Mortgage origination is one of the most cyclical businesses out there. When times are good, the companies do great. When times are bad, they tend to be really bad. This was the case even with the economic disruptions caused by the COVID-19 pandemic. Businesses in this sector need to be ready for that cyclicality or they need to consider not participating.
Wells Fargo (WFC -0.56%) recently announced it will drastically shrink its mortgage banking business. Why is Wells throwing in the towel? Did the cyclicality become too much?
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Mortgage banking is a feast-and-famine business
The past year has been downright awful for the mortgage banking business. During 2020 and 2021, mortgage bankers feasted. The Federal Reserve cut the prime lending rate down to the floor to help stimulate the economy in order to offset the economic drag of the COVID-19 pandemic. This kicked off a massive wave of refinancing activity, as borrowers rushed to take advantage of the low rates.
Mortgage banking volume ballooned in response. You can see the spike in the chart below. Please note that the chart does not contain fourth quarter of 2022 data, which is expected to be well below the third quarter of 2022, driven by both higher rates and seasonality.
US Mortgage Originations data by YCharts
Volumes and profits per loan are declining
Origination volume is only part of the story, however. Most mortgage originators do not hold their originations -- they generally sell them either by securitizing them or selling 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 real estate investment trusts (REITs), pension funds, or sovereign wealth funds. The profit that originators earn on these sales is a critical input into their profitability. Gain-on-sale margins fell for all of 2022, and so far there is no relief in sight.
Wells Fargo management decided that it makes sense to reduce the bank's footprint in the mortgage business as opposed to waiting out a recovery. The mortgage business is being squeezed by a number of factors including sluggish home sales, rising mortgage rates, and intense competition. Over the past year, many mortgage bankers folded, including Sprout Mortgage and First Guaranty. Loan Depot decided to exit the wholesale business and HomePoint sold its corresponding mortgage origination business. Wells Fargo has been a consistent top-five originator, so this is a big event. Wells Fargo isn't exiting completely, however; it will devote its lending to existing banking customers and underserved areas.
Wells will sell much of its mortgage servicing
Wells will also sell a big chunk of its mortgage servicing portfolio. Mortgage servicers perform the administrative tasks of handling a mortgage on behalf of the mortgage-backed security investor. The servicer collects the monthly payments, sends out the principal and interest to the investor, ensures that property taxes and insurance are paid, and works with the borrower in the event of a delinquency. The servicer is compensated 0.25% of the mortgage balance for performing these tasks. So if the mortgage balance is $400,000, the servicer gets paid $1,000 per year. The right to perform this duty is worth something, and mortgage servicing rights are capitalized as an asset on the balance sheet. Mortgage servicing is one of the few assets that increases in value as rates rise.
If the U.S. enters a recession in 2023, two things will happen to mortgage servicing. First, delinquencies will increase, which means a higher cost to service these loans. Second, rates will fall as the Fed pivots toward supporting the economy as opposed to fighting inflation. Since delinquencies and mortgage rates are inputs into the value of mortgage servicing, values have probably increased about as much as they can. Wells Fargo is striking while the iron is hot and will be selling toward peak valuations. In addition, the Consumer Financial Protection Bureau focuses like a laser on servicing, and this helps lower Wells Fargo's profile.
Buybacks are increasing as well
Finally, the government-sponsored entities Fannie Mae and Freddie Mac have been increasing buyback requests, which is an additional headache for loan originators. When an originator packages a loan in a securitization, Fannie and Freddie can demand the seller buy it back if they discover a flaw in the loan. These buyback requests sunk a bunch of originators in the aftermath of the Great Recession and are starting to happen again. This is an industry problem as well as we are seeing smaller mortgage originators exit the business. If Wells cannot pass on the buyback request (since the original lender no longer exists) they will have to buy back the loan. if the loan cannot be fixed, Wells will either have to hold it or sell it into the market at a loss.
While shrinking its footprint won't eliminate the buyback risk, it will prevent it from getting bigger. Given that the fundamentals for the origination business are going to take a while to turn around, Wells Fargo has made the decision to leave the market to non-banks like Rocket Companies and UWM Holdings. Overall, Wells Fargo's exit from the correspondent business will leave the company to pursue more profitable activities. Correspondent lending is a notoriously low-margin business, and it will also reduce the company's regulatory risk, at least somewhat.
