The home Mortgage industry looks a little like a snake that is swallowing its own tail.
Lenders are feeding voraciously on refinancings -- and toting up record origination fees. But as borrowers pay off existing loans, many companies are losing valuable loan servicing assets -- and taking hits to earnings.
In recent weeks, the undesirable part of the refinancing boom has started to outweigh the positive aspects for a number of lenders. And with long-term interest rates continually hitting record lows, there's no end in sight to the trend.
Fleet Financial Group of Providence, R.I., highlighted the problems last month when it announced a $100 million charge to earnings in the second quarter because of prepayments at its 80%-owned Fleet Mortgage.
"What happened to Fleet during the quarter proves our point that a lower-interest-rate environment is not necessarily the optimal situation for mortgage bankers," wrote Sy Jacobs, mortgage banking analyst for Alex. Brown & Sons.
Rights Booked as Assets
Fleet is among a group of lenders that hold large quantities of "purchased mortgage servicing rights." Unlike the loan servicing rights that arise from a lender's originations, purchased rights are booked as assets -- and must therefore be written down when prepayments accelerate.
(A ranking of bank holding companies with high levels of servicing assets appears on page 12.)
Kevin Race, executive vice president and chief financial officer for Fleet Mortgage, said: "After the second quarter, we decided to use hedging techniques, when appropriate. to protect our portfolio and have actually begun some financial hedging."
Charge to Earnings
Marine Midland Banks Inc., Buffalo, had one of the largest exposures to prepayment risk among bank holding companies as of March 31.
But Ernest A. Morton, executive vice president, reports that he has reduced this exposure by about 60% "by writing a check" in the form of a charge to earnings. He expects to sell excess servicing to Fannie Mae and Freddie Mac where possible.
The prepayment drain has been particularly hard on servicers that have small retail origination networks and thus have limited ability, to replace the runoff with new rights,
But even companies with strong origination capacity have been feeling the strain. Countrywide Credit Industries, the nation's largest originator, has been experiencing annualized prepayments in recent months of about a third of its portfolio, double the rate in its fiscal fourth quarter, which ended, Feb. 28.
But the company has managed to partially offset servicing writedowns with gains on hedging instruments. In the first fiscal quarter this year, the company reported a gain of about $27 million on Treasury securities, which rise in value as interest rates fall, helping the company to show a hefty gain in earnings rather than a decline.
With interest rates still sinking and prepayments rampant, further hedging gains are being, logged in the company's second quarter.
Higher Rates Wouldn't Hurt
Mr. Jacobs of Alex. Brown had this to say about Countrywide:
"The very important point -- that lower interest rates are no longer helping CCR's earnings in the short term -- is also true in higher rates would not hurt. Once the market understands that. we expect to see Countrywide's valuation multiples expanding."
David Loeb, Countrywide's chairman, concurs that the currently high originations are probably neutral in terms of reported earnings.
"But long term, the economic effect is beneficial," he said, noting that the average interest rate of the servicing portfolio is coming down. This tends to increase the average life of the mortgages and thus produces a longer stream of servicing income.
Thrifts are also hoping for a rise in interest rates, but for different reasons.
As lenders that hold mortgages, rather than sell them, thrifts generally have only small amounts of purchased servicing rights. And most of their loans are at adjustable rates and thus less likely to be refinanced.
But borrowers have been showing a marked preference for fixed-rate loans. As a result, originations by thrifts have slumped, stunting their asset growth and ceding substantial market share, especially to mortgage banks.
The thrifts reason that a rise in rates will revive demand for the adjustables that have been their bread and butter for many years.
But the top mortgage banks have grown formidably strong in the meantime and have been poaching on the thrifts' territory by getting very skillful at marketing adjustables as well.
So, while low interest rates have already produced an array of winners and losers, it remains unclear whether rising rates will reverse the situation.