Bear Stearns, Lehman Mortgage Growth Crimped by Housing Market
bloomberg.com
March 20 (Bloomberg) -- The U.S. Federal Reserve's fight against inflation is taking a bite out of one of Wall Street's biggest money-makers: the $6.5 trillion market for packaging millions of home loans into tradable bonds.
Executives at Lehman Brothers Holdings Inc. and Goldman Sachs Group Inc. said revenue from mortgage bonds in the U.S. is dropping as rising interest rates depress home sales. Lehman, the fourth-biggest U.S. securities firm, is cutting almost 200 jobs at two home-lending units in California. Bear Stearns Cos. Chief Financial Officer Sam Molinaro said on a March 16 conference call after the company reported first-quarter earnings that he sees ``weakness'' for new mortgages across the industry.
Bear Stearns and Lehman rode the U.S. housing boom from 2000 to 2005 as the top two underwriters of new mortgage securities, which totaled $2.4 trillion last year, data compiled by the New York-based Bond Market Association show. Since June, home sales fell 10 percent, coinciding with the last five of 14 interest- rate increases by the Fed. The benchmark overnight bank lending rate is now 4.5 percent, up from a 40-year low of 1 percent. The drop in sales cut the supply of home loans, which securities firms use to make the bonds, by 65 percent from the 2003 peaks, the Mortgage Bankers Association in Washington said.
Investment banks most exposed to the housing market ``typically suffer during these periods, and I think that will continue,'' Bill Gross, 61, chief investment officer at Newport, California-based Pacific Investment Management Co., said in a March 15 interview. Gross's $92 billion Pimco Total Return Fund holds $57 billion of mortgage securities.
Blemish on Record
``Results in our U.S. residential mortgage business declined due to a slowdown in the U.S. housing market,'' Lehman Chief Financial Officer Christopher O'Meara, 44, said on a March 15 conference call to discuss first-quarter earnings. Molinaro, 48, said a day later on Bear Stearns's conference call that he doesn't expect a ``significant decline'' in revenue from mortgage-backed securities.
Goldman, the second-largest U.S. securities firm by market value, last week reported first-quarter net income of $2.48 billion, the most in the industry's history. Goldman said the outlook is as ``favorable'' as it's ever been. A blemish was mortgages, which ``will slow during the course of the year,'' Goldman CFO David Viniar, 50, said in a March 14 interview.
``We expect home sales to drop by 8 percent in 2006,'' because investor demand is falling and homes are too expensive for some first-time home buyers, said Daniel Mudd, 47, chief executive officer of Washington-based Fannie Mae, the largest U.S. provider of mortgage financing, on a March 13 conference call. ``There are clear downward trends that have emerged.''
`Cash Cows'
A decline in the mortgage market probably won't be enough on its own to stem what's shaping up as a second year of record profits for the U.S. securities industry. Lehman, Bear Stearns and Goldman, all based in New York, reported record first-quarter net income last week, led by trading and fees from advising on mergers.
``There are a lot of cash cows on the Wall Street feedlot,'' and mortgages are just one of them, said Byron Wien, 73, a market strategist who spent 20 years at Morgan Stanley before leaving last year for Pequot Capital Management Inc., a hedge fund company in New York.
The securities industry earned $5.16 billion of revenue in 2005 from underwriting bonds backed by mortgages and related assets, accounting for about 25 percent of all bond underwriting revenue, according to estimates by David Trone, an analyst at Fox-Pitt Kelton Ltd., a London-based unit of Swiss Reinsurance Co. Revenue from underwriting mortgage bonds, which rose 26 percent last year, probably fell 3 percent in the first quarter from a year earlier, he said.
Pioneering Ranieri
Lehman and Bear Stearns are more vulnerable than rivals such as Goldman because their mortgage-bond revenue is ``several times'' the industry average of 2 percent of revenue, Trone said.
``We are coming into a challenging part of the cycle,'' said Kevin White, 42, who helps oversee New York-based Lehman's mortgage-bond group as head of the global structured-finance syndicate unit. ``That's good for us in the long run because 10 of our competitors will have closed up shop.''
Lehman and Bear Stearns officials said they are building up their mortgage units in Japan to counter revenue lost in the U.S. The firms expanded in mortgage bonds in the 1990s to dislodge Salomon Brothers, where Lewis Ranieri pioneered trading in 1983. Ranieri, 59, now runs Five Mile Capital Partners LLC, an investment firm in Stamford, Connecticut, and Salomon is part of New York-based Citigroup Inc., the biggest U.S. financial- services company.
Former Traders
Bear Stearns's co-chief operating officer, Warren Spector, 48, is a former mortgage trader, as are the two heads of the fixed-income division, Craig Overlander, 45, and Jeffrey Mayer, 47. The unit accounted for 44 percent of Bear Stearns's $7.4 billion of revenue in fiscal 2005. Lehman Chief Operating Officer Joseph Gregory, 54, previously led the firm's mortgage group, and CEO Richard Fuld, 59, is an ex-bond trader.
Lehman and Bear Stearns took advantage of surging demand for homes in the U.S. as the Fed cut interest rates to four-decade lows in 2003, the year the Mortgage Bankers Association's weekly index of mortgage applications jumped to the highest since the group began collecting data in 1990.
Investors bought mortgage bonds to get higher yields than offered by U.S. government debt or investment-grade corporate bonds with comparable AAA ratings. Today, the average yield of a fixed-rate 30-year mortgage bond whose payments are guaranteed by Fannie Mae is 5.81 percent, compared with the 4.65 percent yield of the 10-year Treasury note.
California Mortgages
Lehman's mortgage-bond underwriting helped increase profit by 84 percent during the past five years to $3.26 billion in the year ended Nov. 30. Lehman spent $219 million from 2003 to 2004 to acquire companies, including the U.K.'s Preferred Mortgage, that issue home loans to consumers. Those units employed about 3,300 people at the time of the acquisitions, representing about 14 percent of Lehman's current workforce.
One of those units, Aurora Loan Services LLC, filed a notice in January with California's Employment Development Department saying it plans to close an office in Irvine, California, with 92 employees. Another subsidiary, BNC Mortgage Inc., also based in Irvine, filed separate notices that it's dismissing 95 employees.
At Bear Stearns, annual profit jumped 89 percent from 2000 to 2005 to $1.46 billion. A year ago, Bear Stearns started Bear Stearns Residential Mortgage Corp. to issue home loans directly to consumers through brokers. The BearDirect.net Web site was set up to make it easier to get feedback on products and pricing.
Change in Rankings
Mortgage-bond underwriting has become ``a mature, cyclical business,'' said Mark Adelson, 45, director of mortgage-backed and asset-backed securities research at Nomura Securities in New York. ``If volume contracts, Wall Street as a whole makes less money on the business.''
Lehman and Bear Stearns were overtaken in the first quarter in the issuance of bonds backed by the highest-quality mortgages by RBS Greenwich Capital of Greenwich, Connecticut, a unit of Edinburgh-based Royal Bank of Scotland Group Plc, according to data compiled by Bloomberg. Robert McGinnis, head of asset-backed finance and trading at RBS Greenwich, didn't return a phone call. Company spokesman Peter Ward declined to comment.
European companies are clambering into U.S. mortgages. London-based Barclays Plc, the third-biggest U.K. bank after HSBC Holdings Plc and Royal Bank of Scotland, and Frankfurt-based Deutsche Bank AG, Germany's biggest bank, hired more than a combined 50 mortgage bankers and traders in the past year to break into the U.S. market.
Fannie and Freddie
``A rising interest rate environment is going to take a toll on some of these firms, particularly in the second half, due to the slowing in the mortgage market,'' said Robert Hansen, an analyst at Standard & Poor's in New York, who has a ``buy'' recommendation on Lehman shares. He rates Bear Stearns ``hold'' and says Goldman is a ``strong buy.''
Average U.S. home prices are stagnating after rising for five straight years. They declined 3 percent to $261,000 in January from an all-time high of $269,000 in August, according to a report from the National Association of Realtors in Washington.
Wall Street firms also are facing increased competition from Fannie Mae and Freddie Mac, the nation's two biggest providers of mortgage financing, which plan to increase their buying and packaging of home loans that don't conform to insurability standards. Those include loans to people with low credit scores and mortgages to borrowers with good credit but with little documentation of their income.
Until now, Fannie Mae mostly ceded that part of the market to Wall Street, the company said in a filing with the U.S. Securities and Exchange Commission last week. Fannie Mae is creating a wider range of mortgage finance products, such as fixed-rate, interest-only loans, to capture share.
Shopping Malls
``We would expect the second, third and fourth quarters of this year to see headwinds from the mortgage business,'' said Jim Russell, who helps manage $22 billion at Cincinnati-based Fifth Third Asset Management, which holds shares of Lehman and Bear Stearns.
Lehman and Bear Stearns lag behind Wall Street rivals Morgan Stanley, the third-biggest U.S. securities firm, and JPMorgan Chase & Co., the No. 3 U.S. bank, in a part of the mortgage- backed industry that may be growing -- bonds linked to mortgages on shopping malls, office buildings, condominiums and commercial properties, according to Bloomberg data.
``This is shaping up to be a tough year,'' said David Martin, 40, head of residential mortgage-backed and asset-backed securities at UBS AG, the No. 5 mortgage-bond underwriter, according to Bloomberg data. ``But if 2006 is the bottom of the cycle, that's a tremendous thing for the industry, because we've had four tremendous years and will be looking at a better '07 and '08.'' |
