The Looming Mortgage Bubble
Don't bank on it going quietly. And when it does, the vitality of the economy and stock
market are in danger.
by David W. Tice | Jul 01 '04
In a March speech, Donald E. Powell, chairman of the FDIC, shared an interesting insight:
Banks are no longer closely tied to the economic cycle. Chairman Powell noted that the banking industry has added jobs consistently
since 2000, a period that includes the recent recession. In fact, rather than being dependent on the economy, banks actually
have served as a "pillar of strength" for business activity.
As Powell notes, this is quite a turnaround from the 1980s when commercial banks virtually
stopped growing, with earnings stalling out at around $15 billion. But during the 1990s, earnings grew almost five-fold to
more than $70 billion. The FDIC chairman called the 90s a "golden era" for banking, one that he believes continues to this
day. In fact, the FDIC recently reported that banks and thrifts earned $31.9 billion in the first quarter - the fifth consecutive
While it's true that banks have produced exceptional operating performance for some time,
as Powell goes on to say, most of the banking industry's growth has been in mortgage and consumer lending. The reason, to
paraphrase bank robber Willie Sutton, is that that's where the loan demand is.
However, loan demand didn't just show up at the party by accident; it was issued an engraved
invitation and chauffeured in a limo. That is, Federal Reserve policies, and bankers' responses to them, created surging mortgage
and consumer demand that maintained momentum through the Nasdaq collapse, a recession and a war.
The accompanying table shows how residential mortgages play a much larger role in bank
loan portfolios today, while traditional lending has grown less important.
The popularity of "revolving home equity loans" is another example of the expanding role
of real estate-related lending. This loan category was virtually non-existent six years ago, accounting for just over 3 percent
of bank loans. Today the category takes a 7 percent share.
Of course, the shifting loan portfolio is hardly the only change in banking. With Glass-Steagall
now extinct, banks rely on investment banking and even insurance operations to help deliver earnings. Still, the mortgage
bubble's role in boosting bank profits cannot be ignored.
Consider that Wells Fargo regularly ranks as one of the top three mortgage providers in
the country. Last year, the bank's mortgage operations were the largest contributor to non-interest income (20 percent), even
more important than service charges on deposit accounts. This is no small feat given the importance of non-interest income
to bank earning power.
Wells Fargo credits its ability to cross-sell products as one key to its success in the
mortgage business. In fact, in its annual report Wells Fargo notes that 80 percent of its growth comes from selling various
products to existing customers. The bank has certainly succeeded in the mortgage area, as 18.9 percent of its home-owning
bank customers also have Wells Fargo mortgage products. That's double the 1999 percentage.
Similarly, Bank of America's mortgage banking activities accounted for 11.7 percent of
non-interest income last year compared to 5.6 percent in 2002.
Currently, the below-market multiples of bank stocks are attractive to many value investors,
while their historic earnings performance appeals to the racier growth stock crowd. However, judging by bank stock prices,
the new "golden era" has not gone unnoticed. From the March 2000 stock market peak through May of this year, the Philadelphia
Bank Index (BKX) has advanced 20 percent. That's compared to a 27 percent price drop for the S&P 500. Banks even kept
pace with the broad market's sharp advance over the past year. In fact, investors rewarded bank operations by bidding up their
New golden era or not, we can't help but wonder if banking's success can continue in an
environment of weaker mortgage loan demand. For example, if the refinance market continues to shrivel, Wells Fargo will have
fewer chances to cross-sell mortgage loans to its checking account customers. Given that refinancing booms have been recurring
since 1998, will investors tolerate a return to mere normalcy?
The point here is not so much to pick on banks generally, but to expand on last month's
comments regarding the pervasiveness of the mortgage bubble and the importance of all things mortgage-related to the economy.
This is the same mortgage bubble that helped Countrywide Financial reach $8 billion a year in revenues and made it possible
for a car maker (General Motors) to be one of the 10 largest mortgage services in the U.S. Meanwhile, mortgage industry employment
doubled from 1992 to 2002 while annual loan production expanded an even greater 134 percent.
While the mortgage bubble could have further to run given the infatuation with adjustable
rate mortgages and other "sophisticated" products, indications of the mortgage mania's mortality are growing. According to
National Mortgage News, the first quarter's $599.1 billion in mortgage funding was the weakest in seven quarters. Funding
by the biggest 100 lenders fell 33 percent year over year. Compare those results to the third-quarter of 2003 when originations
reached $1.2 trillion.
In his speech, Chairman Powell reminded his audience that "a healthy, well-functioning
banking industry is key to the economic vitality of our nation." We couldn't agree more.
But given that the mortgage bubble has permeated virtually every aspect of the economy,
from mortgage insurers to homebuilders to retailers and to banks, we remain skeptical that today's vitality in either the
economy or the stock market is either healthy or sustainable.
David W. Tice is a CFA and CPA who publishes Behind the Numbers, an institutional research
service publication for money managers. Tice also manages the Prudent Bear and Prudent Global Income Funds. For more information,
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