Indymac’s business model is a hybrid that combines the best elements of mortgage banking and thrift investing. Mortgage banking involves the origination, securitization and sale of mortgage loans and related assets, and the servicing of those loans. The revenues from mortgage banking consist primarily of gains on the sale of the loans; fees earned from origination; interest income earned while the loans are held for sale; and servicing fees. On the thrift side, we generate core spread income from our investment portfolio of prime SFR mortgages, home equity loans, consumer and builder construction loans and mortgage-backed securities.
As a result of the quick asset turn times associated with mortgage banking, it is less capital-intensive than thrift investing and offers higher returns on invested capital; when demand for mortgages and related secondary products is high, more capital can be deployed in this segment. Thrift investing requires more capital than mortgage banking and generates correspondingly lower returns on invested capital. However, the returns tend to be more stable and less cyclical than those from mortgage banking. We allocate more capital to the thrift segment when we believe the secondary market is under-valuing returns on mortgage-related assets. The ability to deploy capital into the segment with the best opportunities at any given time allows us to focus on strong shareholder returns throughout the interest rate cycle.
The following provides further detail on our production, servicing and thrift investing segments:
Our production division originates loans through four main channels: Mortgage Professionals, Conduit, Consumer Direct and Financial Freedom.
Mortgage Professionals — sources loans through relationships with mortgage brokers, mortgage bankers, financial institutions, Realtors® and homebuilders.
Conduit — purchases bulk portfolios of closed loans from mortgage bankers and financial institutions.
Consumer Direct — offers mortgage loans directly to consumers through our Southern California retail banking branches, storefront mortgage loan offices, direct mail, Internet lead aggregators, outbound telesales, online advertising, and referral programs.
Financial Freedom — provides reverse mortgage products both directly to seniors (age 62 and older) and through third party lenders who also offer reverse mortgages to seniors.
Servicing is a key component of our business model, as it is a natural complement to our mortgage production operations. Through mortgage servicing rights (MSRs) retained from our mortgage banking activities or purchased from others, we collect a steady stream of fees and ancillary revenues for servicing loans sold into the secondary market. As interest rates rise, the expected life of the underlying loans is extended, which extends the life of the income stream flowing from those loans. This in turn increases the capitalized value of the associated mortgage servicing rights. Conversely, as interest rates decline, the value of the MSRs will also decline. To mitigate the potential volatility in the MSRs, we hedge this asset to provide a stable source of income throughout the interest rate cycle.
Our servicing portfolio also provides opportunities to cross sell other products, such as home equity lines of credit, checking accounts, CDs and other deposit services. In a declining interest rate environment, it provides an existing base of customers who may potentially be in the market to refinance. Capturing these customers helps mitigate the decline in the value of our mortgage servicing asset caused by early prepayment of the original loan.
Our thrift segment invests in loans originated by our various production units as well as in mortgage-backed securities. Additionally, the division engages in warehouse lending, consumer construction and homebuilder financing. These disciplined investing activities provide core spread income, and historically, a stable return on equity.
Recently, we have seen a decrease in the ROE in our thrift segment, mostly caused by net interest margin erosion in our whole loan and MBS portfolios. We see this as being a part of a broader trend, the continuation of which is inevitable due to three developments. First, there is fierce competition for consumer deposits and consumers are getting more savvy and efficient with their deposit funds, moving them to the highest yielding options. Both of these factors are driving up deposit costs relative to market funding sources and reducing the funding advantage and net interest margins of depository institutions. Second, spreads to Treasury securities on financial assets that can be securitized (home loans and most other consumer loan types) continue to tighten given the efficiency of the secondary market, reducing asset yields and further compressing net interest margins for depository institutions. Third, the regulatory capital requirements for holding these assets (mortgage and home equity loans, in particular) generally exceed those of the secondary market.
In light of this new economic environment, it does not make economic sense for us to grow these portfolios to the extent that we previously planned. Accordingly, going forward our capital deployment and profit growth will likely be more focused on the two broad segments of our mortgage banking business, mortgage production and mortgage servicing.