Last year was extraordinary for the mortgage banking sector. The COVID-19 pandemic caused the Federal Reserve to lower its benchmark interest rates to the floor in order to support the economy. In addition, the Fed began large-scale purchases of mortgage-backed securities in order to push down longer-term mortgage rates.

While much of the mortgage business is conducted by non-bank lenders, a few banks have a large presence in it. One of them is Flagstar Bancorp (NYSE:FBC). In its latest earnings report, it gave an update on the mortgage banking business, which is the main driver of Flagstar's bottom line. I think the analyst community may be underestimating the opportunity here.

Picture of the banking system

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Big increase in earnings on a year-over-year basis

Flagstar reported fourth-quarter earnings per share (EPS) of $2.83, up from $1.00 in the prior-year quarter. However, that was a sequential decrease from its third-quarter EPS of $3.88. Net interest income increased slightly, but mortgage banking revenue fell due to a seasonal decrease in volume and lower gain on sale margins. The story for many originators last year was that they maxed out their fulfillment capacity, and Flagstar spent much of 2020 working to expand its own. Management said on the Q4 earnings conference call that it had increased capacity by 47%. This will help the bank in 2021, which should be another busy year for the mortgage business. 

Mortgage revenue came in at $232 million, which was down 35% from the third quarter. Volume declined by about 9% to $13.1 billion. However, gain on sale margin (which is the profit margin on loans that Flagstar sells or securitizes) fell by 38 basis points to 1.93%. That said, the third quarter's gain on sale margin of 2.31% was a record for the bank.

The other mortgage-related business for Flagstar is warehouse lending, which involves making short-term bridge loans to smaller mortgage originators. These are collateralized by funded mortgage loans, which are overwhelmingly government-guaranteed. 

Higher prepayment speeds take a bite out of servicing income

Flagstar's mortgage servicing business declined slightly during the fourth quarter, largely due to higher prepayment speeds. Mortgage servicing involves administering loans on behalf of lenders. The servicer sends bills, collects payments, ensures principal and interest payments are forwarded to the ultimate investor, and works with the borrower if the loan becomes delinquent. In exchange for these tasks, the servicer gets paid 0.25% of the loan balance per year. The right to perform that job is worth something, and it is capitalized as an asset on Flagstar's balance sheet.

Servicing went through a rough period last year as the COVID-19 crisis caused servicers to worry about a surge in non-performing loans. This caused servicing values to decline. Servicing valuations have started to recover, and Flagstar noted that it increased their multiple on its portfolio. Flagstar did report a decrease in servicing income, though, due to higher-than-expected prepayment speeds. This happens when the underlying loans get refinanced, which causes the servicing right to be written off. Finally, 7% of Flagstar's loan book is in forbearance. However, about 12% of loans in forbearance are making their payments. The company reported that about 35% of its customers in forbearance exited in January.  

Is Wall Street too bearish on mortgage bankers? 

The big question for mortgage lenders like Rocket and PennyMac Financial Services revolves around the decline of margins. Is this a signal that 2021 profit estimates are too high?

First, recognize that 2020's gain on sale margins were record-breaking. That said, another issue has been capacity. Mortgage originators were inundated with would-be borrowers, and they focused on the lowest-hanging fruit. While refinancing volumes may decline from 2020 levels, purchase volumes almost certainly will not. Last year's prime home-selling season (late winter/early spring) was truncated by the onset of the COVID-19 pandemic. The pent-up demand that left will probably materialize this spring. If the mortgage origination business is inundated again, then margins might widen again. So while Wall Street expects mortgage banking earnings to fall precipitously in 2021, the year may turn out to be better than people are thinking.

For the year, Flagstar earned $9.52 per share, and the stock is trading at a trailing 12-month P/E of under 5. The Street forecasts that its 2021 EPS will fall 25% to $7.09, which still puts the stock at under 7 times forward earnings. If the good times continue in the mortgage market, there could be upside to that number.

Finally, Flagstar pays a quarterly dividend of only $0.05 per share, which is pretty miserly given its earnings. Note that in 2019, the bank earned $3.80 and distributed $0.16, so there is potential for it to increase the dividend given its low payout ratio (a mere 2% of net income goes toward paying the dividend).

Overall, Flagstar is priced as if the mortgage business is going to suffer a major decline this year, and that might not be in the cards

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.