Let's retake the mortgage market!

Community financial institutions are grappling with the recent and pending mortgage rules. We fear the Consumer Finance Protection Bureau (CFPB) and government's tendency to fire a bazooka at an ant, causing tremendous collateral damage.

New rules aside, we were not that significant in the mortgage market anyway. Aggressive mortgage brokers hawking products and programs from money center and category killer banks, and government or quasi government agencies such as Fannie and Freddie, were killing us in terms of competition. Lastly and perhaps more importantly, because we collateralize and sell a significant percentage of mortgages into bonds and off of bank balance sheets, the 30-year mortgage became the most prominent. The 30-year carries too much interest rate risk for us.

So we opened the door, let the competition through, and we ceded the mortgage market to brokers, specialists, and the government.

As most FIs are hungry for assets, they are looking for loan volume wherever they can get it. I encourage you to rethink the residential mortgage loan. Two of our clients recently did so, and are finding ways to profitably offer this staple loan product to their customers and communities. With many brokers now out of business, and the government looking for ways to reduce their participation, can we find opportunities to retake what we have previously ceded? I think so.

I recently ran an analysis of all of my firm's product profitability clients to determine exactly how profitable residential mortgages are in the industry. The results were surprising to the client and helped them to peel back the onion further to uncover opportunities to increase production and reduce per-unit costs in their residential lending unit. See the table below for a portion of this analysis.

A note on the data. The profitability of the residential mortgage product is based on fully absorbed costs. So the per-unit cost not only contains direct origination and maintenance costs such as the mortgage originator and the loan servicing department, but also the indirect costs such as a portion of the FIs senior lender, and overhead expenses such as portions of the Finance Department.

What the data shows is that, in an era of needing loans on our books or revenue through our income statement, mortgage loans are doing relatively well. Why shouldn't we do more of it?

One reason may be the variability of volumes. For example, volumes were down in my home state of Pennsylvania from 2009 through 2010, the latest year HMDA data is available. In 2009, there were 374 thousand loans funded for $62 billion. In 2010, 334 thousand loans were funded for $55 billion. This variability is common, and FIs must build their capability with a greater percentage of variable expenses than other lines of business so they can decrease expenses as volumes decrease. But come on people, although down, $55 billion of loans are being funded per year in Pennsylvania alone!

Residential mortgages are critical components of being a community FI. Most of our customers either have them, will need them, or have had them. A fair amount of small business funding can be achieved through residential lending, either through straight mortgages or home equity loans. Big government and aggressive loan brokers made us small players in the market.

I say we should take it back! What do you say?

~ Jeff

Leader Selection: "He's not ready."

Financial institutions are currently struggling to identify the next generation leaders. Should we fall back on our old playbook, selecting highly "experienced bankers" that have been around and are likely to be the mantle bearers for the good old days, or should we think differently?

The manner at which we choose leaders is not very effective, in my opinion. So often we go with those we personally like, or the safe choices such as elevating longevity to top billing. Been here 20 years... here's the gavel. The resistance to putting young talent in positions of executive leadership is baffling to me. Our industry is changing faster than at any time during any of our lives, and yet we listen to pundits tell us that forward looking, and often young, talent is "not ready".

This mentality reminds me of NFL quarterbacks. Yes... quarterbacks. I write this on Championship Weekend, when the Niners and Giants are set to face off for the NFC Championship while the Ravens and Patriots vie for the AFC crown. Tim Tebow was vanquished last week by the Patriots. Tebow, as many of you know, started the season third on the Broncos depth chart. In my opinion and the Broncos coaching staff, he was the third best QB on the roster. When the Broncos went 1-4 to start the season, Tebow became the first signal caller known to me to win the starting job via popular opinion.

When Tebow's number was called and the starter Kyle Orton was released, Tebow was still only the second best QB on the team. Brady Quinn, in my opinion, was a more talented passer. [Disclosure: I'm a Notre Dame fan, Quinn's alma matar] So Tebow, third string clipboard carrier, goes 8-4 the rest of way. I'm pretty sure FI board members and executive recruiters would have said "he's not ready."

How about the Patriots' Tom Brady? Have you ever heard of The Brady Six? These are the six quarterbacks chosen before Brady was chosen (199th, 6th round) in the 2000 NFL draft. Chosen before him were such inauspicious names as Giovanni Carmazzi (chosen 65th), Chris Redman (75th), and Tee Martin (163rd). The most famous and first QB seclected was Chad Pennington (18th, see photo). FI board members on Brady: "he's not ready."

Lastly, what about Kurt Warner (see photo)? Probably one of the most successful QBs in NFL history, Warner went undrafted and sent to exile in the Arena Football League. In 1998, the St. Louis Rams picked him up as third string clipboard carrier behind such high profile names as Tony Banks and Steve Bono. [Disclosure: I'm a Rams fan]

The next year he was promoted to second string behind Trent Green, who proceeded to get hurt in the pre-season, handing the football to Warner in what was feared to be a lost season for the Rams. What ensued was an MVP season followed up by an MVP Super Bowl performance that sprung a Hall of Fame career. Warner would have never started if Green stayed healthy. FI board members: "he's not ready."

Here's my point: There are professionals that do nothing but evaluate football talent, develop them, opine on them, have reams of data to compare them, and they churn out winners like Jamarcus Russell. Perhaps those that select the next level of FI leadership ought to think about those that can lead people through a difficult and changing industry instead of those that have a good loan book/the safe pick. Or perhaps that person isn't ready.

~ Jeff

Guest Post: 4th Quarter Economic Update by Dorothy Jaworski

Before looking ahead to 2012, I can’t resist the traditional temptation to look back at the past year. The markets in 2011 were dominated by earthquakes and the tsunami in Japan, spikes in gas and oil prices, historic Federal Reserve actions where they “promised” to keep rates at their current low levels until mid-2013 and “Operation Twist,” where they are selling their shorter maturity holdings and buying longer term ones in an effort to drive down long term interest rates, and a debt ceiling and deficit debacle where our leaders in Washington cost our nation its precious AAA rating.

These events led to the stock market taking a beating of -12% to -14% in the third quarter, but a fourth quarter recovery of +8% to +12% and a Santa Claus rally of close to +1% saved the day. Volatility, anyone?

Actually, the Dow Jones Industrial Average was the only major stock market index in the world to increase in 2011. The S&P 500 index came in a close second at a change of zero. Europe suffered losses on average of -6% to -17% while Japan, China, and other Asian nations saw declines of -15% to -25% on average. Returns in the bond market were much greater.

Our weak economic growth of about 1.5% in 2011, Federal Reserve actions, and constant worry and fear about the European sovereign debt crisis caused our “beyond crazy low” rates to fall further, with the 10 year Treasury yield ending 2011 at 1.88%, after falling 144 basis points during the year, and returning about 10% to investors.

These rate declines may seem incredible, except when you consider that the Federal Reserve has their foot on the gas with quantitative easing programs I and II, their “promise,” and their $400 billion “twist” operations. Their ultimate goal seems to be a reduction in mortgage rates to help spark a housing market recovery; mortgage rates lagged the change in Treasuries in 2011 by falling 105 basis points. As they say, “don’t fight the Fed,” especially when they are “over-easing.”

Businesses fared okay in 2011. They survived tight credit, lack of confidence, and over regulation to take GDP to record levels, to take corporate profits to record levels, and to make lots of cash so that they can hoard it on their balance sheets to the tune of $2.1 trillion at the end of the third quarter. They are not alone as hoarders; banks hold an equal amount in excess reserves at the Federal Reserve.

Collectively, in May of 2011, we came to the realization that we have spent $3 trillion in the past fifteen years fighting his brand of terrorism, but we finally got Osama bin Laden. For him, terror came in the dark of night in the form of our Navy Seals. Geronimo EKIA.

Consumers fared okay in 2011, too. Unemployment fell to 8.6% in November, 2011 from 9.8% in November, 2010, although we are still seeing people exit the labor force, or go “MIA,” which is highly unusual during a recovery. Consumer spending rose, albeit slowly at times, in every month except one (June) during 2011.

Shoppers came out in force on Black Friday to set new spending records for that day at $11.4 billion, up 6.6% year-over-year. Auto sales have returned to annualized levels above 13 million. Just don’t mention the value of their homes and they will be okay. And who can forget getting up in the middle of the night in April to watch live as Prince William married Kate Middleton—a boost indeed to economies everywhere!

Looking Ahead to 2012

The sheep followed their annual ritual of falling all over each other to get their GDP forecasts out for 2012. They can be a pessimistic bunch, especially the group from AP. Here are their forecasts:

- Federal Reserve 2.5% to 2.9%

- Blue Chip Economic Indicators 2.0%

- National Association of Business Economics 2.4%

- Associated Press Survey of Economists 1.3%

- Wall Street Journal Survey of Economists 2.3%

We remain in the midst of a recovery that is fragile and susceptible to shocks. But I will emphasize that slow growth is not recession. Don’t let the pundits make you think it is. GDP is at a record level of $15.2 trillion (current dollars, seasonally adjusted). Corporate profits are at a record 13% of GDP, compared to the average since 1947 of 9.5%. Job creation has been slow, but steady. In the first six months of 2011, payroll employment grew on average by 131,200 each month, while household employment grew on average by 21,300 each month.

For the period of July to November, the pace for payrolls remained about the same on average at 132,200 and household employment increased dramatically to average 249,200 monthly. The employment picture is slowly improving.

Consumers spent freely for the holidays and it remains to be seen whether they remain in a festive mood or return to their dour deleveraging habits. The Federal Reserve is determined to keep interest rates low so consumers can borrow or refinance cheaply, and just maybe people will buy houses to get the excess inventory off the markets.

As far as the bond markets go, rates, while they can still go lower, probably will not because they are already less than the most recent core rate of inflation of 2%. Mortgage rates may not fall further as investors seem averse to such low rates that bring with them greater duration risks.

As far as the stock markets go, prices, while they can go lower, probably will not because the price earnings ratio of the S&P 500 is already below average at 12 times and the dividend yield of 2.1% is greater than the ten year Treasury yield of 1.88%. GDP is at a record dollar level and corporate profits are at a record when compared to GDP.

There are always wild cards such as the “next” crisis, reduced government spending, and the Presidential election this year. Don’t give up on the economy—there are enough positive signs of future growth and a Fed with their foot on the gas pedal. Stay tuned!

And, in case you have not noticed, she has been quietly moving into mainstream America, with a primetime Thanksgiving night special and a performance on TV on New Year’s Eve wearing what appeared to be a giant birdcage. Lady Gaga is about to announce and embark on a 2012 tour and I am there!

Thanks for reading! DJ 01/03/12

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with First Federal of Bucks County since November, 2004.

Customer Service... blah, blah, blah

My family recently shopped around our homeowners and auto insurance to ensure we were getting a fair shake. We used to use an insurance agent for life, auto, and homeowners. I place value in having an agent because they have access to a number of insurance companies (if an independent agent) and should have our best interests in mind. The owner of the agency is a director at a bank, which is a bonus.

But a past "shop" for auto after a dramatic rate increase led me to go to a "direct" insurer. And now, after our most recent shop, we are leaving to a direct insurer for homeowners. When I notified my agent, he asks me if he could have a chance to look around for me, and to try to win back our homeowners and auto.

My e-mail back to him: "I would have appreciated that service prior to me searching on my own." I was irritated. I expect three things from our insurance agent:

1. An analysis of our needs and recommendations to fit those needs;

2. Periodic reviews of our policies versus what is offered by similarly rated insurance companies in the agent's markets; and

3. Good service when I call with questions and problems.

I received one and three from the agent. But I was pretty disappointed when my shopping resulted in a 20% reduction in my homeowners insurance. I am willing to pay a slight premium above discount insurance companies for the service of an agent. But not 20%. This happened with our auto insurance too.

Our agent clearly dropped the ball on two, and scrambled to make up for it after I notified him I had done it on my own. As Donald Trump would say, "you're fired". When I sounded off to my wife about it, she said "I think you have a blog post." Boom!

I suspect financial institutions think they have great customer service too. But in my experience, what FIs mean by great service is "3" above. After my wife planted the seed of this post in my mind, I asked the marketing director of a multi billion FI if they had "service level agreements" (SLAs). She said that they are required to respond to customer inquiries within a certain amount of time, etc. In other words, "3".

But what of one and two? I know it is an insurance list, but don't we have similar demands from our FI? Don't FIs want to be considered for more than a deposit counter or a money machine? Based on my experience, I think they do. In fact, a competitor of my firm did a survey of FI customers that concluded that both businesses and individuals wanted advice from their FI.

Are we giving them what they want? Are we really good at customer service?

What do you think customer service is?

~ Jeff

In Pursuit of Return on Equity

When performing ratio analysis to determine a company's profitability we should remember that a ratio has at least two data points: a numerator and a denominator. It doesn't matter if it is banking, retailing, or widget making.

In banking, the standard profitability ratio has long been return on equity (ROE). That is... until the financial crisis of 2007-08. It was in the aftermath that capital, the denominator in the return on equity calculation, resumed its place as king.

Where has the pursuit of ROE led us? Yes, it made us focus on profitability, the numerator in the equation. But it also resulted in us looking at bank equity. The smaller the E, the better the ROE, right?

Bond salesman loved the concept. They encouraged their bank clients to borrow from their respective Federal Home Loan Banks (FHLB) or chase high cost deposits to fund the bonds they sold for minuscule spreads. The logic: blow up the balance sheet, eek out incremental profits, and reduce the E. Genius! And equity analysts, who coincidentally worked for the same firms as the bond salesman, loved it too.

During the period 2002-07, when loan growth outpaced the ability to fund it, FIs took on more FHLB borrowings and high cost deposits. This was a higher spread concept, because loans typically had greater yields than bonds. Loans also typically had greater credit risk. FIs did provision for such losses, but accounting rules and how the SEC enforced them did not allow FIs to "over-reserve", whatever that means. This was determined by the high profile case the SEC brought against SunTrust in the Fall of 1998 for managing earnings through the loan loss provision. Read a summary of it from the Atlanta Fed here. The Fed research piece on the subject, written in 2000, is almost comical to read given what has happened.

So, in pursuit of ROE, banks leveraged up their balance sheet. They thinned their capital leaving them more susceptible to distress during economic hard times. This distress was clearly evident when I recently performed some "where are they now" research on the highest performing ROE FIs in 2006, the last normal year prior to the crisis (see table).

A note on the data. I searched all publicly traded banks and thrifts that existed in 2006 and sorted them by the highest ROE. But I also ensured that their prior year ROE was similarly high, in order to weed out one-time gainers. In other words, I wanted consistent, high ROE FIs.

The results are telling. Of the top 10 ROE FIs of 2006, only three are currently profitable. Two are under a regulatory agreement. The remaining five failed. Yes, failed.

How does an FI, sitting atop the ROE chain, fall so far so fast?  As mostly always the case, it was bad loans. But many if not most FIs have had loan troubles. What made so many in this group take the perp walk to the FDIC? I already mentioned their inability to put extra away for a rainy day via the loan loss provision. But the pursuit of ROE encouraged levering up the balance sheet to leave little in excess equity to absorb the losses. Inadequate loan loss allowance, relatively low equity. The recipe for disaster in bad times.

I think ROE will re-emerge as ONE important indicator of profitability. But I don't think we will make the same mistake twice. Having the past three years as history in our loan loss allowance calculations, our regulators and the SEC will probably permit us to be more aggressive in provisioning. Needing the federal government to chip in capital because we did not have enough to withstand the storm is resulting in higher capital requirements, and lower ROE expectations. Analysts take note.

What do you think should be the primary measure of FI profitability?

~ Jeff