The Mortgage Biz Has Lost Its Fizz

Goodbye, refi boom. Hello, sinking profits and industry consolidation

When H&R Block Inc. (HRB ) decided to expand into the mortgage business in the late 1990s, Chief Executive Mark A. Ernst made a big bet that the move would help bolster profits during the lean months between tax seasons. And for years the move paid off. In the fiscal year ended last April, for example, the mortgage division delivered fully 58% of Block's operating income.

But like many financial execs, Ernst is suddenly finding out that the mortgage business isn't what it used to be. With the refi boom largely over since April, earnings are tumbling. Despite a 2.7% rise in mortgage originations for the quarter ended Oct. 31, Block said that its mortgage profits plunged 42%, to $106 million -- pushing it back into the red in its fiscal second quarter. Moreover, analysts expect Block's profits to slide an additional 19% for the quarter that ends Jan. 31. Competitors "are just pricing loans much tighter than what we would have anticipated," Ernst told Wall Street analysts.

Block's woes are symptomatic of the problems sweeping the mortgage business. With activity slumping and the industry still awash in overcapacity, an intense pricing war has broken out, squeezing profits throughout the industry. The fierce pressures are setting the stage for a new round of consolidation in the coming year. Many analysts figure marginal lenders will attempt to cut their losses and sell -- particularly if the Federal Reserve's campaign to raise interest rates boosts mortgage rates high enough to take the remaining steam out of the housing market. As if that weren't enough, the industry's problems could be compounded by the accounting woes of mortgage giant Fannie Mae (FNM ), which will be forced to bolster its capital reserves in the wake of accounting restatements that could wipe out $9 billion of prior earnings going back to 2001.


The roots of the industry's problems are no mystery. Mortgage activity has fallen off sharply since the Fed began hiking rates last spring. From a peak of $1.2 trillion in the third quarter of 2003, mortgage lending slumped to nearly half that amount in the same quarter of 2004. For the full year, mortgage lending looks set to drop 26%, to $2.8 trillion. It's expected to dip an additional 17% in 2005. The culprit: the huge slide in refis. For the third quarter, refis plunged 72%, to just $226 billion -- a drop that overshadowed the healthy 20% rise in mortgages used to purchase new and used homes in the same stretch.

Those pressures could get even worse in the coming year. With Fannie Mae facing the prospect of raising between $3 billion and $13 billion in fresh capital to satisfy its regulators at the Office of Federal Housing Enterprise Oversight, some analysts fear that it could be forced to sharply scale back its purchases of mortgages from banks and other primary lenders. A sudden drop in purchases by Fannie, in turn, could add to the upward move in mortgage rates that is already being driven by Fed rate hikes. And that could threaten the continued boom in sales of new and used homes. The regulatory pressure on Fannie "could have a significant effect on the mortgage market," says Arthur Frank, director of mortgage-backed securities research for Nomura Securities International Inc. (NMR ).

Already, some firms have begun downsizing to adjust to the end of the refi boom: Washington Mutual Inc. (WM ), for instance, which has so far shed almost 9,000 of its 26,000 mortgage-related jobs over the past year, is trimming the number of full-time workers by an additional 1,800 to 2,000 in the current quarter. And across the country, scores of mortgage brokers have begun putting out the "for sale" sign in hopes of getting bought out by a larger lender. "Some small banks and mortgage brokers are bailing out of the mortgage business altogether," notes Bert Ely, an Alexandria (Va.) banking consultant.


For the most part, though, many of the large players that have built up massive infrastructures for processing loans are pushing ahead full throttle. "There has been no falloff in [lending] capacity," notes Keith T. Gumbinger, a vice-president at HSH Associates, a Pompton Plains (N.J.) mortgage research firm. "Right now there's a game of chicken going on in the industry."

The result has been a fierce price war as lenders fight for the remaining business: According to HSH Associates, the average rate lenders are charging for a 30-year fixed mortgage has fallen from a plump two points over the yield in 10-year Treasuries at this time last year to a far skimpier 1.6-point premium. While the price war has been a boon for borrowers -- helping to keep the average 30-year fixed-rate mortgage down around 5.69% -- it's coming at a time when lender profits are already being squeezed by falling demand. Washington Mutual, which bulked up heavily in mortgage lending in recent years, reported a 34% decline in third-quarter profits on falling volume, while Countrywide Financial Corp. (CFC ), the nation's largest mortgage lender, saw profits fall 47%.

To keep their loan pipelines full, many lenders are diversifying their product mix. One hot seller: home equity lines of credit. And some are pushing the envelope to qualify as many would-be borrowers as possible with so-called "Alt A" loans that require minimal income documentation. While lenders insist that these new loans will perform fine, some analysts fear that defaults could rise as a result of more liberal lending standards. "It's going to start hitting the fan about a year from now," says George R. Yacik, a vice-president at SMR Research Corp., a Hackettstown (N.J.) mortgage research firm.

Thinner profits, growing default risk. It's enough to make lenders pine for the good old days of last spring.

By Dean Foust in Atlanta

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