Retail mortgage bank lenders are in for another tectonic shift in their business model. Unfolding over the next few years, this shift will drive mortgage bank lenders – firms not affiliated with a federally-insured bank – into their own versions of either “too big to fail” or “too small to survive.”
The result of the election means that surviving and flourishing will become that much harder for mortgage companies.
A phrase used in the study of history, “Thucydides Trap,” is used as a way to describe how rising powers are likely to come into conflict when they bump up against established powers. The term is often recently used to describe U.S.-China relations. In our case, the rising powers are the retail mortgage banks and the established powers are banks backed by the Federal Deposit Insurance Corp.
One of the obvious factors currently driving this conflict is technology, which is infiltrating the mortgage industry and in particular the customer service experience. However, technology may become less of a factor over time as it will become very common and available to all lenders, assuming they can afford the investment in technological resources.
Due to the recent election results, forces that are in plain sight but not fully appreciated from an existential perspective are making it even more vital for mortgage lenders to retool. These forces include the impact of higher interest rates, a pause if not rollback in various regulatory schemes impacting mortgage lending and a dramatic slowdown in the monetary penalties assessed against mortgage lenders and FDIC-insured banks. How nonbank mortgage lenders deal with these changes will ultimately determine if they will survive or not as competition with banks intensifies.
Higher interest rates are inevitable and will have an obvious effect on the mortgage market. While an increase in rates makes loans more profitable, that is only for loans kept on balance sheet, which is not the case for nonbanks. It is reasonable to predict that a rate increase when combined with other trends could prove toxic for nonbank lenders this time around. To date, many lenders have been paying for their regulatory and technology costs out of their refinancing production profits – which grow in a low-rate environment. These profits will diminish. The need for tech investment will not.
Under President-elect Trump, the regulatory cost burden will likely plateau and possibly curve downwards. However, it is foolish to believe this lessening of regulations will happen overnight; there will be a tail of higher costs for the foreseeable future.
What’s worse, these normally manageable trends will be even tougher to navigate since they will also have an impact on large banks that have recently dialed back their mortgage businesses.
As the world stands now, more than 50% of mortgage lending is done by nonbanks. Furthermore, large banks have moved out of the higher-risk mortgages, such as Federal Housing Administration, and moved into the lower-risk mortgage segments like jumbo loans – a result of past regulatory and economic events.
Going forward, the trends noted above will now go in reverse and favor the large banks. Higher interest rates make banking a more profitable business. Lower regulatory burdens also make banking more profitable and more predictable.
How do the mortgage banks respond to this unwinding of trends that have been in their favor up until now? In other words, how do the mortgage banks manage the coming Thucydides Trap while hanging on to their market ascendancy?
To counter the trends, there are two fundamentally different approaches to take. One, see the coming changes as problems to solve and assume life will go merrily away once solved. Two, address the coming problems as issues to solve so as to get to the next issue awaiting resolution. The former approach is very ad hoc and describes how most mortgage banks manage themselves. The latter approach, which is more trend driven, is how most large FDIC banks address issues.
As fixed costs increase relative to revenue, mortgage banks must answer how does the revenue pie get bigger? As long-term interest rates bite into mortgage production and possibly home appreciation, what types of products can mortgage banks add to stay relevant to customers? Equity products will become more important than cash-out refinances.
Another big unknown is how policymakers will eventually reform the government-sponsored enterprises. Large banks are more immune from any unexpected fallout from a botched reform effort. Unlike mortgage banks, they can continue to write mortgages, taking advantage of the higher rates and portfolio the assets. Gain-on-sale business models, more relevant to mortgage banking, will not have this option.
Banks see the world as a process that they can help steer. Mortgage banks need to adopt this same mindset.
Loren Picard is managing executive of G5, a consulting firm in the marketplace lending industry. Joe Flanagan is a senior director with Marlette Funding LLC.