Mortgage origination, servicing and investment activities account for a significant portion of assets and revenue at U.S. banks, and residential mortgages dwarf all other consumer loan categories in the United States. Yet the mortgage market has been in limbo for more than five years, and government involvement is at an all-time high. Virtually no U.S. politicians, regulators or market participants are happy with Fannie Mae or Freddie Mac--now operating in conservatorship--but the two organizations dominate the mortgage industry.
Several proposals for reform are in progress, but each option is an experiment that would have uncertain outcomes for the U.S. economy and homeownership. Winding down Fannie and Freddie would be the biggest change to the financial system in half a century. Within five years, we expect that banks with scale and low-cost operations--such as 
Wells Fargo (WFC), U.S. Bancorp (USB), and PNC Financial (PNC)--will dominate the industry at the expense of numerous middling players like SunTrust (STI) and Huntington Bancshares (HBAN).
The mortgage value chain
The U.S. mortgage market is split into three parts: (1) the conforming market, made up of loans that meet the standards of government-sponsored enterprises, or GSEs, (2) the nonconforming market for loans that do not meet GSE standards, and (3) loans that are eligible for government guarantees through other entities such as the Federal Housing Administration or the Department of Veterans Affairs. The United States is unusual compared with other global markets because of its long-term fixed-rate mortgages and multiple mortgage support schemes. Other countries--including Canada--use mortgage insurance, guarantees or government-sponsored entities, but the existence of all three in one market is rare. The GSEs play an especially large role, and one that has expanded dramatically since the financial crisis.
While U.S. banks once originated, serviced and financed mortgages, these roles are now usually split among several parties. Banks and other financial firms originate loans. Originators receive origination fees, record gains when mortgages are sold, and earn interest income while mortgages await sale. Large banks often use multiple channels to originate mortgages, including cross-selling directly to their retail customers and obtaining wholesale or correspondent loans from other financial institutions.
Next, securitizers buy mortgages from banks and package them for bulk sale. Government-sponsored entities dominate this segment of the market; issuance of non-agency residential mortgage-backed securities has practically disappeared since the financial crisis. The GSEs receive fees in exchange for guaranteeing the cash flows produced by the securities they issue. Other securitizers rely solely on the spread between the price at which loans are purchased and their value as part of a securitization. Mortgage-backed securities are then sold to private investors, including back to banks.
Lastly, servicers earn fees for collecting and remitting loan payments, providing customer service, holding funds for payment of taxes and insurance and handling delinquencies, including foreclosures and property sales. Loan originators often retain the rights to service loans, or sell these rights to third parties.
Evolution of the GSEs
The modern U.S. mortgage market dates back to the Great Depression. Five years after the crash of 1929, the Federal Housing Administration was created, expanding the availability of mortgages, increasing loan/value ratios and extending loan repayment terms from less than five years to as long as 30 years. Government involvement was expanded further in 1938 with the creation of the Federal National Mortgage Association, or Fannie Mae. Fannie Mae was able to borrow from both the government and private sources to purchase mortgages from the country's savings institutions.
By the late 1960s, Fannie Mae was divided into two entities--the Government National Mortgage Association (Ginnie Mae), which purchased FHA and VA loans, and Fannie Mae, which was privatized. The Federal Home Loan Mortgage Corporation (Freddie Mac) was created soon after as a competitor to Fannie Mae.
As securitization grew in the 1980s, Fannie and Freddie were heavy issuers of mortgage-backed securities, making money on the guarantee fees they charged in exchange for their assumption of credit risk. The savings and loan crisis eliminated many competitors from the market, leaving the GSEs to pick up share. Mortgage-backed securities also became more complex over time, and the GSEs became more aggressive in their business practices, using their low-cost funding and minimal capital requirements to add assets to their balance sheets.
By 2008, the GSEs did not have the capital strength required to maintain solvency as home prices fell. Fannie Mae and Freddie Mac eventually experienced charge-offs exceeding their pre-crisis equity balances. The companies were placed into conservatorship by their regulator, the Federal Housing Finance Agency, with the federal government providing at least US$188 billion in support. Fannie and Freddie have operated under this arrangement ever since.
Proposals for change
The Dodd-Frank Wall Street Reform and Consumer Protection Act was passed more than four years ago, while other ideas are still in the early stages of legislative discussion. Though features of these proposals vary widely, all seek to increase the role of the private sector, protect taxpayers and prevent another financial crisis. However, these objectives must be balanced against the desire to promote homeownership.
The Dodd-Frank Act sought to improve mortgage origination and servicing procedures. One of the first provisions was a requirement for originators to be qualified and registered. The law also resulted in a complex "ability to repay" standard, forcing lenders to make an effort to verify that borrowers would be able to repay mortgage loans under reasonable interest rate and amortization assumptions. Furthermore, it restricted prepayment penalties, which is an important consideration for managing interest rate risk.
Lastly, Dodd-Frank created the Consumer Financial Protection Bureau, which codified the "qualified mortgage" standard in addition to creating servicing standards. Qualified mortgages:
- must have a term less than 30 years;
- cannot have points and fees greater than 3% of the loan amount;
- cannot have interest-only, negative amortization or balloon features;
- must have a debt/income ratio under 43%; and
- must meet GSE standards or be held in the portfolio of a small bank.
The bureau's servicing rules cover nine topics: periodic billing statements, interest rate adjustment notices, prompt payment crediting, force-placed insurance, error resolution, general procedures, early intervention, continuity of contact and loss mitigation.
Elsewhere, mortgage servicing assets were arguably among the hardest hit by the Basel III global capital requirements, including limitations on servicing assets' contribution to Tier 1 common equity capital and increased risk-weighting of servicing assets.
A variety of other bills to reform the mortgage market have been working their way through Congress. Most seek to replace Fannie Mae and Freddie Mac, for example with (1) a nonprofit securitization platform that would set standards for mortgage origination and servicing activities and collect fees, (2) a standardized securitization infrastructure owned by its members--mortgage aggregators, guarantors, originators and other market participants--with the government insuring mortgages (in exchange for fees) through an organization modelled after the Federal Deposit Insurance Corporation, or (3) expanding the role of Ginnie Mae, which would take over responsibility for the securitization process for all qualified mortgages. All of these proposals envision the private sector taking on exposure to first losses--generally around 5% to 10% of credit risk--but with some form of government involvement to insure the remaining credit risk.
Winners and losers
No matter which proposal wins out, we think the mortgage market is likely to be significantly different five years from now. Government involvement will continue, but with lower risk to taxpayers. It will accomplish this by setting conservative standards for government-backed loans and increasing the fees paid for guarantees, whether provided by the government or in the private market. We also expect greater standardization of mortgage-related operations, leading to an increasingly commodified market. In our view, banks with scale, high-quality underwriting, funding cost advantages, revenue-generation ability and operating efficiency will be best positioned to succeed in this environment.
Massive scale is Wells Fargo's primary advantage in the mortgage business. The company maintains a leading market share in both origination and servicing and is also a top deposit gatherer in the vast majority of markets in which it operates. Wells Fargo has only expanded its scale advantage in recent years as competitors were forced to retreat. JPMorgan Chase (JPM) is in second place, also expanding its presence in the wake of the financial crisis. These two banks now control more than 25% of origination and servicing activities in the country.
The next tier includes Bank of America (BAC), which has reduced its activity in mortgages in recent years, along with superregionals like U.S. Bancorp and PNC Financial. We think it will be difficult for smaller banks to match the scale advantages of these originators as mortgage products become even more standardized.
Scale alone does not lead to value creation, though. Countrywide was a huge originator, yet its failure to control underwriting led to disastrous outcomes for both its shareholders and those of Bank of America when it acquired Countrywide. Wells Fargo has often touted the high quality of its servicing portfolio, and indeed the bank suffered far less from repurchases and delinquencies than many of its peers. Other traditionally conservative firms are also well positioned, in our view. U.S. Bancorp has demonstrated superior mortgage underwriting, as have other regionals such as Regions Financial (RF) and SunTrust.
The ability to make loans at a low cost is another area in which mortgage banks can distinguish themselves. Wells Fargo enjoys an extremely low cost of funds, along with M&T Bank (MTB), PNC and Huntington Bancshares. Bank of America, despite its massive deposit base, is not a standout in the funding cost arena and will need to make up significant ground to match Wells Fargo's cost advantage.
The falling profitability of mortgages makes the ability to cross-sell and generate additional revenue from customers even more important. Here again, Wells Fargo is outstanding, producing more revenue per dollar of assets than nearly every other bank we cover. We think this will not only make each mortgage customer more profitable for Wells Fargo but also may allow it to win mortgage business from customers who come to the bank for other services. In this area, regionals like Huntington and Regions Financial fall behind the best-performing banks.
Finally, operating efficiency is critical. This is the only area where Wells Fargo demonstrated subpar performance in 2013; however, its sales-driven business model also produces more revenue. JPMorgan, though middling in other areas, has actually performed very well in keeping expenses low in relation to assets.
