Big Banks Face a Big Question

The results of big banks released recently showed a downturn in their mortgage business thanks to a slowdown in mortgage refinancing. Considering the impact the mortgage business can have on banks' profitability, the question is whether the likes of Wells Fargo (WFC -0.20%), JPMorgan Chase (JPM), and Bank of America (BAC 0.12%) will be able to offset the weakness in refinancing activity by boosting the number of mortgages they're originating for home purchases.

Refinancing activity slows
JPMorgan kicked off earnings season for banks last week, reporting a profit of $5.28 billion, or $1.30 per share, down from $5.69 billion, or $1.39 per share reported for the same period in the previous year. JPMorgan's results, like those of other big banks that reported last week, were negatively affected by mounting legal costs. However, another concern for JPMorgan and other big banks was weakness in its mortgage business. As the table below shows, mortgage loan originations dropped sharply in the fourth quarter of 2013.

Wells Fargo's pipeline of residential mortgages fell from $81 billion at the end of 2012 to $25 billion at the end of 2013. Bank of America saw its revenue from production of mortgages drop 60% to $403 million.

According to most recent data from Mortgage Bankers Association, applications to refinance are down more than 65% from a year ago. Declining mortgage business revenue is a major concern for banks, especially as they face rising legal costs. More importantly, the outlook for mortgage business remains gloomy as refinancing activity is expected to remain weak as an improving economic outlook and the tapering of Federal Reserve's bond purchases will push interest rates higher. As a result, banks may try to boost mortgages to purchase homes to offset the weakness in refinancing activity.

Loosening lending standards
Concerns over declining revenue from mortgage refinancing had already prompted banks to loosen lending standards last year. In a report released earlier this week, Ellie Mae, a provider of on-demand automated solutions for the mortgage industry, the average FICO score for all closed loans in December 2013 was 727, down 21 points from December 2012. The report also noted that 31% of closed loans in December 2013 had FICO scores below 700, compared with 21% in December 2012.

While that data highlights the fact that banks loosened lending standards, the requirements to obtain a mortgage still remain stringent when compared to the pre-financial crisis days. Banks, therefore, may have to loosen their lending standards even further to boost mortgages to purchase homes.

New regulations
Big banks have already spent billions of dollars to settle mortgage-related issues that stemmed from their lending practices before the financial crisis of 2008. Banks have been charged with misrepresenting the quality of mortgages they packaged and sold in the secondary mortgage market, which led to the collapse of the market for mortgage-backed securities and mortgage guarantee giants Fannie Mae and Freddie Mac.

While the mortgage business is a key revenue driver for big banks, I doubt banks will be keen to loosen lending standards any further in the aftermath of the financial crisis of 2008.

Outlook for banks
In the present scenario, I have a cautious outlook on banks. While the likes of Wells Fargo and Bank of America have implemented cost-cutting measures to offset weakness in mortgage business, I would remain on the sidelines in the near term. Longer term though, I believe banks will benefit from rising rates, as it will boost their net interest margin.