As we near the completion of bank earnings season, it is a good time to take a step back and assess where we are. What we know is that the flat yield curve is still wreaking havoc on bank balance sheets, just as people thought we were through the worst of it. Additionally, mortgage gain-on-sale margins remain at depressed levels with little indication of a turnaround anytime soon. Fee growth has also slowed, and credit quality - while still good - has turned the corner and will become more of a headwind in 2006.
The elephant in the room that no analyst has dared point out is how much of a failure Countrywide's bank strategy is becoming. Initially introduced a few years ago as a way for CFC to "smooth" out earnings volatility, it is now clear that management aggressively built out this business heading into what might be one of the worst periods in over a decade for the banking industry. From nothing, Countrywide has now built up more than $70bn in mortgage assets on its bank balance sheet. This strategy works fine in a steep yield curve environment, which we had prior to 2005. Yet management made the fatal flaw of assuming that the curve would stay steep despite the fact that Fed Funds were sitting at generational lows and had nowhere to go but up.
The net interest margin on these loans is now around 2.00%, which I believe greatly overstates the true earnings power of this book. With continued flattening, this margin will surely tumble below 2% in coming quarters and years if the curve does not steepen. Even Washington Mutual, who has a strong deposit franchise, noted that it will be a seller of mortgages going forward as the economics for loan sales are better than holding them on-balance sheet. This is a stunning statement.
Without a true retail, branch-based deposit franchise, Countrywide is unable to fund these assets at attractive rates, instead relying on high-cost jumbo CDs and Federal Home Loan Bank advances. Management has asserted that because they don't have a branch presence, they simply pile those savings on better deposit pricing for customers. In theory this sounds good, but in practice, it does not work. In fact, the bank's ROE YTD is 17% - not bad - but not great when one considers that they've had to nearly double capital levels this year to keep regulatory capital ratios above their minimums. If you annualize their earnings on this new capital base, the ROE drops to a measly 13%, well below industry peers.
So basically, management has taken $2.75bn of shareholder capital since 1/1/04 to build a bank that holds mortgage assets funded by high-cost deposits, earning a margin that will end up being less than 2%. To boost the ROE, management has had to lever the bank up to a point where its regulatory capital ratios are at the bare minimum to be considered "well capitalized" - and even then, still only earn a mid-teens ROE.
This bank strategy has been a total failure. We haven't even seen a credit seasoning of the portfolio, which will surely act as a drag on those poor earnings and put more pressure on capital ratios. Management has committed one of the all-time biggest blunders in banking histroy, yet no one wants to talk about it.
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