Does fee income hedge banks and credit unions from spread swings?

The drum is starting to beat again for fee income in the minds of banking executives and in financial institution strategy sessions. This week I heard "hedge" against interest rate fluctuations, a comment more common in the late 1990's to mid 2000's. So I ran some numbers, and the answer to the post title is: it depends.

Fee income comes in many sources. And for most community banks, which I define as banks with less than $10 billion in assets, fee income comprises 10%-20% of total revenue, on average. See the table for a break down of fee income sources by Call Report category for community banks.

With all the talk about fee income lines of business, much if not most of our fee income comes as additional revenue from traditional spread products, such as deposits or residential mortgages. This makes sense. It is our primary business, and fees improve the profitability of bread and butter banking.

But what about this hedge philosophy? I was skeptical. I know from my company's profitability measurement service that fee income products contributed 1% to profits at the average, and -0.8% at the median of all clients. Admittedly, this includes loss leader products such as safe deposit boxes. But, in the main, fee based products are not dropping much to the bottom line.

However, when I sorted top fee based banks and compared their Return on Average Assets to the industry, it appears as though having significant amounts of fee income does protect the institution from the ski slope decline in financial performance that plagued the industry. In effect, high levels of fee income gave financial institutions a softer landing at the bottom (see chart).

But if financial institutions want more from fee based lines of business than to soften their fall, they must focus on delivering profits. This has been a challenge. When I hear executives clamor over fee income, they more often than not focus on revenue generation, not profits. In my experience, profits have been elusive. 

I hear lots of excuses why fee-based LOBs don't make money: soft insurance market, best efforts execution on mortgages, stock market decline, high pay to keep talent, yadda, yadda, yadda. I once heard a complaint from a head of Trust about having to share the copier expense with another department that used said copier more. 

Bottom Line: Insurance, Trust, Investment Advisory, Mortgage Banking, these are all businesses that are common sense complements to traditional spread banking. Almost all of bank customers demand these services. 

Why can't we deliver them profitably?  

~ Jeff

Mortgage Banking: How profitable should it be?

I recently spoke to an old friend that is a bank equity research analyst and asked him how his coverage universe was doing with second quarter earnings. He said his "mortgage banks did great". Meaning that those that specialized in originating and selling or putting residential mortgages on their books had a great quarter due to the strength of originations.

Occasionally I get asked how much a mortgage banking unit should make. This is a tough question because there are various models. One where all loans are brokered and closed in the funding bank's name (mortgage brokers). Another model is where the bank funds the loans at closing and holds them for a brief period until they are packaged and sold (mortgage banking). The opposite extreme is where the financial institution books and holds the loan until maturity or pre-payment. This model is typically followed by some thrifts and credit unions.

What has proven the least profitable model of late is the mortgage brokering or holding mortgages briefly until sold. These models tend to rely on mortgage originators for volume, versus using traditional bankers such as branch managers or consumer lenders. Mortgage originators are notorious for demanding a significant slice of the revenue pie of the mortgage banking unit. This puts pressure on profitability.

I took a look at banks within my firm's profitability universe to look for models that relied heavily on originations then quick sales. My criteria was to ensure that over 50% of the unit's revenues were from fees on sold loans. It was true that just under half of the revenues of those that I reviewed were from the spread. But I wanted to get a granular look at how much a mortgage unit "should" make. The results are in the accompanying table.

There you have it. If your financial institution has a mortgage banking unit, it seems reasonable to me that your leadership should require profits of 25% of revenue. In efficiency ratio parlance, that is a 75% efficiency ratio. Not exactly knocking the cover off of the ball.

But I have found that many mortgage origination shops subscribe to what one banker described to me as the "five cookies" approach. If there are five cookies on the plate, is it fair that one party should take four and a half and leave the crumbs for the other party? Especially since the crumb-keeper must bear most of the risk.

Why be in a business that isn't improving your bottom line? It's a fair question.

~ Jeff

Let's retake the mortgage market!

Community financial institutions are grappling with the recent and pending mortgage rules. We fear the Consumer Finance Protection Bureau (CFPB) and government's tendency to fire a bazooka at an ant, causing tremendous collateral damage.

New rules aside, we were not that significant in the mortgage market anyway. Aggressive mortgage brokers hawking products and programs from money center and category killer banks, and government or quasi government agencies such as Fannie and Freddie, were killing us in terms of competition. Lastly and perhaps more importantly, because we collateralize and sell a significant percentage of mortgages into bonds and off of bank balance sheets, the 30-year mortgage became the most prominent. The 30-year carries too much interest rate risk for us.

So we opened the door, let the competition through, and we ceded the mortgage market to brokers, specialists, and the government.

As most FIs are hungry for assets, they are looking for loan volume wherever they can get it. I encourage you to rethink the residential mortgage loan. Two of our clients recently did so, and are finding ways to profitably offer this staple loan product to their customers and communities. With many brokers now out of business, and the government looking for ways to reduce their participation, can we find opportunities to retake what we have previously ceded? I think so.

I recently ran an analysis of all of my firm's product profitability clients to determine exactly how profitable residential mortgages are in the industry. The results were surprising to the client and helped them to peel back the onion further to uncover opportunities to increase production and reduce per-unit costs in their residential lending unit. See the table below for a portion of this analysis.

A note on the data. The profitability of the residential mortgage product is based on fully absorbed costs. So the per-unit cost not only contains direct origination and maintenance costs such as the mortgage originator and the loan servicing department, but also the indirect costs such as a portion of the FIs senior lender, and overhead expenses such as portions of the Finance Department.

What the data shows is that, in an era of needing loans on our books or revenue through our income statement, mortgage loans are doing relatively well. Why shouldn't we do more of it?

One reason may be the variability of volumes. For example, volumes were down in my home state of Pennsylvania from 2009 through 2010, the latest year HMDA data is available. In 2009, there were 374 thousand loans funded for $62 billion. In 2010, 334 thousand loans were funded for $55 billion. This variability is common, and FIs must build their capability with a greater percentage of variable expenses than other lines of business so they can decrease expenses as volumes decrease. But come on people, although down, $55 billion of loans are being funded per year in Pennsylvania alone!

Residential mortgages are critical components of being a community FI. Most of our customers either have them, will need them, or have had them. A fair amount of small business funding can be achieved through residential lending, either through straight mortgages or home equity loans. Big government and aggressive loan brokers made us small players in the market.

I say we should take it back! What do you say?

~ Jeff