A surprise spike in mortgage rates threatens to halt a refinancing boom that has delivered strong profits for U.S. banks over the past two years.
The average rate on a 30-year mortgage rose to 4.15% last week, a 14-month high and up sharply from 3.59% in early May, according to the Mortgage Bankers Association. A separate survey released Thursday by Freddie Mac FMCC -5.56% said the rate this week was at 3.98%, up from 3.35% last month.
Refinancing applications last week were down 36% from the first week of May, before rates began climbing, according to the bankers association.
Lenders have been predicting that refinancing would taper off, "what wasn't anticipated was that this move in rates would happen so quickly," said Bose George, a mortgage-finance company analyst with Keefe, Bruyette & Woods.
While a falloff in refinancing business could cut into record profits lenders have enjoyed from the activity, a rise in short-term interest rates could see banks earning higher yields on various types of loans, from mortgages to commercial real estate.
Climbing mortgage rates are one consequence of the swift rise in Treasury yields in recent weeks, as investors bet that the Federal Reserve will start slowing the bond-buying program it launched last year. Mortgage rates tend to track yields on the 10-year Treasury note, which closed Thursday at 2.18%, up from 1.61% in May, which was the lowest level of the year. Bond yields rise as prices fall.
The rate moves highlight the tricky task the Fed faces. Fed officials have been discussing when to pull back on their $85-billion-a-month bond-buying program, which is meant in part to hold down long-term rates, including those on mortgages.
But they don't want to move in an abrupt way that sends short-term interest rates up soon. Investors have shown in recent weeks that they are highly sensitive even to hints of a small adjustment. Fed officials aren't expected to start reducing their monthly bond purchase at their next policy meeting on June 18-19.
"Every speech and statement [from Fed officials] will have the potential to move rates," said Michael Fratantoni, vice president of research for the Mortgage Bankers Association.
On Thursday, bond yields pulled back slightly and stock markets extended a rally after a blog post by The Wall Street Journal suggested that Fed Chairman Ben Bernanke would attempt to calm market fears that the central bank could raise short-term interest rates sooner than expected.
Some lenders and economists say that refinancing could continue despite the recent jump because many borrowers have yet to take advantage of low rates. Rising home prices and an improving economy could allow some homeowners who previously didn't qualify to participate. Also, homeowners who have an adjustable-rate mortgage might also move now to lock in a fixed rate.
"There's still quite a bit of mortgage debt out there that could refinance, even at higher rates," said Charles Himmelberg, mortgage strategist at Goldman Sachs Group Inc. GS +2.45%"We don't think [higher rates] kills it. We think that will slow it."
With rates on the rise, Steve Walsh, president of Scout Mortgage, a brokerage based in Scottsdale, Ariz., said he had to swallow a $7,500 loss in order to close a 3.875% fixed-rate mortgage for a couple last week.
When his clients first applied for the mortgage in late April, rates stood at 3.5%. After processing the application, rates had jumped up, and Mr. Walsh covered the clients' closing costs and took the loss in order to keep the deal from falling through. Even so, the difference between the two rates resulted in a monthly payment that was $80 higher.
"They weren't very happy," said Mr. Walsh.
Banks stand to suffer somewhat, as well. Lenders have seen record profits during recent periods of falling rates in part because refinancing demand has outstripped lenders' ability or willingness to process applications quickly. Analysts at BMO Capital Markets estimate that mortgage-banking fees could drop by 13% this quarter and that core mortgage-banking revenue could fall by 19% overall this year.
Some banks are especially vulnerable to a slowdown, noted Marty Mosby, an analyst who covers large banks for Guggenheim Securities. Refinancing accounted for 87% of mortgage business at Bank of America Corp. BAC +1.14%during the first quarter and 90% at Citigroup Inc., C +1.72%according to industry publication Inside Mortgage Finance.
Refinancing comprised 77% of all mortgage deals at J.P. Morgan Chase JPM +1.86%& Co. and 68% for Wells Fargo WFC +1.66%& Co. Wells Fargo recorded noninterest income of $11.6 billion from mortgage banking last year, up 49% from 2011, and $2.8 billion during the first quarter this year.
Mortgage banking at J.P. Morgan brought in $9.2 billion last year, a 186% gain from the previous year, and $1.5 billion during the first quarter.
A Wells Fargo spokeswoman said the bank is "well positioned" to capture existing business. Representatives of Bank of America, J.P. Morgan, and Citi declined to discuss mortgage-production staffing or strategy.
Higher short-term rates could help boost lenders' net interest margin, a key measure of lending profitability that has been under pressure because of low interest rates. Rising rates could also help raise the profitability of mortgage servicing, or the process of collecting payments from borrowers and passing them along to investors.
U.S. Bancorp's USB +0.17% second-quarter mortgage originations are expected to be higher than in the first quarter, thanks in part to a strong start in the current quarter, Andrew Cecere, chief financial officer of the Minneapolis-based bank, said Tuesday. But he said refinancing would account for about 60% of its originations, down from about 70% in the first quarter. A bank spokesman declined to elaborate.
At a 4% mortgage rate, about 34% of all borrowers with a 30-year fixed-rate mortgage could still drop their rate by more than one percentage point, and 54% of all borrowers could drop their rate by half of a percentage point, according to estimates by analysts at Credit Suisse CSGN.VX +0.65%.
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