By all accounts, most mortgage companies enjoyed a solid 2021 and likely generated decent cash over the last two years. But how that cash was conserved will dictate a company’s long-term viability. As we move forward into 2022, I believe cash will truly be king in the mortgage industry.
There’s already been widespread margin compression with agency conventional products due to the declines in refinances, while government margins will likely start compressing soon as well. Additionally, the Federal Housing Finance Agency’s recent announcement of increased upfront fees for high-balance and second-home loans is bound to create more pressure by pushing borrowers out of the market.
Most seasoned mortgage companies have seen these peaks and troughs and are positioning themselves to adapt to the changing market conditions by focusing on purchase business and other products like non-qualified mortgage loans.
As mortgage company leaders try to overcome this latest cycle of challenges in the industry, there are three ways that I’d recommend focusing on cash:
Build your operational information into cash-forecasting inputs
To develop a robust input, it’s imperative to understand your cash flows, which means knowing your sources and uses of cash. This includes how much cash is used to fund new loans, cycle time on loans in inventory, and how fast you’re selling loans. The more you can increase that velocity, the quicker you generate cash.
In the mortgage business, many expenses are front-ended. For instance, you need to pay loan officer commissions when loans are closed, even though you may not have sold the loan yet to generate the cash needed to pay a commission. The faster you can move that cycle of loans generating cash, the closer the link between your expense and the revenue to cover it.
Having a tight handle on expected payroll will also help you understand future cash needs. Most mortgage companies conduct payroll twice a month, with about a 15-day lag period for paying commissions.
The more you understand that cycle time, the better you can predict potential cash shortfalls. Large expenses such as insurance renewals and marketing costs are important considerations as well as knowing the timing of these, which can help you compile a very strong cash forecast.
Understand your overall liquidity position on a daily basis
This requires not only understanding cash balances but what target cash you need to maintain. It also requires a clear line of sight to contingent funding sources and availability. A contingent funding plan is knowing what your Plan B is in the event there is an unexpected event. Let’s say you expect to have a loan sale of $50 million, but it doesn’t happen and payroll will hit the next day. How do you manage that?
The mortgage industry is a cash-intensive business, so a strong contingent funding plan helps you know what your liquidity sources are so you can remain flexible. It’s important to keep that plan at your fingertips in case a downturn occurs. While there are various liquidity management strategies out there, some companies might utilize a credit card strategy, which provides about 30 days to move expenses, while others alleviate cash needs using a revolving credit line.
However, it’s crucial to understand the lead time required to access the liquidity source because in the mortgage business, the more you fund loans, the more you can generate cash. The production machinery must continue moving.
Comprehend your cash conversion cycle
I like to compare the mortgage-origination business with manufacturing because of the similar business dynamics, as you’re essentially “manufacturing” a loan.
An important question one should ask is, “How long does it take to pay your suppliers or turn your inventory into cash?” You want to understand that velocity to pinpoint weak spots in your cycle and potentially strengthen them.
From a manufacturing standpoint, the cash conversion cycle (CCC) is typically represented as days inventory outstanding (DIO) plus days sales outstanding (DSO), minus days payable outstanding (DPO). In equation form, it reads as CCC = DIO + DSO – DPO.
For the mortgage industry, DIO would be represented by fund-to-sale cycle days, DSO by average accounts receivable/cost of sales, and DPO by average account payable/cost of sales. Typically for mortgage companies, accounts receivable should be minimal, meaning DSO would be a negligible number.
Tackling tougher times
I strongly believe cash is king and it is imperative that companies focus on cash flow management. According to research done by U.S. Bank and cited on the SCORE/Counselors to America’s Small Business, the reason small businesses fail overwhelmingly includes cash flow issues, which is mainly due to poor cash flow management and poor understanding of cash flow. Additionally, 82% of business failures resulted due to poor cash flow management skills or poor understanding of cash flow. However, this can be overcome by taking stock of your liquidity positions and planning for uncertain times ahead, while using all the resources available to you.
Ravi Correa is Chief Financial Officer at Angel Oak Lending.
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