During the fourth quarter of 2005, FTI, formerly a subsidiary of NB Partners, Inc., became a subsidiary of NetBank, FSB. Resource Bancshares Mortgage Group, Inc. (“Resource”) and Republic Leasing Company, Inc. (“Republic”), both of which had been subsidiaries of NetBank, FSB, were legally consolidated into NetBank, FSB and ceased to exist as separate corporations during the third quarter of 2004. Republic now operates as the NetBank Business Finance division of NetBank, FSB. During the third quarter of 2004, Meritage became a wholly-owned subsidiary of NetBank, FSB. Meritage was previously a wholly-owned subsidiary of the Company. In addition, during the fourth quarter of 2004, RBMG, Inc., formerly a subsidiary of NetBank, FSB, was legally consolidated into NetBank, FSB. RBMG, Inc. now operates as the NetBank Funding division of NetBank, FSB.
NetBank was founded in October 1996 and completed its initial public offering of stock in July 1997. It is one of the pioneers of the Internet banking industry, and NetBank, FSB is recognized as one of the first successful internet-only banks. Further information regarding the growth of the Company through recent acquisitions is contained in note 2 of the notes to the consolidated financial statements included in this report and is incorporated herein by reference.
Unless otherwise noted, all dollar figures are presented in thousands (000s), except per share data, and net income per share is presented on a diluted basis. All of the Company’s operations and assets are located within the United States of America.
NetBank’s business model has three basic strategies:
Retail Banking —The retail banking segment is comprised of our personal and s banking operations, automobile financing unit and business financing unit. NetBank, FSB, through its Internet banking operations, operates as an FDIC-insured, federally chartered thrift institution that currently serves approximately 285,669 customers throughout the United States and in more than 90 foreign countries. NetBank, FSB delivers its products and services through remote delivery channels, such as the Internet, telephone and ATMs, that are available 24 hours a day and seven days a week. It does not maintain a branch network to support its banking business. This branchless model provides it with an opportunity to operate with less overhead expense than traditional branch banks. Passing along part of this cost savings to customers through higher deposit rates and better technology has been the cornerstone of our value proposition. NetBank, FSB offers a full line of deposit and loan products, including checking and savings accounts, a small business banking program, online bill payment, auto loans, and financial planning
services. The business finance operation generally provides leasing and other equipment or facility-related funds to small- and mid-sized companies across the United States. These business customers generally have annual revenues in the $200,000 to $5 million range and represent a market segment that generally has been underserved by traditional branch banks that tend to pay greater attention to organizations with much larger revenues. The loans and leases generated through the auto lending and business finance units are generally retained to meet the Bank’s investment needs from a Treasury perspective.
Financial Intermediary —The financial intermediary segment houses our mortgage and specialty lending operations. Through the segment’s various loan operations, we serve as an intermediary between consumers and institutional investors. The bulk of the business in this segment relates to mortgage lending, including both conforming and non-conforming products. We obtain mortgage loans by originating loans directly with consumers or through a nationwide network of brokers. We also buy closed loans from a network of correspondent banks, thrifts and independent mortgage companies. The vast majority of these loans are held for sale on the Company’s balance sheet prior to sale into the secondary market. This approach provides us with several strategic advantages including reducing our exposure to credit and interest rate risk because the loans are held for short periods of time. Additionally we earn fees on the loans originated as well as the opportunity for gains on the sale of the mortgage loans or mortgage backed securities.
The Company has diversified the operations of this segment through acquisition to include the origination of loans for recreational vehicles (RVs), boats and personal aircraft. The loans are either retained by the retail banking segment to meet the Bank’s investment needs or sold to investors in the capital markets under the same intermediary strategy the Company employs in its mortgage businesses.
Transaction Processing —The transaction processing segment includes our ATM and merchant processing business, our mortgage servicing division and a number of start-up operations that deliver banking or item clearing functionality to other financial institutions or merchants. We established this segment in 2003 when we made the strategic decision to leverage many of the core business competencies residing in the retail banking and financial intermediary segments and market them on a business-to-business basis, thereby providing the Company with additional revenue generating opportunity from existing business activity. Through this segment, we have also been an active acquirer of small, profitable processing businesses that complement our overall business strategy. In late 2003, we acquired an ATM and merchant transaction processing operation. During 2004 and 2005, we grew this operation through acquisition and internal growth, and we intend to continue this strategy in the future. This business now operates 9,649 ATMs across the country, which we have made available to our retail banking customers on a surcharge-free basis. This network of ATMs currently ranks as the second largest bank-operated ATM network in the country.
Segmented Revenue Information
Financial information with respect to our business segments for each of the years ended December 31, 2005, 2004, and 2003, including pre-tax income or loss and total assets, is contained in note 18 of the notes to the consolidated financial statements included in this report and is incorporated herein by reference. The following represents the percentage and amount of our total revenues contributed by our business segments for the years ended December 31:
|
2005 |
2004 |
2003 |
||||||||||||||||||||
|
Amount |
Percentage |
Amount |
Percentage |
Amount |
Percentage |
|||||||||||||||||
|
Retail banking |
|
$ |
110,530 |
|
|
40 |
% |
|
$ |
118,140 |
|
|
38 |
% |
|
$ |
110,512 |
|
|
25 |
% |
|
|
Financial intermediary |
|
144,431 |
|
|
53 |
% |
|
180,147 |
|
|
58 |
% |
|
316,415 |
|
|
74 |
% |
|
|||
|
Transaction processing |
|
32,869 |
|
|
12 |
% |
|
31,907 |
|
|
10 |
% |
|
20,685 |
|
|
5 |
% |
|
|||
|
Other/eliminations |
|
(13,527 |
) |
|
(5 |
)% |
|
(18,074 |
) |
|
(6 |
)% |
|
(18,832 |
) |
|
(4 |
)% |
|
|||
|
Total revenues |
|
$ |
274,303 |
|
|
100 |
% |
|
$ |
312,120 |
|
|
100 |
% |
|
$ |
428,780 |
|
|
100 |
% |
|
Retail Banking Segment
The retail banking segment, through its Internet banking operations (“Internet Bank”), competes in a commoditized, highly competitive marketplace for personal and s banking relationships. We provide customers in all 50 states a full line of deposit and loan products along with ancillary account services. It competes head-to-head with large national financial institutions, small community banks and credit unions, and, for certain product relationships, alternative providers, such as brokerages, insurance companies and credit card issuers. However, in contrast to the more traditional brick-and mortar institutions, we operate a branchless business model in which we deliver our products and services through remote channels, including the Internet, phone, ATM and overnight mail delivery, that depend on technology or a third-party partner’s physical infrastructure. Through this strategy, we have the ability to operate with lower overhead expense than traditional branch-based banks, allowing us to return part of this cost savings to our customers through higher deposit rates, which routinely rank among the top in the country, fewer fees and free account services, such as online bill payment, account aggregation and ATM access. However, our branchless operations tend to appeal to a more narrow customer base than traditional banks whose branches serve the significant marketing role of being a constant reminder of their brand. The retail banking segment also includes the operations of Dealer Financial Services, NetBank, FSB’s indirect auto lending division, and NetBank Business Finance, NetBank, FSB’s business financing division.
Market Position
When the Internet Bank began operations in 1996, it was one of the early movers in online banking. Its value proposition and product line was differentiated in the marketplace since few direct competitors existed. Its products and services were designed to appeal to a highly targeted group of technology-savvy consumers who seek both convenience and greater economic value. These customers tend to be highly educated, live in major metropolitan areas, have jobs that typically require travel, and usually rely on technology devices as a means to improve their productivity and stay connected to their business or home.
Its typical customer fits the following profile:
· Late 30s to mid 40s in age
· Married with children
· Two income household
· Homeowner
· College educated
· Well-defined long-term financial goals
The market for online banking has grown exponentially since 1996, and we believe that online banking has reached critical mass acceptance today. According to a November 2004 study by the Pew Internet and American Life Project, approximately 50% of all U.S. Internet users now bank online—making it the fastest growing online activity the annual survey measures. Jupiter Research estimates that 35 million or approximately one-third of all U.S. households banked online at the end of 2004.
The Internet Bank has seen increased competition as consumer demand has grown. Over the past several years, large national banks have deployed and aggressively promoted their own online banking platforms. These competitors have improved their functionality and dropped the fees they used to charge for the channel in an effort to compete more effectively with our offering. These institutions were arguably motivated by the characteristics of the typical online banking customer. Independent market research continues to show that online banking customers tend to be more profitable than offline customers due to the simple fact that these customers are able to help themselves and conduct their transactions electronically without the assistance of a teller in a branch. In addition, online banking customers tend to have lower attrition rates than offline customers. In addition, we have seen increased competition from credit card companies and insurance providers who are actively promoting high-yield money market accounts online today.
The increased competition from large national banks and others has affected the Internet Bank’s ability to differentiate itself in the marketplace. Previously, it was able to compete more effectively on convenience and price. Although competitors have now closed the gap in terms of convenience, we still have an opportunity to differentiate our banking products and services in the marketplace. Management believes it can continue to compete effectively by combining its pricing advantages with focuses on:
· ease of use
· bundled product offerings, and
· highly integrated technology.
Products & Services
The Company’s goal is to be a trusted, comprehensive financial services partner to its customers. In order to achieve this goal and to deliver fully on our strategy of building long-term, multi-product customer relationships, we must offer a complete line of deposit accounts and loan products. Moreover, given the profile of our chosen customer segments, it is critical for us to support these products through ancillary services that are highly flexible and easy to use.
In certain instances, we may identify a product or service we wish to offer that rests outside of our core business competencies. In such cases, we will make it available to our customer through a partnership with a provider that specializes in that particular area of business. This approach allows us to minimize our risks and take advantage of the partner’s scale and prowess. Our credit card services in which we partner with MBNA America Bank, online and brokerage offerings in which we partner with UVestand online bill payment service in which we partner with CheckFree Corporation are examples of this strategy. The partnerships also provide us with additional revenue opportunities. To mitigate some of the inherent reputation risk, we maintain service level agreements with substantially all of our specialty service providers and monitor the solvency of such providers on a periodic basis as part of our vendor management process.
Our full line of financial products and services include the following:
FDIC-insured products include:
· Individual and s checking accounts
· Individual and s money market accounts
· Individual and small business certificates of deposit
Additional products include:
· IRAs
· Mortgages
· Home equity loans and lines of credit
· Auto loans
· Boat, personal aircraft and recreational vehicle loans
· Credit cards
· Overdraft protection
· Brokerage
· Financial planning
· Homeowners and automobile insurance
· Small business payroll services
· Business equipment leasing
· Foreign currency exchange
Ancillary services include:
· Online bill payment and presentment
· Online check imaging
· Online statements
· Online account funding
· ATM cards
· ATM deposit-gathering
· VISA ® Check Card
· Wireless account access
· Account aggregation
· Consumer credit report monitoring
Marketing Efforts
The Internet Bank presently attracts the majority of its new banking customers through highly targeted online advertising campaigns. We invest the majority of our marketing dollars in online advertising as this channel has proven more efficient and economical than more traditional offline promotional vehicles in reaching our targeted customer base. The Internet Bank also relies on marketing alliances with other businesses to reach prospective customers.
The Internet Bank’s online advertising efforts tend to focus on key word searches in various search engines or high-traffic, financial-related sites. Campaigns on these sites are typically presented in banner advertisements that promote a specific product or service along with a cash incentive for first-time customers. Campaigns may also center on sponsorship of an area of the site or specific content. Online advertising costs have risen over the past 18 to 24 months as new entrants into the marketplace and heightened competition for deposit dollars among banks have fueled the increase.
The Internet Bank also has a sales force that pursues affinity marketing alliances with other businesses. Its alliance partners agree to promote certain products and services to their customer bases in exchange for a fee on each successful lead they generate. These partnerships provide us with a highly cost-effective means of marketing to select, targeted groups of consumers. In turn, our partner is able to offer its customer value-added services while generating additional revenue. We often partner with companies that have customer loyalty programs through which their customers earn additional program points by signing up for one of our services. For example, we currently have an affinity program with Delta Airlines through which Delta frequent flyers receive SkyMiles SM when they open and fund an account with us.
We measure the effectiveness of all of our marketing efforts continuously and make adjustments as needed. This process includes proprietary practices that involve the analysis of pull-through rates on applications, the type of customer relationships being established, the expected economics of the relationship over time, and the cost to acquire it.
Significant cross-selling opportunities also exist for the Internet Bank through the Company’s various lines of business. The Company’s mortgage and auto lending operations assist tens of thousands of customers each year. The Internet Bank actively promotes additional banking products and services through these channels whenever possible.
Security & Technology
Online security and protection of customers’ sensitive personal data is critical to our success. We maintain state-of-the art technology and prevailing industry standards to ensure a safe, secure business environment. Data is encrypted and exchanged only over secure connections. The Internet Bank’s operating system does not connect directly to the Internet. It is isolated and protected by “firewalls” that comply with National Computer Security Association standards. We also seek to mitigate our exposure to security risks through continuous monitoring and testing of our systems in an effort to identify irregularities or potential weaknesses. These tests include annual disaster recovery exercises by the Company and its key vendors.
The Company uses a hybrid approach in acquiring technology to run its operations. Although we may develop proprietary applications for certain services, we typically partner with specialty technology providers and work to customize the partner’s existing solution to meet our needs. This outsourced approach is less capital intensive and allows us to take advantage of the partner’s larger infrastructure and operating scale. In addition, we are able to switch to another provider in the future if a competing, more compelling technology emerges.
We do not sell or disclose information on our customers to other businesses for third-party marketing activities. Although we occasionally work with business partners to facilitate transactions on behalf of our
customers, any information that we share is strictly for use in fulfillment of the transaction. For example, our online bill payment system is facilitated by a business partner. The partner is restricted from soliciting our customer directly or from providing any information on the customer to another business for such purposes.
Lending & Investment Activity
The deposits of our retail banking segment are used to fund the origination of assets that can be sold into the capital markets. The retail banking segment lends money on an intra-company basis to several lending units in the financial intermediary segment. These operations include Market Street and Meritage, as well as NetBank Funding and Beacon Credit Services, divisions of NetBank, FSB. These businesses originate residential mortgage, recreational vehicle, marine and personal aircraft loans. Their production is typically sold into forward commitments within the secondary market.
We believe this investment strategy has several advantages. Credit and interest rate risks are reduced because loans are typically sold into the capital markets within 30 to 90 days, thereby limiting exposure to this period. Once the loans are sold, the proceeds can then be reinvested in new originations.
Additionally, the retail banking segment maintains a loan and investment portfolio separate from the funding lines for the financial intermediary segment. The retail banking segment chooses to retain loans made to its core customers. By retaining the loans or servicing rights, we can continue to own the relationship and ensure a more consistent, higher-quality customer experience. If the asset was sold to another provider, then we could not guarantee consistent service or prevent the other provider from cross-selling our customer its own products and services. In addition, from time to time the retail banking segment retains certain mortgage and Home Equity Line of Credit (“HELOC”) products originated by the financial intermediary segment because those products meet certain risk-adjusted return and duration criteria. Likewise, through its NetBank Business Finance and Dealer Financial Services divisions, the retail banking segment originates small-ticket business leases and loans and auto loans for investment in its portfolio.
The retail banking segment must invest excess liquidity it cannot actively deploy through its lending operations. Management believes that deposits are likely to grow more quickly over time than our lending operations’ need for additional funding. Consumer demand affects production within these businesses. In a rising interest rate environment, the lending operations tend to experience lower production levels and, therefore, have reduced funding needs. During these times, the retail banking segment must shift liquidity into other investments to attempt to offset the corresponding drop in earnings from the lending businesses. Further, the Company owns certain mortgage-backed securities as part of its asset and liability management activities.
Servicing Asset
The Company maintains a sizeable portfolio of mortgage servicing rights (“MSRs”), primarily with respect to agency-eligible loans that were securitized and sold by the Company as described below. This servicing asset is a natural economic hedge against our mortgage origination operations, since MSRs tend to increase in value in a rising interest rate environment when origination volumes tend to decline and mortgage lending profitability comes under pressure.
To serve as a more effective hedge, we believe that the size of our servicing portfolio should approximate two-times peak or four-times trough of our annual mortgage production. This implies a general target range of $25 to $30 billion. The portfolio was $13.3 billion at year-end 2005.
While the Company services loans, we earn servicing revenue (usually stated as a percent of the outstanding principal balance). We earn late charges assessed to borrowers on payments not paid when
contractually due. We also receive a float benefit from escrow accounts for taxes and insurance and for collections of principal and interest that have not yet been passed on to the investor. The retail banking segment pays the transaction processing segment an inter-segment subservicing fee for the servicing of the underlying loans.
As a servicer of mortgage loans underlying mortgage-backed securities, we are obligated to make timely payments of principal and interest to security holders, whether or not such payments have been made by mortgagors on the underlying mortgage loans. Similarly, in the event of foreclosure, we are responsible for covering with our own funds principal and foreclosure costs to the extent not covered by mortgage insurance or an FHA or VA guarantee.
The following table shows the delinquency percentages (excluding bankruptcies and foreclosures) of the Company’s portfolio of MSRs (excluding loans serviced under subservicing agreements). We believe the recent increase in delinquencies can be attributed to new bankruptcy legislation enacted in late 2005 as well as the impact recent hurricanes may have had on borrowers.
|
December 31, |
|||||||||
|
Days Delinquent |
2005 |
2004 |
2003 |
||||||
|
30 days |
|
5.04 |
% |
3.70 |
% |
2.99 |
% |
||
|
60 days |
|
1.28 |
% |
0.90 |
% |
0.71 |
% |
||
|
90 + days |
|
2.23 |
% |
0.94 |
% |
0.45 |
% |
||
|
Total delinquencies |
|
8.55 |
% |
5.54 |
% |
4.15 |
% |
||
At December 31, 2005, the portfolio of MSRs had an underlying unpaid principal balance of $13.3 billion with book value of $202 million. The portfolio had a weighted average note rate of 5.89%. As more fully described in note 3 of the notes to the consolidated financial statements included in this report, we account for all MSRs at the lower of cost or market on an aggregate basis. For purposes of managing risk, we segregate our owned portfolio of MSRs into two tranches: available for sale and held for sale. The available for sale portfolio contains those rights which we intend to hold as longer-term investments. The held for sale portfolio contains rights generated as a by-product of recent production which we intend to sell, generally within 120 days. The held for sale portfolio is generally not as susceptible to changes in interest rates and other market factors as the available for sale portfolio since the held for sale rights are generally allocated to a specific forward sales contract.
The following tables provide information regarding our available for sale portfolio of MSRs at December 31, 2005:
|
Year of Origination |
Number of |
Percentage of |
Aggregate |
Percentage |
||||||||||||
|
1995 or earlier |
|
|
2,790 |
|
|
|
2.7 |
% |
|
$ |
97,620 |
|
|
0.7 |
% |
|
|
1996 |
|
|
326 |
|
|
|
0.3 |
% |
|
22,523 |
|
|
0.2 |
% |
|
|
|
1997 |
|
|
952 |
|
|
|
0.9 |
% |
|
67,502 |
|
|
0.5 |
% |
|
|
|
1998 |
|
|
1,948 |
|
|
|
1.9 |
% |
|
150,441 |
|
|
1.1 |
% |
|
|
|
1999 |
|
|
1,130 |
|
|
|
1.1 |
% |
|
77,452 |
|
|
0.6 |
% |
|
|
|
2000 |
|
|
177 |
|
|
|
0.2 |
% |
|
11,828 |
|
|
0.1 |
% |
|
|
|
2001 |
|
|
854 |
|
|
|
0.8 |
% |
|
77,206 |
|
|
0.6 |
% |
|
|
|
2002 |
|
|
12,331 |
|
|
|
12.1 |
% |
|
1,418,667 |
|
|
10.8 |
% |
|
|
|
2003 |
|
|
44,436 |
|
|
|
43.7 |
% |
|
6,027,966 |
|
|
45.9 |
% |
|
|
|
2004 |
|
|
28,781 |
|
|
|
28.2 |
% |
|
4,174,260 |
|
|
31.7 |
% |
|
|
|
2005 |
|
|
8,313 |
|
|
|
8.1 |
% |
|
1,030,061 |
|
|
7.8 |
% |
|
|
|
Total |
102,038 |
|
100.0 |
% |
$ |
13,155,526 |
|
100.0 |
% |
|
Loan Type |
Number of |
Aggregate |
Weighted |
Weighted |
||||||||||||||
|
Conventional fixed |
|
|
95,523 |
|
|
|
$ |
12,112,491 |
|
|
|
5.95 |
% |
|
|
0.317 |
|
|
|
Conventional arms |
|
|
3,706 |
|
|
|
637,010 |
|
|
|
4.67 |
% |
|
|
0.295 |
|
|
|
|
FHA |
|
|
2,098 |
|
|
|
233,732 |
|
|
|
5.99 |
% |
|
|
0.535 |
|
|
|
|
VA |
|
|
360 |
|
|
|
42,626 |
|
|
|
5.75 |
% |
|
|
0.463 |
|
|
|
|
Jumbo |
|
|
5 |
|
|
|
1,801 |
|
|
|
5.89 |
% |
|
|
0.250 |
|
|
|
|
Seconds |
|
|
59 |
|
|
|
1,521 |
|
|
|
8.83 |
% |
|
|
0.467 |
|
|
|
|
Other |
|
|
287 |
|
|
|
126,345 |
|
|
|
5.89 |
% |
|
|
0.326 |
|
|
|
|
Total |
102,038 |
|
$ |
13,155,526 |
|
5.89 |
% |
0.320 |
|
|
Since the Company’s available for sale MSRs are held as longer-term investments, they are subject to interest rate (prepayment) risk. During periods of declining interest rates, prepayments of mortgage loans increase as homeowners seek to refinance at lower rates, resulting in a decrease in value of the related MSRs. Mortgage loans with higher interest rates are more likely to result in prepayments. The following table sets forth certain information regarding the aggregate unpaid principal balance of mortgage loans underlying the Company’s tranche of available for sale MSRs. The table includes both fixed and adjustable rate loans at December 31, 2005:
|
Mortgage Interest Rate |
Loans |
Aggregate |
Percentage of |
|||||||||
|
Less than 5.00% |
|
6,673 |
|
|
$ |
1,013,591 |
|
|
|
7.7 |
% |
|
|
5.00% to 5.49% |
|
14,199 |
|
|
1,995,468 |
|
|
|
15.2 |
% |
|
|
|
5.50% to 6.00% |
|
32,426 |
|
|
4,717,668 |
|
|
|
35.9 |
% |
|
|
|
6.00% to 6.49% |
|
23,671 |
|
|
3,039,579 |
|
|
|
23.1 |
% |
|
|
|
6.50% to 6.99% |
|
13,550 |
|
|
1,450,906 |
|
|
|
11.0 |
% |
|
|
|
7.00% to 7.49% |
|
5,578 |
|
|
502,276 |
|
|
|
3.8 |
% |
|
|
|
7.50% to 7.99% |
|
3,573 |
|
|
290,518 |
|
|
|
2.2 |
% |
|
|
|
Greater than 8% |
|
2,368 |
|
|
145,520 |
|
|
|
1.1 |
% |
|
|
|
Total |
102,038 |
$ |
13,155,526 |
|
100.0 |
% |
The following table sets forth the geographic distribution of the aggregate unpaid principal balance of mortgage loans underlying the Company’s tranche of available for sale MSRs at December 31, 2005:
|
State |
Loans |
Aggregate |
Percentage of |
|||||||||
|
Georgia |
|
9,502 |
|
|
$ |
1,280,844 |
|
|
|
9.7 |
% |
|
|
Minnesota |
|
9,691 |
|
|
1,171,440 |
|
|
|
8.9 |
% |
|
|
|
Massachusetts |
|
4,419 |
|
|
775,386 |
|
|
|
5.9 |
% |
|
|
|
California |
|
5,346 |
|
|
983,400 |
|
|
|
7.5 |
% |
|
|
|
Florida |
|
6,578 |
|
|
822,376 |
|
|
|
6.3 |
% |
|
|
|
Maryland |
|
3,676 |
|
|
585,134 |
|
|
|
4.4 |
% |
|
|
|
Illinois |
|
4,786 |
|
|
643,754 |
|
|
|
4.9 |
% |
|
|
|
Missouri |
|
5,565 |
|
|
598,038 |
|
|
|
4.5 |
% |
|
|
|
Colorado |
|
2,685 |
|
|
432,850 |
|
|
|
3.3 |
% |
|
|
|
Ohio |
|
4,125 |
|
|
453,682 |
|
|
|
3.4 |
% |
|
|
|
All others |
|
45,665 |
|
|
5,408,622 |
|
|
|
41.2 |
% |
|
|
|
Total |
102,038 |
$ |
13,155,526 |
|
100.0 |
% |
To help the Company manage risk related to prepayments in its portfolio of MSRs, the Company has purchased interest-rate floor contracts, which provide an interest rate differential on a fixed portion of the portfolio in the event interest rates fall below a certain level, interest rate caps, interest rate swap transactions, and forward purchase contracts on Fannie Mae to-be-announced mortgage-backed securities (“FNMA TBA”). For a more detailed discussion of derivative instruments we have purchased to hedge interest rate risk associated with our portfolio of MSRs, see note 21 of the notes to the consolidated financial statements included in this report.
In those cases where the Company sells its MSRs on a flow basis or in bulk sales, we may temporarily subservice the loans until the servicing files are transferred to the acquirer of the MSRs. Likewise, the Company subservices loans on behalf of other third parties pursuant to subservicing agreements. Further, certain whole loan sale agreements require us to subservice the loans for several months after sale date. Those subservicing agreements provide for compensation to the Company usually on a monthly per loan basis. At December 31, 2005, the Company was subservicing 6,624 loans under such subservicing arrangements with an aggregate unpaid principal balance of $907 million.
Financial Intermediary Segment
The financial intermediary segment originates and purchases loans to be aggregated and re-sold into the secondary markets in the form of mortgage-backed securities or whole loans. The servicing of such loans is sold on a flow or bulk sale basis to external and internal customers. The financial intermediary segment principally originates (for purposes of this discussion the term “originate” is used to describe both the origination and the purchase of loans) 1-4 family, first and second mortgage loans. Additionally, on a smaller scale, NetBank originates loans collateralized by boats, personal aircraft and recreational vehicles through its Beacon Credit Services division, which it acquired in July 2004. See note 2 of the notes to consolidated financial statements included in this report for additional details regarding this acquisition.
NetBank originates agency-eligible mortgages via its 97 retail branches, operated by its subsidiary Market Street, or its nationwide network of 6,562 brokers and 913 correspondents, operated by its NetBank Funding division. The same channels also originate alternative product—grade A (“Alt A”) and jumbo loan products which generally conform to agency standards from a credit standpoint, but do not conform to documentation, size or certain other agency standards. In addition, we originate non-conforming mortgages through a nationwide network of 14,994 brokers, operated by our subsidiary, Meritage. For the year ended December 31, 2005, we originated $10.1 billion of conforming mortgage loans and $3.2 billion of non-conforming mortgage loans.
Agency-eligible mortgage loans are those mortgage loans that meet the size, documentation, borrower and credit standards to qualify to be pooled into mortgage-backed securities guaranteed by government sponsored enterprises, such as Fannie Mae, Freddie Mac and Ginnie Mae.
After the sale or securitization of agency-eligible mortgage loan production, NetBank, in some cases, continues to service mortgages on behalf of the permanent investor. Servicing activities include collecting and remitting mortgage loan payments, accounting for principal and interest, holding escrow funds for payment of mortgage-related expenses such as taxes and insurance, making inspections of the mortgaged premises as required, making advances to cover delinquent payments, supervising foreclosures and property dispositions in the event of unremedied default, and generally administering agency-eligible mortgage loans. Under our internal reporting structure, the servicing assets retained for internal investment are deemed to be “sold” to the retail banking segment, and the revenues generated from servicing activities are included in the transaction processing segment.
Alt A, jumbo and non-conforming mortgage loans, which are not eligible to be securitized by the aforementioned government sponsored enterprises, are sold to private whole loan investors and private-label mortgage conduits. From time to time, NetBank sells a portion of its agency-eligible product on a
whole loan sale basis to investors if its best execution models indicate that to be more economically beneficial. We generally do not retain an interest in Alt A, jumbo, or non-conforming mortgages once they are sold.
NetBank also sells its entire range of mortgage competencies on a private-label basis to financial institutions that lack the knowledge or infrastructure to originate mortgage loans themselves. NetBank has partnered with the Independent Community Bankers of America (“ICBA”) to offer mortgage services to ICBA’s 5,000 community bank members.
Mortgage Loan Production Channels
Retail Production. Through Market Street, we offer mortgage products directly to consumers through 97 retail mortgage branches located in 19 states. Market Street maintains relationships directly with realtors and builders to focus on purchase mortgage transactions (as opposed to refinancing transactions) business. We also offer construction-to-permanent loans enabling consumers to finance the construction and permanent financing of their new home in one seamless transaction. Although production costs in our retail channel are higher than in the correspondent and broker channels, the retail channel offers us higher margins than those other channels. Likewise, the retail channel offers a direct relationship with the customer, which allows for more potential cross-selling of other products and services to the customer. Market Street’s production is less affected by cyclical trends that affect the volumes and margins in the correspondent and wholesale channels because a larger portion of Market Street’s volume comes from home purchase transactions.
In its retail offices, Market Street’s representatives take mortgage applications, process and underwrite the loans, and fund the approved loans. At its home office in Clearwater, Florida, Market Street performs quality control tests, secondary marketing operations.
Correspondent Production. NetBank Funding acquires recently originated mortgages from a nationwide network of correspondent lenders. Correspondents are primarily mortgage lenders, mortgage brokers, savings and loan associations and small commercial banks. At December 31, 2005, the Company had approximately 913 correspondents originating mortgage loans in 48 states and the District of Columbia. Agency-eligible residential loan production by correspondents is widely dispersed, with the top 20 correspondents supplying the Company with 30% of its dollar volume of correspondent loans.
NetBank Funding attracts and maintains relationships with correspondents by offering a variety of services that provide incentives for the correspondents to sell NetBank Funding agency-eligible mortgage loans. NetBank Funding’s strategy with respect to its correspondents is to provide a high level of service rather than the lowest price. Services provided include timely underwriting and approval or rejection of a loan, timely purchase of loans, seminars on how to process and prepare a loan application and updates on current underwriting practices. In addition, NetBank Funding provides correspondents with a variety of products and delivery capabilities and multiple means of funding loans. NetBank Funding’s business-to-business Internet offering makes it easier for correspondents to interact with the Company by automating the flow of information between the correspondent and NetBank Funding. The site allows correspondent lenders to upload/key files, register and lock a loan, submit a loan to Fannie Mae Desktop Underwriting, print out a fax cover with a bar code to be faxed and routed electronically, submit an electronic file to one of NetBank Funding’s regional operating centers for validation and request closing funds on-line. As the mortgage lending market increases in sophistication and loan-price differentials narrow among mortgage bankers, NetBank Funding believes that the level of service and commitment it provides to its correspondents will be paramount to its success.
Management believes that through correspondent lending it can manage risks and maintain good quality control. Correspondents have to meet established standards to be approved by the Veteran’s Administration (“VA”), the U. S. Department of Housing and Urban Development (“HUD”) or private
mortgage insurance companies. A correspondent qualifies to participate in NetBank Funding’s correspondent program only after a thorough review of its reputation and mortgage lending expertise, including a review of references and financial statements and a personal visit by one or more representatives of NetBank Funding. After a correspondent qualifies for NetBank Funding’s program, NetBank Funding closely monitors the correspondent’s performance in terms of delinquency ratios, document exceptions and other pertinent data. Furthermore, all mortgage loans purchased by NetBank Funding through correspondents are subject to various aspects of NetBank Funding’s underwriting criteria, and correspondents are required to repurchase loans or otherwise indemnify NetBank Funding for its losses in the event of fraud or misrepresentation in the origination process and for certain other reasons, including noncompliance with underwriting standards.
All loan applications are subject to NetBank Funding’s underwriting criteria and the guidelines set forth by the FHA, VA, Ginnie Mae, Fannie Mae, Freddie Mac or private investors, as applicable. NetBank Funding or the correspondent, in the case of a correspondent with delegated underwriting authority, verifies, as appropriate for the loan type, each applicant’s income and bank deposits, as well as the accuracy of the other information submitted by the applicant, and obtains and reviews a credit report from a credit reporting agency, a preliminary title report and a real estate appraisal. Generally, delegated underwriting authority is granted by NetBank Funding to its larger correspondents that meet specified financial strength, delinquency ratio, underwriting and quality control standards.
With respect to FHA and VA loans, HUD and the VA, respectively, have established approval guidelines for the underwriting of loans to be covered by FHA insurance or a VA guaranty. The Company is approved by both HUD and the VA to underwrite FHA and VA loans submitted by specified correspondents and wholesale brokers. We purchase FHA and VA loans only from those correspondents who are approved to underwrite FHA and VA loans and from those correspondents for whom we have been approved to underwrite FHA and VA loans.
Wholesale Production. The wholesale division of NetBank Funding receives loan applications through brokers, underwrites the loans, funds the loans at closing and prepares all closing documentation. Typically, mortgage brokers are responsible for taking applications and accumulating the information prior to NetBank Funding’s processing of the loans. All loan applications processed by the wholesale division are subject to underwriting and quality control comparable to the standards used in NetBank Funding’s correspondent lending program.
NetBank Funding processes wholesale loans through regional operations centers. At December 31, 2005, NetBank Funding had three regional operations centers serving 6,562 brokers. These centers are located in Portland, Oregon; St. Louis, Missouri; and Jacksonville, Florida. Although maintaining regional operations centers involves the incurrence of fixed expenses associated with maintaining those offices, wholesale operations generally provide for higher profit margins than correspondent loan production. Additionally, each regional operations center can serve a relatively sizable geographic area by establishing relationships with large numbers of independent mortgage loan brokers who bear much of the cost of identifying and interacting directly with loan applicants. NetBank Funding’s Internet site is also available to its brokers with the same features and benefits for brokers as enumerated above for the correspondent lending program.
Non-conforming Production. Through Meritage, we originate mortgage loans that normally will not qualify to be pooled into agency-eligible mortgage-backed securities due to loan size, the extent of loan documentation, or borrower credit. Meritage originates such non-conforming mortgages through a nationwide network of brokers. Meritage underwrites and processes loans at two regional processing centers located in Portland, Oregon and Jacksonville, Florida. All non-conforming loans are sold into the secondary market for cash, and Meritage retains no recourse risk beyond that associated with normal seller representations and warranties.
Non-conforming mortgage loans are more expensive to process than agency-eligible mortgage loans. However, the margin on sale makes these products generally our highest profit mortgage offering. Likewise, the majority of the loans funded through Meritage’s non-conforming channel are home purchase mortgage loans as opposed to refinance transactions. Accordingly, Meritage’s production volumes tend to be less cyclical than the volumes in NetBank’s correspondent and wholesale channels.
The following summarizes NetBank’s production volumes by channel for the year ended December 31:
|
2005 |
2004 |
2003 |
||||||||
|
Retail |
|
$ |
3,504,757 |
|
$ |
2,510,558 |
|
$ |
3,059,215 |
|
|
Correspondent |
|
3,799,040 |
|
4,871,980 |
|
8,239,984 |
|
|||
|
Wholesale/broker |
|
2,774,182 |
|
3,263,638 |
|
5,404,629 |
|
|||
|
Total agency-eligible |
|
10,077,979 |
|
10,646,176 |
|
16,703,828 |
|
|||
|
Non-conforming |
|
3,185,732 |
|
2,986,768 |
|
2,217,928 |
|
|||