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Long-Feared Mortgage Meltdown Is Here (Update 2)

Updated with comments from FIG Partners analyst John Rodis and afternoon market action.

NEW YORK ( TheStreet) -- Third-quarter bank earnings will feel an unwelcome jolt as mortgage volume has fallen off a cliff.

Banks large and small have been preparing investors for difficult revenue comparisons by preannouncing the bad news. JPMorgan Chase (JPM - Get Report) CFO Marianne Lake at a conference on Sept. 9 said the bank expected its mortgage origination business to post a net operating loss for the second half of 2013.
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Cardinal Financial (CFNL - Get Report) of McLean, Va., late on Thursday announced that its third-quarter mortgage loan originations had declined by roughly 40% from the second quarter, and that "the marketing gain percentage for mortgages sold has decreased during the third quarter due to increasing competitive pressure related to the changing market conditions."

Cardinal also said "Expense reduction and revenue enhancement measures have been and will continue to be implemented to offset the decrease in mortgage production and the decline in the marketing gain percentage," but that the bulk of the benefit of the cost declines wouldn't be realized until the fourth quarter. The bank was downgraded by several sell-side analysts on Thursday and Friday, and its shares dropped 5% Friday to close at $16.76.

Wells Fargo (WFC - Get Report), the nation's leading mortgage lender, has announced 4,800 layoffs so far this quarter, with the bulk coming from its mortgage production staff, as volume declines. As mortgage revenue declines, some of the expense cuts are "automatic," with many lenders being compensated strictly on commissions, but many staffers involved in processing loan files are also losing their jobs.

Large regional banks will also be cutting back staff. BB&T (BBT) CFO Daryl Bible said at a conference last week that it would be migrating its direct retail mortgage loan originations into a mortgage company subsidiary. While other large regionals have "[started] to lay off certain pieces of their mortgage business," BB&T will "get through this transition first and probably be a quarter or two behind some of our peers until we get the transition fully done, integrated," Bible said.

This means that BB&T will be laying off mortgage origination staff next year. "I would say first half of 2014 is before we start to right-size the business," Bible added. "We will lag a little bit, but we have to do this conversion and get this done first and done properly."

Year-over-year revenue comparisons for revenue from mortgage origination fees and gains on the sale of newly originated loans -- mainly to Fannie Mae (FNMA) and Freddie Mac (FMCC) -- will be particularly ugly. This is because the wave of refinancing crested last year, with record low interest rates and the Home Mortgage Refinance Program, which allowed borrowers with loans sold to Fannie and Freddie to refinance their homes, even of the value of the homes had dropped significantly below the loan amounts being refinanced.

And despite a healthy market for home sales -- when factoring in cash sales -- the sharp mortgage decline is expected to continue. The Mortgage Bankers Association projects a decline in mortgage refinancing volume from $1.247 trillion in 2012 to $973 billion this year, and to plunge to $388 billion in 2014. The MBA expects total mortgage loan originations to decline from $1.750 trillion in 2012 to $1.592 trillion in 2013 and $1.091 trillion in 2014.
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For many smaller and community regional banks, the third-quarter mortgage picture may not be as bleak is it will be for Cardinal Financial, according to FIG Partners analyst John Rodis. "For the typical regional bank, I am not making any changes in EPS estimates going into the quarter. I think mortgage revenue for a lot of regional banks will still be pretty solid, maybe not relative to the past few quarters but better than it has been," Rodis says.

Looking out to 2014, Rodis expects a decline in mortgage revenue for the banks he covers -- mainly community and small regional banks in the Midwest -- of 15% to 20%.

"For most banks, 25% to 20% of mortgage expenses are variable, he says which will offset some of the decline," he says.

Tough Comps for the Big Banks

Atlantic Equities analyst Richard Staite projects a 55% year-over-year decline in third-quarter mortgage production revenue for the eight large-cap U.S. banks he covers, which in addition to JPM and Wells Fargo include Bank of America (BAC - Get Report), Citigroup (C - Get Report), Goldman Sachs (GS), Morgan Stanley (MS), PNC Financial Services Group (PNC) and U.S. Bancorp (USB).

That's a huge figure, reflecting in part the spike in refinancing activity in the third quarter of 2012, however, Staite expects mortgage revenue for the group to decline 45% quarter-over-quarter.
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