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Time to Quit Mortgage Banking?

Banks made a great deal of money in mortgage banking last year, even those who just dabbled in it, but this year is vastly different. Higher rates have reduced volume, refinancings have all but vanished, margins have shrunk, and cut-throat pricing is proving again that in mortgage banking, you're only as smart as your most desperate competitors.

For those wondering if they should keep doing mortgage banking, here are six reasons why it might make sense to get out.

Interest Rate Risk: Mortgage rates have been dropping for 30 years, and it's a good bet that they've already hit their bottom with only one direction to go. Mortgage banking operators always claim to be fully hedged, but sudden spikes in interest rates seem to always catch some of them off-guard. Managing pipeline risk is much different than basic asset-liability matching, and one bad month can and often does wipe out the profit from six to eight good months.

Earnings Volatility and Refis: Mortgage earnings are generally joined at the hip with loan volume, and loan volume is greatly driven by refinance activity. My firm did a study of past refinance waves, and from the peak of a refi boom to the next quarter bust, the drop-off in volume ranged from 84% to 93%. Overall mortgage volume has already dropped 50% to 60% at many banks, with more decreases likely to come.

Effect on Bank Multiples: Mortgage banking is like the little girl in the nursery rhyme: "When she was good, she was very, very good, and when she was bad, she was horrid." When rates are low and volume high, mortgage banking profits are unbelievably great, and generating a 1.5% return on assets is not uncommon. Unfortunately, these profits can disappear overnight and even turn into losses, and the markets often acknowledge this risk by according a lower multiple to mortgage banking-oriented depositories. Not much is accomplished if you double your earnings but see your price-to-earnings multiple potentially cut in half.

Compliance Risk: Does this really need an explanation? The Consumer Financial Protection Bureau's Supervision and Examination Manual is well over 900 pages, and most of it is devoted to mortgage lending. If you retain the servicing rights when you sell your loans, it gets even more complicated. The broader issue is that mortgage compliance is extraordinarily complex, and as someone once put it, if you're dabbling in the mortgage business, you can't be a dabbler anymore.

Repurchases: It used to be that once you sold a mortgage loan, you were typically done with it forever. That's no longer the case. The last five years have devastated lenders that have had to re-purchase loans they had previously sold. Buybacks have slackened, but the point is that this is a whole new area of risk.

Do You Really Need to Offer Mortgages? One of the great myths of our industry is that a mortgage is the foundational product for consumer relationships. With many people having their mortgage payment automatically taken from their checking account, a significant number of borrowers don't even know who their mortgage lender is. And mortgage borrowers are much more interested in getting the lowest rate than in getting a mortgage from their primary bank.

There are many commercial banks that do just fine not offering mortgages. Some offer it through a private-label mortgage company. Some refer borrowers to local mortgage bankers, and most simply don't offer it. Mortgage banking does not generate deposits from customers, and to the extent that customer deposits are a major part of what makes a franchise valuable, mortgage banking does not help.

I cannot think of a single banker who was ever criticized for getting out of mortgage banking, but there are plenty who stayed in too long and lost their job and even lost their bank. Yes, mortgage banking can be very lucrative when times are good, but bank executives must know when to cut back, and they must also have the courage to simply exit this business when it no longer adds value to the bank and its franchise.

Joe Garrett is a principal in Garrett, McAuley, a bank advisory firm in Berkeley, CA. He had been the CEO of two community banks.


(2) Comments



Comments (2)
Dear Sir:

I read today's article in American Banker, rhetorically asking, "Time to Quit Mortgage Banking?" You have articulated what many career mortgage banking professions have said in hushed tones to each other, but have been afraid to say to ownership and management.

In addition to your list of reasons to leave mortgage banking today, let me offer my own observations as to known but not admitted risks to mortgage banking operations.

Shrinking profit margins from Secondary Market operations. A substantial portion of all profits made over the last six years from mortgage banking has not been from the generation of fees, sale of servicing rights, or capitalization of servicing rights values. Profits came from gain on sale of loans to mortgage investors Fannie Mae and Freddie Mac, plus gain on sale of Ginnie Mae securities. As rates dropped, borrowers closed loans locked at application at a higher rate than current market conditions at time of securitization and sale. While technically hedged, the loan pipeline profits provided the turbocharge to mortgage banking earnings, not the profits from more efficient operations.

Balance Sheet Risk on Servicing Rights. Even as rates rise over the next generation, from time to time there will be dips in market rates that will spark short refinance waves. Retained servicing rights capitalize the net present value of the stream of income from sold loans; should a loan prepay earlier than anticipated, the entire residual amount of capitalized servicing value must be run through the income statement immediately. This expense unrelated to operations can, will and has disrupted the profit planning of banking executives, and cost several their jobs.

Reputational Risk. How many commercial lenders have inwardly groaned when a $20 million customer announced a need for a $400,000 mortgage? Why? Because the commercial lender knew his internal partners in the mortgage department will take far longer, ask for much more burdensome documentation, and be much less accommodating to the customer, risking the entire relationship over a small loan request. Leaving mortgage lending may be the best way to avoid customer dissatisfaction. If your mortgage department isn't as good as your commercial department, do you have the resources to be best in class in all things? If the answer is no, get out of it.

Thanks again for your perspective.
Posted by ChCSmith | Wednesday, January 15 2014 at 12:13PM ET
You paint a bleak picture there Joe. I think if you wrote a similarly toned article on being married the jewelry industry might put a contract out on you. Though you do make same very compelling arguments; originating and selling mortgages these days is likened to cuddling with a porcupine.
The real relationship myth in the banking industry is the industry believes the product IS the relationship. The truth is the product is just the gateway to the relationship. You actually have to interact and become intimately acquainted with the customer to be able to form a relationship. In the good old days of 'handshake' banking you were forced to actually sit down and get to know the customer, it was actually a prerequisite of the lending process. You had to discover who that person was before you could make a lending decision. Technology has totally changed that dynamic and relationship building has become a lost art. If you can build the trust and respect of your customer, as well as offer them overwhelming value and service then you won't be forced to abandon your business model when market conditions or regulatory circumstance dictate. A strong relationship allows you to lead your customer along a new path, your new path, as you adapt to market conditions and regulatory circumstance. A strong relationship will open the door to discuss the real needs of the customer which will obviously lead to income producing opportunities.
So, as a bank consultant and advisor what are you advising your customers to do if they are to abandon the mortgage market? Auto loans? Wealth Management/Investments? HELOC's? How should a bank approach that faceless "autodraft" mortgage customer?
You laid out the problems like a pro, but what is the alternative? Where's the solution if I want to stay in the mortgage business? What are you recommending your clients to do to build real relationships with their customers?
Posted by Bill Westrom | Wednesday, January 15 2014 at 11:44AM ET
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