A Recovering Housing Market is Great News for Too-Big-To-Fail Banks

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There was more good news coming out of the housing market yesterday, with the Commerce Department announcing that new residential construction projects, called housing starts, increased by 15% in September compared to the prior month and an even more impressive 34.8% compared to last year’s pace, reaching the highest level in four years. Housing starts are a key indicator for the real estate market and the broader economy going forward, as sustained increases in housing starts indicate that homebuilders anticipate a healthy real estate market in the near future.

Though these latest numbers are strong, they should be viewed in context. Housing starts remain far below numbers seen even before the real estate bubble began to inflate in the late 1990s. But even a modest uptick in residential mortgage construction can have outsized benefits for the economy, as this kind of economic activity supports job growth and spending throughout other sectors of the economy. Deutsche Bank economist Joeseph Lavorgna sees recent strength in the housing market as reason to believe that overall demand in the U.S. economy will improve in 2013.

(MORE: More Signs of Strength in Housing: Does Bernanke Get the Credit?)

There are several reasons why the housing market continues to show relative strength. Existing home prices have fallen far enough to spur interest from new buyers, population growth has built up demand for housing, and overall employment has increased slowly but surely over the past three years. In addition, intervention from the Federal Reserve has brought down mortgage rates to historic lows, making already cheap homes even cheaper when financing costs are considered.

But the U.S. economy is not the only beneficiary of a resurgent real estate market. Many of Wall Street’s biggest banks are also benefitting, as evidenced by third-quarter earnings reports out this week. Both JPMorgan and Wells Fargo reported significant boosts in profits — 22% and 34%, respectively. These banks are both big players in the mortgage market, originating a huge percentage of new mortgages made each year. Each time these banks issue a new mortgage, they earn fees and will usually sell the mortgage on to investors in the secondary  market. So any time that refinancing activity picks up — as it has following the Federal Reserve’s recent decision to buy up mortgage-backed securities — it will help banks that do a lot of mortgage origination.

Even banks like Bank of America and Citigroup, which have a smaller share of the U.S. mortgage market, have had their earnings enhanced by increased mortgage activity. Bank of America, who’s performance has been weighed down by its ill-timed decision to purchase the non-bank lender Countrywide just as the housing market bubble was popping, reported yesterday that its mortgage originations increased 18% compared to a year ago. The mortgage business for Bank of America, however, is still a net drain on the firm, as the legacy mortgages the bank still has on its books – mostly due to the Countrywide purchase – continue to produce losses. Like Bank of America, Citigroup is struggling to unwind toxic mortgage assets on its balance sheet, but also reported increased revenues from mortgage servicing in the U.S.

(MORE: Five Reasons It Could Be the Opportunity of a Lifetime to Buy a House)

Critics of the Federal Reserve’s recent policy moves will point to these earnings reports as corroboration for the idea that quantitative easing helps large banks, but does little for the average consumer. Indeed there is some evidence that contraction in the industry since the financial crisis has enabled a few large banks to corner the mortgage market and avoid passing historically low mortgage rates on to consumers. An analysis by The New York Times earlier this year argued that if profit margins at large banks were at the same place they were a year ago, consumers would be paying 0.5% less on their mortgage interest payments than they are now.

Federal Reserve of New York President William Dudley echoed these concerns at speech on Monday. While mortgage interest rates are at historically low levels, he said they should be even lower given the extent to which the central bank is intervening in mortgage-backed security markets. He blamed this partially on “concentration of mortgage origination volumes at a few key financial institutions.”

Banks claim that their profit margins are higher than they were last year because low rates have increased demand beyond their capacity to handle it. They are reluctant to increase capacity because of uncertainty in the economy, fearing that a sudden downturn could plunge home prices once again and cause this newfound demand to evaporate.

These dynamics, however, can only last so long. If housing continues to recover, these banks will increase their capacity, or other firms will step in and take their business. And while much hated too-big-to-fail banks are benefitting from Federal Reserve policy that boosts the housing market, that doesn’t mean attempting to accelerate a recovery of the housing market is a bad thing. There’s plenty of evidence that the Federal Reserve has been too easy on large banks over the years, and that it should do more to encourage these institutions to downsize. But that is a seperate issue from the Fed’s decision to stimulate the housing market, which by all accounts is effectively bolstering the one leg of the U.S. economy which is consistently bearing good news.

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