Merrill Lynch Finds 2 Bulls : Tustin Pair Leads Way in Mortgage Banking
Despite its prowess as America’s largest brokerage house, Merrill Lynch & Co. Inc. has had its problems maintaining a national presence in the fiercely competitive financial services field of mortgage banking.
But 16 months ago, two Newport Beach businessmen with a knack for projecting interest rate trends persuaded the Wall Street giant to let them establish a pilot program in Tustin to help the company garner a bigger share of the market.
The results achieved by Joseph G. Schretzmann and Matthew B. Burns have given Merrill Lynch reason to believe that it can become the dominant U.S. mortgage banker.
“They’ve done an absolutely masterful job,” said Stephen P. Terry, a former Merrill Lynch executive who oversaw their operation until he left in March to join another mortgage banking firm. Terry characterized their efforts as a “model operation.”
Operating as Merrill Lynch Huntoon Paige Inc., an existing corporate entity, Schretzmann and Burns set up shop in a Tustin office building in March, 1986, with $200,000 in start-up money and a $30-million line of credit from the parent company.
While their business plan projected mortgage loans totaling $88 million and a net loss of $60,000 for their first 12 months of operations, they instead funded $201 million in loans and posted a $1.4-million profit for the year ended in March.
By the end of June, total loans funded had reached $254 million, and net income for the firm’s first 15 months of operations was $1.7 million.
“Actually, there were two major reasons for our success,” Burns said. “The market was incredible, and the people we brought in (as employees) were incredible.”
The subsidiary even flourished in April, a month in which its parent company suffered a $377-million loss in its mortgage capital division resulting from unauthorized bond trading during a rise in interest rates.
Indeed, Schretzmann and Burns advertised in trade publications that they had funded 98% of their mortgage loan commitments during last spring’s interest rate rise--a time when many lenders refrained from funding loans for fear of losing money or making smaller profits.
As a result of their success, Merrill Lynch is allowing the two to open new branches across the country. New offices are already operating in La Jolla and in Larkspur, Marin County. And Burns and Schretzmann hope to open branches later this year in Virginia, Georgia, Illinois, New York and Reno.
Highly Competitive
Mortgage banking is one of the most competitive businesses in the financial services industry. No firm--regional or national--has more than 3% or 4% of the market, and few have even that much, Schretzmann said.
To become a major player, a company has to fund $750 million to $1 billion in mortgages annually. Burns and Schretzmann believe they can reach that level of financing within a year.
“At the time this was set up, the objective was to become a major mortgage banker,” Terry said. And the Newport Beach entrepreneurs have devised a business plan to make certain that goal is reached.
Mortgage banking, in essence, is the middleman operation in the business of supplying mortgages to home buyers. Banks and savings institutions, for instance, often act as mortgage bankers by arranging loans, packaging many mortgages together and selling the packages to investors, usually through quasi-governmental agencies such as the Federal Home Loan Mortgage Corp.
Other mortgage bankers make loans from funds they have raised on the capital markets--brokerage houses and other Wall Street investors--instead of from deposits in banks and savings institutions.
In either case, mortgage bankers can deal directly with customers, which is called retail mortgage banking, or they can make loans through independent brokers, which is called wholesale mortgage banking.
The Wholesale Segment
What makes the Schretzmann-Burns operation noteworthy, Terry said, is that it has managed to succeed by concentrating on the tougher wholesale side of the business, where the profit margin is slimmer because revenues must be shared with mortgage brokers.
For instance, Merrill Lynch Huntoon Paige lets brokers keep all loan fees and points except for a flat fee of $325 per loan. Instead of origination fees, the firm’s primary source of income is the service charges it receives for collecting monthly mortgage payments and providing other services.
In today’s fluctuating interest-rate market, mortgage bankers face two major risks.
If rates go up after a mortgage is approved but before it can be packaged with other loans and sold, the company loses money.
For example, an interest rate increase of 1 percentage point on a $100,000 loan costs a mortgage banker about $6,000, while the typical profit on a loan of that size is just $1,500 for a wholesale mortgage banker, Schretzmann said.
At any one time, Merrill Lynch Huntoon Paige has up to $175 million in mortgages that are being processed or have been completed but have not yet been sold. The potential loss caused by a 1 percentage point increase in prevailing interest rates would be $9 million.
When interest rates go down, home buyers often abandon loan applications for lower rates available elsewhere. That’s when the ability of Schretzmann and Burns to predict changes in rates becomes a valuable tool.
Predictions and Hedging
“The real risk is managing the fallout risk when rates decline, and the only way to do that is to forecast changes in the interest rates,” Schretzmann said.
Burns and Schretzmann coupled their expertise in predicting interest rate changes with their ability to hedge against rate fluctuations on the cash and options markets. Hedging involves the use of securities to protect against losses.
Through their hedging activities, Schretzmann and Burns reaped profits instead of suffering losses when rates either rose or fell. When rates remained stable, the expense of hedging was essentially the same as paying insurance premiums.
Terry said their hedging and risk control are “very unique and extraordinarily advanced” for mortgage banking.
Merrill Lynch was ripe for entrepreneurs such as Schretzmann, 35, and Burns, who will turn 45 next week.
The national brokerage house has been closemouthed about its mortgage banking operations in the past, especially its residential loans, said Perrin Long, an industry analyst with Lipper Analytical Securities Corp. in New York.
“Merrill Lynch hasn’t said anything, except that things weren’t working out well in their retail residential mortgage banking,” Long said. “There is some thinking that their (retail) commercial mortgage banking probably could have been better managed, also.”
‘Off-and-On’ Effort
Long described the firm’s mortgage banking activities over the years as “off-and-on” efforts.
Into the void stepped Burns, a native of Ohio, and Schretzmann, a builder-developer from Florida.
They met in Denver in 1973. Burns was doing some trouble-shooting work for a company. Schretzmann, fresh from Metropolitan State College in Denver, was starting a small home-building and development firm.
Burns invested in Schretzmann’s firm, and their careers have been intertwined ever since.
Predicting changes in interest rates is an expertise the two developed in the late 1970s. They soon began devising interest rate protection programs for banks, savings institutions and developers.
“We coined the phrase ‘interest rate risk management’ back in 1979,” Burns said. “Now it’s a common term in managements and board rooms throughout the nation.”
They moved to Los Angeles with Shearson/American Express Inc. and then joined Shearson Lehman Mortgage Corp. to develop and expand mortgage services.
“There were new (investment) products, and the advent of the computer brought even more,” Burns said. “We were right there sucking up the information. We love to learn. I read, and Joseph thinks.”
Developed Own Concept
They developed their own concept of how mortgage banking ought to operate, including their heavy reliance on hedging and analyzing interest rate changes. But they already worked for an established mortgage banking operation, and they believed they had to go elsewhere to sell their program.
Merrill Lynch was an obvious choice, partly because, as Long noted, it had nowhere to go but up.
Bolstered by its initial successes, Merrill Lynch Huntoon Paige is testing the waters to see if it can develop a market for more services.
While the company continues to deal with mortgage brokers, it expects soon to sell mortgage loans directly to home builders, thus keeping for itself some of the profits it would normally give the brokers.
Schretzmann and Burns are also soliciting banks for potential joint ventures. They are advertising in trade publications that they can help bankers enter the mortgage business with no overhead, labor costs or risks--”just net profit.” Under these ventures, banks would start the loan process and refer the customers to Merrill Lynch Huntoon Paige to complete the loan.
But the two do not plan to build their company indefinitely. So far, they have not worked at any one task for more than about two years, and they expect the itch to move on will begin to bother them in another year or so.
By then, they predict, Merrill Lynch Huntoon Paige will be a major mortgage banker and will be poised to grab an even greater share of the mortgage market.
