Mortgage origination is one of the most cyclical businesses out there. When times are good, companies do great. When times are bad, they are usually very bad. This was the case even with the economic disruptions caused by the COVID-19 pandemic. Companies in this sector must be prepared for this cyclicality or must consider not participating.
Wells Fargo (WFC 3.25%) recently announced that it will drastically reduce its mortgage banking business. Why is Wells throwing in the towel? Has the cyclicality become too great?
Mortgage banking is a business of feast and famine
Last year was terrible for the mortgage banking business. During 2020 and 2021, mortgage bankers feasted. The Federal Reserve cut the prime lending rate to the bottom to help stimulate the economy and offset the economic drag of the COVID-19 pandemic. This triggered a huge wave of refinancing activity as borrowers rushed to take advantage of the low rates.
The volume of mortgage banking grew in response. You can see the jump in the chart below. Note that the chart does not include data for the fourth quarter of 2022, which is expected to be well below the third quarter of 2022, driven by higher rates and seasonality.
Volumes and profit per loan are in decline
However, the original volume is only part of the story. Most mortgage loan originators don’t keep the mortgage originations — they mostly sell them by securitizing them or sell the volume to someone who can securitize. These mortgages end up packaged into mortgage-backed securities where they end up on the balance sheets of mortgage-backed real estate investment trusts (REITs), pension funds or sovereign wealth funds. The profit that original manufacturers earn from these sales is a key input to their profitability. Profit margins have fallen throughout 2022 and there is no relief in sight so far.
Wells Fargo management decided it made sense to reduce the bank’s stake in the mortgage business rather than wait for a recovery. The mortgage business is under pressure from a number of factors, including sluggish home sales, rising mortgage rates and intense competition. Over the past year, many mortgage bankers have folded, including Sprout Mortgage and First Guaranty. Loan depot decided to get out of wholesale and HomePoint sold its respective mortgage origination business. Wells Fargo is a consistent mover in the top five, so this is a big event. However, Wells Fargo isn’t going all out; will dedicate its loans to existing banking clients and underserved areas.
Wells to sell most of its mortgage services
Wells will also sell a large portion of its mortgage servicing portfolio. Mortgage servicers perform administrative tasks of mortgage management on behalf of mortgage securities investors. The servicer collects monthly payments, sends the principal and interest to the investor, ensures that property taxes and insurance are paid, and works with the debtor in case of default. The servicer receives a fee of 0.25% of the mortgage balance for performing these tasks. So if the mortgage balance is $400,000, the servicer gets $1,000 a year. The right to perform this duty is worth something, and the rights to service the mortgage are capitalized as an asset on the balance sheet. A servicing mortgage is one of the few assets whose value increases as interest rates rise.
If the US enters a recession in 2023, two things will happen to mortgage servicing. First, delinquencies will increase, which means a higher cost of servicing those loans. Second, rates will fall as the Fed turns to supporting the economy rather than fighting inflation. Since delinquencies and mortgage rates are inputs into the servicing value of the mortgage, values have probably increased as much as they could. Wells Fargo is striking while the iron is hot and will sell at highs. Additionally, the Consumer Financial Protection Bureau’s laser-like focus on servicing helps lower Wells Fargo’s profile.
Buybacks are also growing
Finally, government-sponsored entities Fannie Mae and Freddie Mac more and more redemption requests, which is an additional headache for loan originators. When an originator packages a loan into a securitization, Fannie and Freddie can require the seller to buy it back if they discover a defect in the loan. These redemption requests sunk a bunch of originators after the Great Recession and are starting to happen again. That’s an industry problem, and we’re also seeing smaller mortgage originators go out of business. If Wells is unable to forward the redemption request (because the original lender no longer exists), it will have to redeem the loan. if the loan cannot be adjusted, Wells will have to either keep it or sell it in the market at a loss.
While reducing its footprint will not eliminate the risk of repurchases, it will prevent it from increasing. Given that it will take some time to turn around the fundamentals of the startup business, Wells Fargo made the decision to leave the market to non-banks such as Rocket companies and UWM Holdings. Overall, Wells Fargo’s exit from the stationery business will leave the company to pursue more profitable activities. Correspondent lending is known to be a low-margin business, and it will also at least somewhat reduce a company’s regulatory risk.
Wells Fargo is an advertising partner of The Ascent, a Motley Fool company. Brent Nyitray, CFA has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.