A price war has broken out in the mortgage industry, a clear sign that rising interest rates are beginning to put pressure on the financial service sector.

With the refinancing boom finished, the big lenders are paying more for loans originated by correspondents, in an attempt to maintain the volume they gained when consumers were refinancing loans last year. In fact, they are paying so much that they would have to take losses to sell the loans in the secondary market.

"We're seeing intense price competition in the correspondent markets," said Steven F. Herbert, chief financial officer of Resource Bancshares Mortgage Group in Columbia, S.C.

"It is pressuring our margins, and we would presume other mortgage originators' margins may come under pressure on the correspondent side."

The margin compression prompted Michael McMahon, an analyst at Sandler O'Neill & Partners, to downgrade Resource's stock to "market perform" on Friday.

In a research note to clients, Mr. McMahon illustrated the price competition with a snapshot of the prices offered by five major home lenders to their correspondents, and the prices offered by Fannie Mae, for 7.5% loans on June 17.

Resource was willing to buy loans for 0.1% less than what Fannie would pay for them, yet it could not bid as high for correspondent production as four depository institutions. Correspondents are small banks or mortgage bankers that fund and close loans in their own name and sell them to larger institutions.

The pricing pressure illustrates why mortgage lending is often the first sector to suffer from rising rates, said Gary Gordon, an analyst at PaineWebber. Typically major mortgage lenders are eventually forced to scale back, he said, adding that credit card and commercial lending could be hurt later if the increase in rates eventually slows the economy.

However, this post-refi-boom price war is expected to be less severe for mortgage banks than the one in 1994. Mr. Gordon said the drop in origination volume in 1994 was greater than it is expected to be this year. What's more, in the early 1990s consumers refinanced their mortgages to get better rates; today some also refinance to take cash out, and that added incentive will probably sustain volume.

For now, the benefits of price competition are being passed on to consumers through retail branches.

"We are starting to see some lenders adopt more aggressive pricing as they try to keep their volumes up," said Bradley W. Blackwell, senior vice president of retail mortgage banking at Washington Mutual Inc.

Wamu has noticed this in intermediate-term, adjustable-rate mortgages, he said, where competitors are pricing loans below what would give them a reasonable return on that product.

"Lenders have a great deal of capacity for origination," having hired legions of loan officers and processors to handle last year's refinance boom, Mr. Blackwell said. "They need to feed their machines."

With volume tapering off this year, he said, these lenders with large infrastructures must either cut back on staff or "find a way to originate more volume, and that means (grabbing) market share.

"It's a classic cyclical phenomenon."

What enables lenders to undercut each other? Mortgage servicing has increased in value, and companies with giant servicing portfolios can use that gain to subsidize pricing on the production side, one mortgage executive, speaking on condition of anonymity, suggested.

Mr. McMahon said that banks and thrifts can price more aggressively than independent home lenders such as Resource because they can finance their mortgage servicing rights with more debt relative to equity.

That extra leverage creates a higher return on equity from the servicing side of the business, which then can be used to subsidize pricing on the production side.

"Every time interest rates go up, people become more aggressive on pricing until excess capacity is taken out of the system," Mr. McMahon said.

He noted that in 1994, when the early-1990s refinance boom ended, industry origination volume fell 24%.

The Mortgage Bankers Association projects total originations this year will come to $1.3 trillion, off 16% from last year's record-breaking boom.

Still, Mr. McMahon found it surprising that a price war of such intensity should be happening now.

After all, the economy is healthy and the housing market, though slowing, is still robust. And $1.3 trillion is not bad.

Back in 1994, he recalled, the Federal Reserve doubled the federal funds rate over 15 months; no one is expecting such a sharp hike this year.

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