What is the risk-return spectrum

It is the relationship between the amount of return gained on an investment and the amount of risk undertaken in that investment.

I was chatting with a well known mortgage banker that is exploring starting a de nova mortgage bank.  He has a history of developing and operating very successful mortgage banks in the past.  His companies have always been high performers and shareholders have always generated sizable returns.  He doesn’t need to do it again, but believes there are huge opportunity today to own and operate a mortgage bank because of the severe barriers to entry and shrinking competition.  We agree, but with a caveat.

It takes capital, experience management, a solid business plan and an ability to execute.  As we all know execution is where the “rubber meets the road”.  One may have the capital and compelling business plan, but if the plan can’t be executed, the company and shareholder loose out.  This operator has the “midas touch” with a stunning history of executing on his plan.  Even with his knowledge and experience he has doubts about pulling it off again based on all of the risks.  We also agree, the stars are aligned, but there are some headwinds of risk. 

Here are some key risks he is considering:

  • Counterparty Risk
  • Regulatory Risk
  • Industry stigma or headline news issues
  • Lack of viable warehouse partners
  • Shrinking secondary market investors
  • Normal business risk operating a mortgage – secondary and operation risk

Unless one makes a decent profit, there is a lot risk owning and operating a mortgage bank today.  What might a decent profit be? 

Over the past year with low rates and high volumes, margins have been stellar.  We’ve seen profits in the 80 to 100 basis points range.   However, if we throw out this past last year, a recent industry study of mortgage banking performance over the past several years showed profit margins of 25 basis point for companies closing around $100M or less per month.

Let’s assume 25 basis points is the benchmark and see if this is adequate earnings for a mortgage bank considering the risks.

If a company funds around $100 million per month, it will need around $5M in capital to support that kind of volume. If the company closes $100M per month and generates $250K per month in profits, it appears this is pretty good profits.  However, losses resulting from one or two loan repurchase or a mismatch in hedges could easily reduce or wipe out those monthly profits. 

Several companies we reviewed last year had more than 1/2 of their annual profits reduced in order to pay for losses resulting from repurchased loan requests.  Let’s assume our phantom company generated $125K per month or $1.5M in pre-tax profits.  The return on capital is 30%.  Some might consider this a pretty good return on capital.  Others might consider this too low because of all the risks associated with owning and operating a mortgage bank.

The key is to not be an average performer in the mortgage banking space. As an average performer, the risk verses reward is slanted more toward the risk side.  Profits margins need to be much higher over an extended period of time considering the known and unknown risks.  My friend is a smart mortgage banking operator and is assessing the risks before deploying his capital into a mortgage bank again.