In business, is big really better? And what about the popular diversification advice to avoid putting all your eggs in one basket? After all, even Mark Twain cautioned us "to put all our eggs in one basket, but watch them."
Even though conventional wisdom today is clearly stacked on the side of growth through mergers and acquisitions, and diversification is a commonly sought strategic goal for many, we think it's critical to question whether these strategies are everything they are cracked up to be.
On one side of the growth and diversification issue are the financial and economic professionals who argue quantitatively that the soundest and least risky strategy for business management is through growth and diversification. On the other side of the same issue are the business policy analysts who argue qualitatively that undisciplined growth and diversification strategies may result in a reduced focus on business advantages and objectives, negating any of the presumed quantitative gains that the "number crunchers" claim to result from growth and diversification.
How relevant is this issue? It is hard to think of any corporate body holding a strategic planning session today that would not discuss the issue of growth and/or diversification. Much federal decision-making is molded by the attitudes policymakers have on growth and diversification, including such things as banking policy, antitrust law, and even how the savings and loan debacle will be resolved.
Consolidation and geographic diversification have received increased attention in many sectors of our economy for reasons that stretch from the simple desire to improve efficiency and lower risk to the need to diversify as the only means for survival. Consider the recent spate of large bank mergers. In the end, it is the American consumer who either gains or loses from the success or failure of these strategic decisions or policies.
To test the practical results of these strategic policy tenets in the context of the mortgage banking industry, we assessed the relative performance of servicers of mortgages backing Ginnie Mae mortgage-backed securities. Some of these servicers were large and diversified and some were small and market-concentrated. Using standardized information from 362 mortgage banking firms that submit the status of their loan portfolios to the Government National Mortgage Association (GNMA), the Risk Analysis Group of Coopers & Lybrand (C&L) set out to evaluate the effects of growth and diversification in the industry. This article discusses the results of that analysis.
PURPOSE AND FRAMEWORK OF THE ANALYSIS
Since January 1990, the C&L Risk Analysis Group has supported GNMA in its efforts to monitor and address risk proactively. The basis of much of the group's risk analysis comes from the aggregation, segregation and synthesis of more than 7 million home mortgage computer records submitted quarterly to GNMA by servicers of GNMA single-family loan portfolios.
Conventional wisdom asserts that:
* Increased geographical diversification lowers the risk of business failure by reducing regional dependency; and
* Growth leads to increased efficiencies through economies of scale, which, in turn, improve competitive advantage.
The Risk Analysis Group decided to test this conventional wisdom by analyzing the loan portfolios of both large and small mortgage institutions with different levels of regional diversification. For the particular analysis discussed here, the Risk Analysis Group looked at the 362 active, non-defaulted institutions, each having GNMA loan portfolios containing more than 1,000 federally guaranteed home loans. The total loan sample studied represents more than 7 million loans and more than $396 billion in outstanding principal. The records analyzed represented the condition of the portfolios as of December 1991.
The measurement used to evaluate portfolio performance was what the Risk Analysis Group calls the DQ3RATIO, the percentage of portfolio loans that are three months or more delinquent. …