More Pain for Mortgage Banks

Countrywide's third quarter points to more softness ahead.
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It's still painful to be a mortgage lender.

Falling home prices, slowing demand for mortgages and loan refinancing, along with higher interest rates have taken a bite out of the profitability of companies like

Countrywide Financial

(CFC)

,

Washington Mutual

(WM) - Get Report

and

Wells Fargo

(WFC) - Get Report

-- all of which depend on mortgage origination and servicing capabilities as a primary business.

Countrywide is the latest lender to post dismal third-quarter results in mortgage banking. The Calabasas, Calif. lender said Tuesday that third-quarter profit rose a meager 2%, to $647 million, or $1.03 a share, up from $633.8 million, or $1.03 a share. But both earnings and revenue failed to meet expectations.

"It's certainly a tough quarter for mortgage earnings" at many banks, says Frederick Cannon, an analyst at Keefe Bruyette & Woods. "Industry volumes declined. We continue to see a lot of competition for the remaining loans, and during the quarter, the yield curve inverted."

The yield curve is said to invert when rates on short-term government bonds are higher than the ones on longer-dated bonds. An inverted yield curve is sometimes a sign of a looming recession. It also makes it difficult for banks that generate profits from reinvesting customer deposits to make money.

The trouble is that the interest rate environment for mortgage lenders is likely to remain a tricky one for quite some time. Worse, there's no indication yet that the slide in the housing market is over, and there's growing concern that homeowner defaults soon may be on the rise if the economy slows down as expected.

"We've seen the effect of this quarter of volume declines and the inverted yield curve," Cannon says. "The question moving forward is will we layer onto those challenges, the challenge of higher credit costs?"

Despite the dour news, Countrywide's stock shot up Tuesday on news that it would buy back up to $2.5 billion in stock and slash expenses in the fourth quarter with another round of job cuts. In afternoon trading, the stock was up $1.77, or 5%, to $36.98.

But the trading picture of other mortgage lenders was more mixed with shares of Wells Fargo falling 35 cents, or 1%, to $36.32; shares of WaMu rising 25 cents to $42.98; and

NovaStar Financial

(NFI)

falling 21 cents to $30.14.

Last week, Seattle-based WaMu reported a 9% decline in third-quarter profit. NovaStar has yet to report earnings.

Countrywide says that mortgage banking in particular had a rough go of it, with declines in loan production, loan servicing and loan-closing services. Mortgage servicing capabilities include collecting monthly loan payments and penalties, record keeping, and the payment of insurance and taxes.

Mortgage companies typically depend on servicing revenue to make up for the lack of earnings contribution from production when interest rates are higher. But in the third quarter, Countrywide "had a situation where volumes were declining and rates were declining, making it an especially tough quarter," Cannon says.

Profit from mortgage banking fell 40% from a year earlier, to $424 million. Mortgage loan production fell 19%, to $106.2 billion, while Countrywide's loans in process fell 15%, to $65.3 billion.

Mortgage banking "continued to experience the effects of a transitional market," saysCountrywide's Chairman and CEO Angelo Mozilo. "Interest rates declined significantly duringthe quarter, putting pressure on loan servicing. Despite the decrease in interest rates, real estate finance activity continued to moderate and, as a result, loan production sector earnings also declined."

Mozilo says he anticipates the fourth quarter to be another slow one for mortgage originations.

Capacity is an ongoing issue in the mortgage sector.

"Currently, there are too many lenders making too few loans," Cannon says and large players need to scale back their operations, while smaller players need to be acquired or exit the business completely.

Small servicing companies "just don't have the scale to deal with this volatility," says Ed Groshans, an analyst at Fox-Pitt Kelton. "On the production side, the scale is also going to come in. These bigger guys can be a little more price competitive."

But for the most part, consolidation has not occurred -- with the exception of several large brokerage houses including

Merrill Lynch

(MER)

,

Morgan Stanley

(MS) - Get Report

and

Lehman

(LEH)

snapping up small niche firms to fill out product offerings.

In the absence of deals, jobs cuts have become a popular way to boost profits. Countrywide and WaMu, two of the sector's biggest players, together have laid off several thousand workers, and more cuts are on the way.

In the third quarter, Countrywide eliminated 847 jobs and plans to ax another 2,500 jobs in the fourth quarter as part of an initiative to reduce expenses by more than $500 million a year.