Market Overview

Mortgage Settlement May Inspire Confidence in Retail Banking

Now that New York and California have joined other states on a $26 billion mortgage settlement with the nation's largest banks, there is hope that renewed confidence in home financing will boost the retail banking sector. A drive towards home loans, whether new or refinances, would benefit some banks more than others, and no bank is greater positioned than Wells Fargo (NYSE: WFC), now that it is the biggest mortgage servicer in the country.

Wells Fargo has rallied in recent months, with a gain of over 15% over the past three months thanks to a string of hopeful news. Hope in renewed consumer confidence helped the stock rally even before strong earnings proved that the bank was on the road to recovery. However, many sector-wide gains were recently hit as concerns over Europe's continuing drama and a surprising hiccup in U.S. consumer spending gave investors pause.

Banking has since returned to an upward trajectory, after the Bureau of Labour Statistics announced that the private sector added 257,000 jobs in January and job openings rose to 3.4 million in December. Now that mortgage applications are up by 7.5%, there is more reason to expect the U.S. mortgage banks to profit.

Executives at Bank of America (NYSE: BAC) must be eyeing growing mortgage demand with mixed feelings. On the one hand, it is a major loan servicer, with $1.77 trillion in mortgage holdings. On the other hand, Bank of America keeps downsizing, and it recently stated that it plans on "continued reductions in the size of the company's mortgage servicing portfolio", according to its Q4 2011 earnings presentation. Such reductions are necessary, since the bank has been losing money on its mortgage operationgs for a while.

Already shrinking operations have hurt the bank's bottom line. Last quarter, pre-provision operating profits fell by 40% partly due to lower margins on loans. Cutting costs might help those margins, but the bank cannot capitalize on a renewed mortgage market if CEO Brian Moynihan follows through with his plan to cut $50 billion in assets and lay off 30,000 employees. A smaller bank will mean less operations, and less opportunities to profit on growth in a resurgent American mortgage market. Yet Bank of America has little choice but to downsize, since its disastrous acquisition of Countryside brought with it the burden of nonperforming loans worth billions.

Other banks may be better positioned to profit from growth in mortgage demand. The third biggest mortgage servicer in America is JPMorgan (NYSE: JPM), who originated $38.6 billion in mortgages last year. However, this is a fraction of Wells Fargo's $357 billion in home loan originations for the year, and JPMorgan is more heavily dependent on institutional credit; it provided $545 billion of credit to businesses in 2011.

No American bank is investing as heavily in home loans as Wells Fargo, which is why it has been exciting investors while limited investment opportunities have made the once invincible investment banks languish. However, as the subprime mortgage crisis demonstrated, diversification is necessary when playing with real estate, and shifting winds in refinancing demand could turn Wells Fargo around if it invests too heavily in the residential mortgage sector. Until then, a deal between state officials and the big banks will likely buoy the financial sector, and strengthen hopes that the ugliness of the subprime mortgage crisis may finally be ending.

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