Cervus financial group Inc. is applying the trailer-fee business model used in the mutual fund and insurance industries to conventional mortgages, a move that will allow mortgage brokers to develop a stable, consistent income stream.

The company’s “customer for life” model pays the mortgage broker trailing commissions for the life of a mortgage, instead of one upfront payment. If the mortgage remains with Cervus for three years, the total compensation is greater than the upfront fees paid by other mortgage underwriters, chiefly the banks. If a 20-year, $200,000 mortgage at 4.8% remains with Cervus for its full term, the broker would receive in total $4,774 in commissions, vs
the traditional $1,900 upfront fee.

The Toronto-based company —which also offers low mortgage rates and approvals in minutes — has industry support and commitments from mortgage brokers for $21.5 billion in business over the next five to seven years. The brokers will receive shares in Cervus as they meet their commitments.

It also has agreements with two major financial intermediaries, Merrill Lynch Canada and the Desjardins Group, to sell the mortgages in securitized bundles to institutional investors. The securities should be particularly appealing to life insurance companies and pension funds, which don’t generally have access to mortgages.

Cervus says the timing is excellent because it is tapping into the rapid growth in mortgage brokerages, whose share of the Canadian market is now about 35%, vs 5% in 1998. Gary Bartholomew, Cervus’s co-founder and CEO, attributes the boom to aggressive marketing, high service levels and a robust housing market. He expects the share will increase to 60%-70% before stabilizing. The well-established U.S.
mortgage brokerage sector has a market share of about 70%.

Both commitments from brokers and its automated platform give it a competitive edge, Cervus says. The technology used is commercially available to its competitors, but putting it together isn’t that easy, says Bartholomew. It requires expertise in mortgage operations and risk management, capital markets, financial modeling and securitization. Cervus has a team with all the necessary skills and has integrated the various software programs using a proprietary work-flow and rules-processing platform.

This was relatively simple, the company says, because it has only one business. For the banks to arrive at a similar system would require integrating existing platforms that encompass a wide range of other functions.
An independent firm might be able to create a similar system, but duplicating the industry support Cervus has would be difficult.

Cervus was formed in January 2004 by
Bartholomew and five others. In April that year, it amalgamated with NetDriven Solutions Inc., a Canadian public shell company. At the time, it had $17.5 billion in mortgage volume commitments.

In September 2004, it received lender approval status from Canada Mortgage and Housing Corp. and wrote its first mortgage.
In early October, it had its first sale of pooled
loans and, by March 31, it had $96 million in residential mortgages under administration.
For the six months ended March 31, 2005, it had gross revenue of $1.3 million, net revenue after broker commissions of $336,000 and posted a loss of $4.3 million.
There is no long-term debt. Assets were $16.4 million and shareholders’ equity was $13.4 million as of March 31.

The share price was trading around $1.15 in mid-May. Cervus shares began trading on the TSX Venture Exchange in August 2004 and moved to the Toronto Stock Exchange on May 11. Management owns 23% of the 50.3 million fully diluted shares outstanding, and directors and advisors have 7%. The partnership of mortgage brokers who have made commitments to Cervus have 8%, and will get another one million shares when other brokers join and bring commitments to the $30-billion target.

The company doesn’t intend to issue further shares to mortgage brokers. The commitments were needed to ensure a predictable revenue flow as the company becomes established. Once the $30 billion in mortgages has been delivered, the business will be well-entrenched, Bartholomew says.

Cervus also intends to be a consolidator of mortgage portfolios for small regional financial services companies and has a vice president of mergers and acquisitions to oversee it. Bartholomew says that business could bring in mortgage assets of $5 billion.

The technology Cervus uses includes
origination and underwriting and fulfillment software developed by Basis 100 Inc., a Toronto-based technology firm that was sold to Filogix Inc., also in Toronto, in 2003.
Bartholomew was chairman and CEO of Basis 100. Cervus’s CFO and the vice president of mergers and acquisitions also came from Basis 100. The rest of the staff was recruited from various Canadian banks and financial services companies.

@page_break@Other benefits of the new business model include:

> The mortgage belongs to the broker rather than the mortgage lender, allowing the broker to sell his business, with its recurring income stream, at retirement for
considerable value;

> Mortgage approval is within minutes, which gives brokers located in real estate offices an opportunity to cement the deal immediately. Cervus also offers pre-approved mortgages;

> Cervus mortgage rates are 100-125 basis points lower than the banks’ posted rates, and only five- to 10 bps above the lowest discounted rates. Although the banks sometimes initially offer discounted rates, renewals are always at posted rates, says Bartholomew;

> Cervus offers one-, three- and five-year fixed rates and a five-year adjustable rate. All mortgages are AAA- (insured) or A-rated conventional mortgages and the company intends to stick to such high-credit quality borrowers.

Currently 56% of the mortgages written are five-year adjustable rate, and 38% are five-year fixed rate. Cervus operates in Ontario, Quebec, Alberta and British Columbia; currently almost 90% of its mortgages are in Ontario. The target is 60% in Ontario, 20% in Quebec and 10% each in Alberta and B.C. Cervus currently has no plans to expand to other provinces.

One would assume such consistently low rates would lead to a flood of customers, but Canadians are accustomed to the idea of getting a mortgage at their bank and it takes time to change consumer behaviour, says Bartholomew. “As the word gets out and the borrowers experience the instant and paperless process, along with preferred pricing, the migration from the banks is happening,” he says.

Cervus generates its revenue from the annual spread between Government of Canada five-year benchmark bonds and the mortgage rate it charges consumers. The profit model assumes its mortgage rate will be 109 bps higher. The securitized mortgage products are priced to give purchasers a 55-bps premium over the five-year Canada rate. The other 54 bps goes to Cervus, with 29 bps as the origination fee and 24 bps as a servicing fee. The origination fee revenue is recognized upfront at the time the mortgage is written — that is, 145 bps for a five- year mortgage — and the service fee is recognized in each year.

The model shows that, with $3 billion in volume, origination fees should deliver 11 bps of earnings before interest, taxes, depreciation, amortization and fixed costs.
Bartholomew says the fixed costs are small.
With a similar $3 billion in volume, renewals should produce 49 bps and servicing 11bps.

According to the model, renewals and servicing drive earnings by the sixth year, which accelerates growth. Average renewal rates for the industry are more than 85%.

Bartholomew will not predict when the company will be profitable, but says it will be very profitable when mortgages under administration reach $30 billion. He can see a $1-billion market capitalization, assuming conservative multiples for Cervus.

Cervus is assuming a continuing healthy housing market. “Canadian real estate is one of the most undervalued in the world,” Bartholomew says. He thinks we will see robust price increases for many years.

The Canadian mortgage market is currently about $530 billion, with the banks’ share about 80%. He predicts growth of about 10% a year. IE