Why Wells Fargo Rules Mortgages

 | Jan 09, 2014 | 5:00 PM EST
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On Thursday, I wrote about the problems facing Bank of America (BAC) as it begins the transition from focusing on legacy issues and non-performing mortgages to originating loans and creating revenue again.

One of the issues the bank faces, along with Wells Fargo (WFC), JPMorgan Chase (JPM) and all the small lenders and originators that sell loans to the money centers, is the new Qualified Mortgage, or QM, rules that go into effect for all loans originated after Jan. 10, 2014. The QM rules are expensive to implement, reduce the profitability of mortgage origination, commoditize the mortgage market, restrict terms available to borrowers, restrict fees that may be charged by lenders, and they face steep financial penalties from the Consumer Financial Protection Bureau for violations.

The good news for the money centers is that it will almost certainly cause many existing small mortgage lenders to exit the business. The bad news for the money centers is that their revenue growth in the residential mortgage market will have to come from originating non-qualified mortgages -- loans that do not meet QM rules. Lenders are still allowed to make non-QM mortgages, but they will give up some regulatory protection from consumer lawsuits under the QM rules. Non-QM mortgages carry interest-only payment options or go to borrowers who may not meet the guidelines for verifying credit, income and assets required for QM loans.

The largest impact will be on the market for loans in excess of the limits eligible to be sold as conventional conforming loans, known as jumbos. For most of the country, jumbos are first- or second-trust mortgages with loan amounts in excess of $417,000. In areas of the country where this is the norm, like Southern California and metro Washington D.C., borrowers will find it more difficult to get a qualified mortgage.

This is where lenders with the ability to offer non-QM mortgages can capitalize. Of the three money centers actively involved in originating residential mortgages, JPM, BAC and WFC, Wells Fargo's expertise in the originating and servicing of non-QM and mortgages they retain for their own portfolio is far superior. Prior to the 2008 financial crisis, the largest residential mortgage lender in the country that originated and kept loans in house in what is called portfolio lending (rather than selling the loan into a mortgage-backed security) was World Savings Bank, a California-based thrift traded publicly as Golden West Financial before it was sold to Wachovia in 2006. Wachovia was then taken over by Wells Fargo in 2008, at the height of the financial crisis.

Wells Fargo acquired the people and systems developed by World Savings Bank to originate, service and manage portfolio mortgages with unique characteristics. World Savings specialized in the adjustable-rate, cost-of-funds index loans that had negatively amortizing payment options, originated mostly without verification of income, and were provided primarily to self-employed and other high-end borrowers. These loans were very profitable with default rates far below the Fannie Mae and Freddie Mac loans, contrary to a prevalent meme since the 2008 crisis.

The ability to reactivate the World Savings Bank portfolio's mortgage systems in order to offer non-QM mortgages to borrowers places Wells Fargo at a substantial advantage over JPMorgan and Bank of America. Although Wells Fargo doesn't currently intend to offer the negatively amortizing products so popular in California prior to the crisis, it's getting ready to roll out interest-only payment options again and it has systems in place to offer negatively amortizing loans as well, if it chooses to do so.

The bottom line for investors is that the QM rules and a lack of large-scale expertise in non-QM portfolio-mortgage products at JPM and BAC put those banks at a disadvantage in the profitable jumbo-mortgage market versus Wells Fargo. As dominant as Wells Fargo has become in the residential mortgage market since 2008, it is about to become even more so.

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