Small lenders begin to feel the squeeze

22 March 2010 | By Paul Muolo

In the US mortgage originators come in two flavours, depositories and non-banks, the latter of which might be considered a dying breed depending on who you talk to - and especially if you speak to Wells Fargo or Bank of America.

Depositories - banks, savings and loans and credit unions - have their savings accounts insured by Uncle Sam courtesy of the Federal Deposit Insurance Corporation.

In the old days before the financial crash the FDIC insured all accounts up to $100,000 per depositor. But once the capital markets went into full-scale meltdown in the autumn of 2008 the FDIC threw in the towel.

In an attempt to stem runs on banks, both corporate and consumer, it basically declared that it would insure every account no matter how large. At heart, America is a socialist society - we just don’t want to admit it.

As you might imagine this ’everything’s insured’ declaration spurred nervous Americans to throw more money into banks, figuring they were better off earning 1% on their accounts than risking it on the stock market in uninsured hedge funds or brokerage houses.

The US could wind up with a system whereby a small number of lenders originate and service loans

This swell of money caused a problem for some banks as they were forced to put all the extra cash to work. Some institutions simply invested in Treasury bonds - a no-brainer - while others decided to beef up their residential lending efforts, generating more competition all around.

As for the non-banks, they didn’t seem to mind too much. Profit margins on mortgage originations were stellar in 2009 and are still darned good. As I’ve pointed out before, it’s easy to make a living in mortgage banking when you can borrow money at 1% and lend it out at 5%.

But I should emphasise here that non-bank mortgage lenders are exactly that - they don’t take deposits from the public and instead borrow in the form of warehouse lines of credit from the mega-banks and large regionals, using that money to make loans to consumers.

Despite the financial crisis there are roughly 2,000 non-bank mortgage lenders left in the US - a 50% decline from 2007 when the housing and mortgage markets peaked. Many of the firms that imploded were non-prime lenders concentrating on originating sub-prime and alt-A loans.

An alt-A mortgage is basically a sub-prime loan made to a customer with a higher credit score than an Ato D one. The 2,000 or so firms that remain today range in size from the small - funding maybe $5m a year - to the large such as the mighty publicly-traded PHH Mortgage of New Jersey which is on track to originate some $30bn in 2010.

As you might imagine the financial crisis has spurred all secondary market investors in residential loans - Fannie Mae, Freddie Mac, and the Government National Mortgage Association - to rethink who they should be doing business with.

In the old days Fannie, Freddie and the GNMA - collectively, let’s call them FFG - required their lenders to have a mere $250,000 in capital. That’s it. So for just $250,000 a non-bank could set up shop, get licensed and seek approval to sell their originations to FFG or have their loans guaranteed. And many did. Some owners of these smaller lending shops even put up their residences as collateral.

But that was then, before everything fell apart. Fannie and Freddie, which are now wards of the US government, recently hiked their minimum capital requirements to service loans to $2.5 and in a few weeks GNMA will be doing the same. The requirement won’t affect top 10 lenders such as PHH Mortgage but for many smaller firms it could be a huge problem.

It’s no secret that for thinly-capitalised lenders selling to FFG the writing is on the wall- raise more money or find a way to survive either by joining an adequately capitalised non-bank or even a bank.

So the FFG guys are tightening the screws because they figure higher capital requirements will drive the remaining industry bad boys and financially weaker firms out of the business.

But there’s also a school of thought over here that says the FFG firms are hiking minimums to intentionally reduce the number of lenders they have to manage.

In other words, they would much rather deal with the industry’s big boys such as Wells Fargo, BoA, Chase and CitiMortgage - than the almost 14,000 bankers and non-banks left operating. Maybe so - nobody at FFG is talking much about the issue.

Of course, if the housing market were not in the tank and Fannie and Freddie were not in need of $100bn of government support and counting none of these capital hikes would have been proposed in the first place.

Still, there’s a fear - not necessarily unfounded - that the big lenders that sell their mortgages to FFG are strongly encouraging the three outfits to hike their minimums even more.

Why? Because they know it will reduce competition - something that would greatly benefit them.

A mortgage insurance executive I know who’s been following the capital rule issue believes this will result in big banks controlling more. He’s not entirely sure it is the government’s intention to accomplish this but it’s an outcome he fears.

He recalls the days when Fannie and Freddie wielded a cartel-like control over the industry and dictated business terms to lenders, servicers, vendors and yes, mortgage insurers like him.

So the US could wind up with a housing finance system whereby a small number of lenders originate and service loans for sale or guarantee to FFG. Fewer players funding loans might be good if you happen to be one of those players but it will mean less choice for US consumers.

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