Originators Lend Less But Profit More on Mortgages

A combination of historically low interest rates and reduced competition are fattening home lenders' profit margins, making up for lost volume.

Though falling rates have failed to stimulate homebuyer demand — the Mortgage Bankers Association's index of purchase loan applications hit a 14-year low this month — they also mean lenders make more money on each loan they originate. This is largely because a loan with an above-market rate will fetch a higher price in the secondary market. Especially when there are fewer sellers.

"There's a ton of [investor] demand, very little supply, and what I'm selling has huge margins," said Matthew Pineda, the president of Castle & Cooke Mortgage LLC in Salt Lake City. "This year we're doing better than we did last year, and there's no stress."

More surprising is that the juicier gains on sales of new loans are more than offsetting the increased costs of origination. Tougher regulation has added expenses like licensing fees, and tighter underwriting standards have forced lenders to spend more on things like marketing — to find qualified borrowers — and back-office staffing, because they must hire more processors and underwriters to review loans.

Pineda said 80% of his business is now purchase loans, where margins are especially rich. "We're closing less volume and making more money," even though he contends that aggregators are not paying him enough for his loans.

Michael Isaacs, the president and chief executive of Residential Finance Corp. in Columbus, Ohio, said he expects to earn an average of $1,167 per loan in the current quarter, a 40% increase from the first quarter, because of reduced competition, lower interest rates and bigger spreads on the sale of loans to investors. "The overall net effect is an increase in profits per loan and an increase in basis points on volume," Isaacs said.

Some of the largest lenders would have posted strong mortgage banking profits had they not had to set aside significant reserves for bad loans.

For example, Bank of America Corp.'s mortgage banking income dropped significantly in the second quarter because of rising repurchases of defective loans from investors. But without the $1.2 billion repurchase expense, B of A's production business "experienced higher margins and volumes," Charles Noski, the Charlotte company's chief financial officer, said on its July 16 second-quarter earnings conference call.

Wells Fargo & Co. said mortgage applications rose 14%, to $143 billion, in the second quarter from a year earlier and its pipeline of loans not yet funded was up 15% from the first quarter, at $68 billion.

The company set aside $382 million in the quarter for repurchases. Wells is the largest originator and second-largest servicer, and B of A vice versa, according to National Mortgage News; neither banking company discloses mortgage banking profits.

"Everybody is enjoying robust operating margins — unless you're an institution consumed with legacy problems," said Tom Meyer, the CEO of Kislak Mortgage, a Miami Lakes, Fla., lender that is a unit of the J.I. Kislak Inc. real estate firm. "Mortgage lenders today are dealing with legacy issues and bad loans from the past, which requires additional personnel and resources devoted to them," he said, "and these are mixed up in the analysis of the profitability of new loans."

The outlook for most lenders is a major turnaround from early this year. Lenders thought interest rates would rise because the Federal Reserve said it would stop buying mortgage-backed securities.

Instead, rates fell, sparking a jump in refinancings in early April that, combined with the first-time homebuyer tax credit, helped inflate volumes (though they did not reach last year's ultra-high levels). Though purchase volume has fizzled since the tax credit expired, refi applications are now at record levels.

Mike Cook, a senior vice president at Capital Markets Cooperative, a Ponte Vedra Beach, Fla., provider of secondary marketing services to banks, said that since April lenders have been building a higher margin into the rates they charge so that they will not be overwhelmed with applications or have to hire more loan officers.

Aggregators such as B of A, Wells, Citigroup Inc. and JPMorgan Chase & Co. typically pay more for loans sold in bulk under what is called a "mandatory pricing" arrangement. In return for the higher prices, the correspondent lenders promise to deliver a certain volume of loans to the aggregator.

If it fails to produce the guaranteed volume — say, because stricter underwriting guidelines disqualify too many applicants — the lender pays a penalty. By contrast, smaller lenders that sell under "best efforts pricing" arrangements accept lower prices while avoiding that risk.

Historically, the spread between mandatory and best efforts pricing has been roughly 25 to 35 basis points, but in recent months this spread widened to 80 basis points, Cook said.

"We have seen initial profit margins increase, pipelines double in volume and mandatory sellers realizing huge profits on their loan sales," he said.

Many lenders are grumbling that underwriting guidelines have become too strict. Lenders are spending far more time and money trying to find borrowers who can be approved for a loan.

Anthony Hsieh, the founder and CEO of loanDepot, an Irvine, Calif., online lender, said it has become much harder to find qualified borrowers and the share of loan applications being funded has hit an all-time low.

"Mortgage companies are talking to more consumers and funding fewer loans, but the loans they're funding have attractive margins because of less competition," Hsieh said. "The challenge to the industry right now is not competitors but the quality of applicants. If the cost structure is higher, that will eventually erode margins."