Confounded Interest: Why Housing Continues to Perplex Lenders

Craig Blunden started Provident Financial Holdings' mortgage shop in 1987, and has witnessed a lot of cycles. The "craziest" time, not surprisingly, came in the mid-00s. Real estate in California's Inland Empire was white hot, and lenders willingly tossed fuel on the fire.

"Stated-income loans were big here; option ARMs were big. You had four hairdressers pooling their money to buy a house and flip it," recalls Blunden, now Riverside, Calif.-based Provident's CEO. "We had to participate in those things to compete. If we didn't do it, we would have needed to lock up our doors."

Today, things are much calmer — too calm for Blunden's taste really. After two years of healthy home price increases and activity, the market is stalling. Inventories of for-sale properties have shrunk and affordability — the median price of a house in southern California is around $300,000 — has become an issue.

In its fiscal fourth quarter, ended in June, Provident's originations of single-family mortgages fell to $477 million, down 43% from the year-earlier period. With the home lending business under pressure, Blunden recently redeployed manpower from mortgage originations to commercial real estate, a sector that he says looks promising, but is still weak. "It's been really slow coming out of this recession," Blunden says.

The herky-jerky revival of the housing market is causing headaches and strategic concerns for banks everywhere. Though the residential real estate market is starting to recover in some places, it remains dormant in others and, perhaps most unsettling for bankers, is prone to yo-yo in areas like southern California and Las Vegas, where big jumps in prices and sales volumes have been followed by lulls.

Average prices are up nationally — 9.3% for the year ended in June, according to the S&P/Case-Shiller Index. The National Association of Realtors reports that sales of existing homes jumped 2.6% in June, the third consecutive month of increases. But new home sales, considered vital to the broader economy, fell 4.9% nationally during the first half of the year, according to the Census Bureau.

The Mortgage Bankers Association predicts that total originations will come in right around $1 trillion for the year, which would be the lowest level in two decades and a steep drop from last year's $1.7 trillion.

"The real disappointment this year has been a weaker purchase market than expected," says Mike Fratantoni, the MBA's chief economist. "We're looking at about a 10% decline in purchase volume relative to 2013."

The housing market's struggles are an issue for revenue-starved banks. According to Keefe Bruyette & Woods, more than 30 percent of industry balance sheets — roughly $3.5 trillion — are directly related to the buying and selling of homes. Throw in loans to ancillary commercial business, such as contractors and retailers, and the figure climbs higher.

"The strength of the housing market is a pretty good indicator for what makes banks profitable," says KBW analyst Fred Cannon. In a healthy market, "collateral values are going up, people feel confident and borrow more, and credit quality is usually pretty good."

KBW notes that the stocks of banks in California and Nevada, where home prices have shown stronger appreciation, have higher median valuations than those in the Midwest or Northeast, where house prices have been more stagnant. "When housing suffers, banks usually don't do as well," Cannon says.

At Wells Fargo, the nation's largest housing lender, second-quarter revenues declined to $21.1 billion from $21.4 billion a year earlier; over the same period, revenues from mortgage originations and sales plunged 71%, to $688 million from $2.4 billion. Earnings rose 3%.

"If you exclude mortgage, they're humming on all cylinders," says Scott Siefers, an analyst with Sandler O'Neill & Partners. "There's no question about it. If you had a normal housing market, they'd be flying high."

The story is much the same elsewhere. In the first quarter — admittedly a rough one due to particularly heavy snowfall in the Northeast and Midwest — the industry's mortgage banking fees were down from the year-earlier period by a whopping 53.6%, to $4 billion, according to the Federal Deposit Insurance Corp. Originations, at $235 billion, were the lowest in recent memory.

The second quarter saw originations jump to an estimated $267 billion, according to the MBA, and many banks reported higher mortgage-related revenues. But it's all a pittance relative to recent years, and profits remain under pressure — especially when the escalating cost of regulation is added to the equation.

The typical lender has been losing money on every new loan, due to rate competition, mandated caps on origination fees and, of course, higher compliance costs, says the MBA's Fratantoni. "Even when the revenues are doing fine, the expenses are going through the roof."

The housing market has obviously caused the banking industry a lot of pain. Beyond the hundreds of billions in losses and mountains of regulatory fallout, bank reputations took a huge hit from which they have yet to recover. It seems barely a week goes by without one bank or another reaching a big-money settlement with the Justice Department or some agency related to the subprime crisis.

The frustration among bankers is palpable; there's a sense that housing owes the industry after six years of saga. As Ed Wehmer, CEO of the $19 billion-asset Wintrust Financial in Chicago, says: "Housing got us into this mess. Housing has to get us out of it."

Yet finding a catalyst remains elusive. While many other lending segments, including auto and commercial, are showing impressive gains, the jumpstart that the housing market — and the broader economy — needs has yet to emerge.

"Everyone believed that the recovery would be spurred by housing," says Liz Jordan, a director who specializes in credit and lending for Deloitte & Touche LLP. "Now that things have slowed, we're seeing concern about the implications for a full recovery."

Originations were thrown a lifeline by the Federal Reserve's Quantitative Easing program, which in recent years fueled an unprecedented refinancing boom that kept lenders busy. In 2013, refis accounted for $1.1 trillion, or 66% of all originations, according to the MBA.

Rates jumped near the end of 2013 when the Fed began signaling a reduction in bond purchases, and the refi boom abruptly halted. In the first half of this year, just north of $200 billion of refi originations were expected.

Barring an unforeseen drop in rates to rekindle refis, it's now up to purchase transactions to keep the momentum going, and that's not happening. At a projected $273 billion in the first half of the year, purchase mortgage volume was off about 15% from the same period last year.

"The refi business is where we thought it would be, but the purchase market hasn't been nearly as robust as we expected," says Michael Todaro, senior vice president for residential mortgage at M&T Bank in Buffalo.

M&T originated about $1.8 billion of mortgage loans in the first half, well under half its production in the year-earlier period. "We thought there was some pent-up demand out there, but it hasn't materialized yet," Todaro says.

Most mortgage professionals agree the big overarching hang-up is a shortage of first-time homebuyers. First-timers accounted for 28% of existing home sales in recent quarters, compared with about 50% in normal times, Fratantoni says.

"We just haven't seen the household formation from the millennial generation that everyone is expecting to materialize," says Peter Boomer, executive vice president of production for PNC Mortgage. "A lot of young adults are still living at home or renting."

Franklin Codel, executive vice president of production for Wells Fargo Home Mortgage, says low buyer demand caused by "misinformation" about the difficulties of qualifying for mortgages, is a key culprit. "There's a widespread belief out there that you can't buy a house without a 20% down payment or perfect credit," he says.

But, Codel notes, the Federal Housing Administration, Fannie Mae and Freddie Mac all offer programs for borrowers with less-than-perfect credit scores and down payments of less than 10%, "provided you have full documentation."

It doesn't help that there aren't as many houses to buy. In June, 2.3 million existing homes were on the market, according to NAR, representing about 5.5 months' supply. In 2007, both figures were double that.

In some markets, such as Baltimore, only about three months' supply is available. "In many of our markets, we're just not seeing normal inventories," Modaro says.

Many would-be sellers are reluctant to put their homes on the market, "because they know it will sell extremely quickly and they'll have nowhere to go," Codel says. Others are still trying to make up losses in equity following the housing crash or are reluctant to give up low rates locked in during the recent refi boom. "If you're sitting on a 3.5% rate, you want to hang on to it," Modaro says.

The sluggish housing recovery is forcing some hard decisions by bank managements. In the past year, most banks have announced significant staffing cutbacks. Wells Fargo, with about 16% of the origination market, saw mortgage banking revenue drop 42 %, to $3.2 billion, in the first half of 2014, and has laid off more than 10,000 employees in the past year.

Overall mortgage industry employment has fallen to 279,000 in June, compared to more than 500,000 during the boom times. That is a particularly dramatic change, though flux in staff levels is a familiar reality for mortgage lenders. "You need to keep your fixed costs as low as possible, and then be able to cut your variable costs very quickly when the market moves away from you," Wehmer says.

Smaller banks are wrestling with how much to invest in a business that now requires pricey systems, processes and personnel. While mortgages are certain to remain a foundational product for most banks, the "profitability dynamics" of the business have changed, says Siefers, of Sandler O'Neill.

Margins are tighter, costs are higher and mortgages — once considered the safest loans on the books — now look a little risky. "When you know a loan can get pushed back on you
10 years later if it goes bad, it changes your perspective," Siefers says.

Many lenders, like Provident, have been slashing or redeploying origination staff to control costs. Some have gotten out of the business altogether — or at least tried to. Following the announcement of its $680 million merger with MB Financial, Chicago-based Taylor Capital Group attempted to sell its mortgage unit, but couldn't find any takers.

"You're seeing a lot of banks at a crossroads. They're struggling with low demand, tighter credit and lower profits," says Jordan, of Deloitte & Touche. "They're asking, 'Where does that leave me with this product? Is it something to bet heavy on? Or do I only offer it as a convenience to my valued customers?'"

Lenders with the capital and patience to withstand a slump — and the scale to efficiently manage stiff new compliance costs — figure to have an advantage. "The challenge, especially for the smaller guys, is, 'Do you have enough volume to spread those high fixed costs around?'" Fratantoni says.

Wintrust has acquired four independent mortgage companies over the past three years, all of them challenged by the costs of higher regulation. It is looking for more deals, confident the market will rebound.

"The market is going to consolidate, and strategically, we think being in the mortgage business is a nice long-term play for us," Wehmer says, adding that he expects a "slow-but-steady return to normalcy" fueled by broader economic growth.

The underlying rationale behind Wehmer's bet — that homeownership remains a vital part of the American Dream — is, not surprisingly, shared by most bankers. But the foundations of that belief have been shaken by the crisis and changing economic, demographic and regulatory landscapes.

Younger families that comprise the bulk of first-time buyers are buried in student loan debt. According to the New York Federal Reserve Bank, some 30 million Americans carried $1.08 trillion in student loan debt at the end of 2013, up more than 10 percent last year alone.

And while jobs are once again being created, real disposal per-capita income, at $37,226 in May, is about 1% lower than it was six years earlier, according to the St. Louis Federal Reserve Bank.

The mechanics and rules of lending also are tougher. Everywhere a bank turns nowadays, there's a regulator focused on either the institution's risk profile or preventing borrowers from overextending themselves.

There are no more low-doc/no-doc loans, no negative amortization or interest-only loans being made to questionable borrowers. In fact, pretty much anyone with a FICO score of 600 or lower is out of luck when it comes to securing housing-related credit.

The Consumer Financial Protection Bureau earlier this year introduced its "qualified mortgage" standards, which among other things limits a homeowner's debt to 43% of gross income — a particularly high hurdle for the growing number of self-employed workers, who often have trouble documenting their incomes.

"In a market where total debt-to-income is now a regulatory constraint on being able to get a loan, we're seeing stagnant incomes keeping people from qualifying for a mortgage," Frantantoni says.

FHA-guaranteed loans, intended to help less-qualified borrowers, filled much of the post-subprime vacuum, with originations of 1.1 million loans in 2009, or roughly 44% of the total. But a recent hike in the premiums for required mortgage insurance has squeezed as many as 1 million potential homebuyers out of the market, officials say.

Some fret that we could be witnessing more of a structural shift, with younger families preferring to rent instead of buy. Multifamily construction has exploded in markets like Chicago, where Wintrust's Wehmer worries about a rental bubble.

Since 2006, the U.S. market has added 5.5 million renter households, while losing 1.6 million owner-occupied households, according to the MBA.

Getting those young renters out of their apartments and into houses has become an emphasis. The question is, how does that happen?

Banks, and even government agencies, are working to get more buyers into the pipeline. The CFPB has granted a seven-year exemption from the QM rule to Fannie Mae and Freddie Mac, meaning that any loan accepted by the two government-sponsored enterprises' automated underwriting systems is accepted, even if it exceeds the debt-to-income ratio.

Banks are making so-called "non-QM" loans to good borrowers who don't quite fit in the box. Earlier this year, Wells Fargo reduced the minimum FICO score for applicants to 600 from 640. Those applications aren't approved as often, come with higher rates and usually are held in Wells Fargo's portfolio. "We see quality borrowers in that cell that, when properly underwritten, demonstrate an ability to repay," Codel says.

Wintrust has resurrected an adjustable-rate mortgage that it used to offer before the subprime rage for "good customers with some issues, such as being newly self-employed," Wehmer says. Those loans don't qualify for sale on the secondary market. "We charge a little premium on it and hold it in portfolio, and then eventually shift the customer into a long-term fixed rate loan," Wehmer explains. "We think we can build that into a four- or five-hundred-million-dollar portfolio that will churn quickly over time."

This is the way the banking industry works. Cycles happen, paradigms change and individual players react. They find ways to innovate around the roadblocks placed in front of them, and others copy them. No good idea remains proprietary for long.

Today's market might be maddening for those who pine for a quick housing rebound, but longtime market observers say what we're seeing is about as normal as things have been in over a decade, before the artificial support of subprime lending created a bubble. It's just going to take some time to work through things. Despite the bumps along the way, the general direction will be upwards.

"As the economy improves,the housing market will get better," Provident's Blunden says. For bankers, that day can't come soon enough.