Sink or Swim

Home builders are in a perfect position to offer home buyers a mortgage, and most of the top builders do just that. Whether through a solely owned subsidiary or a joint venture, builders value and home buyers appreciate one-stop shopping. But should builders really be in the captive mortgage business? Some, such as KB Home of Los Angeles, have gotten out. There are pros and cons to both sides of the business, experts say.

Homebuilders Financial Network, the home-building industry's leading mortgage banking services firm, would say yes to builders' being in the mortgage business. The Miami Lakes, Fla., organization built its company in the early 1990s on a foundation that says captive mortgages are good business for builders — they just need a little help to keep things running smoothly.

"Over the next 5 years, virtually every builder in the top 200 will have their own mortgage operation" solely owned and operated, supervised or joint-venture, says Gary Munson, HFN's vice president of production. "The number of builders we service [has] dramatically increased over the last five years and began increasing at a quicker pace over the last two years."

HFN works with nearly 50 home-builder-owned offices throughout the U.S. to help them establish and manage captive mortgage loan-origination operations. HFN doesn't lend money, but it does recruit, hire, train and manage the builder's mortgage-lending staff. It also manages the mortgage business for the builders.

Already all of the top 25 builders — from Pulte Homes to Trammell Crow Residential — have their own mortgage operation in some capacity.

Mercedes Homes, perched on the 23rd spot with nearly $1.44 million in sales, has its own subsidiary mortgage company: the 15-year-old MHi Mortgage, which supports each of the builder's 14 divisions. And MHi Mortgage is not going anywhere. "[Not] as long as our division is a value-added subsidiary and brings profit to the company," says MHi Mortgage President Sue Stewart, who didn't break out the revenues of the private company. Mercedes had a 24.8 percent increase in closings for 2005 over 2004, according to GIANTS data.

Added control for the builder in regard to closing date is crucial, says Stewart. "For every day an outside lender doesn't close the buyer's loan when the home is complete is another day that the builder pays to hold onto that property."

Stewart also lists additional profits and stronger customer service as reasons why builders should operate their own mortgage company. "Builder-owned mortgage companies do make money for the builder, but that's not the primary reason [builders open these divisions]. The primary reason is that the buyer gets the attention they need and they close when they are supposed to close," says Bill Renner, director of single-family finance for the National Association of Home Builders and other experts. "When a mortgage company is working on behalf of the builder, then they are in business to serve the builder." And builders simply want the home to close on time so they can move on.

Although they provide income and help improve customer service, captive mortgage loans can also be a liability. Just look at KB Home. In July 2005, HUD announced it reached a $3.2 million settlement with KB Home Mortgage Co. in connection with a series of alleged violations of HUD requirements, some of which purportedly caused homeowners to default on their loans.

That's a hefty price to pay for any business, but for KB, it amounted to 18 percent of the $17.6 million in mortgage banking revenue the company brought in the year before — A rather significant sum, even though the Los Angeles-based company downplayed it at the time by publicizing that the mortgage business was merely less than one percent of what the $9.4 billion company rakes in from one fiscal quarter of earnings.

KB has steadily been improving its overall financials, however, making the revenues it pulled from its own home mortgage division a smaller part of the picture. In 2002, it announced then-record revenues of $5.03 billion — the first time the company exceeded $5 billion — plus it was an increase of 10 percent from 2001. But it has since broken many records, with revenues today almost twice what they were in 2001.

But despite these gains, its stock price has spiraled. KB Home's 52-week high of $85.45 happened on July 20, 2005. A year later, it hovered around $39, its 52-week low. Part of that dip could be attributed to the market's cooling for home builders overall, as housing prices fall. The other four builders rounding out the Top 5 have also seen dramatic year-over-year stock declines, but KB Home has unique troubles.

The KB Mortgage-HUD settlement was the largest amount ever collected in the 30-year history of HUD's Mortgage Review Board, which takes administrative actions against lenders approved by the Federal Home Administration.

Brian D. Montgomery, assistant secretary for Housing and the Federal Housing Administration commissioner and chairman of the mortgage review board, said at the time of the settlement that it sends a strong message that the FHA will not tolerate violations of its requirements, especially if they can cause homeowners to default on their mortgages.

The 13 alleged violations by KB Mortgage involved a number of poor underwriting practices, according to HUD, such as approving loans to borrowers who were not eligible, approving loans based on overstated or incorrect income; failing to include all of borrowers' debts, failing to verify properly sources of funds, and failing to ensure gift letters met HUD requirements.

"I ran the mortgage operation for a large tract builder that sold its operation to KB Home in 2004," says Munson. "KB [Mortgage]'s problems, as I understand them (on a limited basis) were due to a lack of oversight. Builders build homes. Lenders transact mortgage loans. It is difficult for a mortgage lender/broker/banker to comply with every state and federal statute and regulation. It is impossible for someone that is not actively involved in the mortgage business, day-to-day, to supervise a mortgage operation, especially one the size KB enjoyed."

Given this dark shadow cast over KB, it only seemed fitting that it took the time to lay a new brick and focus on its core business. It is also quite possible, however, that HUD forced its hand, demanding that KB get out of the mortgage business as a part of the settlement. KB isn't saying, but the announcement to sell the KB Home mortgage business came just about a week before KB and HUD reached their agreement the first week of July 2005.

"We are pleased to reach resolution of these procedural issues with HUD, all of which have been addressed internally by the mortgage company," KB Home spokeswoman Kate Mulhearn said at the time.

On June 30 last year, KB and Countrywide Financial Corp. made a joint announcement that this largest U.S. mortgage lender would acquire almost all the assets of the home builder's mortgage business.

They formed Countrywide KB Home Loans, a 50-50 joint venture that makes residential loans to KB Home customers. Specific terms of the agreement were not disclosed, but KB Home customers have access to Countrywide's mortgage products, and Countrywide will have day-to-day oversight of the venture.

"Home building and financing have evolved into substantially larger and more sophisticated businesses," KB Home Chairman and CEO Bruce Karatz said in a statement. "We believe the transition to working directly with an established lending leader makes sense."

It most certainly does from a financial standpoint, says Jeffrey Levine, the Aventura, Fla.-based managing director of Milestone Advisors, an investment bank in Washington, D.C., that focuses on financial services with significant experience in the mortgage finance sector and joint venture space.

"KB Home should realize more from its 50 percent interest in the joint venture than it would earn by owning 100 percent of its existing mortgage business. Plus, [it] is able to monetize part of its capital tied up in the mortgage company subsidiary and refocus its management time on the core home building business."

The deal between Countrywide and KB Home Mortgage marked the first time a Top 5 home builder exited the captive lending business.

"For home builders of sufficient size, the business case for forming a strategic business alliance with Countrywide is easy to understand. Builders can leverage our expertise and size to their advantage," Ken Harthausen, Countrywide's managing director of strategic business alliances, told GIANTS. "Builders incur lower capital expenditures with a joint venture than when following a merger and acquisitions strategy, and the built-in efficiencies of joint ventures allow for faster growth than a 'de novo' operation.

Despite its benefits, a joint venture is simply an offshoot of captive lending from the buyers' perspective. As most of KB's home buyers will be directed to Countrywide, KB executives hope the broader product mix and more efficient fulfillment capabilities will drive higher volumes and margins — and lower operating expenses.

"[KB's] partnership with Countrywide will definitely provide structure and assistance with compliance as they move forward," says HFN's Munson. "They are a builder with nationwide presence; they need a great deal of flexibility to address all the intricacies and vagaries of the markets in which they operate. Will a joint venture with a single-platform lender do this? Only time will tell."

KB is not the only company to exit the mortgage business in the last 12 months. In April, Dominion Homes finalized a mortgage-banking joint venture with Wells Fargo Home Mortgage, a subsidiary of San Francisco-based banking company Wells Fargo & Co. The joint venture, dubbed Centennial Home Mortgage, is taking over the mortgage-origination services, including qualifying borrowers and processing applications previously handled by Dominion's mortgage-brokerage arm, Dominion Homes Financial Services.

"We are pleased to be able to have such a prestigious partner to handle our customers' mortgage financing," Dominion CFO William G. Cornely said in a release when the deal was first announced in February. "At times, it's confusing to our customers when we serve as both a builder and a loan originator."

Just how confusing the process was for home buyers is overshadowed by the fact that the builder has been criticized for its high foreclosure rate. About 13 percent of Dominion Homes Financial Services's loans insured by the FHA were in default within two years, according to data available through Neighborhood Watch, a database HUD operates that lets consumers monitor the performance of lenders and track defaults and foreclosures by state and ZIP code. HUD cited Dominion on April 26 for 49 violations of lending standards. It found a problem with more than one of every four of the 151 Dominion Financial-originated loans it pulled at random. Problems included overstating the buyers' income, enticing them with improper incentives and failing to verify their employment. Several Dominion homeowners are pushing through a class action lawsuit that alleges the Dublin, Ohio, builder sold houses that were overvalued and overpriced.

Under Dominion's joint venture with Wells Fargo, which will own 50.1 percent of Centennial, Dominion's foreclosure rate will no longer be traceable.

"We wanted [Wells Fargo] to be majority shareholders because we wanted them to be completely responsible for daily operations as well as regulatory compliance," Dominion spokeswoman Lori Steiner told the Columbus, Ohio, Business Journal. Only time will tell if the Dominion/Wells Fargo venture or the KB/Countrywide transaction will encourage similar deals by other large home builders.

It most certainly will, believes Levine of Milestone Advisors, which advised Lennar Financial Services in its acquisition of Eagle Home Mortgage, represented Homebuilders Financial Network in its sale to Fidelity National Financial and advised Comstock Homebuilding Companies in its recent issuance of subordinated debt.

"Other builders, much like many banks, will look at [a] sale [or] joint venture proposition as part of a review of their long-term mortgage banking strategy, as shrinking margins and higher fixed costs affect even the largest captive mortgage lenders," he says.

Overall in the industry, loan production earnings were up slightly in early 2006 despite slowing origination volume, according to Inside Mortgage Profitability, an industry publication that analyzed data from nine leading mortgage lenders. These lenders reported combined loan production earnings of $1.37 billion in the first three months of this year, a gain of 21 percent from the previous quarter, despite the fact that origination volume for the nine companies slumped 17.8 percent.

One of the biggest issues that home builders tend to grapple with in evaluating a joint venture or outsourcing transaction is not the economics of the deal but rather the fear of losing control of their core customers, experts say.

"A common theme I hear from home builders is 'we want to make sure our loans (and home sales) close at quarter-end and year-end, and we're not sure we maintain that control in a joint-venture relationship,'" says Levine. "However, we believe technology and the experience gained from past ventures is helping alleviate many of the 'control' concerns."

These factors, coupled with the prospect of reduced home prices in a softening real estate market, mean that the potential economics of a sale or joint venture are more compelling than ever, he contends.

Shannon Beck of Opteum Financial Services, an Atlanta-based nationwide residential mortgage lender, has another reason why builders shouldn't be in the mortgage lending business or even as a joint venture: "You don't, in my opinion, always find the most talented loan officers in a JV," she says. "Those [loan officers] who really know what they are doing don't want to work for a JV because they are paid less and they aren't working for [a company] with name recognition. [The JV typically has] a name they come up with and it has no national recognition, so a lot of the really good loan officers don't want to go to work for a JV."

Executives at WL Homes, which goes by John Laing Homes, have a straightforward opinion. "Builders do best when they focus on their core business: creating neighborhoods for people to raise their families in," says CFO Wayne Stelmar. "We've chosen to partner with the best providers of mortgages, Countrywide and Wells Fargo. We have no intention of creating and owning a mortgage company."

But when it comes to builders who have partnered with companies like Calabasas, Calif.-based Countrywide Financial Corp. or West Des Moines, Iowa-based Wells Fargo Home Mortgage, they are still under the mortgage umbrella, says Renner.

One of the key drivers of a successful captive mortgage business is its ability to capture the loans from its customers, and that is in large part driven by the personal relationships between the captive lender and the regional builder executives or local subdivision sales managers, regardless of whether the lender is wholly-owned or outsourced to a joint venture partner.

"As far as the customers of those builders [with joint ventures] are concerned, it is still aimed at providing a same high-level of service as when it was a builder-owned mortgage company," Renner says.