Interest rates jumped, pipeline pressure fell, and profit margins on mortgage production appear to have retreated in the fourth quarter.

Judging from the difference between yields in the secondary market and rates that consumers pay (see charts below), however, profitability on originations continued to be healthy during the period. (The relationship between asset prices and yields is inverted, so higher consumer rates relative to secondary market rates indicate higher profits for lenders.)

Still, with higher rates dampening demand for refinancings, the industry has forecast a steep decline in production volume, which, if the historical pattern holds, could simultaneously lead to a further erosion of "gain-on-sale" margins.

The average rate on a 30-year, fixed-rate conforming mortgage increased 36 basis points from September to 4.71% in December, according to Freddie Mac, failing to keep pace with a 66-basis-point increase in the yield on Freddie bonds into which such loans are packaged.

On average across the final three months of the year, consumer rates exceeded secondary market rates by 67 basis points, well off a blowout 88 basis points in the third quarter, but still elevated compared with the middle of the last decade, when production volumes were higher.

Gain-on-sale margins tend to rise when demand for loans strains industry capacity and reduces price pressures on competing originators, and the industry tends to build up capacity in reaction, curtailing margins.

Margins appear to have held at unusually high levels overall during the last three years relative to production volumes, perhaps reflecting the radical consolidation that took place in the industry as the crisis cut down scores of competitors.

Other factors are also likely at work. Discussing Wells Fargo & Co.'s strong third-quarter mortgage results during the company's earnings call in October, Chief Executive John Stumpf said that "there was a time when there was very little margin in the prime business" because there were outsize margins in the subprime business, but that "things change, and we are making a fair return."

Of course, there are other issues in mortgage banking beside production margins these days — most prominently, massive servicing failures and huge costs to repurchase faulty loans underwritten during the bubble years.

And with the Mortgage Bankers Association having predicted that originations will fall by more than a third this year to about $967 billion, business conditions are likely to become less hospitable.


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