2006 was a challenging year in the mortgage banking industry. Industry loan volumes of $2.5 trillion were 34 percent below 2003’s historic high level and 17 percent lower than in 2005. Mortgage banking revenue margins declined further after sharp declines in 2005, and net interest margins continued to compress, as the yield curve inverted with the average spread between the 10-year Treasury yield and the 1-month LIBOR declining from 89 basis points in 2005 to negative 31 basis points in 2006. To cap it off, the housing industry slowed down significantly, increasing loan delinquencies and non-performing assets and driving up credit costs for all mortgage lenders.
Yet, despite these challenges, Indymac® again reached new performance heights in 2006, achieving:
| ‹ | Record mortgage loan production of $90 billion, a 48 percent increase over 2005; |
| ‹ | Record mortgage market share of 3.58 percent, a 78 percent gain over the 2.01 percent share we had in 2005; |
| ‹ | Record net revenues of $1.3 billion, a 22 percent increase over 2005; |
| ‹ | Record earnings-per-share (EPS) of $4.82, a 9 percent gain; |
| ‹ | Record growth in total assets, which increased by $8 billion, or 37 percent, to $29.5 billion; |
| ‹ | Record growth in our portfolio of loans serviced for others, which increased by $55 billion, or 65 percent, to $140 billion; |
| ‹ | Strong return on equity (ROE) of 19 percent, slightly lower than last year’s 21 percent level. |
Notwithstanding our solid results for the year in the face of challenging market conditions, our year ended on a disappointing note. Our fourth quarter EPS declined both sequentially and versus the fourth quarter of 2005, and we fell short of EPS expectations for the quarter. Also, our ROE of 14.6 percent for the quarter, while solid, was at the lowest level in 23 quarters. While I am disappointed with how we finished 2006 and with our outlook for 2007, where EPS will likely be down from 2006 given tough conditions in the mortgage market, I believe we will emerge from this difficult mortgage environment a stronger and more competitive company.
We remain fundamentally committed to our hybrid thrift / mortgage banking business model and our strategies inasmuch as we are outperforming most of our mortgage banking and thrift peers, are earning a solid return on our shareholders’ capital (at what we hope is the low point of our cyclical business) and believe strongly in the long-term opportunities presented in the housing and mortgage markets. Nonetheless, in our constant drive to improve our business, we have taken a fresh look at our hybrid model and decided to fine tune it in ways we feel will make us stronger.
As you know, our hybrid business model balances our mortgage production and servicing businesses with thrift investing. On the mortgage banking side, we generate earnings largely by originating, securitizing and selling loans and securities at a profit and by servicing loans for others. On the thrift side, we generate core spread income from our investment portfolio of prime SFR mortgages, home equity loans, consumer and builder construction loans and mortgage-backed securities (MBS). The combination of mortgage banking and thrift investing has proven to be a powerful business model for Indymac, and, given our strong execution in the past, we have been able to outperform our peers and produce both strong and relatively stable returns on our shareholders’ equity.
An important tool in understanding our strong financial performance has been our detailed segment reporting, where we allocate capital to different segments of our business, calculate ROEs for each segment every quarter and then adjust our capital allocations according to where we can earn the best returns for our shareholders. In the fourth quarter of 2006, we saw a fairly dramatic decrease in the ROE in our thrift segment, mostly caused by net interest margin erosion in our whole loan and MBS portfolios. Of greatest concern to me is that I see this as part of a broader trend, the continuation of which is inevitable. Let me explain.
First, there is fierce competition for consumer deposits, particularly as Wall Street firms and other non-bank entities have over the years made significant inroads in attracting deposits away from banks and thrifts by paying high rates on money market funds. In addition, consumers, assisted by the Internet and deposit insurance, are getting more savvy and efficient with their deposit funds, moving them to the highest yielding options. Both of these factors are driving up deposit costs relative to market funding sources and reducing the funding advantage and net interest margins of depository institutions. Second, spreads to Treasury securities on financial assets that can be securitized (home loans and most other consumer loan types) continue to tighten given the efficiency of the secondary market, reducing asset yields and further compressing net interest margins for depository institutions. While there may be temporary periods where asset spreads widen in the secondary market — such as what we are experiencing as I write this letter — the long-term inevitable trend is toward continued increases in market efficiency and generally tighter asset spreads. Third, the regulatory capital requirements for holding these assets (mortgage and home equity loans, in particular) generally exceed those of the secondary market.