With the price of many mortgage lenders hitting record lows, many people are wondering if now is the time to get into this sector. I am going to spell out my reasoning against investing in this area. To clarify, I am talking about the mortgage lenders which skipped traditional banking and instead focused on originating and selling large volumes of loans.
The basis of my argument revolves around the idea that the "value-added" from this industry is minimal at best. I summarize the mortgage lending business model as this: borrow at market rates from banks, hire a staff dedicated to finding and originating loans, and then sell them to other investors for a profit, and repeat. The whole process uses heavy leverage to make the returns worthwhile. Basically, they're aim is to add value in the originating process by making more profitable loans, whether through higher interest and/or more security (For sub-prime and Alt-A, it was higher rates while hopefully maintaining security) The mortgage lenders could have gone three routes:
A) originate loans to good borrowers that banks would also lend to.
B) Loan to good borrowers that banks would not lend to.
C) originate loans to bad borrowers.
In C there is no viable long-term business model. In Situation A, the "value-added" is minimal- you save the borrower the time from visiting their local bank, and in return add another layer of frictional costs. On average, the mortgage lenders total cost to originate are about 2% of loan value, so you can make a rough estimate of $4,000 per loan in additional costs.
Only in B does there exist a niche market which appears worthwhile. But the market will always occupy only a small niche outside bank lending criteria. If the non-conforming business grew large and the loans being made were truly good loans, then banks could simply loosen their criteria and add new competition, forcing it back to a situation A.
So when the market for Sub-prime and Alt-A grew to 40% of loans originated in 2006, either things got out of hand, or banks fell behind a new shift in acceptable lending. I choose to believe in the former.