Wells Fargo is shrinking its mortgage business. Good.

Big bank Wells Fargo (WFC 3.25%) recently announced plans to significantly scale back its mortgage business, which is a big step when you consider that not long ago the bank was the largest mortgage originator in the country.

Wells Fargo plans to continue providing mortgages for existing customers and home buyers in minority communities. Furthermore, the bank will close its third-party mortgage buying business, in which it would buy mortgages from other lenders. The bank also plans to sell most of its mortgage business.

The move is a big change for CEO Charlie Scharf as he continues to transform the bank, but ultimately one that I think is a good move that will position Wells Fargo more as a modern bank.

The mortgage business is tough

Wells Fargo is one of the few major banks that has remained heavily involved in the mortgage business even after the aftermath of the Great Recession and the subprime crisis.

People are talking in a conference room.

Image source: Getty Images.

In 2021, Wells Fargo was the nation’s second-largest mortgage lender, behind Rocket companies, which generated more than US$228 billion. The refinancing boom in 2021 allowed the bank to collect nearly $5 billion in mortgage banking fees, up from just $3.5 billion a year earlier.

But the mortgage business hasn’t really been attractive since the Great Recession. Low interest rates for much of the last decade have resulted in tight margins, but when rates rise, that can reduce volume, especially when they rise quickly as we’ve seen over the past year.

Business is also quite cyclical. When conditions were extremely fruitful for the mortgage industry in 2021, many analysts warned that this could be the best it could be, which always tends to cloud the industry a bit.

The mortgage industry is also highly fragmented, making it difficult for even the best lenders in the world to gain enough market share to really create a moat. Many would describe mortgages as a product that has become a commodity, so it’s hard to stand out except for the rate the company is offering.

While residential lending has always been a major part of the banking industry, most banks today want to invest their resources in serving clients with whom they can create multiple or strong deposit relationships. Mortgage products don’t really achieve any of that or create a loyal relationship with the customer.

Why this is a positive move for Wells Fargo

It’s no secret that the modern banking model has moved away from the mortgage space to focus more on different types of commercial loans, which are higher yielding loans, many of which will adjust to the federal funds rate.

Relationships with commercial clients also create nicer, lower-cost deposits because the lender will often tell the client that in order to get a loan or line of credit, they must also keep their deposits in the bank.

This model has been more successful over the last decade, and the big banks like it JPMorgan Chase and Bank of America those who leaned towards it were rewarded with higher valuations.

Wells Fargo already has a high-end commercial lending franchise, and Scharf is a protégé of Jamie Dimon, so it makes sense for him to pull back from mortgage lending and invest more in businesses like credit card lending and investment banking. Ultimately, the strategy should generate better returns.

Bank of America is an advertising partner of The Ascent, a Motley Fool company. Wells Fargo is an advertising partner of The Ascent, a Motley Fool company. JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. Bram Berkowitz holds positions at Bank of America. The Motley Fool has positions in and recommends Bank of America and JPMorgan Chase. The Motley Fool has a disclosure policy.

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