Big banks' mortgage units used the third quarter to demonstrate the benefits of scale, posting improved earnings despite falling loan volume.

Norwest Mortgage Inc. reported third-quarter earnings of $70 million, 25% more than a year earlier, even though loan volume has been falling all year. Third-quarter loan volume was off 17% from the second quarter, 32% from the first, and 32% from a year earlier.

Chase Manhattan Corp. and PNC Bank Corp.'s earnings told a similar story.

Norwest Mortgage and its competitors are leaning on loan servicing revenues to get them through a slow period for homebuying and loan refinancing.

The servicing portfolio at Norwest Mortgage, a Wells Fargo & Co. unit, reached a record $274.2 billion in the third quarter, up 3% from the second quarter and 18% from a year earlier. Servicing fees totaled $176 million in the third quarter, representing more than half the mortgage banking operation's revenues -- and 78% more than in the second quarter.

Mark Oman, group executive vice president of the Des Moines-based lender, said that servicing and production are counter-cyclical businesses.

"As interest rates go down and customers pay off, the average life on your servicing portfolio goes down,'' so the investment in servicing must be written off faster, Mr. Oman said.

"As rates go up, the reverse happens -- customers stop refinancing," he said. "While your origination volume falls, because refis fall, your servicing is going to be staying out there longer. You can slow that amortization, which allows you to have more earnings."

Mr. Oman said companies that sell all their production have higher earnings when rates are low; they suffer when rates rise.

James M. Schutz, an analyst at Stephens Inc., said that when rates go up, servicing portfolios become more valuable, because prepayment speeds go down.

"Anybody who's got a mortgage bank is doing this kind of hedging," Mr. Schutz said. "You have to adjust your amortization so that the value of your mortgage servicing rights reflects the market value of your mortgage servicing portfolio. And that's what they are all doing."

But this hedge works only if rates continue to rise, warned A.G. Edwards analyst, David C. Stumpf. If rates stay flat and volume continues to decline, he said, the mortgage bankers cannot keep readjusting the value of their servicing portfolios each quarter.

"The lag effect of higher rates on purchase mortgage volume could negatively impact mortgage banking income -- even for those banks that reported an increase this quarter," Mr. Stumpf said. "If rates don't go any higher, I would be surprised to see mortgage banking for those banks go much higher than it did this quarter."

Mr. Stumpf added that the servicing hedge generally only works for large players, while the smaller and regional lenders stand to lose in this environment.

"We saw some regional banks where the slowdown in the mortgage business noticeably hurt their earnings this quarter. In fact, they didn't make estimates in part because of that," Mr. Stumpf said. "If you aren't a major servicer in a rising-rate environment, you're not going to be able to count on a whole lot of revenue for mortgage banking."

Chase Manhattan Corp. reported third-quarter mortgage servicing fees of $96 million, 123% more than a year earlier. Meanwhile, originations totaling $21 billion were off 19% from the second quarter and 22% from the first.

Thomas M. Garvey, executive vice president of Chase Manhattan Mortgage Corp., said that in the last 90 days mortgage pipelines have been 40% below the March-April peak. He noted that Chase increased its servicing portfolio to about $290 billion on Sept. 30 by buying a $55 billion portfolio from Mellon Bank.

"Servicing and production are terrific natural hedges for one another," Mr. Garvey said. He added that Chase has doubled its home equity production in each of the last two years.

PNC said its residential mortgage banking revenue grew 60% from the third quarter of 1998, despite a 43% drop in originations, to $4 billion. PNC's servicing portfolio grew 22%, to about $73 billion.

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