Back from the Brink

Jacksonville isn’t known for having a hot real estate market. The sprawling metropolis on the Southeastern coastline is home to a large U.S. military presence and 830,000 people more likely to buy second automobiles or second rifles than second homes.

But just like its well-heeled cousin further south, Miami, Jacksonville’s real estate market is surging back from near collapse six years ago. The median single family home price in the Jacksonville area climbed to $170,000 in August, a 23 percent increase from the year prior. Some of the more attractive homes are getting multiple offers, and 14 percent sold for more than the list price in July.

“We just don’t have enough available properties for the demand,” says Carol Zingone, the president of the Northeast Florida Association of Realtors. It’s not just home sellers who are happier than a year ago. There are plenty of lenders in the Jacksonville market willing to offer historically low interest rates for qualified buyers. J.P. Morgan Chase & Co. just opened several new offices in and around Jacksonville. Wells Fargo & Co. does some business here. So does Bank of America Corp.. A huge host of community bankers do as well. Buyers with as little as a 620 credit score can get a loan. The minimum down payment is 3.5 percent for a Federal Housing Administration (FHA) loan. Of course, all buyers have to jump through a rigorous set of underwriting hoops, and many loan products such as no-documentation mortgages are no longer available.

The market has changed dramatically, not just in Jacksonville, but everywhere. Fears about risk and liability are making banks and thrifts extra cautious about the loans they do. Some big banks have almost completely left the mortgage business and a new crop of competitors, including non-bank lenders, are stealing market share as others retreat. There are opportunities ahead for banks that perfect their mortgage processes and offer real value for consumers.

But there also are storm clouds and some banks are likely to get doused. Interest rates are rising, creating additional risk for bank balance sheets. Refinancing is plummeting as interest rates rise, reducing volume but putting banks in the purchase loan market at an advantage. New regulations threaten to upend the business with qualified mortgage and risk-retention rules, creating a gargantuan compliance challenge. Congress is debating ending the lives of quasi-government entities Fannie Mae and Freddie Mac, which, in combination with the FHA, still prop up the vast majority of the mortgage market by buying mortgages and securitizing them, which frees up capital for originators to make even more loans. There is much to worry about in the future of the mortgage business, but there is much to celebrate in it as well.

In Florida and other states such as California, the recovery has been swift. Attracted by low prices, investors backed by hedge funds and private equity companies such as Blackstone Group L.P. have swooped into many of the hot markets and scooped up homes and condos expecting to rent them out and flip them in a few years.

John Tuccillo, the chief economist for Florida Realtors, the association of real estate agents in the state, says fully half the sales there involve investors. Prices fell a whopping 47 percent in Florida between 2000 and 2006, but have recovered to roughly 2004 levels, according to the association. “Florida’s economy has been growing pretty steadily,” he says. “It is growing in all areas.”

It’s not just Florida. There has also been a recovery in the nation as a whole, which never saw prices on average climb as much as they did during the height of the housing boom in Florida, Las Vegas, Nevada, or Southern California. Nationally, prices are now about what they were in 2005. The national median existing home price for all types of homes was $212,100 in August, just 8 percent below the record high set in July of 2006, at $230,400, according to the National Association of Realtors.

The Mortgage Bankers Association (MBA) forecasts that purchase mortgage volume will climb 22 percent in 2013, and another 14 percent in 2014. However, overall volume will fall because refinancing has been a huge part of the mortgage market the last few years as interest rates reached rock bottom. Total market originations should drop about 30 percent in volume in 2014 compared to 2013 because of falling refinance volume, says MBA Chief Economist Jay Brinkman.

That sounds bad, but there actually is opportunity for banks in a market like this, Brinkman says. A lot of the companies who rely heavily on refinance business are non-bank lenders and big institutions who are able to compete heavily on price. But smaller banks that have strong ties to their local markets and real estate agents should be able to take advantage of that as the market shifts from refinancing to purchase. Brinkman thinks banks also have an advantage with low-cost funding through deposits, which non-bank lenders don’t have. He estimates banks have about a 30 basis point cost advantage, as non-bank lenders have to borrow at rates of about 3 percent or 4 percent currently to fund loans.

Plus, many of the big banks also are scaling back in the face of reduced default rates and declining refinance volume, which could create more opportunity for others. Bank of America Corp., J.P. Morgan Chase and Citigroup Inc., have cut employees in the face of a slowdown in refinancing and the need for fewer work-out employees in the bad loan department. Wells also recently got out of several joint ventures to fund mortgages.

A lot of other big players are simply not there. Countrywide Financial was the top mortgage lender in the nation back in 2007. It no longer exists. Washington Mutual, the Seattle-based bank that was another huge lender, is no longer in the market after being acquired by J.P. Morgan Chase during the financial crisis. Wells Fargo, the top mortgage lender in the country, has doubled its market share in the last year to more than one-fifth of all mortgage originations in the second quarter of 2013, according to the publication Inside Mortgage Finance. Chase is the No. 2 lender, followed by Bank of America, which has a market share of just 5.2 percent of all mortgage originations, according to the publication, off from 7.4 percent six years ago.

“The major players are simply not there, so you are seeing others rise to the occasion,” says Cliff Rossi, a professor at the Robert H. Smith School of Business at the University of Maryland. He worked at Citigroup between 2007 and 2009, where he was the chief risk officer for the consumer lending group. There, he remembers then-Chief Executive Officer Vikram Pandit, brought in to upright the teetering ship, corralled mortgage servicing into a holding company for assets the company wanted to sell or eliminate. Citigroup also got rid of correspondent lending, where large institutions lend to smaller banks so they can make loans.

As of the second quarter, the total loans of many big banks were shrinking compared to a year ago while smaller banks were growing their total loans, particularly in terms of single-family housing, according to an analysis by investment bank Keefe, Bruyette & Woods Inc., using Federal Reserve data.

In the place of banks that have scaled back or disappeared, non-bank players such as Quicken Loans Inc., a Detroit-based online mortgage lender, have surged. If you call Memphis-based First Horizon National Corp., once one of the largest residential lenders in the country, and ask for a 15-year or 30-year loan, you will quickly be transferred to a Quicken Loans call center, for example. PennyMac Mortgage Investment Trust is another big player in the lending market, and so is PHH Mortgage Inc., which offers private label mortgage services to banks.

Several big banks just aren’t that interested in maintaining a huge mortgage servicing business, or an origination-to-securitization platform, with all its risks and liabilities and compliance hassles. KeyCorp has $90.6 billion in assets, which makes the Cleveland-based banking company one of the largest in the nation. After getting burned in the financial crisis, when it was a big lender to homebuilders and developers, it got out of that business. It does offer some multi-family and senior housing loans, as well as single-family owner-occupied mortgages. But for owner-occupied mortgages, it has an agreement with PHH to handle the underwriting, processing and servicing. Some loans might end up on KeyCorp’s balance sheet, mostly home equity and adjustable rate mortgages, and others will be sold to the government-sponsored enterprises (GSEs).

“We recognize one of our client’s most important decisions is to buy a home or sell a home,” says E.J. Burke, executive vice president and head of KeyBank Real Estate Capital. “We will always be in residential.” But there are limits. Burke says the bank doesn’t want stand-alone mortgages that don’t come with a banking relationship. “Are we interested in attracting new clients? Absolutely. But if you are interested only in a mortgage and do banking with someone else, we don’t have an interest in that.” KeyCorp doesn’t have the size or scale to really compete nationally on residential loans, Burke says.

Many of the big banks also are dealing with lawsuits over their loan portfolios, getting sued by everyone from investors, to state attorneys general, to the GSEs. “A lot of the big banks are tied up in their shorts, in terms of making mistakes, because they are getting sued every day,” says Lee Kyriacou, a managing director at Novantas LLC in New York, a bank consultancy. Fannie Mae and Freddie Mac are auditing defaulted mortgages and demanding banks buy back bad loans when there was an error in documentation.

The heightened attention to risk is causing some big banks to take two months to close on a purchase loan. Kyriacou said his lender, whom he didn’t want to name, took five months to close on his refinance. Char Roehrig, an owner of ACS Mortgage, a brokerage in Barrington, Illinois, says an underwriter on one of her loans wanted proof that a couple had gotten married by requesting the marriage certificate and photos of the wedding. That sort of environment creates opportunities for small banks willing to close loans quickly and efficiently, while still handling documentation well.

United Bank, a $1-billion asset institution in Zebulon, Georgia, about 50 miles south of Atlanta, is one of those. It acquired a thrift in 1990 and has done mortgages ever since. Last year, the bank originated 430 mortgage loans totaling $66 million, and this year is on pace to beat that with just under 500 loans and about $71 million in volume. “We have had a very good year,” says United Bank CEO Jim Edwards. “We have added mortgage originators and have tried to focus on it. Mortgage represents probably 15 percent of bank-wide earnings this year.”

United Bank has a $300-million loan servicing portfolio, and makes 25 basis points on loans it services for Freddie Mac. It’s not just the income United Bank likes. Servicing offers a competitive edge, because United Bank can promise customers it will service their loans. United Bank customers can talk to a live person seven days per week on the phone, from 7 a.m. until 11 p.m. at night. That’s a real value for the suburban and rural customers who frequent United Bank’s offices in nine counties, some of whom are third generation United Bank customers. United Bank generally closes its loans within 30 days of application.

“We find if we acquire someone’s mortgage, we pretty much become their bank,” Edwards says. United Bank takes mortgage applications face-to-face or over the phone. That provides an opportunity to sell other products and encourage customers to get mortgage payments debited directly from their bank accounts. Mortgage banking also is good from a workforce perspective. The servicing business provides stable income. “We’re a 100-year-old bank,” Edwards says. “It’s not our style to hire 10 people in January and lay them off in December. That’s not to say we don’t make adjustments because we are a business.”

Still, new regulations are a hassle for small and mid-sized banks such as United. The Consumer Financial Protection Bureau (CFPB), created by the Dodd-Frank Act in the aftermath of the financial crisis, has issued a host of new rules governing everything from how loan officers should get paid, to what mortgage forms should say, to how banks should document their customers’ ability-to-repay mortgage loans. New qualified mortgage standards go into effect in January. In exchange for issuing qualified mortgages under the guidelines, banks get safe harbor status for those loans from lawsuits by consumers. Fannie Mae and Freddie Mac loans will automatically qualify under the new rules. Still, Edwards is concerned that some of his customers who don’t qualify for a Fannie Mae or Freddie Mac loan will be shut out of the mortgage market, although he still is working out the details of how his bank’s mortgage products will be impacted.

“I know some banks have backed away from all mortgages and we don’t feel that meets the needs of our community,” he says. The bank has always done mortgages and has built up a nice enough business to do it well. “We can’t walk away from that segment of the market,” Edwards says. Others take a dimmer view of regulation than Edwards does.

“It’s become a very difficult business the last seven or eight years,” says Bill Cosgrove, vice chairman at the MBA and CEO of Union Home Mortgage Corp., an independent, non-bank lender in Strongsville, Ohio. Cosgrove has added quality control officers and uses outside vendors to manage compliance at an additional annual cost of $1 million compared to four years ago. The lender is regulated by the CFPB and 20 states where it does business. “Today the bar is a perfect loan with perfect documentation,” he says. “Full documentation is good. But today, we are over-documenting the files. It’s not good for the consumer.”

Bob Davis, an executive vice president of the American Bankers Association, says that in the past, credit problems and sudden changes in interest rates were the dominant risks in mortgage banking, and now regulatory compliance is one of the biggest risks as well.

“There have never been 4,000 pages [of new regulations] for one line of business before but now we’re here,” he says. “You have to be confident that you have the ability to manage these risks.” Banks that violate the new ability-to-repay standards are in violation of the Truth in Lending Act. Lenders who make loans outside the qualified mortgage standard are opening themselves up to lawsuits from borrowers who later run into trouble with those loans. “Those are nuclear options,” he says. “If you don’t protect yourself against them, it can drive you out of business. It’s a huge business challenge.”

On top of all that uncertainty, Congress is now debating the future of Fannie Mae and Freddie Mac, two entities that enjoyed the implicit backing of the federal government and were bailed out in spectacular fashion during the financial crisis. The private securitization market, which collapsed during the crisis, is still recovering. Non-agency backed mortgage security originations accounted for less than 1 percent of the market in the second quarter, at $4.34 billion, according to the publication Inside Mortgage Finance. Most of that was jumbo loans. Still, it was quite an increase from last year, when every quarter saw fewer than $2 billion worth of mortgages originated outside the umbrella of a government agency’s backing.

What will it take for private investors to purchase mortgages that aren’t backed by the federal government? It will take a more stable regulatory environment where the rules of the road are clear, perhaps. No matter what happens with Fannie or Freddie, Davis predicts that banks that have relied on mortgages as an important part of their business plan will stick with mortgages. Others might drop out. “How much do you really want to understand something that is so complex and is not a key part of your business?” Davis asks.

Michael Schuchardt, a managing director responsible for the credit risk practice at consulting firm Protiviti Inc., in Menlo Park, California, says some of his customers are reassessing whether they want to be in mortgages at all. Most of his clients are lenders with more than $50 billion in assets. Many of them have to revamp their mortgage processes to make them compliant with the new rules. “The housing market is relatively hot,” he says. “It’s like trying to change a tire on a car going 60 miles per hour down the freeway. All this stuff is kind of happening all of a sudden.”

Some options for banks that aren’t comfortable handling all aspects of mortgages in-house include using third party vendors or originators that will underwrite and handle all aspects of the lending process for you. Quicken Loans started a Charlotte, North Carolina-based division in 2010 to offer a non-bank alternative that will pay banks a 1 percent to 3 percent fee at closing to originate a loan for Quicken Loans Mortgage Services. The originating bank fills out the paperwork and Quicken underwrites the loan and then services it, says Tod Highfield, vice president of the division, which did $11 billion in volume last year.

The division works with banks that mostly range in size from $500 million to $1 billion in assets, according to Highfield. They don’t want to turn their customers away by saying, “‘Go down the street and go to Wells Fargo or one of the larger banks,’” he says. “The mortgage business has become a tough business to manage over the years.”

It’s not just compliance risk, but interest rate risk that may become a problem for many banks. Data from the Federal Deposit Insurance Corp. (FDIC) says that the industry’s loan to deposit ratio was 70 percent in the second quarter, down from 90 percent in 2004 and 105 percent in 1999. That means banks are lending out just 70 cents for every $1 of deposits. With slow loan growth and margins squeezed with low interest rates, federal regulators, including the FDIC, have expressed concern that banks are taking on more risk and holding longer-maturing assets to try to improve yield.

“Clearly, exposure to interest rate risk has increased across the country, and it is incumbent upon bank boards to make sure this risk is being managed,” says Dan Frye, area director of the Boston office of the FDIC in a video on the agency’s web site.

The agency says that at the end of 2012, 46 percent of banks had long term assets that amounted to more than 30 percent of their total earning assets, meaning those assets mature or re-price at terms longer than five years.

“We are seeing more and more banks going long to deal with falling margins,” Frye says on the video. There are ways to manage that risk, but the board needs to make sure it is being managed correctly. If hedging strategies are being used, the board should understand those strategies and specify what types of strategies are acceptable, according to the agency. Banks should undergo tests to see how an interest rate shock of 300 or 400 basis points affects the balance sheet, according to FDIC guidance.

Kyriacou says banks are holding more mortgages on their books than in years past because loan growth is so slow, leaving banks with few options on where to invest. The total amount of first lien mortgages on the books of banks is growing at 2 percent to 3 percent per year, he says. That’s less of a problem if those are adjustable rate mortgages, but he suspects banks are taking on more risk to handle slim margins.

“The banks are holding [mortgages] because they don’t have any good use for their deposits,” he says. He suggests board members ask questions about the bank’s policies regarding holding or selling loans. How has the economics of the equation changed? “You are going to get told, ‘We don’t have a lot of options, yields are falling,’ and those are all true,” he says. “But there needs to be a very open discussion on the subject so people know what the risks are going forward.”

Bank boards should be setting the bank’s credit risk tolerance, says Schuchardt. He thinks boards should ask: Is the bank easing its credit standards? If competition is getting tougher, how is the bank staying competitive without loosening standards? What is the bank doing to comply with the new mortgage rules from the CFPB? What are vendors doing? How do the bank officers know whether the bank is compliant with new rules? What systems and controls are in place?

Credit risk is one thing, but compliance is a totally different issue. Lowell Alcorn, a managing director with PwC in the firm’s Charlotte, North Carolina office, says the biggest risk that should concern the board is compliance risk. “[Mortgages] are a business where you can be quite profitable if you can manage the risk,” he says. He suggests the board have direct conversations with the compliance department and even have a third party consulting firm assess the program. Any bank that doesn’t have a strong compliance program ought to pause before getting into the mortgage business.

“If you don’t have much of a mortgage business or operation, but you still want to stay in the mortgage business, there are others who can originate and service on the bank’s behalf,” he says. He suggests that in addition to focusing on compliance risk, banks should invest in technology to improve efficiency and enhance the customer experience. Many young people are more than happy to fill out applications online. In many cases, they prefer that to going to a branch.

He encourages banks to look for talent outside the banking industry, and encourage innovation. In one instance he cited, KeyCorp brought in an executive outside banking to improve operations. The bank figured out how mortgage modifications were held up with cumbersome paperwork that was leading to more phone calls and more employee resources devoted to individual requests. KeyCorp simplified the process and improved its rate of mortgage loan modifications, he says.

“The willingness to embrace radical change-whether that means implementing new technology, reengineering operations or revolutionizing the corporate culture-will separate the leaders from the laggards and the enduring from the extinct,” he writes in a report on the topic.

For now, the survivors are plugging along, quite certain they will be around for five or 10 more years. Edwards is happy his bank is able to offer mortgages with a level of care his competitors can’t. But he does know he will have to adjust to regulatory and market changes. His bank does not have an online application process but expects to get one soon. Mortgage will provide an opportunity for his bank and others that want to invest in operations, technology, compliance and customer service. But those banks will have to take it seriously.

“It’s a different world,” Cosgrove says. “It has literally changed completely.”