Mortgage origination is one of the most cyclical businesses out there. When times are good, companies do very well. When times are bad, they tend to be really bad. This was the case even with the economic disruptions caused by the COVID-19 pandemic. Companies in this sector must be prepared for this cyclicality or they must consider not participating.

fargo wells (WFC 3.25%) recently announced that it will slash its mortgage banking business. Why is Wells throwing in the towel? Has cyclicality become too much?

Couple getting a mortgage.

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Mortgage banking is a party and famine business

The last year has been downright horrible for the mortgage banking business. During 2020 and 2021, mortgage bankers feasted. The Federal Reserve cut the prime lending rate to a minimum to help stimulate the economy to offset the economic drag from the COVID-19 pandemic. This started a massive wave of refinancing activity as borrowers rushed to take advantage of the low rates.

Mortgage banking volume spiked in response. You can see the spike in the chart below. Note that the graph does not contain data for Q4 2022, which is expected to be well below Q3 2022, due to both higher rates and seasonality.

US Mortgage Source Chart

US Mortgage Originations Data by YCharts

Volumes and earnings per loan are declining

However, origination volume is only part of the story. Most mortgage originators do not keep their originations; they generally sell them by securitizing or selling the volume to someone who can securitize them. These mortgages end up packaged in mortgage-backed securities where they end up on the balance sheets of mortgage real estate investment trusts (REITs), pension funds, or sovereign wealth funds. The profit originators earn from these sales is a critical factor in their profitability. Sales profit margins fell throughout 2022, and so far no relief is in sight.

Wells Fargo management decided that it makes sense to reduce the bank’s presence in the mortgage business rather than wait for a recovery. The mortgage business is being pressured by a number of factors including slow home sales, rising mortgage rates and intense competition. Over the past year, many mortgage bankers have retired, including Sprout Mortgage and First Guaranty. loan deposit decided to get out of the wholesale business and starting point sold its corresponding mortgage origination business. Wells Fargo has consistently been in the top five originators, so this is a great event. However, Wells Fargo is not completely exiting; it will dedicate its loans to existing bank customers and underserved areas.

Wells will sell much of its mortgage service

Wells will also be selling a large portion of its mortgage servicing portfolio. Mortgage servicers perform the administrative tasks of servicing a mortgage on behalf of the mortgage-backed security investor. The servicer collects the monthly payments, sends the principal and interest to the investor, makes sure property taxes and insurance are paid, and works with the borrower in the event of a delinquency. The servicer receives compensation of 0.25% of the mortgage balance for carrying out these tasks. So if the mortgage balance is $400,000, the servicer gets paid $1,000 per year. The right to perform this duty is worth something, and the mortgage servicing rights are capitalized as an asset on the balance sheet. Mortgage servicing is one of the few assets that increases in value as rates rise.

If the US goes into recession in 2023, two things will happen to mortgage servicing. First, delinquencies will increase, which means a higher cost to service these loans. Second, rates will fall as the Fed turns to supporting the economy rather than fighting inflation. Since delinquencies and mortgage rates are inputs to the value of the mortgage service, it is likely that the values ​​have increased as much as possible. Wells Fargo is on strike while iron is hot and will sell towards top valuations. In addition, the Consumer Financial Protection Bureau is laser-focused on service, and this helps lower Wells Fargo’s profile.

Buybacks are also increasing

Finally, government sponsored entities fanny mae Y freddy mac Buyback requests have been increasing, which is an additional headache for loan originators. When an originator packages a loan into a securitization, Fannie and Freddie can require the seller to buy it if they discover a default on the loan. These buyback requests tanked a group of originators after the Great Recession and are starting to happen again. This is an industry problem and we are seeing smaller mortgage originators go out of business. If Wells is unable to transmit the repurchase request (since the original lender no longer exists), he will have to repurchase the loan. if the loan cannot be fixed, Wells will either have to retain it or sell it on the market at a loss.

While reducing your footprint won’t eliminate buyback risk, it will prevent it from growing. As the fundamentals of the origination business will take time to change, Wells Fargo has made the decision to leave the market to non-banks such as rocket companies Y UWM shares. In general, Wells Fargo’s exit from the correspondent business will leave the company to pursue more profitable activities. Correspondent lending is a notoriously low-margin business, and it will also reduce the company’s regulatory risk, at least somewhat.

Wells Fargo is an advertising partner of The Ascent, a Motley Fool company. Brent Nyitray, CFA does not have a position in any of the listed stocks. The Motley Fool does not have a position in any of the mentioned stocks. The Motley Fool has a disclosure policy.