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BankThink

Big mortgage lenders are flirting with disaster

History dictates that playing the long game is a winning strategy. Those who have the discipline to stay consistent — even if that means taking on short-term losses — tend to come out on top.

Unfortunately, big banks are lacking both financial consistency and discipline at the moment. Unchecked, it could lead to losses that could lay the foundation for banking’s next crisis.

Banks are currently barreling down the road ahead, sights set on the expected profits if all goes according to one particular plan. So far, it’s working.

The largest banks have experienced record profits in recent years and 2019 marked the best year for bank stocks in more than two decades.

But while the road looks clear ahead, banks are ignoring all of the warning signs in their peripherals. Without action, they may find themselves caught — with all the tunnel vision money can buy — in a failing long game.

It all centers around the swelling appetite for risk that is seeping back into the marketplace after more than a decade since lending collapsed. Yes, leveraged lending to debt-laden businesses (and banks’ arm's-length relationship to it) currently gets the scary headline. But downplaying banking’s role in the borrower risk that is creeping back into the mortgage sector is a mistake.

The money-losing actions banks are taking now have already set off a chain reaction, with effects felt across the industry.

According to data from the Mortgage Bankers Association and the mortgage advisory firm Stratmor, the levels of cash big banks hemorrhaged on mortgages in 2018 was even more staggering than many in the industry assumed.

Large banks withstood an average loss of $4,803 for every retail mortgage originated in 2018 (compared with a net profit of $376 per loan for independent mortgage bankers). Appetite for these kinds of losses is increasing.

Wells Fargo, JPMorgan Chase and Bank of America have all shown an affinity for originating loans with negative margins, by offering certain mortgages with no origination fees, for example.

Losing money on these loans in the short term makes sense for a number of reasons. It’s seen as more than affordable to sit back and take a hit on the profitability of mortgage originations because banks aren’t chasing front-end revenue anyway.

The real money is in mortgage servicing rights, or MSRs. The financial structure prioritizes MSRs over origination revenue.

At the end of 2018, financial forecasts in every corner of the industry predicted rates would increase in 2019, which would have reigned in early payoff risk and boosted MSR portfolios in a big way. This is especially true for large banks that are still some of the biggest players in the mortgage space.

Translation: the gravy train rolls in just as soon as rates start doing what everyone predicted. And in the meantime, while compression ruled the day, banks could rely on a diversified set of revenue-driving tools to offset the losses. A $35 overdraft fee generates as much revenue as does lending out $1,000 at 3.5% for the year.

In other words, losing money on mortgage originations in the short term is perfectly palatable, so long as the bet on interest rates pays off in the long run.

However, there’s a problem. Banks need one thing for this massive bet to pay off that simply isn’t happening: Rates have not gone up.

Interest rates haven’t even stayed stagnant. They're actually at record lows.

This prolonged rate slump has encouraged mortgage refinances by the millions. And the resulting boom means that MSR portfolios are decreasing in value across the industry because prepay risk looms large.

Whether or not the Federal Reserve once again cuts rates remains to be seen. But here’s the reality: It doesn’t matter. Regardless of the moves the Fed makes or doesn’t make, balance sheets won’t look nice.

Furthermore, there’s nothing foreseeable coming along that’s going to lift rates in any significant way to reverse this trend.

The stage is now set for greater risk assumption. After all, something’s got to make up the loss.

By now, the proliferation of non-QM (qualified mortgage) products is a well-known phenomenon. However, many experts have quickly noted that these non-QM products absolutely are not, by any means, the same as subprime lending.

They’re right (mostly). The majority of non-QM loans are specifically structured to give banks and borrowers a little breathing room, while also keeping borrower risk under the dangerous levels of the early 2000s.

But the non-QM products that are typically meant for self-employed borrowers or real estate investors have only inched the industry forward in risk tolerance. And there are some truly eyebrow-raising loan schemes that have begun to follow.

Non-QM specialists are partnering with independent mortgage banks all over the country offering products like these to stay afloat while banks continue to squeeze the market as they wait for interest rates to rise.

Warehouse lenders are the next rung on the risk-tolerance ladder. As they’ve seen their market dry up with the exit of smaller IMBs — and as remaining IMBs have begun to offer non-QM loans — warehouse lenders almost have no choice and but to raise their risk tolerance to compensate.

The chain reaction has already begun. Sooner or later it blows up, at least without an interest rate hike.

Banks need to better understand the big picture in order to truly see how their decisions impact the greater market. Losing money on originations in the short term, in hopes of a larger payout later, is much more significant than just a market efficiency play.

In fact, the move can potentially exacerbate current market conditions, which are fragile to say the least. If the risk ripple effect continues, everyone loses, especially the big banks.

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