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Some recent developments have tipped the scale in favor of a worsening economy. A key mortgage research firm is now calling for more hard times.

In late 1989, the financial outlook was bright for residential mortgage lenders. A whole series of improved conditions and new opportunities lay on the horizon. Three consecutive years of hard times for many mortgage players seemed about to end.

But by mid-1990, the outlook had changed yet again. SMR Research believes mortgage lenders must prepare immediately for another round of hardships. The culprits this time include a lot of bad luck, plus newly proposed regulatory changes.

A number of economic changes have occured that are likely to hit hard on the bottom line. The changes included a likely recession with relatively high interest rates, declining property values in more markets and possible cuts in the mortgage interest tax deduction. Other significant changes have occured that color the outlook, and few of them bode well for lenders.

Seldom have we seen a more abrupt swing in the overall mortgage market outlook. Toward the end of 1989, things looked promising. Back then, we saw the following positive signs, events and trends developing:

* Insolvent thrifts were being

removed from the competitive arena.

This retreat seemed very likely to

reduce pressure on primary market

pricing. * Improved relations with the Soviet

Union were promising to yield a

"peace dividend" in the form of

reduced military spending, thus

providing a new opportunity for the

government to reduce the federal

deficit. This, in turn, was likely to

lead to reduced interest rates,

which would boost mortgage

demand and also mitigate the

possibility of recession. * Many lenders who survived the

1987-1989 "shakeout" period were

more automated, had better cost

controls, and had diversified

successfully in their loan distribution

methods. For that reason, a lot of

companies reported improved

profits, including BancBoston

Mortgage, Norwest Mortgage, Chase

Mortgage and GMAC Mortgage. * Property price depreciation, which

hit New England, New York and

New Jersey earlier had not spread

to many other regions. The time

seemed near for the cycle of

depreciation in the Northeast to end. * New risk-based capital standards for

thrifts and commercial banks were

put in place, assuring that in the

future, these lenders--and their

mortgage banking subsidiaries--would

be stronger financially. * Prices for conventional servicing

were declining, due in part to

the large supply of servicing rights

being brought to market by the

Resolution Trust Corporation. This

created a huge opportunity for

healthy lenders to buy servicing

rights on the cheap, thereby

increasing the value of their asset

base at very low cost.

Understandably, then, the 1989 version of SMR Research's annual Giants of the Mortgage Industry study, predicted improved mortgage profitability. Not all conditions seemed perfect, yet very clearly, plenty of positive events seemed present in the environment.

But the changes since late 1989 have been dramatic. Since the release the 1990 version of its research report in August, SMR has been advising clients to batten down for a harsh, short-term, environment. There are a host of new and unpleasant developments. Eleven of them are found to be most threatening.

New problems facing lenders

1. Real estate prices in the largest urban areas of California by earlier this year had stopped their previous rapid inflation and in some cases began to fall. The number of home sales in the state declined, too. Prior to 1990, California had accounted for some 25 percent of total U.S. residential mortgage volume.

2. Real estate prices in major parts of the Northeast had not headed back up. Instead, they remained in the doldrums or continued to fall.

3. Although price competition from insolvent thrifts had disappeared, other competitors continued to offer special deals on closing costs or other "teaser" pricing on loans. These included some commercial banks trying to become major mortgage players, plus some healthy thrifts, such as Home Savings of America, which introduced a popular "no points" mortgage in 1990 that had a prepayment penalty feature.

4. The U.S. unemployment rate rose, and consumer and business spending began to look spent out. A number of economists had begun to intimate that a recession was imminent.

5. The estimated cost of the thrift crisis had increased significantly, making it much more difficult for politicians to cope with the federal deficit. The Federal Reserve Board indicated it was unlikely to cut interest rates if Congress did nothing about the deficit.

6. Iraq invaded Kuwait, causing oil prices to spiral. Rising oil prices are likely to touch off a new round of inflation, and also made the "imminent" recession appear much more likely. Indeed, at least one major business publication, Business Week, announced that a recession had already begun. While higher oil prices are likely to help local economies in Texas, Alaska and other "oil patch" states, they will hurt the overall economy.

7. The same Iraqi invasion led to an expensive U.S. military response, wiping out the "peace dividend" expected to come from the thaw in East-West relations that was to produce reduced armed forces spending. Suddenly, budget deficit cuts looked all the more remote.

8. Although the Federal Reserve most often has reduced interest rates in order to help avert a national recession, it has not done so when inflation was an overriding concern. Thus, both the Iraqi action and the more intractable budget deficit have increased the likelihood that we will have a high-interest rate recession, a combination that probably would increase delinquencies and foreclosures, while at the same time would push down new mortgage demand.

9. The declining market value of servicing remains a big opportunity for buyers. But with a recession apparently imminent or underway, more mortgage bankers may want to sell servicing than to buy it. For them, the sale of servicing rights, which typically has helped shore up cash flows during periods when business is slow, no longer will generate as much capital since the price is lower.

10. Congress is considering reductions in the mortgage interest tax deduction as one possible way to increase tax revenues. The Mortgage Bankers Association of America (MBA), as well as other real estate and financial trade groups, are opposing such changes. But the new difficulties in coping with the federal deficit add fuel to the arguments of those who favor tax increases of any kind that will produce substantial added revenue.

11. Proposals have been released by the Treasury and others on ways to beef up the capital levels and the regulatory oversight of Fannie Mae and Freddie Mac. These proposals might have modest impact on lenders if put in place very gradually. But if the new rules were put in place rapidly, they could stifle the volume of loans that Fannie Mae and Freddie Mac are able to buy.

A volatile outlook

Although the host of new problems appears formidable at this juncture, many of them could change quickly. Indeed, seldom has the U.S. economic outlook been so volatile and so dependent on foreign affairs.

At the time this article was written, oil prices were rising and Iraqi forces stood across the Saudi border against U.S. and other forces. By the time this article is read, there probably will have been major changes in the Middle East standoff.

If oil prices move back downward, inflation should ease accordingly. The Federal Reserve would be much more likely to fight a recession by engineering lower interest rates. In the short-term, we believe, that would mean that although delinquencies and foreclosures would remain a serious problem, improved mortgage demand would help ease the pain.

However, in a worst-case scenario, not only would oil prices rise, but oil supplies would evaporate due to war, the destruction of Persian Gulf oil fields, a wider embargo, or a wider conflict involving the Saudis or other nations. Most likely, that would prompt one of the more severe recessions in modern times, along with very high interest rates. Portfolio lenders still holding 30-year fixed-rate loans--a poor match against shorter-term liabilities--would suffer dramatically from the twin destroyers of mortgage profitability: interest rate and credit risk. Under such a scenario, mortgage bankers likely would be hurt by very low production volumes and high credit losses.

Unfortunately, no matter which scenario comes to pass, there are other problems in the market currently that are unrelated to foreign affairs. The California and northeastern real estate slumps are among them. And so are the thin profit margins that have plagued the mortgage business for years.

Recent thin margins

For mortgage players, the real crux of the external economic dilemma is that it comes at a time when profitability already is under pressure. The new economic forces of change are volatile. They could get much better or much worse very suddenly. Yet, in either case, the fundamental, underlying profitability of the mortgage business seems weak. If only residential mortgages had fat primary market spreads--if only mortgage lenders were as wealthy as Midas--there would be fewer concerns about the new economic uncertainties.

How many dollars of profit should the residential mortgage industry, as a whole, be generating? We think a good estimate is about $24 billion after taxes. For many years, a standard for excellence in terms of profitability for any lending business has been a 1 percent after-tax annual return on loans outstanding. According to the Federal Reserve, there recently were about $2.4 trillion worth of residential mortgages outstanding. One percent of that is $24 billion. Then that is the approximate pot of gold we should find by adding together the profits of every segment of the business--from depository institutions to mortgage bankers, and including the federal agencies and the secondary market investors. But where is the $24 billion?

Fannie Mae and Freddie Mac earned $1.2 billion in 1989. But it appears that the banks, thrifts, and mortgage bankers, taken together, earned very little.

In SMR's new research study, we separately evaluated the profitability of thrifts, mortgage banks and the mortgage operations of commercial banks. The savings and loan industry, of course, experienced a multibillion dollar loss in 1989. To understand what role residential lending played in this debacle, we divided the thrifts into groups based on their dependence on residential loans versus commercial loans. Those thrifts heaviest in commercial lending turned out to be the worst performers. For example, there were 536 thrifts whose commercial loans were 15 percent or more of their total loan portfolio at year-end 1989. They had a combined return on year-end assets of a negative 2.29 percent.

Unfortunately, the thrifts that were nearly pure residential lenders did not fare very well either. We found 747 thrifts (26 percent of all thrifts) whose commercial loans were less than 3 percent of total assets. These were the more traditional residential mortgage lenders. Their total group return on year-end assets was 0.06 percent. That is a break-even performance. Certainly that is better than a loss, but nothing to write home about.

At commercial banks, we made a study of a 1989 Federal Reserve Board data series called the Y11-AS report. This report requires bank holding companies to file income statement and other items on their nonbank subsidiaries, including entries for those that are mortgage banking subsidiaries. We weeded out a few glitches in the data, and found that, similar to the thrifts, bank mortgage subsidiaries taken together just about broke even in 1989.

We supplemented our research on bank mortgage operations with many direct interviews with senior bank mortgage executives. We did the same with mortgage banking companies not affiliated with banks. Some mortgage companies also file annual reports that SMR reviewed.

At the mortgage banking companies, we found a number of players whose profit results in 1989 were much better than in 1988. Still, for every company with good performance, there seemed another that fared poorly. For example, while Chase Home Mortgage earned $37 million in 1989, making it one of the most profitable mortgage banking operations, Weyerhaeuser Mortgage lost money.

All this research was fleshed out in detail, company by company, and is contained in SMR's published study. Suffice it to say here that the report's prime conclusion was that the $24 billion in profits we were looking for could not be found because it didn't exist. Indeed, among direct lenders, almost none of it seemed to exist. We believe that warrants classifying 1989 as the third consecutive hard year for many mortgage players. Those tough times seemed to commence with the falloff in mortgage demand that occurred in about mid-1987.

This, then, is the somewhat troubling backdrop against which these newer economic problems have arisen. If there is going to be a recession, and one coupled possibly with high interest rates, let alone other difficulties, how much worse can things get? And how should mortgage lenders react?

Few companies get through any recession without pain, especially when earnings are already thin. Nevertheless, we view a number of responses as potentially helpful, and that we will now discuss.

With property values declining in more places, we advise a conservative approach on high-LTV lending. We would be especially wary of 80 percent-plus loan-to-value ratio loans, made with low documentation standards, and without private mortgage insurance (PMI).

Recently, we received new data on thrifts holding large amounts of high-LTV loans without PMI. Those with loan portfolios most heavily saturated with these loans experienced net losses in the first quarter of 1990 much more often than other thrifts.

We advise lenders to turn down the spigot on all "low doc" and "no doc" programs. These programs have frequently contributed in a major way to higher mortgage volume, yet they are beginning to yield high delinquencies in areas such as New York and New Jersey.

Many lenders already have tightened up their low doc loan requirements. Now, if a severe recession comes, they will be happy they did so.

Recessions always hammer at the solvency of consumers. If the next recession is marked by high interest rates, consumers could be hit unusually hard. In prior recessions, consumers, some of whom lost their jobs, were unable to meet their standard monthly obligations. This time, millions of consumers could face higher monthly bills due to rate changes on their adjustable rate loans, including home equity loans. Such rate-sensitive instruments were almost nonexistent in the past.

Bankruptcies already are a serious problem. SMR obtains bankruptcy filing data on consumers in every county of every state in the nation, and the numbers do not look healthy. In the 12 months ended December 31, 1989, the data show the average was 2.50 personal bankruptcy filings for every 1,000 individuals in the country. For the 12 months ended March 31, 1990--a mere three months later--the rate had jumped from 2.50 to 2.58 filings per thousand.

Certainly, now is the time to do something about reducing credit risk.

We believe lenders should shift from high-growth strategies to higher-profit strategies, including a greater focus on primary market loan pricing.

Low pricing to the consumer certainly does help keep the mortgage pipeline filled. It is also true that the mortgage business is continuing to consolidate into the hands of fewer originators. We found that in 1989, the 25 largest one- to four-unit loan originators in the U.S. grabbed 34.7 percent of all new mortgage production. That is a record high for the industry since SMR has been publishing its study. This may prompt some executives to think they must keep pricing low, and, therefore, production high, to avoid being left behind.

But it is much more likely that the survivors of the next round of hard times will be those who focused more on profits than on growth. To make more money, lenders must have an adequate spread between their costs-of-funds and their loan pricing. This leads us to strongly advise lenders to avoid excessive competition on loan pricing.

Stuart A. Feldstein is president of SMR Research Corporation, Budd Lake, New Jersey, a financial research publishing and consulting firm.
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Title Annotation:SMR Research Corp.'s economic forecast for the country and the mortgage business
Author:Feldstein, Stuart A.
Publication:Mortgage Banking
Date:Oct 1, 1990
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