On its face, Citizens Financial Group's decision to buy a large mortgage lender seems to be a case of swimming against the tide.

Several banks have recently dialed down, or outright exited, large-scale mortgage lending as rising interest rates put a damper on refinancing activity.

A closer look shows the logic behind the $154 billion-asset company's deal for Franklin American Mortgage. For starters, the $511 million acquisition, which is expected to close in the third quarter, will dramatically boost Citizens’ fee income at a time when all banks are struggling with weak loan demand.

And Franklin’s specialty — servicing homeowners’ monthly loan payments — is the part of the mortgage industry that typically performs well in a rising-rate environment.

While banks like Flagstar Bancorp, MB Financial and Capital One Financial have tapped the brakes, others have quietly stepped up to fill the gap, said Peter Winter, an analyst at Wedbush Securities, adding that the acquisition should help Citizens form deeper relationships with consumer clients.

“If you’re a traditional bank, mortgage is a key product,” Winter said. “You get deposits. It’s a good opportunity for cross-selling and it helps build customer relationships.”

Because Franklin American sells most of its originations to Fannie Mae and Freddie Mac, the bulk of its profit comes from fees.

That’s exactly what Citizens wanted, and what many other banks need.

Borrower demand, especially for commercial and industrial loans, has been tepid across the industry despite December's corporate income tax cut.

Citizens, meanwhile, has been trying to generate more fees for years, focusing on wealth management and adding a robo-advisory service. The effort has been a struggle; first-quarter noninterest income fell 2% from a year earlier, to $371 million, because of lower capital markets fees and a decrease in customer service charges.

“In our fee-income businesses, we were underinvested prior to the IPO three years ago,” John Woods, the company's chief financial officer, said during a May 15 investor conference.

Franklin American helps Citizens move away from the side of the mortgage business that is harmed by higher interest rates.

There was "general market softness" during the first quarter, Bruce Van Saun, Citizens' chairman and CEO, told analysts during an April 20 conference to discuss earnings. “There was a shift away from refis, rates have gone up and so it was just a tougher quarter than we expected.”

Adding Franklin's $41 billion portfolio of mortgage servicing rights will help, said Brad Conner, Citizens’ vice chairman and head of consumer banking.

Homeowners tend to make fewer prepayments as interest rates rise and monthly payments increase, which reduces a bank’s income. But they continue to make payments, which increases the underlying value of servicing the loans.

“Mortgage servicing rights are a natural business hedge,” Conner said in an interview. “MSRs become more valuable as rates rise and originations fall. We're balancing our exposure."

Franklin American originated $5.8 billion in mortgages during 2017, making it the No. 43 largest mortgage lender in the country, according to federal Home Mortgage Disclosure Act data. Citizens would have originated about $4.8 billion of mortgages in the first quarter, including Franklin American, said Jason Goldberg, a Barclays analyst.

Citizens will handle mortgage servicing for the assets that it’s buying from Franklin in its existing Richmond, Va., operations center. Citizens will hire more staff for the Richmond center, though Conner did not provide details.

Franklin will also provide Citizens with more exposure to wholesale and correspondent channels, creating opportunities with small banks and mortgage brokers.

“We have almost exclusively been a retail mortgage shop,” Conner said. “This acquisition diversifies our origination channels.”

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Andy Peters

Andy Peters

Andy Peters writes about regional banks, consumer finance and debt collections for American Banker.