In most markets -- be it stocks, bonds, or commodities -- most participants never realize the market has topped until it's too late. But for banks and the rest of the nation's mortgage lenders, the signals are as clear as can be. It's becoming painfully evident that the current surge in housing activity probably represents the blow-off to a four-year party.
The latest evidence: The Commerce Dept.'s May 26 report that sales of new single-family homes fell 11.8% -- the biggest monthly drop in a decade. Mortgage demand could decline even more sharply in coming months. Already, refinancing activity is down more than half from 2003's record pace. And overall mortgage originations could tumble 36.5% in 2004, to $2.4 trillion, and an additional 28% in 2005 as demand for housing cools and refis dry up, says Doug Duncan, chief economist for the Mortgage Bankers Assn. (MBA).
Tally it all up, and it may not be a pretty sight for the financial sector. Richard X. Bove, bank analyst for Hoefer & Arnett Inc., a San Francisco brokerage, expects bank and thrift profits to grow by as little as 6% this year and a mere 5% in 2005, after years of 20%-plus growth. Two new forces are likely to play havoc with bank profits: a margin squeeze as the Federal Reserve raises short-term funding costs and the rise in mortgage delinquencies and defaults among borrowers -- many of them with weak credit -- who have opted for adjustable-rate mortgages. Says Bove: "At the risk of a little hyperbole, 2005 is going to be a bloodbath."
Just how much pain will an industry contraction cause? Plenty, for the simple reason that the nation's banks and thrifts have increasingly staked their loan portfolios on the mortgage and home-equity businesses. Over the past year, banks have raised their holdings of residential mortgages by some $125 billion, to $1.35 trillion, or about 18% of their assets. At the same time, home-equity loans have soared by 36% over the past year, to a record $324 billion. To handle these loan volumes, lenders have built up huge infrastructures. According to the MBA, total mortgage-related employment has risen by 120,000 since 2001.
Now it looks likely that banks and thrifts will have to drastically pare back on those extra workers. Indeed, the Seattle thrift, Washington Mutual Inc. (WM), laid off 2,900 in the first quarter after eliminating 4,500 in the prior four months, with most of the cuts coming in the firm's mortgage lending departments. And the end of the mortgage boom is likely to trigger a deeper shakeout within the industry. "There are a lot of regional banks, brokers and mortgage banks that built their operations on refinancings," notes Joe Anderson, a senior managing director at Countrywide Financial Corp. (CFC). "When that business goes away and the margins drop, they don't have other options."
The consolidation is already beginning: In mid-May, Citigroup (C) acquired Principal Residential Mortgage, a Des Moines-based mortgage servicer, while Regions Financial (RF) and Union Planters (UPC) agreed in April to combine their mortgage operations. And on May 21, Washington Mutual's shares climbed nearly 9% on speculation that it might sell out to HSBC Holdings (HBC). A Washington Mutual spokesman declined comment.
For the moment, though, most mortgage lenders are straining to keep the music playing as long as possible. GMAC Mortgage Corp. has slashed its closing fees to as little as $900 and is allowing borrowers to lock in for as long as 60 days before closing, vs. the 45-day window that most lenders provide. "You have to look at your margins and see what you can give the consumer," says Ralph Hall, chief operating officer for GMAC Mortgage (GM).
But some mortgage brokers and credit counselors contend that lenders are loosening their credit standards to qualify as many new borrowers as possible. And they claim that they're pushing borrowers toward adjustable-rate mortgages that sport initial rates as low as 1.6% -- but that could surge to upwards of 8% if rates climb sharply. "There is a much greater willingness on the lenders' part to make the loan than in the past," surmises Steve Bucci, president of Consumer Credit Counseling Service of Southern New England.
Certainly, lenders are writing more loans to so-called subprime borrowers with poor credit histories: The volume of such loans surged 70% in the first quarter of 2004, to $105.6 billion. They now account for 18% of all mortgage activity, vs. 7% in the first quarter of 2003, according to Inside Mortgage Finance, a mortgage trade publication. If rates rise fast enough and high enough, analysts believe banks and thrifts could be facing "some scary defaults in the mortgage business," predicts George R. Yacik, a vice-president at SMR Research Corp., a Hackettstown, N.J., mortgage research firm. "There could be some real pain for lenders here."
Lenders maintain that they remain prudent. For one, they say sophisticated risk modeling with computer programs allows them to better predict the likelihood of defaults and charge more to cover greater losses on riskier loans. Many lenders maintain that they're not basing their lending criteria on the initial level of the ARMs deals they're now offering, but on worse-case scenarios in which rates rise much higher. "The industry has had the benefit of hindsight. We saw the big players -- the West Coast thrifts -- go out of business the last time," explains Anthony T. Meola, an executive vice-president at Washington Mutual.
No doubt about it, the 1980s housing boom had an ugly ending. Will lenders emerge in better shape this time? The amounts involved are much higher today, so let's hope so. Either way, there's a bumpy ride ahead.
By Dean Foust in Atlanta, with Christopher Palmeri in Los Angeles, David Welch in Detroit, and bureau reports