Do Mortgages Still Have Earnings Potential?

Kudos to John Kanas and BankUnited for throwing in the towel and ceasing to originate retail mortgages. The savvy decision recognizes the dilemma retail mortgage lending creates for most bank CEOs: originating and holding these loans pumps up earnings but not shareholder value.

Kanas's decision to exit retail mortgage lending will prove to be one of the most important banking stories of 2016 if other bankers across the country do the math and realize that most residential mortgage lending is an ineffective use of shareholder capital.

BankUnited is far from alone in its inability to earn a satisfactory return on equity from retail mortgage lending. Residential mortgage loans are the largest asset sitting on the balance sheets of U.S. banks — comprising 22% of all loans. But here's the problem: mortgages are also the industry's least profitable product.

The industry faces a number of trouble spots, from declining oil prices to nonbank competition. Just look at stock prices. The share prices for a majority of publicly-traded banks are lower today than they were at the end of 2004. Banks holding on to their mortgage origination business may be contributing to the slide. When your most important asset is also your least profitable, that is not a positive sign.

Here are a few facts regarding mortgage lending in the U.S. in 2015.

In my analysis, I have grouped together the 500 U.S. banks with the most residential mortgages relative to their total loans, and compared those institutions to other peer groups and to the industry as a whole. While the nation's roughly 6,000 banks had a median return on equity of 7.82% through the third quarter of last year, our peer group's median ROE was only 3.5%. Meanwhile, the peer group of banks with the lowest ratio of residential loans to total loans had a median ROE of 9%.

In addition, the median U.S. bank generated 55 cents of net income for every dollar paid in salary and benefits last year. But the 500 banks with the most mortgage loans had a median ratio of net income to salary and benefits of only 31 cents. Banks with the least commitment to a mortgage business had a ratio more than twice as high, at 70 cents.

The 500 banks with the most mortgage loans on their books also are burdened with the highest capital ratios in the country. In other words, they face twin problems: too little income to cover too much capital. But reducing their capital still may not be an answer. Cutting capital in half would still not produce an acceptable ROE for 90% of these banks.

No surprise, the banks with the most residential loans also show the worst efficiency ratios among banks.

The low efficiency ratio reveals three stubborn problems with this type of lending. First, with mortgages, often the consumer looks only for low price. Second, for the vast majority of banks, the product is still delivered via a 20th century labor-intensive distribution model. Third, there appear to be few barriers of entry preventing banks and nonbanks like Quicken Mortgage from ramping up mortgage origination activities.

As a result, pricing is razor thin, distribution costs are exorbitant, and return on investment is inadequate to cover cost of capital.

Now some may argue that dynamics still allow large scale players to succeed in the mortgage business. But that isn't necessarily so. It has to do with how big banks comply with recent capital requirements following their agreement to huge mortgage-related settlements following the crisis.

Capital-happy bank regulators have a quandary they have yet to discuss publicly. Basel rules assign capital based on a bank's historic loss experience. When the nation's biggest banks paid out tens of billions of dollars in legal settlements and fines associated with home mortgages, the banks were required to input these operational losses into their regulatory capital calculations. According to Basel rules, the banks then must show sufficient capital going forward to cover 99.9% of potential losses based on past experience. What this means is that regulatory capital levels for the mortgage business are now so high that it cannot possibly make economic sense for big banks to even be in the business.

Perhaps at some time in the future policymakers will ease the Basel rules, or at least the guidance for complying with them. But until then, there is a question whether the capital requirements and contingent liabilities are so great that megabanks should avoid residential mortgage lending.

Do not be surprised if other shareholder-minded bankers join Kanas and BankUnited in exiting conventional residential mortgage lending. The combination of high origination costs, heavy capital burdens, and incalculable contingent liabilities is bad math for bankers and bank investors.

Richard J. Parsons is the author of Broke: America's Banking System. The analysis for this post is from his new book, "Investing in Banks: Strategies and Statistics for Bankers, Directors, and Investors," to be published by RMA in April.