The nation's largest thrift says it intends to shrink its assets by as much as 40% in the next five years in a bid to increase profitability.

Charles Rinehart, chief executive of Home Savings of America, says the thrift's asset portfolio, now about $50 billion, could be as small as $30 billion by 2001, including its new consumer loans. That means home loans, the traditional bread and butter of thrifts, will take the brunt of the reduction.

Mr. Rinehart says the home loan portfolio, composed almost entirely of adjustable-rate loans, should run down by $2 billion to $3 billion this year as borrowers pay off the loans or refinance elsewhere. But instead of aggressively replacing the loans - a difficult proposition in the present fixed-rate market - Home Savings will simply let the portfolio shrink.

The thrift will supplement normal attrition with loan sales to further erode the thrift's $37 billion of single-family loans over the next several years. Mr. Rinehart said market conditions could result in a smaller shrinkage but that Home Savings was shooting for a major reduction. He said the thrift would originate both fixed-rate loans and adjustables, selling all of the fixed-rate loans and some of the adjustables into the secondary market.

In an interview with the American Banker, Mr. Rinehart said the move comes in response to poor profits from Home's core mortgage business, where margins have been squeezed in recent years by Fannie Mae and Freddie Mac on the lending side and mutual funds on the deposit side. The plan has evolved during Mr. Rinehart's two years at the helm of the thrift.

"If you look at the mortgage loan, you've got a loan where Fannie and Freddie are pulling down the rates, and competition is driving up my costs for my newest deposits, and the government has forced me to raise my capital," Mr. Rinehart said.

As a result, return on equity is being "hammered," he said, and the thrift has decided that the best way to boost returns on equity from an anemic 8% or 9% to a target of 15% is to change its mortgage strategy, slim down, and return capital to shareholders of its parent, H.F. Ahmanson & Co., through share repurchases.

Increasingly, Home Savings will operate like a mortgage bank - originating and selling fixed-rate and adjustable-rate mortgages to the secondary market - and save only the most profitable ARMs for its own portfolio when the market is right. These will include adjustables with low down payments and possibly to borrowers with subprime credit.

On Wall Street, analyst Jonathan Gray of Sanford C. Bernstein & Co., New York, said Home's decision to cut back on its portfolio lending fits in with the general trend of Fannie Mae and Freddie Mac dominating the mortgage market. Still, he considers the step significant.

"We all knew that Fannie and Freddie were busy swallowing the mortgage market," Mr. Gray said. "But when the largest thrift shifts from fourth gear to second gear to first gear and then into reverse, it has significance."

"It is the moral equivalent of the portfolio lender waving the white flag and saying, 'Enough is enough! Fannie and Freddie own the mortgage and portfolio investment business, at least for standard-type mortgage credits,'" he said.

Experts cite two major reasons for the edge that Fannie Mae and Freddie Mac enjoy over thrifts in the mortgage market.

First, because of their implied government backing, the mortgage agencies can issue cheap long-term, fixed-rate, callable debt to fund their purchases of fixed-rate loans. By contrast, banks and thrifts have found it difficult to raise deposits with maturities of more than a year, Mr. Gray said, and the agencies largely have the fixed-rate market to themselves.

Second, Fannie and Freddie are currently required to hold about half as much capital as thrifts, giving them greater leverage. Mr. Rinehart said that because the mortgage agencies have become so big, they set prices in the mortgage market. And the agencies can afford to buy lower-yielding loans than thrifts because of the smaller capital requirements, he said.

Unless the mortgage agencies are required to increase their capital levels, Mr. Rinehart said, other thrifts will also have to cut back their mortgage holdings. He predicted that in 10 years, banks and thrifts would be reduced to serving restricted niches of the mortgage market.

Indeed, many of the nation's largest thrifts are reevaluating their mortgage strategies. Increasingly, large thrifts, including Home Savings, are cutting funding costs by offering checking accounts in addition to the costlier certificates of deposit that have long funded their mortgage portfolios.

They are also diversifying their assets by making higher-yielding auto and home equity loans, and selling investment products, such as mutual funds and annuities.

But Home Savings is the first large thrift to publicly say that despite these changes, returns on its core mortgage business are so low that it must reduce its asset portfolio.

In the tight community of California thrift executives, reaction was mixed.

Mario Antoci, chief executive of American Savings Bank, Irvine, said he was "disappointed."

"They're kind of throwing in the towel," said Mr. Antoci, who worked at Home Savings for 21 years, serving as president from 1984 to 1988 before joining fifth-ranked American in 1989.

"Fannie and Freddie have been a problem. They have created pressures on spreads, and we have to deal with that," Mr. Antoci said. But he said American believes that portfolio mortgage lending is still a profitable business, and does not plan to shrink its holdings.

At Great Western Bank, Chatsworth, Calif., Sam Lyons, senior vice president of mortgage banking, questioned whether a smaller portfolio at Home Savings represents a major strategic change, rather than the anticipated result of an interest rate environment in which it is harder to make adjustable loans.

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