Like large banks, community banks are facing a steep decline in mortgage income over the next few quarters as the refinancing boom that has largely driven profits in recent years finally comes to an end.
But unlike their bigger competitors, smaller banks are resisting the temptation to pare staff or close production offices in response to the slowdown. Many community banks bulked up in mortgage lending at a time when large banks were being more selective, and, for now, they are staying the course in hopes of capturing a "bigger piece of the pie," says Joseph MarcAurele, the chairman and chief executive of $3 billion-asset Washington Trust Bancorp (WASH) in Westerly, R.I
"During the refi boom, you couldn't make a mistake," MarcAurele says. "Now the trick is being intelligent about how you take it back down. You don't want to do it too fast or too deeply."
The mortgage business has always waxed and waned as interest rates have fluctuated, but community bankers say they are better prepared this time around because they acted strategically after the last downturn by expanding into markets that now are benefitting from rising home prices and a housing boom. Washington Trust, for example, has opened loan offices in Boston and Connecticut over the last two years.
"If you're in the right markets, in a situation where the purchase market is fairly strong, then to some extent the purchase market will make up for the fact that refis have certainly abated," MarcAurele says.
Bankers have relied on refinancing activity for the past three years to boost overall profits. But they know that gravy train is coming to an end. Refinance volumes overall are expected to plummet to just $388 billion next year, down from $967 billion this year and $1.2 trillion in 2012, according to the Mortgage Bankers Association.
Home purchases are expected to rise to $703 billion in 2014, from an estimated $615 million this year, not nearly enough to pick up the slack.
Still, banks like Eagle Bancorp (EGBN) in Bethesda, Md., added scores of lenders not just to take advantage of the refi boom, but also to win more purchase business. Over the past 18 months, the $3.4 billion-asset company has increased its share of home purchases to 32% of its mortgage volume, up from just 8%, in part by becoming a preferred lender to condominium developers. Moreover, with home prices rising, more borrowers who were shut out of the refinance market because of negative equity are expected to finally refinance.
"Refis are not totally dead," says Ron Paul, Eagle's chairman and chief executive. "There are a lot of people who waited and they're saying they better pull the plug and do the refinance with rates rising."
The biggest shock will come to those banks that bulked up primarily to handle refinance volume and now face deep cuts.
"Some banks have created an awful lot of overhead, and that was a strategic decision we decided against," says Paul, noting that Eagle generated $1.5 billion in mortgage revenue last year from just two offices.
Some banks are preparing for the transition from the refi to purchase business by working more closely with real estate agents and homebuilders, who control a significant amount of the business.
"The winners and losers in the mortgage banking segment will be really about those companies that control those Realtor and builder relationships on the purchase money business," Christopher Bergstrom, the chief credit officer at $2.9 billion-asset Cardinal Financial (CFNL) in McLean, Va., said last month at an investor conference.
To some degree, mortgage units do benefit from a variable cost structure. Most loan officers are commissioned sales people who are paid incentives based on loan originations. So with fewer loans, operating expenses will decline on their own. But there always comes a point where employees have to be cut if volumes dry up fast too quickly.
"We monitor our operating expenses in comparison to where our volumes are, both on a dollar and unit basis, so we can determine where our efficiencies are over time," says Donavon Ternes, the president, chief operating officer and chief financial officer of $1.2 billion-asset Provident Financial Holdings (PROV), in Riverside, Calif. "Everybody should have their own internal methods and metrics to measure that because those will become indicators of when they need to respond with respect to lowering operating expenses."
He cautions that some lenders may wait too long and "might cut loan sale margins too thin to keep volume up."
"There are things that can be done to respond to total declining volume that might not be the right decision in the end," he says.
Even those banks still in expansion mode have a fallback.
Last week, the $4.4 billion-asset WSFS Financial (WSFS) in Wilmington, Del., announced it was buying Array Financial, a mortgage bank in Haverford, Pa., and a related title company.
Rodger Levenson, WSFS' executive vice president and chief commercial banking officer, says the purchase will double WSFS' lending volume and boost home purchases in the Philadelphia suburbs
"We happen to believe that the markets we're operating in will get a greater share of a shrinking pie," he says.
Even so, Levenson structured the deal so half the price paid was up-front and other half earned out over time to incentivize the newly-acquired mortgage banker to increase market share.
"There's no question that new home purchases will not just pick up immediately," Levenson says. "If we're wrong, we've protected ourselves in the structure of the deal."