity, deposits, credit
  cards, etc.
• Service levels channel and customer based

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Strategies to Harvesting Customer Value

• Use customer level data to drive cash flow
  results
• ACH Targeting Do not convert a customer who
  consistently pays on business day 2 to ACH on
  business day 7
• MLS listings for proactive retention
• Recognize unprofitable customers
• Target for channel migration
• Sell segments viewed as non-profitable or not
  fitting with companys overall strategy

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• Operational Risk Management Sarbanes-Oxley 404
  Basel II

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Operational Risk Management Sarbanes-Oxley 404
and Basel II What Are They?

• Sarbanes-Oxley 404 requires management of a
  Corporation to state that it is their
  responsibility for establishing and maintaining
  an adequate internal control structure and
  procedures for financial reporting. Management
  must also document assertions for what procedures
  have been followed and the effectiveness of
  these procedures in ensuring accurate financial
  reporting as well as compliance with certain FDIC
  laws and regulations.
• Basel II establishes new standards by which
  regulatory capital requirements will be
  determined and spans credit, market and
  operational risk. In addition, Basel II
  introduces new supervisory procedures and the
  effective use of disclosure. Management must
  understand that Basel II focuses primarily on
  risk as opposed to return.

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Operational Risk Management Sarbanes-Oxley 404
and Basel II Does It Impact You?

• For many organizations the value of servicing is
  a material asset to the company
• As servicing managers you are responsible for
• Protecting the value of the servicing asset
  through escrow reviews, default management, etc.
• Collecting millions or billions of dollars in
  payments and processing them timely and
  accurately
• Disbursing millions or billions of dollars to
  investors in a timely and accurate manner
• Mitigating and managing losses as a result of
  repurchase or default
• Managing large cash flow streams related to
  float, fees, advance costs

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Operational Risk Management Sarbanes-Oxley 404
and Basel II Compliance

• Key Risks and Potential Impact
• Financial losses
• Regulator sanctions
• Legal exposure
• Investor sanctions
• Fraud losses
• Repurchases

• Key Servicing Areas Affected
• Default
• Investor Reporting
• Investor Accounting
• Cash Management
• Loss Mitigation and Collections

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Operational Risk Management Sarbanes-Oxley 404
and Basel II Compliance

• The need to work with various constituents to
  accommodate all internal 404 and Basel II
  programs
• Work done upfront to identify all significant
  risks and controls can lead to stronger controls
  and a better understanding of processes which can
  translate to redesign to effect more efficient
  processes
• Policies and procedures will be up-to-date and
  will pass regulatory and audit standards
• Establish performance benchmarks to measure all
  areas of the company (e.g., 404 and Basel II
  compliance)
• It is important to implement strong controls to
  mitigate fraud risks

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• Repurchase Risk Management

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Repurchase Risk Management Reducing Repurchase
Levels

• Strong Front-End Controls - (Get it right upfront
  and avoid the headaches this is the greatest
  potential for savings)
• Rigorous due diligence of third party originators
  (TPOs)
• Broker and correspondent performance scorecards
  that are monitored
• Strong system controls in place
• Imaging system in place to store critical loan
  documents
• Action on root cause analysis

REPURCHASE CONTINUUM
Pre - Origination
Post-Origination Repurchase Request
Loan Repurchased
FRONT END CONTROLS Moderate Cost / High Savings
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Repurchase Best Practices

• Not always going to get it right so, if wrong,
  how can you mitigate your losses?
• Approval
• Approval levels for all repurchases and
  indemnifications
• System edits block approval amounts greater than
  staff threshold
• Repurchase Committee performs monitoring of
  repurchase levels assumptions, policies, and
  collections

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Repurchase Best Practices

• Centralized Database
• Reduces reliance on Excel and Access databases
• Interface directly to other systems (i.e.,
  Servicing, Accounting)
• Tracks investor requests and correspondence with
  brokers and MI companies to ensure that requests
  are processed on time

REPURCHASE CONTINUUM
Pre - Origination
Post-Origination Repurchase Request
Loan Repurchased
MITIGATING CONTROLS Moderate Cost / Moderate
Savings
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Repurchase Best Practices

• Recourse
• Track loans with recourse within the servicing
  system
• Monitor the accuracy and completeness of recourse
  flags
• Due diligence of all originated and purchased
  loans

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Repurchase Best Practices

• Repurchase Reserves
• Reserve assumptions for loss frequency rates
  reflect recent historical experience
• Management assumptions for loss amounts are
  independently reviewed
• Accounting reserve analysis should include
  pending repurchases, make-wholes,
  indemnifications and feedback loans

REPURCHASE CONTINUUM
Pre - Origination
Post-Origination Repurchase Request
Loan Repurchased
MITIGATING CONTROLS Moderate Cost / Moderate
Savings
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Repurchase Best Practices

• Ensure that proper steps are taken after the loan
  is repurchased to reduce costs and future
  occurrences
• Cure the loan and resell into the secondary
  market
• Validate that collections are made in full for
  all loans with recourse
• Implement quality control function to determine
  biggest areas of improvement

REPURCHASE CONTINUUM
Pre - Origination
Post-Origination Repurchase Request
Loan Repurchased
BACK END CONTROLS High Cost / Minimal Savings
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Repurchase Best Practices Management Reporting

• Key metrics can include
• Collection rates
• Aging analysis (files, advances)
• of successful appeals
• Overall loss amounts
• Delinquency analysis of indemnification and
  feedback loans
• Repurchase and make-whole losses by year of
  origination and reason for repurchase
• Actual vs. modeled assumption analysis

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• Summary and Conclusions

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Can you answer the following?

• What are your target markets and customer groups?
• What is the actual cash flow performance of your
  portfolio?
• What effective controls are in place to manage
  repurchase risk?
• How do you manage your capacity? What is the
  cost of your excess capacity?
• What are your cost drivers and how can you
  influence them?
• Can you measure your fixed vs. variable costs?
• Can you measure customer profitability? How do
  you use this information in your service, pricing
  and targeting decisions?
• Do you measure vendors on cash flow performance
  as well as operational performance?
• What controls do you have in place to monitor
  vendors and / or sub-servicers?

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Summary and Conclusions

• There is a lot to do in 2005!
• Reduce costs the right way
• Increase actual cash flow understanding and
  reporting
• Re-evaluate customer relationships and
  profitability
• Comply with Sarbanes-Oxley and Basel II
• Implement front end controls to reduce repurchase
  levels in the future

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• Questions