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) 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.

Cardinal Financial ( CFNL) 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), 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.

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), Citigroup ( C), 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.

In a note to clients on Monday, Staite also forecasted a 20% drop in fixed-income trading revenue, because "July and August were very slow months as investors sat on the sidelines waiting for more clarity on Fed tapering, Syria and the EM slowdown and we believe the weakness has extended into September."

The analyst added that "While FICC and mortgages are clearly major weak spots we think other bank revenues will be relatively stable including net interest income which we expect to be flat YoY." That translates to an expected year-over-year revenue decline of just 5%, however, Staite made some pretty sharp cuts to his third-quarter earnings estimates for some of the big banks:
  • Staite cut his third-quarter EPS estimate for Morgan Stanley by 25% to 38 cents from 50 cents.
  • Atlantic Equities' estimate for Goldman Sachs was cut by 18% to $2.47 from $3.00.
  • Staite's third-quarter EPS estimate for Citigroup was lowered by 14% to $1.05 from $1.22.

"Our EPS estimates for JPM, BAC and WFC were already recently adjusted following comments at an industry conference. JPM was previously cut by 14%, BAC by 10% while WFC was held flat," Staite wrote.

How will investors react? How will you react?

It all depends on your investment horizon. For investors who can commit for several years and ignore several months of volatility from the mortgage decline and the continued hysteria over the eventual curbing of the Federal Reserve's monetary stimulus, the stocks of the largest U.S. banks are trading for significant discounts to smaller regional banks, on a forward price-to-earnings basis, even though shares of the big banks have been so strong this year.

But short-term investors are looking at a rocky road.

Staite favors Bank of America heading into third-quarter earnings season. "While Q3will be a 'noisy' quarter for all major banks including BAC we think BAC will show better underlying cost and revenue trends than its major peers," he wrote. The analyst added that he was forecasting Bank of America's adjusted revenue to fall by only 1%.

"Given these better trends we remain comfortable with our 2014 EPS estimate for BAC that is 16% ahead of consensus. We think the shares remain attractive on a price to tangible book value of 1.05x given our belief the bank can generate a 13% to 14% return on tangible equity over the long term and the stock remains our top pick in the sector," he wrote.

Bank stocks were weak in late morning trading Monday. The KBW Bank Index ( I:BKX) was down 1.7% to 62.51, with all 24 index components seeing declines. Citigroup was weakest among the large-cap banks, with shares down over 3% to $49.62. Goldman Sachs was down 2.8% to $165.03, and Morgan Stanley was down 2.7% to $27.44.


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

>Contact by Email.

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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