Google Stumbles as Slump in Ad Rates Deepens

SAN FRANCISCO — Google views the computing shift to smartphones and tablets as a golden opportunity, but the Internet search leader's second-quarter performance served as an unsettling reminder that it poses a nagging financial challenge, too.

The report released Thursday showed Google's average ad rate fell from the previous year for the seventh consecutive quarter. In an unexpected turn, the decline deepened for the first time in a year.

The average ad rate, or "cost per click," fell 6 percent during the three months ending in June. The magnitude of the declines had eased in each of the previous three quarters, raising hopes that the worse was over. Instead, things deteriorated from the 4 percent decline in ad rates during the first three months of the year.

The regression undercut Google's earnings and revenue. Both fell below analyst forecasts, spooking some investors. Google's shares fell $37.18, or 4 percent, to $873.50 in extended trading after the results came out.

Other unwelcomed developments also loomed over the quarter.

Excluding the costs of stock given to employees, Google's operating expenses climbed 27 percent from last year to $4.25 billion. That increase renewed concerns that Google is pouring too much money on far-flung projects, such as the development of driverless cars and balloons equipped with Internet-beaming antennas, instead of focusing on its main business of Internet search and advertising.

Motorola Mobility, a slumping cellphone maker that Google bought for $12.4 billion 14 months ago, also remains a headache. The subsidiary lost $342 million in the latest quarter, widening from $199 million a year earlier, when Google owned Motorola for only part of the reporting period. Motorola now has lost a total of $1.7 billion under Google's ownership, despite layoffs and divestitures that have whittled Motorola's workforce to 4,600 people, down from 20,300 at the same time last year.

Although he wouldn't forecast when Motorola might start making money, Google CEO Larry Page told analysts on a Thursday conference call that he is excited about the upcoming release of a new phone called Moto X. Page provided no further details about the phone, which he and other Google employees have been testing.

If Google backs the Moto X with an expensive marketing blitz, it would drive up the company's expenses again later this year.

Mobile ads, though, were the biggest issue on investors' minds.

Although the problem isn't as severe as at other companies, including computer makers such as Dell Inc. and Hewlett-Packard Co., Google is still having trouble navigating a technological transition driving more online activity on to smartphones and tablets. Those devices pose a financial challenge for Google Inc. because their smaller screen sizes fetch lower ad rates than the marketing pitches made on traditional desktop and laptop computers.

Google is in a far better position to prosper from mobile computing because it makes Android, the most widely used operating system on smartphones. The software also is gaining traction on tablets challenging Apple's pace-setting iPad. Google is expected to unveil the next generation of its Nexus tablets running on Android next week.

Android typically features Google's search engine and other services, such as maps and Gmail, giving the Mountain View, Calif., company more opportunities to show ads.

Now, Google is taking steps to persuade advertisers to pay higher prices to connect with consumers on mobile devices at times when they appear to be mulling a purchase or may be in a merchant's neighborhood.

Google is trying to drive up prices more quickly by changing the way it sells ads to prod more marketers into buying spots on mobile devices at the same time they plan campaigns aimed at PCs. About 6 million advertisers have already switched to Google's new pricing system. All marketers will be forced to adopt the new approach, known as "enhanced campaigns," by the end of the month.

In Thursday's conference call, Page described the switch to enhanced campaigns as the biggest change that Google has ever made to an online advertising platform launched more than a decade ago.

"I think we're still in the very, very early stages of that," Page said. "We changed a tremendous amount for how our teams operate, how our advertisers operate, how everyone buys those ads, what the users see, and we've done it pretty well."

Wedbush Securities analyst Shyam Patil said he believes Google is headed in the right direction in mobile advertising, despite the second-quarter slip in price.

"They are going to come up with the right solution, although now I am not sure if it is going to happen this year," he said. Patil also said he expects Google's stock to rebound quickly because too many investors believe the company's remains among the best bets in technology.

Google earned $3.2 billion, or $9.54 per share, in the second quarter up 16 percent from $2.8 billion, or $8.42 per share, a year earlier.

If not for the costs of employee stock compensation and charges tied to Motorola, Google said it would have earned $9.56 per share. That missed the average target of $10.80 per share among analysts surveyed by FactSet.

Revenue rose 19 percent to $14.1 billion, from $11.8 billion.

After subtracting Google's ad commissions, revenue stood at $11.1 billion — about $275 million below analyst projections.

DealBook: An Enigma in the Mortgage Market That Elevates Rates

Ted S. Warren/Associated PressA Wells Fargo booth at a mortgage-refinancing workshop in January in Seattle.

Imagine a 30-year mortgage on which you only pay 2.8 percent in interest a year.

Such a mortgage could already exist, but something in the banking system is holding it back. And right now, few agree on what that “something” is.

Getting to the bottom of this enigma could help determine whether mortgage lenders are dysfunctional, greedy or simply trying to do their job in a sensible way.

Right now, borrowers are paying around 3.55 percent for a 30-year fixed rate mortgage that qualifies for a government guarantee of repayment. That’s down from 4.1 percent a year ago, and 5.06 percent three years ago.

Mortgage rates have declined as the Federal Reserve has bought trillions of dollars of bonds, a policy that aims to stimulate the economy. Last week, the Fed said it would make new purchases, focusing on bonds backed by mortgages.

The big question is whether those purchases lead to even lower mortgage rates, as the Fed chairman, Ben S. Bernanke, hopes.

But mortgage rates may not decline substantially from here. Something weird has happened. Pricing in the mortgage market appears to have gotten stuck. This can be seen in a crucial mortgage metric.

Banks make mortgages, but since the 2008 crisis, they have sold most of them into the bond market, attaching a government guarantee of repayment in the process.

The metric effectively encapsulates the size of the gain that banks make on those sales. In September 2011, banks were making mortgages with an interest rate of 4.1 percent. They were then selling those mortgages into the market in bonds that were trading with an interest rate, or yield, of 3.36 percent, according to a Bloomberg index.

The metric captures the difference between the bond and mortgage rates; in this case it was 0.74 percentage points. The bigger the “spread,” the bigger the financial gain for the banks selling the mortgages. That 0.74 percentage point “spread” was close to the 0.77 percentage point average since the end of 2007. Banks were taking roughly the same cut on the sales as they were in previous years.

But something strange has happened over the last 12 months. That spread has widened significantly, and is now more than 1.4 percentage points. The cause: bond yields have fallen a lot more than the mortgage rates banks are charging borrowers.

Put another way, the banks aren’t fully passing on the low rates in the bond market to borrowers. Instead, they are taking bigger gains, and increasing the size of their cut.

So where might mortgage rates be if the old spread were maintained? At 2.83 percent – that’s the current bond yield plus the 0.75 percentage point spread that existed a year ago.

It’s important to examine why the tight relationship between bond yields and mortgage rates becomes unglued.

One explanation, mentioned in a Financial Times story on Sunday, is that the banks are overwhelmed by the demand for new mortgages and their pipeline has become backlogged. When demand outstrips supply for a product, it’s less likely that its price — in this case, the mortgage’s interest rate — will fall. There are in fact different versions of this theory.

One holds that bank mortgage operations are still poorly run, and therefore it’s no surprise they can’t handle an inundation of new applications. Another says banks deliberately keep rates from falling further as a way of controlling the flow of mortgage applications into their pipeline. If mortgages were offered at 2.8 percent, they wouldn’t be able to handle the business, so they ration through price, according to this theory.

Another backlog camp likes to point the finger at Fannie Mae and Freddie Mac, the government-controlled entities that actually guarantee the mortgages. The theory is that these two are demanding that borrowers fulfill overly strict conditions to get mortgages. Banks fear that if they don’t ensure compliance with these requirements, they’ll have to take mortgages back once they’ve sold them, a move that can saddle them with losses.

As a result, the banks have every incentive to slow things down to make sure mortgages are in full compliance, which can add to the backlog. Once this so-called put-back threat is decreased, or the banks get better at meeting requirements, supply should ease.

But there is a weakness to the backlog theories.

The banks have handled two huge waves of mortgage refinancing since the 2008 financial crisis. During those, the spread between mortgage and bond rates did increase. But not anywhere near as much as it has recently. And the spread has stayed wide for much longer this time around.

For instance, $1.84 trillion of mortgages were originated in 2009, a big year for refinancing, according to data from Inside Mortgage Finance, a trade publication. In that year, the average spread between bonds and loans was 0.89 percentage points. And the banking sector was in a far worse state, which would in theory make the backlog problem worse.

Today, the sector is in better shape, with more mortgage lenders back on their feet. But the spread between loans and bonds is considerably wider. In the last 12 months, when mortgage origination has been close to 2009 levels, it has averaged 1.1 percentage points. This suggests that it’s more than just a backlog problem

Some mortgage banks seem to be having little trouble adapting to the higher demand. U.S. Bancorp originated $21.7 billion of mortgages in the second quarter of this year, 168 percent more than in the second quarter of last year.

Wells Fargo is currently the nation’s biggest mortgage lender, originating 31 percent of all mortgages in the 12 months through the end of June. In a conference call with analysts in July, the bank’s executives seemed unfazed about the challenge of meeting mounting customer demand.

“We’ve ramped up our team members in mortgage to be able to move the pipeline through as quickly as possible,” said Timothy J. Sloan, Wells Fargo’s chief financial officer. He also said that the bank had increased its full time employees in consumer real estate by 19 percent in the prior 12 months. Not exactly the picture of a bank struggling to expand capacity.

But if banks are readily adding capacity, why aren’t mortgage rates falling further, closing the spread between bond yields? Perhaps a new equilibrium has descended on the market that favors the banks’ bottom lines.

The drop in rates draws in many more borrowers. The banks add more origination capacity, but not quite enough to bring the spread between bonds and loans back to its recent average.

The banks don’t care because mortgage revenue is ballooning. But it all means that the 2.8 percent mortgage may never materialize.