Christopher Whalen: The death of mortgage lending
It's not the CFPB's fault
Over the past couple of weeks, you may have been given the false impression that Richard Cordray and his colleagues at the Consumer Financial Protection Bureau are working to destroy the US mortgage market. Likewise, you may have the false impression that various consumer groups and advocates are making mortgage lending unattractive as a business for banks and non-banks alike.
But the truth of the matter is that even if Richard Cordray was back in Ohio, where he formally served as Attorney General — a reality where the CFPB and said housing groups didn't exist — the US mortgage market would still be in trouble.
Were there no CFPB or Dodd-Frank Wall Street Reform and Consumer Protection Act, banks and non-banks alike would be backing away from the mortgage business. The significant withdrawal of players such as Nationstar and Bank of America from retail lending, and the collapse of the mortgage wholesale and correspondent markets, is just the start of a more generalized retreat of capital from residential mortgage lending that has its origins long before 2010, before Dodd-Frank passed and the CFPB was created.
The simple reason for this statement is that the mortgage business, as it stands today, is not particularly profitable, in a nominal sense.
If you actually take the time to look at mortgage lending based on a risk-adjusted return on capital, it quickly becomes clear that no rational investor would want to put capital behind a standalone lending operation.
Let’s start with the basic economics of the mortgage lending business, ignoring the additional costs attributable to CFPB regulation, the mortgage settlement, Basel III and the various other laws and regulations that have been put into place since 2010. We’ll also ignore the extraordinary gain on sale opportunity that was available to mortgage lenders before the 2007-2009 crisis and then through 2012 thanks to the zero interest rate policy put in place by the Federal Open Market Committee.
Those days are over.
The simple fact is that to make the loan and pay the related fees to the lending personnel, compliance consultants, lead providers and other third parties, puts the average lender in the hole for a couple of points at the time of closing. We’re not talking here about the cost of the loan to the consumer, but rather the cost to the lender. In order for the lender to break even on the loan, the asset must be retained and serviced for at least three years. Only at that point, the loan will begin to be profitable to the lender/servicer, but then only to a relatively modest degree, especially compared to other asset allocation choices available.
In the most recent Q1 2014 earnings reported by JPMorgan Chase, for example, the bank reports that its loan applications fell by 57% year-over-year. The readers of HousingWire might be tempted to believe that this precipitous drop in new loan applications is the result of aforementioned regulatory pressures, but in fact the folks at Chase don’t really want to make mortgage loans.
Since 2010, it seems, the overall lack of profitability in mortgage lending has caused Chase, and others, to slowly move away from this asset class. This is why that total mortgage banking headcount at JPMorgan was down nearly 3,000 since the end of the year and about 14,000 since the beginning of last year, according to the conference call on Friday.
Simply stated, there is nobody available to take that theoretical loan application.
“The new regulations are a very convenient excuse for the large banks to get away from what is a crappy business,” one former senior mortgage banker recently told me. “When you look at mortgage lending compared to buying more Treasury bonds, the choice is clearly the latter. Mortgage lending was a loss leader even before the new CFPB regulations were put into place.”
Now reading the latest earnings reports and conference call transcripts, you might think that the big banks are working hard to reverse the decline in mortgage banking.
Chase noted during the conference call:
Overall Mortgage Banking net income was $114 million for the quarter. Despite a relatively favorable rate environment, the market got off to a slow start in 2014. We’re seeing tight housing inventory in some markets and the purchase market was affected adversely by the severe weather. This led to a challenging quarter to the mortgage business with production of $17 billion, down 27% quarter-over-quarter and 68% over last year.
If you understand that every dollar of mortgage banking revenue is, on net, costing Chase and the other big banks money, then the decline in volumes and revenue is not really bad news at all. Sure, it takes time and money to redeploy people and assets to other lines of business, especially if you are a public company that must manage revenue and earnings on a quarterly basis. But shrinking the mortgage business is actually a sign of rationality at banks like JPMorgan Chase – even before you factor in the added cost imposed by Dodd-Frank and CFPB regulation into the equation.
There is probably a minimum size that the largest banks will find acceptable for mortgage lending operations, a base capability that will allow the institution to service important customers and show regulators that they are compliant with standards like the Community Reinvestment Act. But as the largest depository institutions slowly evolve into narrow banks, with no principal trading activities and limited risk profiles on their customer facing activities, the residential mortgage lending business is likely to shrink to a tiny fraction of pre-2010 levels.
Areas such a commercial real estate, commercial lending, credit cards and investment management are going to receive the lion’s share of the capital and management attention. The gross yield on earning assets at all Federal Deposit Insurance Corp. insured banks focused on mortgage lending was less than 3.6% at the end of 2013, for example, but was more than 10% for credit card specialization banks. Even with a higher cost of funds, credit cards is a far better lending business that residential mortgage lending.
The real question is whether or not non-bank firms are going to be able to make lending work as a standalone business, without combining it with special servicing and distressed asset strategies to generate overall profit. When you look at the totality of the cost of lending, including origination and fulfillment, servicing, default management, IT, premises, risk management and corporate overhead, most lenders today are not even close to being profitable on many of the loans they write.
Consultants talk about expedients like reorganizing process change, IT enablement and outsourcing as the secret sauce for returning the mortgage business to profitability, but these are marginal fixes at best. Much as some people would like to blame the death of residential mortgage lending on Richard Cordray and the happy campers at the CFPB, they really don’t deserve the credit. Though Dodd-Frank and the CFPB clearly are making things worse in terms of the cost of lending, the fundamental economics of the residential mortgage lending business would still stink without them.
The reality is that mortgage lending is a tough, miserable business with shrinking spreads and rising costs.
Without the opportunity for outsized gains on sale into a vibrant securitization market, there are really few incentives for many lenders to stay in the game. Indeed, most large lenders are targeting significant net reductions in loan servicing portfolios over the next several years.
The mortgage market is in a sustained decline in terms of retained portfolios, loan sales and new origination volumes from the unsustainable levels of 2001-2007.
And no one entity can be held responsible.