Short-Term Mortgage Pain Is Long-Term Gain for Banks

NEW YORK ( TheStreet) -- Rising long-term interest rates will hurt banks' gains on the sale of new mortgages, but the improving housing market will offset any pain.

The yield on 10-year Treasury bonds climbed to 2% on Monday for the first time since April 25. The increase will eventually bode well for banks' profitability, as yields on other long-term assets rise.

Atlantic Equities analyst Richard Staite on Tuesday said the recent rise in mortgage-backed securities (MBS) yields has led to a contraction in the primary secondary mortgage spread to 82 basis points from an average of 123 last quarter. That means smaller profits on the sale of newly originated mortgage loans to Fannie Mae ( FNMA) and Freddie Mac ( FMCC).

Staite said lower secondary market mortgage spreads is of major concern for Wells Fargo ( WFC), since the company "is most exposed to a contraction with over 14% of revenue from mortgage production and potentially as much as 20% of profits."

Wells Fargo's fourth-quarter mortgage revenue grew 9% sequentially and 30% year-over-year, totaling $3.1 billion. The company has been the strongest and steadiest earnings performer among the "big four" U.S. banks, also including Bank of America ( BAC), JPMorgan Chase ( JPM) and Citigroup ( C), all through the credit crisis and its aftermath.

Wells Fargo's 2012 operating return on average assets (ROA) was 1.41%, according to Thomson Reuters Bank Insight, compared with 0.94% for JPMorgan, 0.33% for Citigroup and 0.13% for Bank of America.

According to Staite, the spread between mortgage loan rates charged to customers and the rates charged when the government-sponsored giants package loans into securities has averaged 50 basis points historically. But the spread widened to 122 basis points during the second half of last year. The main factor was the Federal Reserve's decision in September to increases its purchase of agency MBS by $40 billion per month.

The analyst estimates that Wells Fargo's quarterly banking revenue will decline slightly during the first quarter, eventually sliding to $2.2 billion, with total mortgage revenue declining by roughly $1 billion year-over-year to $10.7 billion. Staite expects a sharper drop in Wells Fargo's mortgage revenue in 2014, to $8.4 billion.

But the improving economy and housing market, along with share buybacks, will more than offset the decline in mortgage revenue, according to Staite. The analyst says Wells Fargo's earnings per share will increase from $3.36 in 2012 to $3.77 in 2013 and $3.91 in 2014.

Staite reiterated his "neutral" rating on Wells Fargo, with $38 price target, and said he prefers Bank of America "as a better play on a recovering housing market."

For Bank of America, improving credit quality means an eventual reduction in mortgage putback claims against the company and loan-servicing expenses. Mortgage repurchase claims totaled $28.3 billion as of Dec. 31, increasing from $12.6 billion a year earlier. The company on Jan. 7 announced the settlement of its very long-term dispute with Fannie Mae, and also announced a major sale of mortgage-servicing rights.

Investors clearly were seeing light at the end of Bank of America's mortgage tunnel during 2012, sending the company's shares up 110%. The shares closed at $11.48 Monday, down slightly so far this year.

Staite rates Bank of America "overweight," with a $12 price target, and said after the announcements on Jan. 7 that the sale of mortgage-servicing rights "is positive as it will accelerate the reduction in abnormal legacy asset-servicing costs, thus boosting ... profitability."

The analyst estimates that Bank of America will earn $1.23 a share in 2013, with EPS increasing to $1.53 in 2014.

-- Written by Philip van Doorn in Jupiter, Fla.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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