Lenders Switch On Their Back-Up Systems

It was a bad week in mortgage land. On June 28, two days before the Federal Reserve raised interest rates, Washington Mutual Inc. (WM ), one of the nation's largest mortgage lenders, announced that its earnings for the year will be at least 17% below analysts' expectations because of lower loan volumes and higher costs. The news knocked down the shares of WaMu and other lenders as investors wondered if the nation's three-year-long mortgage bonanza might end not with a soft landing but with an earnings-pummeling thud.

Bad as the news was for WaMu investors, however, many mortgage companies that have been anticipating a downturn should hold up as the market cools. More diversified banks should see a rise in business loans if the economy continues its recovery. And mortgage lenders are emphasizing adjustable-rate loans, home-equity loans, and loan-servicing businesses that should benefit from increases in interest rates. At the same time, mergers among companies and employee layoffs are expected to lower costs. "Is the rest of the industry going to have trouble on par with WaMu? No," says Sandler O'Neill & Partners banking analyst John Kline. "But it's going to be a very soft market going forward, and it will be proven players that weather the storm best."

There's little doubt that the mortgage industry is in the last innings of a long game. Despite the many Americans who rushed out to buy homes before the hike in interest rates, new applications for mortgages for the last week of June were running at only one-third the level as the same week in 2003. For the full year, the Mortgage Bankers Assn. expects that the total volume of mortgages originated will fall 36% from last year's record $3.8 trillion. Home purchases overall are expected to be flat in dollar terms, while total refinancings could fall by more than half.

Large mortgage lenders are bracing for leaner days ahead. Countrywide Financial Corp. (CFC ), based in Calabasas, Calif., has shifted some of its marketing efforts from refinancings to home-equity loans and loans to customers with less-than-stellar credit histories. Those businesses are less dependent on low interest rates and considered a fairly safe bet because the company packages most of its loans and sells them to outside investors. Countrywide also retains the right to collect mortgage payments, which generates income from fees. Still, the lender expects that its earnings this year will be flat or lower than last year's. "The last three years were extraordinary," says Countrywide Chairman and Chief Executive Angelo R. Mozilo. "We're telling investors to expect more normal conditions."

Rival Golden West Financial Corp.'s (GDW ) strategy is to focus entirely on adjustable-rate mortgages (ARMs), a type of loan that has been gaining popularity as borrowers stretch to buy ever more expensive homes. It may be a riskier strategy, but adjustable lenders like Golden West are hoping that rising loan payments will offset defaults by buyers who bought a larger house than they ultimately could afford.

Meanwhile, consolidation of the industry and downsizing are becoming more common. On July 2, Citigroup (C ) announced that it is laying off nearly half of the 800 employees at the headquarters of its recently acquired Principal Financial Group mortgage business. Even WaMu may be a takeover target: The company, which has grown rapidly through a series of acquisitions, has seen its own stock bounce around on merger rumors.

For the past three years, mortgage lenders have been on Easy Street. Over the next three, only the savviest will thrive.

By Christopher Palmeri in Los Angeles

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