Refi Boom Drives Profits, But Can It Last?

Mortgage refinancings once again drove banks' profits last quarter and, with interest rates at record lows, most industry experts expect the trend to continue at least through the end of the year.

Still, it is not too soon for bank executives to be thinking about the end of the refi boom. In conference call after call this earnings season, CEOs were asked how they intend to make up for the lost profits when interest rates rise and the number of borrowers eligible to refinance ultimately peters out.

"Margins now are fat and everybody loves them," says Joe Garrett, a principal at the consulting firm Garrett, McAuley & Co., in San Francisco. "But at some point, everybody who can refinance has refinanced and eventually all parties come to an end."

Many CEOs were prepared for questions about how they plan to offset an inevitable slowdown in mortgages, saying they are diversifying their revenue streams, expanding into new areas of lending and, of course, cutting costs. Joseph Campanelli, the chairman and CEO at Flagstar Bancorp (FCB) in Troy, Mich., repeatedly used the word "diversify" to explain how the $14.4 billion-asset bank plans to sustain the momentum generated by mortgage originations. Flagstar posted its first quarterly profit in four years in the second quarter, thanks to a 170% jump in residential mortgage originations from the same period last year.

"We continue to use strong mortgage banking revenues to help fuel the growth in other lines of business" — primarily commercial lending — "thus diversifying and lessening the volatility of our revenue streams over time," Campanelli told analysts.

In the short-term, refinancing activity is expected to continue to drive profits. Refi applications soared to their highest level last week since 2009 as the average 30-year fixed-rate mortgage dropped to new lows of 3.74%, according to the Mortgage Bankers Association. Refinancings now make up a whopping 80% of all mortgage applications while home purchases remain anemic by historic standards.

"Both the first and second quarters were really strong and we really haven't seen pipelines slowing," says Jeffrey Harte, a principal at Sandler O'Neill & Partners. "With rates getting as low as they are, refinancing is again economically viable, kicking in a whole new wave of borrowers who have already refinanced and are doing it again."

On top of borrowers refinancing at ultralow rates, the largest mortgage servicers have been inundated since January with a wave of new refinance applications for the revised Home Affordable Refinance Program, known as Harp 2.0. The program has help mostly underwater borrowers with high loan-to-value ratios who previously could not refinance and whose loans are guaranteed by Fannie Mae or Freddie Mac. Harp 2.0 program has brought in an additional 25% of all refinance applications. It also has been criticized for boosting big banks' profits.

Several other factors may help sustain strong mortgage revenue and profits into the second half. Other than Wells Fargo (WFC), the nation's largest retail mortgage lender, most banks are not adding much additional staff to handle the increased volume. Scott Buchta, head of mortgage strategy at Sandler O'Neill & Partners, says a 50-basis-point rise in interest rates could lead to a dramatic drop in refinancing applications and banks simply do not want to be stuck with too much staff when the refi boom slows. Plus less overhead means higher profits.

"Capacity is being built, but banks don't want to build it fast so it doesn't disrupt primary-secondary spreads," says Buchta, referring to the difference between the cost of 30-year loans and yields on Fannie Mae mortgage securities that determine lender's profit margins.

Also, Wells Fargo's exit from wholesale lending and Bank of America's (BAC) exit from correspondent lending has allowed smaller lenders to add market share.

Wells Fargo's mortgage banking income in the second quarter jumped 79% from a year earlier, to $2.9 billion, contributing 63% to the San Francisco bank's total earnings of $4.6 billion in the second quarter. Its originations more than doubled to $131 billion year-over-year as its pipeline of loans hit $102 billion at the end of the quarter.

Chris Marinac, an analyst at FIG Partners, says that banks' mortgage pipelines "were pretty darn full at the end June," which bodes well for third-quarter profits, but eventually banks will be forced to cut expenses to replace strong mortgage revenue.

"This industry needs to get leaner and meaner and there is plenty of fat to trim," he says. "The CEOs know it and low interest rates pressuring net interest margins and the eventual slowdown in mortgage fees is going to have to focus back on process improvements."

McAuley & Co.'s Garrett says that while there's enough refi demand to sustain profits through early next year, banks need to be preparing now for the eventual rise in rates. He advises clients to create board-approved exit plans with clear definitions and specific steps to take when rates rise and refi demand slows. Such plans would kick in when mortgage applications drop by a certain percentage for several consecutive weeks, which could help banks avoid widespread staff cuts.

Still, Willie Newman, president of Cole Taylor Mortgage, a unit of Taylor Capital Group (TAYC) in Chicago, says banks that are truly committed to mortgage lending can only cut staff so much.

"It takes more people to process an application and there's a higher degree of scrutiny for every data point and loan file," Newman says. "The whole industry is just harder."

Mortgage lending once again drove profits at the $4.8 billion-asset Taylor Capital, but the company continues to strive for balance. It recently opened a commercial lending office in the Milwaukee area, its second in Wisconsin, and just launched a nationwide equipment leasing division targeting middle-market firms. The unit is headed by Edward Dahlka, the former president of LaSalle National Leasing in Towson, Md., where Taylor's new leasing arm is also based.

"I've known Ed for many years, and the highly experienced team has an established network in the marketplace," Mark A. Hoppe, Cole Taylor's president and CEO, said when the division was launched in July. "We expect that Cole Taylor Equipment Finance will become a strong source of balance sheet growth and fee revenue for the bank and further contribute to the diversification of our earnings."