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Banks burdened with compliance costs outsource loans

Ryan Carson cooks dinner with his wife, Jenny

Ryan Carson cooks dinner with his wife, Jenny Roraback-Carson, and their daughter, Clara, 3, on July 2, 2014, in their home in Seattle. Credit: AP

As banks lose money on mortgages and retreat from the business, PHH Corp. is rushing to cash in.

PHH, the biggest U.S. outsourcer of home loans, processes and originates mortgages on behalf of small banks and some of the world’s largest financial firms, including Morgan Stanley and HSBC Holdings. PHH chief executive Glen Messina is so convinced he can make money where others can’t that in July he sold the company’s cash-producing fleet management unit and plans to plow the proceeds into mortgages.

Lenders are backing away from home loans as an array of new regulations in the aftermath of the housing crash push up compliance costs. Banks lost an average $194 a mortgage in the first quarter, according to the Mortgage Bankers Association. The losses may spur banks to increase outsourcing of home loans by $180 billion a year while keeping their brand name on the mortgage, Messina said on a July 8 call with analysts.

“The biggest banks have the resources to implement the new regulations, but if you’re a smaller bank or a wealth manager, it may not make sense to invest in all that infrastructure,” said Bose George, a mortgage analyst at Keefe, Bruyette and Woods Inc. in New York. “The risks are too high for companies to lend without a very high level of compliance expertise.”

Investors drove up PHH’s share price 12 percent to $23.78 on May 21 when Messina announced the company was in talks to sell the profitable corporate car and truck fleet unit. That was the biggest jump in more than two years for Mount Laurel, New Jersey-based PHH. The stock has since pared that gain, retreating to $23.31 on Friday.

Messina, who spent 17 years in executive positions GE’s retail finance, mortgage and equipment management businesses, said on the July call that PHH would net about $821 million from the sale, after taxes and transaction costs. About $450 million will go to repurchasing shares, $200 million will be used for debt reduction, and the rest will be spent on expanding its mortgage operation with acquisitions and investments in technology, he said.

Messina said the goal for PHH, which also services home loans, is to increase lending to $80 billion a year. That would be a 57 percent increase from 2013’s volume for PHH, which in the first quarter was the sixth-largest U.S. lender.

“We are seeing a meaningful increase in demand from regional community banks looking for an outsourcing solution,” Messina said in July. “We think our model plays very well in this part of the cycle.”

The sale of the fleet-management business, which leaves PHH dependent on the mortgage market, comes with risks. Without a steady stream of income from the unit, which accounted for 58 percent of PHH’s 2013 revenue, the company will be vulnerable to mortgage-market volatility, Jeffrey Zaun and Stephen Lynch of Standard & Poor’s Financial Services LLC said in a report last month. PHH may not post a profit until the second half of 2015, the analysts said, as they lowered the company’s rating to B+ from BB- while upgrading its outlook to stable.

PHH will report second-quarter earnings after the close of the New York Stock Exchange Monday. The company probably will post a loss of $7.4 million, according to the average analyst estimate in a Bloomberg poll, because of a decline in revenue as the mortgage market contracts. That compares with a profit of $90 million in the year-earlier period. For the year, PHH probably will lose $39.2 million before earning a profit of $28.5 million in 2015, according to the Bloomberg poll.

Dico Akseraylian, a PHH spokesman, said the company couldn’t comment because of its pending earnings report.

In January, the federal Consumer Financial Protection Bureau implemented more than 1,800 pages of new mortgage regulations stemming from the 2010 Dodd-Frank Act. The rules include strict standards for the documentation of income, assets and employment.

The cost of originating a mortgage rose to a record $6,253 in the first quarter, up 21 percent from the end of 2013, according to MBA, the industry’s largest trade group. The $194 net loss per loan in the first quarter compares with a profit of $150 in the fourth quarter.

Banks have slashed their lending staffs to the lowest level since 2001, the beginning of the real estate boom. In June, they had 1.7 million lending employees after the number declined for 12 consecutive months, according to the Bureau of Labor Statistics.

Banks shrinking or exiting their mortgage businesses will turn to outsourcing because they still want to offer home financing to attract customers, said Keith Gumbinger, vice president of, a mortgage-data website based in Riverdale, New Jersey.

“Compliance is eating up lending profits, but banks need those mortgage customers for cross-selling their other services,” Gumbinger said. “You have to bare your financial soul to get a mortgage, and that’s information banks can use to see if you are a potential customer for a credit card or investment products.”

PHH’s size — it has about 6,000 employees and is the second-largest nonbank lender by volume after Quicken Loans Inc. — makes it easier to carry the regulatory burden. PHH, which handles every step of the loan process for its clients, sells 80 percent of its mortgages to Fannie Mae, Freddie Mac and Ginnie Mae.

In many cases, customers never know their bank has outsourced their loan to PHH because all the work, even answering the phone, is done using the bank’s name.

“We have the benefit of scale and the spreading across multiple clients. That enables us to achieve a level of economics, and an investment in compliance” that banks find too costly to make, PHH’s Messina said.

As compliance costs surge, Messina also faces the challenge of having to renegotiate existing outsourcing contracts, said Paul Miller, managing partner and bank analyst with FBR Capital Markets Corp. in Arlington, Virginia.

“PHH’s compliance costs went up too, so just as they hope the new regulations will spur more banks to outsource, they are dealing with the same issue when it comes to multiyear contracts negotiated in the old regulatory environment,” Miller said. “They won’t make money until their existing contracts are profitable.”

PHH was spun off in 2005 from Cendant Corp., which at the time was the largest U.S. real estate company. The following year, Cendant spun off Realogy Holding Corp., now the largest U.S. real estate brokerage, and Wyndham Worldwide Corp., a hotel franchiser. The remaining car rental business became Avis Budget Group and the Cendant name was retired.

While outsourcing accounts for about 67 percent of PHH originations, it also makes home loans through a joint venture with Realogy, which has more than 700 real estate offices and is the franchiser of the Century 21, Coldwell Banker and Better Home and Gardens brands. PHH is the exclusive name that Realogy brokers recommend to clients needing a mortgage, according to PHH regulatory filings.

About 29 percent of PHH’s outsourced lending is on behalf of Merrill Lynch, a division of Bank of America Corp., and 12 percent is for Morgan Stanley, according to the filings. PHH also handles U.S. mortgage processing for HSBC Holdings Plc., Europe’s largest bank.

Bank of America, Morgan Stanley and HSBC declined to comment.

“PHH is a very low-profile company, what I call white label because their core business is originating under someone else’s name,” said George, the KBW analyst. “The costs and the complexity of making a loan today has grown so much, there may be more brand names that want someone else to do their lending for them.”

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