Rafferty Capital Markets analyst Richard X. Bove takes a close look at Wells Fargo & Co (NYSE:WFC) with regard to recent reports of it getting back into the subprime mortgage game.
Reuters published a story today that indicated that Wells Fargo & Co (NYSE:WFC) is re-entering the subprime mortgage markets. This story is interesting at a number of levels. To me this raises questions as to whether the conforming mortgage markets are profitable; what the government wants to do; and whether Wells is being pushed out on the risk curve to resuscitate this business?
From my perspective there is no likelihood that any bank will enter the sub-prime market without government guarantees. Therefore, if Wells Fargo & Co (NYSE:WFC) actually goes forward with its supposed intention it will be with government backing. It is impossible to imagine that the bank will operate in the non-subsidized private sub-prime market. The risks are just too high.
The Wells program, if put in place, would likely work like this. The bank would underwrite its loans to meet all of the qualified mortgage requirements established by the Consumer Financial Protection Bureau (CFPB). Plus, the loans would then be guaranteed by the Federal Housing Administration (FHA) or Veterans Administration (VA).
The bank would demand these guarantees because the guarantees do more than protect principal and interest payments. Since the housing insurance agencies (FHA & VA) meet all of the criteria set by the CFPB, obtaining their insurance for the loans is also obtaining their certification that the loan was properly underwritten. This is important should there be lawsuits once one of these loans defaults.
If I understand this new system correctly, what is amazing is that the borrower can also sue the bank under the theory that s/he was induced to take the money by the bank so it could make a profit. In theory, a savvy individual could game the banking system seeking a mortgage from some bank. After making a few payments on this loan the homeowner defaults and sues the bank for misleading him/her into believing that s/he could actually make the required payments. Then it becomes hazy but it is very likely that the savvy individual will wind up with the house and a penalty payment from the bank. The CFPB has set up a system that places all of the responsibility on the bank to see that the homeowner makes all payments.
However, there are more reasons why a bank is unlikely to underwrite mortgage loans for low income households without government backing. The risk weighting rules, established by the regulators, assess high capital penalties on those banks that make private market loans.
Setting aside the origination issue for a moment, the question needs to be asked as to what the government’s appetite is to aid the sub-prime market? This is important because if the government does not want to help, the banks are not going to play. And, the problem that quickly emerges when attempting to gauge the government’s interest is that the government does not want to play.
A joint statement released by the Treasury and the Housing and Urban Development Department (HUD), approximately 12 months ago, backed by the President, clearly indicates that it is the intention of the government to get out of the housing finance business. Moreover, this white paper also suggests quite clearly that it is no longer the policy of the United States government to see that every household has its own home.
There are more tangible issues, however. The FHA, which is supposed to insure the bulk of the new sub-prime mortgages, has been operating with negative net worth for at least the last 24 months and possibly longer. Admittedly, the negative number has shrunk from $16 billion to $1 billion and the FHA is projecting sizable profit going forward. However, sub-prime mortgages caused the big losses and it is unclear how rapidly the FHA is willing to jump into this arena again, and if it re-enters the business how many loans it is willing to insure.
Under the Treasury’s “third amendment,” the GSE’s are supposed to take their capital down to zero by 2017. They are also supposed to shrink their loan portfolios to $250 billion apiece. If they cannot expand the size of their portfolios and guarantee mortgages, when they reach zero capital, these entities will not be supporting the sub-prime mortgage markets or any other housing markets for that matter.
Why is Wells Fargo interested?
Presumably, Wells Fargo & Co (NYSE:WFC) is as aware of these developments more so than I am. So why would the bank indicate it might be interested in re-entering the sub-prime markets? One theory is that the bank has cut a deal with the government to help low income households obtain mortgages. The government is beginning to understand what it has done. It has cut its constituents, low income households, out of the housing market. This is going to cause serious political problems and the government may have requested that Wells do something to avert this growing problem. Wells adamantly denies this is the case, however.
A second reason as to why Wells Fargo & Co (NYSE:WFC) is seeking entry into sub-prime lending is because the standard conforming markets are not attractive any longer. One can make the case that originating and servicing the conventional mortgage market is not a profitable effort any longer. While Wells disputes the argument to be presented here claiming that through the cycle mortgages are a profitable product, the bank does not claim that at all points in the cycle the business is profitable. Let’s disaggregate the profit segments of the industry:
In my view, originating housing loans is a money losing business. The government, through lawsuits, fines, and copious regulation, has eliminated as much of the automated systems used in originating these loans as it could. Therefore, originating a mortgage loan is now a very labor intensive effort. The labor intensity has been accentuated by the constant threat that any loan being made will be deemed to have been improperly underwritten and the underwater will get the loan back along with a lawsuit and the obligation to make a penalty payment.
Once a mortgage loan has been approved and before it is sold, it is held by the bank is what is euphemistically called a warehouse. When the cost of money is very low and mortgage yields relatively high, as is the case now, the warehouse profit is quite high.
Selling the mortgage as part of a loan package is an uncertain process. In most periods it is profitable effort. Now, however, that may be changing. The CFPB’s qualified mortgage rules are forcing all banks to make conforming qualified loans. The buyers for these products may be declining particularly if the GSEs actually are forced to withdraw from the markets. Thus, an increase in conforming loans is flowing into markets where the demand for the product is declining. This will drive sales prices down and possibly eliminate profit.
Loan servicing, which was one of the most profitable efforts in the industry has to have been a huge money loser in the past five years. If the banks were properly cost effecting the business they would be counting the litigation expenses and the put-back charges as part of the cost of servicing and they would have to admit that they never priced for these events and are not doing so now either.
Therefore, it just may be that Wells Fargo & Co (NYSE:WFC) must go to the extreme ends of the Bell Curve to find profit in the mortgage sector. Wells has already established a strong position at the right side of the curve underwriting non-conforming so-called “jumbo” mortgages. Now it may be moving to the left hand side of the curve by seeking to underwrite government backed sub-prime mortgages.
The rates in the sub-prime markets outside of banking is believed to be 9% and above. This is double the current Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) (FMCC/$3.00/NR) rate. It is attractive enough to entice Wells into the markets.
Wells Fargo & Co (NYSE:WFC)’s decision to re-enter the sub-prime mortgage markets is a very bad signal. It suggests that the conforming mortgage market is no longer profitable. It implies that the bank must stretch to regain profits lost in these markets.