Bankers: How Should It Be?

I have been sitting on an airport tarmac for 45 minutes. Twenty-first in line. Waiting for a re-route from the tower to avoid the rain drops. Such is the way that it is.

But how should it be?

In banking, do we ask ourselves how it should be?

My firm analyzes bank processes to identify how it is, versus how it should be. But the question goes deeper than how a wire is done versus how it should be done. Answers are typically “it depends”. And what it depends on is in the eye of the beholder. Is the beholder the employee? The customer? The regulator? The shareholder?

Last year I did a blog post Build Your Own Small Business Loan Platform. In it I described having a series of options to fund small businesses. Some options were on the bank’s balance sheet, some not. What the post does not say is just because you could advance a loan to the customer, doesn’t mean you should.

Take the following example:

Suppose Jane and John Doe, owners of J&J Bikes, come into your bank for a mortgage loan. The bike shop has been doing well the past couple of years and the Doe’s want to upgrade their lifestyle into a bigger house.

So they find one. And come to your bank to finance it.

Your bank has a robust menu of mortgage loan programs. And the Doe’s are pushing their limit on loan-to-value, and debt-to-income. But based on the last two bumper years at the bike shop, they are feeling pretty good about their future and moving to a new, tony neighborhood.

You recognize that the Doe’s business is cyclical, and suffers revenue setbacks during recessions. Their ability to service the mortgage payments on their dream home would be significantly impaired if their revenue dropped as little as 20%.

But they would qualify for the mortgage with one of your loan programs. Since your bank sells the mortgage to investors, and you would meet the investor’s underwriting criteria, the risk of the Doe’s defaulting would fall on the investor. And your mortgage originators only get paid on closed loans.

Do you do the loan?

How it should be…

A relationship driven bank would be concerned about more than the risk of the investor putting back the loan to the bank. It should be concerned about the potential downward spiral of the Doe’s should the bike shop befall hard times and they can no longer service the mortgage.

The Doe’s are not the financial experts that know what would happen if they can’t make the mortgage payments. You are.

So you counsel them on the pitfalls of pushing their financial limits to live in a large home. Values of larger homes fall more in recessions because buyers become scarce. So if they can’t make payments due to a recession impacting their bike shop, they may not be able to sell their home at its current value either.

You tell them to look at past recessions, and the bike shop’s decline in revenue. And look at homes where they can sustain the mortgage in hard times.

I’m not suggesting telling them no, you won’t do it. But be the financial counselor your strategic plan wants you to be. The Doe’s may not appreciate your advice initially. But you would be their trusted advisor for a long, long time.

Or you can put them in that new high LTV loan program from your aggressive investor so you can pay your originator and hit the budget.

How should it be?

~ Jeff

Uncle Sam: Get out of my house!

Freddie Mac posted a $4.5 billion fourth quarter profit. Fannie Mae did not yet report but made $1.8 billion in the third quarter. So our Government Sponsored Enterprises (GSEs) are minting over $25 billion to their owners... Uncle Sam. Folks, revenue to the government is like crack. Congress won't be taking up GSE reform anytime soon.

This poses a challenge for bankers. Twenty five percent of our loans are in residential mortgages (see chart). Eighty percent of mortgage originations currently pass through the GSEs. In other words, Uncle Sam owns the mortgage market and dictates its terms. Ever heard of a QM (qualified mortgage)? I would not call myself a libertarian because there are legitimate reasons for the government to participate in free markets. When the payoff is long term, such as drug research, comes to mind.

But residential mortgages are not the same as the cure for pleuropulmonary blastoma. The market is fairly mature. FHFA (regulator for the GSEs) Director Edward DeMarco recognizes this and is working on developing a sustainable mortgage trading platform that can eventually be in private hands. Mortgages can be done by banks, credit unions, and the shadow banking system, without Uncle Sam's assistance.

If you believe what I say is true, and perhaps our Congress finds religion to make it so, there will be changes. Some of these changes will not benefit consumers in the short term. Mainly, we are likely to see a decline in the number of 30-year mortgages.

Now, I have a 30-year mortgage. Who wouldn't with rates so low? But, truth be told, there is no way a financial institution (FI) can find 30-year funding. I understand that the "average" mortgage loan lasts seven or eight years because people move. And that there is some cash flow to the FI because the loan amortizes. But there is no seven year funding FIs can tap either. 

If the mortgage market became more private, the 5-1 or 7-1 ARM would assume a higher perch. This is more palatable to FI risk managers and would allow for them to put more of these loans on their books. If booking the loans, they don't have to worry about the tail risk and all of the other bad things that can happen as a result of government intervention and QMs.

I don't believe 30-year mortgages would go away. Their would still be a secondary market with private investors to purchase pools of mortgages. Additionally, FIs may determine to book some 30-years, and to accept the interest rate risk or hedge it. But the 30-year will begin to be priced to market, instead of artificially low because of all the government interference.

The end result will be a resurgence of local FIs willing to lend and book their customers residential mortgages. There will be more choices for borrowers. And yes, borrowers will more frequently have to accept interest rate resets sooner than 30 years out.

How do you think FIs can more fully participate in residential mortgage lending?

~ 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

Mortgage Refinance: Thanks Uncle Sam!

My wife and I are in the throes of refinancing our mortgage. The impetus was trading down from a 5.875% rate to 4.375%. This week, we received our loan application package, that includes the Good Faith Estimate (GFE) of mortgage costs, on the lesser-known form HUD-GFE.

Background information: Mortgage rates are at all-time lows due to continued economic weakness, Federal Reserve policy keeping short-term Fed Funds rates near zero, the Fed's policy of buying government bonds in the open market and keeping long-term rates low, and government support for Government Sponsored Entities (GSE's, i.e. Fannie Mae, Freddie Mac) that continue to finance home mortgages. My wife and I would like to lower our monthly payments over the same term we have remaining on our current mortgage. Makes sense to me, then we received our application package.

The package contained 36 pages of difficult to understand disclosures. They required us to affix our signature 23 times. The GFE estimated our settlement charges at $7,941.75. Yes folks, to refinance our mortgage through the same financial institution that currently services (although does not own) our current mortgage, we have the opporunity to pay them $8k. To be fair, only $2,175 goes to the lender, which is paydown points for getting the low rate. Another charge is to fund an escrow account, which sounds ridiculous to us considering we have an escrow account with the same lender on the same property for our current mortgage.

Other charges include title services, including insurance. This is another part of the refinance process that makes no sense. We bought our home six years ago and paid for the title search and insurance at that time. Must it be done again to refinance? Where that requirement comes from, I don't know. But it is emblematic of the perplexity of the mortgage financing business.

This is an example of "We're from the government and we're here to help" good intentions combined with bad results. I think there could be mortgage finance rules drafted in a one or two page piece of legislation that makes it easier on all of us... borrowers, lenders, investors, and regulators.

Here is what I recommend to improve the process:

- For refinancing to the same homeowner on the same piece of property, an electronic title search is all that is required for homes where title insurance has been purchased within the last ten years;

- Permissions to verify income and account information can be done on a one-page letter;

- GFE's can be made much simpler and more condense. I predict my 11 year-old could come up with a more understandable form;

- Create an automated form that enumerates tradeoffs with financing closing costs or paying them. I went through a mathematical exercise because of my knowledge of the industry, re-investment rates, etc. to make my determination. Does or could everyone do the same so they make an informed decision?

- Create an automatic query and bid system once a mortgage application is made to settlement agents and title insurers. My guess is not many of us have "relationships" with these firms, so selecting nearby agents that participate in an electronic bid system would be extremely helpful. The same could be done for appraisers. I think if hotels.com and priceline.com figured this out for hotels, we could get something going for these service providers. These costs can go on the GFE directly from the bid system.

My guess is costs for the title, settlement, and appraisal engine would come down as a result of the competition. Right now, borrowers probably go with the company(s) recommended by the lender. This puts a premium on getting and staying on the lenders' recommended lists, which probably equates to many expensive dinners and tickets to great seats at sporting events.

At the end of the day, borrowing money and using your home as collateral should be easier, much easier, than it currently is. I think if we sat back and asked ourselves, "what makes sense here", the process would be a lot different... and probably less expensive for the borrower, less difficult for the lender, and easier to regulate.  What are your thoughts on the mortgage process?

The Mortgage Market Meltdown & Uncle Sam

There is a lot of troubling discussion about what to do so the mortgage meltdown that occurred in late 2008 does not happen again. Public outrage was first directed at banks in general, then migrated upstream to the big "fat-cat bankers", i.e. those top 19 banks that were told to take TARP funds.

Now, politicians and former Fed officials (namely, former Fed Chairman Paul Volcker) are calling for a reinstatement of Glass-Steagall, that depression era law that separated commercial banking from investment banking. It's worth considering, if it will prevent the rapid housing bubble that caused the mortgage market collapse. But wait...

According to the San Francisco Fed, banking's share of the mortgage market peaked at 75% in the mid 1970's (see http://tinyurl.com/frbsf10-09 for the Fed's letter). That percent shrunk to 35% in 2008. Why? Government Sponsored Entities (GSE) (i.e. Fannie Mae, Freddie Mac, Ginnie Mae) dominated the market, and still do so to a greater degree today.

Government guaranteed bonds (now, post GSE bailout, we know they are government guaranteed) flooded the mortgage market with money, allowing even the diciest of borrowers to own their piece of the American dream. Housing values bubbled, the bubble burst, borrowers defaulted, loans went bad, bonds backed by mortgages were severely devalued.

Now we want to blame the fat-cat bankers and split their trading operations. How about, instead, the government slowly exits the housing market? Here is what I think would happen:

- Mortgage brokers, who originated most of the poor-quality loans, will be squeezed out, leaving only the most reputable in business because the hucksters won't have anyplace to sell their bad loans;

- Banks would utilize underwriting discipline because they will keep the loans on their books or the private mortgage buyers will hold them accountable for misleading underwriting practices;

- Banks will create mortgages that are palatable to their balance sheets (i.e. straight ARMs or 5/1's, etc.). Right now, banks are leery of keeping 30-year mortgages because there is no funding source with that long of a duration... and I predict people will buy them because the 30-year will now be priced with the duration risk it deserves because the government won't be keeping prices artificially low;

- Alt A and sub-prime will rebound, but will be prudently managed as small portions of a balance sheet or private investor portfolios, and will be correctly priced;

- No extreme housing bubbles. There will still be ups and downs, but not like skiing Killington!

The current climate is too politically charged for acting on this proposal right now. But, if our objective is to solve the problem, let's get it right on exactly what caused the problem.

Your thoughts?????