By David Henry
NEW YORK (Reuters) - In September 2008, JPMorgan Chase & Co (NYSE:JPM) executives sifted through the rubble of Washington Mutual, the failed home loan bank that they had just won in a U.S. government auction.
They found something unexpectedly good: about $30 billion of mortgages on apartment buildings, which earned strong returns whether the economy was performing well or not.
"It was an unexpected bonus," JPMorgan Chief Executive Jamie Dimon told Reuters in an interview, adding that the apartment lending business is the single most valuable asset that JPMorgan acquired in the auction.
Washington Mutual's apartment lending business was the biggest of its kind in the United States and Dimon has made it even bigger. JPMorgan now holds some 20 percent of the U.S. bank loans on apartment buildings.
Before the crisis, the bank ranked closer to 20th. JPMorgan now has $52 billion of these loans outstanding, giving it a stronghold in a market that is increasingly important in the United States after the housing crisis brought down the homeownership rate.
Within JPMorgan, apartment lending is a relatively small business, accounting for less than 2 percent of its $2.6 trillion of assets. But the unit is seen as a model for how JPMorgan wants to run its lending business overall: make smart lending decisions in good times, like now, so that it can be strong enough to buy distressed assets on the cheap during bad times.
That's how JPMorgan's apartment lending business grew so much during the crisis: the bank bought assets from Washington Mutual and Citigroup Inc (NYSE:C) at low prices, which are generating solid income now. The bank is plowing income from crisis assets back into its business, to make it more efficient and better prepare it for the next downturn.
For example, JPMorgan is building systems that will allow it to approve loans in 15 to 20 days, half its current time, which is already fast by industry standards. The bank believes that when it can make loans faster than rivals, it will win more business without having to lower its credit standards.
Lending fast is critical for the niche that JPMorgan focuses on: small apartment building owners, who are served by fewer lenders than big building owners, and will therefore generally pay banks slightly higher rates—around 3.625 percent instead of the 3.5 percent charged for loans of more than $3 million.
The bank's apartment business could be tested in at least two ways in coming years. As the Federal Reserve raises interest rates, the value of apartment buildings, which are bond-like assets, could decline, making it harder for some landlords to refinance their loans.
Also, in some metro areas developers have built many new apartment buildings, which could cut into the value of the collateral backing JPMorgan's loans. But the bank is working to reduce its risk by taking steps like avoiding markets where building is happening at a torrid pace.
CHERRY-PICKING
JPMorgan's business is headed by former Washington Mutual executive Al Brooks, 58. He had been with JPMorgan for barely a year, and the economy was still fragile, when Dimon asked him what apartment lending assets he wanted to buy. Brooks said that he had heard Citigroup wanted to sell its apartment loans as part of its plan to shrink the company after having been bailed out by the government.
Within days, JPMorgan was negotiating to buy $3.5 billion of loans from Citi, which was willing to let him and his team choose loans one-by-one, he recalled in an interview with Reuters.
"We cherry-picked them," Brooks said. "There were great customers in there. These were 100 percent performing loans with long repayment histories. We felt really fortunate."
A Citigroup spokesman declined to comment.
Those loans helped boost JPMorgan's apartment lending earnings, which reached $600 million in 2014. Expenses in the unit, which include the costs of processing loan applications and running offices, were only 22 percent of net interest income, low in an industry where 35 percent is considered good, Brooks said.
Low expenses boost a key measure of profitability for JPMorgan—its return on equity from the business is about 17 percent, Brooks said. That is at least two percentage points better than the return reported by New York Community Bancorp Inc, whose portfolio of apartment loans accounts for almost half of its assets, and, according to data from SNL Financial, is the second-biggest of any bank.
To make smaller loans profitable, Brooks automates as much of the loan process as possible, which JPMorgan tries to do with other high-volume businesses, such as issuing credit cards and mortgages on houses. Brooks is now upgrading his systems to allow loan work to be done by different people at the same time, instead of following a rigid assembly line sequence that can be held up by a single person.
"They have built a great business there," said Mark Myers, head of commercial real estate lending at Wells Fargo (NYSE:WFC) & Co. "It is a model that is hard to replicate. They have executed it very effectively."
That performance could face increasing challenges. For one, Brooks said he anticipates more competition from other lenders as their confidence in the economy builds. Brooks is competing with banks, which in total own some $250 billion of apartment loans, and also with bond investors, insurance companies, government agencies and others who, according to the Mortgage Bankers Association, own another $700 billion or so of debt backed by apartments.
JPMorgan is also managing risk in the sector by lending relatively low sums of money compared with the values of the buildings. The bank's average loan is less than 60 percent of the value of the building. The most the bank will lend is 75 percent of the value. The bank bases its building valuations primarily on the rents they earn, not sales prices of comparable buildings, which can be inflated during booms.
Brooks is focusing lending on places with local government limits on development, such as coastal California. He also likes older, rent-regulated buildings in New York City, San Francisco and Los Angeles. Those buildings rarely have vacancies because tenants want to keep their inexpensive leases.
JPMorgan's loans are expensive to make because they are small—averaging $2.5 million, about one-third the size of the average loan made by Wells Fargo. Making a smaller loan can take just as much work as making a bigger loan, which is why so many other banks try to focus on larger deals.
Brooks also pushes lending teams to decide which loans the bank really wants to make, and for how much and at what price, before an application is completed. Someone from the bank goes inside every building to make sure it is being kept up before accepting an application. The goal: No time wasted with weak applications brought in by overly optimistic salesmen.
"When it comes down to controlling your costs, not working on stuff that won't pay off is essential," Brooks said. "No fishing expeditions."
