Capital One and the mortgage domino effect

As Capital One shuts its mortgage operations, experts say more commercial banks are teetering on shaky ground. Fortune's Katie Benner reports.

By Katie Benner, Fortune reporter

NEW YORK (Fortune) -- Capital One's shuttered GreenPoint Mortgage is the latest mortgage banking explosion to bump Wall Street's panic meter up a notch, and industry insiders say it is just another indicator that retail banks will be stung by the credit mess they helped create.

"Banks are not going to want to be in the mortgage business after all this is over," says Richard Wilkes, a mortgage industry veteran who ran First Nationwide Mortgage before it became a part of Citigroup.

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"It happened to the insurance companies in the 1980s when players like Travelers and Prudential owned mortgage banking operations. They just couldn't stand the cyclicality and the banks won't be able to either."

But big names in retail banking like Capital One have become deeply entwined in the mortgage lending industry, particularly at the beginning of the decade. Loan originators made boatloads of cash selling mortgages to investment banks that turned them into the asset-backed bonds.

The game ended when the mortgage-backed bonds turned out to be toxic waste for investors, and high-profile write-downs on their value sparked the credit crunch that is strangling the markets. However, it won't be so easy for banks to get out of mortgage lending altogether.

True, Capital One shuttered GreenPoint, which specialized in "Alt-A" loans, meaning mortgages for people with decent credit scores who still did not meet the standards for prime mortgages. But it will still retain a $12.5 billion mortgage portfolio and make new loans through its Home Loans unit and its bank branches.

"The banks dominate the mortgage banking industry now. Other than Countrywide, the large banks are really the main originators," says Tom LaMalfa, managing director of mortgage research company Wholesale Access. "Mortgage lending is a trillion dollar market, and they can't leave people with nowhere to turn. [We've lived through] the S&L crisis of the 1990s, and I think regulators would preclude banks from exiting this business and leaving us in a lurch."

It is difficult to imagine who could step in and fill the gap should consumer banks like Capital One or Wells Fargo exit mortgage lending operations altogether, particularly given how badly the business has suffered. Nearly 120 mortgage lenders in the past nine months have closed their doors, declared bankruptcy or been sold off to the highest bidder, including stock darlings like New Century Financial and private equity-owned businesses like Aegis. That's about three lenders a week. Not only have companies closed, thousands of layoffs now dot the country where booming economies once stood.

"A severe economic slowdown is unavoidable given the seizure we've had in the financial markets," says Tom LaMalfa, managing director of the mortgage research company Wholesale Access. "As providers become fewer, it will increase the cost of mortgage financing until you get to the point where no one can get a loan."

What does it all mean for the retail banks? Losses, earnings hits, and, inevitably, falling stock prices, whether or not their mortgage units dealt in sub-prime loans. Capital One (down $2.03 to $66.72, Charts, Fortune 500) downgraded its 2007 earnings estimate by $2.15, or about 30 percent and said it could not predict future performance despite the fact that its other business lines are healthy. Be on the lookout for similar problems at banks like Wachovia (Charts, Fortune 500), Bank of America (Charts, Fortune 500), and Wells Fargo (Charts, Fortune 500), which all have mortgage banking and servicing units.

"We're right on the front end of problems for the mortgage banking business," says LaMalfa. Top of page