By Richard DeKaser's calculations, it takes just 16.5% of the average consumer's income to make payments on a 30-year mortgage for an average priced home. The last time the ratio was this low was 1968.

"This is the most-affordable market most Americans have ever lived in," says DeKaser, deputy chief economist at The Parthenon Group, a management consulting firm in Boston.

Yet buyers remain on the sidelines, contributing to the national sense of dread about a housing bust that looks poised to get worse before it gets better.

One way or another, every bank in the country is affected, and their response generally can be categorized according to size — but not necessarily along expected lines.

The top 10 mortgage players — including Wells Fargo, Bank of America, JPMorgan Chase and Citigroup — together control 90% of all originations and servicing. For them, the ongoing housing stress amounts to a staggering body blow — one that has bankers like Michael Heid, co-president of the mortgage unit at Wells, busily tackling a part of the business over which they have some control: costs.

"We have a very intentional part of the business model where we ramp up and ramp down, in terms of office capacity and numbers of people," Heid said.

But the severity this time around suggests something more than a cyclical downsizing. There are fundamental changes afoot in the U.S. housing market, and big banks are not the only institutions to have noticed.

Emboldened by the sharp drop in the number of independent mortgage banks and brokers, cash-flush community banks are starting to view the disarray as an invitation to the market. Many that focused on commercial and industrial loans — an area with a recent uptick in activity but a dearth of yield—are looking instead to mortgages as a place to put deposits to work.

Joe Garrett, a San Francisco consultant, says he's helping banks that were strictly commercial and construction lenders to buy or build mortgage operations.

"They're saying, 'My loan-to-deposit ratio has never been lower and my net interest margin is under pressure. It's almost impossible to find good C&I loans, commercial real estate is dead, and the board would kill me if I did any construction lending,'" Garrett explains.

"Suddenly, mortgage banking looks very attractive to them. You get the gains from selling the loan, and holding a loan with a 4.5 percent rate on your books—even if it's just for a few weeks—looks pretty good compared to Fed funds."

No question, the industry is disappointed by the number of mortgages being underwritten. Originations surged briefly in late 2010, when low rates generated a flood of refinancing activity. But with little help to be had from homebuyers, volume quickly plunged again — by 35% — in the first quarter of 2011.

"Mortgages are a bread-and-butter business for us," says Jack Hartings, CEO of The Peoples Bank, a $350 million-asset lender in Coldwater, Ohio, that lately has been originating about 15 mortgages a month. "We're real estate lenders, but right now we're running at about half the volume we saw in 2009 and 2010, due to the economy."

If there is any upside at all to the dearth of mortgages, it might be that the timing coincides with a moribund securitization market.

While Fannie Mae, Freddie Mac and the Federal Housing Administration continue to issue securities for conventional loans, investors seem too skittish to put their money into private-label offerings without a government guaranty. It was big news earlier this year when Redwood Trust, a California real estate investment trust, sold its second round of securities backed by jumbo mortgages.

Lawmakers seem intent on doing away with Fannie and Freddie—which together own 31 million conventional home loans totaling roughly $5 trillion. But without the government-sponsored enterprises, something else would be needed to facilitate the securitization of mortgage loans.

Wells CEO John Stumpf notes that of the 71 million homes in the United States, 55 million carry mortgages, worth a combined $11 trillion. He says banks need an active securitization market to help manage their balance sheets and make more loans.

"At some point, the GSE guarantees will have to change. Taxpayers don't want to be involved in that," he said. "But we have to have a secondary market. Banks can't hold $11 trillion in mortgages. When you add it to other forms of debt, there aren't enough deposits in the country."

The Obama administration has proposed several options for replacing Fannie and Freddie. One would limit government backing for mortgages to a handful of groups, including veterans and low-income families. Another idea would build on the first, adding an emergency government backstop provision for all loans in times of crisis.

A third option — one that has the support of large banks — would maintain uniform underwriting standards, but back mortgages with private capital, replacing Fannie and Freddie's implicit government guarantee. The federal government would act as a reinsurer in cases of catastrophic risk, much like the Federal Deposit Insurcance Corp. (FDIC) backs up deposits.

The question is: Who would own and manage the new system? A logical answer might be the big servicers, which already work with the majority of borrowers. But community bankers don't like that idea.

"Our members don't want to have to sell the servicing, and then worry about their customers being cross-sold products by bigger competitors," says Ron Haynie, CEO of ICBA Mortgage, a subsidiary of the Independent Community Bankers Association (ICBA). The ICBA has proposed that an independent cooperative securitize loans instead.

But that's all off in the future. Right now, banks are focused on the immediate steps they can take to manage the pain.

At Wells, which accounts for a quarter of the country's mortgage — origination market, revenue from mortgage banking dropped 27% from the fourth quarter of 2010 to the first quarter of 2011. The decline was driven mainly by a 34% slump in originations.

Heid said he expects the cost cuts in Wells' mortgage division to help shore up the bottom line soon. He acknowledges a difference between the latest downsizing and other cyclical corrections.

"We've had to adjust our expense load more rapidly this time," Heid said. "But this is something you need to be able to do if you want to be successful in the mortgage business."

The underlying dynamics at play are not as predictable as they used to be, however, arguing for a thorough recalibration by industry players.

Administrative expenses tied to the mortgage business have soared. Wells, for one, has hired more than 10,000 additional people to work on loan collections, loss-mitigation efforts and foreclosures, and more bodies will be needed. It has modified about 700,000 loans over the past two years, which is "essentially like re-underwriting the loan," Heid says.

Legal expenses are piling up, too. The largest servicers are expected to collectively pay somewhere between $5 billion and $20 billion to settle charges brought by state attorneys general over the so-called "robo-signing" controversy.

In late June, BofA agreed to pay a separate $8.5 billion to settle a lawsuit brought by investors in more than $400 billion of private-label mortgage-backed securities gone sour. BofA inherited the repurchase exposure when it acquired Countrywide Financial in 2008.

Beyond the balance sheet hit delivered by the mortgage mess, there has been a cost to banks that is less easy to quantify: the reputational risk involved with the handling of so many defaults.

A steady stream of bad press, lawsuits and investigations over the way banks have dealt with foreclosures has been almost as relentless and as tough to manage as the crush of bad loans themselves. In June, JPMorgan Chase ousted mortgage chief David Lowman — perhaps best known for being mobbed last year by angry borrowers during a congressional hearing — after a series of transgressions, including illegally charging military homeowners higher rates and fees than permitted by the Servicemembers Civil Relief Act.

Community banks have not been swept up in such drama, and the absence of a securitization market is less limiting to them than it is to the big institutions.

Hartings says that Peoples has about $200 million of loans on its books and services another $76 million in conforming loans that it has underwritten and sold to Freddie. About 80 percent of the loans Peoples writes are mortgages, and 60 percent of those are nonconforming, mostly jumbos or farm houses on big acreage, all with adjustable rates.

Peoples always has held the nonconforming loans on its balance sheet, because they're attractive credits with good yields. Hartings, a member of ICBA's executive committee who has testified before Congress about the mortgage market, says the same is true for most community bankers.

"The vast majority of us like to hold these loans on our books," Hartings said. "It's viewed as an excellent way for us to enhance our earnings."

The issue for him is how the conforming market evolves-the goal being to keep it from coming under the control of the big banks and to ensure equal access for community banks like his. He'd also like to see healthier mortgage-lending volume in general.

The hesitation by prospective homebuyers is fueled partly by the abundance of property banks still need to sell.

Of the 3.7 million homes on the market nationwide, 35 percent are bank-owned, compared with less than 5 percent historically, according to Clifford Rossi, a teaching fellow in finance at the University of Maryland's Robert H. Smith School of Business. Another 1.7 million homes—about a five-month supply of homes that includes pending foreclosures and loans seriously on the edge of default—fall into the "shadow inventory" category.

Throw in 170,000 new homes presently for sale, and there's roughly a 17-month supply of houses on or near the market; in healthier times, the figure is more like six months. And that doesn't include another 2 million homes where borrowers are underwater by 50 percent or more and at risk of defaulting.

"We're seeing all of this inventory getting ready to enter a market that's already completely saturated," Rossi said. "Supply is the major driver of slumping home prices."

Robert Shiller, the Yale University economist and namesake of the Standard & Poor's/Case-Shiller Home Price Indices, has warned that prices could drop significantly more in the coming year-as much as 25%. While other economists argue that we're simply bumping along the bottom, nearing a rebound, the truth is that no one knows. And in residential real estate, the paralyzing fear generated by the uncertainty—among would-be buyers and lenders—can transform those misgivings into a self-fulfilling prophecy.

"People are afraid they're going to lose equity the minute they sign the sales agreement," said Parthenon's DeKaser.

That fear looks to be well founded. Data from CoreLogic indicated that 9.8% of mortgages originated just last year already are underwater.

"In 2005, a house was viewed as the surest way to get rich. Today, it's seen as the surest road to financial ruin. It's the exact inverse of where we were six years ago," says DeKaser, a former chief economist at National City. The regional bank based in Cleveland was one of several notable victims of the housing meltdown to sell out to more stable competitors—in its case, PNC Financial Services Group — a step ahead of mortgage-induced failure.

Fixing the troubles in the housing market will require Washington's leadership, but the crisis response efforts of lawmakers and regulators—a hodgepodge of strategies including first-time homebuyer tax credits, loan modifications and proposed risk-retention requirements—have been "fragmented and reactive," Rossi said.

In any case, the evidence suggests that they haven't done much good.

Rossi, a former chief risk officer for the consumer lending division of Citi, has proposed a public-private policy initiative promoting the use of products that would allow banks to share in the equity gains (or losses) on a mortgaged property when it is sold, in exchange for lowering payments.

He's also an advocate of creative mortproducts that would offer jittery buyers insurance against falling house prices and bring back net-worth certificates—a type of low-interest note issued with success by the FDIC during the thrift crisis — to encourage lenders to modify performing loans with negative equity.

"You have to attack the demand situation," Rossi said.

"Borrowers don't want to enter a market that's slipping downward. It's about reducing the uncertainty and feeding consumer optimism."

But tougher underwriting standards are keeping some would-be borrowers on the sidelines. Stories abound of applicants with jobs and 800 FICO scores being turned down for mortgage loans.

Bankers argue that that the new regulatory realities — the additional paperwork, the tougher appraisals, the new Fannie and Freddie requirements regarding down payments and underwriting standards — has made it difficult for borrowers to qualify. And with no securitization market, pretty much all but conforming loans must be held on the books.

"There's a climate of fear. Examiners are being extremely tough, and in some cases, extremely harsh," says the ICBA's Haynie. "The loan closes. Everything is fine. The borrower's paying. And then an auditor comes in and finds you made a mistake on the good-faith estimate."

As for credit quality, most bankers assert that the worst of the problem is behind them. But the impact is still apparent.

BofA's mortgage operation was expected to cost shareholders more than $1 per share in the second quarter, according to a note by Andrew Marquardt, an analyst for Evercore Partners in New York. The bad news includes the $8.5 billion investor settlement, a $5.5 billion reserve build, a $2.6 billion goodwill charge and $4 billion in additional mortgage-related expenses divided fairly evenly among litigation, assessment waivers and a servicing-rights impairment.

"The profits we saw six years ago were illusory. Banks thought they were earning 40% returns on equity from the mortgage business, but we were fooling ourselves," Rossi said. "This business will never be as profitable for the big banks as people once thought it was."

Getting to the eventual rebound in the mortgage business won't be easy, and the way these operations are run is likely to change. But Barbara Desoer, president of Bank of America Home Loans, the No. 2 originator and No. 1 servicer in the country, says that mortgages always will be a viable business, because they are a linchpin product for consumer relationships.

"Will the volumes be the same as in the past? No," Desoer said. "But will we be able to deliver adequate returns from the product as part of a larger consumer relationship? Absolutely

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